Learning From Peter Keefe

It was the beginning of the world’s biggest investing event of the year, and Omaha had once again opened its arms to an army of investors eager to hear Warren Buffett share his investing insights, life lessons, and worldly wisdom. This year, my three adult children joined me on a tour to meet some of the world’s most successful investors.

Our day began with breakfast, where we were joined by Chuck Akre, who arrived relaxed, dressed in a light blue cashmere jumper and denim jeans. Chuck casually mentioned he had invited a friend to join us. We were about to spend the next hour in the company of two investing legends.

Chuck Akre and Peter Keefe captivated us with stories of their investing endeavors, philosophies, and the timeless lessons that have shaped their careers. Both share a philosophy that has allowed them to outperform the S&P 500 over decades. Their rapport was closer than mere friendship, rooted in a shared history—Chuck had hired Peter early in his career as a stockbroker.

Over decades of studying successful investors, I’ve found that many approach investing with a fresh perspective, unburdened by the constraints of typical business courses. This unique viewpoint often allows them to spot opportunities that others might miss, and both Peter and Chuck exemplify this perspective.

Peter has spent over three decades in investing, outperforming the S&P 500 by approximately 2.5% per annum. Having followed his letters for years, I admire his approach, which is deeply rooted in multidisciplinary thinking and a keen focus on finding and holding great businesses. Peter emphasizes the importance of visionary leadership, long-term value creation, and a disciplined approach to managing market downturns.

Peter and Chuck made an excellent pair of conversationalists, and our exchange was both insightful and engaging. As our conversation drew to a close, I asked Peter if we could continue our discussion in the future. The following points are drawn from that recent chat and offer a glimpse into his investment philosophy and experiences. I hope you find them as enjoyable and enlightening as I did.

On Education & Liberal Arts

“When I got into the business, I had never set foot into a business or an accounting classroom. I was a politics major in college and I was an uninspired student, to put it mildly. So I had this liberal arts background, but as you point out, I think a lot of terrific investors have come from a non-linear or non-analog background, as I call it.

In fact, I think sometimes the accounting or business administration, finance, MBA, and CFA, channels you into a way of thinking that is not necessarily productive to creating great investment results. Sometimes when you don't know what you don't know, it's an advantage.

When you approach investing from a liberal arts standpoint, you bring in a lot of different disciplines. And of course, the late Charlie Munger talked about the advantages of a multi-disciplinarily approach. So I think it can be an advantage to not have, for example, the accounting skills. I'm not disparaging the accounting trade at all, but it is a trade and you can learn the skills.

I was entirely self-taught with respect to accounting. In fact, Chuck Akre hired me as a stockbroker at Johnston, Lemon and Company in 1981. I'd been briefly with another firm, but it was on the cusp of a significant market decline. As I recall, I made my first trade on the last day, the Dow closed over 1000 and it lost 25 % of its value, bottoming it out around 750.

And I had no idea why these businesses that my research department had told me were so wonderful were going down in value. I was what they used to call on Wall Street a ‘bleeder’. I just couldn't stand the fact that everything I touched was turning to lead or worse. So I got on a bus because I didn't have a car and went up to Northern Virginia Community College and bought a bunch of accounting books and taught myself double ledger accounting. And that allowed me to do my own research on businesses. I learned that actually the liberal arts is a great training for accounting because every entry in an income statement or a balance sheet is an abstraction. That means that Shakespeare's got something to say about income statements and balance sheets. Now the cashflow statement gets you closer to reality. But the first two, the income statement and the balance sheet, are entirely abstractions.

So if you can understand things like the motivations of people and why someone might choose this form of accounting over another form of accounting, I think you've got an advantage. So that was kind of a meandering way of introducing how I got into the business and how I got into the business of actually looking at businesses.”

Compounders and the Evolution of Investing

“The investment philosophy [at our new fund, Rockbridge Capital] is exactly the same: great businesses, great managers, bargain price. That remains unchanged.

The implementation has evolved over time. Great businesses, great managers, great price—it's kind of like mom and apple pie. I mean, who’s opposed to it? It’s axiomatic that these things work, but I believe your approach to implementation should change over time. When you start out in this business, as I did, being handed someone else’s sell-side research, you look at it and think, ‘Well, this is great.’

Omaha 2024 - Peter Keefe & Chuck Akre

You don’t really know what makes a business great. You don’t really understand what contributes to compounding. You want a business with all the great characteristics—growth, rapid growth, sustainable growth—but you don’t know how to evaluate one business against another. You don’t know which businesses are mayflies and which are incredibly durable with multi-decade runways.

Learning how to discern and implement those three criteria does evolve over time. Another thing that evolves is the recognition that there are only a tiny number of businesses you will own over the course of a career that will compound and give you that 100-bagger effect or the 300-bagger effect—what Munger called the Lollapalooza effect. Those opportunities are incredibly rare.

But you spend your entire career looking for them. On day one, when you enter the business, you might think, ‘Well, maybe I’ll find it today,’ but you’re probably not going to find it today, tomorrow, or the day after. So what has evolved for me is the realization that when you find a compounder, don’t let it go.

I think Chuck’s way of phrasing it is to hang on to the compounders until they stop compounding. Fortunately for him, that’s often been a matter of decades. So the best way I can articulate it is to find the compounders and hold on to them until they stop compounding. They are so infrequently encountered in this business, and then you have to recognize them.

I think most people in the investing business end up passing on a number of businesses that turn out to be great compounders. I remember passing on Microsoft in the 1980s because, you know, what is this software stuff? How does it really work? I mean, it’s a floppy disk. I’d rather have my money in a factory that’s belching smoke somewhere in the Allegheny Valley of Pennsylvania. And, of course, your understanding of how businesses work and what contributes to business value evolves over time, as it did with me.”

Portfolio Correlations

“I don’t worry about correlations within the portfolio. There are correlations. For example, we have some software and technology stocks, which tend to go up when interest rates go down, and we have some insurance and financial services stocks, which tend to go down when interest rates go down. I guess someone who is statistically oriented would say they’re negatively correlated. So these things exist, but I don’t care about them.

It doesn’t make any difference. You’re just trying to find the great compounders and let all the other noise filter itself out. You try to find 10 or 12 of these businesses; I’m not sure you’ll find 10 or 12 in a career. So you have 10 or 12, what you hope will be compounders in the portfolio. And if you’re lucky, two, three, or four of them will end up being those multi-decade hundred-baggers.”

Position Sizes

“The most painful experiences I've had have been involved in trimming positions or reducing the size of a position to achieve some arbitrary percentage goal within the portfolio. I'm still twitching from having sold Pool Corporation many years ago because I had calculated that it was trading well in excess of its intrinsic value and was too big a part of the portfolio.

What do you learn as you progress in this business? You keep the investment criteria the same, but in terms of its implementation, I've learned not to sell the great businesses. Pool Corporation is up eightfold from where I sold it.

So I’ll tell people out of the box, ‘I'm a rotten seller.’ I’ve never gotten it right. I've never gotten this idea right of trimming positions. When I hear people talk about trimming positions, it's like chewing aluminum foil. What are you really doing? If you sell one share, shouldn't you sell all of your shares? There’s this chicken-and-egg way of managing that conundrum by selling a portion of your holdings and reducing the size of the position.

Warren had 45% of the Buffett partnership in American Express after the salad oil scandal. People can do this; it takes a lot of conviction to do it. But most people don't have the conviction to do that.

Every time I've trimmed a position and it involved a great business, it wound up being a huge mistake.

Now, we had this conundrum recently. We own a lot of Microsoft, which we bought back in the Balmer days. So it's been in the portfolio over 10 years. We've made 10 times our money in the business, and it's appreciated to have a very significant percentage of our portfolios.

Microsoft got a big bid recently because of the artificial intelligence stuff, and I don't know enough about artificial intelligence to have a responsible opinion. But you can argue that there's a trillion dollars' worth of value in Microsoft attributable to AI. Do I trim the position? Well, based on the mistakes I've made in the past, no. But at the same time, is a 35 or 40 multiple sustainable for a company that's already worth three trillion dollars? It's hard to make that argument. And particularly when you're managing both taxable and tax-exempt capital, you can make a pretty good argument that you should trim it. But again, that's never worked out for me. So we are where we are.”

Simple Theses

“I’m always looking for the one insight. I’ve got this saying: your argument in favor of owning a business could go on for pages and pages, single-spaced, nine-point font. But in my experience, the outcome of every investment I’ve ever made could be written out in full, with room to spare, on the back of a business card.”

Visionary Leaders and Multi-Baggers

“I try to think about the one insight that will serve the owners of the capital who have invested in this particular business for a dozen years or more. Every time we've had a business that's compounded more than 10x—and we've had a couple that have compounded at 100x—there's always been a leader and visionary who is a person of humility, thinking about their business in multi-decade timelines. Without exception, 10, 100, 200-baggers were always a person.

Omaha 2024 - Peter Keefe & Chuck Akre

A person you could trust with 10 or 20% of your capital. Forget about the business for a moment—you also need your capital in a business with people you can trust. That’s not to say there are a lot of dishonest people in the business, but there are many who run great businesses without fully appreciating how great the business is. They just know they're in a great business.

They understand that the capital they invest compounds more rapidly than it would elsewhere, but they may not be thinking in 10, 15, or 20-year terms. They might be thinking, ‘This is a great business, and we're going to exit it in five years,’ following the private equity model, or in 10 years, or when they reach 65.

Those people tend not to be the artists truly responsible for the hundred-baggers. They're not thinking about an exit or the next thing; they're thinking in 10, 20, 30-year time periods.

These people are artists. They're focused on building something of great value—not just to accumulate wealth, but to create something valuable to society. To borrow from Tom Gayner, these are businesses that do something for people instead of to people. They are financially interested, but the finances are a means of keeping score rather than acquiring more things or a better jet. Those are the people I shy away from. The real artists see beauty in what they're building and are focused on creating value for all stakeholders, especially the owners of the business.

When discussing people who want to serve all stakeholders, it's not about rank-ordering which stakeholders to reward first. It's about understanding that a business can do well for its employees, shareholders, and vendors. Munger talked about this all the time.”

Win-Win

“Charlie Munger understood that a business is just people organized around an idea or capital organized around people and then an idea. If you start from that foundation, you can appreciate that there are many ways to create value in terms of rewarding shareholders without offending other constituencies and the factors that contribute to your success, whether it's human capital or financial capital.”

Pool Corporation Thesis

“We're attracted to the business because they are the dominant supplier of pool supplies and equipment in the United States. But what really makes the business work—and the back-of-the-business-card thesis—is that every pool in the United States is an annuity for Pool Corp. Full stop.

Even during the global financial crisis, when banks were receiving keys in the mail every day for foreclosed properties, you can't let that pool ‘go green,’ as they call it in the trade. If it goes green, it costs a fortune to recover. So the mortgage company would send a servicer to make sure the pool stays blue and doesn't go green. Regardless of whether you're current on your mortgage or have been kicked out, that pool gets maintained. This illustrates the durability of the business.

The back-of-the-business-card insight is this: when you fly, those blue dots you see—each one represents an annuity for Pool Corporation.

They consolidated the pool service businesses around the United States. They had the network, warehouses, and distribution that forced pool builders and pool servicers to do business with them because they could be cheaper and better. It's one of those distribution businesses with lots of vendors crowding the funnel on one side, but on the other side, you've got Pool Corporation and a small number of other distributors. It doesn't take a genius to see who has the pricing leverage.”

Dr. Hendrik Bessembinder

“I've become a big fan of Dr. Hendrik Bessembinder, whose work your readers and listeners are no doubt familiar with. He’s talked about how 4% of all publicly traded equities have created 100% of the return above the five-year Treasury going back to 1926. A mistake some people make is thinking those 4% are the great businesses. No, they are just the 4% of businesses that have created the return above the Treasury. It's a much smaller subset within that 4%. Dr. Bessembinder also noted that portfolios that have been abandoned—where mutual fund companies can't find their owners, who may have died or moved and forgotten they had it—illustrate that those portfolios do better than actively managed portfolios.”

Temperament and Market Downturns

“I don’t know how many people are in the investment management business, but there must be hundreds of thousands in the United States alone, and who knows how many millions worldwide. It would be the height of arrogance for me to think that I’m any smarter than the average in this business.

People ask, ‘What makes you different?’ Well, it’s not my process. Everybody wants great businesses and great managers and to buy them at a bargain price. Nobody says they’re not a value investor or that they don’t like what Buffett does. So I think a major differentiator in this business is temperament. If I have an advantage, it’s that I don’t feel like I’m coming unglued when the world is coming unglued. I don’t know why that is; it’s just part of my makeup, but it’s an advantage because low prices are good for investors.

When you have big market declines, people begin to question their judgment. It’s easy to be a bull market genius; everything you thought or wrote about seems right when the market is going up and stock prices are rising. You go home and tell your spouse, ‘Business and work are great today. The market was up, and my stocks were up even more.’

When the reverse happens, most people question themselves. They ask, ‘Did I get this right? Did I rationalize this? Did I take an intellectual shortcut?’ They start looking for problems in their investments and portfolios. And if you look for them, you’ll find them.

To control for that, and to manage the emotionalism in this business, I try to conduct a mental exercise before I buy the first share: How will I feel if this business is down 40% because the market’s down and they’ve missed earnings two quarters in a row? Will I feel like an idiot?

You can’t check off every risk box, and you’re likely to miss something during your initial underwriting. But I try to have a gut check: What could make me run from this?

It’s a matter of temperament. Your temperament must align with the discipline of addressing risks early and understanding them. It’s about knowing what you own and why you own it. If you can’t be comfortable owning it down 40%, maybe you should consider another line of work, because it will happen.

It’s been proven that it helps, not to not care—‘indifference’ is the wrong term—but to have a doctor’s agnosticism about his patient’s pain. A doctor must be agnostic about pain to provide the right treatment for many conditions. Sometimes, the easiest way to relieve pain during market declines is to go to cash. But that’s usually the worst thing to do.

Part of the yin and yang of this business is having a bit of an antisocial personality, which can actually be an asset when navigating major declines. Hopefully, some people, including myself, can triangulate between being the doctor who must be agnostic to pain and someone who can be helpful to people managing a drawdown.

Temperament is a differentiator in this business. Those who can handle the tough situations will do better than those who lose sleep just because the market or their business is down 10%. It’s all about how well you’ve underwritten it in advance.”

American Tower and Character

“The biggest compounder I've ever had in the investment business was American Tower. I was fortunate enough to figure out American Tower before it was even a public company. It was a footnote in the 10-K of a company called American Radio Systems. American Radio Systems was run by a brilliant, thoughtful capital allocator who fits into this liberal arts bucket I talked about earlier. Steve Dodge went to Yale and was an English major there.

Steve did cable transactions for one of the big New York banks. He got the idea that recurring revenue businesses or contractual revenue were great. So he moved into the cable business and then into the radio business. Around the time of the Telecom Act in the mid-1990s, digital networks for cell networks were beginning to roll out. Steve had people come to him and say, ‘We’d like to hang some of these digital antennas on your radio antennas.’ They also owned a portfolio of television broadcast antennas. They needed structures in suitable locations for these antennas.

That’s the genesis of American Tower, which was just a footnote. I remember calling Steve and asking about it. He basically hung up on me. I had a good relationship with him, so I knew I was onto something.

Long story short, American Tower was spun off and went to over $40 a share. Then came the dot-com bust. There had been a land rush in the tower business, and many companies had gotten levered up.

This was when I learned one of my early lessons about leverage, although it eventually helped me. American Tower dropped to under 80 cents a share from $44. Now that’s a drawdown.

I went up to Boston, where American Tower was headquartered. Chuck Akre was with me, and we met with Steve. He said, ‘I’ll tell you anything that I can legally tell you. I want you to know upfront that I don’t have much time. I have a business that needs my attention. It needs more attention than I can possibly give it because there's only 24 hours in a day. I think that we can save this thing and I'm not sure that we can, but I also want to tell you, I am solely responsible. This is the worst thing that's happened to me in my business career, but you're looking at the guy who made the mistakes that got us in the pickle that we're in.’

There was none of the usual excuses like ‘The dog ate my homework,’ or blaming the pandemic or the dot-com bust. Steve gave us none of that.

Steve figuratively raised his hand and said, ‘I messed it up, and I am sorry. I will do my best to get you and all the other shareholders out of this pickle.’

That kind of character in a moment of great crisis inspired me and others to make American Tower a more significant position, despite its distress.

We were convinced that the business wasn’t going to zero. It had one of the greatest business models in public companies’ history. A business where 100% of incremental revenue flows through to free cash flow and was growing by 20 to 30% a year. It was highly likely the business would be recapitalized. I can’t think of a financing environment where it wouldn’t be.

Steve’s character and willingness to accept responsibility were crucial in our decision to increase our position. It went up 300-fold from there.

Character counts and matters in this business. If I can’t look you in the eye as the owner of capital that I manage and say, ‘You’re a good guy, I’m a good guy, but the CEO? Not so sure,’ I can’t do that, especially in a concentrated portfolio.”

Reading and Ideas

“My library is sort of divided up between business books and books about everything under the sun, from history to mythology to the outdoors.

Pulak Prasad's book, What I Learned About Investing From Darwin, simply organized a theme that I have felt existed forever: there are universal rules in systems, and a market is nothing more than a system governed by rules everywhere. I spend a lot of time out in the woods. I enjoy the outdoors. If you look around the woods, you see ecosystems that are governed by markets. You see business models.

I have a place in the mountains and there's a lot of coyotes there. Being a coyote is a great business model. They’re like great investors. They attack infrequently, but when they do, it’s only when the odds are overwhelmingly in their favor. The things on which they prey are less good business models or maybe awful business models. If you look around, you can see echoes of what we try to do, which is to identify great businesses and buy a lot of them all around you. They abound in nature. And Prasad's book is all about that.

Bill Gates said that one of the best books, in fact, he said at the time it was the most important book he'd ever read, was Thomas Pinker’s The Better Angels of Our Nature. Pinker, for those who are not familiar with him, is a Harvard sociologist, political scientist, philosopher. He is a multi-disciplinarian in the broadest sense of the word. He’s just a brilliant polymath who knows a lot about seemingly everything.

The thesis of the book is that human-on-human violence has been in secular decline for a couple of thousand years and that each century has seen a sequential decline in human violence, which may come as a surprise. You’d think the 20th century with figures like Hitler, Stalin, and Pol Pot, was worse than the 19th century. Pinker argues pretty persuasively that no, that’s not the case.

That book had a section on animal rights and how the animal rights movement originated in Europe and it was inevitable that it would eventually find its way to the United States. And sure enough it has. If you have a pet, if you have a dog or a cat, I hope you have pet insurance because veterinarians can get very expensive. That led us into an investment in Trupanion, which we have since sold. I’m not sure we should have made good money on it, but we did nonetheless.

But the bottom line is this: reading Pinker got me thinking about an investment that we eventually made. So, you’re going to find inspiration, particularly if you have the liberal arts bent like I have, just everywhere, whether it’s sitting outdoors in the woods or reading Thomas Pinker or the Bible or something else. It’s all around you if you’re looking for it.”

Summary

Through more than three decades of investing, Peter Keefe has demonstrated that the key to identifying multi-bagger investments lies in recognizing visionary leaders who operate with a multi-decade mindset, embody humility, take responsibility, and are committed to creating lasting value. His outstanding performance reflects a unique temperament, especially during market downturns—an ability to remain composed, make rational decisions, and stay invested when times are tough. This discipline is anchored in a deep understanding of the businesses owned and a commitment to long-term thinking.

Peter's approach also emphasizes the value of drawing inspiration from diverse sources, such as literature on markets, human behavior, and observations of natural systems. By identifying the universal principles that govern both natural ecosystems and financial markets, investors can uncover insights that guide thoughtful and successful investing.

As Dr. Hendrik Bessembinder’s research highlights, only a small percentage of companies generate the majority of market returns, and similarly, few investors outperform the market over the long term. Peter Keefe is among those rare investors, demonstrating the impact of his thoughtful and disciplined approach—one from which all of us can learn to become better, more thoughtful investors.

Further Reading:
Rockbridge Capital Letters
‘Learning from Chuck Akre,’ Mastersinvest, 2019.
‘Chuck’s 3-legged Stool,’ Mastersinvest, 2018.

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TERMS OF USE: DISCLAIMER

 Note: This post is for educational purposes only. I have no relationship with Rockbridge Capital.

Master Series: David Rolfe

Warren Buffett has long likened compounding to a snowball of sticky snow, and the longer the runway the snowball has to gather that sticky snow, the better. One manager that started rolling that ball a quarter of a century ago, was David Rolfe of Wedgewood Partners. And thanks to the power of compounding that snowball has grown a lot faster than the S&P500, with annual returns of 13.1%pa gross compared to 9.6%pa for S&P500. In part, Wedgewood’s market-beating performance stemmed from a preparedness to embrace technology stocks and challenge traditional value investing heuristics. I was fortunate to chat to David recently where we discussed his strategy, portfolio management, Berkshire and all things investing. I hope you enjoy the insights as much as I did.

Early Career

“The planets aligned for me really early in my career. Wedgewood was founded in 1988 by my current business partner Tony Guerrerio. 1988 was also coincidentally the year that I left the sell-side of the Street. I left PaineWebber in 1987 after being there for about a year and a half out of college. In early 1988, shortly after the crash in 1987, I was very fortunate to get a job as a portfolio manager at a big bank in St. Louis called Centerre Trust, the old First National Bank of St. Louis. Shortly after I joined, they merged with the second largest bank in St. Louis called Boatmen's, and they kept the name Boatmen's. So my CV says Portfolio Manager of Boatmen's Trust.

What's really key to this time period, is that the combined banks did a huge custody business. And pre-internet, it's kind of funny to think about this, we had annual reports, quarterly reports, mutual fund reports, money manager commentaries from the outside money managers that the clients used from the bank; all of that information came in and it was being filed. So my continuing study of the great investors of the day really launched – particularly the focused managers. There's a file of all the old shareholder letters from Mason Hawkins at Southeastern before he launched the Longleaf fund, mutual fund reports from the original gang at Janus – Bailey, Craig and I think Marsico joined them in 1986.  A ton of reports from John Neff’s Windsor fund.  The great writings from George Michaelis at Source Capital. A ton of Mario Gabelli. There were annual reports from Berkshire Hathaway going back into the early 1970’s. We even had the internal corporate reports from the old Templeton Investment Counsel before Franklin bought them in 1992. It was a goldmine!

So in 1988, I became a portfolio manager and what was really fortunate for me at a very young age all of the portfolio managers at Boatmen's Trust, were assigned fully discretionary equity accounts that we could do whatever we wanted with. If you beat the S&P, you got a bonus. It was a one, two and three year rolling metric, audited by the old Arthur Andersen. I did pretty good those four years beating the S&P 500 in three of those. So our current focused strategy was born back in early 1988 and I have been on the performance clock ever since going on 33 years.

I did that for almost four years until I heard through the grapevine at a meeting of the CFA Society of St. Louis that this investment firm out in St. Louis County, had a founding CIO who was leaving. And so with track record in hand, at the ripe old age of 30 and I knew all the mysteries of the stock market at the age of 30 [laughs], I met my partner, my then boss, Tony Guerrerio.

My predecessor, God bless him, he passed away recently, what a great guy. He was very nice to me. He was older than Tony, he retired. Wedgewood only had $10 million or so under management. The other side of the business, a discount brokerage like Quick & Reilly or Schwab that kept the lights on. So literally as the new CIO I had a whiteboard to start the investment management side of Wedgewood. And I've been doing the same thing ever since 1992.”

Wedgewood Team

“There’s just four of us on the Team – but if I may brag on the crew, a highly productive crew. Tony Guerrerio, Michael Quigley and Chris Jersan and I make up the team. Tony’s primary role is as portfolio manager for our older private family relationships that go as far back prior to Tony founding Wedgewood Partners in 1988. Michael Quigley has been with Wedgewood since interning in high school. He is an ‘old,’ very experienced forty year-old since he has been on the team since 2006. Chris Jersan joined Wedgewood in 2016. Chris has extensive investment experience as both analyst and portfolio management since entering the business in 1998. Michael, Chris and I wear the CFA hats. We are all analysts and portfolio managers – essentially generalists. Given that our focused portfolio typically contains just 20 stocks I want the entire team to have a ‘career-ownership stake’ in the entire portfolio. As CIO I have veto power. The culture of the team is one of intense collaboration on security analysis and portfolio management. Key too is making fewer but more impactful decisions, plus making sure there aren’t too many cooks in the kitchen.”    

Mental Frameworks

“Every successful active manager has a competitive edge. And it must be repeatable. Focus is our edge. We have layered in a synthesis of the classic tenets of both growth company and value investing. Specifically, we want to own a select list of companies that are competitively advantaged earning high returns on capital, but also have the ability to reinvest a healthy portion of retained earnings at continued high rates of capital. We then try to have patience to buy at intelligent valuations. Rinse and repeat. But not too often.  Our annual portfolio turnover is typically between 20 to 25%.

We embrace the founding philosophical thoughts and wisdom from the greats like Warren Buffett, Charlie Munger, Benjamin Graham, Charlie Ellis, Sir John Templeton and such, plus the focused greats of our era. Price is what you pay, value is what you get rings true with everything we do here at Wedgewood.”

Tech Investing

“Investing in ‘technology’ stocks has evolved over the years. Particularly in the so-called capital ‘V’ value crowd. I think some of these mental frameworks like circle of competence and moats and all these other Buffett, Munger type of attributes of how you should think and act are wonderful, but sometimes I think maybe people take them to extremes.

It wasn't that long ago the value investing mindset was ‘there's no such thing as value in tech, period. Technology stocks don’t have ‘moats.’  You don't know what the business models are going to look like, so how can you even estimate five or ten years out’. Only a rare specialist will possess a ‘circle of competence’ investing in tech.   

When you think back to Buffett's early aversion to tech, you've got to go back in time. Buffett made that great call to shut down his partnership in '68 and he has talked often about the conglomerates which all blew up back then. Of course there was the '73, '74 brutal market decline – really a long, slow-motion crash. But before that I think maybe a little bit less known, which I can't help but think had a significant impact on Buffett, was the tech crash of 1968 through 1970. Stocks like NCR, EDS, Control Data, Mohawk Data, that were largely hardware tech, which back in the day wasn't so much personal computing, it was tech for businesses fell 70 to 80%. It was cyclical, it was cutting edge CapEx and as the economy headed into a little bit of a recession the first thing that probably gets cut is this new tech stuff, ‘let's cut the orders for IBM, et cetera’. Even the ‘blue-chip’ tech stocks got smoked.  Texas Instruments, IBM, General Instruments, Polaroid, Xerox.  Of course the ‘Too Many Fred’ conglomerates like Litton, LTV, Levin-Townsend and Kidde literally vanished.

If you think back to the fact of how much tech was really hardware, enterprise hardware before software. And even with Microsoft in the early days of software, it was kind of boom-bust, you didn't have this subscription stuff. You would buy software and you'd get your floppy disk and then when the company came out with their new improved version a year and a half later, they did everything they could to get you to buy that. So, I get all of the elements of tech is hard to figure out, but maybe in terms of evolution, tech has evolved. Tech is very different these days and tech has vastly more consumer discretionary and non-discretionary attributes.

But for the longest time, too many in the value crowd said, ‘If Buffett can’t figure out tech, then who am I to even try?’ It became a crutch.

Well, fast forward today, and much has changed. ‘Tech’ has become quite common place across the investment style spectrum. Heck, even notable ‘deep value’ guru Seth Klarman at Baupost currently has big positions in both Facebook and Google. Even Buffett took a swing at IBM building a $14 billion position in the stock by 2015. His IBM position was notable still for being, at the time, his largest equity position by cost ever – even eclipsing his $13 billion, 500 million cost stake in Wells Fargo. IBM was a bust for him, but not to be deterred, he immediately started building a mammoth position in Apple. His cost in Apple peaked in 2018 at $36 billion.  

Speaking of Apple, we first invested in Apple in '05. It wasn't that long ago obviously that Apple was mainly hardware and some software and people viewed it as classic hardware tech, maybe a bit consumer discretionary tech. It really wasn't doing much enterprise business. Then all of a sudden, the iPod appears and boom, then here comes the iPhone and the evolution of Apple to a consumer staple began in earnest. Heck, the early iPods and iPhones were always at my kid's heads. To my kids, it wasn't even discretion, it was a utility. Sauerkraut and asparagus are discretionary to my children (laughs). So Apple's a great example I think of how tech has morphed, and next thing you know, Buffett has a multi-billion dollar position in Apple, you know, the guy who swore off technology.

I'm 59 now. I'm lucky that I got started at a pretty young age, but someone who's a portfolio manager today at a so-called value fund, if they want to call themselves that, and they're 35 or 40, I’m not sure they have any hesitancy to invest in tech, like my early generation did. It's been interesting to see how tech has evolved. In the very early days automobiles were ‘tech,’ look at say Progressive, what would Progressive’s business model look like today if they didn't whole heartily embrace tech – particularly telematics? Heck, advanced telematics is now table stakes in auto insurance.”

Evolution as an Investor

“Where we have evolved, and I think every investor has had to evolve is the Fed’s growing influence in financial markets, even back to the infamous Greenspan Put back in the late 1980’s. Back in the day the phrase ‘Don’t Fight the Fed’ was stamped on rookies’ foreheads on the first day in investing boot camp. We can thank Marty Zweig for those pearls of wisdom.  When one looks back on the DotCom boom/bust and the housing boom/bust and today with QE Infinity, it seems that the Fed has become both the arsonist and the fireman. Prior to say 2012, before central bankers barked ‘do whatever it takes’ to today’s yield control, when interest rates were allowed to find more free-market based levels, if a business was growing at say 12%, then the max P/E one might pay would be a high-teen multiple, certainly no more than say 22X unless it was a truly exceptional company. Fast forward today, 35 to 40X is the new 22X in the zero. It’s not the ‘Powell Put’ any longer, it’s become the ‘Powell Trampoline’.

And so what we've done over the last number of years is we have not been as steadfast to sell a stock outright because of valuations, we've been slower to trim it and conversely pay up a bit and build positions more slowly too. That said, we’ve maintained the discipline to sell even the best of businesses when valuations get absurd. Such was the case of our sale on NVIDIA last September.

When you look at the current valuation of our portfolio, if somebody were to have a crystal ball and they were to show me today the valuation, say, on a trailing or forward basis, if you would show me what the valuation is today, say, 10 years ago, certainly 15 years ago, I would have thought I’d gone mad.

But I think that's been a rational, intelligent adjustment to make. Let's face it, growth companies tend to be longer duration assets. Interest rates get lower, the valuation gets higher. We've learned or adjusted to the environment.  Of course, the catch is that we all know if Powell & Company announce on morning, ‘no more QE’ we all know what would happen to the stock market. It would be October 19th, 1987, The Sequel.”

