Entrepreneur Arbitrage Spreads and The Commonality Of Locality

There is a great book that was written in 2000 by Amar Bhide called “The Origin and Evolution of New Businesses.”

In “The Origin and Evolution of New Businesses,” Bhide’s research showed that almost all businesses are started to take advantage of an arbitrage spread and in “Competition Demystified,” Bruce Greenwald also explains the concept of locality of a business. (The importance of thinking local.)

The two abstract concepts “arbitrage spread and locality” had me thinking for the last few weeks about how an effective business uses these advantages to start and continue to use it as an advantage whilethey scale. There are two types or start-ups described by Bhide: the first, a promising start up like Microsoft, Google, Soda Stream, or Tesla, and the second a marginal start-up like a gas station, landscaping business, motel, hair salon or convenience store.

Marginal startups have low uncertainty, low investment requirements and low likely profit. Promising startups have high uncertainty, low investment requirements and low likely profit.

When it comes to locality of a business a mental model should be made. Think back to just the last few weeks as we watched the Olympic Games unfold in Russia or even the last time you heard about someone you knew from high school, post secondary school or a past job, complete or succeed at something astonishing, publicly.

A greater connection is made with someone (or something) that has a prior associationestablished. This association comes from perceiving a commonality.

In the case of the Olympics maybe you knew someone who grew up in your province or state, even a town close to your own, or quite possibly the same town itself. Did you find yourself cheering them on and telling friends about their triumphs?

Why do we feel a greater connection to the athletes that are “closest to home?”

Why do local businesses and products create an emotional response?

This is because of the commonality of locality, or having an association that is pleasant to the subconscious mind. Small businesses in small towns know this effect quite well as likely does Wal-Mart and other encroaching box stores on the opposite side of the spectrum.

Think Local”

We have likely all heard variations of this saying at one point or another in our lives but have we thought of the metaphorical keys it may hold? In the present business environment where the flow information is quicker, transportation is cheaper, and today’s competitive advantages may be undone in relatively little time, it is important to have a concentrated strategy.

As Greenwald explains, competitive advantages that lead to market dominance are more likely to be found when the distribution and consumption takes place locally versus a large and scattered geographic region. This is ironically because competitive advantages tend to be specific, concentrated and local versus general, vague and diffuse. The more distance or time distribution must be traveled to meet consumption, the higher the costs of logistics. The less distance a message has to travel the quicker information can be absorbed. The stronger the connection or association to the service or product, the greater the emotional attachment.

Thinking local in a globalized world seems to be very counter-intuitive and framed as a paradox. Upon closer examination we find that if emerging markets follow the path of the developed markets the majority of their services and manufacturing will be consumed locally. We consume the majority of what we produce and import goods to make up for the insufficient capacity and excess demand. To paraphrase Adam Smith, the wealth of a nation is determined by what surplus can be produced relative to the demands of the country of origin and traded to other countries that have sufficient demand, creating a positive trade balance.

“The key to investing is … determining the competitive advantage of any given company and the durability of that advantage.” – Warren Buffett (TradesPortfolio

Are entrepreneurs risk takers?

Gates’ opportunity cost when he dropped out of Harvard to start Microsoft (MSFT) was exceptionally low. His labor was probably not worth very much in market at the time. If Microsoft failed he could have simply returned to Harvard to finish his degree.

One could state Gates faced uncertainty and ambiguity, but not risk.

Think back to our example of the gas station attendant for a moment. This gas station attendant realizes that there are no gas stations for nearly 30-mile radius and that people are forced to drive all the way to fill-up. He uses some of his savings to open up shop and he faces little risk of failure, as people will need to fill their cars with gas and an alternative is 30-miles away. If the venture does fail the man can go back to working as an attendant at another gas station or find another job. Things begin doing well for him but he is not likely to end up a billionaire as a result.

The arbitrage spread is the 30 miles between gas stations.

As business begins to boom and becomes more profitable competitors begin to encroach, opening gas stations 20 miles away, than 15 miles and finally 10 miles away, until the arbitrage spread is dissolved. He was collecting the spread until other entrants show up. The durable portion of the equation comes from being able to maintain or increase the arbitrage spread. The gas station has a wonderful competitive advantage when it starts, but that advantage is not durable. Hence it would make a poor investment.

Arbitrage spread comes from three “advantage pools”

1. Supply
2. Demand
3. Scalability

The good news is that the arbitrage spread can last for years. Given enough time, durable barriers to entry may be created such as a brand or supplier discount. Jumping from niche to niche, taking advantage of new arbitrage spreads is the only way to scale, usually the result of demand and supply opportunities.

“Durable competitive advantage is usually the result of unpredictable and rare random events, like IBM’s call to Microsoft to sell them a PC operating system when Microsoft had never built an operating system before and did not have one to sell. These events have no pattern and cannot be forecast when a startup is being formed. They happen to a very small minority. Once a startup has acquired a durable competitive advantage, and investors get an opportunity to buy in well below intrinsic value, backup the truck.” – Mohnish Pabrai (Trades,Portfolio)

Excerpts from Mosaic: Perspectives on Investing (Mohnish Pabrai)

The following paragraphs are from the book Mosaic: Perspectives on Investing and were found scattered across the Internet. It is 11,000 words of pure pleasure and I would also recommend Mohnish Pabrai’s other book The Dhandho Investor: The Low-Risk Value Method to High Returns. The latter is a lot more affordable as Mosaic sells for over $150 on Amazon. It would also be insightful to add Pabrai’s 13-F filings to your list of holdings to examine every 3 months.

mosaic

Seventeenth century French scientist Blaise Pascal is perhaps best remembered for his contributions to the field of pure geometry. In the 39 years that he lived, he found time to invent such modern day fundamentals as the syringe, the hydraulic press, and the first digital calculator. And, if that weren’t enough, he was also a profound philosopher. One of my favorite Pascal quotes is: “All man’s miseries derive from not being able to sit quietly in a room alone.”

