Category Archives: Avoid Stupid Mistakes

6 Ideas for Giving Your Portfolio a Makeover

I am in the process of reviewing my portfolio so that I have a high level of conviction in all my positions.  Nobody is right all the time – people make mistakes – but I want to clearly know why I hold each of my positions.  If a position doesn’t work, I want to be able to look back and say that I bought it for such and such a reason and I was wrong.

If you are not completely settled with your existing positions, it can be a distraction, and it can cost you money.  Ideally, you should be spending your time looking for new ideas.  When you find one that looks interesting, you need to completely focus on that idea.  You need to put to become an investigative journalist and determine if the company is truly a good value.

If you are still concerned about your existing positions, it can rob you of the focus you need to research and think about your new idea.

Also, one of the best ways to evaluate a new idea is to compare it to what you already hold.  It’s a great filter because you can quickly eliminate a prospective idea if it is not at least as good as what you are already holding.  You can’t do this is you don’t really understand your holdings.

Here are a few of my (humble) suggestions on how to remedy this problem

1.      Go back and do a thorough review of your portfolio. Go back and look at all your positions and decide whether you would buy them today.  Do you understand each of your investments, i.e. how they make money, what the key variables are, if they have a durable competitive advantage?  Do you have a high level of certainty about how each business will develop over the next five to ten years?  Investing is about trying to peer into the future.  With most businesses this is impossible or at best highly imprecise.  Focus your capital on those situations where you have a high level of certainty about what will happen going forward.

2.      Write down why something is a good value. You should make an ironclad rule to always do this before you invest.  If you’ve skipped this step, do it now and resolve to never skip it again.  “I’m buying/holding X shares of ACME Corp because…”  If you can’t complete the sentence, you should sell the stock.  Investing should be based on careful analysis, not wishful thinking.  If you can’t answer this question, you are speculating.

3.      Sell stocks you backed into or bought for the wrong reasons. Maybe you are holding stocks that are left over from a previously managed account.  You did not select them, your advisor did.  Maybe you are holding a stock that you purchased on a tip or where the only reason you bought it is because somebody else did.  These are generally not good reasons to buy or hold a stock.  Aside from you not knowing if they are good investments, you may also lack conviction in these positions and sell them after the market has gone down.

4.      Sell stocks that are overvalued. You may be holding a stock that is way ahead of the business’s underlying economics.  If you are, you’re speculating.  Even the best companies can become so overvalued that it can take years for the situation to be corrected.  Granted, there are some companies that are so good – that is, they can continue to grow their intrinsic value at a high rate as far as the eye can see – that you can hold them forever.  Buffett puts Coke in this category.  However, even Buffett has suggested that he should have sold Coke in the late 90’s when it became stratospherically overvalued.

5.      Sell meaningless positions. You should work to focus your portfolio on your best ideas.  If you’re holding a number of marginal positions, you need to ask yourself why you’re doing so.  A position of 50 basis points is almost a waste of time.  Even if it doubles or triples, it will have a marginal impact on your portfolio.  In the meantime, it can cause you to become distracted.  Can you really keep on top of fifty or one hundred different businesses?  In addition, if you’re holding too many stocks, you’re probably running a closet index fund.  If so, be honest with yourself.  The way to beat the market is to hold a concentrated basket of investments that are cheaper than the market.  If you’re not going to do this, you might as well hold an index fund and save yourself the trouble.

6.      Sell investments where you’re overpaying. The most common culprit here is an overpriced mutual fund.  Most mutual funds don’t deliver enough value to cover their expenses.  If you’re holding such a fund, it’s time to move on.  Also, be aware if you are being double dipped on fees.  That is, you’re paying your advisor a percentage of your assets and your advisor in turn has invested your funds in investment products which charge their own fees.

The best reason of all to review your portfolio is that you may be costing yourself money – potentially lots of it.

More on Investing Checklists

If you are a reader of my blog, you know that I am a big believer in checklists because they are an effective and simple way to counter human error, which can be very costly. Here is a checklist from South African value investor Tim du Toit who writes at EuruShareLab. I am posting it because it is well thought out and a provides a good point of departure for developing one’s own list.