Debt Levels

“If you look at a median or weighted average calculation of the debt of the companies that we own, it's never been higher than it is today over the past, since we’ve been doing this since 1992, but it hasn't been excessive. If debt capital is the cheapest capital, use it. If your equity is the cheapest, use it. Look at how successful Apple has been, borrowing super cheap money to buy back cheap enough stock to enhance their earnings per share. But Apple is the exception. Most C-Suites are terrible at capital allocation and dreadful at value-destroying share buybacks.” 

Holding Great Business Through Thick And Thin

“I need to have a page in our pitch book on the top 10 worst investment decisions at Wedgewood Partners in our 29-year history. And the one thing they all have in common, it's not necessarily valuation, it's we didn't understand how good and how resilient the business model was. We owned Home Depot for quite a while and we thought there were some problems, and there were for a few quarters or so, but we didn't get back in. Medtronic, same type of thing, Microsoft, Intuitive Surgical and United Healthcare and Amazon and Analog Devices and Apple Materials! I will admit to you, one of the hardest things when you're managing public money is on the one hand you have to take the long- term view, but you've got this quarterly score card, yearly scorecard, and I'd be less than honest if it hasn't affected us from time to time. When I think of the money that we left on the table in some of these stocks, it would have ... well, the numbers would have been even better.”

Banks As Growth Companies

“We've never invested in what I would call really deep cyclical companies like a Caterpillar or a John Deere, but in times past we have invested in more economically sensitive businesses like banks. That said, but only banks that are considerably superior to their peers. Years past we have owned the old Norwest, then Wells Fargo; the old Cherry Hill, New Jersey based Commerce Bancorp, U.S. Bancorp and MTB Bank. We own First Republic right now. If you look at their growth numbers, if you didn't know what they did, and you just looked at their numbers your jaw would be drop once you found out it’s a bank. They are incredible operators. An amazing franchise.”

New Ideas and Studying 13F’s

“Myself and our team, we're always digging up new names. Always looking for that emerging diamond in the rough. One of the areas that we are constantly on the lookout for are growing mid cap companies that are doing really well. On their way to becoming a large cap stock. The minimum market cap that we would consider is $10 to $15 billion. So part and parcel of our research bench are those smaller companies that are breaking into the large cap area that we can own.

Another area we're always looking at the competitors of the stocks we currently own. Years ago we owned Intel for a long time, from that we became familiar with Micron Technology. While that didn't work out for us that well, from that experience, we came across Linear Technology, which is probably one the greatest business models I've ever seen, particularly for a semiconductor company. Linear’s voodoo analog design engineers were the 1927 Yankees.

The last area we look at is that we study 13F’s. There's a lot of smart people in this business, very smart people and I keep a watch list of many investment firms that I respect and I'm always curious to see their 13F’s, It keeps you honest and humble. And so ideas can come from a lot of different areas, but those are the big ones.”

Position Sizing

“Over the last couple of years we haven’t had much chance to swing large on new portfolio positions. We usually initiate a position at two, two and a half, maybe three percent in the hopes that we can continue to build it. Typically, we're trying to buy companies when maybe the industry's out of favor or maybe the company has hiccuped a little bit and we want to get in at decent valuation and hope to own more. So in a 20 stock portfolio in our minds, a 5% weighting is average, 7%, 8%, 9% is large. We won't own anything over 10%. And then anything under 4% is considered on the smaller side.

Very key as a focus investor all of our stocks in the portfolio have a higher weighting than the weighting in a style benchmark or the S&P 500. It's high conviction focus, high active share so why waste time with tiny positions that are either benchmark weight or too small to move the performance needle. What's challenging for a lot of managers is the likes of Apple, Microsoft and Amazon are so gigantic, unless you run a focused portfolio, even if it's one of your top holdings, chances are it's just a benchmark weight. In the Russell 1000 growth, I think the top six stocks are 40% of the benchmark.”

Focused Investing - Diversify by Business Model

“We contend focused investing doesn't have to be risky if you stick with higher quality companies, however, we think a more intelligent way to diversify is to diversify by business model. So obviously Progressive has nothing to doing with Apple in terms of their business model. We're not going to own four or five semiconductor companies, we're not going to own four or five medical device companies. We've been a long-term investor in Visa. We've never owned MasterCard at the same time, because our thinking is those business models - there are some differences on the debit side of things - but they're alike enough that if something goes wrong with Mastercard it is unlikely that Visa escapes unharmed. So the last thing we want in our portfolio is when we make our inevitable mistakes, we don't want pin action in other parts of the portfolio.”

Stock Sell-Offs

“I've got plenty of scars too when we haven't gotten it right. I remember one of the early ones, when I joined Wedgewood, I guess it was Spring of 1993. ‘Marlboro Friday’, when Philip Morris came out on a Friday morning and said, ‘We've got to cut prices, we're losing market share to some of our competitors.’ It wasn't really an expensive stock at that time, but the next trade it's down 25%. Wall Street is pretty good of ripping the band-aid off. Rooting for a stock to go down runs against the grain, but some of those opportunities in hindsight have been wonderful. Again, it's going to hurt near term in a 20 stock portfolio, but when we can take a 5% holding that gets banged up someday, now it's a 3.5% weighting, and we can make it a 7% weighting and then we're right after that, when we look back on that difficulty that day or that week, when stocks blow up like that on a hiccup, it's not a fatal hiccup, but the valuation is pricey, the damage gets done pretty quick.”

Now, the ones that really hurt is where the business model has gone terribly wrong and oftentimes it could be fraud. Back in the day, we owned WorldCom, we got out when the cash flow statements started to look a little bit goofy, but we didn’t suspect fraud. Same thing with Lucent Technologies. If management wants to cook the books eventually it comes out. But those are episodes that you have to deal with. Fortunately, we've got scars, but they haven't put that dagger in our heart.

The thing that I probably admire the most are individuals who have been doing this for a long, long time, because without fail, they've all been hit by stock blow-ups and dusted themselves right off. Think of that book by Philip Carret, ‘A Money Mind at 90’, I mean, are you kidding me? I hope they pull me out of my office in a pine box when I'm 90, that's awesome. I don't care what profession you're in, if you can write a book on what you've done when you're at 90 years of age and you're still doing it, well, how cool is that?”

Berkshire Hathaway

“We sold our Berkshire Hathaway stock in 2019 after owning the stock in size since January 1999. We sold a third of our position in late May 2019 and the rest soon after in early August. All told, Berkshire stock gained about 370% over those +20 years.  The gain in the S&P 500 was about 235%. Investing in Berkshire and attending many annual meetings was a further education beyond reading and studying Mr. Buffett and Mr. Munger. A highlight of my career. The stock was terrific for our clients. 

On the first trim of Berkshire, we bought shares in Motorola Solutions (MSI). Since then (mid-May), Berkshire stock is slightly ahead of MSI, gaining about 44% versus 41% for MSI. After more buys of MSI, the stock today is our 3rd largest holding. The final sale of Berkshire really moved the needle for us. With those sale proceeds we increased our long-held position in Alphabet (GOOGL) by almost two-thirds to an 8% weighting and initiated a new position in NVIDIA (NVDA). Since then (as of mid-May again) GOOGL has gained about 90%, double that of Berkshire. GOOGL is currently our largest position at 9.6%. NVIDIA would turn out to be a moonshot. Over the course of the NVDA position we added to our original position once, trimmed twice and sold the stock in early September 2020. On the final sale of NVDA, the stock outperformed Berkshire over our holding period 215% versus 4%. Finally, we rolled the last NVDA sale proceeds into a new position in First Republic Bank (FRC). Since that purchase, FRC has gained about 67% and Berkshire Hathaway stock has gained about 39%.

Our sale thesis on Berkshire Hathaway was three-fold. First, too many capital allocation miscues. In a world of Fed-induced zero cost of capital, plus untold billions in private equity, Berkshire has long been at a competitive disadvantage in bagging gazelles and elephants. Compounding this problem, Mr. Buffett refuses to compete in investment banker-led buyout auctions and his disdain for leverage, typically a good thing, has all but rendered Mr. Buffett to, well, play solitaire while deal-making booms around he and Mr. Munger. Quite frankly, the phone rings more for the lonely Maytag repairman than it does in Omaha these days. Relatedly, we had long, long been an advocate for Buffett & Co. to cool the elephant hunting and bag the elephant in their backyard Omaha Zoo – Berkshire shares themselves (laughs). 

Capital allocation miscues, well, they've starting to add up - Precision Castparts, Kraft Heinz, Lubrizol, IBM and Wells Fargo.  On the equity portfolio let’s give credit where credit is due. Berkshire’s huge position in Apple was a terrific purchase and in elephant size as well. It really moved the needle. However, the lack of omission in the equity portfolio in large holdings of ‘Buffett-esque’ circle of competence stocks like Mastercard, Visa, Alphabet, Costco and Microsoft are head-scratchers. I understand Mr. Buffett’s reasoning on Miscrosoft that he didn’t want to take advantage of his friendship with Bill Gates, but that doesn’t square with his long friendship with Tom Murphy, key in delivering Mr. Buffett’s 1980’s-1990’s ABC/CapCities/Disney/GEICO masterstroke.  

The fact that Mr. Buffett looks like he has called off elephant hunting in lieu of buying back Berkshire stocks also reduces another related risk, that of complexity. At what point does a huge conglomerate become too big, too complex for Greg Abel to effectively manage? The supposed good news for shareholders after years of conglomeration are the seven or eight Fortune 500 sized companies within Berkshire. The bad news on this conglomeration is that Greg Abel is ultimately responsible that they are all managed well.  Tall order.  

I get the idea of ‘management by abdication’ long espoused by Mr. Buffett and Mr. Munger, but perhaps a little less abdication and a little more, what?, usurpation?, may have kept BNSF from underperforming Union Pacific, or GEICO underperforming Progressive. And speaking of GEICO, it’s been a year and a half since portfolio manager Todd Combs was named CEO of GEICO. I may be mistaken, but I thought Combs was to be a temporary CEO.  

The second part is the deteriorating quality of too many businesses within the Berkshire conglomerate, particularly in their MSR (Manufacturing, Service and Retailing) division. Outside of the recent addition of Clayton Homes in this segment, it is easy to conjecture that this group barely earns its cost of capital. We would know for sure if Mr. Buffett would provide a balance sheet for this segment. That said, the other key parts of the conglomerate are better than the average business. Again, BNSF is good, but under-performing Union Pacific. GEICO's is good, but underperforming Progressive. Berkshire Energy is fantastic, particularly on the tax credit side and their continued policy of reinvesting all of their earnings – quite unlike other large utilities. But here's the rub, you don't need Berkshire Hathaway or Mr. Buffett to get the ‘best of Berkshire.’ Who doesn’t own Apple these days? Instead of GEICO you can get Progressive on your own. Instead of Burlington Northern you can get Union Pacific on your own.  Replacing Berkshire Energy would be difficult because they're reinvesting in all their earnings, they don't pay a dividend and they have all of these tax credits. In a tax-exempt account, you can maybe buy a utility ETF and reinvest the dividends as a replacement proxy of Berkshire Energy.

The third, quite honestly, I think as the years go by now, there's significant management risk, succession risk. Mr. Buffett’s and Mr. Munger’s cognitive abilities and stamina continues to amaze, but unfortunately Father Time won’t be denied.  

Maybe one last thought on Mr. Buffett; I've have the greatest respect for Mr. Buffett.  I wouldn’t be in this business since 1986 without him as a guiding light. Mr. Buffett chooses his words carefully, both spoken and written. And I've certainly noticed, it's been remarked by many others too, it wasn't long ago, a few years ago, where he stated at annual meetings, essentially, ‘We think we have a collection of businesses that should do better against the S&P 500.’ Those words are gone. More recently the verbiage was ‘Maybe we'll keep pace with the S&P 500.’  Those words seem to be gone too. Even after the strong run of Berkshire stock versus the market since last June, the stock is still considerably behind the S&P 500 over the past three and five years. There's probably less downside in the stock relative to the S&P 500, maybe. But quite frankly, the people who hire us, want us to beat the S&P 500 and I don't think Berkshire, particularly at current valuations and its collection of businesses, will. The S&P 500, it's tough to beat, even for the best of us. I think it's going to be much tougher for an overdiversified conglomerate that isn't growing that much more than GDP. Mr. Buffett warned shareholders long ago the performance deadening perils of size. Shareholders will never again see examples of Mr. Munger’s ‘lollapalooza’ dynamism at Berkshire such as the brilliant transaction path of ABC/CapCities/Disney/GEICO/Coca-Cola.

After an incredible two decades in the stock for our clients, too many of the former competitive advantages of Buffett & Co. at Berkshire later, in our view, became disadvantages. That’s why we sold.”

Influential Books

“I finished school in late 1985 where I’d been fortunate to have a very influential investment professor, who was a stock market junkie. He dispensed with all of the textbook stuff and he just talked about the stock market. He was instrumental in pointing me to outside reading, outside of textbooks. And I was fortunate to get my hands on, in the early '80s, the classic 1980 book by John Train, The Money Masters. That was my first exposure to Buffett, Templeton, Graham, Carret, Rowe Price. It became an obsession literally overnight. I was hooked - hook, line and sinker. I got into the brokerage business in early 1986, that's when Peter Lynch's first book came out, and I didn’t want to be a salesman anymore. I wanted to be a stock picker, I wanted to be a portfolio manager, I wanted to be an analyst. 

Today we in the business are blessed with many classic, must read books. We get to sit on the broad shoulders of the greats. The Intelligent Investor; chapter 8 on margin of safety, chapter 20 introduces the concept of Mr. Market, those are must reads – every year too. But some of the early books, all of Train’s books obviously, Buffett's shareholder and his partnership letters. Even today, I'll go back and and I'll pull up say history 1981 shareholder letter, and though it’s a delightful trip down memory lane, it's still refreshing to read. It’s batting practice. Buffett’s such a great writer and it's like that old textbook ... It's like an old friend and you get to have that conversation again with that old friend.

Anything Charlie Ellis wrote. His Loser’s Game and The Paradox are among the pantheon of must reads.

But the one book that I have already mentioned that probably made the biggest impact on my career in those early formidable years back in the day was Peter Lynch's ‘One Up on Wall Street’. My two takeaways was when Peter Lynch went into some detail that even in his best years, his stock ideas, he batted just .500, one of the great investors of all time and he’s admitting that half of his stock picks don’t work out. What an eye opener. It was liberating, it really was. 

When I first got into this business, like many, I wanted perfection, I wanted every stock to work.  All the best have the proper ego and intelligence to take a loss and move on. So here's one of the greatest of all time saying, "Hey folks, half my ideas didn't work out." And then related to that, when he would say, "The worst thing that can happen is if the stock goes to zero." Now, if you're managing public money and you have too many of those, you're going to have to find another line of work, I get it. But then Lynch said, ‘The best thing that can happen is a stock may double or quadruple,’ his famous ten-bagger. 

Here comes some scars. Micron Technology, we bought that stock in March 1996, I think it was March 15, 1996. It never seemed to go up. The big demand for computer memory needed for Windows 95 and the new Pentium cpu was priced in. And DRAM surplus came on like Niagara Falls. Again, on any given day the stock wouldn't go up, and we bought some more, and more. At the same time, I'm looking at this company called Linear Technology, a completely different business model. So about six months later, we sucked it up, and we sold Micron Technology to buy Linear Technology and our clients were like, ‘Wait a minute, you're selling what technology to buy what technology, are you kidding me?’ But in the big scheme of things, I think we lost 40%, 45% on Micron and it stung, no doubt about it, but that 50% loss in one stock, hopefully we learned from it, pales in comparison to the money we made in Linear Technology. And so Peter Lynch's book, among other wonderful anecdotes he had in there, it took the pressure off me. I didn't have to be perfect and I stopped trying to be perfect, and if I stuck with the better businesses, even if I, in hindsight, I found out that I maybe paid a little bit too much for it, a growing, best of breed business often bails you out.”

Summary

You can see how Rolfe’s snowball has both first gathered and then continued to gather snow. His success has been earned over long years and it’s clear that his humility in admitting investment mistakes, his openness to the thoughts and opinions of others, and his willingness to challenge those opinions - even some of the greats - have all contributed to that investment success.

I’m incredibly grateful to David for both his time and his incredible insights and look forward to the next time we can speak. In the meantime, I hope some of the insights above can help your snowball grow.

Further Reading:
Wedgewood Partners Investor Letters.

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TERMS OF USE: DISCLAIMER

Master Series: Francois Rochon

Let’s face it, for most, achieving decent returns from investing can be remarkably difficult at times. Achieving consistent returns is even more so, and outperforming the markets over the long term is harder still. Few investors can do it. Francois Rochon is one of those who can and has; his Rochon Global portfolio¹ (that serves as a model for clients at Giverny Capital) has delivered a 15.3%² annual compound return for nearly three decades, outperforming the benchmark³ by more than five percent per annum. By 2020’s year end, the Rochon Global portfolio’s cumulative return since inception in 1993 stands at 4,969% versus the benchmark’s 1,103%.

While Francois carries a relaxed demeanor, it masks the emotional fortitude he possesses that is required to navigate challenging market conditions. No better example of his rational composure comes to mind than during the pandemic induced collapse of global financial markets last year. In the midst of the crisis, Francois penned a 2-page memo to his partners reminding them that their portfolio of companies had the capacity to weather the crisis and he implored them not to be influenced by stock market fluctuations. In the eye of the storm, it was a lighthouse guiding investors; the Giverny portfolio had been crafted to survive the most treacherous swells, provided investors could avoid the rocks of emotion. A recount of the most important market corrections of the last sixty years and their subsequent recoveries made clear that smooth sailing ahead was inevitable [see table below].

“It is only those who sell in panic in declines who become the real losers of the volatility inherent in financial markets.” Francois Rochon - March 16, 2020

Giverny Capital Letter - 16 March 2020.

Sage advice indeed.

Francois’ genuine humility is evident in everything he does. A few years back, after reaching out to him about content for the MastersInvest site, Francois invited us to meet with him in Omaha while we were attending Berkshire’s AGM. He willingly gave us his time while we were there, and we were able to discuss a wide range of topics and learn more about his thinking, his investment philosophy and the practical art of investing.

A few weeks ago we had the opportunity to chat with Francois once more, and gain his insights into how he sees the world, some opportunities he’s finding attractive and collect some timeless investment wisdom⁴.

Market Crises [Covid 19]

“When valuations are low and pessimism is high and you have a long term horizon I think you have to at least stay invested. If you have available capital you just have to have faith and invest.”

Current Valuations

“I always say, high valuations, most of the time, translate into lower returns. You have to accept that. You can justify paying 50 or 60 or 70 times earnings, as some stocks trade today, by expecting many years of high growth and discounting them with a very low interest rate. But that also means that you'll have lower returns if you discount them with a lower discount rate. I believe that there are many stocks that are expensive and many quality names are trading at pretty high ratios. You have to accept that if you want to own those names you'll probably have lower returns going forward. I’m not saying negative returns but for the S&P 500 in general, I think it's going to be hard to earn a total return in the next five years of more than let’s say 6% annually, which is okay but not as high as it's been in the last decade, that's for sure.”

Opportunity Set

“We still, as always, can find great companies that trade at reasonable valuations. If you build a portfolio of such securities, I think you can do better than the average. I take the example of Markel for instance. I think Markel is a great company and the market doesn't really see it that way. I think that's one example of a company I don't believe it's trading at high valuation at all.”

Financials

“In general, everything that is seen as interest rate sensitive or financial, has come back [up] a little bit but is still out of favor. Banks or insurance companies, they're not what young and dynamic investors want to own because that's not really exciting. But you know I always say, I'll favor stable, durable, competitive advantaged, great management, good return on equity, lower valuations and I will live with the ‘dull’ nature of the business.”

“We own two banks, Bank of American and JP Morgan. I think those two banks are very well managed, they have solid balance sheets. Their stocks have rebounded lately but I still think if you own them for the next five years you'll do okay.”

Tech Stocks

“I'm not against owning technology names. I mean I've owned some of them for many, many years. If I go back to the first years like 1994, I think back then I owned Intel and Sun Microsystems. One lesson I learned is that if you look at Sun Microsystems for instance, it was a great company in 1994, I bought it at very reasonable valuation and I had a very good return. While the company still exists, as part of Oracle now, it's not as dominant. It's far from as dominant as it was 20 years ago.”

Facebook & Google

“I think the situation with Facebook and Google is a little different. I don't really see them as technology companies, they offer a service and they've built this incredible network. I think they've got an extraordinary brand. I don't see them as sensitive to technology change as a company that sells hardware or software.”

“If you look at Facebook, it's trading at around 25 times this year’s earnings. It's still growing pretty fast. I think it can grow between 15 to 20% a year going forward for the next five years. It's a very reasonable valuation. These are clean earnings, meaning that everything that has to be expensed has been expensed - like stock options for instance. That's not the case with many companies that even trade at 40, 50 times earnings [non-GAAP, without stock options expensed earnings which I'm not a big fan of. I'll do my own calculation of earnings and adjust them for the stock option expenses]. If you look at Facebook, I think the valuation is very reasonable for such an outstanding company.”

Progressive

“If you look at Progressive, the auto insurance company, they've gained market share in the last 20 years and they're as strong, their model is as strong today as it was 20 years ago. There's many technology companies you can't say that at all. How durable is the competitive advantage is a key question you have to ask when you invest in any security.”

Apple

“I think Apple is more than just a hardware product. It's really an ecosystem where there's the phone, there's all these services and the fact is today, compared with 20 years ago, your cell phone is much more important to your daily life than it used to be. So many little things in your daily lives are built into your phone. It's a big thing to change your phone today. It wasn't a big thing 15 or 20 years ago to change a phone but today it is. I think Apple’s dominance is great. The thing you have to ask yourself, once you're so dominant, how are you going to come up with a lot of growth going forward. That's a question I think you have to ask with any already dominant businesses.”

Finding Opportunities

“I love baseball and so I watch, I don't know how many games a year. I don't do it because I want to learn about baseball or be a better baseball connoisseur, it's really because I enjoy watching the game. After a while you kind of know almost all the important players, the best players, the best pitchers, and the ones that have a better batting average. You know about those players because you're interested in this game. It's similar with an art collection. I'm interested in everything in the history of art, I try to go to every major show and visit the museums in Montreal, New York City, Chicago, Los Angeles. After a while I know a lot of artists and great artists. I think I can have a general view on which ones are the most important artists, the ones I believe are really the outstanding ones that will still be considered important in 50 years.

It's a similar process when you invest in companies. You look at almost every company, even private ones, but you're more interested in the public ones so you want to learn about every important public company in the world. When you find something, a company that looks exciting, that looks like they've got this great business, you want to understand why its so great, and what's the source of their greatness. You find CEOs that you admire like Mark Leonard at Constellation Software. When you've read a lot of annual reports I think you can find, you can see when there's something special about a company because you've seen so many of them; you can find one that really stands out. It's really a daily process for the last, in the case of investments, 28 years. Just looking daily at a lot of companies because I enjoy the process. I enjoy discovering companies and learning about the history of companies and I am always on the quest of finding new companies because finding a new company is exciting.”

“When I travel in the US, I'll go to a new restaurant chain I've never heard about and try it. If I like the food, if I like the experience, I'll say lets look at the stock. But sometimes just reading a friend’s annual letter and, "Oh, my friend bought this new company and I don't know about it so I'll read about it." I know how he thinks so since I share a similar investment philosophy as him, it might be at least worth reading. That's one source of ideas of course.”

Investment Edge

“I think a lot of opportunities in the stock market arise not because we have more insights into understanding businesses. I think a lot of people can pretty quickly identify the great businesses. I think our edge as investors is really our behaviour, it’s not to focus too much on the short term but really we're there for the next five to ten years. So even a great company can have some periods of uncertainties in their business or short term problem or if there is a recession and that makes the company growth rate be a little lower for a while; if we think the fundamentals over the long term are intact, it can be an opportunity for us. So our edge is really our behaviour and our long term horizon which is so rare today because people want good results in a very short time period. Of course, people can do whatever they want as an investment style; but we believe that the short term horizon of others is probably at the source of many of our investment opportunities because we have a longer term horizon than most people.”

Autohome

“There's some opportunity in the internet and technology sector, Facebook is one. We own a Chinese company called Autohome, which is by far the leader in China, a website where you can do some research about buying a new car or some car related products. It's a great company and I think Wall Street is a little worried about a Chinese company listed in the US so the stock has gone down at least 10 to 15% recently. If you look at Autohome’s valuation, I think it trades at something like 20 times this year's earnings. I think it can be a 15, 16, 17% grower going forward. It’s very well managed, the balance sheet is very good and the valuation is very reasonable. It's at a discount to the S&P valuation ratio.”

“Where did I find Autohome? I like to read annual letters from great managers. I think it was a top holding of a money management firm I admire in the US. I'd never heard about that company so I read the annual letter; I went to the website. I thought it was a good company and we talked to management and we did all the research and decided to buy shares.”

On Berkshire

“Warren Buffett is such a good steward of capital, he doesn't do anything risky. He doesn't use debt, he doesn't acquire companies by paying very high ratios. So of course in the last five years it's been hard for him to acquire companies because many other acquiring entities are using debt, are paying high ratios - the competition has been much less prudent than he is. Knowing Warren, that won't change his approach. Preservation of capital I think is still a cornerstone of his approach. He used to say that the first rule is don't lose money and rule number two rule is don't forget rule number one. He still is very prudent. This prudence has been probably one reason he has so much cash on the balance sheet, I think it's something like 140 billion dollars. That's a lot of capital because I don't know exactly the numbers but it would represent something, at least a quarter of the equity. So when a quarter of the equity is invested in something that yields close to 0%, it's hard for the whole thing to earn 10 to 12%. The rest has to compensate and it's very hard to compensate that much. That's been a drag on the return of Berkshire.”

“At some point I think until [company] valuations come back a little bit to more reasonable levels, I think the best thing he can do is buy back stock and return the excess capital to shareholders. If he continues to do that, and he's been doing that for the last two quarters very aggressively, I think it's nine billion per quarter in the last two quarters. From what the annual letter said he’s still doing this in the first quarter of 2021. That's $36 billion a year so that's about 7% of the market value of Berkshire. Well if you return 7% per year going forward, I think it's going to be a better stock than it was in the last few years, at least relative to the S&P 500 so I still think the whole thing can continue to grow at 5 or 6% annually at least. But if you add a 7% buyback, it's really a good return of capital to the shareholders. I think that Berkshire can do something like 12% going forward.”

Evolving

“The world is always changing and you have to evolve with it. If you don't evolve you'll probably stay behind, very slowly but surely. You have to accept that you have to always rethink everything and do postmortems on investments on what went well and what went wrong. We're doing that on at least a yearly basis with our yearly medals for the top three mistakes.”

Mistakes & Margin of Safety

“Year after year what I realise is most mistakes I've made is not paying perhaps a higher price than I should have for great companies. I think I probably have already evolved on that. I'm ready to pay 20 times earnings for good growth companies but sometimes there's not that much difference between 20 times and 25 times. There is between 20 and 60 but between 20 and 25, perhaps I'm trying to be a little too precise, or to prudent, and sometimes miss the big picture that if you find a great growth company and it doubles its earnings every five years, well perhaps valuation to some degree should be flexible a little bit. So I probably have evolved a little bit over the years with that.”

“You have to be careful because how much do you stretch? You can stretch to 25 and then 30 and then 40, I mean it never ends. You have to accept you still want a margin of safety and I think that's the key element in The Intelligent Investor and when you read Ben Graham’s writings. Seventy years later, I believe that the key lesson from Ben is still the importance of margin of safety.”

“The margin of safety is not just in the price you pay, it's also in the quality of the business, it's in the balance sheet of the business and the accounting and also in terms of the quality of top management. When we bought shares of Constellation Software, I don't remember how much we paid but we paid a reasonable valuation, I think 18 or 19 times earnings. To us the real margin of safety was Mark Leonard. We thought he was a great investor, a great manager and I mean to us it was not the valuation that was the key criteria it was really because of management.”

Portfolio Companies

“I think if you look at the portfolio, there's some differences in the style of the businesses but they all have similar themes. They are all great business, already profitable, already dominant in their industry, that have good growth prospects - not 40% a year - but between let's say 8 and 20% more or less. They have good balance sheets, we like the management and we think they're good capital allocators. All the companies we own, we believe share those characteristics. They're in different industries, they're different sizes. We own some small companies and some very large ones, but they have a similar style of businesses.

I know that I have some colleagues that would say, ‘Well, I invest in this young company that is not profitable yet but if everything goes well it can increase 10 times.’ Well to me that's a little risky. I've seen so many companies disappear over the years and I don't want to own a company that needs to go to the capital markets on a regular basis because either it has too much debt or is not profitable. You never know when there's going to be a financial crisis. I've seen a few of them in the last 28 years. I mean in 2000, 2001, and 2002 when the tech bubble burst it was very, very hard for those technology companies to get new financing. If you look at 2008 or 2009, there were some companies that had some debt and went to the financial markets and couldn't find capital at all. So I don't want to own companies that if there's a crisis or a recession, could be in the weak position of having to raise capital at very bad levels for shareholders or through expensive debt.

To avoid that I just avoid companies that are not profitable or have too much debt on the balance sheet. Even though I see that there is some upside potential, I see the downside in case of a recession or financial crisis because I've seen and I’ve lived through them. So I know they can happen and they will probably... I don't want to use the word conditional because it's not a conditional situation. There'll be recessions, there'll be crisis and I want the portfolio to survive them. We want the companies to be survivors not ones that will need to go to the capital markets at the worst possible time.”

Partner with Management

“There's all sorts of reason why some companies are not properly valued by the stock market. Sometimes it's just because it's non-exciting; a little dull business or a low profile manager. Some CEOs speak very well, they're good salesmen. That’s fine, that’s business. I like to see CEOs as partners because that's really what you are doing when you are buying shares; you're becoming a partner with the top management CEOs. I want partners that are low profile, are really focused on building something for the long run, ideally that are humble. They're not trying to pump up their stock. They want to build wealth over the long run, they're trying to build solid businesses and they know that in the end if the company does well the stock will eventually reflect that. They know that.”

Book Recommendations

“There's the classics of course like the books of Ben Graham, Peter Lynch and Philip Fisher. John Train wrote two good books in the 80’s, ‘The Money Masters’ and ‘The New Money Masters,’ which I liked. William Thorndike wrote the ‘Outsiders’ which was one of my favourite books over the last few years. Larry Cunningham wrote a few books on Warren Buffet and Berkshire Hathaway which I think are very interesting. My friend Guy Spier wrote the book, 'The Education of a Value Investor’.