I’ve often thought that Pascal’s words, slightly adapted, might apply well to a relatively new subset of humanity: “All portfolio managers’ miseries derive from not being able to sit quietly in a room alone.”

Why should portfolio managers sit and do nothing? And why would that be good for them? Well, let’s start with the story of D.E. Shaw & Co. Founded in 1988, Shaw was staffed by some of the brightest mathematicians, computer scientists, and bond trading experts on the planet. Jeff Bezos worked at Shaw before embarking on his Amazon.com journey. These folks found that there was a lot of money to be made with risk-free arbitrage in the bond markets with some highly sophisticated bond arbitrage trading algorithms.

Shaw was able to capitalize on minuscule short-term inefficiencies in the bond markets with highly leveraged capital. The annualized returns were nothing short of spectacular — and all of it risk-free! The bright folks at Shaw put their trading on autopilot, with minimal human tweaking required. They came to work and mostly played pool or video games or just goofed off. Shaw’s profit per employee was astronomical, and everyone was happy with this Utopian arrangement.

Eventually, the nerds got fidgety — they wanted to do something. They felt that they had only scratched the surface and, if they only dug deeper, there would be more gold to be mined. And so they fiddled with the system to try to juice returns.

What followed was a similar path taken by Long Term Capital Management, a fund once considered so big and so smart on Wall Street that it simply could not fail. And yet, when economic events that did not conform to its historical model took place in rapid succession, it nearly did just that. There was a gradual movement from pure risk-free arbitrage to playing the risky arbitrage game in the equity markets. A lot more capital could be deployed, and the returns looked appealing. With no guaranteed short-term convergence and highly leveraged positions, the eventual result was a blow-up that nearly wiped out the firm.

Compared to nearly any other discipline, I find that fund management is, in many respects, a bizarre field –where hard work and intellect don’t necessarily lead to satisfactory results. As Warren Buffett succinctly put it during the 1998 Berkshire Hathaway annual meeting: “We don’t get paid for activity, just for being right. As to how long we’ll wait, we’ll wait indefinitely!”

Buffett and his business partner Charlie Munger are easily among the smartest folks I’ve come across. But, as we’ve seen with Shaw and LTCM, a high I.Q. may not lead to stellar investing results. After all, LTCM’s founders had among them Nobel Prize-winning economists. In the long run, it didn’t do them much good. In fact, they outsmarted themselves. In a 1999 interview with BusinessWeek, Buffett stated:

Success in investing doesn’t correlate with IQ — once you’re above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.

Events at Shaw and LTCM show that high-IQ folks have a hard time sitting around contemplating their navels. The problem is that once you engage in these intellectually stimulating problems, you’re almost guaranteed to find what you think are the correct answers and act upon them — usually leading to bad results for investors.

Having observed Buffett and Munger closely over the years, and gotten into their psyche through their speeches and writings, it is clear to me that, like the folks at Shaw and LTCM, both men need enormous doses of intellectual stimulation as part of their daily diet. How do they satisfy this intellectual hunger without the accompanying actions that get investors into trouble?

Consider the following:

While Buffett plays bridge (typically 10-20 hours per week), Munger spends his time mostly on expanding his worldly wisdom and constantly improving his latticework of mental models. He is a voracious reader of intellectually engaging books on a variety of subjects, ranging from the various Ice Ages to The Wealth and Poverty of Nations. He spends considerable time in applying perspectives gained from one field of study into other disciplines — especially capital allocation.

At the Wesco annual meeting this year, Munger acknowledged that the first few hundred million dollars at Berkshire came from “running a Geiger counter over everything,” but the subsequent tens of billions have come from simply “waiting for the no-brainers” or, as Buffett puts it, “waiting for the phone to ring.”

Buffett still has a tendency to run his Geiger counter over lots of stuff. It’s just too enticing intellectually not to. How does he avoid getting into trouble? I believe there are three reasons:

1. Running the Geiger counter can work very well if one knows when to run it. Reflect on the following two quotes:

In 1970, showing his dismay at elevated stock prices, Buffett said: “I feel like a sex-starved man on a deserted island.”

In 1974, expressing his glee at the low levels to which the market had fallen, he said: “I feel like a sex-starved man in a harem filled with beautiful women!”

By 1970, he had terminated his partnership and made virtually no public market investments until 1974. The P/E ratio for the S&P 500 dropped from 20 to 7 in those four years. By 1974, he had acknowledged selling “stocks he’d bought recently at 3 times earnings to buy stocks selling at 2 times earnings.”

Then, from 1984-1987, Buffett did not buy a single new equity position for the Berkshire portfolio. Berkshire Hathaway was sitting on a mountain of cash, and still he did nothing. In the latter half of 1987, Berkshire used that cash pile to buy over a billion dollars’ worth of Coca-Cola over 5% of the company. He invested 25% of Berkshire Hathaway’s book value in a single company that they did not control!

