Monthly Archives: October 2010

Links of Interest – October 15, 2010

Special report: What if Elvis ran a hedge fund? | Reuters – Profile of David Ackman

U.S. Stock Funds Continue Bleeding – WSJ.com – More evidence of investors looking in the rear-view mirror.

Buffett FAQ – A nice compilation of Buffett notes organised by topic.

The Manual of Ideas on Business Leader Henry Singleton, Founder of Teledyne (audio) – The Manual of Ideas — Seeking Alpha – More information on the great capital allocator Henry Singleton.

Activist Investing Resource Blog – Good resource for learning about activist investing.

Business Insider interviews Jim Grant

Thanks to Jacob Wolinsky at ValueWalk.com for posting value investor Guy Spier’s presentation to the 2010 Aquamarine Fund Partners Meeting. I am posting it because it is an example of a good investment philosophy and process. It also contains several investment ideas.

Partners Meeting Zurich New York October 2010

Know Your Limitations

At the 1989 Berkshire Hathaway shareholders meeting, Buffett said that he had recently received a letter from the daughter of David Dodd. Dodd’s daughter wrote that her father thought it was important to know your limitations. Buffett added that this was one of Dodd’s favorite themes.

“Knowing your limitations” has been studied by behavioral finance, which has labeled the lack of this virtue overconfidence bias. Numerous studies have shown our strong inclination towards this bias, even when we are made aware of its presence. It seems to be a kind of useful short-cut mechanism from a utilitarian perspective that is used in everyday life when there is nothing really riding on expressing a particular point of view, for example, predicting the outcome of a football game.

This bias is practiced so frequently, and it is so psychologically ingrained, that it can be a real challenge to check it when you are dealing with something that requires absolute accuracy grounded in facts. Its stubborn presence has been a material factor in everything from airplane crashes to botched medical procedures. Check lists have been recognized as a surprisingly simple and effective way to counter this bias.

Investing is an art that has no place for overconfidence bias and many fortunes have been lost as a result of it.

Investing presents a particular problem because it inherently involves making predictions about the future based on imperfect information. Moreover, greed acts as a kind of magnet drawing us towards an imagined positive outcome, even if our conclusion about the probability of that outcome is not grounded in facts.

The trick in fighting this bias is to be brutally honest about what you know and what you don’t know. This is where knowing your limitations comes in. You must first isolate what you really know and then determine if it is enough to make a prediction. If not, you should take a pass. If it is, then, according to Buffett, your task essentially comes down to determining the chance that you are correct times the amount of possible gain minus the chance that you are wrong times the amount of possible loss.

One useful thought experiment is to imagine giving a presentation on your investment thesis to a group of knowledgeable industry executives. Could you do it? Write down your thesis. Share it with another savvy investor.

One other word of caution. Big money is made by taking meaningful positions when you are certain the odds are in your favor. This requires a high degree of certainty. You can delude yourself into thinking that you know what you’re doing by only investing a trivial amount in a stock relative to your net worth. This is why Buffett says that diversification is a hedge against ignorance. The more you invest this way the more likely it is that your returns will equal that of a stock index. Put another way, taking only small positions is a way of perpetuating overconfidence bias because you can pretend you know what you’re doing when in fact you’re really speculating.

Outstanding Investor Digest, June 23, 1989, pages 5, 6.

Henry Singleton: A Master of Capital Allocation

A reader of the blog was kind enough to send me a 1979 article from Forbes about Henry Singleton. Singleton co-founded Teledyne in 1960 and built it into a highly profitable U.S. corporation. The company serves as a template for capital allocation. Singleton simply refused to invest money into projects or divisions that did not promise a high rate of return and shunned Wall Street orthodoxy by following this tenet wherever it lead him including making massive buybacks of Teledyne stock and making large purchases of deeply undervalued public companies.

“Singleton has an almost uncanny ability to resist being caught up in the fads and fancies of the moment. Like most great investors, Henry Singleton is supremely indifferent to criticism.” I think this trait is essential and that it can be cultivated by 1) defining with razor-sharp clarity your investment framework and then following it with great discipline, and 2) always doing your own work (thinking) when making investment decisions. The second trait does not mean that you won’t generate ideas from others, most notably other proven value investors, but that you then make them your own.

