4 Of The Greatest Investing Lessons From Peter Lynch

Johnny HopkinsPeter Lynch Comments

One of my favorite Peter Lynch interviews is one he did with PBS. Lynch ran Fidelity’s Magellan Fund for thirteen years (1977-1990). In that period Lynch he averaged a 29.2% annual return, consistently more than doubling the S&P 500 market index and making it the best performing mutual fund in the world. During his tenure, assets under management increased from $18 million to $14 billion. Lynch has also written three great books, Beating The Street, Learn To Earn, and One Up On Wall Street.

While it’s a very long interview worth reading in its entirety, I pulled out four of his most important lessons for investors. Here’s an excerpt from that interview:

On what is the secret to investing:

Well, I think the secret is if you have a lot of stocks, some will do mediocre, some will do okay, and if one of two of ’em go up big time, you produce a fabulous result. And I think that’s the promise to some people. Some stocks go up 20-30 percent and they get rid of it and they hold onto the dogs.

It’s sort of like watering the weeds and cutting out the flowers. You want to let the winners run. When the fun ones get better, add to ’em, and that one winner, you basically see a few stocks in your lifetime, that’s all you need. I mean stocks are out there. When I ran Magellan, I wrote a book. I think I listed over a hundred stocks that went up over ten-fold and I owned thousands of stocks. I owned none of these stocks. I missed every one of these stocks that went up over ten-fold. I didn’t own a share of them.

I still managed to do well with Magellan. So there’s lots of stocks out there and all you need is a few of ’em. So that’s been my philosophy. You have to let the big ones make up for your mistakes.

In this business if you’re good, you’re right six times out of ten. You’re never going to be right nine times out of ten. This is not like pure science where you go, “Aha” and you’ve got the answer. By the time you’ve got “Aha,” Chrysler’s already quadrupled or Boeing’s quadrupled. You have to take a little bit of risk.

On investors lack of research before making a stock purchase:

Well, for some reason, the public looks at stocks differently than they look at everything else. When they buy a refrigerator, they do research. When they buy a microwave oven, they do research. They’ll get Consumer Reports. They’ll ask a customer “What’s your favorite kind of oven? What kind of car would you buy?” Then they’ll — they’ll put $10,000 in some zany stock that they don’t even know what it does that they heard on a bus on the way to work and wonder why they lose money, and they do it before sunset. Well, you’ve got plenty of time. You could have bought Wal-Mart ten years after it went public — Wal-Mart went public in 1970. You could have bought it ten years later and made 30 times your money. You could have said, “I’m very cautious. I’m very careful. I’m gonna wait. I want to make sure this company — they’re just in Arkansas and I want to watch ’em go to other states.”

So you watch, five years later the stock’s up about four-fold. You say, “I’m still not sure of this company. They have a great balance sheet, great record.” I’m going to wait another — wait another five years, it goes up another four-fold.

It’s now up twenty-fold. You still haven’t invested. You say, “Now I think it’s time to invest in Wal-Mart.” You still could have made 30 times your money because ten years after Wal-Mart went public they were only in 15 percent of the United States. They hadn’t saturated that 15 percent and they were very low cost. They were in small towns. You could say to yourself, “Why can’t they go to 17? Why can’t they go to 19? Why can’t they go to 21? I’ll get on the computer. Why can’t they go to 28?” And that’s all they did. They just replicated their formula. That doesn’t take a lot of courage. That’s homework.

On market timing:

People spend all this time trying to figure out “What time of the year should I make an investment? When should I invest?” And it’s such a waste of time. It’s so futile. I did a great study, it’s an amazing exercise. In the 30 years, 1965 to 1995, if you had invested a thousand dollars, you had incredible good luck, you invested at the low of the year, you picked the low day of the year, you put your thousand dollars in, your return would have been 11.7 compounded.

Now some poor unlucky soul, the Jackie Gleason of the world, put in the high of the year. He or she picked the high of the year, put their thousand dollars in at the peak every single time, miserable record, 30 years in a row, picked the high of the year. Their return was 10.6. That’s the only difference between the high of the year and the low of the year. Some other person put in the first day of the year, their return was 11.0. I mean the odds of that are very little, but people spend an unbelievable amount of mental energy trying to pick what the market’s going to do, what time of the year to buy it. It’s just not worth it.

On buy and hold investing:

They should buy, hold, and when the market goes down, add to it. Every time the market goes down 10 percent, you add to it, you’d be much — you would have better return than the average of 11 percent, if you believe in it, if it’s money you’re not worried about. As the market starts going down, you say, “Oh, it’ll be fine. It’ll be predictable.”

When it starts going down and people get laid off, a friend of yours, loses their job or a company has 10,000 employees and they lay off two. The other 998,000 people start to worry or somebody says their house price just went down, these are little thoughts that start to creep to the front of your brain. And they’re the back of your brain.

And human nature hasn’t changed much in 5,000 years. There’s this thing of greed versus fear. The market’s going up, you’re not worried. All of a sudden it starts going down and you start saying, “I remember my uncle told me, you know, somebody lost it all in the Depression. People were jumping out of windows. They were selling pencils and apples.” It must have been a great decade to buy a pencil or an apple, but they were always — there must have been everybody selling pencils. That start to — we laugh about it. People start to think about these things with the market going down. These ugly thoughts start coming into the picture. Gotta get ’em out. You have to wipe those out and you — you either believe in it or you don’t.

Great Investors Focus On Absolute-Performance Rather Than Relative-Performance – Seth Klarman

Johnny HopkinsSeth Klarman, Warren Buffett Comments

Earlier this month The Washington Post published an article titled – Warren Buffett’s $100 Billion Problem. The article was reporting on the $100 Billion that Berkshire has accumulated in cash over the years, stating:

Warren Buffett celebrated his 87th birthday a few days ago, but the bigger number in his life is the $100 billion mound of cash that his Berkshire Hathaway has stockpiled.

Buffett created his cash-gushing conglomerate out of an ailing textile firm that he took over more than 50 years ago. Berkshire Hathaway now has dozens of subsidiaries, from railroads to utilities to candy companies. It has 367,000 employees, $24 billion in annual profit and market capitalization approaching $500 billion.

The conundrum Buffett faces is an enviable one: What to do with all the money? In this case, $100 billion. The Sage of Omaha acknowledged the difficulties of deploying his cash during Berkshire’s annual meeting in May.

“The question is, ‘Are we going to be able to deploy it?’ ” he told the thousands of faithful who made the pilgrimage to Omaha.

By necessity, the investor must hunt for big game; it takes a big acquisition to meaningfully move the bottom line of a company the size of Berkshire Hathaway.

In order to answer the question of Berkshire’s growing stockpile of cash this seems like a good time to remember the lessons of Seth Klarman in his book – Margin of Safety. One lesson in particular discusses the importance of focusing on absolute-performance rather than relative-performance. It’s a valuable lesson for all investors, large and small.

Here’s an excerpt from the book:

The flexibility of institutional investors is frequently limited by a self-imposed requirement to be fully invested at all times. Many institutions interpret their task as stock picking, not market timing; they believe that their clients have made the markettiming decision and pay them to fully invest all funds under their management.

Remaining fully invested at all times certainly simplifies the investment task. The investor simply chooses the best available investments. Relative attractiveness becomes the only investment yardstick; no absolute standard is to be met. Unfortunately the important criterion of investment merit is obscured or lost when substandard investments are acquired solely to remain fully invested. Such investments will at best generate mediocre returns; at worst they entail both a high opportunity cost—foregoing the next good opportunity to invest—and the risk of appreciable loss.

Remaining fully invested at all times is consistent with a relative-performance orientation. If one’s goal is to beat the market (particularly on a short-term basis) without falling significantly behind, it makes sense to remain 100 percent invested. Funds that would otherwise be idle must be invested in the market in order not to underperform the market.

Absolute-performance-oriented investors, by contrast, will buy only when investments meet absolute standards of value. They will choose to be fully invested only when available opportunities are both sufficient in number and compelling in attractiveness, preferring to remain less than fully invested when both conditions are not met. In investing, there are times when the best thing to do is nothing at all. Yet institutional money managers are unlikely to adopt this alternative unless most of their competitors are similarly inclined.

20 Timeless Investing Lessons From Joel Greenblatt

Johnny HopkinsJoel Greenblatt Comments

One of our favorite investors here at The Acquirer’s Multiple is Joel Greenblatt. Greenblatt is the Managing Partner of Gotham Capital, a hedge fund that he founded in 1985, and a Managing Principal of Gotham Asset Management. He is also the author of four books, You Can Be A Stock Market Genius, The Little Book That Beats The Market, The Big Secret For The Small Investor, and The Little Book That Still Beats The Market. Over the years Greenblatt has provided investors with many value investing insights. Here’s a collection of some of the best:

1. The great thing is, there’s always something happening. Dozens of corporate events each week, too many for any one person to follow. But that’s the point: you can’t follow all of them, and you don’t have to. Even finding one good opportunity a month is far more than you should need or want.

2. On Wall Street, there ain’t no tooth fairy!

3. Stock prices move around wildly over very short periods of time. This does not mean that the values of the underlying companies have changed very much during that same period.

4. The strategy of putting all your eggs in one basket and watching that basket is less risky than you might think. If you assume, based on past history, that the average annual return from investing in the stock market is approximately 10 percent, statistics say the chance of any year’s return falling between -8 percent and +28 percent are about two out of three. In statistical talk, the standard deviation around the market average of 10 percent in any one year is approximately 18 percent. Obviously, there is still a one-out-of-three chance of falling outside this incredibly wide thirty-six-point range (-8 percent to +28 percent).