There's older books such as John Paul Getty’s book, ‘How to be Rich’. It contains a chapter on stock market investing which I think is very good. You can read biographies or autobiographies by great business builders. Many years ago I read the book by David Packard which was very good and Ken Iverson’s, the guy that built Nucor. Bill Gates’ book from 1994 when the internet was just starting called ‘The Road Ahead’ was very good. I’d also recommend a book by S. Cathy Truett who started Chick-fil-A, the chicken burger chain. I thought that book, ‘How did you do it Truett?,’ was really good. I've been hoping that Chick-fil-A becomes a public company since then.”

Summary

Francois’ passion for investing is as obvious as his humility, and is mirrored in his deep interest in both baseball and art. His returns have been nothing short of outstanding over the years and are the envy of many. We’re very grateful to Francois once again for his insights and thoughts on matters. Truly he has painted a masterpiece of his own and we expect that his batting record will only continue to climb in the years to come.

Further Reading:
‘Investment Masterpieces - Francois Rochon’ - Investment Masters Class, 2017.
Giverny Capital Annual Letters

Follow us on Twitter : @mastersinvest

TERMS OF USE: DISCLAIMER

Learning from Nick Sleep

True investment success is rare, and even more so is the prospect of long term success; an investor’s returns that outperform the index year on year. Rarer still is the prospect of gaining insights into how the most successful in the investing world have achieved that success. And let’s be honest; we’re all looking for information that will give us an edge; those pearls of wisdom that allow us to intimately understand the thoughts and mental models of the great investors. But this information is sometimes so hard to find, it’s almost like searching for the Dead Sea Scrolls - We know it exists but we’re not quite sure where to look.

If the Dead Sea Scrolls had an investing equivalent, Nick Sleep’s letters would be it. For a long time these letters have been as rare as hen’s teeth, and because of this, and the gems contained within, they have been coveted by investors the world over. Only in the last few months have they surfaced publicly. Having spent the better part of the last few decades studying the world’s best investors, businesses and CEO’s, I’ve read hundreds of letters, interviews and books. And what I have found is that Mr Sleep’s remarkable insights and creativity in investing are almost without peer.

In 2001, after a decade in the industry, Sleep and his partner Qais Zakaria launched the Nomad Investment Partnership under the tutelage of Jeremy Hosking at Marathon Asset Management. The fund was spun out in 2006. After trouncing the index for thirteen years [20.8%pa vs index 6.5%pa], Nomad was closed in 2014 as Sleep & Zakaria sought more ‘caring pursuits’.

Like many of the world’s great investors, Nick Sleep came to investing from unorthodox beginnings. He didn’t study business or finance, but geography, a multi-disciplinary subject that nurtured a love of asking questions.

“Geography is a subject with an identity crisis – it is the confluence of geology, physics, chemistry, oceanography, climatology, biology and that is just physical geography. Human geography deals with sociology, psychology, statistics, economics – so it is the ultimate polymath course. Geography just reached in to other subjects and grabbed what it thought it had to have. Indeed, the reason I studied Geography at all was because of this polymathic quality.”

“But because Geography is so broad, it claims little territory of its own.. Because Geography is seen as an academic gate-crasher, practitioners have had to ask themselves questions that other more homogenous subjects such as physics or chemistry have not.”

And it was Geography combined with Robert Pirsig’s seminal book, one occasionally referenced by the great investors, that reshaped his perspective on the world.

“I was reading ‘Zen and the Art of Motorcycle Maintenance’ by Robert Pirsig at the time, and the two just combined to change how I viewed the world. So I have this tendency to return to the basic questions.”

Mirroring the journey of many of the Investment Masters, Nick Sleep evolved as an investor. In Nomad’s early years the fund had almost half its assets in typical ‘value’ plays - discounted asset based businesses and deep value workouts - the ‘cigar butts’ that characterise Benjamin Graham’s investing style. Notwithstanding, Sleep could see that Nomad’s destination was in owning ‘honestly run compounding machines’. Nomad’s 2004 letter set out ‘the likely evolution of Partnership Investments’ which he referred to as the ‘terminal portfolio’ - where he wanted to go. By the time the partnership wound down the fund was characterised by a portfolio of these compounding machines; businesses deploying ‘scale-economic-shared’ models largely run by their founders.

Charlie Munger has often said ‘take a simple idea and take it seriously’. Sleep embraced this philosophy, grasping the market’s perennial undervaluation of ‘scale-economics-shared’ businesses. He formulated creative investment theses that he fortified through the mental models he collected from disparate disciplines; many not ordinarily applied to investing. When combined with a deep understanding of psychology, the application of relentless patience and a steadfast focus on each company’s destination, Nomad achieved an astonishing track record of performance.

There are so many lessons to draw from this incredible collection of investment letters it’s almost difficult to know where to begin. Sleep’s prescient views on Amazon are laid out in a roadmap in the early letters. A contrarian view on Costco from Nomad’s formative years is now conventional wisdom. I’ve included some of my favourite learnings below.

Think Long Term

“We own the only permanent capital in a company’s capital structure – everything else in the company, management, assets, board, employees can change but our equity can still be there! Institutional investors have never really reconciled their ability to trade daily with the permanence of equity.”

“There is a lot to be said for gentle contemplation. And of course, a long investment holding period allows one time between decisions to ‘retreat and simmer a little.”

“We are genuinely investing for the long term (few are!), in modestly valued firms run by management teams who may be making decisions, the fruit of which may not be apparent for several years to come.”

Focus on the Destination

“Destination analysis is consciously central to how we analyse businesses these days. It helps us ask better questions and get to a firm’s DNA.”

"The only real, long term risk, is the risk of mis-analysing a company's destination."

Compounding Machines

“We can do better with the compounding businesses these days- and they are much less stressful.”

“If we had out time again, we would hope not to be seduced by some firms (apparent) economic cheapness but weigh more heavily their DNA, if you like. One of the things we have learnt over the last few years is our most profitable insights have come from recognising the deep reality of some businesses, not from being more contrarian than everyone else. Old habits die hard but, even so, I am finally attending classes at CBA, Cigar Butts Anonymous!”

“We estimate that around three quarters of the portfolio is invested in growth businesses, which have the potential to compound for many years, and the balance in more cigar butt like investments (we just could not help it!).”

“Investors know that in time average companies fail, and so stocks are discounted for that risk. However this discount is applied to all stocks even those that, in the end, do not fail. The shares of great companies can therefore be cheap, in some cases, for decades.”

Ignore the Noise

“At its heart, investing is simple, and to make it seem anything but, with the frequent repartition of short-lived facts and data points, may be a conceit. Indeed, it could be argued that a running commentary obfuscates a discussion of the things that really matter.”

“Information, like food, has a sell by date - after all, next quarter's earnings are worthless after next quarter. And it is for this reason the information Zak and I weigh most heavily in thinking about a firm is that which has the longest shelf life, with the highest weighting going to information that is almost axiomatic: it is, in our opinion, the most valuable information.”

“The investment industry, as well as many economic commentators, spend so much time shouting. So much commentary espouses certainty on a multitude of issues, and so little of what is said is, at least in our opinion, knowable. The absolute certainty in the voice of the proponent so often seeks to mask the weakness of the argument. If I spot this, I metaphorically tune out. In our opinion, just a few big things in life are knowable. And it is because just a few things are knowable that Nomad has just a few investments.”

Psychological Advantages

“Charlie Munger’s ‘Psychology of Human Misjudgment’ speech given at the Harvard Law School in the mid 1990’s is the finest investment speech ever given. Not that he talked directly about investments. And that tells you something. But the most enduring advantages are psychological. And the trick here is to first understand them. And then train yourself out of them!”

Focus on the Business

“We own shares for multi-year periods and so our continued investment success has far more to do with the economics of the underlying businesses than it has to do with their last share price quote.”

"The trick, it seems to us, if one is to be a successful long-term investor, is to recognise the sources of enduring business success, get in early and own enough to make a difference."

“We can all observe that stock prices, set in an auction market, are more volatile than business values. Several studies and casual observation reveal that individual prices oscillate widely around a central price year in year out, and for no apparent reason. Certainly, business values don’t do this. Over time, this offers the prospect that any business, indeed all businesses, will be meaningfully mis-priced.”

Customer Relationships

“[Nomad’s firms’] cultures are focused on the customer experience, not on the competition or the profit and loss statement. Our firms tend to chase the vision, not the money.”

"To be precise, the wealth you receive as partners came from the relationship our companies' employees (using the company as a conduit) have with their customers. It is this relationship that is the source of aggregate wealth created in capitalism."

“One trick that Zak and I use when sieving the data that passes over our desks is to ask the question: does any of this make a meaningful difference to the relationship our businesses have with their customers? This bond (or not!) between customers and companies is one of the most important factors in determining long-term business success. Recognising this can be very helpful to the long-term investor.”

Business Models

“Zak and I observe several business models that work in the long run, and scale economics shared is one of these... that is why companies that share scale with the customer make up around sixty percent of the portfolio.”

“The basic business models that lead to success don’t change that much and there aren’t that many of them.”

“We have little more than a handful of distinct investment models, which overlap to some extent.”

Management

“Our job is to pass custody of your investment over at the right price and to the right people.”

Founders & Management

“Almost ninety percent of the portfolio is invested in firms run by founders or the largest shareholder, and their average investment in the firms they run is just over twenty percent of the shares outstanding.”

“The best entrepreneurs we know don’t particularly care about the terms of their compensation packages, and some, such as Jeff Bezos and Warren Buffett have substantially and permanently waived their salaries, bonuses, or option packages. We would surmise that the founders of the firms Nomad has invested in are not particularly motivated by the incremental dollar of personal wealth… These people derive meaning from the challenge, identity, creativity, ethos (this list is not exhaustive) of their work, and not from the incentive packages their compensation committees have devised for them. The point is that financial incentives may be necessary, but they may also not be sufficient in themselves to bring out the best in people.”

“Nomad’s investments may be in publicly listed firms but these firms are also overwhelmingly run by proprietors who think and behave as if they ran private firms.”

Scale Economics Shared

“Nomad’s firms are, on average, so cost advantaged compared to many of their competitors that the worse it gets for the economy, the better it gets for our firms from a competitive position.”

“The simple deep reality for many of our firms is the virtuous spiral established when companies keep costs down, margins low and in doing so share their growing scale with their customers. In the long run this will be more important in determining the destination for our firms that the distractions of the day.”

“Scale Economics Shared operations are quite different. As the firm grows in size, scale savings are given back to the customer in the form of lower prices. The customer then reciprocates by purchasing more goods., which provides greater scale for the retailer who passes on the new savings as well. Yippee. This is why firms such as Costco enjoy sales per foot of retailing space four times greater than run-of-the-mill supermarkets. ‘Scale economics shared’ incentivises customer reciprocation, and customer reciprocation is a super-factor in business performance.”

"In the office we have a white board on which we have listed the (very few) investment models that work & we can understand. Costco is the best example we can find of one of them: scale efficiencies shared. Most companies pursue scale efficiencies, but few share them."

Price Give-Back

“We would suggest that investment in price-giveback, so favoured by Nomad's firms, is the most long-lived of the investment spending items if it engenders consumer habit. It may, therefore, be the most valuable to long-term investors.”

Risks of Pricing Power

“Early in a firm’s development it makes sense to reward customers disproportionately as customer referrals and repeat business are so essential to the development of a valuable franchise. With maturity this bias can be reduced and shareholders can reasonably take a greater slice of the pie. Too much, however, and the moat is drained with negative consequences for longevity. The temptations are enormous because capital markets will reward profiteering. There are many examples of companies which ‘harvest’ excessively, when perhaps they should focus on longevity. This may have been what happened at Coca Cola which has leant excessively on bottlers, or Gillette where advertising has been cut, or even at Home Depot which has boosted gross margin in recent years. Shareholders often suffer a double whammy as highly rated companies enter ‘growth purgatory’, because growth slows just at the time when shareholders spot the mis-analysis of reported profitability.”

Risk with High Margins

"The risk with super-normal profitability is that profits are an incentive for a new competitor, far better to earn less, but for a much longer time.”

Lollapalooza Moat

“There is not a prior reason why a comparative advantage should be one big thing, any more than many smaller things. Indeed an interlocking, self-reinforcing network of small actions may be more successful than one big thing… Firms that have a process to do many things a little better than their rivals may be less risky than firms that do one thing right [e.g. develop/own a patent] because their future success is more predictable. They are simply harder to beat. And if they’re harder to beat then they may be very valuable businesses indeed.”

Misunderstood

“[We] invest in firms that are misunderstood by many. For example, we invest in firms that pay their employees 80% more than rival companies (Costco); firms that lower prices as an article of faith (Amazon.com); firms that force an equitable distribution of commissions in an industry dominated by an eat-what-you-kill culture (Michael Page); a low cost airline for the masses in a region served by airlines for the rich (Air Asia); and a company that thinks table top figurine games are cool, really, (Games Workshop). Isn’t it wonderful that these firms are behaving in this way despite being misunderstood by the outside world? All the social pressure will be to conform with industry norm but these companies have a deep keel that keeps them upright.”

Recognising & Weighing the Right Information

“What investors needed to understand, and attribute sufficient weight to, in order to hold Colgate-Palmolive shares for the last thirty years, and so enjoy the fifty-fold uplift in share price, was the economics of incremental products (often referred to as “line extensions”, from the first “Winterfresh” blue minty gel in 1981 to “Total Advanced Whitening” today) and the psychology of advertising. Other items were important too, discipline in capital spending in particular, and there were lots of other things that seemed important along the way (stock market crises, country crises, management crises and so on) but it was the success and economics of line extensions and advertising that, in our opinion, was what the long-term investor really needed to embrace. A similar story can be told at Nike and Coca-Cola (manufacturing savings funneled into dominant advertising) or Wal-Mart and Costco (scale savings shared with the customer). Recognising and correctly weighing this information in-spite of the latest news flow is a matter of discipline, and it is that discipline that is so richly rewarded in the end.”

Inaction - SOYA

“One common psychological trap that agents may fall into is that clients expect action, or to be more accurate, fund managers expect their clients to expect action! The investor Seth Klarman was once challenged on whether Buffett’s track record was statistically significant as he traded so little? To which Klarman answered that each day Buffett chose not to do anything was a decision, too. It is quite possible that we may not change the companies we have invested very much over the next few years.”

“There are, broadly two ways to behave as an investor. First buy something cheap in anticipation of a price rise, sell at a profit, and repeat. Almost everybody does this to some extent. And for some fund managers it requires, depending on the number of shares in a portfolio and the time they are held, perhaps many hundred decisions a year. Alternatively, the second way to invest is to buy shares in great businesses at a reasonable price and let the business grow. This appears to require just one decision (to buy the shares) but, in reality, it requires daily decisions not to sell the shares as well! Almost no one does this, in part because it requires patience.”

“The decision not to do something is still an active decision; it is just that the accountants don’t capture it. We have broadly, the businesses we want in Nomad and see little advantage to fiddling.”

“The runway ahead for our businesses may be very long indeed. Inaction on our part is counter-cultural and deliberate, and is easier said than done. Really… As Berkshire Hathaway Vice-Chairman, Charlie Munger says, you make your real money sitting on your assets!”

“Our portfolio inaction continues and we are delighted to report that purchase and sale transactions have all but ground to a halt. Our expectation is that this is a considerable source of value add!”

The Real Mistakes

“The biggest error an investor can make is the sale of a Walmart or a Microsoft in the early stages of the company’s growth. Mathematically, this error is far greater than the equivalent sum invested in a firm that goes bankrupt. The industry tends to gloss over this fact, perhaps because opportunity costs go unrecorded in performance records.”

The Value in Mistakes

"In investment terms, once lessons have been learnt, mistakes can be put on a price earnings ratio of one and the resultant, good behaviour on a ratio of more than one. In other words, mistakes become net present value positive."

Position Sizing

“It is common-place for overall portfolio construction to be as a result of stock weighting built up from one to two to three percent of a portfolio and so on up to a target holding. This means that weightings are anchored at a small number with only outliers reaching double digits. There is another way to construct a portfolio, which is to invert and start at a hundred percent and work down! If fund managers did this, I am sure they would end up with completely different portfolios. Now we are not advocating all the fund in Amazon (well, not just yet at least), but in allowing past habits to anchor portfolio construction we have probably made the mistake of a starting holding that was almost certainly too low.”

Diversification

“The church of diversification, in whose pews the professional fund management industry sits, proposes many holdings. They do this not because managers have so many insights, but so few! Diversity, in this context, is seen as insurance against any one idea being wrong. Like Darwin, we find ourselves disagreeing with the theocracy. We would propose that if knowledge is a source of value added, and few things can be known for sure, then it logically follows that owning more stocks, does not lower risk but raises it!”

“In our opinion, just a few big things in life are knowable. And it is because just a few things are knowable that Nomad has just a few investments.”

“Sam Walton did not make his money through diversifying his holdings. Nor did Gates, Carnegie, McMurtry, Rockefeller, Slim, Li Ka-shing or Buffett. Great businesses are not built that way. Indeed the portfolios of these men were, more or less, one hundred percent in one company and they did not consider it risky! Suggest that to your average fund manager.”

Learning

“We still have much to learn.”

“As a young(ish) man there is something slightly depressing about thinking things through for a while, arriving at a somewhat reasoned conclusion only to find that others have been there before, and years earlier. In some respects we are fifty years behind Buffett, but that’s ok, so long as the average investor is at least fifty-one years behind!”

“Discovery is one of the joys of life, and in our opinion, is one of the real thrills of the investment process; the cumulative learning that leads to what Berkshire Hathaway Vice-Chairman Charlie Munger calls ‘Worldy Wisdom’. Worldly wisdom is a good phrase for the intellectual capital with which investment decisions are made and, at the end of the day, it is the source of any superior investment results we may enjoy.”

Patience

“At the beginning of the AGM of the Berkshire Hathaway Company they show this little video and each year Buffett is asked what’s the main difference between himself and the average investor, and he answers patience. And there is so little of it these days. Has anyone heard of getting rich slowly?”

“Good investing is a minority sport, which means that in order to earn returns better than everyone else we need to be doing things different to the crowd. And one of the things the crowd is not, is patient.”

Summary

These observations are but a fraction of the insights espoused in Nomad’s letters. Discourses on investment edges, the ‘robustness ratio’, business models, ‘value vs growth’, the ‘equity yield curve’, fee structures and behavioural finance more generally, while not included here, are worthy of their own posts. Sleep’s observations on habit change and the implications for internet retailing are imminently relevant in light of today’s Covid-19 inflicted consumer landscape.

Nick Sleep didn’t rely on complex models, non-public information or business relationships to deliver his returns. Like Munger, he reached into other disciplines for mental models he could apply to his thinking. Asking questions, thinking things through, turning ideas upside down and challenging conventional wisdom led to insights other investors couldn’t see. Sticking within his core competency, keeping it simple, and recognising the basic nature of the businesses he owned accorded him the patience to remain invested in compounding machines. Despite Nomad’s closure, Sleep remains invested in Amazon and Costco to this day.

Like Buffett’s missives, Nomad’s wonderfully articulate letters are likely to prove a rewarding resource that can enhance investment success. I implore you to read them. And then, re-read them. These are an absolute rarity that have recently come into the public domain, and offer as much relevant wisdom in today’s landscape as they did when they were first written. The Dead Sea Scrolls, indeed.

Further Reading:

The NOMAD Investment Partnership Letters - 2001-2013 are available on Mr. Sleep’s charitable foundation website here .. I.G.Y Foundation

Follow us on Twitter : @mastersinvest

TERMS OF USE: DISCLAIMER

Learning from Polen Capital

One of the keys to sound investing is having the right information. Its everywhere around us; we just need to know where to look. One of my preferred methods for finding new facts and for learning is to listen to podcasts, and you can’t go past Columbia Business School’s Podcast series: ‘Value Investing with Legends.’

I enjoyed their recent interview with Polen Capital’s Dan Davidowitz and Jeff Mueller. Polen Capital’s track record of outperformance over three decades stems from their ownership of high quality businesses. I’d put them in the class of investor with the likes of Chuck Akre, Nick Train, Terry Smith, Francois Rochon, Paul Black and Nicholas Sleep, who’ve earned their returns from the compounding power of the underlying businesses they’ve chosen to own. These ‘compounding machines’ are often large well-known businesses, each with enduring competitive advantages that support high returns on capital, defying capitalism’s reversion to the mean. Rather than focus on buying cheap and selling higher, these successful investors ride the exponential curve these great companies create. While these stocks may not appear optically cheap, it’s the power of compounding that can render them structurally undervalued for long periods of time.

The podcast reminded me of some useful mental models that only surface from time to time, some of my favourites were the need for a long runway for growth, ‘Culture’ as a competitive advantage, the concept of ‘Attacking the Moat’, and the lollapalooza effect of many competitive advantages working together.

I’ve included some notes below:

Compounders

“The first take away is that nearly all compounders have high returns on capital and high returns on equity. Capitalism is a brutal place and if you don't have the comparative advantage to protect your high returns, new entrants are going to come in and eat away that competitive advantage.

The fact a company sustains high returns is a signal. The necessary condition is the competitive advantage - the high return on equity or capital is typically the output. All compounders tend to have high returns on capital but not all companies with high returns on capital are compounders. That’s important because it means you can’t just run a screen and buy. There is real critical thought and judgement required.

The second takeaway, is that P/E multiples that are optically expensive are often very cheap prices for compounders. No matter how many decimal places you go out to in excel, you're not going to find critical judgement in a spreadsheet. So a clear understanding of a compounders’ sources of competitive advantage is critical for owning one for long periods of time. You have to have a competitive advantage and that has to be rock solid. It has to exist and be sustainable.

Oftentimes for compounders you need low total addressable market penetration, ideally in a very large total addressable market and even more ideally, in one that is growing. This is often an enabler of reinvesting free cash flow at high incremental returns on each dollar invested. The very act of redeploying this capital back in the business at higher returns not only enables the compounding but it also serves to improve, expand and extend the business’ competitive advantages if allocated properly.” Jeff Mueller

“Structurally with the market, it’s very rare that even the third year of earnings is priced into these business [compounders] let alone the fifth, seventh or tenth year. When you find these companies with real durability that can compound for long period of time, the optically high multiple, when in hindsight that was a smoking deal five years ago” Jeff Mueller

What is Value?

“What does ‘value’ mean today? It doesn’t necessarily mean low PE or low price to book. That style of investing is increasingly difficult because it's easier to arbitrage away. It's easier in a modern age of technology and speed of networks and information to find big outliers before they become really big outliers. I think that’s why you’re finding less opportunity in the so-called cheap, deep value places and where you are seeing them is usually in structurally challenged industries. 

Our definition of ‘value investing’ is not just finding companies at a discount to intrinsic value but a permanence to their business and a margin of safety much more tied to the strength of their financials, and a massive competitive advantage and some big secular tailwind usually being created by the company itself that is driving them over the long term.

The market has a hard time discounting properly great growth companies. They have a really hard time putting a near term PE multiple on a company that can grow earnings at 15-20% for ten, fifteen, twenty years. So we find those companies to be structurally undervalued a lot of the time even though their near term multiples look relatively high.” Jeff Mueller

“Using the term ‘value investing’ became a loaded term a long time ago. If you ask me, I’m not a value investor, I’m a growth investor. But it doesn’t really matter. They are two sides of the same coin. We are all searching for the same thing - people want to buy companies at a discount to their intrinsic value and benefit from the growth in that intrinsic value. I think there are plenty of opportunities. We invest in some of the biggest most well-followed companies in the most efficient market in the world. If we can do it, I can imagine there are other people. We are not the brightest people on the planet.” Dan Davidowitz

Long Term

“The industry is structurally built for the short term. How many people are engaged every day are ‘calling the quarter?’ We are playing a different game. We have a five year time horizon and beyond.” Jeff Mueller

Source: Polen Capital - Q1 2020 Newsletter - Focus Growth

Patience

“The first thing we do is really take our time. Our average holding period is a little over five years. This gives you plenty of time to do the research and do diligence on all the companies that might be in the on-deck circle. In 2015, we worked on Adobe for 15 months. Taking your time is critical in assessing the sustainability of competitive advantages.” 

Competitive Advantages

“Competitive advantages come in many forms. There are network effects; Facebook is a terrific example. I would say culture is a competitive advantage that a lot of people would probably take issue with me mentioning because it can’t be measured. But you look at O’Reilly or Rawlins - phenomenal cultures. Intellectual property, like Align Technology, or biotech companies like Allergan. Switching costs can be a competitive advantage; Microsoft 365 or Oracle. It’s been said switching off Oracle is like dental surgery without anesthesia. Economies of Scale and Monopolies and Brands are other examples. Business Model Innovation like Vail resorts. They come in many forms.” Jeff Mueller

Lollapalooza Effects

“There’s this song by Blink 182 called ‘All the Small Things’. For some reason when I think about competitive advantages it pops into my head. The best compounders I’ve studied and the best ones we’ve invested in don’t just have one competitive advantage where you point to it and say ‘yep, that’s it’. They usually have built this mosaic pulling from almost all the competitive advantages; they have networks, and a great culture, and a safe or aspirational brand and also economies of scale. When you get a lot of these working in the same direction it makes the companies almost impossible to really compete with out in the market place.” Jeff Mueller

Keep It Simple

Polen’s Dan Davidowitz

“We’re trying to do it the easiest possible way. We’re not looking to discover the undiscovered gem. We are looking for very very obvious competitive advantages. They are no secrets. You're going to know most of those companies [we own]. They are well covered. Yet still, there’s great opportunities in those companies. We are looking to get the compounding of earnings growth and hopefully the returns in the easiest possible way with the most advantaged companies. It sounds a little too good to be true you can do it that way, but we've been doing it for thirty years and it’s still there”. Dan Davidowitz

Compounding

“We’ve only owned 123 companies in 31 years and that includes the 21 we own today. The compounding is really what drive the returns. You align yourself with 20 or 25 great companies that can compound for not just years but decades oftentimes and they do the hard work for you. You can sit back and spend your time getting to know the companies. We’re getting the same information as everybody else. We are usually asking much longer term questions as we want to understand long term strategy. We don’t care about this quarter or next quarters earnings. We care about where the company is going over the long term.” Jeff Mueller

“You cannot invest in businesses that go very wrong. You need to stay in the game and compound; that is the name of the game. That’s why we try to keep things relatively simple and straightforward and respect our guardrails. The compounding is not that hard as long a you don’t do anything stupid.” Dan Davidowitz

Humility / No Perfection

“The more you know, you start to realise there is a lot more that you don’t. That’s an enlightened place to be. You can study and study companies but you’re never going to know everything you’d like to know. You’re going to know a fraction of what an insider knows and they don’t know everything either. You have to be careful because you’re never going to know everything. So for us it’s a never ending quest for knowledge on our companies. Everyday you have to try to keep finding more and more about the companies you want to know more about.” Jeff Mueller

‘Moat Attack’

“There is a theory you can’t truly know the moat or barriers to entry exist until that moat is attacked and the attack is repelled. The bigger and more well-capitalised the attacker the better. I think of capitalism like nature, it’s just a brutal place; these attacks are happening all the time. This isn’t a concept that has any absolutism but I do think it is a useful tool. When these things happen there is something probably there. We don’t have any blackboxes at Polen. You can open up the Financial Times and see that there is a large company attacking a company or partnering with a company to attack a company and investigate it, ask Why?” Jeff Mueller

Guard Rails

“Which guard rail is the most important? There is a lot of simplicity around our five guard rails. ROE of 20% or greater sustained is a real signal there is something special going on. You know mathematically you could add leverage and really juice the ROE, so the fact the majority of our companies are in a net cash position and also have sustainable ROE of 20% or greater is a pretty special group of companies. Munger said the number one rule of fishing is ‘fish where the fish are’. These guard rails take us down to the pond we like to fish in. In difficult times like this, not only can our companies go on the defensive, but a lot of their competitors are twisting and turning trying to avoid debt covenants in a credit stressed environment. So by widening the gap, they are even more advantaged relative to people who have become less disciplined with their balance sheets.” Jeff Mueller

Human Behaviour

“I think about the world in pretty simple terms. The one thing that hasn’t changed is that behind a lot of the movements in markets are humans and human behaviour. That is important to know because you can take advantage of opportunities when human behaviour drives companies valuations to places they shouldn't go either on the upside or downside.”

Change

“Things change in the real world. Competitive advantages change, the way humans behave changes. It requires good thought and pragmatic thought to figure out which companies are going to benefit. You don't need to find 1,000’s of good ideas. A handful is all you have to find.” Dan Davidowitz

Summary

There are some critical mental models in this; things to look for when you’re searching for those great businesses. Polen’s Guardrails such as a sustainable ROE of >20% and a strong balance sheet, taking a long term view when looking at a company’s future earnings rather than those to be found in the next quarter, and a business having a host of competitive advantages rather than just one. Even more interesting, a large number of the underlying success factors described by Polen can’t be found in a spreadsheet: Culture, Human Behaviour, Critical Thought and Judgement, and Humility are some good examples of those.

Oh, and when searching for and assessing high quality businesses they like to keep it simple. Like Munger has said: ‘the number one rule of fishing is ‘fish where the fish are’.

Source:
Columbia Business School Podcast Series - Polen Capital

Further Reading:
Polen Capital Interview - Graham & Doddesville. Columbia Business School Newsletter. Winter 2019.
Polen Capital Website - Insights

Follow us on Twitter: @mastersinvest

TERMS OF USE: DISCLAIMER

Note: This post is for educational purposes only. I have no relationship with Polen Capital or Columbia Business School.

Learning From Chris Bloomstran

Whilst I’m a long-time avid follower of all of the Investment Masters, and I have to say a veritable devourer of their collected wisdom, there is nothing more valuable to me as an investor than actually speaking with these amazing people. Whether it’s a meeting at Berkshire, the odd telephone dialogue or even an interview, all of these interactions deepen my understanding of their unique views on financial and business matters and for that matter, the investment world.

Recently I had a wonderful opportunity to Interview Chris Bloomstran of Semper Augustus. Chris is a veteran of the Investment Fraternity and a recognised Master; The stocks in his portfolio have compounded at 4.7% above the S&P 500 since launching Semper Augustus more than 20 years ago. I’ve always valued what he has to say and our interview was no exception.

We covered many topics in the few hours in which we spoke, and I am incredibly grateful to Chris for being so open in sharing his knowledge and experience. I have collected the gems from our interview below.

Eclectic Value Investor

“For lack of a better nomenclature you’d put us into the value camp. Value is such a broad brush definition. We simply think of growth as part of the value equation. Growth is important. We are pretty eclectic in our process. We own compounders and we also own some out of favor, high-quality cyclicals; we’ll do the long side of merger-arb here and there. You can’t put us in a style box and I think that’s a big advantage.”

