Review: ‘Why Are We So Clueless about the Stock Market?’

Are you clueless about the stock market? Or perhaps better, could you admit to being clueless? For myself, as much as I purport to know about businesses, the stock market frequently baffles the mind. Reflecting the investing world’s immediate hopes, fears, beliefs, and dreams, the movement of prices seemingly offers a window into the shallower parts of our soul. Even for the seasoned observer, the market’s waves of euphoria and despair cast him reeling for clues–a narrative, a story–that can explain and predict its moves.

In the midst of the storm, Mariusz Skonieczny of Classic Value Investors offers the interested observer a map—Why Are We So Clueless about the Stock Market? (Investment Publishing, 2009)

Written with the beginning investor in mind, Skonieczny provides a compact, readable introduction that teaches how to analyze financial statements, value businesses, discern competitive advantages, and scout for bargains in the stock market. Skonieczny also puts his tools to the test by surveying four excellent businesses with durable competitive advantages—Burlington Northern Santa Fe, Thor Industries, Wells Fargo, and Moody’s. These case studies alone are worth the price of admission.

Throughout, I appreciated Skonieczny’s persistent attentiveness to economic moats and competitive advantages. Following Pat Dorsey’s The Little Book That Builds Wealth (Wiley, 2008), economic moats derive primarily from four sources—a) intangible assets, like brands, patents, and regulatory licenses, b) high switching costs, like that enjoyed by Alcon’s ophthalmological surgery equipment, c) network effects, enjoyed by services like Match.com, and d) cost advantages. While these four competitive advantages are rarely quantified on balance sheets, they provide a consistent tailwind for future business returns, particularly when measured over years and decades.

Of course, those same advantages—once fully utilized and recognized by the market—may encourage industry leaders into sloth. And sometimes the sleepy stumble and fall.

If I had one quibble with Skonieczny, it would be with his rather sanguine analysis of Moody’s. As we’ve worried about here and here, despite Moody’s regulatory imprimatur, network effects, and switching costs, their future looks much less certain than anytime since the 1930s. Whether too sleepy or greedy, Moody’s foray over the last decade into all manner of Wall Street’s structured financial products has tarnished its reputation, and perhaps more importantly, its cash flows. As late as 2007, structured finance ratings provided near half of Moody’s Investor Service’s revenues. And until the structured finance markets return (and assuming that they will), Moody’s will not be able to grow their earnings at the 10-20% that they—in the past—easily have.

All told, I enjoyed Why Are We So Clueless about the Stock Market? and would readily introduce it to family and friends interested in thinking about stocks as shares of a business.

Disclosure: None

Invest Like a Dealmaker

What’s the old bromide—never judge a book by its title? In the case of Christopher Mayer’s Invest Like a Dealmaker: Secrets from a Former Banking Insider (Wiley, 2008), my mind conjured up understuffed chairs in a sleepy room filled with Donald Trump, Wallace Wattles, and a confused Hank Paulson. Perhaps my imagination runs further than others.

In truth, Invest Like a Dealmaker is less about deals, secrets, and banking insiders, and instead a readable and useful introduction to valuing companies and uncovering undervalued securities. Author Christopher Mayer, who edits two newsletters Capital and Crisis and Mayer’s Special Situations for Agora Financial, surveys the analytic tools used by prominent investing gurus and peppers his text with interesting tales of underappreciated characters in the field.

Most simply, Mayer argues that investors should value a business by what a control investor (the mythical “dealmaker”) would pay for the whole thing. Relatively immune from the vagaries of technical charts, macroeconomic issues, earnings reports, earnings forecasts, and dividend rates, the mature investor concentrates on the “dealmaker’s ratio”—that is, enterprise value (EV) to earnings before interest, tax, depreciation and amortization (EBITDA). And for certain industries, asset values deserve attention and scrutiny. By scouring the newspaper and SEC filings, the investor can observe the business valuations that dealmakers use in acquiring their targets, and then can apply those valuations to other businesses trading publically.

Like Jay Gould, dealmakers never have the habit of selling what’s gone down and buying what’s gone up (3). Like Seth Klarman, dealmakers concentrate on tangible assets, which “usually have value in alternate uses, thereby providing a margin of safety.” (41) Like James Tisch, dealmakers invest where other fear to tread—in his case, in empty tankers trading for scrap value (49). Like the seventeenth century Josef Penso de la Vega, dealmakers opportunistically take advantage of panicky sellers (56). Following Marty Whitman, dealmakers realize that “the most inefficient tax way to create wealth is to have reportable operating earnings… the most efficient way… is to have unrealized appreciation of asset values.” (64).