5. Most people have no business investing in individual stocks on their own!

6. Investing is a fun game and you want to find the people who are just smitten with it. I wouldn’t say for the best ones that it’s about the money – it may fall off the back of the truck, but it’s not at all why they play the game.

7. There’s a virtuous cycle in people having to defend challenges to their ideas. Any gaps in thinking or analysis become clear pretty quickly when smart people ask good, logical questions. You can’t be a good value investor without being an independent thinker- you’re seeing valuations that the market is not appreciating. But it’s critical that you understand why the market isn’t seeing the value you do. The back and forth that goes on in the investment process helps you get at that.

8. A lot of smart people can do the spreadsheets and analysis. What sets people apart to us is a combination of passion, creativity and an ability to put ideas into context. Value investors know things go in and out of favor – the best ones know when that’s happening and how to take advantage of it.

9. Generally, if I am good and I get 4 out of 6 right or how many I get.  I look out three years. I take my best shot; I look for a wide disparity.  I always looking for a catalyst or the market will realize what I see.   What will make people see what I see? Eventually, in three years or more you don’t even need a catalyst.  There are a lot of things that can happen.  The efficient market people are right but only long term.  But eventually the facts come out.  Whatever people were uncertain about now over the next two or three years, they find the answer to. There are a lot of people out there trying to figure out what something is worth.

10. Paying a bargain price when you purchase a share in a business is a good thing. One way to do this is to purchase a business that earns more relative to the price you are paying rather than less. In other words, a higher earnings yield is better than a lower one.

11. Though not easy to do, even maintaining a three- to five-year horizon for your stock market investments should give you a large advantage over most investors. It is also the minimum time frame for any meaningful comparison of the risks and results of alternative investment strategies.

12. Somehow, when ownership interests are divided into shares that bounce around with Mr. Market’s moods, individuals and professionals start to think about and measure risk in strange ways. When short term thinking and overly complicated statistics get involved, owning many companies that you know very little about starts to sound safer than owning stakes in five to eight companies that have good businesses, predictable futures, and bargain prices. In short, for the few who have the ability, knowledge, and time to predict normal earnings and evaluate individual stocks, owning less can actually be more—more profits, more safety . . and more fun.

13. Although over the short term Mr. Market may price stocks based on emotion, over the long term Mr. Market prices stocks based on their value.

14. It turns out that if you just stick to buying good companies (ones that have a high return on capital) and to buying those companies only at bargain prices (at prices that give you a high earnings yield), you can end up systematically buying many of the good companies that crazy Mr. Market has decided to literally give away.

15. Perhaps, since the measurement of potential gain and loss from a particular stock is so subjective, it is easier, if you are a professional or academic, to use a concept like volatility as a substitute or a replacement for risk than to use some other measure. Whatever the reason for everyone else’s general abdication of common sense, your job remains to quantify, by some measure, a stock’s upside and downside. This is such an imprecise and difficult task, though, that a proxy of your own may well be in order.

16. Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.

17. Buying a share of a good business is better than buying a share of a bad business. One way to do this is to purchase a business that can invest its own money at high rates of return rather than purchasing a business that can only invest at lower ones. In other words, businesses that earn a high return on capital are better than businesses that earn a low return on capital.

18. So one way to create an attractive risk/reward situation is to limit downside risk severely by investing in situations that have a large margin of safety. The upside, while still difficult to quantify, will usually take care of itself. In other words, look down, not up, when making your initial investment decision. If you don’t lose money, most of the remaining alternatives are good ones.

19. Most investors won’t (or can’t) stick with a strategy that hasn’t worked for several years in a row.

20. Traditional value investing strategies have worked for years, and everyone’s known about them. They continue to work because it’s hard for people to do, for two main reasons. First, the companies that show up on the screens can be scary and not doing so well, so people find them difficult to buy. Second, there can be one-, two- or three-year periods when a strategy like this doesn’t work. Most people aren’t capable of sticking it out through that.

This Week’s Best Investing Reads

Johnny HopkinsValue Investing News Comments

Here’s some of this week’s best investing reads:

Markets Are Hard: Seth Klarman Edition (A Wealth of Common Sense)

A Few Charts and a Few Thoughts at All-Time Highs (The Irrelevant Investor)

Ray Dalio, The Steve Jobs of Investing (Tim Ferriss)

Delivering Alpha Conference Notes 2017: Robertson, Dalio, Chanos, Cooperman & More (Market Folly)

Overvalued Stocks are Ruining the Economy (Sprott Money News)

Diversification overrated? Not a chance! (Jason Zweig)

Tiger Management’s Julian Robertson: Market is very high on a historic basis (CNBC)

Why Fear Is an Investor’s Worst Enemy (Morningstar)

Episode #71: Radio Show, “How to Outperform One of Investing’s Most Beloved Strategies” (Meb Faber)

Ben Graham on Passive Investing (Alpha Architect)

Finding Companies That Break the Rules, w/ David Gardner – [Invest Like the Best, EP.54] (The Investor’s Podcast)

Stock Market Breadth Is Much Worse Than This Popular Measure Indicates (The Felder Report)

Are Factors Losing Their Edge? (Barron’s)

You Need To Do What Others Don’t (MicroCapClub)

Why is Value Investing So Difficult? (Behavioural Investment)

How Disciplined Will You Be in the Next Downturn? (Betterment)

My Stock Valuation Manifesto (Safal Niveshak)

There Is Value in the Value Factor (CFA Institute)

What Should You Do With Under-Performing Stocks That You’ve Held For A Long Time? – Daniel Kahneman

Johnny HopkinsDaniel Kahneman Comments

One of the greatest challenges facing all investors is what to do with those under-performing stocks that have been sitting in your portfolio for a long time. Most investors prefer to wait until the under-performing stock gets back to its original purchase price, then they’ll sell it. The problem is if you hang on to those under-performing stocks for too long you may be missing out on other potential opportunities where that capital would be better invested.

One of the answers to this common predicament can be found in the book called – Thinking Fast And Slow, by Daniel Kahneman. Kahneman is a psychologist notable for his work on the psychology of judgement and decision-making, as well as behavioral economics, for which he was awarded the 2002 Nobel Memorial Prize in Economic Sciences (shared with Vernon L. Smith). In 2015, The Economist listed him as the seventh most influential economist in the world.

Here’s an excerpt from the book:

Two avid sports fans plan to travel 40 miles to see a basketball game. One of them paid for his ticket; the other was on his way to purchase a ticket when he got one free from a friend. A blizzard is announced for the night of the game. Which of the two ticket holders is more likely to brave the blizzard to see the game?

The answer is immediate: we know that the fan who paid for his ticket is more likely to drive. Mental accounting provides the explanation. We assume that both fans set up an account for the game they hoped to see. Missing the game will close the accounts with a negative balance. Regardless of how they came by their ticket, both will be disappointed—but the closing balance is distinctly more negative for the one who bought a ticket and is now out of pocket as well as deprived of the game.

Because staying home is worse for this individual, he is more motivated to see the game and therefore more likely to make the attempt to drive into a blizzard. These are tacit calculations of emotional balance, of the kind that System 1 performs without deliberation. The emotions that people attach to the state of their mental accounts are not acknowledged in standard economic theory. An Econ would realize that the ticket has already been paid for and cannot be returned. Its cost is “sunk” and the Econ would not care whether he had bought the ticket to the game or got it from a friend (if Econs have friends). To implement this rational behavior, System 2 would have to be aware of the counterfactual possibility: “Would I still drive into this snowstorm if I had gotten the ticket free from a friend?” It takes an active and disciplined mind to raise such a difficult question.

A related mistake afflicts individual investors when they sell stocks from their portfolio:

You need money to cover the costs of your daughter’s wedding and will have to sell some stock. You remember the price at which you bought each stock and can identify it as a “winner,” currently worth more than you paid for it, or as a loser. Among the stocks you own, Blueberry Tiles is a winner; if you sell it today you will have achieved a gain of $5,000. You hold an equal investment in Tiffany Motors, which is currently worth $5,000 less than you paid for it. The value of both stocks has been stable in recent weeks. Which are you more likely to sell?

A plausible way to formulate the choice is this: “I could close the Blueberry Tiles account and score a success for my record as an investor. Alternatively, I could close the Tiffany Motors account and add a failure to my record. Which would I rather do?” If the problem is framed as a choice between giving yourself pleasure and causing yourself pain, you will certainly sell Blueberry Tiles and enjoy your investment prowess. As might be expected, finance research has documented a massive preference for selling winners rather than losers—a bias that has been given an opaque label: the disposition effect.

The disposition effect is an instance of narrow framing. The investor has set up an account for each share that she bought, and she wants to close every account as a gain. A rational agent would have a comprehensive view of the portfolio and sell the stock that is least likely to do well in the future, without considering whether it is a winner or a loser. Amos told me of a conversation with a financial adviser, who asked him for a complete list of the stocks in his portfolio, including the price at which each had been purchased. When Amos asked mildly, “Isn’t it supposed not to matter?” the adviser looked astonished. He had apparently always believed that the state of the mental account was a valid consideration.

Amos’s guess about the financial adviser’s beliefs was probably right, but he was wrong to dismiss the buying price as irrelevant. The purchase price does matter and should be considered, even by Econs. The disposition effect is a costly bias because the question of whether to sell winners or losers has a clear answer, and it is not that it makes no difference. If you care about your wealth rather than your immediate emotions, you will sell the loser Tiffany Motors and hang on to the winning Blueberry Tiles. At least in the United States, taxes provide a strong incentive: realizing losses reduces your taxes, while selling winners exposes you to taxes. This elementary fact of financial life is actually known to all American investors, and it determines the decisions they make during one month of the year investors sell more losers in December, when taxes are on their mind.

