Tag Archives: culture

Finding Quality

So how can investors beat the market? Click to enlarge Photo: Jason DeFillippo. Source: Morguefile There are lots of answers to that question. One approach is to find a stable of well-managed companies and stick with those. It’s harder than you think. For one thing, good management is hard to find. A great CEO can inspire people to deliver results that even they don’t think they can do; to envision markets that don’t exist right now; and to avoid professional and personal potholes that erode trust and poison the culture. These are hard to do, and they’re even harder when you’re a CEO with fiduciary responsibilities. The only person you can talk to about all your problems is your Priest or your dog. There are some extraordinary leaders out there, a lot of mediocre ones, and a few really bad apples. It’s hard, from a distance, to identify who the superior managers are, to separate the wheat from the chaff. At Charter, we look at corporate financial performance as well as manager compensation. When they treat the company as if it’s their personal piggy bank, that’s a bad sign. One investor has noted that the extravagance of a corporate office is inversely proportional management’s commitment to shareholders. Warren Buffett bought a stake in an insurance company when he saw that they had linoleum floors in their headquarters. “They’re cheaper to clean,” the CEO told him. Great leaders can make potato chips or dumping trash exciting for those who work for them. Owning stocks based on management competence and financial performance is a solid, fundamental approach to adding value. It doesn’t require a lot of trading. And management isn’t as volatile as the market. There are plenty of ways to add value. Finding a manager that you can grow with is a good way to do this.