1. Operating cash flow higher than earnings per share
2. Free Cash Flow/Share higher than dividends paid
3. Debt to equity below 35%
4. Debt less than book value
5. LT debt less than 2 times working capital
6. Pre-tax margins higher than 15%
7. FCF Margin higher than 10%
8. Current asset ratio greater than 1.5
9. Quick ratio greater than 1
10. Growth in EPS
11. Management shareholding (> 10%)
12. Altman Z Score > 3
13. Substantial Dilution?
14. Flow ratio (Good <> 3)
15. Management incentives?
16. Are the salaries too high?
17. Bargaining power of suppliers?
18. Is there heavy insider buying?
19. Is there heavy insider selling?
20. Net share buybacks?
21. Is it a low risk business?
22. Is there high uncertainty?
23. Is it in my circle of competence?
24. Is it a good business?
25. Do I like the management? (Operators, capital allocators, integrity)
26. Is the stock screaming cheap?
27. How capital intensive is the business?
28. High Profitability
29. High Return on Capital
30. Enormous moat
31. Profitable reinvestment
32. Future growth
33. Net share buybacks?
34. Strong cash flow
35. What has management done with the cash?
36. Where is Free Cash Flow invested? Share buybacks, dividends, reinvested, ROE & ROCE, incremental BV growth

(read enitre article)

B-17 Cockpit Checklist

In order to stimulate thinking regarding making an investor checklist, I thought it would be interesting to look at the pilot checklist for a B17 Flying Fortress. Charlie Munger often refers to aviation as a model discipline in the use of checklists. In the 30’s when it was developed, the plane’s complex new technology put its future in jeopardy after the prototype crashed. The development of a checklist was instrumental in making the plane safe to fly. It would go on to be a workhorse in WWII.

This is from the website http://www.galbreath.net/bill/checklist.htm.

“From the Pilot Training Manual for the Flying Fortress – p.55 – 56

APPROVED B-17F and G CHECKLIST

PILOT’S DUTIES IN RED
COPILOT’S DUTIES IN BLACK

BEFORE STARTING
1. Pilot’sPreflight-COMPLETE
2. Form 1 A-CHECKED
3. Controls and Seats-CHECKED
4. Fuel Transfer Valves & Switch-OFF
5. Intercoolers-Cold
6. Gyros-UNCAGED
7. Fuel Shut-off Switches-OPEN
8. Gear Switch-NEUTRAL
9. Cowl Flaps-Open Right- OPEN LEFT-locked
10. Turbos-OFF
11. Idle cut-off-CHECKED
12. Throttles-CLOSED
13. High RPM-CHECKED
14. Autopilot-OFF
15. De-icers and Anti-icers, Wing and Prop-OFF
16. Cabin Heat-OFF
17. Generators-OFF

STARTING ENGINES
1. Fire Guard and Call Clear-LEFT Right
2. Master Switch-ON
3. Battery switches and inverters-ON & CHECKED
4. Parking Brakes-Hydraulic Check-On & CHECKED
5. Booster Pumps-Pressure-ON & CHECKED
6. Carburetor Filters-Open
7. Fuel Quantity-Gallons per tank
8. Start Engines: both magnetos on after one revolution
9. Flight Indicator & Vacuum Pressures – CHECKED
10. Radio-On
11. Check Instruments-CHECKED
12. Crew Report
13. Radio Call & Altimeter-SET

ENGINE RUN-UP
1. Brakes-locked
2. Trim Tabs-SET
3. Exercise Turbos and Props
4. Check Generators-CHECKED & OFF
5. Run up Engines

BEFORE TAKEOFF
1. Tailwheel-Locked
2. Gyro-Set
3. Generators-ON

AFTER TAKEOFF
1. Wheel-PILOT’S SIGNAL
2. Power Reduction
3. Cowl Flaps
4. Wheel Check-OK right-OK LEFT

BEFORE LANDING
1. Radio Call, Altimeter-SET
2. Crew Position-OK
3. Autopilot-OFF
4. Booster Pumps-On
5. Mixture Controls-AUTO-RICH
6. Intercooler-Set
7. Carburetor Filters-Open
8. Wing De-icers-Off
9. Landing Gear
a. Visual-Down Right-DOWN LEFT
Tailwheel Down, Antenna in, Ball Turret Checked
b. Light-OK
c. Switch Off-Neutral
10. Hydraulic Pressure-OK Valve closed
11. RPM 2100-Set
12. Turbos-Set
13. Flaps 1/3-1/3 Down

FINAL APPROACH
14. Flaps-PILOT’S SIGNAL
15. RPM 2200-PILOT’S SIGNAL
Back side of checklist

AFTER LANDING
1. Hydraulic Pressure-OK
2. Cowl Flaps-Open and locked
3. Turbos-Off
4. Booster Pumps-Off
5. Wing Flaps-Up
6. Tailwheel-Unlocked
7. Generators-OFF

END OF MISSION
1. Engines-Cut
2. Radio-On ramp
3. Switches-OFF
4. Chocks
5. Controls-LOCKED
6. Form 1

GO-AROUND
1. High RPM & Power-High RPM
2. Wing Flaps-Coming Up
3. Power reduction
4. Wheel Check-OK Right-OK LEFT

RUNNING TAKEOFF
1. Wing Flaps-Coming Up
2. Power
3. Wheel Check-OK Right-OK LEFT

SUBSEQUENT TAKEOFF
1. Trim Tabs-SET
2. Wing Flaps-UP
3. Cowl Flaps-Open Right-OPEN LEFT
4. High RPM-CHECKED
5. Fuel-Gals per tank
6. Booster Pumps-ON
7. Turbos-SET
8. Flight Controls-UNLOCKED
9. Radio Call