The tax advantage is available all year, of course, but for 11 months of the year mental accounting prevails over financial common sense. Another argument against selling winners is the well-documented market anomaly that stocks that recently gained in value are likely to go on gaining at least for a short while. The net effect is large: the expected after-tax extra return of selling Tiffany rather than Blueberry is 3.4% over the next year.

Closing a mental account with a gain is a pleasure, but it is a pleasure you pay for. The mistake is not one that an Econ would ever make, and experienced investors, who are using their System 2, are less susceptible to it than are novices.

A rational decision maker is interested only in the future consequences of current investments. Justifying earlier mistakes is not among the Econ’s concerns. The decision to invest additional resources in a losing account, when better investments are available, is known as the sunk-cost fallacy, a costly mistake that is observed in decisions large and small. Driving into the blizzard because one paid for tickets is a sunk-cost error.

Imagine a company that has already spent $50 million on a project. The project is now behind schedule and the forecasts of its ultimate returns are less favorable than at the initial planning stage. An additional investment of $60 million is required to give the project a chance. An alternative proposal is to invest the same amount in a new project that currently looks likely to bring higher returns. What will the company do? All too often a company afflicted by sunk costs drives into the blizzard, throwing good money after bad rather than accepting the humiliation of closing the account of a costly failure.

This situation is in the top-right cell of the fourfold pattern, where the choice is between a sure loss and an unfavorable gamble, which is often unwisely preferred.

The escalation of commitment to failing endeavors is a mistake from the perspective of the firm but not necessarily from the perspective of the executive who “owns” a floundering project. Canceling the project will leave a permanent stain on the executive’s record, and his personal interests are perhaps best served by gambling further with the organization’s resources in the hope of recouping the original investment—or at least in an attempt to postpone the day of reckoning. In the presence of sunk costs, the manager’s incentives are misaligned with the objectives of the firm and its shareholders, a familiar type of what is known as the agency problem. Boards of directors are well aware of these conflicts and often replace a CEO who is encumbered by prior decisions and reluctant to cut losses.

The members of the board do not necessarily believe that the new CEO is more competent than the one she replaces. They do know that she does not carry the same mental accounts and is therefore better able to ignore the sunk costs of past investments in evaluating current opportunities.

The sunk-cost fallacy keeps people for too long in poor jobs, unhappy marriages, and unpromising research projects. I have often observed young scientists struggling to salvage a doomed project when they would be better advised to drop it and start a new one. Fortunately, research suggests that at least in some contexts the fallacy can be overcome. The sunk-cost fallacy is identified and taught as a mistake in both economics and business courses, apparently to good effect: there is evidence that graduate students in these fields are more willing than others to walk away from a failing project.

Dividend Yield – Investors May Be The Victims Of Pathetic Manipulation – Seth Klarman

Johnny HopkinsSeth Klarman Comments

Recently I had a conversation with a close friend of mine regarding one of his stocks. He told me that one particular stock was performing so badly that if he sold his current position he would stand to lose $20,000. I asked him why he initially bought the stock and he told me that it pays a good dividend. This situation is not uncommon for a lot of investors that chase dividend yield without any consideration for the price they pay for the stock.

It seems timely to remember what Seth Klarman wrote in his book – Margin of Safety regarding buying stocks solely on the basis of dividend yield.

Here’s an excerpt from the book:

Dividend Yield

Why is my discussion of dividend yield so short? Although at one time a measure of a business’s prosperity, it has become a relic: stocks should simply not be bought on the basis of their dividend yield. Too often struggling companies sport high dividend yields, not because the dividends have been increased, but because the share prices have fallen. Fearing that the stock price will drop further if the dividend is cut, managements maintain the payout, weakening the company even more.

Investors buying such stocks for their ostensibly high yields may not be receiving good value. On the contrary, they may be the victims of a pathetic manipulation. The high dividend paid by such companies is not a return on invested capital but rather a return of capital that represents the liquidation of the underlying business. This manipulation was widely used by money-center banks through most of the 1980s.

What’s An Investor Supposed To Do Today? Trennert & Zweig – WealthTrack

Johnny HopkinsJason Zweig Comments

It’s not surprising that some investors are finding it very difficult in today’s market with the number of index funds surging, fewer publicly traded stocks available, and computer dominated trading.

One of the most staggering statistics (below) reflecting current market conditions is that there are now more benchmark indexes than stocks, over 5,000, to meet the demand of passive index investing, especially ETF’s. So the question is; What do these dramatic market changes mean for investors?

Jason Trennert and Jason Zweig attempt to answer some of these questions in the latest interview at WealthTrack. Trennert is Co-Founder and Managing Partner at Strategas Research Partners and Jason Zweig is of course a journalist at The Wall Street Journal.

(Source: YouTube)

Here’s the interview:

Value Investing Woes Reflect Anxiety Among Equity Buyers

Johnny HopkinsValue Investing News Comments

A recent article at the Financial Times attempts to explain the present level of anxiety amongst equity buyers using the current value investing environment as an example:

Here’s an excerpt from that article:

It has become commonplace to ask how stock markets can be rallying when the world is confronted by so much uncertainty. Financial factors such as interest rates and earnings still matter more to stock markets than politicians’ populist gestures, even when it reaches the level of nuclear sabre-rattling.

But there is a deeper, and even harder, question to answer: how is the stock market performing so well when almost everything about it apart from its overall level suggests that investors are indeed as worried as financial laymen think they should be?

To illustrate, we need to examine the value style of investing. In its purest form, this means the painstaking search for a few companies so undervalued by a capricious market that investors will scarcely lose, even if they go bust. That is still a good but very demanding way to make money.

But these days, when investors talk about value they tend to mean a way of analysing a market, or almost giving it an X-ray, by looking at how individual factors are performing, once it is assumed that all other factors are held equal. It is not difficult to isolate exactly how much a low price/earnings multiple, or a high projected stream of future earnings, has on stocks’ performance.

Generally, factors perform well when they are thought to be in short supply. When times are bad, investors gobble up stocks that can show growth, because this is in short supply. When the economy has momentum, they choose “value” stocks as their way to participate most cheaply in the upswing. So value underperformance generally implies that investors are feeling negative. And value, all across the world, is enduring a terrible year.

In Germany and Japan, MSCI’s value indices have underperformed growth indices by 6.6 and 7.7 per cent respectively, while US value has taken a particular pounding, underperforming by more than 11 per cent. A strong rally in the immediate aftermath of the US election, when hopes were high for a few weeks that the administration would usher a growth agenda, has now been cancelled out.

Using quantitative tools, we can see a little more of what is happening. Andrew Lapthorne of Société Générale compared the five factors that are of greatest interest to investors – profitability, quality (which generally means a strong balance sheet and consistent earnings – a conservative approach), and momentum, which entails buying whatever has been doing well recently, as well as growth and value.

In the past year, growth was plainly triumphant, but there is also great concern to buy profitable companies with strong balance sheets. These are the preferences of conservative and worried investors, which we would normally expect to see at a time of high recession risk.

Comparing the valuation of different stocks suggests that value is radically out of favour. Value stocks will always by definition be cheaper than others, but at a global level they are trading at a deeper discount to other stocks, in terms of price/earnings multiples, than at any time in a decade. There appear to be compelling bargains out there, but people are still not picking them up.

The term “value” is itself an oversimplified term. Looking at different multiples that can show that a stock is cheap, Mr Lapthorne shows that over history it is free cash flow yield – where investors look for companies throwing off a lot of cash in relation to their value – that has fared best. Buying low free cash flow yield stocks is ultra-conservative, as it distrusts both GAAP-related earnings, and leverage (as debt service costs will eat into free cash flow).

But over time it has worked very well – until the past three years, when the lowest free cash flow yield stocks have lagged behind the main universe by 15 percentage points. The only time it fared worse was during the dotcom bubble, when many literally believed that it was impossible to pay too much for a stock. There is no such mania this time, but there is a similar disregard for value.

Trends differ by country. When Style Research, a London-based research group, broke down performance by factors and by geography, they found a sharp change for the US this year. Value did well last year, with all the factors linked to value performing well; and has done terribly this year, with growth factors taking over. Investors are particularly bidding up prices of stocks with strong predicted growth.

China is different. The same analysis by Style Research shows value factors outperforming last year and this, with little variation. The country is in a clear-cut shift towards value, suggesting that investors have confidence that there is growth to be found there. The US market has done a better job of making investors rich over the past two years as a whole, but the internal pattern suggests that they badly lack confidence compared to China.

One final quantitative finding shows the level of worry about the US. Mr Lapthorne found that companies with strong balance sheets did very well, while those with weak balance sheets have been punished. Investors may not be discerning in other ways, but they are definitely worried about leverage.

How do we reconcile a calmly rallying market with so much turmoil? The most likely explanation, I believe, is monetary policy. With bonds still so expensive, investors are still buying stocks, relatively indiscriminately, but not enthusiastically. And they are very worried about what happens to the most indebted companies when interest rates rise. It is an unpalatable picture, but it seems to be an accurate one.

You can find the original article here.

Here’s A Couple Of ‘Tricks’ Greenblatt Teaches His MBA Students To Assess Potential Investments

Johnny HopkinsJoel Greenblatt Comments

One of the biggest problems facing investors is trying to figure out a good starting point for assessing potential investments. Additionally, another problem we face is trying to make comparisons between potential investments to figure out which one is the better investment.

Some of the best answers to these challenges can be found in one of Joel Greenblatt’s lesser known books – The Big Secret For The Small Investor. Greenblatt provides a couple of tricks that he uses with his MBA students to 1) find a good starting point for assessing potential investments and 2) how to make comparisons between potential investments to figure out which one is the better investment. As is usual with all of Greenblatt’s teachings, sometimes the answers we’re looking for are best answered by making the challenge easier or not trying to answer the question if it’s too difficult.