Singleton is an example of how an extraordinary manager can get extraordinary results – 30% plus returns on equity and EPS growth of over 1,200% in only ten years – in very ordinary businesses: “offshore drilling units, auto parts, specialty metals, machines tools, electronic components, engines, high fidelity speakers, unmanned aircraft and Water Pik home appliances.” I have made the point before that we, as investors, need to seek out these .400 hitters and hitch a ride.

The combination of Singleton’s capital allocation principles and his laser focus on them was Teledyne’s durable competitive advantage.

“Now everyone understands that all new projects should return at least 20% on total assets,” said Singleton of his managers. This was a core requirement that drove much of Teledyne’s success. You can emulate this by insisting that your investments have a similar – or higher – return on capital.

“After we acquired a number of businesses we reflected on aspects of business. Our conclusion was that the key was cash flow.” Investors should not focus on accounting profits but free cash flow that can either be redeployed in the business at a high rate of return or returned to shareholders. Singleton, like Buffett, refused to pay a dividend because Teledyne could reinvest earnings at over 30%, a level he felt his stockholders could not match if investing their own funds.

Singleton had disdain for managers who, while their own stock sold for five times earnings, would not think twice of paying ten or fifteen times earnings for a big acquisition. In stark contrast, Singleton only used his stock as currency when it sold at multiples of “40, 50 or 60 times earnings.” This is Mr. Market 101, yet it (he) requires great patience and discipline to fully exploit.

When Singleton decided to allocate his capital by investing in the stock market, “He rejected Wall Street dogma.” His investment checklist was simple. He bought companies that were 1) well run and 2) undervalued. This is the secret sauce that is hiding in plain sight: buy good businesses at cheap prices. Singleton was confident that the multiple of these investments would rise over time.

Singleton was willing to concentrate his investments. At one point he had over 25% of his portfolio in Litton. He liked undervalued stocks where the business was facing an isolated problem, not a general one. He also stayed well within his circle of competence, buying stocks in companies that paralleled the divisions of Teledyne: industrial conglomerates, oil stocks that did geological exploration and made drilling rigs, and insurance.

Singleton liked to buy pieces of companies at six times earnings. That’s an earnings yield of almost 17%. This level of undervaluation provides a large margin of safety and could serve as a sound hurdle rate for investors looking for common stocks. These opportunities show up, but most investors are not in a position to exploit them because they have either already committed their capital to sub-optimal investments or lack the courage to step up to the plate when the sky is falling – or both.

Singleton hated projections and clearly knew the difference between what is important – capital allocation at high rates of return – and what is not – he called splitting his stock a nonevent, “paper shuffling.” He should be studied.

One final thought shows the influence of Singleton. When I attended the Fairfax Financial annual meeting last April in Toronto, Prem Watsa made it clear the he has made a careful study of Singleton, leaving me with the impression that Prem will continue to draw deeply from those lessons in running Fairfax. That’s good news for shareholders.

Singleton 1979 Forbes

My Watchlist – October 12, 2010

I have reviewed issue 7 of Value Line and added companies that have exceptional returns on equity. I have also included several stocks that are widely held by prominent value investors. The list is not perfect and some judgment is required in deciding whether to include a particular stock. As always, I welcome your feedback and comments.

The idea here is to have a dashboard of substantially all the high quality businesses in the U.S. in one place that you can review at least weekly to see what Mr. Market is making available to you.

Here is the updated watchlist.

Stocks Added This Week

Emerson Electric Co. (EMR)

FLIR Systems, Inc. (FLIR)

Garmin Ltd. (GRMN)

Amphenol Corporation (APH)

Intel Corporation (INTC)

Apple Inc. (AAPL)

Dell Inc. (DELL)

Hewlett-Packard Company (HPQ)

International Business Machines Corp. (IBM)

Western Digital Corp. (WDC)

Lexmark International, Inc. (LXK)

Expected return calculations were added for the following stocks because they were wthin 10% of a 52-week low:

U.S. Bancorp (USB)

Colgate-Palmolive Company (CL)

FLIR Systems, Inc. (FLIR)

Expected return calculations were added for the following stock because their earnings yield exceeded 8%:

Garmin Ltd. (GRMN)

Intel Corporation (INTC)

Hewlett-Packard Company (HPQ)

Western Digital Corp. (WDC)

A few thoughts…

Please note that I used 10-yr sales growth in lieu of 10-yr EPS growth for the expected return estimates for FLIR and WDC. Also, I used 10-yr asset growth for USB in lieu of 10-yr EPS growth.