Dual Margin of Safety

“We are trying to find outstanding businesses at low prices to give us a dual margin of safety.”

Investment Time Horizon

“Having invested for 20 years at Semper Augustus and run money for thirty years, our process is very eclectic. We have businesses, such as Berkshire Hathaway, that we’ve owned since early 2000. For the duration of our owning it its been undervalued and it’s become an outsized position in a lot of our accounts. We’ve only sold it when mandate or need for diversification compels a sale. We’ve owned Mercury General and Washington Federal even longer, for the better part of twenty years, and have a history trimming companies like this when they’re rich and adding to the positions when they are cheap. We’ve owned things cyclically where we don’t have a long term horizon such as deep water drilling businesses. Today we own Subsea 7. It’s an engineering and construction company in Norway. We’ve also done things very opportunistically.”

Arbitrage Opportunity

“In 2008 we built a big position in the electrical utility Constellation Energy when it was to be acquired by Berkshire Hathaway. Although we ordinarily don’t like electrical utilities because of mediocre regulated returns, no pricing power and limited growth, we know how to price them. Generally they trade rich because investors are attracted to the dividend yield, which usually consists of most of profits. To us, Constellation was an attractive arbitrage opportunity and we traded the position actively as news broke again and again.

Berkshire offered to buy the business for $26.50 to keep Constellation out of bankruptcy. To effect the deal, Berkshire had to put in a billion dollars to shore up the derivative book of a merchant business Constellation owned in Texas. We had a bit of cash and the market volatility meant an attractive deal spread. EDF, who had a JV with Constellation to develop nuclear plants, ultimately made a counteroffer at $37 and Constellation accepted. As EDF was more of an unknown in the middle of the financial crisis, Constellation’s stock price tanked when Berkshire announced they were out. The stock dropped from $24 to $21 to $19 to $17 then $15 and we bought it at every one of those points except the last, when our final limit didn’t fill. It all happened fast. By the end of 2008 it was our second largest holding. We stayed in it until near the close, actually EDF bought the nuclear assets and the utility was ultimately sold to Exelon in Chicago. We exited in the mid $30’s.”

Position Size

“The businesses at the top of my portfolio are not necessarily going to be the ones that perform the best over the long term but are the ones I know will perform. Generally we’ll start with a 1% or 2% position size. Then as we continue doing our homework, absent some underlying business deterioration, we prefer stock prices to decline which gives us a chance to add to the position size.”

Dealing With Market Turmoil

“Being in the investment business for thirty years and knowing the businesses we own so well, is the best edge to deal with market turmoil. Because we have an anchor in the appraisals of the businesses we own and follow and we’ve done our homework - made accounting adjustments, drilled down to economic earning power and management quality - we don’t have to do a lot of work when price gives us an opportunity. For that reason, we are very non-emotional in times of stress.”

High Quality Companies

“Sustainable returns on equity aligned with very high quality management teams running the businesses is how we define high quality companies. It’s taken a very long time for us to get to that. Leverage is anathema to our thinking. We are running a very unlevered portfolio in terms of the collective balance sheets of the assets we own. Cash largely offsets debt now. Our returns on capital are not far off the underlying returns on equity of the businesses.”

No DCF’s

“We don’t run DCF’s. We think long and hard about the inputs [of a DCF] but we think the model lends itself to assumptions where you can get some crazy results.”

Owning Berkshire

“We’ve bought and still buy Berkshire at 15-20% position size, and it’s grown to 35% in some of our taxable accounts. BRK is unique to us and it’s the only business we would concentrate in that kind of size. We almost use BRK as a bond surrogate, really as our opportunity cost of capital, given a very predictable 10% ROE, which in a worst case could be an 8% ROE. To us, it’s a highly predictable, highly knowable business so for that we are willing to own BRK as a lower return business relative to the balance of the portfolio. It’s the most knowable thing we own. At a 10% unlevered ROE its undervalued by a lot, and if it trades closer to intrinsic we’ll earn something north of 10. If it earns 8 (ROE) for the next 10 or 15 years it’s fairly valued and we’ll likely earn 8.”

Company Issues Provide Opportunity

Investment Master - Chris Bloomstran

“Usually company specific issues provide opportunities. My experience has been that when the whole market sells off and everything gets cheap, it’s hard to want to make changes because we already like what we own. We’ve also proven unwilling to trade down the quality spectrum during a rout like ‘08, even though you’re going to make way more during the recovery. That won’t change.”

Portfolio Turnover

“We’ve had on average about 15% turnover for the last 20 years. Our turnover in 2008 was probably 70%. We had about half of our capital in financials at the end of 2007 which included insurers. None of our holdings failed. In fact, some were rewarded for their conservatism with failed assets more or less given to them at fire sale prices.”

Thinking About Management

“We have learned to think a lot more and spend a lot more time assessing management quality. We are spending a lot more time in the proxy statement than we used to. In our portfolio we only have about 20% of our businesses profits coming back to us in dividends which means management teams are retaining 80% of the profits. It is incumbent on us to work out how those people allocate capital. There are so many levers management can pull and we are very deliberate in assessing how well capital gets invested in the businesses we own.”

The Proxy Statement

“We are spending more time with proxy statements. We try and tie in year to year changes. What we’ve learned by looking at the evolution of proxies over a period of ten or more years, by observing how compensation committees award and incentivise management, is that you can really ferret out underlying changes in the business.

As an example, General Mills’ bonus structure is tied to two yardsticks, none of which are capital related. One is organic sales growth and the other is free cash flow growth. Ten years ago they were using 3-4% organic sales growth as the hurdle for paying half the bonus. Over time that became 3%, then 2%, then 1.4% and in the last couple of years the hurdle has become negative. Think about that! Rev up the acquisition machine. Buy Blue Buffalo. You don’t count a deal in year one but if its a growing business you sure get your organic growth in the out years, regardless of profitability.

Many consumer packaged goods businesses are under-investing in their business and it’s evident in the free cash flow. It’s pretty easy to dial up free cash flow growth by cutting advertising and growth initiatives. I guarantee these people lay awake at night thinking about how to get supremely wealthy in the next five years and not how they are going to grow or protect the business over the next thirty years. If you don’t have a motivation to make decisions based on returns on assets or capital or equity you can get all kinds of nutso behavior. You might as well take a giant pile of money and light it on fire.”

The Macro

“I wish we didn’t have to think about macro. We spend almost all of our time turning over rocks and looking at businesses, but, in my investing lifetime, we’ve seen aggregate debt levels systemically rise to levels we think are unsustainable. And that does enter our thinking. With on-balance sheet debt alone now at 350% of US GDP and 320% of global GDP, we don’t have room for a term structure of interest rates even remotely similar to where it was prior to the financial crisis. The days of 5-7% interest rates don’t work when debt is 350% of GDP.

The notion that debt levels are unsustainable and we are unlikely to grow our way out of what we think is excess leverage, lends to our thinking that interest rates will probably stay far lower for far longer than would be the case in a more normal, unlevered society. For that, you do allow for higher multiples somewhat than would have been the case historically. By contrast, we also think because the debt numbers are unsustainable we very much worry about long term stability in the financial system. The flip side of low rates driving higher multiples is that low rates are reflective of too much debt which goes hand in hand with disallowing growth. Therefore you can’t justify multiples that purely reflect low rates. Paying high prices for no growth won’t work out. Look at Japan for the past 30 years. We have small positions in two gold companies which are really just hedges against central banks doing bad things. Combined they are a mid to high single digit exposure.”

Anchoring - Mistakes of Commission

“Our single biggest error of commission was Ross Stores. We bought the position when small caps were cheap in 2000 for less than 10x earnings and 50% of sales. We loved the business and we loved the unit economics. We bought it as such a discount that during the 2000-2002 downturn which saw the S&P fall 50% we made about two and a half times our money over that period. When it traded for something like 20x we thought we could sell it at what looked like a full valuation and ease back into the shares at some point when valuations were a lot more attractive. I was probably anchored to having bought the stock at 10x earnings. It never traded at 10x again. It traded in the mid teens. After we sold the stock, it went on to be another twenty bagger. A gravely expensive mistake.”

Costco & Growth

“I learnt a lot about the growth component of the value equation by watching Ross Stores. A couple of years after we sold Ross we bought Costco, which has provided an invaluable education about how capital really works. Costco is the same deal as Ross Stores. We love the unit economics, we love the management. Costco had a similar number of stores to Ross when we first bought it. They’d just started paying a dividend. We bought Costco when their gross margin was about 14% and they were earning 11% on capital. We understood, having followed high quality businesses like Walgreens, Walmart and Home Depot for a lot of years, the embedded unit economics of Costco where lots of stores that have been opened recently and don’t reach maturity for six or seven years. Therefore the 11% return on capital was very much understated by the relative installed base compared to new stores that had been opened.

I paid 20x earnings. I was still a classic value guy and value guys don’t pay 20x for things. Fast forward today and Costco trades for over 30x, so you’ve made over 50% on the multiple expansion, but we’ve made over 10x our money on Costco because they’ve grown the store base profitably.

The gross margin has been driven down from 14% to 11%. Wall Street typically kills a company for shaving gross margin, however Costco has taken the scale and purchasing power of the business and they’ve passed their cost savings through to their customers. Returns on capital have gravitated upward towards to the high teens or higher if you account for the cut in tax rates [Costco will likely be one of the first companies to compete away the tax cuts]. Our returns over owning the business for a long time have gravitated toward the underlying return on capital of the business.”

Most Valuable Lesson

“I look at the amount of money we made on Costco and we could have paid 35-40x earnings at the time. Everything they do as a retailer is best in class. You just can’t get anchored to classic valuation pricing methods even if you call yourself a value investor. This is probably the most valuable thing I’ve learned. The extension of that is, if you own a business that really is a true genuine compounder where you have a ramp to grow and particularly for re-investment at high rates of return, don’t sell it, and definitely don’t sell it all. I get cute with a lot of other things that aren’t your classic compounders but any time I’ve sold shares in one of the handful of businesses that I think we can own forever it has proven to be a mistake. ”

When Compounders Mature

“The durability of compounders is really only obvious in arrears. There are very few that are knowable. The risk is when you own a compounder and it matures and starts to face its own competition. Walmart for example, having killed retailers in small towns started facing competition. First from Costco and the like and then internet retailing. Look at Coke for the last 20 years. The core business weakened at the same time it traded for a nosebleed valuation that was awarded because of a glorious past.”

Price Matters

“A great business at the wrong price can be a disaster.”

Long Term Focus

“We have stocks that have some common threads. They have all suffered in one form or another. We’ve been able to look through the short term suffering which is just that, it’s short term. Richemont is a great example. We’ve owned it for a handful of years. Richemont owns Cartier and Van Cleef & Arpels in jewelry. They have ten or so very high end watch brands including Vacheron Constantin, IWC and Jaeger-LeCoultre. Then they own some one-off brands like Peter Millar and Purdey shotguns. The Ruperts, the family that founded the firm had South African tobacco holdings which they sold to BAT probably 30 years ago. Within a holding company structure, they started buying up luxury brands. They’ve done a marvellous job preserving the brands and building them out and growing them intelligently.

Richemont’s watch business, when you count watches sold by Cartier, comprise about half the revenue, experienced a huge growth curve on the back of Asian demand. Richemont grew their distribution by using the store inside a store concept. Retail outlets were located in the best zip codes in Hong Kong, Macau and the rest of the high end world. A few years ago two things happened - the Chinese cracked down on graft and travel visas which really put a dent in high-end watch sales. It gave us the opportunity to buy the stock.

We watched how the CEO, Mr Johann Rupert and the management thought about the long-term viability of the brands they own. Mr Rupert talks about being a temporary steward of Vacheron which was founded in 1855. When sales declined, management recognised an excess of inventory in the retail partner channel. The first thing retailers do when sales slow and they have excess inventory is mark it down. The last thing you want to see happen if your customer just paid $20,000 for a watch is to see it sell six months later on on the grey market for $15,000. Richemont approached their retail partners and bought back a whole bunch of inventory and in some cases physically melted down the precious metal content of the watches.

Richemont is a 65% gross margin manufacturer. Initially I presumed the value of a $20,000 or $200,000 watch was largely in the precious metal or jewel content. Far from it. The higher up the price point, the higher the gross margin. On a $200,000 watch the gross margin can be ninety percent plus. It’s the brand. So to preserve brand they destroyed watches.

They also didn’t want to be in a situation where retail partners could kill the brands so they built out more of their own distribution. They spent a lot of money building out their own bricks and mortar. They sacrificed operating margins for the durability of the brand. The watch business is a good business but will likely only grow 4-6% organically, above nominal GDP, but it’s the fashion jewellery business where the upside lies. Fashion jewellery is very early, it’s maybe 10% of all the jewellery sold and there is a long curve to teach wealthy families about the appeal of high end jewellery lines. Once you’re into a line you’re kind of hooked on it. They’ve now fully bought into the internet. Control of distribution is a common theme across several names in our portfolio.”

Disruption & Change

“Disruption is happening at a much faster pace which makes investing that much harder. What looked to be a durable brand or franchise can get dislocated in a hurry. Things like cutting out wholesalers and middlemen and going direct to consumers, I think we are in the early innings of it.”

“If you get fundamental change on a compounder and you bought it at a high price, the combination of the fundamentals deteriorating and then the multiple revaluation downward can be lethal.”

Understand

“There are reasons we will stop the investment process. We start with either unknowability of industries or industries we don’t like because the economics don’t work for us. They would be the easiest decisions (e.g. Electric utilities without growth and the complexity of pharmaceuticals).

When I think back to the branded pharma companies we’ve owned, despite making a bunch of money, we really didn’t know what we were doing. It’s the unknowability. We’re not scientists and I’m not sure the scientists inside those companies know what’s going to go through the FDA or the EMEA. We don’t have an edge. Being lucky is not a replacement for understanding.”

Business Fundamentals

“Once we get past knowability, it’s onto the blocking and tackling which is the business fundamentals, management quality and how they’re compensated, price & volume, the durability of product lines and all the myriad accounting adjustments we make.

If we have an edge it’s adjusting every business’ GAAP numbers. Most businesses overstate what they earn. We are very good at getting to economic earnings from GAAP or IFRS which is just the starting point.”

Waiting for Price

“We’ve built a working list over the years of c450 companies that we track peripherally. We try and update our thinking on them through the course of the year. We maintain a rough intrinsic value target. When we get a stock trading south of that number we might get interested. It’s a function of sitting around and waiting for price. In the meantime thinking about where you are wrong on the valuation or the fundamentals. Price is then kind of the last thing we look at. When we have done work for 20 years on a business and the price now makes sense it’s very easy for us to put 1-2% to work. To the extent we’ll have to do more work we’ll do it. If we get comfortable we’ll make the position size even larger.”

Circle of Competence

“I would tell my younger self, ‘your circle of competence is way more narrow than you think it is.’”

Independence of Thought

“From a psychological perspective, you need independence of thought, but not to a fault. You need an understanding that the crowd at the extremes is wrong, but for a long time they can be right.”

Client Alignment

“Client expectations are never aligned. Clients expect results and if you’re not racing ahead when markets are, nobody likes to get richer slower. We spend a fair amount of time with process over the years, and telling the same story. It still doesn’t make it any easier. Human nature doesn’t make it any easier. Most people wrongly view the stock market as a casino, and it’s not. It’s a joy and refreshing to find clients who get it, who think about the long term, that are realistic about expected returns and think about what can go wrong and right. It makes way more sense to focus on long-term business performance and not short-term stock price performance, but that’s really hard for most people. It’s easy to see the stock price. You have to work to understand the business.”

Free Cash Flow

“We’re looking for businesses that have an opportunity to invest and build out capacity. We are looking for retail concepts that can grow units over time on an accretive basis and expand returns on capital. Can I build a plant or distribution facility and earn high returns on the investment? Free cash flow in that setting is a terrible concept. It’s a great yardstick if you are in a business that is mature and isn’t going to grow. There are all kinds of flaws with various pricing metrics. It would be easier if maintenance capex was a disclosed number. It’s not. So you’ve got to talk to management and get a sense of what it really takes to replace your capital stock.”

Listen to Transcripts

“We read the transcripts but we might also listen to the transcript to see the nuances, to hear how something is said. The value might be in the Q&A and listening to what was asked and how management has answered the questions.”

Value Line vs Broker Research

“We read and see very little sell side research. We do read Value Line, both the large cap and the small and mid cap editions every week. It allows me to cover the gamut of a lot of companies and industries very efficiently. Thirteen editions. It’s not in-depth but you see each company and industry four times per year.”

Questioning Management

“We don’t want to talk to management about quarterly earnings. We are trying to get to the durability of the business franchise. I want to understand why an insurance company can raise prices by 6.9% but not 7%. That answer is meaningful for me. It’s not something discussed in a SEC filing. But there’s value in knowing that stuff.”

Summary

Chris also suggested some book titles he has read and recommended to others. These include: Sol Price, Merger Masters by Kate Welling, Economics in One Lesson, Freedom’s Forge, The Forgotten Man, Shoe Dog, Railroader, and The Bare Essentials. He gives copies of The Richest Man in Babylon and The Intelligent Investor to lots of students. All of these tomes include fascinating and valuable insights into both business and investment worlds.

Chris is a Master. Even with more than twenty years of my own in investing, Chris still manages to teach me things that add value to my own thinking. He is humble and was very generous with his time, and I am grateful for the opportunity to have spoken with him.

Further Reading:
Chris Bloomstran: The New Super Investors - Investment Masters Class
Chris Bloomstran - Annual Letter [Part II] - Investment Masters Class
Chris Bloomstran – What Makes a Quality Company – Invest Like the Best - Podcast

Semper Augustus - Investor Letters

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TERMS OF USE: DISCLAIMER

Learning From Chuck Akre

One of the traits that sets the Great Investors apart is the ability to be grounded - to remain calm under pressure and sensible when things get hairy. All the Masters have it but none more so than Chuck Akre.

Grounded: Mentally and emotionally stable, admirably sensible, realistic, and unpretentious.

And ‘Grounded’ quite possibly is the perfect word to describe Chuck. If you’ve been an active reader of our blog over the last few years, I’m sure you’ll remember our post on Chuck Akre and his Three Legged Stool. Like Buffett, he prefers to work away from the noise of Wall Street. His office is based in a small Virginian town that boasts a single traffic light. His humility and expertise are synonymous with those we call Master Investors and Chuck has been kind enough to give of his time to us on a number of occasions. He is someone we follow avidly.

Chuck was recently interviewed on one of our favourite Podcast series: ‘Invest Like the Best’ with Patrick O’Shaughnessy. O’Shaughnessy typically has a great line up and as usual, he delivered big time on his recent talk with Chuck. Chuck’s explanations and investment approach are refreshing in their simplicity. Over more than fifty years of investing experience, Chuck has distilled the essence of great investing into three key criteria which he refers to as his ‘Three Legged Stool.’ And while Chuck might be reluctant to disclose insights into his favourite stock positions, he does share a key insight in the Podcast which took him decades to appreciate. The podcast gets to the core of what great investing is all about. The Podcast is replete with pearls of wisdom and anecdotes, all straight from the legend’s mouth. It’s the perfect mental detox to remove the daily noise we get caught up in as investors.

Following are some of our favourite quotes from the Podcast:

Read

“I spend a lot of time reading. That’s how ideas bubble up in my universe. Mostly it is a serendipitous, non-quantitative approach.”

Imagination & Curiosity

“In my career I’ve literally run across thousands of people who were very very bright, but not necessarily good investors. Pure knowledge, in and of itself, is not a ticket to being a good investor. Imagination and curiosity are what’s hugely important. We’ve discovered things over the years purely by being curious and continuing to keep involved in the search process to find these exceptional businesses.”

“I find that curiosity has been useful to me in searching for investments. Relating real life experiences allows me to pursue lines of thought to find a stock that might be interesting.”

“Curiosity and imagination go hand in hand in being creative and identifying businesses.”

Education & Smarts

“I had no background whatsoever in the business world; I was an English major and I’d been a pre-med student and had no courses in business whatsoever. So I had a clean canvas and a willingness and a desire to learn and so my voyage was: ‘What makes a good investor, what makes a good investment?’”

Stocks Outperform Long Term

“I examined early on, and continue to do so, rates of return in all asset categories and made the observation that rates of return in common stocks over a long period of time was higher than anything else on an unlevered basis.”

Compound Returns

“Thomas Phelps, wrote the book, ‘100 to 1 in the stock market’ in 1972, and to this day it remains inspirational to me and fundamental to me in terms of thinking about the issue of compound returns.”

Return on Equity

“A return in an asset will approximate the ROE [FCF return on owners capital] given a constant valuation and given the absence of any distributions. You get that from your quantitative background. There are no constant valuations so you work hard to have a modest starting valuation.”

“If our goal is to have above average outcomes we need businesses to have above average returns."

“We try to identify businesses that have had high returns on the owner’s capital for a long time and we spend a lot of time trying to figure out why that’s so and what caused that. What’s does the runway ahead of them look like? Is it broad and long? Do they still have the opportunity to earn above average returns on capital?”

“Rate of return is what drives us. Did I understand that implicitly thirty years ago or fifty years ago? No! Stuff that is right in front of your face sometimes doesn’t reveal itself in terms of its importance for a long time. I carry a coin in my pocket that says, ‘I am a chartered member of the slow learners.’ And that’s in fact the case.”

‘Three Legged Stool’

“Leg one [of the three-legged stool approach to investing] is the quality of the business enterprise. Leg two is the quality and integrity of the people who run the business and the third leg is, what is their record of reinvestment and what is their opportunity for re-investment? Once we have those in place, we say we’re just not willing to pay very much for these businesses. Those are the three legs of the stool.”

Disclosing Positions

“We try not to talk very much about the companies in our portfolio and we certainly never talk about ones that are coming in and going out.”

In March of 2010, Chuck added their first position to MasterCard. Due to regulatory concerns, MasterCard and Visa were selling at 10 or 11 times. In regards to return on capital, Chuck noted “there isn’t a word in the English language superlative enough to talk about them. You could cut the margins in half twice and you’d still be above average for an American business. So clearly something extraordinary is going on there. It also tells you there is a big target on their back; everybody wants some of that. It tells you they are probably jamming everything they can in the income statement to try to reduce how good the margin is they are showing. We think we know what causes that and we’ve quit talking about it. If you read any research from Wall Street, and we read very little, there is no-one who talks about rates of return they are earning on their capital. Because Wall Street, in general has a completely different business model than we have. Our business model is to compound our capital. Wall Street’s business model, generically, is to create transactions. What is the best way to create transactions? Create false expectations, they are earnings estimates. We call it ‘beat by a penny and miss by a penny.’ That gives us opportunities periodically.”

Keep it Simple

“Everything should be made as simple as possible. Lots of very bright people can build really intriguing complicated ways to find out why something is cheap or expensive. We try to keep things as simple as possible.”

Management

“[The managers we have owned] don’t have a screen in their office showing them the price of their stock. And lots of them do. Sometimes you find it in the lobby of a company and sometimes you find it on the CEO’s desk. That doesn’t interest us. Their focus is on the wrong thing, in our judgement.”

“We have an expression, ‘Our experience is that once a guy sticks his hand in your pocket, he’ll do it again.’ So we just have no reason to go there. We constantly find people’s behaviour which is antithetical to our interests.”

Post-Mortems

“We explore, we learn and we observe; we think a lot about the businesses we have sold. Was that the right decision? We’ve concluded in a number of cases is was not. But who does it perfectly?”

Right Once or Twice + Long Runway

“Here’s an important notion: You only need to be right in your investment decisions once or twice in a career. The challenge is how do you identify that? Typically you want something that’s small.”

Collect Data, Form Judgements

“A pre-med major, an English major, someone involved in the investment business - they’re all the same. They are about collecting data points and forming judgements around them. It’s all the same.”

Not Selling Exceptional Businesses

“If we own exceptional businesses, one of the hardest things in the world is to not sell them. All businesses have hiccups in their business operations and all businesses have things occur that are unplanned for. Nothing is perfect. Not selling maybe is one of the hardest things to do. Maybe one of our greatest assets is our ability to not sell.”

Read Biographies

“Reading business biographies you learn about people’s behaviour. Sometimes you see it through the eyes of a biographer who has a rose tint to the glasses, sometimes you see it through pure actions.”

Career Advice

“Follow your passion. That’s the most important thing. And read like crazy and be curious about everything. It’s relating real life experiences.”

Pricing Power

“I’m always looking for ways to understand pricing power because pricing power is key. What is the source of their pricing power? Think about MasterCard and Visa; we have our notions and we don’t talk about it anymore. And you’ll notice the company never talks about it.”

It’s Not all Quantitative

“If this business was susceptible to purely quantitative approach, they wouldn’t need me and you would just a punch a button and it would solve for all your problems. That hasn’t happened.”

A Question for CEO’s

“One of the questions we like to ask [the CEO particularly] is, how do you measure if you’ve been a success managing this business? As you might expect some say the price of the stocks goes up, or we hit our earnings target, or we delivered on all the things the board asked of us. It’s a rare occasion that the CEO articulates an idea that shows he understands the idea of compounding the economic value per share. Why is that so? Because they’re trained to run businesses. They’re not trained to think about compounding the intrinsic value per share, which is really the single most important thing.”

Learning

Whilst Chuck has continued to out perform the Index for many years, it is interesting to note that his recent above average performance has been done entirely without any of the FAANGS. Many of the Masters cannot say the same; the likes of Google and Apple and Amazon feature in many of their portfolios. Chuck says it was simply because he ‘wasn’t smart enough or quick enough to figure them out.’ Humility indeed. But that said, it doesn’t say he’s not open to considering them.

“Everyday is a learning day and we have to figure out which of those businesses [FAANGS], if any of them are truly attractive, and not subject to rapid changes in technology or governmental intervention or retaliatory issues relating to different countries in different parts of the world.”

Curiosity and Reciprocation

Chuck tells the story of how curiosity, observation and imagination led him to a tyre company with a history of very high returns on capital, a company called ‘Bandag’, which had done well for a long period of time. Chuck arranged a meeting with the company and when he walked into the CEO’s office, the CEO had his feet up on the desk and was eating an apple … “we got a different feel right off the bat,” Chuck noted.

Bandag’s returns were three or four times the competitors. Chuck’s goal was to go meet them and figure out what business they were actually in. Bandag was a tyre company that dealt with independent tyre dealers who retreaded Bus and Truck tyres. Bandag had taken the savings generated when key input costs fell and distributed the windfall to their dealers on the basis the dealers had to use the money in their business, ‘They couldn’t buy new Cadillacs, but they could buy a new store.’

As all the Bandag stores were franchised, each was an independent dealer who worked long hours compared to the competition. In contrast, employee dealers had no share in the profits and worked shorter hours. Bandag very wisely shared the wealth with their dealers instead of passing it all onto their shareholders. As a result they built a huge loyalty network of independent dealers, who continued to use the Bandag products instead of the national tyre companies. This resulted in much higher returns on capital than other tyre companies.

Summary

Just like successful athletes develop strategies to mentally prepare for the emotional rigour of a race or big game, investors can do the same. I find setting aside some time early in the day to re-visit insights from the great investors, be it Akre, Munger, Buffett, Lynch or others, keeps me grounded and mentally prepared for when volatility strikes.

Chuck’s ‘Three Legged Stool’ criteria for identifying great investments is beautiful in its simplicity. His lessons and mental models on other aspects of business and finance are incredibly handy to have at your disposal.

You don’t have to have a major in business to succeed, nor it seems do you need to be the quickest of the mark. It’s Chuck’s innate curiosity and imagination that have allowed him to spot great companies that quite often others have missed. We’re glad to have him in our community of Master Investors and we look forward to many more inspiring lessons.

Berkshire Meeting: Omaha 2019

Source: ‘Invest Like the Best’ Podcast. Chuck Akre interview with Patrick O’Shaugnessy. 2019. Apple Podcasts.

Further Reading: ‘Chuck’s Three Legged Stool’, Investment Masters Class.

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Learning from Jim Simons

To be an Investment Master, one must be innovative, humble, open to learning, and, above all, have an outstanding track record of success.

And when it comes to investment track records, few, if any, come close to those of Jim Simons.

Unlike most of the investors we’ve covered in the The Investment Masters Class, Jim is an anomaly. He’s a Quant, in fact I’d go so far to call him the undisputed King of the Quants. His firm, Renaissance Technologies, is also an outlier. Instead of hiring business or finance graduates, they recruit scientists, programmers, physicists, cryptographers, computational linguists, and mathematicians. These critical thinkers are tasked with sifting through vast amounts of data to profit from the world’s financial markets.

These atypical investors focus on developing algorithms that exploit market inefficiencies, uncovering profitable patterns to trade across the globe.

Jim’s story of how he came to investing is unconventional, to say the least. He’s a math genius who worked as a codebreaker for the U.S. government and only dabbled in the stock market on the side. It doesn’t get more unconventional than that. He then left codebreaking to start an investment fund, initially adopting a fundamental investment approach. When this failed, Jim decided to use his math skills to apply quantitative processes to exploit inefficiencies in the market, and when he did, the results were remarkable.

‘Dr. Simons received his doctorate at 23; advanced code breaking for the National Security Agency at 26; led a university math department at 30; won geometry’s top prize at 37; founded Renaissance Technologies, one of the world’s most successful hedge funds, at 44; and began setting up charitable foundations at 56.’ William Broad, NYT

Over the years, I’ve always enjoyed reading about Jim’s firm, Renaissance Technologies. The firm’s methods are shrouded in secrecy, and employees sign a lifetime non-disclosure agreement. I recently enjoyed listening to an interview with Jim, part of a three-lecture series on ‘Maths, Money and Making a Difference’, where the second lecture focused on his experience in the markets. While Jim was careful not to reveal Renaissance’s methods, he did share a few valuable investment insights. Needless to say, it seems the scientists at Renaissance have built an amazing money-making machine.

‘There are times that go by where we don’t make money in a month. It’s very rare we don’t make money in a month. But once in a while that happens. But it’s always come back.’ Jim Simons

I’ve included some highlights from the interview below:

Continuous Change

‘In a business like this you have to just keep making things better. Improving the system. Because other parts of the system will wear out after a while. People will catch onto it. Like any business you’ve got to try and make things better and better and better, because that’s what everyone else is trying to do. We try and hire the best scientists we can.’

‘You have to keep running. People will discover some of the things you’ve discovered and they’ll get traded out so you just have to keep coming up with more and more things.’

Change Causes Inefficiencies

‘Efficiencies eventually do get traded out if they get discovered. But the market is not static, it’s dynamic; things change. Therefore I think there’s room for new inefficiencies to materialise. I think it’s never going to be that all inefficiencies are out with nothing new to discover. So far our returns have been more or less stable for a long time. We keep finding new things and throwing out things that are no longer working.’