Here’s an excerpt from the book:

We’ll begin by tackling the toughest problem of all. How in the world do we go about estimating the next thirty-plus years of earnings and, on top of that, try to figure out what those earnings are worth today? The answer is actually simple: we don’t. Instead, we just make the challenge easier.

We start with the assumption that there are other alternatives for our money. In my book, the main competition that any investment has to beat is how much we could earn “risk-free” by loaning money to the U.S. government. For our example (and for some reasons I’ll discuss later), we’ll assume that we could buy a ten-year U.S. Treasury bond that will pay us 6 percent a year for ten years. This is essentially lending the U.S. government money for those ten years with a guarantee that they will pay us 6 percent each year and then pay us all of our money back at the end of that time.

Now we finally have a simple standard that we can use to compare all of our other investment choices. If we don’t expect an investment will beat the 6 percent per year that is available risk-free from the U.S. government, then we won’t invest. That’s a great start! Let’s see what happens when we use our new tool to evaluate an investment in Candy’s Candies.

If you remember Candy’s Candies from Chapter 2, it’s really just our neighborhood candy shop. The business is for sale at a price of $100,000. Our best guess is that the business will earn $10,000 after taxes next year and that earnings will continue to grow a little bit each year as the town continues to expand. So here’s the question. If we invest $100,000 to buy the entire Candy’s Candies business and we earn $10,000 on our investment next year, is that better than taking that same $100,000 and investing in a U.S. government bond paying a guaranteed 6 percent per year for the next ten years? Let’s see.

The most obvious thing we can say right off the bat is that earning $10,000 in the first year on an investment of $100,000 is equal to a 10 percent return on our money (10,000 ÷ 100,000 = 10%). This is usually referred to as an earnings yield of 10 percent. That’s certainly higher than the 6 percent risk-free return we can get by lending money to the U.S. government. But, unfortunately, that’s not the end of the analysis. The 6 percent from the government is guaranteed, while the 10 percent from Candy’s Candies is just our best guess. Also, the 6 percent is guaranteed for ten years. The 10 percent return is our best guess for only next year’s earnings.

On the other hand, in future years we expect that 10 percent return to grow as earnings increase each year. In short, we are comparing a guaranteed 6 percent annual return that doesn’t grow or shrink to an expected but risky 10 percent return that we think will grow each year (but since it’s a guess, it could also shrink or disappear completely). How do we compare the two investments?

Here’s where it gets interesting. Are we very confident of our earnings estimate for Candy’s Candies? Are we very confident that earnings will grow over time? Of course, if we are, a 10 percent return that grows even larger as each year goes by could well be very attractive when compared to a flat 6 percent return. If we’re not very confident about our estimates, we might determine that the sure 6 percent from the government is a better deal. But that’s not all we can do with this analysis.

Now, we also have a way to compare an investment in Candy’s Candies with some of our other investment opportunities. Let’s say we also have a chance to buy our local Bad Bob’s Barbeque Restaurant. Bad Bob’s is also available for $100,000 (Bad Bob and batteries not included). We expect Bad Bob’s will earn $12,000 next year. That’s a 12 percent earnings yield for the first year. We also expect that earnings will grow even faster than Candy’s Candies over time. In addition, we are more confident in our estimates for earnings and future growth prospects for Bad Bob’s than we are for Candy’s Candies.

So while we still don’t know if either investment is more attractive than a government bond, we at least know that we think Bad Bob’s is a more attractive investment than Candy’s Candies. Why? This one’s easy. We expect to earn a 12 percent first-year return on our investment in Bad Bob’s versus 10 percent for Candy’s Candies, we expect that 12 percent return to grow faster than Candy’s Candies, and we have more confidence in our estimates for the local barbeque place than we do for the candy store.

So first we compare a potential investment against what we could earn riskfree with our money (for purposes of our discussion and for reasons that will be detailed later, we have set the minimum risk-free rate that we will have to beat at a 6 percent annual return). If we have high confidence in our estimates and our investment appears to offer a significantly higher annual return over the long term than the risk-free rate, we’ve passed the first hurdle.

Next, we compare our potential investment with our other investment alternatives. In our example, Bad Bob’s offers a higher expected annual return and a higher growth rate, and we are even more confident in our estimates than we are for Candy’s Candies. So we obviously prefer Bad Bob’s over Candy’s Candies. Of course, if we have high confidence that both investment alternatives offer a better deal than the risk-free government bond, we can always decide to buy both. But, in general, this is the basic process that I go through when evaluating and comparing businesses to invest in for my own portfolio.

When I teach this concept to my MBA students, at this point in the discussion I always ask them the following questions: What happens if we are trying to value a company and we’re having a hard time estimating future earnings and growth rates? What if the industry is very competitive and we’re just not sure if current earnings are sustainable? Maybe we have a question about whether some of their new products will be successful. Sometimes we’re not sure how new technologies will affect a company’s main service or product. What are we supposed to do then?

My answer is always simple: skip that company and find one that’s easier to evaluate. If you don’t have a good idea about what’s going to happen in the industry, with the company’s new products or services, or the effects of new technology on the company, then you can’t really make good estimates for future earnings or growth rates. If you can’t do that, you have no business investing in that company in the first place!

But I know what you’re thinking: Thanks for the advice, but this stuff still sounds really hard to do.

In reality, I don’t expect even my best MBA students to be very good at making estimates of future earnings and growth rates for most companies. In fact, I tell them not to bother. In the stock market, no one forces you to invest. You have thousands of companies to choose from. I tell them the best course of action is to find the few companies where you have a good understanding of the business, the industry, and the future prospects for earnings. Then make your best estimates and comparisons for the handful of companies you can evaluate. For these companies, an evaluation can also include relative value analysis, acquisition value analysis, or some of the other methods that we’ve already discussed.

But that’s what I tell them. What I’ll tell you is that you’re absolutely right: this stuff is hard. But that was my point all along. All that I want is for you to begin to understand some of the challenges faced by professional investment managers. I want you to appreciate how tough it must be to make confident estimates for dozens and sometimes hundreds of companies. I want you to understand the questions that need to be asked, the comparisons that need to be made, and the complicated assessments that have to be reached about the future.

In fact, these issues are so tough, it’s kind of like we’re all stuck taking that Shakespeare final together! But don’t worry yet. If Hamlet can make it, so can we. (Wait, did Hamlet make it?) Anyway, there’s plenty more ahead including a discussion about all the things I tell my students to do, an examination of what most professional investment managers actually do, and finally, advice for what most of you should do (hint: it doesn’t involve making a single estimate!).

But first, let’s go to the summary and review what we’ve learned so far.

SUMMARY

1. It’s hard to make earnings estimates for the next thirty-plus years. It’s hard to figure out what those earnings are worth today. So we don’t.

2. Instead, when we evaluate the purchase price of a company, we make sure that our investment will return more than the 6 percent per year we could earn risk-free from the U.S. government (see the box [below summary] on this page for further explanation).

3. If our investment appears to offer a significantly higher annual return over the long term than the risk-free rate and we have high confidence in our estimates, we’ve passed the first hurdle.

4. Next, we compare the expected annual returns of our potential investment and our level of confidence in those returns to our other investment alternatives.

5. If we can’t make a good estimate of the future earnings for a particular company, we skip that one and find a company we can evaluate.

6. It’s really hard for investment professionals to make estimates and comparisons for dozens and sometimes hundreds of companies.

7. We’re about to learn what I tell my students to do so that they can meet some of these challenges.

8. If Hamlet can make it, so can we! (Unfortunately, I just checked and it turns out Hamlet is a tragedy.)

Why is 6 percent the minimum annual return that any investment should beat? Why do we look at the ten-year U.S. Treasury bond? What if the tenyear Treasury bond is paying less than 6 percent? What if the ten-year bond is paying more than 6 percent?

——————————————————————————————————————————–

Obviously, if we can earn 6 percent per year on our investments without taking any risk, we should invest in something else only if we have confidence that that investment will pay us a much higher rate over the long term. The ten-year U.S. government bond, though not perfect, is the closest we can come to a guarantee of a risk free fixed interest rate and the return of all of our initial investment.

Although the risk-free U.S. government bond rate is sometimes less than 6 percent, we use 6 percent as our minimum to be conservative. We look at the ten-year bond because ten years is a relatively long time (using a thirtyyear bond rate would also be acceptable).

If the ten-year bond rate is above 6 percent, we would use that higher number. Obviously, if we could earn 8 percent risk-free, that would be the rate our other investments should have to beat.

What if we find a company for $100,000 that we expect to earn only $5,000 next year? Could we ever buy that company, since that would only give us a 5 percent annual return? The answer is actually yes. If we had high confidence that in a few years that company’s earnings would grow so much that it would be earning $10,000 or $12,000 per year, we might consider it.

In other words, the company would soon be returning 10 percent or 12 percent per year even though next year it would only be returning 5 percent. Under these circumstances, it could be better than our risk-free return.

Here’s What Great Fund Managers Do When There Are Few Opportunities – Seth Klarman

Johnny HopkinsSeth Klarman Comments

According to a recent article at Bloomberg, Seth Klarman the head of Baupost is returning capital to his investors because he can’t find sufficient opportunities in the market today. This is not the first time Baupost has returned capital to its investors. The hedge fund did the same thing in 2010 and 2013.

Here’s an excerpt from the article:

Seth Klarman’s $30 billion Baupost Group plans to return some capital to investors by year end because the hedge fund doesn’t see enough opportunities in the market.

Investors were told in recent weeks that the firm expects to return capital for the third time in its history, according to a person with knowledge of the matter. Boston-based Baupost is holding 42 percent of its assets in cash and wants to balance the money it manages with potential opportunities, said the person, who declined to be named because the information is private. It is unclear how much will be given back.