With the principles in hand, where should the investor prospect for targets? For one, Mayer’s “all-time favorite hunting ground” is tracking the recent purchases of successful investors—Seth Klarman, Bill Miller, Marty Whitman, and the like. Second, net tangible asset screens have consistently produce valuable ideas. And third, taking his lead from Joel Greenblatt, Mayer closely tracks spin-offs and employs the “Magic Formula” screen (which ranks stocks with high returns on investing capital and low earnings yields).

All told, Mayer offers a useful and readable introductory text for the relatively green investor with some business sense. Unfortunately, there is little here that the more experienced investor or analyst will find original. Though it offers a few brief vignettes describing Mayer’s investing successes, the student of investing will desire more detail and deeper analysis. Here familiar investing principles and rules abound, yet many readers may wish that Mayer was more candid in showing how he used those principles to better his own work.

Disclosure: I requested and received a complimentary review copy of this book from the publisher.

Reviewing Malcolm Gladwell’s Blink

Is investing more art or science? Cash flow analysis and industry assessment submit to quantitative measures. Yet, economic moats and management’s rationality less so. The most successful investors use both quantitative and qualitative assessments to find undervalued businesses, though the former is certainly the standard route. For most, investing is primarily a science.

Ostensibly Malcolm Gladwell’s book Blink: The Power of Thinking without Thinking (Back Bay Books, 2005), is not a book about investing. Being interested in the human mind making judgments, Gladwell highlights situations in which rational, well-considered judgments are more inaccurate than reactive, non-reflective judgments. Peppered with memorable, illustrative anecdotes, Blink contrasts scientific rationality with the aesthetic, to see which more reliably guides us to make correct decisions (spoiler: it’s not an either/or).

It is our basic prejudice to think that lengthy, thoughtful, verbose defenses of our judgments are more likely to produce correct judgments than unexpressed, implicit ones. For example, Gladwell tells the story of the J. Paul Getty Museum’s $10 million acquisition of a sixth century BC marble kouros in the 1980s. Employing typical caution and prudence, the Museum solicited a handful of experts—geologist included—to assess the piece. “I’ve always considered scientific opinion more objective than esthetic judgments,” said Getty’s curator of antiquities Marion True. And the experts gave the green light; two days with a stereomicroscope confirmed the presence of calcite on the statue’s exterior—significant because dolomite can turn into calcite only over the course of hundreds of years.

Of course you may suspect how the story ends—the kouros was a fake. The museum though was not without warning, for no fewer than three additional experts had expressed their concern. Federico Zeri, an Italian art historian, found the sculpture’s fingernails odd. The first time Evelyn Harrison, a Greek sculpture expert, saw the kouros, she thought something was amiss. Thomas Hoving, former director of the Metropolitan Museum of Art in New York, met the statue and found it “fresh.” Not exactly the first impression that a sixth century BC statue should expect.

Long story short, time revealed the fraud. But Gladwell’s interesting observation is that the latter three experts all felt an “intuitive repulsion” when they first saw the kouros, and they were absolutely right. Inexpressible at the time, yes. But correct. What Gladwell ultimately aims to explore is whether our initial, “gut” reactions are reliable tools for making correct judgments.

As Gladwell observes, “when it comes to the task of understanding ourselves and our world, I think we pay too much attention to grand themes and too little to the particulars of fleeting moments.” (16) In those fleeting moments, a practiced and prepared expert can expose truth with unreflective judgments. In sum, people who are “very good at what they do… owe their success, at least in part, to the steps they have taken to shape and manage and educate their unconscious reactions.” (16)

Reading the book with an eye on investing produced two conclusions. First, quick judgments—even unexpressed—may incorporate sophisticated unconscious mental skills, such that an initial response to a prospective investment deserves one’s special attention.  Second, and I quote, “being able to act intelligently and instinctively in the moment is possible only after a long and rigorous course of education and experience.” (259) I guess I’d better get back to the 10-Ks…

Be the Dumber Guys in the Room

Business, most simply, is the practice of persuasion with the aim of making money. And the wise, worldly investors like Charlie Munger have done well in large part because of their familiarity with basic incentives and common methods of persuasion. One of Munger’s favored guides in his study has been Dr. Robert Cialdini, and in particular, his book Influence: Science and Practice, now in its 5th edition [see our previous discussions here, here, and here].