Hire Smart People & Work Collaboratively

‘The model has been, first hire the smartest people you can. Work collaboratively. Let everyone know what everyone else is doing. We have one system and once a week there is a research meeting. If someone has something new it gets presented. It gets chewed up and looked at. The code is there, everyone can look at the code and see what they think, does this really work? It is a very collaborative enterprise and I think that’s the best way to accelerate science.’

‘Just hire great young people into the business, it’s the best thing you can do.’

Fees & Size Limitations

After years of very high returns, the management decided to close the firm to outside capital and return any external capital to outside partners. The firm’s Medallion fund continues to manage only the staff’s capital. The original fee card was likely one of, if not, the highest in the world.

‘First we raised fees to 5 and 36 and the investors complained but wanted more exposure. And then we raised them to 5 and 44 and it was still a good return at 5 and 44. We realised there was a limit to how much we could manage. The system could manage a certain amount but not huge, huge amounts, not hundreds of millions or trillions. So we decided first no new investing from outsiders and then we decided to buy in the outsiders in 2003. By 2005 we had bought in all the outsiders.’

Madoff Experience & Understanding

Interestingly, Jim explained how he had invested in Madoff’s ponzi scheme. He also explained how he got out of it because he did not understand it. After Madoff’s fund blew up, the SEC investigated Renaissance’s fund, given the firm’s secrecy and consistent, exceptional track record. As Jim noted, at this time they were only running internal capital in the fund. External capital was the missing input for a ponzi scheme.

‘We had had money invested with Madoff for a very long time: Not the firm, but relatives of mine, and our foundation had an investment with Madoff, and I knew him a little bit. He was really amazing. He kept coming up with these very very steady returns, come rain or shine. At a certain point I said ‘this guy has to know something that we don’t know’. I had all the trade confirmations going back years so I asked one of the guys to analyse these trades he was doing and tell me what you learn, what’s his secret. So this guy went to work and here was his conclusion: ‘when they put on a position and are buying something they generally get a very good price, maybe the low of the day if they are buying or the high of the day if they are selling. He said, ‘that accounts for maybe ten percent of their profit’. They claim they have T-bills sometimes so there was also interest, but eighty percent of the profits were a complete mystery.

They would put on a big position according to the tickets, with stock that would approximate the S&P index, and then buy a put or call to protect themselves from outside moves. From what we understood they had huge amount of money under management so you would think when they put on the puts or calls it would actually move the market. But we could see no evidence of that. I thought, let’s get out of this.

Even Medallion [Fund] had a little bit. We sold it and nothing happened. Several years went by and my relative called and said ‘do you still like Madoff?’ I said, ‘I can’t tell you to take your money out because he’s been going for a long time and he keeps on going. He must know something’. I said ‘I took my money out’. I couldn’t advise someone to take their money out. It never dawned on me it was a Ponzi scheme. I didn’t know what the heck he was doing, I just didn’t like the looks of it. That’s why we got out. Five years later the crap hit the fan and he was outed. It was the craziest thing in the world.’

Fundamental Investing

‘[Fundamental investing] is a perfectly legitimate way to invest. Look at Warren Buffett, I don’t think he has a computer on the premises, except maybe to count his money.’

‘I think there is a world of difference between being a good fundamental investor and a good quant. A good fundamental investor wants to evaluate the management, have a sense of the human beings running it, a sense of where the market might be going. It’s a set of skills. And some people are very good at it. Quantitative stuff is a different set of skills.’

Source: Bloomberg

Luck Helps

‘Luck plays quite a role in life; we’ve been lucky.’

Work Hard

‘Work hard, hire good people.’

Summary

Jim Simons doesn’t practice fundamental investing, which makes him stand apart from most of the other masters we’ve reviewed. As Jim notes, Buffett prefers to assess a company’s management, culture, and market position before making an investment. In contrast, quants rely on computer algorithms to identify inefficiencies first, then base their investment decisions on that data. Despite these differences, both approaches can deliver impressive track records.

While many investors favor the fundamental approach, Jim is not as isolated in his quantitative style as one might think. Like Ed Thorp, he recognized that his unique skill set was best suited for a quant strategy and pursued it relentlessly. Interestingly, despite their different methods, quants and the other Investment Masters share a common trait—they all apply deep, analytical thinking to achieve exceptional returns.

‘I like to ponder. And pondering things, just sort of thinking about it and thinking about it, turns out to be a pretty good approach.’ Jim Simons

It’s clear there are multiple paths to success in investing. Whether fundamental or quant, both strategies have their place in the market. Jim’s remarkable success is a testament to that truth.

Source:

“Maths, Money and Making a Difference” S. Donald Sussman Fellowship Award Fireside Chat Series. MIT Management Sloan.

Further reading:

“The Secret World of Jim Simons” by Hal Lux
”Jim Simons, the Numbers King” by DT Max. The New Yorker.
“Inside a Moneymaking Machine Like No Other” by Katherine Burton. Bloomberg.
“The Mathematician Who Cracked Wall Street” TED Talk.
“Seeker, Doer, Giver, Ponderer - A Billionaire Mathematician’s Life of Ferocious Curiosity” by William Broad. New York Times.
“James H. Simons, PhD: Using Mathematics to Make Money,” Journal of Investment Consulting, Vol. 22, 2023.
“A conversation with Renaissance Technologies CEO Peter Brown,” Goldman Sachs Exchanges: Great Investors, 2023

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Learning from Ken Langone

I’m sure you’ve realised by now that I love learning. And stories about successful investors and business people are right at the top of my list when I choose what it is I want to learn. I believe I understand my own strengths and limitations, however because of that, I’ve found that enhancing my knowledge of how other people have come to be at the top of their game is truly invaluable when it comes to my own investment processes and thinking.

And Ken Langone and his book ‘I Love Capitalism’ is a man I have learnt a lot from.

‘I Love Capitalism’ is the rags to riches story of billionaire US investor, businessman and philanthropist, Ken Langone. And what a story it is. I came across the legendary Ken Langone in the book about Home Depot, ‘Built From Scratch’. The son of a plumber, a knock-about-student who almost got expelled from college. Rough as diamond, and a brilliant story teller who is poles apart from your typical Wall Street banker, Langone takes you on an exciting journey through Wall Street, weaving lessons of investing, business, people and philanthropy. Langone’s story is also available in a self-narrated audible book, which I highly recommend.

Langone started out as a misfit on Wall Street, landing his first job at a second tier investment bank selling securities. Dabbling in capital raisings, Langone hit the big time when he won the mandate to float Ross Perot’s EDS. With a knack for numbers and sniffing out opportunity, Langone invested in lots of different businesses, including a US home-improvement retailing chain called ‘Handy Dan’. When Handy Dan’s CEO and CFO were improperly fired, Langone encouraged them to start a new competitor with funding he raised alongside his own; this was the beginning of Home Depot. Langone’s later successes spanned health care, laser patents and an early investment in Stan Druckenmiller’s hedge fund.

With a raspy New York accent, and plenty of expletives, the story is enjoyable from start to end. It concludes with a very funny story of Langone’s brush with Ponzi Scheme extraordinaire, Bernie Madoff, where after the meeting Langone asks, “What the f*ck is wrong with that guy?”

I’ve included some of my favorite extracts below..

Capitalism Works

“Capitalism works. Let me say it again: It works! And- I’m living proof - it can work for anybody and everybody. Blacks and whites and browns and everybody in between. Absolutely anybody is entitled to dream big, and absolutely everybody should dream big. I did. Show me where the silver spoon was in my mouth. I’ve got to argue profoundly and passionately; I’m the American Dream.”

Love

“The truth is that I loved what I was doing from the day I went to work, which is one of the great joys in life, I’ve found.”

“I learned early how essential it was to love the work I was doing. Sometimes I look back and wonder, how did all this happen? Then the answer comes. Shit, I know how it happened; I was at a place where I was having the time of my life! I still remember what Hudson Whitenight said to me sixty years ago: ‘If you really love your work as much as I think you’re going to, you’re going to be a big success.’ So I’m saying to a kid, I learned this ex-post facto; ‘you should learn it in front!’”

“I still love my work today; all of it. At eighty-two, I’m still excited to get out of bed in the morning, still charged up about what the next deal might bring. I can honestly say that if it came down to it, I would pay to go to work every day. How many people can say that?”

Education and Smarts

“I was never academically curious. I didn’t apply myself at all. I did the absolute minimum. I was too busy having fun and working at all my various jobs: the butcher shop, Bohack, caddying at the country club, selling Christmas wreaths.”

Learning & Curiosity

“All I knew was that I wanted to make money. And where did you make money? Wall Street… All I knew about Wall Street was that was where you bought and sold stocks and bonds. In other words, I knew nothing. But I read Fortune religiously every month, in the library at Bucknell. I was intrigued by mergers; I was intrigued by companies growing and how they financed their growth. I don’t know why I was so fascinated by Wall Street. I wasn’t from an Ivy League school. I really had no family connections.”

Understand

“I don’t know beans about options: puts and calls and strips and straddles and all this other crap. All I do is pick stocks, and I never buy anything I don’t understand.”

Humility

“The one thing I can’t say and never will say is that I’m self-made. I’m not. To say that would be an injustice to all those people who bought me to the party. I’m grateful to every one of them.”

“Arrogance is the enemy. For many years, Bernie Marcus and I never, ever went into a Home Depot store - never once - unless we were pushing carts in from the parking lot. I used to pray I would see a piece of trash on the floor so I could pick it up. Why? Those are entry-level tasks for the kid who works in that store. When he sees the top guying doing them, he can say to himself, ‘If it’s not too small for them, it’s not too small for me.’ The minute you take away all the artificial barriers between you and your people, you’re on your way to phenomenal success. But it takes a bit of humility.”

Generalist

“[Investing in health care and now home-improvement.. ] Contradictory? Sure! Life is full of left turns, and I’ve taken quite a few of them, following my nose, which has very often pointed me in the right direction. The truth is I can’t help myself; I am a deal junkie. If the phone rings, I’m like the proverbial fire-house dog - off to the races. Who knows who might be calling. More often than not, it’s someone who has a very interesting business proposition. Doesn’t matter what kind of business it is.”

Confidence

“The first big lesson Bindy taught me was one he taught by example. I’d begun encountering some of the big, big guys on Wall Street, legendary guys, men I’d read about in Fortune. These men were gods to me, and I saw right away that Bindy simply wasn’t in awe of them. In short order, he taught me to understand that a man’s public persona usually has very little to do with his private persona. Without that lesson, I would have felt subservient toward these muckety-mucks, but with that lesson under my belt I felt completely equal to anyone I dealt with. And without Bindy in my life, I don’t think I would be as certain of myself as I am and as outspoken as I am.”

Resilience and Creativity

“The Home Depot didn’t exactly get off to a flying start .. If there’s anything I would take a bow for throughout this whole process [Home Depot’s IPO], it would be this: never give up, and thinking creatively, instead of just re-actively, when the chips are down. It’s a style I recommend highly.”

“Yes, I’ve been lucky, incredibly lucky, and you can’t learn good luck. My old man used to say to me, ‘You could fall in a bucket of shit and come up with a gold watch and chain’. But we all fall in that bucket from time to time. What distinguishes the winners from the losers is the ability to turn adversity around: resilience and creativity.”

Focus on People

“People are always your best investment.”

“As I began my tenure [as Chairman of NYU Hospital] my first role was just to lift morale. It was a big lift. I decided to do some of the same things we did at Home Depot; hold town meetings, walk the halls, talk to the staff. Put my arm around people’s shoulders, tell them how much we appreciated them and what we were going to do for them - and deliver. In other words, don’t promise pie in the sky unless you’ve got the recipe to make it… There was a natural suspicion of me at first, as an outsider and non-medical person. A rich guy who maybe wanted to throw his weight around. And I’m proud to say I defused it - by never pretending to be anything I wasn’t, by being genuinely interested in everyone I met, but mainly by being present.”

“Everybody talks about the bottom line, but as I’ve seen time and time again, you ignore the human element of business at your peril.”

Source: WSJ.

Culture

“Home Depot’s great strength was (and still is) it’s culture, and culture isn’t about statistics. In our culture, you don’t measure the intangible value of a sales associate saying to a customer, ‘Can I help you?’, or, ‘You don’t really need that. Come over here and look at this. It doesn’t cost as much, but you’ll be fine with it.’

Store Visits

“Back when the company had first started, I’d recommended a policy requiring every director to visit three Home Depot stores every ninety days, casually dressed and as inconspicuous as possible, and report on his or her findings. What the directors were now finding on their store visits was that something was amiss [post Bob Nardelli’s appointment as CEO].”

Destroying Culture

“When I went to Bob [Nardelli] and told him that I’d been in the [Home Depot] stores and morale was not good, he said, ‘They’re a bunch of crybabies’. ‘Bob, they may be a bunch of crybabies to you, but they’re the most precious thing we have’, I said. ‘They’re the only thing that separates us from everybody else. They’re our secret sauce, our secret weapon. They’re what makes us what we are as a company.’

“My first impression of Bob Nardelli - ‘he’s a real people guy; we’ve got a great operator here’ - had been exactly 50 percent right. The guy really was a great operator. But I came to realize - too damn slowly - that the whole people equation of Home Depot, the essence of our culture, had completely eluded him. To me, the whole issue with Bob was the damage to the culture. There’s nothing like these people in our stores. They’re special. Now, how do you get these special people? Well, you start by treating them special. You let them know they matter. You let them know you appreciate their opinion. You let them know that if they think there’s a better way of doing things than the way they’re doing them, they have an obligation to tell us, and we have an obligation to listen. You also let them know that anybody can build a big store space and put all kinds of inventory in it; the glue that holds Home Depot together are these values. We don’t just say them. We believe them, and we practice them consistently.”

“Bob was a great leader until he wasn’t. Was I too slow to see the writing on the wall? Definitely. Bob was racking up great numbers but ignoring the human equation, and in business good numbers can be like sunlight: blindingly bright.”

Value Employees

“Bob [Nardelli] had developed the mind-set that these people, who started at well over minimum wage and got a raise every year if their performance reviews were good, were a cost. And they were a cost! They were a significant part of the company’s overall costs. And therefore Bob spent a lot of time trying to figure out how he could take that cost down. In my mind, it was like the reverse of the straw and the camel’s back. Nardelli kept taking one straw off, and it reached a point where something very valuable was being lost.”

“We’ve never paid anybody minimum wage at Home Depot. We had a simple belief: minimum wage, minimum talent. We always wanted to have good kids who wanted careers and not feel they had to compromise their pay. We paid them two or three bucks an hour more than minimum. We reviewed them every six months. And from the beginning we were growing like a weed, so we created enormous upside mobility.”

Complacency

“Complacency is the enemy. If we don’t stay focused on our mission every single day, every minute we’re awake, Home Depot will go to sleep.”

Win-Win

“You want my whole philosophy in a nutshell? I want everybody to do well. The world is a lot more fun if we’re all rich instead of just some of us.”

“Capitalism is brutal, but it’s rarely a zero-sum game. Both sides of a transaction should get something out of the deal.”

“One of the most important lessons of my life is this: leave more on the table for the other guy than he thinks he should get. And one of the most important rules in capitalism is incentive.”

Mistakes

“I have no problem admitting my mistakes: I’m loaded with them. But I never bought a pencil without an eraser on it, and God invented erasers on pencils for people like me.”

Philanthropy

“Warren Buffett says that wealthy people should give away at least half their wealth to philanthropic causes. I signed Warren’s Giving Pledge years ago, but in my case it was academic: I’d already given away more than half my net worth.”

“But as much as we give, it keeps coming back; we’ve made all the money we’ve given away and more.”

“We will make sure we’ve given most of our money away by the time we die, with the exception of what we leave to our kids. We want to pass along enough for them to live reasonably well, but not so much that they can do anything foolish with it. We want them to have a roof over their heads, but we also want them to have the meaning in their lives that comes from having to make their own way.”

Success

“As I said, I’ve been rich and I’ve been poor, and rich is better. Yet, too many people measure success the wrong way. Money should be at the bottom of the list, not the top.”

Curiosity

‘A lot [of how I learnt about business] was sheer stubborn curiosity. Whenever I served on a corporate board, I was notorious for asking more questions than any other director on the board. I didn’t give a shit if my question showed how stupid I was. A lot of people are scared to ask questions because they don’t want people to know how dumb they are. I’ve never had that problem.”

Career Advice

“Wall Street got a very bad reputation after the financial crisis, yet 40 percent of college graduates today are going into finance. I tell kids that’s a big mistake. I tell them they should learn the nuts and bolts of a business before going out and trading that business’s stock. I didn’t realize how stupid I was back when I was a salesman at Pressprich! I would look in the most superficial way at the companies whose stocks and bonds I was selling; I never truly understood how those business worked. It wasn’t until I got wealthy enough to buy pieces of companies that I developed a much deeper understanding of them.”

“If there’s one lesson I could pass along to kids today, it’s this; the opportunities in America today are the very best they’ve ever been. You might have to look harder for them than in my day, but they’re there. Boy, do I wish I were twenty-one again and just starting out.”

Summary

Rough language aside, there is a wealth of learning to be taken from Langone. And beyond many of the aspects that denote success that have appeared so many times in other businesses I have reviewed - humility, curiousity, treat your people right and have the right culture - one of the other things that I love is how Langone is not afraid to ask questions, even if they appear dumb to other people. Buffett has said that if you’re reliant on the income that being a Director brings, then you shouldn’t be a Director; you’re unlikely to offer contrary opinions or advice as it may affect that income. Langone’s brusque approach to questioning things he doesn’t understand is crucial if not vital in my opinion - how can we learn if we don’t ask a question now and then? If you’re staying quiet in any effort to not appear dumb, then I believe you have failed miserably.

Further Reading:
‘I Love Capitalism - An American Story’, Ken Langone, May 2018.
‘I Love Capitalism - An American Story’, Ken Langone [Audible - HIGHLY RECOMMENDED].
‘Culture, Enculturation and the Cult of Home Depot’, The Investment Masters Class.
‘Learning from Arthur Blank’, The Investment Masters Class.
‘Talks at Goldman - Ken Langone’, June 26, 2018.

 Keep learning on Twitter: @mastersinvest

TERMS OF USE: DISCLAIMER

Chuck's 3 Legged Stool

Investing is full of uncertainties. You know the story; there are known unknowns and unknown unknowns, but there ain't no perfection, secret formulas or guaranteed riches. Investors have been searching for that elusive recipe for success for ages, and have mostly come up blank. Despite this, there IS one immutable law of investing, that if followed religously and diligently applied will ensure your wealth grows. And rapidly at that. What is it?

It is the 'Power of Compounding'.

And if there's one investor that both understands and seeks to harness that power, it's Charles T Akre. 

"I usually ask my friends this question: Which would you rather have, $750,000 today or the outcome of doubling a penny a day for 30 days. What do I hear? 'Penny.' So that's the question. Compounding our capital is what we're after, that's what makes it a great investment for us. What's the value of compounding? Well the answer in this case is simply astounding. Double a penny a day for 30 days gets you, who knows, $10 million, $737,000 change." Chuck Akre

"Striving for sustained, uninterrupted compounding over long periods of time is smart investing, and that’s precisely our goal. Many people think of us as a 'value investor' and others ask whether we are a value or a growth investor. We’ve started to say, we’re neither, we are a compounding investor." Chuck Akre

Charles Akre, or 'Chuck' for short, runs his namesake fund, the $6b Akre Capital, out of a 'one-traffic light' town in Virginia. Away from the hullaballoo of Wall Street, Chuck and his team spend their days searching for attractively priced 'compounding machines'; rare businesses that have contributed to Akre's long history of market beating returns. 

“At our firm we spend nearly every waking hour trying to identify what we refer to as 'compounding machines'. Chuck Akre

Over the years I've always enjoyed reading Chuck's letters and interviews and to my great delight, I had the pleasure in meeting this down to earth and thoughtful investing legend in Omaha this year. 

Like many successful investors, Chuck has studied and adopted many of the investing lessons laid out by Warren Buffett. Akre is far more latter-day Buffett, with a real penchant for identifying capital light, high quality businesses throwing off cash which can be deployed into high return opportunities.

The Three Legged Stool

Chuck Akre uses the visual analogy of an early 20th century 'three legged milking stool' to describe his investment process; a metaphorical 'stool' provides a more stable and reliable footing than a standard four-legged stool amidst the topography of chaotic markets. It also leverages the Power of Compounding. 

"The essence of our investment approach is perfectly captured by the visual of a “three-legged stool.” This metaphoric three legged stool describes what we look for in an investment: (1) extraordinary business, (2) talented management and (3) great reinvestment opportunities and histories. I have an old three-legged milking stool in our conference room and it is clear by looking at it that it is sturdy and durable. We believe our stool is just as sturdy and durable based on our many years of experience!" Chuck Akre

The investment process starts with the recognition that shares are really pieces of a business.

"Our focus remains entirely on the long-term prospects of the businesses we own. Our simple view is that we will be successful (1) if the businesses we own are successful, and (2) if we do not overpay when buying shares of these businesses."

Let's look at each of the stool's legs in a little more detail...

Leg One : Extraordinary Businesses

The first leg of the stool is the Quality of the Business. The foresight for the first checklist item was in part a result of Chuck's early investment in Berkshire Hathaway; Berkshire's growth in book value was driving shareholder returns.

"I became the best student of Buffett I could and first bought Berkshire Hathaway shares when it had a $100 million market cap. From that happy experience, it became clear to me that the best way to see if a business is adding shareholder value is by the growth in its book value per share."

Chuck also noticed that the long term annual US stock market return had approximated the aggregate return on capital of it's constituent companies. 

"I look at it this way: The average annual total return from equities over long periods of time has been around 10%. When you clean up the accounting, the real return on equity [ROE] of American business averages in the low teens."

Over the long term, he figured that a company's returns were determined by it's ongoing return on capital. A fact well espoused by Charlie Munger.

"Over the long term, it's hard for a stock to earn a much better return than the business which underlies it. If the business earns 6% on capital over 40 years and you hold it for 40 years, you're not going to make much different than a 6% return even if you buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result. So the trick is getting into better businesses." Charlie Munger

When it comes to compounding, it's the rate of return that matters.

“The bottom line of all investing, whether it be Aunt Tillie's C.D. or Uncle Jack's venture fund, is compound rate of return.” Chuck Akre

“We believe that all investing is ultimately about rate of return.” Chuck Akre

Not surprisingly, Chuck looks for businesses with superior returns on capital. 

"Our conclusion is that a stock’s return will approximate the company’s ROE over time, given a constant valuation and absent distributions. So we choose to swim in the pool of companies where the returns are a whole lot better than average, in the 20% range." Chuck Akre

“We recognize that over long periods of time, the share prices of our holdings should grow at a pace driven by the economics of the underlying businesses.” Chuck Akre

Source: Akre Capital

"If we buy companies in which shareholders’ capital compounds at a 20% rate of return over a reasonable time period and we pay a below-average multiple for it, our investors will do extremely well." Chuck Akre

The trick is identifying businesses with high returns on capital and ascertaining what the key factors are that allow those high returns to endure. Often, the secret to those high returns lies in the qualitative, not the quantitative factors. They are not always obvious.

"We endeavor to look past the non-essential details and tune out the often deafening noise. We want to identify the “essence” of each business. So, for instance, what is it about MasterCard that enables them to generate after-tax margins approaching forty percent? Why have the Rales brothers been so successful buying and fixing businesses? How has Markel managed to compound book value per share at fifteen percent for the past twenty years despite falling interest rates and a competitive underwriting environment?" Chris Cerrone, Akre Capital

"The source of a business’ strength may not always be obvious. Therefore, understanding that first leg of the stool, the business model, has its own level of difficulty. It’s also where the fun is, I might add, and we believe it is absolutely critical. As I said, we spend countless hours at our firm working on these issues every week." Chuck Akre

Some of the characteristics that Chuck looks for are set out in the adjacent table found on the Akre Capital website. Through his annual letters and a few insightful Value Investor Insight interviews, Chuck has expanded on the qualitative characteristics which can contribute to above average returns.

"High return businesses have something special which allows them to earn above average rates on employed capital. That may be intellectual property, scale economies, a regulatory advantage, high customer switching costs, or some sort of network effect. We want to see evidence the business model produces unusual returns, to understand why and to believe that’s likely to continue. Part of that is a function of the opportunity yet to be realized – we’re always asking, 'How wide and how long is the runway?'" Chuck Akre

"We believe that the successful business reliably compounds owners’ capital at an above-average rate; provides a highly valued or essential service to customers, with limited competition, and is often a leader in a market that enjoys strong long-term growth." Chuck Akre

“Our favorite businesses will be those which exhibit real pricing power with their brands, which require modest amounts of capital to prosper, which are run by people with equal parts skill and integrity, and which have demonstrated an ability to reinvest virtually all the excess capital that the business generates.” Chuck Akre

Another attraction of owning high quality businesses is the resilience they tend to display in difficult markets. Consistent profitability through business cycles combined with solid balance sheets protects against the permanent loss of capital.

“The practice of not losing money is significantly advanced by the selection of superior businesses.” Chuck Akre

"Our primary frontier of risk management isn’t wide diversification, but the quality of the individual businesses, their balance sheets and the people who run them." Chuck Akre

Meeting the Investment Master Chuck Akre, Omaha 2018

“We want companies that are positioned to withstand almost any economic environment and that have the financial resources to take advantage of opportunities as they appear, be it acquiring new assets, or repurchasing their own shares at very attractive prices (the reinvestment piece).” Chuck Akre

“The relative low level of risk comes not from the absence of volatility, but rather, from the strength of the businesses themselves. This strength is reflected in their balance sheets, their superior returns on capital, and the outstanding quality of their managements.” Chuck Akre

Leg Two: Talented Management

Chuck recognizes the importance of management. Once again, a key learning from the world's Investment Masters is that management matters. Ordinarily good management have a track record of success, are shareholder-orientated, and are capable capital allocators.

"You want to find management that is terrific in managing the business and presumably they have demonstrated that by the time we get involved. We ask them how do you measure your success at this company, by what means? We listen to what they have to say and make our own judgment. Sometimes you get answers such as 'well if the stock price goes up'. Sometimes you find CEO's with screens on their desk watching their stock price all day long. That's not a characteristic we find particularly attractive. My quick judgment would be their eyes are on the wrong thing." Chuck Akre

Source: Akre Capital

"We’re looking for managers who have demonstrated they are 'killers' at business execution, and who have a history of always acting in the best interests of all shareholders." Chuck Akre

"We read piles of shareholder letters, proxy statements, and biographies. We frequently leave our offices in idyllic Middleburg to visit corporate headquarters, manufacturing facilities, and retail locations. We try to ask open-ended questions so we can see how managers think. It doesn’t always hit us over the head right away so sometimes we have to go back more than once." Chris Cerrone, Akre Capital

"I’m not interested, for example, in CEO's who appear personally greedy. I frequently ask CEO's how they measure success. They often speak about meeting the needs of their various constituencies, including shareholders, employees, customers and the community. Many have said they measure their success by the rise in the share price. The closer they get to saying they measure success by growth in the company’s real economic value per share, the more interested I am." Chuck Akre

"We want to invest not only in highly capable managers, but also those with clear track records of integrity and acting in shareholders’ best interest. I’ve found that when a manager puts his hands in shareholders’ pockets once, he’s much more likely to do so again." Chuck Akre

It is paramount management show a history of acting in shareholders interests. Oftentimes helped by a strong alignment of interest.

"Not only do we want to have great business managers but we want see they treat public shareholders as partners even as though don't know them." Chuck Akre

"A company’s shareholders are often anonymous to its managers. Do managers nonetheless feel an obligation to treat those shareholders fairly? A close reading of the proxy statement can be instructive. We look at both the size of the pay packages as well as the incentives that trigger cash and equity bonuses. We love to find managers that have “skin in the game” through outright ownership of common stock." Chris Cerrone, Akre Capital Management

“We look for managers who are owners, and who have always acted in the best interest of ALL shareholders. This leg is the trickiest: our experience shows us that we must follow what these managers have actually done, rather than what it is that they have said they have done. (You know, just the reverse of our parents' admonition: "do as I say, not as I do").” Chuck Akre

Leg Three : Great Re-Investment Opportunities

Chuck Akre's final leg of the stool is capital allocation. Once again, a tenet that is well recognised by the Investment Masters.

"After ten years in the job, a CEO whose company retains earnings equal to 10% of net worth, will have been responsible for the deployment of more than 60% of all capital at work in the business.” Warren Buffett

It's a company's ability to redeploy capital at high rates of return that turns into a compounding flywheel. 

"Over a period of years, our thinking has focused more and more on the issue of reinvestment as the single most critical ingredient in a successful investment idea, once you have already identified an outstanding business." Chuck Akre

Source: Akre Capital

"Does the company have the capital-allocation skills necessary and the market potential to invest all the excess cash generated by the business in projects that can earn above-average returns? In my experience this is perhaps the single most important issue facing any CEO, and is also the area in which management can create or destroy value most quickly and permanently." Chuck Akre

"The ability to earn earnings upon earnings is essentially the definition of compounding. In the long run, we feel strongly that the rate at which the value of a business compounds will approximate its returns on reinvestment." Chuck Akre

"With an outstanding reinvestor at the helm, even an ordinary business can become a remarkable compounding machine. There are abundant examples, including of course Berkshire Hathaway, which began its compounding journey as a struggling textile mill." Chuck Akre

And being a great CEO doesn't imply someone is also a skilful capital allocator.

"Disappointingly, we often discover that managers who excel at running their businesses fall victim to “fuzzy thinking” on the issue of capital allocation. The most common example that we have encountered recently is the payment of a dividend solely to enlarge the potential shareholder base (some funds by charter will only invest in companies that pay dividends). The decision to pay a dividend, in our mind, should be based on a careful examination of alternative reinvestment options (namely, a lack thereof) and an expensive stock that makes more tax-efficient buybacks unattractive. Other commonly encountered examples of fuzzy thinking include a fixation on the near-term “accretive” or “dilutive” impact on earnings per share of acquisitions, or buying back shares irrespective of valuation." Tom Saberhagen, Akre Capital

Three Legs = Compounding Machine

Chuck Akre understand compounding. When the three areas of the analysis line up, the business is referred to as a “compounding machine”. 

“The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine.” Warren Buffett

Source: Akre Capital

The next step is to purchase these businesses at a modest valuation. And then, provided the 'legs of the stool' remain intact, hold for the long term.

“We will be very disciplined about the price we are willing to pay, as in the end our rate of return will be determined not only by the quality of the businesses we choose to own, but importantly by the starting price as well.” Chuck Akre

"Our timetable is five and ten years ahead, and quarterly “misses” often create opportunities for the capital we manage." Chuck Akre

“If you are selling because of a missed earnings report or the trend of the market or something, you’ve stopped looking at the rate of return the company can achieve over time.” Chuck Akre

As Munger highlighted above, even if you pay an expensive looking price, you'll be rewarded in the long term.