Baupost, a value-investment firm that profits from cheap assets, is finding it challenging to dig up bargains as central bank policy has helped prop up stock prices. Other hedge funds have made similar decisions because of worries over frothy markets. ValueAct Capital Management, the activist fund run by Jeffrey Ubben, planned to return $1.25 billion to investors in May amid concern that company valuations were too expensive.

Diana DeSocio, a spokeswoman for Baupost, declined to comment.

Baupost also returned capital to investors in 2010 and 2013 for similar reasons.

Jim Mooney, president of Baupost, warned in a July investor letter that a low volatility environment could create conditions for another financial crisis because it encourages risk-taking through increased use of debt.

Klarman, 60, who wrote the preface to the sixth edition of “Security Analysis,” the landmark 1934 book by Benjamin Graham on value investing, has been a portfolio manager with Baupost since its inception.

You can find the original article at Bloomberg here.

Great Investors Create Their Own Version Of Omaha – Buffett, Munger, Klarman, Pabrai

Johnny HopkinsCharles Munger, Guy Spier, Mohnish Pabrai, Seth Klarman, Warren Buffett Comments

One of the biggest problems facing investors is the amount of ‘noise’ that we get from the financial media and commentators. Financial news sections, the internet, and podcasts are continually bombarding us with the latest ‘hot stock’ or miracle investing strategy. Meanwhile investors get caught up in the noise checking their stocks daily to see what’s performing well and what’s under-performing.

It is therefore no coincidence that the very best investors have found some unconventional ways to shut out the noise and focus on what’s important in order to achieve outstanding returns. But how do they manage to do it?

One answer can be found in the book – The Education Of A Value Investor, by Guy Spier. In Chapter 8 titled – My Own Version Of Omaha, Spier illustrates how he and some of the world’s great investors such as Buffett, Munger, Pabrai, and Klarman have set up their work environments in such a way as to minimize distractions and cut out the noise from financial markets. While some of these methods of created a distraction-free environment may seem unconventional, clearly they work, at least from these great investors. Spier himself made the decision to move to Zurich from Manhattan to create what he calls – his own version of Omaha.

Here’s an excerpt from the book:

So I started actively to consider alternatives to Manhattan. For a while, I thought seriously of moving to Omaha, given how well it had worked for Warren. I also considered Irvine, California, where Mohnish lives. I contemplated other American cities like Boston, Grand Rapids, and Boulder. And I thought about relatively low-key European cities such as Munich, Lyon, Nice, Geneva, and Oxford. But in the end, Lory and I agreed on Zurich. I had gone there often as a child and had always liked it.

Zurich also struck me as a place where I could live in mental peace—a quiet, pleasant, slightly bland setting where there isn’t too much going on. Here I could focus on my family and my fund without undue disturbance. Occasionally people ask me, “But isn’t it boring there?” My answer: “Boring is good. As an investor, that’s exactly what I want.” Because distraction is a real problem. What I really need is a plain, unobtrusive background that’s not overly exciting. And I’m certainly not alone in finding Zurich conducive to clear thought. Historically, the city has provided a space for free contemplation to residents as diverse as Carl Jung, James Joyce, Richard Wagner, Vladimir Lenin, and Albert Einstein—not to mention Tina Turner.

Next, I set about finding the perfect office—another key component of my new environment. Initially, I made a mistake, renting an office for a year on the Bahnhofstrasse, a ritzy street that is Zurich’s own enclave of Extremistan. It’s an elegant area, full of expensive stores. But super-rich settings like this are not ideal for me since they stimulate unhealthy appetites. So I soon decided to move to an office on the other side of the river, a 15-minute walk from the Bahnhofstrasse’s glitz and glamour. For me, this feels like a safe distance.

I also began to recognize that other investors I admire had adopted a similar approach to building their environment, whether consciously or not. Mohnish, for one, works in a less-than-glamorous office park in Southern California with no other financial institutions nearby. I once asked him why he hadn’t set himself up in an attractive office in one of Irvine’s fancy shopping centers, close to his favorite restaurants. “Oh, Guy,” he replied. “I don’t need all that razzmatazz!” I have no doubt that he understands what the area around him can do to his mind.

Likewise, Seth Klarman, one of the most successful investors on the planet, works out of a decidedly unflashy office in Boston, far from the intoxications of Wall Street. If he wanted, he could easily rent the top floor of a gleaming skyscraper overlooking the Charles River. Nick Sleep set up his office in London near a Cornish pasty shop on the King’s Road, far from the grandeur of Mayfair, which has become Britain’s hedge fund mecca. Allen Benello, the manager of White River Investment Partners, works out of a nondescript office in San Francisco, nowhere near the city’s financial district. And Buffett, as we’ve discussed, is tucked away in Omaha’s Kiewit Plaza—another building that is not exactly known for its razzmatazz.

This strikes me as a significant yet largely unrecognized factor in the success of these investors. Small wonder, then, that I wanted to create my own version of Omaha.

That said, I’m different from Buffett—and not just in terms of IQ points. For one thing, it’s important for me to have a pleasant view from my office, whereas he’s not fussed about such aesthetic considerations. While I like to look out on trees or something similarly cheering, he routinely keeps the blinds drawn in his office. But in other substantive ways, I consciously modeled the environment he’d created in Omaha. For example, Warren lives about a ten-minute drive from his office, which is slightly outside the city center. Mohnish’s office in Irvine is also about ten minutes from his home, and it’s slightly outside the city center. I mirrored them, selecting an office that’s a twelve-minute walk or seven-minute tram ride from my home and that’s slightly outside the city center.

For me, it works to be outside the heart of the city, partly because this makes it less likely that too many people will drop by the office opportunistically. They need a stronger reason to make this effort, so their visits tend to be more worthwhile.

These decisions were carefully considered. For example, Mohnish and I had specifically discussed commuting times, reaching the conclusion that the ideal commute takes around ten to twenty minutes. This is close enough to improve one’s quality of life, but far enough to establish a separation between work and home. For people like me who get obsessive about their jobs, it’s useful to have this separation. We need to see our families and spend time at home when we’re not just buried in work.

As I’ve mentioned, one of my flaws is that I’m amazingly easy to distract, and I need to address this problem in designing my physical environment. Unlike Buffett, who can operate brilliantly without a computer or an email address, I rely on my computer. But I’m also aware that the Internet and email can become appalling distractions for me. To counteract this and to help me remain focused, I physically divided my office.

At one end of the corridor, I have a “busy room,” with a phone, a computer, and four monitors. But I keep the computer and the monitors on an adjustable-height desk, which I typically position so that I have to stand beside it. Responding to emails is a low mental task, but it’s easy to get sucked into it for long stretches of time. So I’ve intentionally set up the desk in a way that prevents me from sitting at it. This might seem perverse, but the goal is to create an office that gives me the space to think quietly and calmly. Minor adjustments like this awkward positioning of the computer help to stack the odds in my favor.

At the other end of the corridor, I have a room that I call the library. Here, there’s no phone or computer. I want to encourage myself to spend more time sitting and thinking, so this room is designed to be warm and welcoming. I can take piles of financial documents to study in there or select a book from the shelves that line the walls. If I close the door, it means that nobody is allowed to bother me. The library also serves as a nap room. Not coincidentally, Mohnish also naps in his office, and Warren told us that he has a place in his office where he can nap too. This isn’t a matter of sloth—or, at least, not entirely! A daytime snooze keeps the mind fresh, shuts out the noise, and provides a chance to reboot the system.

About a year after our charity lunch, Warren Buffett generously gave Mohnish and me an impromptu tour of his office in Omaha. I was fascinated to see how he had structured his own environment to enhance his ability to make rational decisions. Perhaps the most striking feature of his office was that it contained so little that could clutter his mind. He had only two chairs and no space for large meetings—a practical means of discouraging unnecessary interactions. His window shades were closed, presumably helping him to focus on the task at hand.

On the wall behind his desk, Warren had a prominently displayed photo of his father, Howard Buffett, whom he greatly admires. Lowenstein’s biography of Warren describes Howard as an “unshakably ethical” Congressman who “refused offers of junkets and even turned down a part of his pay. During his first term, when the congressional salary was raised from $10,000 to $12,500, Howard left the extra money in the Capitol disbursement office, insisting that he had been elected at the lower salary.” It’s not hard to see this influence on Warren, whose modest salary for running Berkshire reflects a similar sense of integrity and altruism. More to the point, the photo is a reminder of how helpful it can be to include images of our role models when we are constructing our own work environment.

As for Warren’s desk, it was so small that there was no room for piles, obliging him to process his reading efficiently. An in-box and an out-box lay on top of his desk, along with a box labeled “Too Hard”—a visual reminder that he should wait patiently until the perfect opportunity arrives. As he puts it, “I will only swing at pitches I really like.”

There’s an element of playfulness about his “Too Hard” box, but its presence must also have a subtle effect on the way he thinks. These cues wouldn’t help much if Buffett didn’t also have an extraordinary mind. But it’s interesting that even a man of his intelligence sees fit to keep that box on his desk as a physical aid that keeps his mind on track. To me, this shows a remarkable humility about his abilities.

I also found it telling that there was no Bloomberg terminal in Buffett’s office. Apparently, there’s one at the other end of the building, used by a Berkshire employee who manages a bond portfolio. Buffett could no doubt access it if he wanted to, but he’s consciously chosen not to have this informational fire hose within easy reach.

Likewise, when I visited Nick Sleep’s office in London, I was intrigued to discover that he kept his Bloomberg awkwardly positioned so that he could use it only while sitting on an uncomfortably low chair. Like Buffett, he had consciously designed his environment to discourage his use of a terminal that costs more than $20,000 a year to rent. Why? After all, a constant flow of information is surely the lifeblood of any professional investor.