What were Buffett and Munger doing from 1970-1973 and 1984-1987?  Both men realize that successful investing requires the patience and discipline to make big bets during the relatively infrequent intervals when the markets are undervalued, and to do “something else” during the long periods when markets are fully priced or overpriced. I’m willing to bet that Buffett was playing far more bridge in 1972 than he was in 1974.

2. The Geiger counter approach works better in smaller, under-followed companies and a host of special situations. Given their typical smaller size, investing in these companies would do nothing for Berkshire Hathaway today. So Buffett usually makes these investments for his personal portfolio. A good example is his recent investment in mortgage REIT Laser Mortgage Management (LMM), where there was a decent spread between the liquidation value and quoted stock price. These LMM-type investments are significant for Buffett’s personal portfolio and, more importantly, soak up intellectual horsepower that might lead to not-so-good results at Berkshire Hathaway.

Being versatile, he moves his Geiger counter away from the equity markets to other bastions of inefficiency whenever the public markets get overheated. These include high-yield bonds (Berkshire bought over $1 billion worth of Finova bonds at deep discounts in 2001), REITs (bought First Industrial Realty in 2000 for his own portfolio at a time when REIT yields were spectacular), or his recent investing adventures in silver.

3. The Munger/Buffett relationship is an unusual one. Both men are fiercely independent thinkers, and both prefer working alone. When Buffett has an investment idea, after it makes it through his filter, he usually runs it past Munger. Munger then applies his broad latticework of mental models to find faults with Buffett’s ideas, and shoots most of them down. It is the rare idea that makes it past Buffett, and it has to be a total no-brainer to make it past both of them.
The Buffett/Munger approach of multi-year periods of inactivity contrasts starkly with the frenzied activity that takes place daily at the major exchanges. Which brings me back to the fundamental question: Why have we set up portfolio managers as full-time professionals with the expectation that they “do something smart” every day? The fund management industry needs to reflect on Pascal’s potent words and how Warren Buffett and Charlie Munger have figured out how to sit quietly alone in a room, indefinitely.
“It’s a real tragedy when you buy a stock that’s overpriced; the company is a big success and you still don’t make any money.” Peter Lynch, “One Up on Wall Street,” New York, Penguin Books, 1989, p. 244.

Microsoft shares recently have been trading at about $70, off more than 40 percent from a high of $119.93. They went as low as $40 a share in December 2000. Is Microsoft a buy at $70? Is it a compelling buy if it dips down to $40 again? What is Microsoft worth and what type of annualized return would one derive from buying the stock today?

Before we try to answer those questions for Microsoft, let’s consider another one:

Let’s say a neighborhood gas station is put up for sale for $500,000. Further, let’s assume that the gas station can be sold for $250,000 after 10 years and free cash is expected to be $100,000 a year for the next ten years. Let’s say that we have an alternative risk-free investment that would give us a 10 percent annualized return on the money. Are we better off buying the gas station or taking our 10 percent risk-free return?

“Any business is worth the sum of free cash flow it will generate from now to eternity, discounted to present value using a reasonable risk-free interest rate” (John Burr Williams, Ben Graham, Warren Buffett, et al.)

Applying this notion of intrinsic value to the gas station yields a present value of $710,000. In other words, the gas station represents a better deal and a return substantially higher than 10 percent annually (Table 1).

The bigger the discount to intrinsic value, the more compelling the business becomes as a buy. All the great qualities of a business get fully reflected in its ability to earn cash in the future. Hence, regardless of the quality of the business, no business should be purchased above its intrinsic value.

Microsoft is a wonderful business. It has several exceptional traits that are rare to find together in a single company. Some of these are its recurring revenue stream (from upgrades), ability to raise prices and reduce costs ahead of inflation, it’s near-monopoly in most of its markets, its strong installed base, brand, etc.

Microsoft’s Intrinsic Value

The question an investor should ask when looking at Microsoft, or any other company, is not what the stock is priced at, but what the market capitalization of the company is. Like the gas station selling for $500,000, Microsoft is selling for $380 billion. Most investors fix on the stock price. Microsoft, however, through splits or reverse splits, can make its stock price whatever it wants it to be. Think of it as a business, just like you think of the gas station as a business.

Microsoft’s free cash flow is vastly different from reported net income. Like many technology companies, Microsoft issues stock options to virtually all employees. It has historically spent a large portion of its net income buying back stock to offset the dilution effect of options. The share buybacks annually are less than the options exercised each year. So the money used to buy back stock (less the amount received from employees when they exercise options) should be subtracted from net income to get closer to free cash flow. In effect, the money spent buying back stock might as well have been delivered in the form of checks to employees. The end result is the same.

In fiscal year 2000, Microsoft had net income of $9.4 billion, but spent about $4.9 billion buying back its stock. So ignoring other minor balance sheet items, free cash flow was around $4.5 billion. Let’s assume that Microsoft grows at 10 percent annually through 2005, and eight percent thereafter for the next few years. Let’s also assume that free cash flows are a healthy 25 percent of revenues after stock buy backs. Finally, let’s assume a sale of Microsoft in 2011 for a rich 15 times cash flow or almost 2 times its 2010 growth rate (Table 2).

Microsoft’s book value is about $41 billion. If I (generously) give them 100 percent credit for all of it being excess capital, the total intrinsic value of Microsoft is about $168 billion or $23 a share. The growth assumptions on Microsoft and the assumption that they will hit no road bumps or disrupters in the next 10 years are quite optimistic. If $23 a share is the correct intrinsic value, then value investors would want a Ben Graham/Warren Buffett “margin of safety” to justify the investment. This margin in a technology-centric business should be at least 40-50 percent.