SUBSEQUENT LANDING
1. Landing Gear
a. Visual-Down Right-DOWN LEFT
Tailwheel Down, Ball Turret Checked
b. Light-ON
2. Hydraulic Pressure-OK
3. RPM 2100-Set
4. Turbo Controls-Set
5. Wing Flaps 1/3 – 1/3 Down
6. Radio Call

FINAL APPROACH
7. Flaps-PILOT’S SIGNAL
8. RPM 2200-PILOT’S SIGNAL

FEATHERING
1. Throttle Back
2. Feather
3. Mixture and Fuel Booster-Off
4. Turbo Off
5. Prop Low RPM
6. Ignition Off
7. Generator Off
8. Fuel Valve Off

UNFEATHERING
1. Fuel Valve-On
2. Ignition On
3. Prop Low RPM
4. Throttle Cracked
5. Supercharger Off
6. Unfeather
7. Mixture Auto-Rich
8. Warm up Engine
9. Generator On

SEQUENCE OF POWER CHANGES

INCREASING POWER
1. Mixture Controls
2. Propellers
3. Throttless
4. Superchargers

DECREASING POWER
1. Superchargers
2. Throttles
3. Propellers
4. Mixture Controls”

Seth Klarman on What Can Go Wrong (and a few thoughts on how to mitigate risks)

In part 2 of the “Wisdom of Seth Klarman” article from Distressed Debt Investing, which I posted on October 9, 2009, there is a great quote about what can go wrong with your investments. If you study Klarman, it is clear that he thinks about risks before rewards, and he takes seriously his commitment to preserve the hard earned capital of his investors.

“For most investments, much can go wrong, including numerous factors beyond an investor’s control: the economy, the markets, interest rates, the dollar, war, politics, tax rates, new technology, labor problems, competition, litigation, natural disasters, fraud, dilution, accounting gimmicks, and corporate mismanagement. Some but not all of these risks can be hedged, often only imprecisely and always at some cost. Other factors are under an investor’s control, but are not always controlled: discipline; consistency; remaining within your circle of competence; matched duration of client capital with underlying investments; prudent diversification; reacting rationally to news or market developments; and of course, not overpaying”

I want to add a few thoughts on how investors can hedge against the risks that Klarman lists.

1. Study economic history and the history of markets. For example, Buffett is a great student of the history of markets and has commented that the Long Term Management blowup was a repeat of Northern Pacific in 1903. He has also commented that he finds many MBAs lacking in their knowledge of financial history. As Twain said, “History doesn’t repeat itself, but it rhymes.”

2. Always invest with a margin of safety. Graham has written that all investing comes down to these three words. Buffett has said repeatedly that Chapter 20 on the Margin of Safety in The Intelligent Investor, along with Chapter 8 on market fluctuations, is the most important thing ever written about investing.

3. Become increasingly cautious and fearful as the general market averages rise. Use basic common sense indicators to measure market valuation, such as the yield of the S&P 500 to that of 10-year U.S. Treasuries and the ratio of the market’s capitalization to U.S. GDP.

4. Look for investments that are not highly correlated with the general market averages. In the 50’s and 60’s, Buffett used control investing and arbitrage for this purpose. He also found a way to hedge multiple compression in his holdings of undervalued large cap stocks, although he does not disclose the specific technique.

5. Don’t be adverse to holding cash if you cannot find opportunities with downside protection and a mathematical expectancy that meets your investment hurdle rate.

6. Having a meaningful percentage of your companies’ earnings come from outside the U.S. is a way to hedge against future devaluation of the dollar.

7. Having companies that have the ability to raise prices and that have modest maintenance capex requirements along with high returns on invested capital can help hedge against inflation.

8. Avoid companies whose earnings are exposed in a material way to countries with political instability or capricious application of the law.

9. Invest in companies that have a clearly identifiable sustainable competitive advantage.

10. Carefully read the 10K’s, 10Q’s and proxy stamements to understand risks to the company, such as litigation and under-funded pension obligations.

11. Pay attention to free cash flow in addition to GAAP earnings and learn to detect financial statement fraud, for example by studying Financial Shenanigans by Howard Schilit.

12. Look for companies whose management has a meaningful ownership of the company’s stock, and, ideally, where management has purchased stock in the open market as opposed to option grants. Judge management by its actions, not its rhetoric.

13. Use extreme caution with companies that are exposed to technical obsolescence or short-term creative disruption.

14. If you don’t have conviction or its too complex, take a pass. There are plenty of other opportunities out there.

15. Think about risks first and rewards second. As 2008 proved, years of gains can be wiped out quickly and successful track records humbled when risk is not managed or given its proper due. Always consider what “black swan(s)” is present in your portfolio or strategy.