“If you paid 20 times for a business that was compounding the economic value per share in the mid-teens and have some level of confidence it is likely to do that for a reasonable long level of time, you will get to heaven doing that.” Chuck Akre

The key point, is holding on for the long term. 

Summary

For more than a quarter century Chuck Akre has invested in compounding machines. His simple 'three legged-stool' process has delivered through different business and market cycles, and has consistently produced enviable returns. It's little wonder he's sticking with his process. 

And as he has said, Compounding Machines are very rare. Akre Capital spend much of their time scrutinising organisations and management teams to determine if they fall into this small category, and most often find that despite holding one or two aspects of the '3-legged stool checklist', many of these businesses fall short. But they do exist, and through diligence and research you will find them.

"Whatever the future holds, we will stick to our process. We are not guaranteed of getting what we want all the time—far from it—but we believe it is the best foundation for getting what we want over time." Chuck Akre

Further Reading:

Akre Fund - Pitch Book
Speech: Chuck Akre - 8th Annual Value Investor Conference: 'An Investor's Odyssey: The Search for Outstanding Investments'
Speech: Chuck Akre - Talks At Google
Chuck Akre Letters https://www.dropbox.com/sh/dvfi54xr6lzgynh/AAAtjtuDZmqRNJdqCW3EV-DEa?dl=0
Interview: Chuck Akre - Compounding Machine - Wealth Track
Interview: Value Investor Insight - Chuck Akre Interview 2006/2011
Website: Akre Capital

Note: This post is for educational purposes only. I have no relationship with Akre Capital.

Learn more with us on Twitter: @mastersinvest

TERMS OF USE: DISCLAIMER

John Neff - a Fifty Seven Bagger!

I can't recall how I came across John Neff's book. It must have been recommended by one of the Investment Masters, but to be honest, the name John Neff didn't jump out at me, and the book certainly didn't either. With pictures of currency symbols on the front cover, I'd be inclined to think John Neff was a currency trader. And I'm embarrassed by that oversight. During the thirty years that John Neff ran the 'Windsor Fund', he increased the initial stake an incredible fifty-seven times. In the process the Windsor Fund became the largest mutual fund in the United States, and John Neff became an investing legend.

"John Neff is the investment profession's investment professional. Nobody has ever managed a large mutual fund so very well for so very long a time. And no one is likely to do so ever again." Charles Ellis

While the commonalities with Neff and the world's Investment Masters are striking, like each of those Masters, Neff had his own style. While he was a low 'Price to Earnings Ratio' guy in every sense of the word, earnings growth was always front of mind. He hunted for things the crowd disdained. And when the crowd's affections turned, he was always happy to oblige. Neff never fell in love with his stocks; every stock Windsor owned was for sale. Neff continually and tactfully recycled funds into 'behind-the-market', undervalued stocks. He condemned institutional group-think and spent his entire career 'arguing with the market'. 

I thoroughly enjoyed John Neff's memoir, 'John Neff on Investing.' While Neff shares his insights into the characteristics that defined him and his investing approach, he does so while taking the reader on a journey through the market action of the 1970's, 80's and 90's. This is such a rare quality to any investment book and can help provide context when looking at markets today. Successful investing, after all, requires an understanding of history. In this regard, Neff's book is an invaluable guide.

"At least a portion of Windsor's critical edge amounted to nothing more mysterious than remembering lessons of the past and how they tend to repeat themselves. You cannot become a captive of historical parallel, but you must be a student of history." John Neff

I've included some of my favourite quotes below ... 

Be Curious and Disciplined

"An inventory of my skills on entering college revealed a relentless curiosity, faculty with numbers, an ability to express myself, and firm self-discipline."

Contrarian Nature

"My whole career I have argued with the stock market."

"Windsor's success ultimately flowed from our willingness to step outside the crowd's embrace and be exposed to the risk of embarrassment."

"Taking the unpopular view was how we made our money."

"Savvy contrarians keep their minds open, leavened by a sense of history and a sense of humour."

Low P/E Works

"Carloads of research statistics demonstrate that low p/e investing works, but no evidence I have seen speaks more convincingly than Windsor's track record. During my 31 year tenure, we beat the market 22 times. By the time I retired, each dollar invested in 1964 had returned $56 versus $22 for the S&P500."

"I attribute success not to genius or blinding insights, but to a frugal nature and lessons well learned. Therein rest my enduring principles, stamped indelibly with the merits of low p/e investing."

"The challenge is to foster opportunities for a free plus, and low p/e investing is the most reliable method I know. If you own a stock where negatives are largely known, then good news that comes as a surprise can have outsized effects."

High Flyers Can be Dangerous

"Unlike high-flying growth stocks poised for a fall at the slightest sign of a disappointment, low p/e stocks have little anticipation, no expectation built into them. Indifferent financial performance by low p/e companies seldom exacts a penalty. Hints of improved financial performance trigger fresh interest."

"Accounting practices leave ample wiggle room. Most companies that are close to earnings targets should meet those targets - particularly when the stock price hangs in the balance. In high p/e territory, if lofty growth expectations are missed by an inch, it may mean that a company has really missed by a mile." 

"When shares of a stock change hands for 30 times earnings, who doesn't recall the day when shares fetched only 12 times earnings? But where were the buyers then? Most were cowering in fear of the latest news report or piling onto the speediest growth-stock bandwagon, even if its wheels were about to fall off.”

“Investors typically bristle at the notion that the crowd governs their behaviour. Countless self-proclaimed contrarians declare that General Electric is a buy at 40 times earnings because it is such a good company.  Hang around long enough and you'll hear variations on that assertion repeatedly. The truth is, General Electric is a very good company - a great company, in fact. But with very few exceptions, markets don't work that way. You can't up the ante forever. Eventually even great stocks run out of gas. So if you bet that GE will go up to 80 times earnings, you're betting against the odds. At Windsor, we tried to keep the odds in our favour."

“Almost routinely, in the aftermath of excessive overvaluation, there is a compensatory penalty on the downside.” 

Low P/E and Late Bull Markets

"Aside from late bull markets, in which good low p/e candidates were largely ignored while growth stocks reached strained and dangerous levels, Windsor's edge was usually formidable."

"Ironically, the merits of low p/e ratios are most compelling amid the clamor for hot stocks and hot sectors, but that is when investors are least likely to listen."

"All investing trends seem to go to excess eventually. In the Sixties, the go- go era swept investors in and judgement out. In the early Seventies, the Nifty-Fifty ruled supreme. In 1980, some experts foresaw a $60 barrel of oil, transforming oil companies to gold. These fads clattered to their inevitable conclusions when expectations encountered reality."

"Owing chiefly to the relentless din or experts who fan delusions (with help from the media), the timing and the magnitude of inflection points take most investors by surprise. But some signals are unmistakable. The marketplace always becomes momentum-laden as inflection points draw near, rife with warnings that starry-eyed investors dismiss."

"The capacity of investors to believe in something too good to be true seems almost infinite at times, especially when the market is crying for a sobering inflection point."

When Low P/E is 'Dead'

“Unfavorable news flags my attention. About the time experts declare low p/e has no future and that stocks ‘du jour’ will rule forever, inflection points are drawing near."

Look Forwards Not Backwards

"Adapting to changing circumstances, we try not to be cowed or intimidated by our own lack of success."

"It would be nice to be able to invest yesterday, but investors don't have that option. You can spend your time regretting that you didn't buy Cisco before a tenfold rise, or you can organise for future performance. That's the nature of the daily investment challenge."

Investment Process

"Sufficiently removed from Wall Street's hullabaloo, Windsor applied our low P/E sometimes boring principles in consistent fashion. We weren't fancy, just prudent and consistent. We always took note of prevailing opinion, but we never let it sway our investment decisions."

"I can't think of a better way to start to understand a company's performance than by poring over its results with pencil and paper."

"My motto has not changed: keep it simple."

"Playing the technical or momentum game has always seemed misguided to me."

"We never sought to own market weighting. We concentrated assets in undervalued areas."

"Rather than load up on hot stocks along with the crowd, we took the opposite approach. Our strength always depended on coaxing overlooked, out-of-favour stocks to move from undervalued to fairly valued. We left 'greater-fool' investing to others."

“A wise investor studies the industry, it’s products, and its economic structure. Industry trade magazines supply very valuable information long before it finds its way into the general consensus. Prudent investors always stay abreast of developments, which is why casual investors usually get wind of change after the stock price adjusts.” 

Stock Characteristics

"My emphasis was on stocks with a future instead of stocks with a past."

"The stocks Windsor bought usually had had the stuffing beaten out of them. Their p/e ratios were 40 to 60 percent below the market."

"Typical Windsor fare featured good companies with solid market positions and evidence of room to grow."

"I assigned great weight to a judgement about the durability of earnings power under adverse circumstances."

"Absent the ability to dominate markets, products and services cannot command premium prices." 

"Growth rates less than 6 percent or exceeding 20 percent (our customary ceiling) seldom made the cut."

“Return on Equity (ROE) furnishes the best single yardstick of what management has accomplished with money that belongs to shareholders.”

"You don't need glamour to make a buck. Indeed, if you can find a dull business that makes money, it is less likely to attract competition."

Source: John Neff on Investing. 1999. John Wiley & Sons Inc..

"What we always tried to do: select the outstanding company in a difficult industry or environment, and fight our way upstream as those qualities became more obvious to the market."

"When areas of the marketplace are under attack, investors can buy the best at little or no premium."

"Dull, ugly stocks found prominence at Windsor, owing to their frequent unpopularity. Insofar, as they were capable of expanding their price-earnings multiples, they fit our profile."

Neff's 'Total Return Ratio'

“No solitary measure or pair of measures should govern a decision to buy a stock. You need to probe a whole raft of numbers and facts, searching for confirmation or contradiction.”

"In Windsor's lexicon, 'total return' described our growth expectations: annual earnings growth plus yield. As a way to measure the bang for our investment buck, total return divided by initial p/e could not have been more succinct. We just never found a catchy name for it other than 'Total Return Ratio'."

"Academicians probably don't celebrate this measure; it's a bit too unsophisticated by their lights. But I never found a better way to express total return relative to what we paid for it."

"Windsor hunted for stocks with a cheapo profile; their total return divided by the p/e ratio was notably out of line with industry or market benchmarks. To put it differently, we preferred stocks whose total return, divided by the p/e, exceeded the market average by 2 to 1."

"For many years, Windsor routinely snatched stocks whose P/E equaled half of the total returns. As the Nineties progressed, this target became tougher to realize. By early 1999, S&P500 earnings were growing long-term at an 8% clip. This plus a 1.1% average yield pegged total return at 9.1%. Meantime, the going p/e hovered around 27 times."

"A stock whose 'total return ratio' exceeds 0.7 matches Windsor's traditional edge."

[Note: While John Neff utilized quantitative data he also focused heavily on qualitative information. In John Train's book, 'Money Masters of our Time', a chapter dedicated to John Neff discusses his investment in Ford which netted Windsor almost $500m in profit. You'll notice similar cultural characteristics which also contributed to the astonishing returns of Home Depot and Walmart..

“Explaining the investment merit of Ford, Neff pointed out that the company had little debt and $9 billion cash. The difference betweeen Ford's management and GM's, he says, is night and day. GM is arrogant, while the men who run Ford are 'home folks' who know how to hold down costs and avoid delusions of grandeur. The president eats with the men from the assembly line, so he knows what they are thinking. A Ford assembly-line worker makes several thousand dollars a year in bonuses, while a GM worker gets next to none. Neff began buying Ford heavily in 1984, when popular disillusionment with the automobile manufacturers had driven the stock down to $12 a share, two and half times earnings! Within a year he had accumulated 12.3 million shares at an average price under $14. Three years later the stock had reached $50 a share and had brought Windsor a profit of almost $500 million.]”

Stock Market Predictions Aren't Necessary

"We were not skilled at predicting the path of the market."

"It is always hard to be too penetrating or too precise about the outlook for the market in general."

Don't Fall in Love

"Falling in love with stocks in a portfolio is very easy to do and, I might add, very perilous. Every stock Windsor owned was for sale."

Don't Just Own your Company's Stock

"Be wary, however, of investing exclusively in the company that writes your paycheck. You may like your employer's prospects, but if business goes awry, you don't want to see your nest egg vanish along with your salary."

Three Areas of The Economy to Watch

“I always watch three areas of the economy for signs of excess: (1) capital expenditures, (2) inventories, (3) consumer credit.”

Summary

John Neff allocated his clients assets into areas of the market that were out-of-favour and cheap in a rational and disciplined manner. And while Neff's strategy outperformed, it didn't always. At times when markets were momentum-laden and valuations were stretched, Neff tended to under-perform. An imminent inflection point was usually at hand.

It's ironic that at the time time Neff published his book in 1999, one of the greatest investment bubbles in history was approaching its climactic end point. In the book's final chapter titled 'De Ja Vu', Neff noted the S&P500 was trading at 28 times offering just a 1% yield. And although, Neff could not see the typical warning signs he looked for, [capital expenditures, inventories and consumer debt] he recognized the risks... 

"With no signs of excess visible in the [typical areas of excess] ... we always have to remain alert to other excesses that are not measured as acutely. The market itself suggests excess."

"Red-hot Nasdaq stocks seem most exposed to reality checks, particularly because five stocks command almost 40 percent of the market capital of the Nasdaq 100 Index. Four of these five stocks advanced more than 140 percent in 1998. This growth is quite unsustainable. Even if growth had been less than 140%, that's impressive, to be sure. My point is: They have enjoyed superlative growth for several straight years. Does the market believe they'll grow in excess of 30 percent for the several straight years? I don't...

If there is any classic lesson in the market place, it's that at some point reversion to the mean occurs. Sooner or later, something happens and growth, particularly high-magnitude growth, is diminished."

Neff's lessons remain timeless: History has a tendency to repeat. While most people forget the lessons of the past, Neff's book is a great reminder of many of those lessons, particularly in light of today's momentum driven market. De ja vu, indeed.

 "All things considered, if I started again in January 2000, I'd follow the identical course."  John Neff

Further Reading:
'John Neff on Investing', by John Neff. 1999. John Wiley & Sons.
'Money Masters of Our Time' by John Train. 2000. HarperCollins [Chapter 9 'John Neff - Systematic Bargain Hunter']

Learn more with us on Twitter: @mastersinvest

TERMS OF USE: DISCLAIMER

Widening Moats + Culture

If you've been keeping abreast of my posts in the last twelve months, you will no doubt have noticed the common trend of the Investment Masters to want to buy Great Businesses. These of course are companies with healthy rates of returns, strong future earnings potential and usually come with a significant competitive advantage. And when the Investment Masters look for competitive advantages, one of the most important a company can possess is a strong corporate culture. 

A couple of weeks ago I had the opportunity to attend a speech by Kurt Winrich about just that subject: 'Corporate Culture'. Winrich and his partner Paul Black run WCM Investment Management, and together manage a $26b global equities portfolio out of Laguna Beach, California. 

A good corporate culture is key to business performance. It is clear that Companies with good cultures outperform those with poor ones. In the recent Robert Cialdini post we talked about a 'cultural flywheel' driven by the powerful trait of human nature, reciprocation. If Corporates treat their staff well, the staff reciprocate by working harder, customers benefit and reciprocate, and the company prospers. In a recent CNBC interview, Paul Tudor-Jones discussed research showing companies that look after their staff and customers and produce quality products, typically earn an average 7% higher ROIC and heavily outperform those that don't. Basically, companies that prioritise staff and customers above shareholders and management perform better.

Culture can be a competitive advantage that's almost impossible to replicate. Winrich and Black's WCM spend 95% of their time looking for companies whose moats are growing and who have corporate cultures that are aligned with those competitive advantages.

And they're not alone in recognising that an expanding moat is a key trait to success. Buffett himself has said that widening the moat is more important in any given year than a company's profit.

"If you are evaluating a business year-to-year, you want to — the number one question you want to ask yourself is whether the — could the competitive advantage have been made stronger and more durable before — and that’s more important than the P&L for a given year." Warren Buffett

“Widening the moat.. that is essential if we are to have the kind of business we want a decade or two from now. We always, of course, hope to earn more money in the short-term. But when short-term and long-term conflict, widening the moat must take precedence." Warren Buffett

"We think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And we tell our managers we want the moat widened every year. That doesn’t necessarily mean the profit will be more this year than it was last year because it won’t be sometimes. However, if the moat is widened every year, the business will do very well." Warren Buffett

It's WCM's recognition of culture as a key input into a company's competitive positioning that makes their investment process somewhat unique. And with outperformance of 500bps pa over the last 10 years, they were clearly something worth digging into. In my quest to learn more about WCM's partners, I found some great interviews and podcasts. One of my favourites was Ted Seides, Capital Allocator's podcast interview with Paul Black. Below you'll find insights from that interview and a few others with links below.

Learning From Failure

"We got here from a lot of hard work, a lot of good fortune and learning from past mistakes and making almost every one you could possibly make, but using that as a source of strength to get better and better. Anyone who doesn't believe that most of life is learning from your failures just doesn't quite get it or they're too young to get it." Paul Black

Focus on Great Companies

"A growth stock investor has a different perspective on the world. You have to be optimistic about the future. I like it because I tend to see the world more positively. It's consistent with where I am psychologically. To me optimists rule the world. I think optimists are the ones who ultimately get it right. Buffett says it all the time, 'Never bet against America'. I'd say never bet against great growth companies with superior cultures that are highly competitively advantaged." Paul Black

People Matter

“A lot of people think it is all in the numbers, we think it’s all in the people” Kurt Winrich

"If you read Phil Fisher's book Common Stocks and Uncommon Profits, I think he has a 25 point checklist on how to analyse a company and interestingly of the twenty-five, probably fifteen are qualitative elements. Which is just the reverse of what most people on Wall Street do." Paul Black

“My favourite example in the US is Costco vs Sam’s club (Walmart division). Those businesses look the same but Costco sales per square foot are more than double, revenue per employee stronger, employee turnover much lower (Sam’s club 44%). Costco pays employee more. Employees are the starting point of customer satisfaction. When people are really happy they give more. A lot of people think company should treat shareholders best. Costco thinks key is to treat employees best.” Kurt Winrich

Focus on the Direction of the Competitive Advantage

"95% of our work is around identifying businesses with growing competitive advantages." Paul Black

"A couple of things define a great growth company. [What we do] is very different from what most people do. We've found if you're just looking for high quality, wide-moat businesses selling cheaply, today you are going to find yourself in a lot of value traps. We've made the mistakes in the past buying high quality, wide-moat businesses cheaply. What we learned because of our mistakes of significantly under-performing the market, is that you have got to stay focused on the direction of the competitive advantage. Everybody's businesses is either getting strong versus your competitors or you're getting weaker. You want to be able to make the case, through pattern recognition and other tools around 'moat-typologies' as we classify it, that the company you're looking to invest in has a strong likelihood of growing its competitive advantage over the next five, ten and fifteen years. If you get that right, any valuation work you do is going to look ludicrously cheap five and ten years out. That's a huge part of what we do that's different." Paul Black

"A lot of people think you just want the biggest moat. Our contention is you need to pay attention to a moat that is growing. A moat that is shrinking can be dangerous. If we find a growing moat how do we have any confidence it will keep growing. We found the number one way that convinces us of that is the culture is aligned to the moat. We want to see behaviours that enhance the competitive position.” Paul Black

"What's more important than just a big competitive advantage is buying a business where the competitive advantage is actually getting stronger. Where you can make the case over the next 5, 10, 15 years the competitive advantage is going to be stronger. If you get that part of the equation rights your going to go a long way to having a successful investment." Paul Black

Place a Premium on Culture

“Culture is a huge differentiator between successful organisations and unsuccessful organisations.” Kurt Winrich

"The second thing we do that's really significant and very different is that we put a huge premium on corporation's culture. That doesn't mean we just want shareholder friendly management team. We want to understand the DNA of the business. We want to know what the core values of the business are, and how those core values relate to the competitive advantage. Because if you can buy a company where the core values of the organisation are aligned with its competitive advantage." Paul Black

"To us the distinguishing characteristic in any investment has got to be determining what the core values are, what animates that culture and making sure there is an alignment." Paul Black

Ensure Culture aligns with Competitive Advantage

"We worked with a guy named James Heskett, a Harvard Business Professor, and wrote a book called the Culture Cycle. It's one of the more interesting books on culture. He's really the person who helped us understand that when you're assessing a culture, the strongest companies are going to be where the cultures and value are aligned with he competitive advantage." Paul Black

"What are the core values of great retailers? It's about taking care of your people. We take the example of Costco versus Sam's Club. Those are two companies in the same industries where the stores look the same. But you look at the financial metrics of Costco, they're twice Sam's Club on every metric. Same store sales 4-5% at Costco versus 1-2% at Costco, Sales per Sqft $1,000 versus $500, Employee Turnover 12% versus 50% at Sam's Club. ROIC 12% versus 4%.  What account for that? To us it has to come down to the culture and the values in the business. In Costco they truly care about their people, they want happy employees. In retail you want happy employees, because when people get a great experience they are going to come back and spend more. The whole value side comes directly from the top. The founder of the company, Jim Sinegal owned a lot of shares but never made more than $300k a year. How different is that from other companies where the CEO is making $20m, $30m, $40m or gets fired and gets a $200m golden parachute. That doesn't usually bode well for the long term cultural success of the firm." Paul Black

"Sam Walton really embraced the notion that you have to bring people along, you have to get people excited, you have to make people happy. You have to pay people well and tie them into the bottom line. He built this culture where people just loved coming to work and they had a lot of fun doing it. As a result they took on these old stale bureaucratic centralised organisations. That works for a retailer. But do you really need happy employees to run a railroad? Probably not. You want people that are highly accountable, that probably think in certain way, more linear, because it's all about delivering an on-time product in an efficient cost effective manner. There is a high cost of failure. Different stresses. Very difficult corporate culture is needed for that than for a retailer. We found there are different cultures you for different businesses that are effective." Paul Black

Assessing Culture and a Widening Moat

"When you are trying to assess a culture one of the best things to do is not just talk to the CEO or CFO but it would be to talk to people who have left on good terms. Of course you to talk to suppliers, vendors and competitors to find who do they/don't they respect. If you talk to people who used to work there and left on good terms you usually get a pretty good picture. What you are doing is building a mosaic when you're going after culture. A lot of people don't do it because you can't quantify it, you can't put it in a box and score it, or scale and number ranking. You really have to build a mosaic." Paul Black

"You can't just walk into a business and say tell me about the culture. If someone goes on for 30 minutes on culture it's important to them." Kurt Winrich

"One question [we ask on culture] is 'what would you tell a friend on how to be successful in your company? What are the three things to tell them to be successful? What's really hard for new hires to really get used to? What are some difficult scenarios? Tell me about your failures, where have you made mistakes. Most people don't want to talk about their mistakes. They move on as if their career was just filled with success." Paul Black

“How do you measure if a moat is getting stronger? It’s pretty easy ex-post. It’s probably best seen in ROIC. Think about it from a competition perspective.  If you have a very profitable business and you have protection then your profits can continue to grow. If your competitors can attack you and copy you, your profits disappear. A rising ROIC is a great ex post measure of growing competitive advantage. Only one problem is that it’s practically useless because the good news is already in the stock price long before its shows up in the financials. You need to find a reliable ex ante measure. We settled on a simple form of pattern recognition. It comes from studying great examples of growing competitive advantages and their life cycle in the past. We’ve studied the great businesses of the past in a case study way and we’re trying to identify and catalogue the markers that tell us in a contemporaneous way whether the moat is growing or shrinking. We can learn something from these things. The ideas are that if the markers are present we feel confident, when they disappear we lose our confidence.” Kurt Winrich

“When you have a culture that isn’t empowering or doesn’t encourage engagement, you’re already hamstrung. A great incentive for engagement and empowerment is ownership - not just from the CEO but other employees.” Kurt Winrich

“To really know which businesses have an edge you’ve got to do the in-the trenches-research, it’s not getting more numbers, it’s just talking to people who know the business. That’s why we us a large network to talk to current employees, former employees, customers, vendors, competitors. Ask questions about competitive advantage and culture. Phil Fisher called it scuttlebutt research. That’s critical.” Kurt Winrich

Rising ROIC Correlates with Returns

"Most managers screen for a hurdle on ROIC over the last 5 years. What we've found more valuable than just the level of the ROIC is the direction. There is a 1: 1 correlation between the direction of the ROIC over a 5 year period of time and stock performance. If you break the market down into five quintiles from the top quintile where they have the most rapidly rising ROIC to the bottom where they have declining ROICs, there is a 1:1 relationship between the best performing stocks on the top quintile and the poorest performing stocks on the bottom." Paul Black

"We'd prefer a company that maybe five years ago had a 4% ROIC  growing to five , six, seven, eight. That's a much better investment than a company that's at a 12% ROIC that might be stagnant over that period of time." Paul Black

Models Won't Give You The Answers

"Most people spend 95% of their time crunching numbers, running DCF models, which by the way has zero competitive advantage because you have thousands upon thousands of people doing the same work. Where we can get a massive competitive advantage is by doing the things that other people are not." Paul Black

Long Term Horizon

"There aren't that many great cultures with alignment to their competitive advantage, but when you find them, you hold them for a long time, ten years."  Paul Black

"In investing, time is your friend. The people who make a lot of money in investing are those that buy great businesses, in our case with expanding moats, and they give them time to work for them over 5, 10 and 15 year pulls. All the people that have created a lot of wealth for themselves didn't do it in a week, or 3 months or 6 months. They did it over a generation." Paul Black

A Tailwind

"You certainly want to have tailwinds. It's just an acknowledgement that is how life works. Anyone that doesn't acknowledge that is just not being honest. I think having tailwinds is essential to success. I think a big advantage we have is we tend to own businesses in the growthier sectors like tech, healthcare and consumer. If you think about the emerging middle class around the globe, as people get wealthier in Brazil, Indonesia, India and China, they're going to buy products from the companies we own. They sell products as these people get richer - that's a beautiful tailwind that not going away for fifteen or twenty years, it's something you can really take advantage of." Paul Black

Manage the Downside

"Everything we do in this portfolio is to manage on the downside. One way is being more times than right on direction of competitive advantage. Because in difficult times if you can own the company that isn't constrained by the financial markets and can allocate capital in to the space their weaker competitors cannot. what you find is that those companies hold up really well. Of course we do the basic portfolio construction and diversifying among sectors and industries and making sure we never have more than 4-5% in anyone name. At the end of the day, everything we manage is to to do well in tough markets. Where we really expect to do well is tough markets. Very counter intuitive. But to me it goes to the heart of what we are doing differently" Paul Black

Ignore the Pessimists

“Our advice is ignore the pessimists. I think humans are naturally wired to look at everything that can go wrong and we tend to miss what is good which dominates most of the time. You watch the news are all you see is crises. Yet when you look back over the 20th century and into the 21st  you find out things end up working really well.” Kurt Winrich

Out of Town

"It's a massive competitive advantage for us [being in Laguna Beach]. There's so much noise in New York and San Francisco and Chicago. The beauty of being in Laguna Beach is that you're not subject to the constant chatter that goes on, which really forces you to be short term in your orientation - to make decisions in 3 and 6 months periods of times versus five and seven year periods of times. We are able to be more thoughtful." Paul Black

Summary

I really like Winrich's comment that you can't just walk into a business and say, "tell me about the culture." Those without good cultures will lack substance in their reply. It clearly is not something they rate. If, as Kurt says someone goes on about culture for thirty minutes, however, then its obviously important to them.

It's clear that companies who build effective Corporate Cultures are better performers. They have a competitive advantage that sets them apart from the rest of the market, giving them a wide moat. And moats are hard to cross. Those businesses that can continually widen their moat each year will likely also continue to grow earnings for long periods of time because they become harder and harder to compete against. Its a no-brainer. Even Buffett says so. 

Follow us on Twitter: @mastersinvest

TERMS OF USE: DISCLAIMER

Sources:

Gratitude, Fun and Growth Stocks - Capital Allocators
Global Investing Webinar with Paul Black
The Rules of Investing: Is value dead? - Livewire

Note: This post is for educational purposes only. I have no relationship with WCM IM.

Learning from Joel Greenblatt

You will have noticed, no doubt, my belief that the information we use to make investment decisions comes from a variety of sources. The data is lurking out there in a wide range of forms for us to discover. Reading is an obvious one, as is meeting and talking with interesting, successful people. Listening is another valuable source of information and I have found podcasts to be both an extremely informative and efficient way of digesting information over time. Given today's excellent variety of formats in which we could hear these sound bites, you can listen in the car on the way to the office, during lunch, or even at work.

One of the best Podcast series I've found is Barry Ritholtz's interviews titled, 'Masters In Business'. Ritholtz runs a great blog. He intuitively understands markets and investing, and he gets a first class line-up of interesting subjects from a diverse array of fields -  from finance to physics professors and even poker champions. Some of my favorites have included Ed Thorp, Brian Greene, Yuval Noah Harari, Marc Andreessen, Jeffrey Sherman and Ray Dalio to name but a few. I enjoyed a recent episode where Ritholtz interviewed Investment Master, Joel Greenblatt. Greenblatt's early success included running Gotham Capital, a hedge fund which compounded capital at an astonishing 50%+pa between 1985 and 1995. I've included some of my favourite comments below ... 

On Diversification...

Greenblatt notes one way to get high returns is to be concentrated. When he ran Gotham Capital, six to eight ideas comprised 80 percent of his fund. He notes that while portfolio management theory doesn’t agree with that strategy, Warren Buffett provides a useful counter:

"[Buffett says] Let’s say you sold out your business and you've got $1 million and you are living in town and you want to figure out something smart to do with it. So you analyze all the businesses in town and let’s say there's hundreds of business. If you find businesses where the management is really good, the prospects for the business are good, it’s run well, and they treat shareholders well, you divide your million dollars between eight businesses that you researched well. No one would think that’s imprudent, they would actually think that was pretty prudent.

"But when you call them stocks and you get stock quotes daily on these pieces of paper that bounce around, people put numbers on it, and volatility, and all these other things where really it’s not that meaningful. You know from one sense if you’re investing in businesses and you did a lot of research and invested in eight different businesses with the proceeds of your sale, people would think you’re a pretty prudent guy.

"All of a sudden if you invested in stocks and did the same type of work, people think you’re insane. It’s just an interesting analogy that I think of when people make fun of me that I was concentrated."

Patience and Hedge Fund Fees - A Conundrum

"I have sat on Penn’s investment board for 10 years, and I saw most of the [hedge fund] managers out there and not many justify one and a half and 20 or two and 20.

