RANDOM MUSSINGS (ii)

Hugh Hendry issued a new piece. He is always an entertaining and highly recommended read. Especially, if his last opus was almost 2 years ago (he did not have what to say). One of the greatest contrarian thinkers at the moment.

What puzzled me is his love for “stop loss” (which also connects with my recent piece about “sell your losers and ride you winners”). I do not understand it. He gives as an example tragic death of Jesse Livermore, who was right on his macro call but market remained irrational longer than he remained solvent. Volatility killed him (by the way he was shorting the market around 1930) and his panacea could have been stop losses.

I would say that, from what I understood (disclaimer: apart of this article, I know nothing about Jesse Livermore), he was killed not by volatility but by leverage or maybe also asymmetric nature of shorting individual names.

Stop loss is a practical thing to say that I do not understand what I am doing.

If one operates with sufficient margin of safety, even considerable volatility should not scare. It is always advisable to have low expectations. You cannot time the market so that you will always buy in the lowest point. That is impossible. It should be comforting that premature accumulation is a sin of all the greatest value investors.

It takes time for intrinsic value and price to converge. I follow a general rule of 3 years (I took it from Pabrai’s “Dhandho Investor”), which should be enough for your story to play out and admit a mistake. Intrinsic value in most cases is changing slowly – definitely not like when you watch big daily plunges on the stock market.

Lehman produced many stories of 50% plunges and 200-300% recoveries in less than 3 years. I do not know how to be that smart and sell it after e.g. 20% drop, then buy back after 50% down (total) and ride it up 3 or 4x. I do not know people who bet the entire farm back in March of 2009. You are fooling yourself if you think that you will dare to move in the darkest hour.

FOR BEGINNERS (PART II)

I. Business

I. a) Understanding of Business

The key in stock picking is not to lose your principal amount. This can be achieved investing only in sound businesses at sensible prices. The first part of the dilemma is distinguishing good business from mediocre and the second one is valuation. When you get a grasp on business quality, you can delve into “average” businesses having full knowledge of the situation and what you are doing.

Micro economy or bottom-up approach is what leads to the overall macro picture because macro is a sum of micro units. Some industries are doing better and some units are doing better than others inside an industry. This is common sense. How to distinguish a good from bad?

A quick way to filter is looking at the return on invested capital (profit / capital needed to run the business) (10-year numbers). High profit margins (profit / sales) could be another hint [NB: a very distant break-even point can also very a powerful competitive advantage; e.g. think of Coca Cola making 1c from every serving…]. High values in both parameters should lead you to good businesses. It sounds simple but really common sense – if you can charge high margins, you must be doing something great for you customer (they still buy from you) and are better than competitor (they cannot offer anything better), and if you can pay back invested capital quickly and reinvest generated money at high return rates, this means that you have a lot of invisible / unquantifiable capital and value. Now you just have to make sense of those invisible things. [NB this does not mean that high capital requiring industries are bad investments – they are of a different kind, like financial companies, and could be very profitable investments]

The trick is to find out what is invisible and determine if it is sustainable (i.e. cannot be destructed by capital and creativeness). In other words, profits are protected by moats (Buffett’s vocabulary) or competitive advantages (Michael Porter), which are continuously under assault of creative destruction.

Moats or Competitive Advantage 

“[What counts is] competition from the new commodity, the new technology, the new source of supply, the new type of organization... competition which... strikes not at the margins of the profits and the outputs of the existing firms, but at their foundations and their very lives.”  Capitalism, Socialism and Democracy by Joseph Schumpeter

The topic of business moats / competitive advantages is one of the most interesting in business studies. The basic concept is easy to grasp (I will try to make some sense of it below), however, life is a dynamic process and new moats are emerging while old, supposedly sustainable ones, are becoming must-haves and ubiquitous elements of businesses. And really, the key concept here is sustainability.

It is important to remember that if the best possible management meets the worst industry / business, the latter will prevail. Think about textiles – does it make a difference if you can buy a 2-times more efficient machine, which can be bought by anybody? Such a “first mover” (or machine buyer) advantage can last for a few months, which does not bode well for sustainability.

So, what can make a firm unique and having capacity to take money profitably from its customers for long time? There are 2 aspects: a) industry structure; and b) business specific features.

If we still remember that industry is stronger than management, industry structure becomes crucial for determining predictability of profits. It is common sense that if you have fewer competitors, profits can be larger. When there are 2 or 3 remaining, nice things can happen to profits, especially if those remaining in action can demonstrate pricing discipline or, in other words, agree on pricing without discussing the subject, which is illegal.

Without going into great detail, I will give you reference where you can dig further. First of all, Michael Porter developed a useful chart of 5 forces (all charts are borrowed from M. Mauboussine & K. Bartholdson paper “Measuring the Moat”).

After practicing this chart on a few businesses, you should develop a useful habit of running any industry fundamentals through such lenses. One of the key concepts to discuss is barriers of entry. Obviously, if they are high, there will be less competition.