On the Importance of Investment Checklists

Checklists are surprisingly effective at dramatically improving performance, even when those involved are highly trained, smart people. The benefits of improving outcomes are particularly evident when a complex task is involved, however, the benefits can also be dramatic when simple tasks are performed.

The New Yorker ran an article in December of 2007 by Atul Gawande called “The Checklist” that forcefully makes the case for the efficacy of checklists. Take, for example, something as straightforward as preventing infection when a line is inserted into patients at a hospital I.C.U. In 2001, John Hopkins adopted the following checklist to reduce infection: (1) wash hands with soap, (2) clean the patient’s skin with chlorhexidine antiseptic, (3) put sterile drapes over the entire patient, (4) wear a sterile mask, hat, gown, and gloves, and (5) put a sterile dressing over the catheter site once the line is in. It was observed that in more than a third of the patients, at least one step was skipped.

After nurses were empowered to raise the issue if a step was skipped, the rate of infection over the subsequent year dropped from 11% to 0. After fifteen months, it was determined that following this simple checklist was responsible for saving eight lives and generating savings of $2 million. The article gives several other equally compelling examples of how checklists have made a profound positive difference in both medicine and aviation.

In a talk at the Columbia Business School, value investor Monish Pabrai spoke about checklists. He argued that they work because, “Our brains are designed to take short-cuts and arrive at answers quickly. When you see the lion, you run. You don’t process your options, you just run. We are also a mix of rationality and emotions. When we notice a great business, we read up on it, run through a number of concerns/questions and arrive at a decision – not as effective as checklist.” That’s why great investors like Charlie Munger recommend the use of checklists.

Here’s what noted short seller Joe Feshbach had to say about checklists in the book The Art of Short Selling by Kathryn F. Staley. “Money managers make the same mistake over and over – that’s part of the whole reactive process. We’ve developed a check list of good short criteria and a training manual based on successful and unsuccessful actions.” (page 31) I would argue that most investors make recurring mistakes.

Even great investors make mistakes. For example, Buffett has said that he made a mistake not selling Coke when its valuation reached stratospheric levels during the Internet bubble. Perhaps he was unduly influenced by his being on record numerous times as saying he would hold positions like Coke forever. This is known as confirmation bias: the tendency to act in conformity with past statements or commitments.

Charlie Munger purchased Cort during the Internet bubble based on its strong earnings. What he missed was that those earnings were the result of unsustainable tailwinds from the Internet boom. Pabrai thinks we should learn from this mistake and add the following to our own investment checklist, “Are the revenues and cash flows of the business sustainable or overstated / understated due to boom or bust conditions?”

So where do you start if you want to make an effective investment checklist? A good place is your past mistakes. Look at where you’ve lost money in the past and convert the lessons learned into rules you can put on your checklist. Also, as you come across wise investment counsel – such as only buy a stock in a business you understand – add it to your list. Buffett strongly suggests that we all make a written statement of why we’re buying a given stock and why it’s undervalued. Add the written thesis of why a stock is undervalued to your checklist.

I think a good checklist can also save a lot of time. Nobody has time to look at everything. Using a few good checklist questions when searching for prospective investments such as “Can I lose my investment?”, “Is there a sufficient margin of safety?” and “Is the idea within my circle of competence?” can act as a kind of investment triage by quickly filtering out investments that are non-starters. Such a practice can potentially also save you a lot of money.

Don’t Miss the Easy Ones

Have you ever been looking at a stock you like and you see that in the past year it traded at a price that was way too cheap? It’s frustrating. You’re working hard to find the next bargain, and you realize that, on such and such a day, a stock you understood was available at a price that you would snap up in an instant if it were available to you today.

These are somewhat like Buffett’s “sins of omission” – situations where he should have loaded up, but he did not pull the trigger. What I’m talking about is a little different. In Buffett’s case, he had the elephant in his sights and did not pull the trigger. In the case I’m talking about (to stretch the analogy a bit), the elephant was right in your backyard, but you did not even realize it.

What can we learn from these situations?