Dr. Cialdini, with Noah Goldstein and Steve Martin, has recently co-authored a shorter, more accessible account of social psychology’s established findings on human persuasion, entitled Yes! 50 Scientifically Proven Ways to Be Persuasive (Free Press, 2008). All told, it offers 50 brief vignettes that describe effective tactics of persuasion. Though the reader will find some reprises from Influence, I found much of interest and use.

For example, the authors describe the danger of being the brightest person in the room, or in one’s field. James Watson and Francis Crick are well-known as the discoverers of the double helix structure of DNA, even though Rosalind Franklin was the most intelligent scientist working on the problem in those days. Presumably like Franklin, Watson and Crick had clearly identified the most important problem to probe, dedicated their minds fully to its pursuit, and were passionate about their work. Yet, their advantage was their collaboration. Whereas the most brilliant tended to work alone, Watson and Crick sought advice and insight from all resources.

And more recently, behavioral scientists Patrick Laughlin and his colleagues have confirmed the value of collaboration, finding that “the approaches and outcomes of groups who cooperate in seeking a solution are not just better than the average member working alone, but are even better than the group’s best problem solver working alone” (100). Multiple minds working together stimulate more creative solutions and command wider knowledge and perspectives. Further, multiple actors can work on specialized tasks, expediting progress and enabling “parallel processing.” However, despite these benefits, Goldstein et al. argue that decisions made completely by committee are “notorious for sub-optimal performance” (101). Hence, their ultimate recommendation is that information be gathered and accessed collectively, but that decisions are made by a leader.

What lessons can we take from this knowledge of our patterned behavior? In investing, collaboration has clearly produced unprecedented returns for the team of Buffett and Munger. Yet, neither is shy in admitting that Buffett makes most of the buying decisions—at times, not even consulting Munger. Practically speaking, as one gathers information about a potential investment, there is a temptation to myopia, particularly if one is initially inclined to buy or sell. Data that confirms our inclination stands bold; disconfirming data melts into the mess. Crucial then is the intentional act of building and weighing the case against the proposed action. For each security one buys, he must achieve equal fluency in the case for selling. And vice versa. Only amid the trial of contending voices can the decisive agent invest intelligently.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

‘Buffettology’ Review

Today I spent some time with Mary Buffett and David Clark’s Buffettology (Simon & Schuster, 1997), which highlights Buffett’s divergence from his teacher Ben Graham over the years, leaving behind the “cigar butt” approach to investing in favor of buying excellent businesses at good prices.

Though the book offers few quotes from Buffett and is rather impressionistic, it does seem to fairly represent his approach. Of course, we took particular interest in Buffett and Clark’s description of excellent businesses.

They observe that an excellent business either: 1) “[makes] products that wear out fast or are used up quickly, that have brand-name appeal, and that merchants have to carry or use to stay in business,” 2) “provide a repetitive service manufacturers must use to persuade the public to buy their products,” and 3) “provide repetitive consumer services that people and business are consistently in need of” (119).

One obvious similarity is that recurring revenues are key. Not only do repeat customers imply that they have a deeply felt need for the products, but they ensure that long-term capital expenditures can profitably return capital. However, rather than invest in the retailers of such products (they get lots of repeat customers after all), one must concentrate investment capital in manufactures, for buyers want Coca Cola and couldn’t care less about the venue that sells it to them. The retailer then needs the product, more than the manufacturer needs the retailer, and thus the retailer holds little leverage against the manufacturer to negotiate on price.

Similarly, rather than invest in the vehicles of communication (cable, radio, and newspapers), better to buy the advertising agencies which build the “conceptual bridge” between manufacturers and customers. Network television and newspapers have lost numerous eyeballs and substantial revenue to the Internet, but advertising companies are still needed to shape a message, regardless of how it is ultimately delivered.

Lastly, Buffett and Clark argue that it is better to invest in companies that provide repetitive consumer services—like tax services, or credit card networks, or pest services—than dispensable services. In a slow macroeconomic environment, some may give up personal conveniences, but they will still need tax expertise, credit cards, and insect control.

Given this emphasis on recurring revenues, the majority of the book’s examples derive from basic consumer goods—Coca Cola, Philip Morris, Kraft, Conagra, The Hershey Company, Campbell Soup, Pepsi, Kellogg’s, Sara Lee, McDonald’s, and WD-40. Though few would deny that these are excellent businesses, this recognition is about as basic and common as could be, and all of these companies accordingly trade at premium valuations (even in the midst of a bear market).