So, at most, Microsoft may be a buy at under $13/share. It’s a far cry from the $70 a share it is currently trading at. It’s important to remember that investors who buy Microsoft at $23 a share will net a 10 percent return if there are no road bumps. Investors buying at $40, $50 or $70 a share will see a much lower return that starts to approach zero.

As Ben Graham succinctly put it, the stock market is a voting machine in the near term and a weighing machine in the long term. In the long run, all companies will trade around their intrinsic values. So, unless the fundamental business improves dramatically, we are bound to see a lack luster performance by Microsoft stock over the next decade — even though the company continues to grow and prosper.

Let’s do the math from another angle. Microsoft has a market cap of $235 billion. If someone invested in Microsoft thinking it was a good long-term investment, they might be looking for at least a 15-20 percent annual rate of return from this blue chip tech company.

If a 20 percent annual return has to be realized over a five-year period, Microsoft needs to have a market cap north of $600 billion in 2005 (including employee option exercise dilution). To justify a valuation of $600 billion, Microsoft needs to be generating free cash flow in the range of $50-60 billion a year in 2005. How many companies in the United States have ever generated that type of cash flow? The answer is zero. It is very unrealistic that free cash flow will grow 10-fold in the next five years. Even GE does not generate that type of cash flow.

Investors would be well served to look for great businesses within their circle of competence and then calculate intrinsic values for those businesses. If they are being sold well above intrinsic value, just take a pass. On the other hand, if they are available at deep discounts to intrinsic value, back up the truck!

ST. JOHN’S COLLEGE IN ANNAPOLIS, Maryland is an unusual place. Students are rarely lectured, they are never given any tests and there are no electives. In fact, there are no professors at St. John’s. Students spend their entire four years reading and discussing a range of great books.

They go from the Greeks (Homer, Sophocles, Aristophanes and the like), to the Roman, medieval and Renaissance periods (Chaucer, Dante, Machiavelli, Shakespeare etc.), to the 17th and 18th centuries during their third year (Hobbes, Cervantes, Milton, Bernoulli and so on). Finally, it’s all concluded in their senior year with works like the United States Constitution, various Supreme Court opinions, Darwin’s Origin of Species and poems by the likes of T. S. Eliot and Yeats.

Students get a broad-based education. They get nearly all their input directly from the original source. When learning about Physics and Astronomy they read the words of Newton and Galileo. On mathematics, the readings include the formidable words of Euclid, Pascal and Archimedes. These great books are the real teachers at St. John’s.

The common theme that emerges in interviews with alumni is how their years at St. John’s taught them how to think. One emerges from St. John’s with a broad cross-section of worldly wisdom and an unusual ability to analyze new information in the context of all that worldly wisdom.

The notion of worldly wisdom comes up often when Warren Buffett’s partner Charlie Munger is talking about the art of investing. Charlie gave one of his rare speeches to students at the University of Southern California’s School of Business in 1994. That speech unified the seemingly disparate notions of Worldly Wisdom, Success Investing and The Latticework of Mental Models.

Two of my favorite quotes from that remarkable speech are:

“To a man with only a hammer, every problem looks 
like a nail.”

and

“What is elementary worldly wisdom? Well, the first 
rule is that you can’t really know anything if you just 
remembered isolated facts and try and bang ’em back. If 
the facts don’t hang together on a latticework of theory, 
you don’t have them in a usable form. You’ve got to 
have models in your head. And you’ve got to array your 
experience – both vicarious and direct – on this 
latticework of models.”

Investing is perhaps one of the broadest of disciplines. When you look at any business today and then try to extrapolate what that business looks like 5, 10 or 20 years from now, it starts to get very murky. The number of factors that can affect the future prospects of any business are mind-boggling. At the same time, if one does not have a clear perspective on what that business really looks like in a few years, then one will likely join the ranks of 90 percent of professional fund managers and individual investors whose portfolios regularly underperform the major indices.

MBAs minted out of the nation’s best business schools represent the person with the hammer. They have analytic tools coming out of their ears when they graduate. They can all make Excel dance and tear apart financial statements in their sleep. However, the financial statements of any business simply tell us about the past. Making investment decisions based on past financials is akin to driving a car with a fixation on the rear-view mirror.

Since the future drivers of most businesses are a function of a myriad of factors, one needs to draw upon a wide array of mental models to try to build a picture of what factors really matter. Getting a pulse of the factors that matter most is fundamental to investing success. And one of the only ways of getting to those critical drivers is to have a very broad base of worldly wisdom and experience to develop a latticework of mental models. It is this latticework that should lead to a convergence decision on whether a given investment is a good one to make.

Let’s consider Berkshire Hathaway’s investment in Coca Cola common stock in 1988. Virtually all of Berkshire’s investments are made by Warren Buffett in consultation with Charlie Munger. Their modus operandi is one where Buffett comes up with investment ideas and calls Charlie who applies his broad worldly wisdom and latticework of mental models and usually shoots nearly all of them down.