  1. You need to do your homework. In order to pull the trigger with confidence, you need to have identified at least a handful of prospects that you understand and a price at which buying them would be a “no brainer”. John Templeton would do his valuation work, put in rock-bottom good-til-cancelled buy orders when the market’s outlook was still rosy and wait.
  2. You need to have cash to buy when stocks are low and fear is predominant. This requires holding your powder and not committing your capital to mediocre opportunities. Set a minimum required ROI and don’t invest unless it’s clear you can get it. Buffett is said to use a 15% minimum hurdle.
  3. Learn how to think (properly) about market prices. As Buffett has said many times, people are happy when the items they buy everyday – food, gas, clothes, etc. – go on sale because they can purchase them at a bargain. But when stocks go on sale, most “investors” want the safety of cash or the warmth of the herd. This is folly and damaging to your long-term returns. Learn what you’re doing so you can buy with confidence when others are heading for the exits. (Study carefully chapter 8 of The Intelligent Investor.)
  4. Set up a system so things don’t fall through the cracks. As human beings we are subject to numerous frailties. One of them is the tendency to neglect things that are important to us – to “take our eye off the ball”. Important – sometimes critical – things come onto and off of our radar all the time, things that it is in our interest to stay on top of. To counter this we need systems. It does not matter so much what the system is as long as it is in place and you stay with it. Resolve today, if you have not already done so, to put a system in place so you don’t miss the next investing “fat pitch”. Maybe it’s checking the new low list EVERY week, or going through Value Line on a regular basis, or running a basic screen each week of low P/E stocks. None of these is perfect and there are lots of other ways to generate ideas, but such a minimal system will pay off if done consistently. One day in the future you’ll wake up, check your system, and one of those big fat moving elephants will be right in your sights.

We don’t back into decisions

While we’re at it, I mention that I sold a few stocks on Friday into the strength of the rally. I chose a few stocks that have been in my portfolio for a while and that were holdovers from a managed account I used to have. A couple showed good gains; one did not, which is beside the point. I sold them because I did not understand them well (I did not pick them in the first place) and therefore I could not value them with confidence. I believe a good portfolio is one where the investment thesis for each holding is clear. “If you don’t know where you’re going, any road will take you there.”

Buffett talks about this in his 1998 shareholder letter regarding Berkshire Hathaway’s purchase of General Re. “Once we knew that the General Re merger would definitely take place, we asked the company to dispose of the equities that it held. (As mentioned earlier, we do not manage the Cologne Re portfolio, which includes many equities.) General Re subsequently eliminated its positions in about 250 common stocks, incurring $935 million of taxes in the process. This “clean sweep” approach reflects a basic principle that Charlie and I employ in business and investing: We don’t back into decisions.”

Cerberus’ Acquisition of Chrylser: A Cautionary Tale

Over the weekend, The New York Times ran an article “For Private Equity, a Very Public Disaster” which gave a sobering account of the acquisition of Chysler by the private equity firm Cerberus. There are many lessons in what happened that are worthy of reflection. As anyone who has built up some assets knows, earning money is difficult. Assets, along with reputations, are built over a lifetime, but can be lost or damaged in a very short period. Everyone who invests will make mistakes, but a lot more progress can be made if you simply avoid severe drawdowns to your portfolio. Successful investors think about risk first and study financial history to learn from it. In investing, the allure of massive gains makes turnarounds very attractive. The problem is that few of them actually turn. Here are some thoughts from this “very public disaster”.

Walk away from deals that are “too hard”. “Maybe what we should have done was not bought it.” – Steve Feinberg, a co-founder of Cerberus. The beauty of investing is that you do not have to invest. “I call investing the greatest business in the world,” Buffett says, “because you never have to swing.” You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! And nobody calls a strike on you. There’s no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it.”

Avoid the “institutional imperative”. Thomas Brown defines what Buffett calls the institutional imperative as, “Any company’s inherent propensity to do dumb things (or avoid doing smart things) simply for the sake of doing them.” Plumbers plumb; painters paint, private equity firms do deals (sometimes that simply should not be done). The allure of transforming an American icon and bringing it back to prosperity may have clouded Fienberg’s judgment. Individual investors would be wise to avoid investing in any company where there is evidence of the institutional imperative, such as a track record of overpaying for value destroying acquisitions.

Good (or even great) management is not enough. The article reports that Feinberg, “Can play a decent game of chess while blindfolded”, and that he is a graduate of Princeton. He is obviously a smart, accomplished businessman and one can safely assume that the Cerberus is loaded with similarly smart and accomplished people. Cerberus’ management contended that, “They had the smarts and managerial prowess to repair companies of any size.” This is usually not enough, however, to overcome a business that is structurally challenged.

Writing to shareholders in 1985, Buffett said, “My conclusion from my own experiences and from much observation of other businesses is that a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row (though intelligence and effort help considerably, of course, in any business, good or bad). Some years ago I wrote: “When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.” Nothing has since changed my point of view on that matter. Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.”

Avoid excessive debt. The article reports that the, “Situation was made worse by hefty interest payments on more than $10 billion in debt that Cerberus arranged for Chrysler as part of the takeover, which left the automaker carrying piles of debt just as auto sales were about to plummet.” The situation is always made worse by excessive debt and leaves an individual or corporation with no margin of safety for the inevitable downturn. Avoid investments in companies that have excessive debt and pay close attention to when debt is coming due. Jim Rogers charts out all future debt, year by year, so he knows exactly when it is due.