My own relationship with the Bloomberg terminal is similarly ambivalent and tortured. It’s a formidable tool, and there are times when I’ve found it helpful as a way to get stock data or news in a hurry. In my New York vortex years, my Bloomberg subscription also served the dubious purpose of bolstering my ego. It made me feel like a privileged member of a club that could afford the most expensive toys; without it, I might not have felt equal to my peer group. But beyond this foolishness, there’s also a more serious downside to using a Bloomberg—or, for that matter, rival systems sold by companies like Reuters and FactSet.

All of these products—but especially the coveted, top-of-the-line Bloomberg—are ingeniously designed to lure the subscriber with the seductive promise of nonstop information. The terminal delivers such a relentless flood of news and data into investors’ brains that it’s hard to muster the self-discipline to turn off the spigot and concentrate on what matters most. You see stock tickers flashing before your eyes, news alerts blaring for your attention. Everything links to something else, so you often find yourself ricocheting into deeper and deeper recesses within this informational netherworld.

Initially, I was totally hooked. In my early years as a money manager, I would arrive in my Manhattan office and immediately fire up my Bloomberg. It would light up like a Christmas tree, its bright colors subconsciously spurring its users to action. But as I became more self-aware, I began to realize that this call to action wasn’t helping me at all; nor were the endless hours of information surfing. I started to ask myself, “Is this really the best and highest use of my attention?” If I have only a limited amount of willpower, how much of it should I squander in trying to resist the temptation to snack on all of this informational sugar?

During the financial crisis, I saw more clearly than ever what an unhealthy addiction the Bloomberg had become. The constant barrage of bad news could easily have exacerbated my irrational tendencies, when what I needed most was to screen out the noise and focus on the long-term health of my portfolio. So I went cold turkey. In late 2008 and early 2009, as the market collapsed, I turned the monitor off for days on end. Another tactic that I used to distance myself from the Bloomberg was to stop having a personal login, though we still had a company login. I also changed the color scheme on my home screen so that it was dull and muted, thereby minimizing the risk that all those bright, flashing colors might jolt my irrational brain into unnecessary action.

In setting up my office in Zurich, I had to decide once again how to tackle the Bloomberg conundrum. By now, I was used to having the service. Psychologically, it would have been painful to let it go. I also knew that occasionally it was extraordinarily useful. But I was equally aware that, for me, it did more harm than good. So, in the end, I came to an uneasy compromise. I relegated the Bloomberg to the adjustable-height desk in my busy room. The fact that the desk is adjusted so that I usually have to stand means that there’s little danger that I’ll be tempted to use the Bloomberg for hours, grazing in a state of helpless distraction. Nowadays, I often go weeks without turning on the Bloomberg at all. Still, it’s there if I ever need it—my own exceptionally expensive version of a toddler’s security blanket.

Of course, the rational part of my brain tells me that I’d be better off getting rid of the Bloomberg entirely. Why bother paying more than $20,000 a year for a distraction that I can so easily do without? But I accept my fallibility. Instead of pretending to be perfectly rational, I find it more helpful to be honest with myself about my irrationality. At least then I can take practical steps that help me to manage my irrational self. Perhaps this is the best that any of us can do.

25 Timeless Investing Lessons From Charles Munger

Johnny HopkinsCharles Munger Comments

One of our favorite investors here at The Acquirer’s Multiple is Charles Munger. Over the years Munger has provided us with a number of investing gems and one of the best sources of Munger’s quotes can be found in the book – Poor Charlie’s Almanack. While there are hundreds of Mungerisms in the book I picked out twenty five timeless investing lessons.

Here’s an except from the book:

1. There are two kinds of businesses: The first earns twelve percent, and you can take the profits out at the end of the year. The second earns twelve percent, but all the excess cash must be reinvested-there’s never any cash. It reminds me of the guy who sells construction equipment-he looks at his used machines, taken in as customers bought new ones, and says, “There’s all of my profit, rusting in my yard.” We hate that kind of business.

2. If mutual fund directors are independent, then I’m the lead character in the Bolshoi Ballet.

3. If you take the best text in economics by Mankiw, he says intelligent people make decisions based on opportunity costs-in other words, it’s your alternatives that matter. That’s how we make all of our decisions. The rest of the world has gone off on some kick-there’s even a cost of equity capital. A perfectly amazing mental malfunction.

4. If you took our top fifteen decisions out, we’d have a pretty average record. It wasn’t hyperactivity, but a hell of a lot of patience. You stuck to your principles, and when opportunities came along, you pounced on them with vigor.

5. Our game is to recognize a big idea when it comes along, when one doesn’t come along very often. Opportunity comes to the prepared mind.

6. People who have loose accounting standards are just inviting perfectly horrible behavior in other people. And it’s a sin, it’s an absolute sin. If you carry bushel baskets full of money through the ghetto and made it easy to steal, that would be a considerable human sin because you’d be causing a lot of bad behavior, and the bad behavior would spread. Similarly, an institution that uses sloppy accounting commits a real human sin, and it’s also a dumb way to do business.

7. To say accounting for derivatives in America is a sewer is an insult to sewage.

8. One of the key elements to successful investing is having the right temperament-most people are too fretful; they worry too much. Success means being very patient, but aggressive when it’s time. And the more hard lessons you can learn vicariously rather than through your own hard experience, the better.

9. Our approach has worked for us. Look at the fun we, our managers, and our shareholders are having. More people should copy us. It’s not difficult, but it looks difficult because it’s unconventional – it isn’t the way things are normally done.

10. The idea that it is hard to find good investments, so concentrate in a few, seems to me to be an obviously good idea. But ninety-eight percent of the investment world doesn’t think this way. lt’s been good for us-and you-that we’ve done this.

11. There are two types of mistakes: 1) doing nothing, what Warren calls “sucking my thumb” and 2) buying with an eyedropper things we should be buying a lot of.

12. Lumpy results and being willing to write less insurance business if market conditions are unfavorable … that is one of our advantages as an insurer we don’t give a damn about lumpy results. Everyone else is trying to please Wall Street. This is not a small advantage.

13. If you’re going to be an investor, you’re going to make some investments where you don’t have all the experience you need. But if you keep trying to get a little better over time you’ll start to make investments that are virtually certain to have a good outcome. The keys are discipline, hard work. and practice. It’s like playing golf-you have to work on it.

14. The number one idea is to view a stock as an ownership of the business and to judge the staying quality of the business in terms of its competitive advantage. Look for more value in terms of discounted future cash flow than you are paying for. Move only when you have an advantage. It’s very basic. You have to understand the odds and have the discipline to bet only when the odds are in your favor. We just keep our head down and handle the headwinds and tailwinds as best we can, and take the result after a period of years.

15. People have always had this craving to have someone tell them the future. Long ago, kings would hire people to read sheep guts. There’s always been a market for people who pretend to know the future. Listening to today’s forecasters is just as crazy as when the king hired the guy to look at the sheep guts. It happens over and over and over.

16. I think there’s something to be said for developing the disposition to own stocks without fretting. [But] temperament alone won’t do it. You need a lot of curiosity for a long, long time.

17. I think there’s some mythology in this idea that I’ve been this great enlightener of Warren. He hasn’t needed much enlightenment. But we know more now than five years ago.

18. I’m glad we have insurance, though it’s not a no-brainer, I’m warning you. We have to be smart to make this work.

19. How can professors spread this [nonsense that a stock’s volatility is a measure of risk]? I’ve been waiting for this craziness to end for decades. It’s been dented, but it’s still out there.

20. We believe there should be a huge area between everything you should do and everything you can do without getting into legal trouble. I don’t think you should come anywhere near that line. We don’t deserve much credit for this. It helps us make more money. I’d like to believe that we’d behave well even if it didn’t work. But more often, we’ve made extra money from doing the right thing.

21. You need to have a passionate interest in why things are happening. That cast of mind, kept over long periods, gradually improves your ability to focus on reality. If you don’t have that cast of mind, you’re destined for failure even if you have a high l.Q.

22. If you buy something because it’s undervalued, then you have to think about selling it when it approaches your calculation of its intrinsic value. That’s hard. But if you buy a few great companies, then you can sit on your ass. That’s a good thing.

23. It is occasionally possible for a tortoise, content to assimilate proven insights of his best predecessors, to outrun hares that seek originality or don’t wish to be left out of some crowd folly that ignores the best work of the past. This happens as the tortoise stumbles on some particularly effective way to apply the best previous work, or simply avoids standard calamities. We try more to profit from always remembering the obvious than from grasping the esoteric. It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.

24. If you have competence, you pretty much know its boundaries already. To ask the question [of whether you are past the boundary] is to answer it.

25. It’s hard to sit here at this annual meeting, surrounded by smart, honorable stockbrokers who do well for their clients, and criticize them. But stockbrokers, in toto, will do so poorly that the index fund will do better.