All told, the most interesting and illustrative example was their description of Buffett’s purchase of General Foods in 1979. Buying shares between $28 and $37, Buffett’s stake was eventually bought out by Philip Morris for $120 in 1985. Here was a company selling well-known brands of consumer goods, purchased at six to seven times trailing earnings, when Treasury bonds were yielding 10%. Because General Foods could grow retained earnings at an above average rate (and protected the investor from paying tax on the full share of earnings), it ultimately outperformed the bonds. In this, General Foods looks similar to Buffett’s later purchase of Coca Cola. In both cases, the equity was not obviously cheap (relative to other investment options), yet both still beat the market’s returns.

‘The Dhandho Investor’ Review

Mohnish Pabrai begins his The Dhandho Investor: The Low-Risk Value Method to High Returns (Wiley, 2007) with a stunning observation: “one in five hundred Americans is a Patel… [but] over half of all the motels in the entire country are owned and operated by Patels” (1). For those less worldly, Patels are from a tiny area in Southern Gujarat, which resides in the Indian state of Gujarat, the birthplace of Mahatma Gandhi. Having only started arriving in the United States as refugees in the early 1970s, Patels today own over $40 billion in motel assets. How was this quick concentration of wealth possible? Dhandho.

“Dhandho” is a Gujarati word that, most literally, means “endeavors that create wealth.” But more specifically, Pabrai observes that Dhandho is the pursuit of wealth in low risk, high return business opportunities. Pabrai’s father was an early practitioner of the Dhandho way, when, in 1973, he staked all his savings and some borrowed money on a 20 room motel. According to Pabrai’s calculations, if his father failed, he would only be out his original stake of $5000; if he succeeded, he would have an investment whose net present value was worth $93,400. And the odds of success Pabrai puts at 90%. This is pure Dhandho–the no-brainer bet that all investors seek, “Heads, I win; tails, I don’t lose much” (12).

Pabrai uses this Dhandho way in managing his Pabrai Investment Funds. That means, more specifically, that he seeks simple businesses, with durable competitive advantages, in industries with an ultra-slow rate of change, often in situations of temporary distress. When Pabrai finds such businesses, he bets heavily, so long as the odds are favorable, and the price falls significantly below the business’ intrinsic value. Such investments offer low risks and high returns—investing the Dhandho way.

Given our interests at Wide Moat Investing, I found Pabrai’s discussion of durable economic moats fairly brief. Noting that few moats are permanently durable, Pabrai highlights Charlie Munger’s observation that “of the fifty most important stocks on the NYSE in 1911, today only one, General Electric, remains in business… That’s how powerful the forces of competitive destruction are. Over the very long term, history shows that the chances of any business surviving in a manner agreeable to a company’s owners are slim at best” (68). Building from this observation, Pabrai concludes that “even such invincible businesses like eBay, Google, Microsoft, Toyota, and American Express will all eventually decline and disappear” (68). Capitalism’s competitive destruction compels Pabrai to never calculate a discounted cash flow stream for longer than 10 years, nor expect the sale of a business ten years hence at more than fifteen times cash flows (69). Though businesses like Chipotle, Coca-Cola, H&R Block, BMW, Harley Davidson, WD-40, and Tesoro have wide economic moats and durable competitive advantages today, the Dhandho investor is unwilling to make investments based on the projection that they will be even wider or more durable in the future.

All told, The Dhandho Investor was a quick, enjoyable read that succinctly describes Pabrai’s nine investing principles, as well as a few successful Dhandho investments (Servicemaster, Level 3 convertible bonds, and Frontline). While Pabrai spends less time analyzing successful businesses than we might like, he does well to habituate his reader into seeing potential investments probabilistically.

‘Fooling Some of the People All of the Time’ Review

Over the last couple of days, I’ve buzzed through David Einhorn’s Fooling Some of the People All of the Time (Wiley, 2008), which describes Einhorn’s six year saga shorting Allied Capital. As Joel Greenblatt tells it in the foreword, this was a saga in which the good guys were dragged through the mud and the bad guys carted off millions. At least for a while.