Stay within your circle of competence. The article reports that, “Don Johnson, a former Chrysler employee, says he worked on initial production of the Jeep Liberty at a plant in Toledo, Ohio, in summer 2007, when Cerberus won the right to buy Chrysler from Daimler of Germany…. Mr. Johnson says he was always skeptical about the carmaker’s new owners. “Cerberus did not have a clue about the automotive industry,” he says. “I don’t think anything could have been worse.” If you don’t understand a business, you should not invest. You are simply at too great of a disadvantage because it is impossible to thoroughly analyze the business.

Avoid businesses that need to spend their retained earnings (and more) just to maintain current operations. The automobile industry is characterized by an insatiable appetite for cash simply to maintain the business. There is little or no cash leftover for shareholders and the stocks of these companies usually reflect this reality. Consider the following account of General Motors from the book “Buffettology”:

“Between 1985 and 1994 it [GM] earned in total approximately $17.92 a share and paid out in dividends approximately $20.60 a share. During the same time period the company spent approximately $102.34 on capital improvements. If General Motors’ earnings during this period totaled $17.92 and it paid out as dividends $20.60, where did the extra $2.68 that it paid out in dividends and the $102.34 that it spent on capital improvements come from?

From the beginning of 1985 to the end of 1994, General Motors added approximately $33 billion in debt, which equates to a per share increase in debt of approximately $43.70. The company also issued 132 million additional shares of its common stock. General Motors’ per share book value also dropped $34.92 a share, from $45.99 in 1985 to $11.74 in 1994, as new-car-development costs sucked up retained earnings. What did all this do for increasing shareholders’ wealth? Nothing.

In the beginning of 1985 General Motors stock traded at $40 a share. Ten years later, at the end of 1994, the stock traded at, you guessed it, $40 a share.”

Here is an extended quote taken from the 1985 letter to shareholders regarding Buffett’s experience with investing in capital intensive businesses. It is highly instructive.

Though 1979 was moderately profitable, the business [Berkshire Hathaway’s textile mill] thereafter consumed major amounts of cash. By mid-1985 it became clear, even to me, that this condition was almost sure to continue…

I should reemphasize that Ken and Garry have been resourceful, energetic and imaginative in attempting to make our textile operation a success. Trying to achieve sustainable profitability, they reworked product lines, machinery configurations and distribution arrangements. We also made a major acquisition, Waumbec Mills, with the expectation of important synergy (a term widely used in business to explain an acquisition that otherwise makes no sense). But in the end nothing worked and I should be faulted for not quitting sooner. A recent Business Week article stated that 250 textile mills have closed since 1980. Their owners were not privy to any information that was unknown to me; they simply processed it more objectively. I ignored Comte’s advice – “the intellect should be the servant of the heart, but not its slave” – and believed what I preferred to believe.

The domestic textile industry operates in a commodity business, competing in a world market in which substantial excess capacity exists. Much of the trouble we experienced was attributable, both directly and indirectly, to competition from foreign countries whose workers are paid a small fraction of the U.S. minimum wage…

Over the years, we had the option of making large capital expenditures in the textile operation that would have allowed us to somewhat reduce variable costs. Each proposal to do so looked like an immediate winner. Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable expenditures in our highly-profitable candy and newspaper businesses.

But the promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide. Viewed individually, each company’s capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.

Thus, we faced a miserable choice: huge capital investment would have helped to keep our textile business alive, but would have left us with terrible returns on ever-growing amounts of capital. After the investment, moreover, the foreign competition would still have retained a major, continuing advantage in labor costs. A refusal to invest, however, would make us increasingly non-competitive, even measured against domestic textile manufacturers. I always thought myself in the position described by Woody Allen in one of his movies: “More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness, the other to total extinction. Let us pray we have the wisdom to choose correctly.”

For an understanding of how the to-invest-or-not-to-invest dilemma plays out in a commodity business, it is instructive to look at Burlington Industries, by far the largest U.S. textile company both 21 years ago and now. In 1964 Burlington had sales of $1.2 billion against our $50 million. It had strengths in both distribution and production that we could never hope to match and also, of course, had an earnings record far superior to ours. Its stock sold at 60 at the end of 1964; ours was 13.

Burlington made a decision to stick to the textile business, and in 1985 had sales of about $2.8 billion. During the 1964-85 period, the company made capital expenditures of about $3 billion, far more than any other U.S. textile company and more than $200-per-share on that $60 stock. A very large part of the expenditures, I am sure, was devoted to cost improvement and expansion. Given Burlington’s basic commitment to stay in textiles, I would also surmise that the company’s capital decisions were quite rational.

Nevertheless, Burlington has lost sales volume in real dollars and has far lower returns on sales and equity now than 20 years ago. Split 2-for-1 in 1965, the stock now sells at 34 — on an adjusted basis, just a little over its $60 price in 1964. Meanwhile, the CPI has more than tripled. Therefore, each share commands about one-third the purchasing power it did at the end of 1964. Regular dividends have been paid but they, too, have shrunk significantly in purchasing power.