From 1984-87, Berkshire Hathaway was sitting on over a billion dollars in cash and did not make a single investment in any public equity. Then, in 1987, they invested about $1.2 billion in Coca-Cola Common stock – buying every share they could get their hands on over a six month period. Berkshire ended up owning about six percent of Coca-Cola. Amazingly, they invested 25 percent of Berkshire Hathaway’s entire book value in a single company. Since 1987, Berkshire has not bought (or sold) a single additional share of Coca-Cola. Berkshire bought its stake at a split-adjusted $6 per share and has earned over a nine fold return on its investment over the last 14 years – excluding dividends. Its Coke investment has outperformed the market by a massive margin.

Coca-Cola has billions of customers around the world who are intimately familiar with its products and consume it every day. In 1988, it had over 20 Wall Street analysts following the stock (most analysts were bearish on Coke’s future prospects). How can a company in such a limelight be undervalued to such a large degree? By Buffett’s own admittance, Berkshire made the investment in Coke relying primarily on Coke’s past annual reports. He and Charlie never spoke to Coke management and indeed Coke’s board learned about Buffett’s purchase when he had nearly completed acquiring his stake. What did Buffett and Charlie see in Coke that over a billion people couldn’t see?

Here is a cross-section of some of the factors that went into their building a latticework of mental models on Coke.

1.Buffett is a huge sugar-addict and had been a lifelong passionate consumer of Pepsi Cola – until 1987. He used to add cherry syrup to his Pepsi before Cherry Coke was concocted. When he was seven years old, he used to count the discarded bottle caps around vending machines and carefully tabulate which drink people were having the most. He remembers being astounded with the overwhelming numbers of Coke caps (over 80%) relative to the numbers for all other drinks.

2.Buffett is rumored to have a subscription to Advertising Age magazine. He asked himself what it would cost to replicate the Coca-Cola brand in a few years. The conclusion Charlie and he reached was that it probably could not be done – even with $100 billion given to the best marketing team on Earth. At the time, one could have bought the entire Coca-Cola company for under $20 billion. So, here was a company whose brand alone was worth well over $100 billion and the entire company could be bought for under $20 billion.

3.Buffett pored over the last 80 years of Coca-Cola annual reports. He found that, like a software company, their gross margin on their syrup sold to bottlers is well over 80%. Coke’s future success was a function of the number of servings of coke sold worldwide. The more the servings, the more the cash flow. He found that over the last 80 years, their syrup volumes sold had risen every single year. The last 80 years included many ugly world events – World War I, the great depression, World War II, The Korean War, The Vietnam War, The Cold War, numerous recessions, being kicked out of India in the 1970s et cetera. Through all of that, Coke has grown every single year. The question Munger and Buffett posed to each other was simple – What volume of syrup might The Coca-Cola Company conservatively be expected to ship in the year 2000…2025…2050? They probably came up with some mouth-watering numbers, then extrapolated free cash flow (about one cent per eight-ounce serving) and finally arrived at a present value of all that future cash flow.

4.In 1886, when Coke was first concocted, it sold for five cents per eight-ounce serving. Today, one can buy eight ounces of Coke on sale for under 17 cents. If Coke’s pricing had moved in lockstep with inflation, we’d be paying several dollars for a single can. This is a very unusual product whose unit price has declined dramatically over the years. Very few consumer products have demonstrated the level of decline in prices that Coke has over the last century.

5.Billions of people around the world have yet to have their first Coke. In addition, the daily per capita consumption of bottled beverages around the world is miniscule compared to that of the United States and Europe. However, it has risen dramatically in various countries as per capita incomes have risen. We are likely to see big increases in per capita incomes in the third world over the coming decades.

The typical hammer-wielding Wall Street analyst is fixated on the next few quarters, not the next half century when trying to figure out any given company. No Wall Street analyst’s mental model of Coke in 1988 was comprised of the latticework that Munger and Buffett fixated upon. Individual investors will do well if they only made investments within their circle of competence based on an independent latticework of mental models. When all your mental models all converge at about the same intrinsic value for a given business, and that value is well above the price of the business, back up the truck. 
I’d recommend reading Robert Hagstrom’s outstanding book, Latticework – which I referenced for this article.

Hewlett Packard and Compaq represent the pinnacle of entrepreneurship and free enterprise, yet both companies could not possibly be more different. As startling as it may sound, HP was not created with a profit motive. When Bill Hewlett and David Packard setup shop in that famed Palo Alto garage in 1938, their mission was not to make a lot of money and get rich.

They set out to create a company where they could exercise their creative and entrepreneurial energies to build innovative products in their fields of interest and make meaningful contributions to society at large. It did not stop there. They wanted to attract like-minded souls and create a passionate, dedicated team that fostered intense individual creativity. Finally, they wanted to be part of a company that was deeply committed to community involvement at all levels.

Like Konosuke Matsushita, they recognized that profits were necessary to fulfill all the other objectives of the company. Profitability was treated as the best single measure of their contribution to society and the ultimate source of corporate strength. They clearly laid out a profit maximization goal — but only to the extent that it was consistent with all the other objectives of the company.

Hewlett and Packard were intensely focused on achieving these lofty and counter-intuitive goals. They created a world-class company, which has met every objective they laid out, and then some. While they became rich in the process, neither fixated on personal wealth or extravagant lifestyles. Both gave away 90 plus percent of their multi-billion dollar estates to their respective charitable foundations.

Compaq, on the other hand, was a Ben Rosen venture-backed well-funded startup that had a straight profit maximization objective. They wanted to build IBM PC-clones, scale up quickly and get to over $100 million in revenues in the first year. Compaq achieved these monetary goals and became the first company in history to have over $100 million in revenues in its first year.