The story begins with a bang in May of 2002 when David Einhorn, then a relatively unknown hedge fund manager, gives a speech at the Tomorrows Children’s Fund charity event in which he lays out his case for shorting Allied Capital. Word of the speech races from the event, and the next morning, Allied opens at $21, a 20% drop. As Einhorn recalls, “I did not for even a minute consider covering any of our short.” (55)

Of course, one can quickly look at the ticker to see how the story ends. But in between lay six years’ worth of accusations, name-calling, “pretexting,” and criminal charges, all from the ultimate loser’s side. Along the way, the reader sees into the state of regulatory oversight, contemporary business ethics, and corporate America. It is an interesting and highly detailed narrative that I would recommend to anyone interested in today’s equity markets.

Particularly interesting was Einhorn’s account of starting his Greenlight hedge fund with $900,000, over half of which came from his parents’ pockets. Even with an abundant contact list, he and his partner “soon realized that almost no one would invest with a couple of twenty-seven-year-olds with no track record.” (19) Yet, his early returns made up for his perceived inexperience, netting partners 3.1% in May of 1996, 6.9% in June, and 4.8% in July. After getting their first million dollar partner that August, money rapidly found its way to their door.

Most useful was Einhorn’s brief descriptions of his earliest investments. Successful investors (particularly Buffett) are often asked where they would be investing with a small, million dollar portfolio, and here Einhorn gives a glimpse into the opportunities that these inquiring investors most covet. In 1997, Greenlight pushed money into insurance company demutualizations, spin-offs, Pinnacle Systems, and some short sales, like Boston Chicken and Samsonite. Boston Chicken bombed because its accounting practices “enabled it to recognize up-front revenue and profit when franchisees opened restaurants. Boston Chicken financed the openings and up-front fees and earned interest on loans to the franchisees. The underlying restaurants were not profitable enough to support the payments to the parent.” (25) In 1998, Greenlight’s short target was Computer Learning Centers, a for-profit education company; in 1999, Seitel, which had a multi-client library of seismic data used to find hydrocarbons.

All told, I thoroughly enjoyed it, and I was reminded what good research really looks like.

‘Only the Paranoid Survive’ Review

Only the Paranoid Survive (Doubleday, 1996), by Andrew Grove, former CEO and Chairman of Intel Corporation, is a book about “inflection points” in businesses and careers. Inflection points require radical change, but our habits of mind and past investments can make change difficult at these points. Yet, without the requisite change, the ultimate cost is even higher. Grove peppers his insights with numerous anecdotes from Intel’s experience with inflection points in personal computing, and the book serves as a extended illustration of what a CEO’s mind must be to survive—paranoid.

For Grove, Intel’s primary inflection point confronted them in the middle of the 1980s, when they, a company known for their memory chips, were in an increasingly weak competitive position relative to Japanese chip manufacturers. As Grove observes, “when a strategic inflection point sweeps through the industry, the more successful a participant was in the old industry structure, the more threatened it is by change and the more reluctant it is to adapt to it” (50). Intel’s case confirms the point. They were consistently losing money on their memory chips while trying to compete; some recommended building a new, more efficient factory; others recommended more research and development in the hope that a better product would emerge.

The inflection point came in 1985, after Intel had been waffling about their chip problems for almost a year. Grove and then-chairman and CEO Gordon Moore were sullenly batting around ideas when Grove asked “if we got kicked out and the board brought in a new CEO, what do you think he would do?” “He would get us out of memories” was Moore’s response. And from that day, Moore and Grove began the long and difficult journey of persuading Intel to cast aside its accumulated identity and shift its attention solely to microprocessors.

Given the interests of this blog, we found Grove’s laundry list of inflection points to be most useful. In retail, Wal-mart’s efficiency in logistics and its corresponding low prices have required competitors to specialize (e.g., Home Depot, Office Depot) or fail. The introduction of sound into film-making compelled actors to transform their skills or dwindle into obscurity. Containerization enabled the rise in prominence of Singapore’s and Seattle’s ports (where there was sufficient room to expand), and the decline of New York’s. General Motors’ aim to offer “a car for every purse and purpose” resonated with customers more than Ford’s formulaic duplications—“it takes you there and brings you back.”

All these examples highlight an exceedingly important point. Today’s competitive advantages may subtly erode much faster than even the most astute and attentive observers recognize. Wide economic moats protect the castle, but very few endure across a lifetime. Inflection points are the norm, and investors and executives must constantly be looking for them; cultivating paranoia may be wise. To have an economic moat is not enough, for the moat must endure to provide the investor with significant safety.

Disclosure: I, or persons whose accounts I manage, own shares of Office Depot at the time of this writing.