This Week’s Best Investing Reads

Johnny HopkinsValue Investing News Comments

Here’s some of this week’s best investing reads:

A Dozen Lessons about Investing and Money from Dan Ariely (25iq)

The Wrong Side of Right (Farnam Street)

The Unintended Consequences of Innovation (A Wealth of Common Sense)

A Chat With Daniel Kahneman (Collaborative Fund)

Markets don’t care who is President (Bloomberg)

The Myth of Stock Market Tops (wsj.com)

If you’re going to make predictions, make them often (The Reformed Broker)

When Is the Best Time to Invest in the Stock Market? (betterment.com)

The Dhandho Investor’s Guide to Calculating Intrinsic Value (Safal Niveshak)

Episode #70: Radio Show: The 13F Guru Meb Would Follow Today (Meb Faber)

How ETF Trading Works: A Deep Dive Into ETF Market Making (Alpha Architect)

Factors, Dividends, and Angel Investing, w/ Meb Faber – [Invest Like the Best, EP.53] (The Investor’s Field Guide)

The Latticework Podcast: Robert Robotti on the Role of Active Management in the Modern World (Dataroma)

Is Value Investing Broken? – Morningstar

Johnny HopkinsValue Investing News Comments

Just finished reading a great article titled – Is Value Investing Broken? – at Morningstar. The article demonstrates that while a value investing strategy can be difficult to stick to at times, it’s still a commonsense strategy that outperforms over time, based on the principle: cheap stuff outperforms expensive stuff over the long term.

Here’s an except from the article:

It hasn’t been easy to be a value investor lately. The Morningstar US Growth Index has whipped the Morningstar US Value Index during the past several years–and things have been especially rough this year. But at the Morningstar ETF Conference, a panel of value practitioners pointed out that it’s never easy to be a value investor, and that value stocks today are behaving just as they should.

Moderator and Morningstar analyst Dan Sotiroff kicked things off with a broad question for the panel: Is the performance drought in value during the past decade simply a temporary lull or something more persistent?

“Value has been crushed,” admitted John Ameriks, head of Vanguard’s quantitative equity group. “There’s no magic strategy that’s always going to work. But if you believe in this flavor of investing, it’s been getting more attractive on a go-forward basis.”

“The world is unfolding exactly as it should,” added John West, managing director at Research Affiliates. Almost any factor or style of investing goes through 10 years of underperformance. To invest in any particular style, you need to go in with very a long time horizon, he noted–at least 10 years.

“The expected return of this strategy is 2%–plus or minus 10%,” said West. Those unwilling to accept this possible range of returns in any given year shouldn’t engage in value investing. Along with a long time horizon and an ability to accept a wide range of returns, investing in value strategies requires the fortitude to invest in “uncomfortable” stocks, those that others won’t touch.

“You’ve got to own the pain, you’ve got to buy the cheap stuff everybody hates,” argued Wes Gray, CEO of Alpha Architect. “You’ve got to own all this stuff that Amazon (AMZN) is going to rip off the planet. It’s not like Macy’s (M) is going to kick Amazon’s butt, but Macy’s may not go bankrupt. Buying cheap stuff that stinks can be the best investment in the world.”

And that’s the premise behind value investing: cheap stuff outperforms expensive stuff over the long term. But what metrics are best to use to determine what’s cheap: price/book, price/earnings, price/sales, or some combination thereof?

“There’s no one right way to be a value investor,” said Ameriks. The “right” metrics may depend on what company, type of stock, or sector you’re considering.

“We try to use a broad array of measures,” noted West. Further, the typical value metrics tend to track each other over the long term.

Some value managers will overlay additional criteria–say, a quality screen or a maximum sector percentage–to the process, in an effort to thwart risk and perhaps add a bit of extra return.

“You have to start with value, with the stuff that’s uncomfortable,” reminded West. “And then if you want to focus on higher quality, go ahead and maybe you can get some incremental improvement in return.”

Though, conversely, adding too many layers of criteria can dampen the effectiveness of the value effect over time.

“It gets much harder as you add additional overlays,” noted Ameriks.

Gray noted that the more you sector-neutralize, the less you’re capturing the value premium.

“Anything related to Amazon is a value stock–retailers are correlated today,” he said. “If it’s all cheap because it’s in Amazon’s path, you need to own a lot of it.”

Rather than adding too many overlays, value investors can instead diversify across a large number of stocks or own bigger rather than smaller companies–though the panelists agreed that, in general, most factors are more effective with small-cap stocks, due to less information and efficiency in that part of the market.

“The concept of not overpaying makes sense in large caps and small caps,” noted Ameriks.

Though value investing can be trying at times, it’s a commonsense strategy rooted in one basic investing principle: as prices go up, expected returns go down.

“It’s called math,” concluded Gray.

Susan Dziubinski does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

You can find the original article at Morningstar here.

Howard Marks Latest Memo: Yet Again?

Johnny HopkinsHoward Marks Comments

Howard Marks has recently released his latest memo titled – Yet Again? In this memo Marks reflects on the response he received to his previous memo titled – There They Go Again…Again.

Marks wrote the following about the response he received to his last memo:

There They Go Again . . . Again of July 26 has generated the most response in the 28 years I’ve been writing memos, with comments coming from Oaktree clients, other readers, the print media and TV.  I also understand my comments regarding digital currencies have been the subject of extensive – and critical – comments on social media, but my primitiveness in this regard has kept me from seeing them.”

“The responses and the time that has elapsed have given me the opportunity to listen, learn and think.  Thus I’ve decided to share some of those reflections here.”

While the latest memo contains lots of great supplemental investing insights on the State of The Market, Passive Investing, Bitcoin and the FAANGS, the section that I found most interesting is titled – Investing In A Low Return World. Here’s an excerpt from the latest memo:

Investing in a Low-Return World

A lot of the questions I’ve gotten on the memo are one form or another of “So what should I do?” Thus I’ve realized the memo was diagnostic but not sufficiently prescriptive. I should have spent more time on the subject of what behavior is right for the environment I think we’re in.

In the low-return world I described in the memo, the options are limited:

Invest as you always have and expect your historic returns.
Invest as you always have and settle for today’s low returns.
Reduce risk to prepare for a correction and accept still-lower returns.
Go to cash at a near-zero return and wait for a better environment.
Increase risk in pursuit of higher returns.
Put more into special niches and special investment managers.

It would be sheer folly to expect to earn traditional returns today from investing like you’ve done traditionally (#1). With the risk-free rate of interest near zero and the returns on all other investments scaled based on that, I dare say few if any asset classes will return in the next few years what they’ve delivered historically.

Thus one of the sensible courses of action is to invest as you did in the past but accept that returns will be lower. Sensible, but not highly satisfactory. No one wants to make less than they used to, and the return needs of institutions such as pension funds and endowments are little changed. Thus #2 is difficult.

If you believe what I said in the memo about the presence of risk today, you might want to opt for #3. In the future people may demand higher prospective returns or increased prospective risk compensation, and the way investments would provide them would be through a correction that lowers their prices. If you think a correction is coming, reducing your risk makes sense. But what if it takes years for it to arrive? Since Treasurys currently offer 1-2% and high yield bonds offer 5-6%, for example, fleeing to the safety of Treasurys would cost you about 4% per year. What if it takes years to be proved right?

Going to cash (#4) is the extreme example of risk reduction. Are you willing to accept a return of zero as the price for being assured of avoiding a possible correction? Most investors can’t or won’t voluntarily sign on for zero returns.

All the above leads to #5: increasing risk as the way to earn high returns in a low-return world. But if the presence of elevated risk in the environment truly means a correction lies ahead at some point, risk should be increased only with care. As I said in the memo, every investment decision can be implemented in high-risk or low-risk ways, and in risk-conscious or risk-oblivious ways. High risk does not assure higher returns. It means accepting greater uncertainty with the goal of higher returns and the possibility of substantially lower (or negative) returns. I’m convinced that at this juncture it should be done with great care, if at all.

And that leaves #6. “Special niches and special people,” if they can be identified, can deliver higher returns without proportionally more risk. That’s what “special” means to me, and it seems like the ideal solution. But it’s not easy. Pursuing this tack has to be based on the belief that (a) there are inefficient markets and (b) you or your managers have the exceptional skill needed to exploit them. Simply put, this can’t be done without risk, as one’s choice of market or manager can easily backfire.

As I mentioned above, none of these possibilities is attractive or a sure thing. But there are no others. What would I do? For me the answer lies in a combination of numbers 2, 3 and 6.

Expecting normal returns from normal activities (#1) is out in my book, as are settling for zero in cash (#4) and amping up risk in the hope of draws from the favorable part of the probability distribution (#5) (our current position in the elevated part of the cycle decreases the likelihood that outcomes will be favorable).

Thus I would mostly do the things I always have done and accept that returns will be lower than they traditionally have been (#2). While doing the usual, I would increase the caution with which I do it (#3), even at the cost of a reduction in expected return. And I would emphasize “alpha markets” where hard work and skill might add to returns (#6), since there are no “beta markets” that offer generous returns today.

These things are all embodied in our implementation of the mantra that has guided Oaktree in recent years: “move forward, but with caution.”

Since the U.S. economy continues to bump along, growing moderately, there’s no reason to expect a recession anytime soon. As a consequence, it’s inappropriate to bet that a correction of high prices and pro-risk behavior will occur in the immediate future (but also, of course, that it won’t).

Thus Oaktree is investing today wherever good investment opportunities arise, and we’re not afraid to be fully invested where there are enough of them. But we are employing caution, and since we’re a firm that thinks of itself as always being cautious, that means more caution than usual.

This posture has served us extremely well in recent years. Our underlying conservatism has given us the confidence needed to be largely fully invested, and this has permitted us to participate when the markets performed better than expected, as they did in 2016 and several of the last six years. Thus we’ll continue to follow our mantra, as we think it positions us well for the uncertain environment that lies ahead.

inTEST Corporation Still Undervalued Despite 100% Gain – Small & Micro Cap Stock Screener

Johnny HopkinsStocks Comments

One of the cheapest stocks in our Small & Micro Cap Stock Screener is inTEST Corporation (NYSEMKT:INTT).

inTest Corp (inTest) is an independent designer, manufacturer and marketer of thermal, mechanical and electrical products that are used by semiconductor manufacturers in conjunction with ATE, in the testing of ICs.

A quick look at inTest’s share price history over the past twelve months shows that the price is up 100%, but here’s why the company remains undervalued.