There are different layers and twists, some concepts are dependent on each other or complimentary but I think that the list provided below is a useful checklist:

== cost advantage (think about: economies of scale, location, process, access to unique resource, proprietary process, quick learning curve, etc.)

== proprietary product / service and / or technology / process (think about: patents, brands, regulatory licenses, contracts; the key test for brand strength is if it can charge a higher price; in other words – captivity induced by habit; yes, business can create habits)

== switching cost (key word here again is captivity; changing vendor is always a hassle – psychological, monetary, time, training, very important component and low % of total cost, etc.)

== network effects (value of products and services increases with the number of users – build a critical mass and let the snowball grow by itself)

== capital requirements (apart of obvious, think also about advertising spending)

== access to distribution / selling channel (best is if the channel is created in-house – think of multi layer marketing, Coca Cola sign is usually max 50m from you on the street, etc.)

== government regulation (government is famous and very capable of creating monopoly monsters but the best thing is to have many small concessions than one big and easy removable)

== expected retaliation (balance sheet strength is very important here)

Please let me know if you know how to improve the list.

Note that efficiency and differentiation are absolutely essential in any business.

Finally, company specific moats (in addition to industry situation) and the strongest moats are usually combinations of many smaller moats and factors. In value investing slang it is called lollapalooza effect. You will definitely be a better person if you read these 2 pieces:

Elementary Wordly Wisdom or Artof Stock Picking by Charlie Munger (there are only about 100 models worth studying which cover almost all life tricks)

Practical Thought AboutPractical Thought by Charlie Munger (Coca Cola case study) (email me for a photocopy from Of Permanent Value)

READING RECOMMENDATIONS (iii)

Seth Klarman’s writings are always refreshing. In his 2011 Shareholder Letter (email me if you are looking for it) he gives a romantic summary of how a successful investment operation should look like: 

“You would see a sound process, highlighted by a calm, reasoned, and dispassionate atmosphere for decision-making. No second guessing or whining or double-jeopardy for anyone. A respect for and openness to all points of view. Decisiveness at critical junctures. The humility to know that a decision might be wrong, that we can never be completely sure, and the equanimity to live with both successes and mistakes and move on. You would never see us get deal heat, though you would often see us become intensely focused on timely exits. You would see the determination to separate emotion from our process, the effort never to confuse facts with opinions and, most importantly, the tireless pursuit of excellence. You would see portfolio actions taken never for the wrong reasons of ego, personal advancement, arrogance, fear, or greed, but for the proper, well-considered reason that it is the right thing to do for our long-term investment success.”

I would work for Baupost for free…

READING RECOMMENDATIONS (ii)

I wanted to document a few good reads.

First, I reread a few times a few weeks old John Mauldin’s Outside the Box with Dr. Lacy Hunt of Hoisington Investment Management. If you are going to read a single piece on macro this year this one qualifies quite well. It is a very powerful reminder on where we currently stand – protracted deleveraging; and on the trend direction of treasury rates – down. Consumers are spending their savings and are taking more debt – this does not spell well on growth prospects. There are plenty of graphs and non-noise insights.

Second, I recommend always reading Jeremy Grantham’s quarterly missives. His latest one resonates well with my thinking about individual investor’s edge – it is simply absent, at least in terms of thinking of a professional investment manager.

A few interesting thoughts from the letter: 

“You don’t have to be a PhD mathematician to work out that if the average Chinese and Indian were to catch up with (the theoretically moving target of) the average American, then our planet’s goose is cooked, along with most other things.” 

“…: there have been several recent decades in which the BTU equivalent price of natural gas did, at least for a second, reach parity with oil. But now it is at just 14% of BTU equivalency, the lowest in 50 years. Everyone who has a brain should be thinking of how to make money on this in the longer term.” 

Jeremy Grantham made an interesting twist on S&P fair market value. He is saying that top quality quarter of S&P is fairly priced (5.5% real annual returns for next 7 years), while the poor quality 75% is moderately overpriced and will deliver negative returns over the next 7 years. At current price GMO projects 1% real annual return for S&P 500 for the next 7 years.

I believe that he still thinks that FMV of S&P should be close to 950 – 1,000. Therefore, S&P at 1,370 clearly warrants a fully hedged position. I think that IWO (Russell 2000 Growth) could be the most convenient hedge – it is volatile and @ 93 has only 0.65% yield (if you have no time to identify the most mispriced poor quality stocks).

Interestingly, J. Grantham and L. Hunt views differ on long duration treasury rates. The first believes that long duration bonds is almost the most risky investment at the moment. The second projects that 30Y Bond will go down to 2% (now ~3.1%). Maybe they do not contradict each other because interest rates may go down first before jumping up. 

READING RECOMMENDATIONS (i)

Warren Buffett recently wrote great article about investing in gold.

"In God We Trust" may be imprinted on our currency, but the hand that activates our government's printing press has been all too human.

John Hussman is one of a must weekly readings. Over the weekend he put it simple but not too simple about the current recovery:

Each time underlying credit strains emerge, demand backs off as consumers and businesses become averse to spending. Then, each time central banks launch some massive new intervention, there is a jolt of pent-up demand that is interpreted as sustainable growth.