Base Hits Vs. Swinging For The Fences

I just got done reading Jeff Bezos’ annual letter to shareholders , which is outstanding as it always it. As I finished it, I spent a few minutes thinking about it. He references Amazon’s (NASDAQ: AMZN ) style of “portfolio management”. He doesn’t call it that, of course, but this passage got me thinking about it. Since I wrote a post earlier in the week about portfolio management, I thought using Bezos’ letter would allow me to expand on a few other random thoughts. But here is just one clip from many valuable nuggets that are in the letter: Bezos has always gone for the home run ball at Amazon, and it’s worked out tremendously for him and for shareholders. Would this type of swinging for the fences work in investing? I’ve always preferred trying to go for the easy bets in investing. Berkshire Hathaway ( BRK.A , BRK.B ) is an easy bet . The problem, though (or maybe it’s not a problem, but the reality), is that the easy bets rarely are the bets that become massive winners. Occasionally, they do – Peter Lynch talked about how Wal-Mart’s (NYSE: WMT ) business model was already very well known to investors in the mid 1980s, and it had already carved out significant advantages over the dominant incumbent, Sears (NASDAQ: SHLD ). You could have bought Wal-Mart years after it had already proven itself to be a dominant retailer, but also when it still had a bright future and long runway ahead of it. So sometimes, the obvious bets can be huge winners. But this is usually much easier in hindsight. After all, Buffett himself couldn’t quite pull the trigger on Wal-Mart in the mid 1980s – a decision he would regret for decades. At the annual meeting in 2004, he mentioned how, after nibbling at a few shares, he let it go after refusing to pay up: “We bought a little and it moved up a little and I thought maybe it will come back a bit. That thumbsucking has cost us in the current area of $10 billion.” So sometimes, obvious bets can be huge winners. But many times, the most prolific results in business come from bets that are far from sure. Jeff Bezos has always had a so-called moonshot type approach to capital allocation. The idea is simple: there will be many failures, but no single failure will put a dent in Amazon’s armor, and if one of the experiments works, it can return many, many multiples of the initial investment and become a meaningful needle-mover in terms of overall revenue. Amazon Web Services (AWS) was one such experiment that famously became a massive winner, set to do $10 billion of business this year, and getting to that level faster than Amazon itself did. The Fire phone was the opposite – it flopped. But the beauty of the failures at a firm like Amazon is that while they are maybe a little embarrassing at times, they are a mere blip on the radar. No one notices or cares about the Amazon phone. If AWS had failed in 2005, no one today would notice, remember, or care. So this type of low-probability, high-payoff approach to business has paid huge dividends for Amazon. I think many businesses exist because of the success of a moonshot idea. Mark Zuckerberg probably could not have comprehended what he was creating in his dorm room in the fall of 2004. Mohnish Pabrai has talked about how Bill Gates made a bet when he founded Microsoft (NASDAQ: MSFT ) that had basically no downside – something like $40,000 is the total amount of capital that ever went into the firm. “Moonshot” Strategy is Aided by Recurring Cash Flow One reason why I think this approach works for businesses, and not necessarily in portfolio management, is simply due to the risk/reward dynamic of these bets. I think a lot of these bets that Google GOOG , GOOGL ) and Amazon are making have very little downside relative to the overall enterprise. Most stocks that have 5-to-1 upside also have a significant amount of downside. I think lost dollars are usually much more difficult to replace in investing than they are in business, partially because businesses usually produce recurring cash flow. Portfolios have a finite amount of cash that needs to be allocated to investment ideas. Portfolios can produce profits from winning investments, and then these profits can get allocated to other investment ideas, but there is no recurring cash flow coming in (other than dividends). Employees, Ideas, and Human Capital Not only do businesses have recurring cash flow, they also have human capital, which can produce great ideas that can become massive winners. Like Zuckerberg in his dorm room – Facebook (NASDAQ: FB ) didn’t start because of huge amounts of capital, it started because of a really good idea and the successful deployment of human capital (talented, smart, motivated people working on that good idea). Eventually, the business required some actual capital, but only after the idea, combined with human capital had already catapulted the company into a valuation worth many millions of dollars. There was essentially no financial risk to starting Facebook. If it didn’t work, Zuckerberg and his friends would have done just fine – we would have most likely never have heard of them, but they’d all be doing fine. If AWS flopped, it’s likely we would have never noticed. There would be minor costs, and human capital would be redeployed elsewhere, but for the most part, Amazon would exist as it does today – dominating the online retail world. Google will still be making billions of dollars 10 years from now if it never make a dime from self-driving cars. So, I think this type of capital allocation approach works well with a corporate culture like Amazon’s. Bezos himself calls his company “inventive”. They like to experiment. They like to make a lot of bets. And they swing for the fences. But the cost of striking out on any of these bets is tiny. And you could argue that any human capital wasted on a bad idea wasn’t actually wasted. Amazon – like many people – probably learns a ton from failed bets. You could argue that these failures actually have a negative cost on balance – they do cost some capital, but this loss that shows up on the income statement (which, again, is very small) ends up creating value somewhere else down the line due to increased knowledge and productive redeployment of human capital. So, I think there are advantages to this type of “moonshot bet” approach that works well within the confines of a business like Amazon or Google, but might not work as well within the confines of an investment portfolio. This isn’t always the case – I recently watched The Big Short (great movie, but not as good as the book ), and the Cornwall Capital guys used these types of long-shot bets to great success. They used options (which inherently have this type of capped downside, unlimited upside risk/reward) and turned $30,000 into $80 million. But I think this would be considered an exception, not the rule. I think most investors have a tendency to arbitrarily tilt the odds of success (or the amount of the payoff) too much in their favor with these types of long-shot bets. They might think a situation has 6-to-1 upside potential, when it only has 2-to-1. Or they might think there is a 30% chance of success, when there is only a 5% chance. It’s a subjective exercise – this isn’t poker or blackjack, where you can pinpoint probabilities based on a finite set of outcomes. So, I think many investors would be better off not trying to go for the long-shots – which, in investing, unlike business, almost always carry real risk of capital destruction. Berkshire Hathaway manages a business using a completely opposite style of capital allocation. Instead of moonshots, it goes for the sure money, the easy bets. It’s not going to create a business from scratch that can go from $0 to $10 billion in 10 years. But nor does it make many mistakes. There is no right or wrong approach. As Bezos says, it just depends on the culture of the business and the personalities involved. I think certain businesses that possess large amounts of human capital, combined with the right culture, the right leadership, and a collective mindset for the long term can benefit from this type of moonshot approach. They can, and should, use this style of capital allocation. Ironically, I think investments in such well-managed, high-quality companies with great leadership and culture are often the sure bets that stock investors should be looking for. Either way, from a portfolio management perspective, I think it’s easier to look for the low-hanging fruit.