The following data is from the company’s latest financial statements, dated June 2017.

The company’s latest balance sheet shows that inTest has $8 Million in total cash and cash equivalents. Further down the balance sheet we can see that the company has zero debt. Therefore, inTest has a net cash position of $8 Million (cash minus debt).

If we consider that inTest currently has a market cap of $78 Million, when we subtract the net cash totaling $8 Million that equates to an Enterprise Value of $70 Million.

If we move over to the company’s latest income statements we can see that inTest has approximately $10 Million* in trailing twelve month operating earnings which means that the company is currently trading on an Acquirer’s Multiple of 7.30, or 7.30 times operating earnings. That places inTest squarely in undervalued territory.

The Acquirer’s Multiple is defined as:

Enterprise Value/Operating Earnings*

*We make adjustments to operating earnings by constructing an operating earnings figure from the top of the income statement down, where EBIT and EBITDA are constructed from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries and sectors possible, and, by excluding special items–income that a company does not expect to recur in future years–ensures that these earnings are related only to operations.

A quick look at the company’s latest cash flow statements shows that inTest generated trailing twelve month operating cash flow of $7 Million and had $0 Million in Capex. That equates to $7 Million in trailing twelve month free cash flow, or a FCF/EV Yield of 10%.

It’s also worth considering inTest’s annualized Return on Equity (ROE) for the quarter ending June 2017. A quick calculation shows that the company had $40 Million in equity for the quarter ending March 2017 and $42 Million for the quarter ending June 2017. If we divide that number by two we get average equity of $41 Million. If we consider that the company has $5.61 Million (ttm) in net income, that equates to an annualized Return on Equity (ROE) for the quarter ending June 2017 of 14%.

Lastly, inTest’s current revenues of $51 Million (ttm) are an historical high as is its book value per share of $4 (ttm) and operating margins of 53% (ttm). The company’s net income of $5.61 Million (ttm) and free cash flow of $7 Million (ttm) are also five years highs.

In terms of inTest’s current valuation, the company is trading on a P/E of 13.7 compared to its 5Y average of 15.6**, a P/B of 1.9 compared to its 5Y average of 1.3**, and a P/S of 1.5 compared to its 5Y average of 1**. inTest has a FCF/EV Yield of 10% (ttm) and an Acquirer’s Multiple of 7.30, or 7.30 times operating earnings. The company has an annualized Return on Equity (ROE) for the quarter ending June 2017 of 14% (ttm) and remains financially sound with a Piotroski F-Score of 7, an Altman Z-Score of 5.25, and a Beneish M-Score of -0.67. All of which indicates that inTest remains undervalued.

** Morningstar

About The Small & Micro Cap Stock Screener (CAGR 22%)

Over a full sixteen-and-a-half year period from January 2, 1999 to July 26, 2016., the Small & Micro Cap stock screener generated a total return of 3,284 percent, or a compound growth rate (CAGR) of 22.0 percent per year. This compared favorably with the Russell 3000 TR, which returned a cumulative total of 265 percent, or 5.7 percent compound.

How Can We Learn To Follow In The Footsteps of Buffett and Munger? – Mohnish Pabrai

Johnny HopkinsMohnish Pabrai, Podcasts Comments

One of our favorite investors here at The Acquirer’s Multiple is Mohnish Pabrai. Pabrai is the Founder and Managing Partner of the Pabrai Investments Funds, the Founder and CEO of Dhandho Funds, and the author of The Dhandho Investor and Mosaic: Perspectives on Investing​.

One of the best Pabrai interviews was one he did with our good friends Preston and Stig at The Investors Podcast. During the interview Stig and Preston asked some great questions on all things investing, here are a couple of them:

Stig asked Pabrai:

Despite your massive success, you humbly call yourself a “cloner” of other fund managers. How can we learn to follow in Buffett and Munger’s footsteps?

Pabrai’s response was:

Warren and Charlie have been very generous as they have shared a lot of their wisdom in the public domain. The first question for people that want to follow the footsteps of Warren and Charlie is are you wired for it? The psychological template of who you are as a person is determined by genetics and early childhood experiences, which cannot be easily changed. If you are wired to be a high-speed trader, you are probably not going to be happy with Warren and Charlie’s style of investing. Figuring this out is not easy as it takes effort to evaluate the choices of how you spend your time and the amount of satisfaction you get from doing certain activities. Warren and Charlie have an intense passion for reading and learning new things. If that is also a part of your intrinsic personality, then you are on the right path of following Warren and Charlie. It is not a path for everyone, but people can certainly pick up great habits to align with their approach.

Here’s Part 1 of the interview:

Stig also asked Pabrai:

You said in an interview that you do not like to have analysts. I suspect that the reason might be because one would unconsciously be influenced to invest in a company simply for the sake of investing not necessarily because it is the right decision.

Pabrai’s response was:

Before starting my own investment funds, the only models I was aware of were those of Warren Buffett and Charlie Munger. Their models made a lot of sense to me, so I cloned them. There are several aspects to the way Warren and Charlie run their business. What I discovered only several years later was that their rules were not random. Rather, they were thought through intensely. One of the rules they hold is that they have no analysts and even today, Buffett does not have analysts.

This might seem odd for a huge company like Berkshire Hathaway. I used to assume that this decision was based on keeping costs low and focusing more on performance. Later I realized that it is advantageous to not have an investment team because having analysts means you are missing out on learning about the businesses you are investing in. Buffett has said previously that no part of the investment process should be outsourced. A young analyst has once told me that he was assigned to study U.S. railroads. The problem with this is that the question should not be which railroad company is the best to invest in. It should be which companies are the best investment options out of all the possibilities of various different industries.

Here’s Part 2 of the interview:

For more great interviews like these make sure you check out The Investors Podcast.

The Definitive Guide On Identifying Companies With An Economic Moat – Warren Buffett

Johnny HopkinsMichael Mauboussin, Warren Buffett Comments

With so much talk about a company’s economic moat it’s important to recognize how to clearly identify a moat, understand how wide it is, and figure out how long it will remain in place. One of the best papers ever written on the subject is Michael Mauboussin’s – Measuring the Moat, Assessing the Magnitude and Sustainability of Value Creation. The paper also provides investors with a collection of Warren Buffett’s quotes on identifying economic moats and great insights into how companies can create and maintain their economic moat.

Here’s an excerpt from that paper:

Warren Buffett on Economic Moats

What we refer to as a “moat” is what other people might call competitive advantage . . . It’s something that differentiates the company from its nearest competitors – either in service or low cost or taste or some other perceived virtue that the product possesses in the mind of the consumer versus the next best alternative . . . There are various kinds of moats. All economic moats are either widening or narrowing – even though you can’t see it.

Outstanding Investor Digest, June 30, 1993

Look for the durability of the franchise. The most important thing to me is figuring out how big a moat there is around the business. What I love, of course, is a big castle and a big moat with piranhas and crocodiles.

Linda Grant, “Striking Out at Wall Street,” U.S. News & World Report, June 12, 1994

The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.

Warren Buffett and Carol Loomis, “Mr. Buffett on the Stock Market,” Fortune, November 22, 1999

We think of every business as an economic castle. And castles are subject to marauders. And in capitalism, with any castle . . . you have to expect . . . that millions of people out there . . . are thinking about ways to take your castle away. Then the question is, “What kind of moat do you have around that castle that protects it?”

Outstanding Investor Digest, December 18, 2000

When our long-term competitive position improves . . . we describe the phenomenon as “widening the moat.” And doing 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 longterm conflict, widening the moat must take precedence.

Berkshire Hathaway Letter to Shareholders, 2005

A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns . . . Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all . . . Additionally, this criterion eliminates the business whose success depends on having a great manager.

Berkshire Hathaway Letter to Shareholders, 2007

Mauboussin’s executive summary explains economic moats as follows:

Sustainable value creation has two dimensions—how much economic profit a company earns and how long it can earn excess returns. Both dimensions are of prime interest to investors and corporate executives.

Sustainable value creation as the result solely of managerial skill is rare. Competitive forces drive returns toward the cost of capital. Investors should be careful about how much they pay for future value creation.

Warren Buffett consistently emphasizes that he wants to buy businesses with prospects for sustainable value creation. He suggests that buying a business is like buying a castle surrounded by a moat and that he wants the moat to be deep and wide to fend off all competition. Economic moats are almost never stable. Because of competition, they are getting a little bit wider or narrower every day. This report develops a systematic framework to determine the size of a company’s moat.

Companies and investors use competitive strategy analysis for two very different purposes. Companies try to generate returns above the cost of capital, while investors try to anticipate revisions in expectations for financial performance. If a company’s share price already captures its prospects for sustainable value creation, investors should expect to earn a risk-adjusted market return.

Industry effects are the most important in the sustainability of high performance and a close second in the emergence of high performance. However, industry effects are much smaller than firm-specific factors for low performers. For companies that are below average, strategies and resources explain 90 percent or more of their returns.

The industry is the correct place to start an analysis of sustainable value creation. We recommend getting a lay of the land, which includes a grasp of the participants and how they interact, an analysis of profit pools, and an assessment of industry stability. We follow this with an analysis of the five forces and a discussion of the disruptive innovation framework.

A clear understanding of how a company creates shareholder value is core to understanding sustainable value creation. We define three broad sources of added value: production advantages, consumer advantages, and external advantages.

How firms interact plays an important role in shaping sustainable value creation. We consider interaction through game theory as well as co-evolution.

Brands do not confer competitive advantage in and of themselves. Customers hire them to do a specific job. Brands that do those jobs reliably and cost effectively thrive. Brands only add value if they increase customer willingness to pay or if they reduce the cost to provide the good or service.