And the other part that’s wrong with the hedge fund businesses is that when people pay those kind of prices [ie fees], they are not very patient. So it’s the worst of all worlds. You know, you’re charging too much to your clients and they don’t stay very long because they’re impatient when they're paying so much."

Reading and Mentors

"One of the reasons I read books is because my mentors really came from reading. People who were kind enough to share with me their wisdom over time, people like Andrew Tobias and Benjamin Graham and even Buffett in his letters and David Dreman, who wrote Contrarian Investment Strategy and John Train who wrote the Money Masters. All these people really were helpful in forming and getting me involved in investing and you know I wanted to share some of the things that I learned too, because that’s how I learned.

It really wasn’t so much you know them, some of these people were dead and [yet] they were still sharing [knowledge] with me."

Investors Can't Stick with Winning Funds

"From 2000 to 2010, this was a period where the market was flat but the best-performing mutual fund for that decade was up 18 percent a year. The average investor in that fund managed to lose 11 percent a year on a dollar-weighted basis by moving in and out at all the wrong times. 

Every time the market went up, people piled into that fund, and when the market went down, they piled out. When the fund outperformed, they piled in, when the fund under-performed they piled out. They took that 18 percent annual gain when the market was flat, so that’s great on an annualized basis over 10 year period to beat the market by 18 points, but for outside investors, they went in and out so badly that the average investor on a dollar weighted basis lost 11 percent a year."

Great Managers Underperform & Are Hard to Stick With

"I wrote up a study of institutional managers that showed the top-performing institutional managers for the same decade, 2000 and 2010. Who ended up with the best ten-year record? And, who ended up in the top quartile, what did the results look like?

What the study showed was that 97 percent of those who ended up with the best 10-year record spent at least three of those 10 years in the bottom half of performance. Not shocking. But to beat the market you have to do something different. 

Seventy-nine percent of those who ended up with the best ten-year record spent at least three of those 10 years in the bottom quartile of performance.  And what I love is that 47 percent that ended up with the best 10-year record, spent at least three of those 10 years in the bottom decile, the bottom 10 percent of performers.

So, you know, no one stayed with them."

Remaining Independent & Disciplined

Greenblatt tells the story of how he used an experiment to teach a group of ninth graders from Harlem the concept of independent work and decision making.

"For just one day a week, for an hour a week, we'd come in and teach them [ninth graders] about the stock market ...   I had a fresh opportunity - blue sky with them not know anything about the stock markets - so I really thought long and hard about how I was going to explain the stock market to them.

And so on the first day's class, I brought in a big jar — one of those old-time glass jars filled with jellybeans.  I passed out 3 x 5 cards and I passed the jellybean jar around and I told them to count the rows and do whatever they had to do, and write down how many jellybeans they thought were in the jar. I then went around the classroom and collected the 3 x 5 cards.

Then I said I’m going to go around the room one more time and ask you in front of everybody else how many jellybeans you think are in the jar. I told them you can keep your guess from your 3 x 5 card, or you can change your guess, that’s completely up to you. One by one I went around the room and I asked each student how many jellybeans they thought were in the jar and I wrote that answer down.

So let me tell you the results of the experiment. The average for the 3 x 5 cards, the first guess, was 1771 jellybeans. That’s what it averaged to. There was actually 1776 jellybeans in the jar. So that was pretty good. When I went around the room one by one asking each person publicly how many jellybeans they thought, that average guess was 850 jellybeans.

I explained to the kids that the second guess was actually the stock market.  What I was trying to teach them to do is be the first guess; be cold and calculating, count the rows, be very disciplined in valuing the businesses and not influenced by everyone else around them. When the second guess came in what happened?  What everyone heard was what everyone else was saying and in the stock market, everyone reads the newspapers, they talk to their buddies, they see what everyone else is saying and doing and reading. They're seeing the results in the news every day and they are influenced by everything around them and they’re not being cold and calculating and disciplined.

And so I was going to teach [the students] how to be cold and disciplined and that’s what we try to do. We have a very disciplined process to value businesses and that’s what I was teaching them to do and that is what stocks are, ownership shares of businesses. All the noise, 99.9 percent of the noise you read in the paper every day is really noise, and so that’s — you know, that lesson really resonated"

The Big secret 

"If you can step back and take a longer time horizon, that is the big secret"

Summary

A lot of this speaks to my last post on independent thinking and being out of town. Joel's lesson to the ninth graders is a very powerful message on how we can be influenced by the noise from the herd. How, after careful analysis and independent thought, the class on average was able to accurately determine the contents of the jar. And then, when given another opportunity, they were influenced by the 'noise' of those around them, somehow believing the class knew more then they did, and changed their estimate to one that was inherently incorrect. And how true is that? How often is the market affected by uninformed decisions like this? How often are we influenced by others that know less than us? Joel's thoughts and opinions are valuable to us all and I strongly recommend that you listen to the podcast.

Further Reading:
Greenblatt - WealthTrack Interview
Greenblatt - Talks at Google
Greenblatt - Interview with Howard Marks @ Wharton
Greenblatt - Graham & Doddsville Interview

Books: 

Follow us on Twitter: @mastersinvest

TERMS OF USE: DISCLAIMER

Chris Bloomstran - Annual Letter [Part II]

As I mentioned in my last post, Chris Bloomstran's latest letter is a very worthwhile read. Not only does it cover his views of the market's new breed of Super Investors, it also offers insights into the current market environment. And this is valuable to all of us. Hearing the views of someone with skin in the game and a long term track record of success is going to always offer more value than an analyst's perceptions.

Once again I hope you'll note the similarities between his insights and the Investment Masters Class tutorials. Below are his key points concerning recent market activity and his investment considerations ...

Time for caution?

"When smooth sailing is the forecast, it’s usually a good time for caution."

"When the herd stampedes, danger rises."

"Recent returns over the last several years have outpaced underlying fundamentals across nearly all asset classes"

Reversing the Fed's Balance Sheet

"We have no idea how this reversal in the Fed’s balance sheet plays out. The increase was unprecedented and so will be the reversal."

"Think about interest rate increases as the Fed reloading its pistol. You need ammo if you are going to a gun fight, and when rates were taken to zero, the Fed was out of bullets. It needs to reload to fight the next slowdown, and if rates are zero it has no bullets (that’s how we got QE)."

Bond Buyers?

"With the Fed, for now, no longer in the bond buying business, but rather net selling its debt holdings, who will lend needed capital to the US Treasury, especially if the deficit is growing? The answer can only be private investors, those same investors who were able to allocate capital to assets other than Treasuries when the Fed was scarfing up issuance."

"An investor in fixed income today is beginning a compounding stream with the curve at the mid-1% level on cash to under 3% at 30 years. A rising interest environment will penalise the owner of long-dated debt with price declines, the longer the maturity the more severe the decline. A sustained increase in rates will help by allowing for re-investment at higher yields, but an expectation of returns much above initial yields would be asking for a lot"

Rate Hikes and Recessions

"Every major stock market decline and every recession in the last 100 years was preceded by the Federal Reserve raising short term interest rates by enough to provide the pin to prick the balloon. Note the emphasis on every. Yes, there have been periods where the Fed raised rates and a recession didn’t ensue. Everyone knows the famous saw about the stock market having predicted nine of the past five recessions! That may be true, that rising rates don’t necessarily cause a recession. But as an investor you must be aware that every major stock market decline occurred on the heels of a tightening phase by the Fed. More importantly, there have been no substantive Fed tightening phases that did not end with a stock market decline."

The Importance of Price

"The price paid for an investment is a key determinant of outcome."

"The price paid is the initial bracketing endpoint in a compounding series. The same business at twice or thrice the price can’t be as nice."

Time Arb and Patience

"Time is generally required for investment decisions to bear fruit. We think it is a huge advantage to have the patience, and patient clients, to allow prices to ultimately reflect underlying fundamentals."

Dual Margin of Safety: Price and High Quality

"Our dual margin of safety approach combines high business quality with attractive price. One important aspect of business quality is a modest to reasonable use of debt in the capital structure."

Low Corporate Debt and Outperformance

"We believe the far more modest use of leverage [on balance sheets] is important in many ways and strongly has contributed to our outperformance during all bear markets and times of financial crisis over our two-decade existence. Included are the 2000-2002 and the 2008-2009 episodes, which shaved 50% and 65%, respectively, from the index."

"Low debt levels allow managements versatility on the capital front in times of crisis or distress. An unencumbered balance sheet can tolerate the addition of debt when opportunity presents itself."

Earnings Yield

"The inverse of the P/E is the earnings yield, and it’s one of the most important numbers in investing."

"Our core assumption over time, [is that] if we've assessed profitability properly, we should earn the earnings yield of the portfolio, not even allowing for future growth. In addition, we also expect to earn the closing of any discount to our appraisals of intrinsic value"

Source: Semper Augustus 2017 Letter

Portfolio Analysis

"The stock portfolio is now priced at 13.7 times normalised earnings [versus 23.4X for the S&P500], giving us a 7.3% earnings yield, which becomes our new base case return expectation for a ten to fifteen year horizon."

"Our businesses possess a higher margin structure than the amalgamation of the businesses comprising the S&P500"

"As we survey the managements of the companies we own, we have never had a better roster of management teams"

"Our companies earn far more on their invested capital, which we think is a huge advantage. We also possess far higher EBIT on total capital invested."

"We have $73,000 in earnings power per $1 million working for us against $43,000 for the market. Our relative advantage is as great as it was at the last peak in 2000"

Buy-Backs and Incentives

"Captains of industry, who spend scant few years at the helm, on average, have little incentive to think long-term about return on capital when their horizon to get crazy rich spans the short-term. Stock buybacks, regardless how expensive, are a buy ticket. They reduce shares outstanding and are accretive to earnings per share, period. That they are made at absolute levels which drive profits properly measured downward is largely irrelevant."

Capital Allocation

"The reinvestment of retained earnings is one of the most important jobs of the managers of public companies that retain shareholder profit. Assessing how well they invest those retained profits is one of our most important jobs as investors."

Great Investors don't always Outperform

"The great track records are not produced in linear fashion, and are far from consistent. Outperforming over many market cycles is not done each year, or every three years, or five years, or ten years. There are long periods of underperformance that go with every outstanding track record. All the great investors have had clients leave them after periods of underperforming. Walter Schloss, who compiled one of the all-time brilliant track records, shrugged as he was losing clients in the late 1990’s because he was underperforming and wouldn’t give them the tech and internet exposure they felt they needed. He had seemingly “lost his touch” and was out of touch with modern thinking. Many that fired him had been clients for decades, having invested with him since the 1950’s and 1960’s. It must be expected that long term outperformance will come with durations of underperformance, perhaps as much as half of the time over short-term intervals. As the intervals lengthen, periods of underperforming recede. At the end of the day, we all know what happened with the tech bubble. It ended badly."

Acknowledging Fear

"How many investors do you know that sold everything in 1974, or 1987, or 2002, or 2009? We’ve met plenty. And of those, most have rushed back in, but only after sustained recoveries, when the appearance of risk has receded."

Recommended Books

"Ben Graham’s, The Intelligent Investor - the best investment book ever written for the lay person"

"Ben Graham and David Dodd’s Security Analysis is the bible for value investors."

Passing Investing

"A takeaway for those passively invested or index-hugging: It is very difficult making money when the price paid is high."

"The proportion of the stock market passively owned and flowing into passive investment strategies are at records. The concept of passive investing is simple, efficient and grounded in logic. However, a good idea taken to excess can produce a terrible outcome."

"An index holder owns the whole index – every component at the prevailing price, regardless of quality or price. No exclusions. We saw this picture show in the 1990’s and it ended badly. Money is funnelling into the largest of index components, pushing valuations and index weights to extremes. Risk is mounting in passive portfolios, and it’s largely of the passive investor’s own making."

"Large flows [from indexing] can impart a momentum effect, driving narrowing prices in certain assets higher. Often, those allocating capital don’t even realize they are contributing to momentum-induced returns. Many are simply reacting to a fear or envy of not having an allocation in microcaps in countries beginning with Z, especially if all the other kids are already there and making money. The mindset breeds mediocrity at best, and ultimately can be a dangerous thing."

"If we owned the S&P 500 we’d probably be ill from watching companies squander capital. We’d own companies with aggressive accounting that write down assets to boost returns on equity and capital. We’d have shares being bought at prices that we would never pay. We’d own businesses with huge unfunded pension funds that have little chance to earn enough on their plan assets to fund plan liabilities. We’d own companies that exclude one legitimate expense after another from their “pro-forma” or “adjusted” earning presentations. No thanks."

"Mr. Buffett has made clarifying remarks about his advice regarding indexing and passive investing. He duly notes that outperformance can’t be accomplished without certain elements. It requires devoted work and proper wiring, which involves a willingness to deviate from the herd or the crowd. Outside of a value-based approach, there aren’t approaches that have the right orientation."

"As money moves from ETF to ETF, somebody is making an active decision with passive investments. You could make the case that flows to the ETF world are done with less, or little, concern for valuation, with no attempt to capture a disparity that may exist between price and underlying value."

"At what point does the growing proportion of indexed assets become dangerous? The S&P 500 as a proportion of the stock market is far more concentrated now than at any time. Some of the increase is surely the result of mergers and acquisitions. But the degree is concerning. Also, as the index marches higher, it attracts more capital and the momentum drives prices up far faster than underlying value, at a point making it impossible for future results to come close to anything reasonable or expected."

"Recall the logic, or lack of, that for every $100 invested, $3.80 must now go to Apple shares. $2.90 must be allocated to Microsoft. Amazon gets two bucks, Facebook a buck eighty, and so on. It does not matter the price to value. It does not matter if the business will go bankrupt. If it’s in the index you must own it, in the proportion at which it exists. The more money gravitates to the index, away from other pools or strategies, the higher the largest components will rise. Somewhere between then and now, the amount of momentum-induced concentrated risk rises. At a point, prices are no longer reflective of fundamentals. To a passive investor, it matters not. It matters quite a bit to us, however, and it presents opportunity."

"Large cap active investors have been replaced en masse with a passive approach."

"Words can't do justice to the degree to which passive investing is now in an epic bubble, with money funnelling into a narrow group of names. Behold the insanity... Wow, I would never have guessed that passive index flows could create this kind of unnatural disparity across every major equity index! [see table below]"

Source: Semper Augustus 2017 Letter

"Capital allocators keep feeding the fat kid"

"Money is pushing the largest even higher and it likely doesn't correlate to underlying fundamentals. It's flow, baby"

Source: Semper Augustus 2017 Letter

"We don’t know when the situation will reverse itself. If you believed flows to passive funds and strategies would continue to run, why not just own the five biggest components of each index? Had you done that in 2017, you would have looked like a genius. When the flows finally reverse course, the money invested in passive portfolios is going to get hurt."

"Capitalizing on opportunity requires thought, which can’t be done with software allocating $3.80 of every dollar invested to Apple because that happens to be its weight in an index."

"Passive investing is done with computers allocating capital based on component size in an index. Attention is not paid to business quality, and a rising price attracts more capital. It can be a self-fulfilling phenomenon, until flows reverse. Investing as we know it requires thought, experience, patience and reason. Too much active investing is done poorly." 

Chris has identified many important aspects in his commentary that should provide valuable insight to us all.  Whether its the history of Fed hikes, the evolving status of central bank balance sheets, the comparisons of the similarities between the tech bubble and today, or any of his other perceptions, all should go a long way to assisting you to look at your own investment activity with a little more knowledge. And that can't hurt, right? 

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TERMS OF USE: DISCLAIMER

Christopher Bloomstran: The New Super Investors

I always enjoy reading the letters of investment managers with long term records of success; whether it's a new investment idea or perhaps a new ways of thinking about the economy, markets, psychology, risk or market history, there is always something to learn. Give me a letter from a practitioner with skin-in-the-game over a Wall Street analyst any day of the week.

And Christopher Bloomstran's are no exception.

Christopher Bloomstran founded his firm Semper Augustus Investments in late 1998, toward the peak of the internet bubble. He named the firm Semper Augustus after the most rare and valuable of the high-end tulips during the Tulip mania.

Bloomstran's 2017 Annual Letter, is a fascinating 44 page journey through the current market environment. There are two key areas of learning within its pages. Firstly, as it wades through Bloomstran's perceptions of the market, it compares the similarities between the tech bubble and today, provides insights into the history of Fed hikes, delves into the evolving status of central bank balance sheets, ponders the implications of the transition away from quantitative easing, and provides metrics delineating the Semper Augustus portfolio with the S&P500. It also highlights the trends and risks in passive investing. Secondly, and for me the most enjoyable section of the letter, it identifies the common threads that run through what Bloomstran refers to as, the New Super Investors.

Given its size and the amount of territory it covers, I've decided to split his letter into those two areas and therefore two separate posts - the current market environment, and the topic for this post; the New Super Investors.

The New Super Investors

One of the things that should strike you almost immediately is the striking parallels between the characteristics and traits Chris identifies of these Super Investors, and the topics contained in the Investment Masters Class tutorials.

"It’s not the nuts and bolts that go into a track record that matter. It’s the people behind the record. The light finally went on once real thought went into identifying the commonality between these investors and friends."

It’s not why they own a certain company or even how high is too high a price to pay for an outstanding business. The single common thread shared by the very best investors in our circle is a love of and passion for business analysis. Ours is not a business but a profession, and the best live, breathe and eat it. Understanding a business is like a solving a puzzle. They are curious. They are also deeply devoted to their families and live moral and ethical lives. Knowing them is a privilege. In thinking about them collectively, those who would be perfectly suited at managing our families’ capital if we couldn’t do it, what they earned over the last one, three or five years is irrelevant. Each should outperform markets over the very long haul, but that’s not what’s relevant either. It’s the threads regarding character and philosophy that count, with character being by far the most important.

On Character: Every outstanding investor we know is humble. The investment business teaches it, as does life. At the same time, each is happy and successful.

An ability to admit and know when they are wrong. Investing provides plenty of mistakes to be made and to learn from. Mistakes learned from lead to confidence. Confidence can only be earned through failure. The best freely discuss mistakes and use them as lessons.

All have an insatiable desire to learn, and a high work ethic. Intellectual curiosity is hard wired.

It’s never a job and there is no time clock. Some snuck in annual reports on honeymoons (not advice for you young guys who haven’t yet been initiated to the bliss of marriage). Some friends would lay on the floor reading company filings by the tub as their toddlers bathed.

Many had a chip on their shoulder. Each wanted a better life and independence from worries about money.

Perhaps it’s the nature of our small corner of the value world but everyone is extremely collegial and nice.

Willingness to teach and give back for the gifts of wisdom learned from others is a common thread.

Contrarianism. When it matters, not for the sake of it.

Extreme patience.

Independence of thought. This goes hand in hand with contrarianism. None are hindered by large group think or decision by committee. Even in larger groups, the individual is allowed autonomy of process and thought. In fact, some of the very best investors work together in partnership with like-minded peers and as a group are collectively outstanding.

On Philosophy: All possess a core belief that a disparity can exist between price and value. It’s the key concept of value investing. Price matters greatly. The best are disciplined on both business quality and price. Growth is a part of the value equation and the price paid for it matters. The investment process to each is consistent, repeatable, easily understood and explained, and is a competitive advantage.

Risk is a permanent loss of capital. It’s not the volatility of price. Price volatility simply creates opportunity at times when price and value are disparate. The best I know spend far more time worrying and thinking about what can go wrong than modeling what will go right. Without a deep understanding of the downside, even of the unfathomable, conviction and concentration can be dangerous to disastrous.

Each own concentrated stock portfolios in deeply understood businesses, with high conviction about the business and its value. Without the appreciation of risk, however, these unique aspects of great investing can become the Achilles heel of value investing. We see too many young bucks wanting to build a track record in three years, swinging for the fences in only a few extremely concentrated ideas. Stewardship isn’t on the radar. When the unanticipated comes along, and we’ve seen it with the young and inexperienced as well as with the seasoned, big bets that weren’t well thought out or that misunderstood risk that was there all along, can produce disaster. The best investors understand diversification but know when it’s too much, and when it’s not enough. None are index huggers, it would be anathema to their belief system. None are concerned about having investments across multiple or all sectors. But they all appreciate risk.

Unconstrained. You don’t know where the next opportunity will come from, you have the capability to research and understand it, and you have the mandate to invest in it. Those that are boxed into certain segments invariably must invest in those segments, even if the entire segment is uninvestable from a business quality or price standpoint. We know very good industry analysts that wouldn’t make for good investors.

Not managing too much money. Many have stopped taking new assets or clients on. An ability to buy smaller cap and mid-sized businesses in meaningful enough size when value exists in smaller names is important to the best we know. One of the silliest things seen is the investor who must sell an outstanding business that has grown too large for his “mandate.” Size is an anchor, but so is too little time. Knowing if you are being pulled in too many directions is a common issue and the best understand and deal accordingly with it. Time for reading and thinking is a necessity and the best guard it well.

Every outstanding investor we know lives in the footnotes. Deep research on individual companies is in their DNA, and it’s a never-ending process. Business changes, risks that didn’t exist appear, sometimes slowly and sometimes suddenly. At the same time, however, living in the footnotes isn’t done so deeply that you get so bogged down in an irrelevant data point that you miss the Mack truck barreling full speed right at you.

Patient temperament that results in low portfolio turnover. Active management shouldn’t require activity. Until you own businesses whose share prices grow to three, five, ten times your original investment, you don’t really have an appreciation for compounding. Time is the arbiter of value, and when you have businesses that grow, and those that don’t, only then, over the passage of time, can you truly understand the drivers of compounding. It’s all right there in a discounted cash flow formula, but until you live and breathe it, I don’t think you can understand or appreciate it. Investors that buy and sell all the time, thinking high levels of activity add value, don’t allow themselves to learn the nature of compounding. All great investors we know have companies in their portfolios that have compounded for years.

Expanding on the last point, by owning businesses that have compounded for years, an appreciation for growth and what growth is worth is a common characteristic. Mr. Munger talks about Mr. Buffett’s evolution as an investor. We see it in the businesses our contemporaries have owned for years and decades. Cash is another anchor, and held too long drags returns downward. Holding cash for long periods of time doesn’t help. We’ve never seen it help others. It certainly hasn’t helped us. Allowing cash to accumulate briefly as part of the investment process can be necessary to the process. When it happens, it should be during the rare times of very high market overvaluation. The opportunity cost of waiting around for years for prices to fall is an expensive one, particularly when cash yields are far below available earnings yields.

Aware of one’s circle of competence. This comes with the humility listed first that we see every day in the best investors, and it also comes with having made mistakes by treading too far outside the circle. Universally, mistakes aren’t brushed under the rug but they are studied and used as teaching tools or reminders. The passion for the business and the amount of ongoing learning that goes on works to expand the circle over time.

Act like business owners. No one thinks about stocks without thinking about owning the business first.

Investing is a profession, not so much a business. They don’t invest using different “strategies”. Investing is not a strategy but a philosophy. Some do have multiple “products” and make it work, but the core research process is the same. The very best don’t have teams covering myriad sectors or caps or regions. The best groups are made up of generalists, and the investment philosophy is universally shared. There is a sacrifice involved in investing well, and it often results in fewer assets managed. You can’t be all things to all people and you can’t serve multiple masters, and they don’t.

Expectation of underperformance, even for many years. Intelligent allocation of capital takes time to work. Good investors understand this, and don’t think in the same time intervals as many who allocate capital to them for management. It’s an enigma of the investment world. Too often, when periods of underperformance create doubt, both from within and from the outside, the temptation exists to change from what is seemingly not working, not producing relative results, for what apparently is. Those who understand why what they do works over time don’t change philosophy and do develop the ability to deal with and address the doubts. It often requires the ability to communicate well.

Whether working individually or as a group, a culture of excellence and stewardship exists. Compensation and ownership is structured logically and avoids any motivation to behave badly.

Much more could be added to these common threads of character and philosophy, only because we are blessed to know some outstanding human beings. Life is easy when the people around you are extraordinary. Whether in the investing arena or at home with family, life is a joy thanks to people that make it that way. The motivation for discussing the commonalities among the great investors and friends we have the privilege of sharing the arena with wasn’t to let you know we have the succession planning box checked. We do, but that’s not it. We wanted to highlight the characteristics of active investors that do it right and who understand risk deeply. With the capital allocation world pouring money into passive strategies, there is going to be a reminder that risk is a four-letter world. The logic behind indexing makes perfect sense, but its overuse today is likely going to harm a lot of people.

It really is no surprise to me that Chris also recognises these success traits among both the Investment Masters and the new Super Investors. Time and time again we see the similarities that exist in all of these people, even as we notice their tremendous track records.

Chris' letter also contains a significant amount of insight into the current market environment and his portfolio characteristics that we will cover in our next post.

Further Reading:
'100 Common Threads of the Investment Masters' Investment Masters Class

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Learning From David Einhorn

David Einhorn, the President of Greenlight Capital, has one of the best long term investment track records on the street. From inception in May 1996 to the end of 2016, Greenlight Capital compounded at 16.1% pa net, significantly outperforming the S&P500.  

David is a value investor, but unlike your typical value investor, David takes the traditional value investor’s process and inverts it ... "The traditional value investor asks “Is this cheap?” and then “Why is it cheap?” We start by identifying a reason something might be mis-priced, and then if we find a reason why something is likely mis-priced, then we make a determination whether it’s cheap." Oftentimes there will be a short term structural reason for the cheapness - a special situation such as a merger, a spin-off, a debt issue or significant complexity or uncertainty etc - that is creating an opportunity.  

I enjoyed a recent rare interview with David at the Oxford Union Society. In a similar fashion to inverting the typical value investor's process, David also inverts the natural tendency for investors to think they're right when a position moves against them. I enjoyed hearing David articulate how his natural presumption when a stock goes against him is not that 'he's right', but that 'he's missed something'.  A useful mindset to help overcome confirmation bias.  

David discusses the similarities between poker and investing, why he's maintained his short basket despite his reticence to short stocks solely on valuation and the cultural and behavioural keys to successful investing. 

I've included some of my favourite quotes below [Please click on the links to see the Investment Masters insights into those topics]

Love

“I love it. I love trying to solve puzzles. I love trying to find investments. I love trying to figure out what it is that is motivating a situation where we have a difference of opinion”

Thinking

“If I had to pick one reason [for Greenlight's success] it’s critical thinking skills. It’s the ability to look at a situation and see it for what it is, which isn’t necessarily what is presented to you. When something doesn’t make sense, question it, challenge it, look at from a different way and you often come to the opposite conclusion. You don’t have to do that very often. Most of the time when someone tells you something, it makes sense, but sometimes it really doesn’t make sense and there is another side to it. When you can come to a view, maybe just a few times a year, where you have an important difference of opinion with what everybody else is thinking about a particular situation and you can figure it out and it’s important, we’ve been able to make a small number of large investments that the vast majority of the time have worked out very well. [It’s] because we really have had an important difference of opinion between what we think and whoever is on the other side of the transaction ”

Culture, Humility & Change

“The culture of the firm is a lot of smart nice people.  I think we interact well, there is a lot of humility. People respect one another, they respect one another’s views. People respect me, I respect them. I respect their time which is an unusual management culture for senior management people to truly respect the time of junior people.  You wind up with a group of people who are critical thinkers, that think and reason things out before they speak, that can adjust to new facts, that can adjust to feedback and work well within a culture”

Humility, Constant Re-assessment & Patience

“It’s not about sticking to our guns [in contrarian positions]. It’s about re-assessing constantly. When positions don’t work and go against you the presumption is not “we’re right, the presumption is “we might have missed something here”. Then you have to go back and think about it again and again and again. You have to understand the other side and see if anything has changed, see if your view has changed and if it has changed to modify the position. You might eliminate it, or you might reduce it or you might sometimes increase it, but very rarely. Generally speaking my inclination is, when the position is not going well, it’s more likely we’ve missed something so the choice is generally either reduce or eliminate or simply keep it if we think its right. On the other hand if we continue to think we’re right, I find patience is the way to go. We have to wait and let the story play out, while we continue to re-asses it to see in fact we were wrong”

What you Know, Can Infer and the Range of Outcomes

“Investing in a poker game and investing in stocks, at least the way I do it, is a very similar skillset. You have certain facts you know, in stock investing it’s whatever objective information you know about a company or a situation - what is the stock price, what the company does, what are their sales etc. Then there are things you can surmise, but you don’t really know. That would be – what is the motivation of the CEO, what is the strategy, what are the interests, what does the competition look like. These aren’t objective but through work you can make educated guesses about, but you don’t really know. And then you have a range of things that you don’t know that are going to come in the future.  These are future events that are fundamentally unpredictable but they live within a range of possible future events. So you combine what you know, with what you think you can surmise, combined with understanding the range of outcome related to the uncertain things and say “is this a good place to commit a fraction of my capital"

And you can translate that to poker. What is it you know; you know how many chips you have, you know what cards you're holding, you know the cards displayed face up on the table as you can see those. Then you can surmise what you opponents cards are likely to be; I can get information from how he is betting the hand or by sitting at the table playing with him for a while I can see his personality, his style, his skill and I can make inferences about the present hand based upon his past behaviours. Those are things you are trying to deduce. Then there is the uncertainty; the range of future cards concealed in the deck that are yet to be displayed that are important and there is a range of those possible outcomes. You take a look at all those things and you say "do I want to play this hand?", do I want to bet chips into this hand”

Understand

“The most exciting part is when you think you’ve figured out the joke. When you get the joke and you understand what it is that you’re doing and why it is you have an opportunity now. You’re going to be able to deploy capital and its very likely to work out. Those situations come up few and far between when you really have it”

Mistakes

“We are wrong often and we have to constantly question whether we are wrong. There are lots of times when you buy a stock and after a certain amount of time a certain event happens and you have to look at it a different way, and say nope that’s not it, we should have done the opposite. Then you change course”

Risk Management

“We take a layer by layer approach [to risk management]. What is our risk on this investment, that investment and the next investment. We tend to think about risk as how much can we lose in our worse case. If it’s a $10 stock the downside is $10. That’s how I think about it”

Developed Markets

“We are invested in developed markets. I have no aspirations to get further away [from developed markets] because I find that once you get into places further away you’re subject to what’s going on with the insiders and there are local rules and customs, and local knowledge. It’s very hard to compete with that sitting in NY even if you get on an aeroplane and go visit once in a while”

Process

“We re-evaluate all of our investments [whether they have worked out good or bad]. Ones that have worked we sell or reduce because they have worked and we are not interested in them anymore. Some that haven’t worked we exit or reduce because we decide that whatever it was we were thinking is no longer true or is unlikely to be born out. We modify the positions accordingly and we do that on a position by position basis and we do that whether things are going well for us or not going well for us. It’s part of our ongoing process.”