Compaq has been a success in its own right. However, unlike HP, the DNA structure of Compaq is not that of an innovator. To put it bluntly, it is a profit maximizing focused PC-clone maker that has never delivered any meaningful innovations, nor has it been able to do anything but PC hardware. HP, on the other hand, has delivered a plethora of innovations in a diverse range of disciplines. Compaq’s original DNA programming is diametrically opposed to the HP way. Blending these two disparate cultures is trying to mix oil and water, and guaranteed to fail. Ben Rosen is as sharp as they come. The only reason Compaq is being sold is because he believes that he has indeed extracted every ounce of profit out of it that he possibly could, and continuing independently will lead to eventual demise.

So why is Carly Fiorina hell-bent on pursuing this merger? The biggest mistake HP made was in hiring an individual as its CEO who fundamentally does not subscribe to the HP way. The founders were not money motivated. Fiorina needed an outrageous $75 million package to sign on as CEO. That should have been the first clue to the board that she was the wrong choice. Secondly, unfortunately, many Fortune 500 CEOs measure their success by their rank on the Fortune 500. The ranking system is based on company revenues. If the list were based on the 500 companies with the largest free cash flows and then ordered by the average percent increase in per share free cash flow over the last five years, we’d see radically different CEO behavior.

The only thing the merger accomplishes in the near term is a substantially higher Fortune 500 ranking — which is precisely what a high-ego, low HP-way ethos CEO would want. The new HP, in the long run, will only be a small shadow of its present glory.

Another way to examine the merger is doing an intrinsic value analysis. At HP’s present stock price, HP is paying about $21 billion for Compaq. It appears to me that virtually all of Compaq’s assets are required to maintain its marker position and cash flow. What is the future of Compaq? With revenues dropping from $42 billion to $33 billion is a year and profits dropping from $1.7 billion to $170 million, it’s not a rosy picture. Figuring out Compaq’s future is murky. I do see a business model and cost structure that’s vastly inferior to Dell. My most optimistic assessment of Compaq’s intrinsic value is well under $10 billion. Adding in a Ben Graham margin of safety, I would not want to pay more than $5 billion for the company. HP is paying four to seven times optimistic valuation — and paying it with HP stock that, at present prices, is well under its intrinsic value. It’s a very bad deal for HP stockholders and a blessing for Compaq shareholders.

When one charts the stock performance of Southwest Airlines, Dell or Walmart over the last five years, the results are very impressive. Dell is up nearly 600 percent while Walmart is up 400 percent and Southwest is up more than 300 percent. All three have trounced the S&P 500, which has gone up a modest 50 percent in the same period (see Figure 1).

All three companies compete in very challenging industries where it’s tough to earn a double-digit return on equity, yet they’ve outperformed the S&P 500 average on the order of six to 12 times. Let’s take a look at Dell. Selling PCs is a very tough business. You’re essentially selling a commodity, and price is a big driver. Yet Dell has consistently outperformed its industry peers, Gateway and Compaq, which have both lagged the S&P 500 over the last five years and netted investors a negative return over the same period (see Figure 2).

The contrast in performance between retailers Walmart, Sears and K-Mart is especially stark. Retailing is a tough way to make a buck, and among the most transparent of industries. Trade secrets are virtually non-existent. Competitors can uncover Walmart’s strategy just by walking through its stores. All the data one would care to know — pricing, product lines, merchandising strategy — is displayed on the shelves. Yet, while K-Mart has decimated all shareholder value with its recent bankruptcy filing and Sears is simply treading water, Walmart has delivered spectacular returns to shareholders (see Figure 3).

Warren Buffett jokes that if he ever gets the urge to buy an airline stock, he dials an 800 number to reach Airlines Anonymous to talk him out of his delusion. After living through the gyrations of his US Air investment, he learnt his lesson and will probably never buy an airline stock again. The basic economics of the business are very bad. You have organized labor that believes a pilot making $300,000 is underpaid and can choke off your entire revenue stream with a strike. Add to that the high fixed costs of airplanes and finally, pricing that is determined by the moves of your dumbest competitor, who’s only trying to recover marginal costs. The combination can be lethal!

Not only have Delta and United not earned a dime for their shareholders in the last five years, they’ve proceeded to lose some of the principal as well. But Southwest has more than tripled investors’ original stakes in the same period. Indeed, Mr. Buffett should note that had an investor invested an equal amount in Berkshire Hathaway and Southwest Airlines in 1990, he would have made a stunning 15 times his original investment with Berkshire Hathaway, but Southwest would have given him more than 29 times his original investment. So much for all airlines being a crappy investment! (See Figure 4).

How does one explain the wide difference in performance between Southwest, Dell and Walmart and their respective competitors? There is no discernible difference in the direct-sales strategies of Dell and Gateway. Nor is there a difference in the discount- retailing model of Walmart and K-Mart. United’s Shuttle operation in California was an exact replica of Southwest’s model of going point to point, turning planes around rapidly and flying only Boeing 737s, except that United lost tens of millions of dollars in the endeavor and eventually folded not only California’s, but its entire U.S. Shuttle operation!

The difference between Southwest, Dell and Walmart and their competitors lies in their leadership. The CEOs of these three companies are fairly similar to their counterparts in capability and intellect. But they possess other qualities that give their companies a competitive advantage.

I recently read three unrelated books that provide deep insights into how fundamental differences in business leadership styles, unrelated to competency, can become big drivers for dramatic performance differences between companies: Power vs. Force by David Hawkins, Matsushita Leadership by John Kotter and Good to Great by Jim Collins. All three are exceptional and provide many of the answers.