The Wisdom Of Charlie Munger

As you may know, Charlie Munger is the low-profile partner of Warren Buffett and vice-chairman of Berkshire Hathaway (NYSE: BRK.A ) (NYSE: BRK.B ). You may have seen Munger sitting alongside Buffett during the famous annual Berkshire Hathaway shareholder meetings. Charlie Munger, with the younger Warren Buffett Although Munger is six years older than Buffett, they each refer to themselves as each other’s alter egos. Both come from Omaha. Both worked in the same grocery store in Omaha when they were kids – although at different times. At one time, Munger and Buffett were so close that they spoke on a daily basis. Today, they say they don’t have to because they already know what the other one is thinking. Looking at their personal balance sheets, Buffett is by far the more successful investor. Munger’s net worth is a mere $1.2 billion compared with Buffett’s $63 billion. Yet, when they sit side-by-side in interviews, it soon becomes clear that Munger is the more interesting character, with the broader range of both interests and knowledge. Buffett is quick to admit as much. The Mind of Munger Munger prides himself on being an intellectual iconoclast, relishing his role both as a curmudgeon and a foil to Buffett’s folksy image. He is a smart guy, having graduated second in his class at Harvard Law School, and takes pride in having pissed off most of the faculty in the process. Bill Gates said Munger has the “best 30-second mind in the world.” In my view, Munger is a classic INTJ personality, based on the Myers-Briggs test . He is a “mastermind” who thinks in terms of latticework intellectual models. Folks with this type of personality also account for a disproportionate number of the world’s top investors. Munger believes in studying the great ideas across all the disciplines not only to generate investment ideas, but also to live a rich and interesting life. While Buffett cites Dale Carnegie’s “How to Win Friends and Influence People” as a key book in his life, Munger quotes Greek stoics like Epictetus and Roman lawyers such as Cicero. It’s not that Munger never read Dale Carnegie. It’s just that he probably couldn’t be bothered to put what he read into practice. Five of Munger’s Big Ideas Munger’s thinking is eclectic, drawn from a wide range of disciplines and insights. Since he never has written these down, you need to tease them out of his occasional speeches to graduating law school and business school classes. Here are five of Munger’s insights that stuck with me, among the many. 1. Ignore the Propeller Heads of Modern Finance Munger disdains the army of academics who created the discipline of modern finance. He argues that defining financial risk as a function of a security’s volatility – the fundamental insight that won Harry Markowitz and William Sharpe the Nobel Prize in Economics in 1990 – has deluded generations of investors. Like Buffett, Munger was weaned on the mother’s milk of Ben Graham’s philosophy of value investing. But Munger also outgrew Ben Graham along the way, opening himself to the ideas of Philip Fisher. Fisher, the famed Silicon Valley-based investor, focused more on the idea of investing in high-quality companies at a reasonable price. Munger thus transformed Graham’s idea of a value-based “margin of safety” into the idea of a “moat” – a sustainable competitive advantage over time. This moat – say, a brand or some intellectual property – was the key to a company’s ability to generate returns for investors over a long period of time. Buy the right stock in the right company and you may never have to sell it. 2. Avoid Difficult Decisions Munger believes you should avoid difficult decisions. By limiting yourself to investing in the most simple and straightforward investment ideas, you are much more likely to be successful. Munger also recommends that you play to your strengths. This applies both to life and investing. Sadly, this strategy of “avoidance” demands a level of discipline that few investors possess. But if you’re 5″2″, you don’t make playing in the NBA your long-term goal. IQ won’t help you. Stick to what you’re naturally good at doing. 3. Don’t Trust Wall Street Munger disdains what he terms Wall Street’s “locker room culture,” which puts winning above everything else. This leads to counterproductive competitiveness and a willingness to push ethical boundaries just to keep up with the Joneses. This culture of greed and envy – two sins you should work hard to avoid, says Munger – are the source of much of the financial industry’s problems. 4. The Importance of Trust Munger emphasizes trust in investing. That’s why Berkshire invests in companies with sound and ethical managements who are motivated more by the compulsion to do a good job than by mere financial rewards. This emphasis on trust leads to some surprisingly anachronistic business practices. Berkshire’s acquisition of See’s Candies was done on a single sheet of paper. This was despite the fact that Munger is not only a lawyer, but also has his name on one of the most exclusive law firms in the country – Munger, Tolles and Olson, based in Los Angeles. 5. Understand the “Psychology of Human Misjudgment” Perhaps Munger’s most important insight is an understanding that human psychology is the key to successful investing – or what he has termed “the psychology of human misjudgment.” As with his other insights, these appear only sporadically in his speeches and writing. The recent work of behavioral economists and psychologists such as Richard Thaler or Daniel Kahneman echo some of Munger’s own views. Still, these academics’ insights pale in comparison to Munger’s cross-disciplinary “real world” approach. “Mr. Market’s mood swings” – “fear” and “greed” – as described by Ben Graham in “The Intelligent Investor” are a key part of both Buffett’s and Munger’s investment philosophy. But it’ll be a while before behavioral economists start writing on the impact of “envy” on your investment returns. That’s not the kind of research that’s going to get you tenure at an elite university. The Miracle of Munger If you take a step back, what Munger and Buffett have achieved together is astonishing. How is it that a couple of old guys sitting in Pasadena, California; and Omaha, Nebraska, became two of the most successful investors in the world, while generations of the best and brightest on Wall Street have come and gone, never to be heard from again? Munger would say it all comes down to “accurate thinking.” If that’s all it is, accurate thinking is the rarest of qualities, indeed.