This devastating outcome for the shareholders indicates what can happen when much brain power and energy are applied to a faulty premise. The situation is suggestive of Samuel Johnson’s horse: “A horse that can count to ten is a remarkable horse – not a remarkable mathematician.” Likewise, a textile company that allocates capital brilliantly within its industry is a remarkable textile company – but not a remarkable business.

Is Value Investing Dead?

An article in Barron’s this weekend entitled “Not Your Father’s Value-Growth Rotation” had a sub-title which asked the question, “Is value investing dead?” The article asked readers to consider the following facts which, presumably, might lead one to answer in the affirmative.

Value stocks trailed growth stocks in the first half of the year as measured by a comparison of the Russell 1000 Growth Index (up 11.3%) with the Russell 1000 Value Index (up 2.87%).

Stocks that seemed cheap by traditional metrics – Citigroup, Freddie Mac, General Motors, etc. – turned out to be a disaster. These and other problems affected prominent investors such as Marty Whitman, Warren Buffett, and Bill Miller. The caption of a cartoon running alongside the article says that even these three luminaries have been puzzled by the recent markets.

In fairness, the article more or less concludes that value investing is not dead, but does not go far enough in clearing up some common misunderstandings regarding value investing.

In my judgment, the thesis that value investing is dead is based on number of faulty premises.

Emphasizing short term returns. What happens in any six, or even twelve-month period, in terms of performance is just as likely to be a function of chance as it is skill. Use at least a three-year period to evaluate investing performance results.

Emphasizing outcome over process. Sometimes you can have a good process and still get a bad outcome, for example, a sports team that does everything right to prepare for a big game and then loses. The takeaway is not to abandon the good process, but, rather, to keep at it with the confidence that, if you do, good things will happen. Value investing (which might be better named simply “investing”) is trying to figure our through careful research (reading financial reports, those of competitors, trades, business press, interviews, etc.) what a business is worth, and then trying to exploit the market’s periodic overreactions to purchase its stock at a bargain. The opposite – doing little or no research and having no regard for how much you pay for something – is not a strategy likely to produce good results over time.

Failing to recognize that all stocks go down in a bear market. All stocks, including stocks that are already undervalued, will decline in a steep decline of the general market. The difference is permanent loss of capital. Stocks that are purchased at a meaningful discount to their intrinsic value will decline in a bear market, but will then recover as their price ultimately rises to reflect the value of the business. Speculative stocks that are purchased without regard to the price paid, for example, many Internet companies in the late 90’s, go down in market declines and never recover. Value investors can also benefit by deferring purchases of stock if the general market is overvalued.

Failing to account for human error. Benjamin Graham held that investing (as opposed to speculating) is based upon thorough analysis. Now it’s a given that you cannot analyze what you do not understand. In this past cycle, several value investors violated this important principle because they probably did not, in my opinion, fully understand the complex derivatives on the books of many financial firms. In fairness, almost no one did. In investing, there are no style points awarded for effort. If you don’t understand a company or its financial reports, put it in what Charlie Munger calls the “Too-Hard” pile and move on.

Treating growth and value as too distinct types of investments. Growth is simply one of many attributes of a business that must be valued, along with current earnings power, competitive position, assets, etc. Buffett wrote a mini-essay on the relationship between growth and value in his 1992 letter to shareholders. It’s definitely worth reading, or re-reading, whatever the case may be.

“Our equity-investing strategy remains little changed from what it was fifteen years ago, when we said in the 1977 annual report: “We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety. We want the business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and (d) available at a very attractive price.” We have seen cause to make only one change in this creed: Because of both market conditions and our size, we now substitute “an attractive price” for “a very attractive price.”

But how, you will ask, does one decide what’s “attractive”? In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition: “value” and “growth.” Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.

We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.

In addition, we think the very term “value investing” is redundant. What is “investing” if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value – in the hope that it can soon be sold for a still-higher price – should be labeled speculation (which is neither illegal, immoral nor – in our view – financially fattening).

Whether appropriate or not, the term “value investing” is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics – a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – are in no way inconsistent with a “value” purchase.

Similarly, business growth, per se, tells us little about value. It’s true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.

Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.” [Here’s a link to the 1992 letter, if you care to continue reading.]

Buffett and the Folly of Human Nature

In 1979, Warren Buffett wrote a telling piece in Forbes entitled “You pay a very high price in the stock market for a cheery consensus” about the folly of human nature when it comes to investing. Buffett’s point was that many investors seem almost “hard wired” to take actions that are not in their best interests.


“Pension-fund managers continue to make investment decisions with their eyes firmly fixed on the rearview mirror. This generals-fighting-the-last-war approach has proven costly in the past and will likely prove equally costly this time around.