Buffett was asked in a 2009 interview with Fortune what his favorite metric is for valuing a bank. Here is his answer:

It’s earnings on assets, as long as they’re being achieved in a conservative way. But you can’t say earnings on assets, because you’ll get some guy who’s taking all kinds of risks and will look terrific for a while. And you can have off-balance sheet stuff that contributes to earnings but doesn’t show up in the assets denominator. So it has to be an intelligent view of the quality of the earnings on assets as well as the quantity of the earnings on assets. But if you’re doing it in a sound way, that’s what I look at.

Over the last ten years, U.S. Bancorp has averaged a return on assets of about 1.75% and currently has assets of $281 billion. There are 1.859 billion shares outstanding. This would suggest normalized EPS of $2.64. If USB can grow its assets at 5% a year, which seams conservative given its strong position and the large number of bank failures, earnings could reach $3.37 in five years. At a P/E of 13, which is its median P/E over the past ten years per Value Line, USB would have a stock price of $43.80. That’s a return of about 14.5% from today’s price and it does not include dividends.

USB has a long-term record of strong dividends and I expect, based on comments from management, that the dividend will be reinstated when they are comfortable that they understand the final outcome of efforts to reform banking regulations. Berkshire Hathaway owns 3.6% of the shares outstanding.

Also of note, the FPA Capital Fund has built a 5% position in WDC. The stock has an earnings yield of almost 14% based on estimates for 2011 earnings.

The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures. The data and information presented in this blog entry is believed to be accurate but should not be relied upon by the user for any purpose. Any and all liability for the content or any omissions, including any inaccuracies, errors or misstatements in such data is expressly disclaimed.

EV/EBIT Ratio Trumps P/E Ratio

Investors should make the ratio of a company’s enterprise value (EV) to its earnings before interest and taxes (EBIT) a primary tool to evaluate its earnings power and to compare it to other companies. This is the ratio that Joel Greenblatt uses for his magic formula and that Buffett appears to use when evaluating a business.

The P/E ratio is useful as a crude screening tools but it has serious limitations. One such limitation, which the EV/EBIT ratio addresses, is that the P/E ratio does not take into account the balance sheet and, as a result, it can materially misrepresent the earnings yield of a business.

To take a very simple example, imagine that you were considering the purchase of a commercial lawn care business in your town and you had narrowed it down to two candidates. Business 1 has an asking price of $500,000 and earnings of $100,000. Business 2 has an asking price of $700,000 and earnings of $100,000. Business 1 looks like the better bargain with a P/E ratio of 5, compared to a P/E of 7 for business 2.

The problem is that without looking at the balance sheet you cannot reach a conclusion about which business is cheaper. Going back to our example, further imagine that business 1 has a bank loan for $200,000 and business 2 has a Certificate of Deposit worth $200,000. In that case, you’d really be paying 7x earnings to purchase business 1 and only 5x earnings to purchase business 2, the exact opposite of the conclusion reached by not taking the balance sheet into consideration.

Although the preceding example did not make the distinction, EBIT is also superior to GAAP earnings in that it eliminates distortions and differences arising from different tax rates.

EBIT itself is also a short-hand measure of sorts in that, without further adjustment, it assumes that a company’s expense for depreciation and amortization is equal to its expense for maintenance capital expenditures (capex). Greenblatt’s Magic Formula makes this assumption in order to simplify the calculation required for the selection of stocks. This provides an opportunity for investors who wish to improve upon the magic formula’s mechanical approach by doing further business analysis.