It is impossible for me to capture these three books in a few paragraphs. I’d strongly recommend that the reader delve into all three. To summarize, it turns out that shareholder value can be significantly enhanced by certain traits in a company’s leader. Companies, even in challenging industries, will do far better than their competitors if, in addition to competence, the CEO possesses the following traits:

No ego. A singular focus on truth. Truthful CEOs do not send “messages” to shareholders, employees or customers. They speak core truths that they deeply believe in. None would ever even think of “delivering a tailored message.” This is a very critical characteristic, and the definition of truth is very broad and deep. They are deeply in love with their companies and their stakeholders. Their primary motivation comes from this dear love. The company is their temple.

This combination of lack of ego, love, truth and capability is potent. Leaders who possess these rare traits will deliver astounding results. If a CEO, tries to fake it, it does not work. Stakeholders can see through the fake eventually and react appropriately.

When corporate boards look for CEOs, they often look for charisma and marquee names ¾ turning to high-ego leaders like Al Dunlap or Carly Fiorina. High-ego CEOs may, at best, do well during their terms, but their companies inevitably fall apart after they leave. On the other hand, Walmart’s Sam Walton, Southwest’s Herb Kelleher and Berkshire Hathaway’s Buffett have built companies that will endure and perform well for decades beyond their tenures. As Buffett says of Berkshire Hathaway, “It’s been lovingly created.” Kelleher expressed his feeling for Southwest through the company’s quirky ticker symbol, “LUV”.

A good way to gauge CEO ego, or lack thereof, is to assess the extent to which CEOs promote themselves, versus their companies. In the case of Southwest, there is no bio of Herb Kelleher on the entire Southwest Web site. He’s a business legend who has no interest in talking about himself. Contrast that with the bios of Delta and United CEOs posted on their companies’ Web sites. Interestingly, the United CEO’s bio does not even talk much about United! Judging from their Web sites and business press, both Michael Dell and Gateway’s former leader, Ted Waitt, are very high-ego CEOs. Gateway fell apart after Waitt left. The data suggests a not-so-rosy picture for Dell post-Michael.

Investors can identify CEOs with the right combination of value-driving personality traits — lack of ego, truthfulness and love for their business — by assiduously mining the wide array of data that on public companies that is available from the business press, Web sites, earnings conference calls and annual reports. Try characterizing the personality traits of the CEOs of the companies in your portfolio. If you can buy a great company well below its intrinsic value, and it’s run by a very low-ego, totally truthful, high-capability CEO who is deeply in love with his business, back up the truck. Otherwise, keep on driving and read those three books.

Wall Street loves consistency and certainty about the future prospects of any business, and will usually over-reward for certainty. Just look at the market valuation of Automatic Data Processing (ADP) or its cousin Paychex (PAYX). ADP trades at a lofty trailing P/E of more than 40 while PAYX has a P/E of 49! ADP has a record of meeting or beating Street expectations and consistently rising dividends and earnings for more than 40 years. There are very few businesses that can claim a record of no major blimps in their operations for such a long period of time.

The primary business of both companies is the boring and cumbersome task of outsourced payroll processing. Even with the enormous growth both have enjoyed over the years, they have a very small percentage of the entire market for payroll processing. It is a highly fragmented industry with very high switching costs and big barriers to entry. 
Due to the lofty valuation of companies like ADP, returns to investors who decide to buy the stock in 2002 and hold it for five years will probably be lackluster. More importantly, there is no Ben Graham margin of safety when buying these stocks. Were there to be a single missed quarter, the stock would tank. It would only take one bad quarter to see a 50 plus percent decline in market cap. In the case of ADP, the disrupter may be a Web-based payroll processor with its entire back office in Bangalore, with customers just printing emailed checks at their site. Such an entity could potentially charge 80 percent less than ADP and still be quite profitable.

A missed quarter seems very unlikely for ADP or PAYX, but one can look at any number of companies that at one point looked invincible and subsequently really left a lot of investors hurting. A good example is Tellabs (TLAB) (Note: The author was an employee of Tellabs from ‘86-‘91). Tellabs was a wonderful company with an exceptional founder and CEO, Mike Birck and a terrific management team and corporate culture. The company really started to hit its stride in the early 1990s with the release of its flagship product, the TITAN 5500. The TITAN 5500 was an optical cross-connect that helped voice and data service providers groom and manage their T1, T3 and OC-X pipes. The product was superior to all others on the market and rapidly gained customer acceptance at a number of blue chip companies including MCI, Sprint, the various RBOCs, various cellular, paging and data service providers. Through the 1990s, Tellabs enjoyed rapid sales growth and was one of the top 10 stocks in all performance from 1991-1999. Sales increased tenfold from under $200 million to more than $2 billion and profitability increased more than twenty fold over that period.

An expert looking at the networking space as late as 1999 could only forecast continued good times ahead for Tellabs. Tellabs had a market cap of more than $30 billion in 1999 against revenues of about $2 billion. Today the company has a market cap of $6 billion — with more than $3 billion in cash and hard assets! Investing in Tellabs in 1999 again had no Ben Graham margin of safety and was a highly risky investment. In addition, being a technology business, Tellabs is more prone to getting disrupted. The experts who saw nothing but good times ahead in 1999 would today not be able to assure us that there will even be a Tellabs in 10 years.