What You Know, Concentration & Portfolio Construction

“The way you deal with unknown unknowns is through portfolio construction. We like to run a concentrated portfolio but even our best idea we are not going to put all our money in. You have to set some kind of a limit, have some kind of risk management, some level of diversification. We have some amount of longs and some amount of shorts and have some amount of market risk we are willing to take on a knowing basis. Then you have the idiosyncratic risk relating to the individual investment. When people say there is a stock at $10 with $1 of downside and $10 of upside, I say NO, it has $10 of downside because you can lose your whole investment when you make it.  We manage risk further by the level of investment we make"

Leverage

"We are not levered, we don’t borrow more money to make even more investments. That’s one way you avoid risk. If you don’t have to ever repay anybody you're not subject to lending terms and conditions”

Value at Risk

“One of the things that was most exposed in the financial crisis is the flaw in the mathematical modelling of tail risk. So called Value-At-Risk. It is a method used by all of the large banks  and institutions. What VAR basically does, it basically says, if the risk is something that is going to happen beyond a certain level of frequency, you don’t have to put any capital aside. They put capital aside to cover 95% of all possible outcomes, but not for really remote things beyond the tail”

Short A Bubble Basket - Lots of Small Positions

“We decided if we could look at company[s], none of the companies were profitable or materially profitable, and we didn’t know what the business was, but we knew what the financial statements were and we knew the projected financial statements, and we thought a little bit about the business, but we didn’t even know what the business was - if it was an office supply company, a paper-maker or Netflix - and we closed our eyes and said what would you pay for the stock.  If the answer was 90% less than where it was trading, we created a basket of about 40 or 50 of these and shorted a small amount of a large number of them. Over time, at least until the beginning of this year that basically worked out.  Even though we had 2 or 3 or 4 that really worked against us in a pretty big way, a big number of those 40 or 50 ultimately failed or de-rated and the stocks went down a lot. The gains were roughly enough to offset the ones that appreciated. This year that has not been the case. Pretty much everything that has remained or we put into the basket has continued to go up. But the thesis on all of them is that none of them are actual, viable businesses. And the market might disagree with us on this, but when they start showing real profits then we’ll take a different point of view on particular names”

"We generally don't short stocks just on valuation. But when we came to a point with certain stocks that the valuation was so extremely out of whack it wasn't really a debate about whether the stock was in a range of fair value, in other words it was 90% or so overvalued. You don't need a computer to help you figure that out. Even if you are wrong by 100% instead of it being 90% overvalued its 80% overvalued.

Seeking Perfection

"We do not sit around all day and try and figure out the precise value of individual stocks. Because those are not relevant to our actual ability to make decisions. So if we have a stock and its $10 the goal is not to figure out if its worth $11 or $11.50 or $12. The goal is to figure out is it worth a lot more than $10 and not being precise about that. If we buy at $10 it doesn't really matter whether its worth $18 or $20 or $25 and there is no point in us trying to figure that out right now. The only decision we have is - do we want to own the stock at $10, and if we think its undervalued by a lot that's good enough for us to decide to own it now. By the time it starts approaching higher values we can re-asses and fine-tuning on an ongoing basis. We do our assessments in a very imprecise way"

Investments as Puzzles

"We view investments as puzzles. There are a few things you can know but they are not the most important things as everybody knows them. The most important thing is what is it you can infer and how good are you at assessing a possible range of outcomes, either the known unknowns and the unknowns unknowns and how can you construct that into a portfolio" 

Margin of Safety

"Our goal is to find things that are widely misunderstood by a large margin"

Time Arbitrage

"I think one of the inefficiencies in the market is investors are generically too short-term oriented and time arbitrage is one of the best inefficiencies in the market."

Activism

"When we get involved in pushing an agenda, which is very rare, our view invariably is if it doesn't help in the short term, intermediate term and long term, then its not a good solution to what the problem is"

Structural Problems

“As I looked at the global financial crisis as it happened I thought there were three or four or five really obvious structural problems that were exposed. Institutions that were thought to be able to fail, in fact were deemed to be too big to fail. You had structured credit where risk was being transferred but it wasn’t really being transferred or properly evaluated. You had the problem of credit rating agencies, only two or three major ones, so you wound up with a centralised decision maker as to who is creditworthy and who isn’t – that’s a really bad way to allocate credit. You really want a large number of people evaluating each credit to determine the creditworthiness. If you have one or two you create crisis of confidence when the one or two change their mind and you lose the opportunity to go into the market and find other people who might look at it differently from the credit rating agencies. That was separate to the corruption relating to the triple-A ratings. I think there was a lesson learnt about derivatives. They could have been dealt with differently, but instead we’ve created a clearing house for derivatives which has essentially created another too big to fail institution where all the credit is on an undercapitalised entity that everyone assumes will perform under all circumstances which of course it can’t as counter-parties begin to have problems. So from my perspective if you took all of the obvious problems from the financial crisis, we really kind of solved none of them.. I think it has the left basic structure more or less as it was and I think it is susceptible to the same type of event or series of events sometime in the future.”

Further Reading:
Fooling Some of the People All of the Time, David Einhorn
Charlie Rose Interview - David Einhorn

Investment Masterpieces

Have you ever stopped to consider the difference between science and art? How some things fall rather naturally into one or other of the categories, (like the 'science of engineering' or the 'art of film production'), yet many other things remain difficult to categorise. They may even belong to both.

Part of the distinction between the two is that if something is a 'science', then it will naturally follow formulae and rules and can typically be proved or practiced via logical methods. 'Art' on the other hand is a form of expression, and invariably involves some level of creativity or innovation. If you think of music as an example, it can be successfully argued that it is both a science and an art at the same time: if a musician follows the 'science of music', then they will practice classical methodology and you can expect that their performances will be clinically perfect yet potentially lacking in 'soul'. Followers of the 'art of music' by comparison might be more innovative, and typically can improvise and express a wider range of emotions and unique qualities in their playing.

I've always considered investing more 'Art' than 'Science'. If there was a formula for success the world's greatest investors would all be mathematicians. They're not. Successful investing requires more than just analysing numbers, it too requires creativity and innovation. 

When it comes to Investing 'Artisans', Francois Rochon is one. Francois has a passion for both investing and art, he even named his fund Giverny Capital after the city where the famous Impressionist artist, Claude Monet lived. Over the last two-plus decades Giverny Capital has ranked in the top 1% of investors delivering returns c6.7%pa above its benchmark annually. Since 1993 the firm has clocked up a total return of 3,080% versus 686% for the benchmark.

Over the years I've always looked forward to reading the Giverny Capital annual letters. Not only is Francois an Investment Master he's also a master wordsmith.

Francois recently gave an enlightening presentation titled 'The Art of Investing - Analysing Numbers and Going Beyond' as part of the Talks at Google series.

While Francois trained as an engineer, he found the rigidity and precision of engineering to be a handicap to successful investing. Engineering and investing are almost diametrically opposed; there is no precision in investing. As an investor you can be considered successful even when wrong 40% of the time. As an engineer, if you're wrong 0.4% of the time, you're toast. Notwithstanding, at times engineering calls for more than just numbers - be it for a new design or solution to a problem. To emphasise this, Francois draws on a quote by one of the world's greatest engineers, Nikola Tesla:

"Instinct is something which transcends knowledge. We have, undoubtably, certain finer fibers that enable us to perceive truths when logical deduction, or any other willful effort of the brain, is futile." 

The Investment Masters likewise see investing as more art than science.

Accordingly you need to master the 'Art of Investing'. Like mastering any art form, begin with an art form you love. You'll need to study the art's masters, and as a painter paints, you must invest. You'll develop your own unique style, an independent mind, and you'll need to always strive for improvements.

Like most great artists, it's likely you will be seen as a little eccentric, rash and unconventional. If your goal is to obtain better results than the average, you'll have to be able to stand on your own. You cannot achieve this by applying the same logical approaches as the herd.

Investors whose mindset and time horizon mirrors everyone else, those who own lots of companies and believe they are "smarter" and can predict the market, don't beat the market. It's the investors who think for themselves, own very few, carefully selected companies and develop the right behaviours (rationality, humility and patience) that become the Masters of Investment.

Francois outlines the stock selection process that has delivered Giverny Capital's outstanding returns. The firm focuses on the financial strength of a company searching for companies with an ROE greater than 15%, with EPS growth above 10% and a debt to profit ratio below four times.  They search for good business models; those businesses which are market leaders, have competitive advantages and low cyclicality. They then ensure the management teams have skin in the game, capital allocation competency, and are long term thinkers. Finally, Giverny require an acquisition price which affords them the opportunity to double their money over a five year period. To estimate this they need an estimate of what the company can earn in five years time.

As in his art collecting, Francois is attracted to investment 'beauty' or 'corporate masterpieces'. Not surprisingly these are both unique and rare. By studying the investment masterpieces through history - National Cash Register, Ikea, Geico, Apple, McDonalds, Gillette, Google, Starbucks Coffee etc - Francois has discovered the qualities that made them so unique.

The defining character of the uniqueness in either the product, the service or the culture of corporate masterpieces is usually the equivalent of a moat that protects the economic castle from competitors. So in short, you have to find companies with moats.

"Moats always keep changing. There are always new companies with moats; some are expanding, some are shrinking. So we have to follow that closely. If I had to choose one criteria to help me decide what is the direction of the moat - it's the management. Moats aren't built by angels, they are built by human beings. What makes a moat grow is something in the culture of the company, it doesn't come from thin air. It comes from top management that build that culture, then it translates into a moat and high return on equity for shareholders."

Francois sets out his psychological edge in investing. The three behavioural competitive advantages he believes an investor can employ are patience, humility and rationality. In terms of humility, Francois recognises he can't predict macro-economic events so he doesn't try. Francois recognises his 'circle of competence', he strives to recognise mistakes, and is always looking for improvements.

"I would say the greatest quality of Warren Buffett is not necessarily intelligence, it's the humility. He is the greatest investor of all time, but he is still very humble. He is always looking to improve and learn. He's 87 years old and he's still striving for new learnings every day. If you have those qualities I think you'll succeed in almost anything you do."

Every year Francois dedicates a chapter of Giverny's annual letter to the year's best mistakes, awarding a bronze, silver and gold medal.

"We make many mistakes and we only choose three to give medals to: bronze, silver and gold. Most of the time the mistakes are omissions. Starbucks is an example, its a company that fits all our criteria. And we decided not to buy for simplistic reasons and you miss a 10,000% gain over 25 years. We try to give medals to the most costly mistakes." 

When it comes to rationality, Francois advocates avoiding fads, even if it means others are making more money than you. And if you don't understand a company, stay away.

"You play an easier game when your'e very selective and you just go for companies you understand."

As hard as it may be, it's critical to be impervious to stock market quotations in the short run. By accepting you don't know the future, you can focus on what's controllable, which is finding companies you can understand and which have a competitive advantage. Then, should you own great companies and markets fall, over time you will still be okay.

"Owning great companies, and not trying to predict the stock market is the key to beating the index over the long run." 

To overcome the psychological pressures on investors to do the wrong thing at the wrong time, Francois has developed the 'Rule of Three'. This set of rules states that; 1) one year out of three the stock market will decline by 10% or more; 2) one stock purchased out of three will not perform as expected, and; 3) one year out of three, you will under perform the index. If you set expectations from the start, when you have some bad years and bad investments, you'll be better prepared psychologically to deal with it.

In terms of patience, Francois points not to the 'ability to wait' but the 'ability to keep a good attitude while waiting'. A 'good attitude' is one where you focus on what is happening to the company, NOT the stock price. Provided the underlying company's earnings are growing, you'll find over time the stock price should reflect those improved earnings. Don't confuse patience however with stubbornness. When an investment doesn't work check to make sure the company's fundamentals aren't deteriorating. If they are, get out.

In his quest to buy investment 'masterpieces', Francois often faces a conundrum. Masterpieces can be expensive and tend to trade at higher price-earnings multiples than widely perceived value stocks. While most investors focus on the current price-earnings ratio, Francois suggests instead to look to the long term and estimate what the company's value might be then. If buying at today's price and selling at that future value can deliver a 15% pa return it's likely to be an attractive investment notwithstanding a higher multiple. This process is also useful in eliminating optically 'cheap' stocks which are actually value traps.

"We try to focus on the very long term, so we try to look five years in the future and come up with our best judgements of what the EPS should be in five years... Having this long term horizon help you to de-focus on the [higher] PE ratio today. It goes the other way; if you find a cheap stock but you look five years in the future and you don't see any growth prospects, there is no real reason to believe the stock will be higher in five years. It can be higher in three months just because the PE has gone from 10 to 12. But we don't try to invest for three months we try to invest for at least five years."

The wise investor must be able to balance the dualities in many human activities. While you want to love the art you must remain rational and not fall in love with stocks. You want as large a field of knowledge as possible while remaining within your circle of competence. You need to be open-minded yet maintain a balance of thought. You need to be able to value the business but be able to go beyond the numbers. You must have patience but not stubbornness. Finally, you need discipline but also the wisdom to break the rules.

In summary, the artistic or unconventional investor focuses on intrinsic value, maintains a long term horizon, is agnostic about many things including where the stock will be in the short term, focuses on what to own as opposed to when to buy and resists fads and popular beliefs.

While the majority of investors underperform, Giverny Capital's results have significantly bettered the stock market. Its clear that while they do things differently to most investors, many of their traits and practices are common to those whom we recognise as Investment Masters. They treat the bulk of their investing as an art form, and trade logic and formula for creative thinking.

So how do you approach your investing? As a science or an art form? Do you try to engineer your results, using a set formula or logic, or do you follow a more artistic approach, utilising innovation and creativity? The differences between the two are vast, and whilst scientific method might provide you with short term success, its only through the 'art of investing' that you can go beyond the numbers and create your own long-term performance masterpiece.

[note: click on any links above for further reading on that topic]

Transcript

Learning from Lou Simpson

One of the fascinating things I have discovered in my studies of the Investment Masters is that almost to a man, the Masters all come from obscure and unique roots. Since those beginnings, most have fought their way to the top, learning from their mistakes and along the way picking up vast reams of knowledge. Success for each of them came from long years of hard work and bitter experiences; a veritable baptism by fire. They are the quiet achievers and through it all have earnt the right to be called an Investment Master.

Among these, Lou Simpson is hardly a household name, even among investment professionals. In 1979 Jack Byrne, the CEO of Geico, was looking for a new chief investment officer to run Geico's investment portfolio. Jack had identified four candidates and had then sent them to Omaha to meet Warren Buffett who was a shareholder. ''I sent three of the four to meet Warren,'' Mr. Byrne recalled. ''And after a four-hour interview with Lou, he called me and said: "Stop the search. That's the fella." Lou stayed on for over 25 years racking up returns that bettered the S&P500 by an astonishing 6.8%pa.

In his 1995 letter Buffett noted "Lou takes the same conservative, concentrated approach to investments that we do at Berkshire, and it is an enormous plus for us to have him on board. One point that goes beyond Lou's GEICO work: His presence on the scene assures us that Berkshire would have an extraordinary professional immediately available to handle its
investments if something were to happen to Charlie and me." Eleven years later, in his 2006 letter, Buffett suggested Lou would “fill in magnificently for a short period.” if something happened to either himself or Charlie but given Simpson was just six years his junior, “a different answer” was needed for the long-term. 

Charlie Munger had this to say about Lou Simpson ..

"It's not unheard to beat the averages for a couple of years, maybe even five or ten years. But imagine beating the S&P500 by an average annual gain of 6.8 percent over twenty-five years! This extraordinary track record speaks for itself - Lou has one of the greatest investment minds of our time. He is, as Warren says, "a shoo-in for the Investment Hall of Fame".

Lou left Geico in 2010 and started his own fund, SQ Advisers in 2011. SQ Advisers, which now manages more than $3 billion, has a management strategy [as per the 2016 brochure lodged with the SEC] developed and implemented using the following principles as guidelines:

• Think independently

• Invest in-high return businesses run for the shareholders

• Pay only a reasonable price, even for excellent businesses

• Invest for the long-term

• Do not diversify excessively

Like Buffett, Lou is a value investor looking to buy quality businesses below intrinsic value; "Generally, SQ advisers believes that identifying a significant difference between the market value of a security and the intrinsic value of that security is what defines an investment opportunity."

As a Senior Fellow and Adjunct Professor of Finance at the Kellogg Institute [well worth adding their website to your bookmarks..], Lou recently sat down for a rare interview with Robert Korajczyk, a professor of finance. It shouldn't be a surprise that Lou's views on investing parallel those of the other Investment Masters. I've included links to relevant tutorials in Lou's quotes from the Kellogg Institute interview below.

"The essence [of my investment philosophy] is simplicity"

"What we do is run a long-time-horizon portfolio comprised of ten to fifteen stocks. Most of them are U.S.-based, and they all have similar characteristics. Basically, they’re good businesses. They have a high return on capital, consistently good returns, and they’re run by leaders who want to create long-term value for shareholders while also treating their stakeholders right."

"You can only know so many companies. If you're managing 50 or 100 positions, the chances that you can add value are much, much lower.

"... be very careful with each decision you make. The more decisions you make, the higher the chances are that you will make a poor decision."

"One thing a lot of investors do is they cut their flowers and water their weeds. They sell their winners and keep their losers, hoping the losers will come back even. Generally, it’s more effective to cut your weeds and water your flowers. Sell the things that didn't work out, and let the things that are working out run."

"If I’ve made one mistake in the course of managing investments it was selling really good companies too soon. Because generally, if you’ve made good investments, they will last for a long time."

"Of course, things can change. Amazon is changing the retail business quite dramatically."

"I think you need a combination of quantitative and qualitative skills. Most people now have the quantitative skills. The qualitative skills develop over time."

"Everyone talks about modelling—and it’s probably helpful to do modelling—but if you can be approximately right, you will do well."

"One thing you need to determine is: Are the company’s leaders honest? Do they have integrity? Do they have huge turnover? Do they treat their people poorly? Does the CEO believe in running the business for the long term, or is he or she focused on the next quarter’s consensus earnings?"

"There are a few factors that we look at. First, is this the business we thought it was? If you figure out that a business is not what you thought it was, that’s a bad sign."

The second factor is the management, which can also differ from what you thought. Unfortunately, a lot of managements are very short-term oriented, and that can be another reason to sell. This goes back to the basic integrity and the focus of people in charge.

The third factor is an overly high valuation, and this is often the most difficult, because you’re investing in something you wouldn’t buy at current prices, but you don’t want to sell because it’s a really good business and you think it’s ahead of itself on a price basis. It might be worth holding on to it for a while."

"The biggest difference between Warren and me is that Warren had a much harder job. He was managing 20 times the amount of money we were."

"If somebody’s going to invest using hot tips, or listening to CNBC, or investing with so-called wealth managers at brokerage firms, I think it’s a loser’s game for them."

Once again, a successful Investment Master espouses beliefs that mirror those of many others. Keep it Simple. You wont always be right - Learn from your Mistakes. The Value of Good Culture. Don't sell your position in Great Companies. Back yourself. Things Change. And be Humble. Because from humble beginnings, great things can grow...

Source: Image - 'Portrait of a Disciplined Investor - Berkshire 2004 Annual Report'
“One of the Investment Greats” Explains His Portfolio Strategy: A Q&A with renowned investor Lou Simpson - Kellogg Institute - Robert Korajczyk, 2017.

Learning from Ray

Ray Dalio is without doubt a member of the master class of the world's investors. He runs Bridgewater Associates, one of the most successful and the largest Hedge Fund in the world. 

Similarly, like many of the Investment Masters, Ray believes in seeking the truth by testing investment ideas, learning from mistakes and remaining humble. This was never more evident than in his experience in predicting the Debt Crisis in the early 1980's. Whilst his prediction was uncannily accurate, Ray also predicted that the stock market would fall at the same time. The reality was something different, however, and when the market actually rose instead, Ray lost so much of his own and client's capital that he was forced to let go all of his staff, and had to borrow $4,000 from his father to simply pay his household bills. It's fair to say that Ray felt the pain of his mistake deeply. Ray stated that the pain of this error allowed him to change his attitude towards mistakes, and to see them as puzzles that needed to be solved instead. It also allowed him to start asking himself what he would do differently in the future to avoid the pain.

“I believe that anyone who has made money in trading has had to experience horrendous pain at some point. Trading is like working with electricity; you can get an electric shock.  With the pork belly trade and other trades, I felt the electric shock and the fear that comes with it. That led to my attitude: let me show you what I think, and please knock the hell out of it.” Ray Dalio

"I met a number of great people and learned that none of them were born great. They all made lots of mistakes and had lots of weaknesses - and that great people become great by looking at their mistakes and weaknesses and figuring out how to get around them." Ray Dalio

Other Investment Masters have also learnt the same lesson.

“I lost my stakes a couple of times, which taught me risk control and risk management. Losing those stakes in my early 20s gave me a healthy dose of fear and respect for Mr. Market and hardwired me for some great money management tools.” Paul Tudor Jones

“My dad was a retail pharmacist and after I started attending law school he said ‘well you have to learn how to be an investor.’ He and I traded tiny amounts of tech stocks and mining stocks together. So I became very interested in markets and trading. In the period of time from 1967-1974 he and I found just about every possible way conceivable to lose money. So when I started Elliot in 1977 I was determined to engage in a trading strategy that made money all the time. So for the first 10 years of Elliot’s existence the primary strategy was convertible bond hedging.” Paul Singer

"And just as in blackjack, my first investment was a loss that contributed to my education." Ed Thorp

"I went into this tech stock with 100% short position, and all the money I saved up because I thought I had this one locked down. We had fully positioned ourselves, myself and all my customers and clients I was advising, and then a technology writer dubbed the company the 'Son of Intel'.  The stock went promptly from about $16 to $40. I got margin called all the way up until I was completely wiped out. I lost all of my money. I was apoplectic. I thought the world was going to end. I remember that like it was yesterday. That was the greatest thing that ever happened to me - losing all of my money on something where I knew I was right. From an investing perspective, getting completely wiped out and thinking it was the end of the world, and thinking I was an abject failure, and this investing thing wasn't for me. Looking back at it, it couldn't have happened at a better time in my life. You want that to happen as early in your career as it can and you want it to be the most devastating blow that could possibly hit you, to teach you, to bring humility into your investing and teach you that you should never set yourself up for the knockout punch. It teaches you never to put 100% into anything. It teaches you a lot about sizing, it teaches you a lot about life, no matter how much you think you have your arms around a situation, you never do." Kyle Bass

“There is nothing like losing all you have in the world for teaching you what not to do. And when you know what not to do in order not to lose money, you begin to learn what to do in order to win. Did you get that? You begin to learn!” Jesse Livermore

"Making money through an early lucky trade is the worst way to win. The bad habits that it reinforces will lead to a lifetime of losses." Naval Ravikant

It was the recognition of the need to learn from mistakes that led to the development of Ray's Principles.

"You have to learn from mistakes to keep getting better. And it's through learning from those mistakes that you learn what reality is and how to deal with it, which is called Principles."

Interestingly, Ray is about to release a new book entitled 'Principles'. This will be an absolute must-read and I have already pre-ordered it. Ray released the first document titled 'Principles' on the Bridgewater Associates website back in 2011. The original 'Principles' focuses on Ray's most fundamental truths about life and in addition, his beliefs and ideals regarding people management. Over the years I've often referred back to the original text, and while Ray has updated it in the new book, the original document remains a favourite of mine.

Bridgewater Associates investment style differs from many of the Investment Masters in so much as they invest across a broad spectrum of asset classes and regions, both long and short, and seek approximately 100 different return streams that are roughly uncorrelated to each other. While there isn't a lot of commentary on investing per se in the original 'Principles' document, it does include the psychological insights and approach to learning that parallel with other great investors and give Bridgewater their edge. 

This is evident in the company's employment philosophies. On the Bridgewater Associates website's career page, they ask potential employees to ask themselves a number of questions before applying to work there. These include:

"Do you want to: Discover your strengths and weaknesses? Work to get better fast? Put aside ego barriers to learning? And, demand others to be truthful and open, and are you prepared to to do the same?"

In conjunction with the release of the new book, Ray has given a very insightful Ted Talk [only 16 minutes ... see below] where he discusses the processes he developed to successfully navigate the markets. Ray describes himself as a hyper-realist; he's a broad thinker who meditates and recognises there are many lessons to be learnt from nature and history. It was by studying history that provided Ray with the insights to anticipate the Global Financial Crisis.  

It's no surprise Ray features prominently throughout the tutorials included in the Investment Masters Class. Here's a taste of some of the Principles which are behind Ray's success..

"I learned that failure is by and large due to not accepting and successfully dealing with the
realities of life, and that achieving success is simply a matter of accepting and successfully
dealing with all my realities."

"I learned that finding out what is true, regardless of what that is, including all the stuff most people think is bad—like mistakes and personal weaknesses—is good, because I can then deal with these things so that they don’t stand in my way."

"I learned that there is nothing to fear from truth. While some truths can be scary—for example, finding out that you have a deadly disease—knowing them allows us to deal with them better. Being truthful, and letting others be completely truthful, allows me and others to fully explore our thoughts and exposes us to the feedback that is essential for our learning."

When investing, it's important to maintain humility, study history, learn from mistakes and test investment ideas - the foundations of both Ray Dalio's, and the Investment Masters success.

Further Reading:
Ray Dalio Principles - 2011
Ray Dalio - Academy of Achievement
Ray Dalio - Charlie Rose Interview
Ray Dalio - Alpha Masters
Ray Dalio - Hedge Fund Market Wizards
Ray Dalio - The New Yorker

Learning from Ed Thorp

Ed Thorp's track record of returns is astonishing. Not only did Dr. Thorp deliver an average 20% return over thirty plus years, he rarely ever had a month where he lost money. His original fund, Princeton Newport Partners, ran for nineteen years with only three down months [the largest loss was below 1%]. As Jack Schwager so cleverly articulated in his book 'Hedge Fund Market Wizards', if the market was efficient, the odds are a trillion times better of selecting one atom on earth than a trader achieving such a record of positive months.

Dr. Thorp isn't your typical Investment Master. The way he came to investing is unlike any other. His new memoir, 'A Man for All Markets' tells the story of his early curiosity, his background in mathematics, and how he challenged conventional wisdom to beat the casino and the stock market.   

During his time as an MIT professor, Dr Thorp, was the first person to work out that Blackjack, the 'unwinnable' casino card game, could be beaten. He invented the art of card counting which gave the player an edge against the casino. In 1961 he detailed the winning system in the best-selling book, 'Beat the Dealer', after which casinos across America altered the rules of the game. Having overcome the odds in Blackjack, a year later Dr Thorp and Claude Shannon, built the world's first wearable computer to beat Roulette. This contraption provided a 44% edge against the casino by predicting where the ball would land.

Often banned and at times threatened by the casinos, Dr Thorp recognised there was a far safer and greater casino than all of Nevada - Wall Street. Dr Thorp parlayed his knowledge of gambling games to build a system to beat the stock market. After a voracious study he developed a similar formula to the yet undiscovered 'Black-Scholes' option formula, to profit from option exchanges across America.

As one of Wall Street's first quants, Dr Thorp managed his portfolio with mathematical formulas, economic models and computers. His early hedge fund was even vetted and approved by Warren Buffett for one of his investors after the Buffett partnership was closed. Dr Thorp's other accomplishments included inventing and implementing statistical arbitrage, identifying Bernie Madoff as a fraud decades before his ponzi scheme collapsed and being the first investor of Ken Griffin's Citadel.

While Ed Thorp's investment process required a level of mathematical aptitude superior to even the world's greatest investors, you will notice a lot of commonalities in his thinking with the Investment Masters - the use of mental models, the need for an edge and risk management techniques, the consistent testing of ideas and theories etc. The book is a highly engaging read in which I unearthed quotes that paralleled with over a third of the 100 tutorials contained in the Investment Masters Class.  Here are some of my favourites:

"Though we didn't have helpful connections and I went to public schools, I found a resource that made all the difference: I learned how to think"

"I was largely self-taught and that led me to think differently. First, rather than subscribing to widely accepted views - such as you can't beat the casinos - I checked for myself"

"Mathematics taught me to reason logically and to understand numbers, tables, charts, and calculations as second nature. Physics, chemistry, astronomy, and biology revealed wonders of the world, and showed me how to build models and theories to describe and to predict. This paid off for me in both gambling and investing"

"The surest way to get rich is to play only those gambling games or make those investments where I have an edge"

"Assume you may have an edge only when you can make a rational affirmative case that withstands your attempts to tear it down"

"Betting too much, even though each individual bet is in your favor, can be ruinous"

"People mostly don't understand risk, reward and uncertainty. Their investment results could be much better if they did"

"Just as in blackjack, my first investment was a loss that contributed to my education"

"Stories sell stocks: the wonderful new product that will revolutionise everything, the monopoly that controls a product and sets prices, the politically connected and protected firm that gorges at the public trough, the fabulous mineral discover, and so forth. The careful investor, when he hears such tales, should ask a question; at what price is this company a good buy? What price is too high?"

"The stock market also is a game of imperfect information and even resembles bridge in that both have their deceptions. As in bridge, you do better in the market if you get more information sooner and put it to better use. It's no surprise that Buffett, arguably the greatest investor in history, is a bridge addict"

"Though the institutions of society have difficulty learning from history, individuals can do so"

"Over a sufficiently long time, compound growth at a small rate will vastly exceed any rate of arithmetic growth, no matter how large! For instance, if Sam Scared made 100 percent a year and put it in a sock and Charlie Compounder made only 1 percent a year, but reinvested it, Charlie's wealth would eventually exceed Sam's by as much as you please. This is trues even if Sam started with far more than Charlie, even $1 billion to Charlie's $1."

"We analyzed and incorporated tail risk, and considered extreme questions such as, "What if the market fell 25% in one day?" More than a decade later it did exactly that and our portfolio was barely affected"

"[I didn't believe in]  the efficient market theory... We didn't ask, Is the market efficient? but rather, In what way and to what extent is the market inefficient? and How can we exploit this?"

"Bernard Madoff showed, thirteen thousand investors and their advisers didn't do elementary due diligence because they thought the other investors must have done it"

"Every stock market system with an edge is necessarily limited in the amount of money it can use and still produce extra returns"

"I learned to make proper risk management a major theme of my life"

"The lesson of leverage is this: assume the worst imaginable outcome will occur and ask whether you can tolerate it. If the answer is no, then reduce your borrowing"

"I think of each hour spent on fitness as one day less that I'll spend in a hospital" 

"When J Paul Getty was the richest man in the world and manifestly not fulfilled, he said the happiest time of his life was when he was sixteen, surfing waves off the beach in Malibu, California"

Time to let Ed Thorp help you beat the market!

Further Information:

I've recently listened to two great Podcast interviews with Ed Thorp ..  click the links to the right [I suggest the Bloomberg/Barry Ritholtz one first..]

You also can check out Ed Thorp's website here

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