This assumption can distort a business’s true earnings yield and the comparison of its earnings yield to that of other businesses. The growth portion of capex in a growing business may materially understate EBIT if a distinction is not made between growth capex and maintenance capex. It is very useful to be able to evaluate what the business would look like in a steady state so you can see how cheap it is and how it compares to other opportunities.

To get a more accurate view of a business, you should calculate EBIT by subtracting actual maintenance capex from EBITDA. If a business does not disclose its maintenance capex, you can usually derive it by making some reasonable assumptions.

Interestingly, regarding the calculation of intrinsic value, some investors use EBITDA – maintenance capex in their calculation of earnings power and in their discounted cash flows, giving full credit for the free cash used to reinvest and grow the business. My own thought is that this approach can make sense if the returns on the reinvested growth capital clearly exceed the cost of capital and are therefore value creating.

Buffett was asked at the 1998 Berkshire shareholders meeting how he estimates intrinsic value for companies where the free cash flow is largely offset by reinvestments to grow the business. The shareholder specifically mentioned McDonald’s and Walgreen’s as examples. Buffett, in seeming contrast to the approach mentioned above, said that he only gives credit for the cash that is left after growth capex. He figures that if the investments are made wisely the growth in future free cash flows should more than offset the discounted value of those cash flows. If it does not, Buffett figures it was not a good use of that cash.

Buffett reiterated his view that the best kind of business is the one that grows free cash with little or no-reinvestment, although he stated he is also quite happy to own a business that requires reinvestment of capital but provides a satisfactory rate of return on that reinvestment.

EV is superior to market value as a measure of how much you’re really paying for a business because it includes not only the cost of the company’s equity but also the cost of the company’s debt. It also gives the company credit for its cash, which can be used to offset the purchase price – for example, through a special dividend – or to retire debt.

Bruce Greenwald recommends not subtracting 100% of the cash but leaving an amount equal to 2% of revenues for use as working cash. I have also seen Joel Greenblatt comment that he won’t just assume that the cash is worth full value. He analyzes the situation and may give cash only partial credit depending on his judgment of how it will be used.

It is always fascinating to me when I find a stock that does not look particularly cheap when I look at its P/E ratio that turns out to be cheap when I calculate its EV/(Adjusted EBIT). I strongly suggest that you make this a part of your analysis of any potential investment.

Buffett has said that he will generally pay 7x EV/EBIT for a good business that is growing 8-10% per year.

If you wish to learn more, please see the appendix to The Little Book That Beats the Market by Joel Greenblatt and Value Investing: From Graham to Buffett and Beyond by Bruce Greenwald et al.

Links of Interest – October 8, 2010

Small Stocks: Should Value Investors Only Buy Microcap Stocks? – 4 Stocks People Ignore – Gannon On Investing – Gannon On Investing

Investing 101 Toolbox: 12 Books, 3 Lectures, 4 Blogs, and 5 Interviews for Investors – Gannon On Investing – Gannon On Investing

Financial Statement Interpretation books?

YouTube – Coca-cola better hedge against inflation over Gold – Yacktman

YouTube – David Dreman and Donald Yacktman on Finding Value In Beaten-Down Stocks

John Malone of Liberty Media | Street Capitalist: Event Driven Value Investments

Buffett: Why Own Bonds When You Can Own Equities? | The Rational Walk

These Former Colleagues Are in a Value League of Their Own

Buffett Partnership Letters: Lessons for Professional Investors « Stableboy Selections

Zweig: Tactical Asset Allocation Has a Lot to Prove

Picking Stocks the Warren Buffett Way-Understanding ROE

Market Valuation Update – October 7, 2010

I have updated the market valuation data based on closing prices for October 6, 2010. The S&P 500 has advanced approximately 10% since September 1, 2010, when I last updated the indicators. Equities still appear attractive on a relative basis given the historically low yield on government and corporate bonds.

Buffett recently commented at the Fortune Most Powerful Women Summit that, “It’s quite clear that stocks are cheaper than bonds. I can’t imagine anybody having bonds in their portfolio when they can own equities, a diversified group of equities. But people do because they, the lack of confidence. But that’s what makes for the attractive prices. If they had their confidence back, they wouldn’t be selling at these prices. And believe me, it will come back over time.”