Stocks now sell at levels that should produce long-term returns far superior to bonds. Yet pensions managers, usually encouraged by corporate sponsors they must necessarily please (“whose bread I eat, his song I sing”), are pouring funds in record proportions into bonds.

Meanwhile, orders for stocks are being placed with an eyedropper. Parkinson–of Parkinson’s law fame–might conclude that the enthusiasm of professionals for stocks varies proportionately with the recent pleasure derived from ownership. This always was the way John Q. Public was expected to behave. John Q. Expert seems similarly afflicted. Here’s the record.

In 1972, when the Dow earned $67.11, or 11% on beginning book value of 607, it closed the year selling at 1,020, and pension managers couldn’t buy stocks fast enough. Purchases of equities in 1972 were 105% of net funds available (i.e., bonds were sold), a record except for the 122% of the even more buoyant prior year. This two-year stampede increased the equity portion of total pension assets from 61% to 74%–an all-time record that coincided nicely with a record-high price for the Dow. The more investment managers paid for stocks, the better they felt about them.

And then the market went into a tailspin in 1973-74. Although the Dow earned $99.04 in 1974, or 14% on beginning book value of 690, it finished the year selling at 616. A bargain? Alas, such bargain prices produced panic rather than purchases; only 21% of net investable funds went into equities that year, a 25-year record low. The proportion of equities held by private noninsured pension plans fell to 54% of net assets, a full 20-point drop from the level deemed appropriate when the Dow was 400 points higher.

By 1976, the courage of pension managers rose in tandem with the price level, and 56% of available funds was committed to stocks. The Dow that year averaged close to 1,000, a level then about 25% above book value.” (continue reading)


The more things change, the more they stay the same. An article in today’s Wall Street Journal entitled “Rally Spurs Stocks to ’09 Highs” quotes Kevin Mahn, Managing Director & Chief Investment Officer of Hennion & Walsh. Mr. Mahn said, “Institutional and retail investors are so anxious to make up the lost returns of the last year, they are using any cue to buy aggressively. We got to the point in the first quarter, when everyone was so risk averse they lost out. And, in just six months, they have now become overly aggressive.”

As I wrote in the Comments section at WSJ.com, “It never ceases to amaze that many people would not touch stocks that were “screaming buys” just four months ago. Now, the same people are clamoring to get in after these same stocks have made massive moves to the upside – many over 100%.”

Takeaway: Learn to think properly about market prices. Faulty, self-defeating behavior can be overcome through education and discipline. “How to think about market prices” will be a topic I will broadly cover on this blog.

Lessons from Harvard’s Endowment Fund

A new article in Vanity Fair, “Rich Harvard, Poor Harvard” chronicles how Harvard is reeling from massive losses in its once mighty endowment fund. Financial journalist Edward Jay Epstein of the Huffington Post estimates that in the second half of 2008, the endowment declined as much as 50%, which would equate to an $18 billion loss. If memory serves, there was a time not so long ago when alumni were clamoring to gain access to the endowment’s fund managers. Now, Harvard is facing large operating deficits and hard choices about where to make cuts.

The situation at Harvard is once again a reminder of some important financial lessons. It is amazing that we need to keep learning these same lessons over and over.

1. (Very) Smart people are capable of doing dumb things. This speaks for itself and is reminiscent of Long Term Capital Management, whose founders included two Nobel Prize winning economists.

2. Don’t risk what you need for what you want (and don’t need). Harvard’s $39.6 billion endowment was the envy of academia, and there was every reason to believe, given Harvard’s uber-successful alumni, that large gifts would continue. Why then did the University take on this kind of risk?

3. Don’t invest by looking in the rear-view mirror. Between 1990 and 2008, Harvard’s endowment “boasted an average annual growth rate of 14.3%”. It appears that Harvard’s leadership came to think that these past returns were a kind of guarantee of similar returns in the future.

4. Don’t spend beyond your means. Harvard used its gains to ratchet up spending in the form of a huge expansion program, big pay raises, and a program that made tuition free for large numbers of students. These decisions now seem high on hubris and low on prudence.

5. Stay within your circle of competence. It is very hard to believe that Harvard’s fund managers really understood all the investments they put on. In my judgment, anytime you invest in something you don’t understand, you are speculating.

6. Think about risk first – and then rewards. Value investing is about taking risk seriously, not the kind of risk that academicians measure with Beta, but the risk of losing most or all of your capital. That type of risk management was not on display at Harvard.

7. Beware of the danger of an asymmetric incentive system for investment managers. “Heads I make tens of millions of dollars in bonuses, tails I walk away (and leave Harvard holding the bag.)” You generally can expect to get the type of behavior that your incentive system encourages.

8. Beware of the dangers of leverage. The article documents that over time Harvard’s fund managers added considerable leverage in order to jack up returns. As I wrote about yesterday regarding John Griffin, you have to build your ark on sunny days to withstand periods of great distress.