Generally speaking, from month to month relatively little changes in these indicators. The trick is to develop the discipline to follow them on a regular basis. Doing so, along with developing a rational investing framework, should improve your odds of being greedy when others are fearful and fearful when others are greedy.

More Thoughts on Small Cap Investing

On October 4, 2010, I wrote a post entitled Small Stock Investing: The Path to Riches?, which outlined some of the differences between investing in small caps and large caps.

The post considered the idea that there is more opportunity in small caps. Upon reflection, perhaps it would have been better to make the distinction between micro-caps and large-caps, as micro-caps – stocks with market capitalizations less than $250-300 million – are more the area of the market I was writing about.

I have a few more thoughts on this thread.

I don’t think there is as much opportunity in this area as there was when Buffett was operating his partnership. There were no value-oriented hedge funds scouring the market with computer screens, so the market was less efficient. In 1963, there were 284 candidates for the CFA. In 2007 there were nearly 100,000 CFA charter holders.

Munger has made the point that the Great Depression so shell shocked equity investors that it caused a lasting multiple compression that created a period of opportunity for early value investors. Using Munger’s metaphor, now, when you run your Geiger counter looking for mispriced micro-caps, it may not click. The practical implication here is that to operate in this sector – given the potential paucity of candidates – you may find yourself reaching for companies of questionable quality.

A point that was made in the prior post – but that deserves re-emphasis – is that Buffett was an exceptionally gifted investor. He was the only student to get an A+ in Ben Graham’s investment class and is widely acknowledged as the best investor of his generation, if not all time. The point is that investing in micro-caps can be tricky. These companies don’t typically have the resilience of large caps and the lack of information that contributes to their mispricing may make it difficult to determine their intrinsic value.

For what it’s worth – and it may say more about me as an investor than the risks of micro-cap investing – I have lost more money in this area than in investing in large caps. Perhaps it would be prudent to “cut your teeth” in large or mid caps and prove to yourself that you know what you’re doing before seeking opportunity in micro-caps.

A case in point of the challenges of micro-cap investing is the example of Paul Sonkin. Sonkin is a hedge fund manager who specializes in micro and nano-cap investing (market caps under $50 million). Bruce Greenwald has looked at Sonkin’s trades and concluded that his initial positions were only minimally profitable and that the majority of Sonkin’s returns came from buying more stock as the price declined below his original purchase price. This means that Sonkin had to have a high degree of confidence in his valuations to be able to buy more stock as the priced declined. This could be a recipe for disaster if you didn’t know what you were doing.

Finally, a couple thoughts regarding Buffett.

First, Buffett points out in his partnership letters that he had a built-in hedge when investing in under-valued micro-caps. If he established a position and the stock went up, he made money. If the stock price stayed low, or declined further, Buffett could keep buying and eventually acquire a controlling interest in the business. He could then unlock the value in the business by changing management. Very few investors are in a position to utilize this hedge.

Second, Buffett did not put all his eggs in one basket. He made three types of investment in the partnership: 1) undervalued securities (what he called “generals”), 2) workouts, and 3) control situations.

I am not trying to discourage investing in micro-caps, but rather trying to point out some of the challenges so that, if you decide to do so, you will maximize your odds of success.

My Watchlist – October 5, 2010

I have reviewed issue 6 of Value Line and added companies that have exceptional returns on equity or growth in book value. The list is not perfect and some judgment is required in deciding whether to include a particular stock. As always, I welcome your feedback and comments.

The idea here is to have a dashboard of substantially all the high quality businesses in the U.S. in one place that you can review at least weekly to see what Mr. Market is making available to you.

Here is the updated watchlist.

Stocks Added This Week.

Fastenal Company (FAST)

Lowe’s Companies, Inc. (LOW)

The Home Depot, Inc. (HD)

Sherwin-Williams Company (SHW)

The Clorox Company (CLX)

Colgate-Palmolive Company (CL) – within 5% of 52 week low

Kimberly-Clark Corporation (KMB)

Newell Rubbermaid Inc. (NWL)

The Procter & Gamble Company (PG)

WD-40 Company (WDFC)

A few thoughts…

In general, stocks do not look particularly cheap. This is not surprising given the run-up in stocks over the past three months.

Although it’s a very crude indicator, the number of stocks within 5% of their 52 week high – those with cells colored red in the “% below 52 week high” column – gives a useful quick read of how cheap or expensive the market is. Waiting for the majority of stocks to be within 10% of their 52 week lows – cells in the “% above 52 week low” column colored green (within 5%) or yellow (within 10%) – may be a constructive period to start becoming greedy.

Small Stock Investing: The Path to Riches?

Some years ago, Buffett created a stir of sorts when he stated that if he were investing $1 million today he could generate annual returns of 50%. I wrote about it in an earlier post.

In an interview with blogger Jacob Wolinsky, value investor Whitney Tilson was asked if Buffett’s investment style had changed as a result of his different circumstances at Berkshire and if he would be a net-net investor if he was managing less cash. Here’s Tilson’s answer:

Yes, that is absolutely true. He has been asked this question many times and responded that if he were to be managing very little money he would be looking in the nooks and crannies looking for extreme temporary mispricings. If you know where to look, you can sometimes find extreme temporarily mispriced stocks. However these stocks are usually small and it is hard to put much money into them. Not in a million years would Buffett own Kraft if he was managing $10 million.

Recently on The Corner of Berkshire & Fairfax Message Board, an excellent investing forum run by value investor and investment manager Sanjeev Parsad, the question was asked “What percentage of your portfolio is in Fairfax Financial?” The level of discussion on the board is quite high and it’s clear many of the members are capable investors.

For those who are not familiar with the company, Fairfax is an insurance company with outstanding investing capabilities that has compounded book value at a rate of 25% over the past twenty-four years under the leadership of Pre Watsa. Fairfax is often compared to an earlier stage Berkshire Hathaway. Many members of the forum have a material investment in Fairfax.

One member, rick_v, criticized having a large investment in Fairfax because, in his view, it is easy to find cheaper micro-caps with greater opportunity. In response, another member, coc, defended investing in Fairfax and challenged the idea that it is easy to find micro-cap investments that will outperform the market.

I thought the exchange crystallized some of the important decisions investors face when defining their own investment process and philosophy. The exchange also provides some food for thought to those who, inspired by Buffett’s remark, choose to seek opportunity in micro-caps.

Here’s rick_v

I truly hope that all you guys mentioning stakes of 20-30%+ in Fairfax are either passive investors or older in age.

I think its a shame for a young or professional value investor to have such a large percentage of their portfolio in a stock like Fairfax. Afterall, even if Fairfax doubles in a few years that is not how you are going to generate alpha or get rich for that matter…

As a young or professional value investor you should be studying Fairfax and Buffet’s performance to identify your own value plays. Thats where the alpha will come from.

It is very easy with permanent capital to find securities which will outperform the market when you are looking in the 0-250m range. This range is not looked at by Prem, Buffet, and most of the other major value investors anymore due to their size. As such it represents where I see most of the opportunity for up and coming value investors.

Just my thoughts…

Here’s coc’s response:

I’m surprised you all let this go. I’d like to comment on two things, both of which I consider nonsense.

1. It is “very easy” to find securities that will outperform the market.

2. Holding Fairfax is inferior to running around finding these “very easy” securities.

I think investors vastly underestimate how good Warren Buffett was at his job back in the 1950’s and 1960’s when he was buying these niche securities. He’s even better now, but obviously runs so much capital that his returns are lower. There seems to be this “Buffett envy” going on in value investing circles whereby investors feel the need to look for little cigar butts similar to what Warren used to – largely influenced by his talks to students and his biography.

And yet, I have seen precious few investors who have successfully done it. Beyond the platitude that smaller areas of the market are “inefficient,” there are considerable risks. You are usually investing in second rate businesses that destroy value, or at least are not really building any. Often these businesses are run by inexperienced managers and have little advantage over their competitors. Thus, the business risks you assume are big ones, although most investors think a cheap valuation makes up for it. Sometimes, but not always.

Take for an example Dempster Mill Mftg – a well known Buffett investment way back when. If you think through the situation, there was a good probability that the investment was not a wise one. It took heroic efforts by a new manager to keep Dempster from going under, and even then, it was not an absolute home run. Yet, most Buffetteers admire these types of investments Warren used to make.

But what was Warren’s largest partnership investment? American Express, a well known company then and now, not a micro-cap dishwasher manufacturer. He also had a successful investment in Disney, and one in GEICO, again two companies that were well known. What was probably his best stock investment at Berkshire? The Washington Post, not exactly “unknown.”

Yet we’re told that he made all of his great returns back then because he could look small. Well, as with everything in life, the answer is yes and no. I think there is a great myth that you need to look where no-one else is looking and be creative in the investment process. That you should get points for creativity or something. But the very same people propagating this myth are students of Charlie Munger, who once wrote to Wesco shareholders that “We try to profit more from always remembering the obvious then grasping the esoteric.”

Let’s talk about a few more of Warren’s home runs. Petrochina, one of the largest companies on the planet. Freddie Mac, one of the largest companies on the planet. Coca-Cola, the most well-known brand on the planet. BYD, one of China’s most well-known and well-respected companies. These are investments where, for the first 5-10 years, he made 25%+ compound annual returns. Who are these people not getting rich by consistently generating 25% compound returns? Where is this stock market where 25% annual returns don’t generate “alpha”? Why do small investors need to run around looking at micro-caps?

***

Let’s also look at some other legendary investors. What sort of returns did they achieve and what were they buying? Lou Simpson – 20%+ type returns buying very well known companies. Rick Guerin – 25% type returns investing in a pretty broad range of securities small and large. Ruane, Cunniff – 15% over 40 years investing in large stocks. Eddie Lampert at ESL – you would probably know of almost every company he ever invested in – 30% CAGR for a 15-20 year period. Glenn Greenberg at Chieftain – did 25% for about 20 years, again you’d probably recognize almost every stock he owned.

These guys are legends, they’re all rich, and they invested in a huge range of securities.

Who do we know of that was investing in small securities that no one has heard of? Here’s two: Schloss and Graham. Did either of them do 50% compounded? Hell no. They’re hall-of-famers with 15-20% returns. Do I need to bring up Charlie’s returns? What has he bought over time?

So I dispute this notion that investors are somehow doing themselves a disservice by sticking with companies they know well and that others know well. Well-known companies are often just as mispriced as small ones. “To a man with a hammer, everything looks like a nail,” says Munger. Yet the Buffetteers seem to only admire one tool for finding cheap stocks (size constraints), when myopia, ignorance, and a host of other biases are just as powerful in creating misvalued securities.

To wrap this up a little, I’m not saying there aren’t lots of small mispriced stocks. Buffett did very well with them, and there are probably others doing great, too. But recognize two things: 1. Huge CAGR’s are really, really hard. 2. You can do extremely well investing in larger companies, great companies, and well-known companies, without a lot of the risks of investing in broken-down nags. This is well proven.

So if you rationally evaluate Fairfax and come to the conclusion that you’re going to get 15-20%+ CAGR (eminently reasonable given the fact that they are a relatively small player in a gigantic global insurance market and are run by one of the smarter investment teams on the planet), don’t worry about how much “alpha” you’re not generating by looking elsewhere. Was it a mistake to invest in Berkshire when it had a billion dollar market cap and was well known? I repeat, there are no points for creativity. Don’t forget it takes a unique cast of mind to just sit on some great companies and compound at high rates with no taxes, professional investor or not.

I’m probably not going to convert anyone who believes strongly that they have to be looking in the dirty alleys for cheap stocks, but if you’re on the fence, hopefully this is food for thought.

Here’s a link to the thread if you want to read more.

My own opinion is that there is no reason to limit yourself to certain investments based on market capitalization, just like it doesn’t make sense to make a false distinction between value and growth. You can get rich investing in either. For example, today large caps offer unusually strong risk-adjusted returns.

In investing, what really matters is how much cash you get back and when for the cash you invest and how certain you are of the outcome. I do think it’s fairly obvious that Buffett would be more active in small and micro caps if he were investing far less money, although not to the exclusion of investing in large caps. He would simply have greater options.