The dichotomy is that seemingly low uncertainty businesses are not necessarily low risk for the investor. ADP and Paychex are high-risk investments at today’s prices — just as Tellabs was in 1999.

The flip side is that when the future in uncertain, Wall Street punishes the company and usually the punishment is really rigorous! Stewart Enterprises (STEI), also mentioned as an example in a previous column, is the second largest company in the “death care” industry worldwide. Stewart has about $700 million in annual revenues and owns about 700 cemeteries and funeral homes in nine countries, with the bulk of them in the United States.

As shown in Figure 2, Stewart was trading at about $2 per share for several months during Q3 and Q4 of 2000. Its historical high was about $28 per share (achieved in 1999). At the time, Stewart had a book value of $8.50 per share. It was thus trading at less than one quarter of book value.

At the time, Stewart’s free cash flow was about $0.72 cents per share. The stock was trading at less than three times cash flow! It was also trading at about one quarter of annual revenue. Like ADP, Stewart has a highly predictable revenue stream. We don’t know who will die in Boise, Idaho in 2006, but any number of life insurance actuaries can tell you with a fair degree of accuracy how many will die in Boise in 2006 — or for that matter any year for the next 10 years. Why was Wall Street pricing Stewart at three times cash flow and ADP at more than 40 times cash flow?

The reason was that Stewart is a leveraged company with a lot of debt. About $500 Million of that debt was coming due in 2002 and there was no clear answer in July 2000 as to how the company was going to pay it. Wall Street assumed the company may have to declare bankruptcy when it defaulted on its debt and tanked the stock to under $2 per share (from $28 per share).

When I looked at Stewart, I envisioned three possible scenarios for Stewart over the next 24 months:

Each individual funeral home is a distinct stand-alone business. Stewart was a roll-up that had bought hundreds of family-owned funeral homes. It had kept the same name etc. Most customers did not know that ownership had even changed hands. Thus, to raise cash, Stewart could elect to sell some of their “stores.” Presumably, many of the previous owners might buy them back. The company had typically paid eight or more times cash flow for each home. They should be able to sell these for at least five to eight times cash flow. Thus 50 to 100 homes might be sold to take care of the debt.

Stewart’s lenders or bankers could look at the company’s solid cash flow and predictable business model and extend the loan maturities.

Stewart goes into bankruptcy. In a bankruptcy reorganization like Stewart, the judge would order that some of the stores be sold and cash proceeds be used to repay defaulted debt. In a distress sale, these stores should still go for at least five to seven times cash flow due to competition among buyers. more than 100 stores get sold and the company emerges clean from bankruptcy.

Even under scenario three, the stock was mispriced at $2 per share. Once one of the above scenarios unfolded, I thought that the uncertainty would go away and the stock would go to 10 times cash flow or $7 to $8 per share. The Pabrai Investment Funds bought Stewart at about $2 per share in Q3 and Q4 of 2000 with the intent of exiting at anything more than $4 per share within two years.

In Q4 2000, the company announced its intent to sell some international funeral homes and in Q1 2001 had definitive buyers. The stock was at $4 per share by the end of Q1 2001, for a 100 percent gain in less than nine months. The funds exited their entire position at about $4 per share. Subsequently, Stewart has been trading between $6 and $8 per share.

Stewart had high uncertainty about its future course in Q3 2000. However, there was very low risk in terms of shareholder return or the company’s future. Wall Street could not distinguish between risk and uncertainty and got confused between the two. Savvy investors like Buffett and Graham have been taking advantage of this handicap that Mr. Market possesses for decades with spectacular results. Occasionally, you’ll see a company like Stewart which shows three interesting characteristics — Low Risk, High Uncertainty and High Return Possibilities. The combination of these three attributes at the same time in the same company makes for some very satisfying investing returns. Take advantage of Wall Street’s handicap!

I’ve been a long-time admirer of Infosys and its outstanding management, specifically N. R. Narayana Murthy and Nandan Nilekani. The corporate culture, talent pool, world-class client base and deep management strength are formidable. These are big barriers that allow Infosys to have a near-permanent lock on its current clients and to be very well positioned to get new ones. Hewitt named it the best company to work for in all of India, while the Far East Economic Review rated Infosys the number one company in India.

However, over the last few months, as revenues and earnings have continued to grow at a triple digit rate, the stock has plummeted from $375 to $48. Market capitalization has fallen from about $25 billion to $3.2 billion in the last 18 months — a drop of over 87 percent! Might it be time to start buying Infosys? Can Infosys go any lower than it already has?

Before investors call their brokers to buy Infosys, they should ask themselves: What is Infosys really worth? What annualized rate of return can be expected if the stock were bought today? To answer these questions, one needs to understand how to calculate intrinsic value. The intrinsic value of any business is the sum of free cash flow it will generate from now to eternity, discounted to present value using a reasonable interest rate. (John Burr Williams, Ben Graham, Warren Buffett, et al.) For further insight into intrinsic value please see the article entitled “Intrinsic Value” in the July 2001 issue of siliconindia.

So, it’s fairly simple. If one can project the future cash flow that Infosys will generate, then its intrinsic value can be easily derived. Infosys had revenue and net income of $131 million and $39 million respectively for the quarter ended June 30th. While the company has grown at an annualized rate of more than 65 percent for the last seven years, it projects just 30 percent growth in the coming year.

High-growth companies appear to have growth engines that will continue to propel them unabated for decades to come. However history has taught us that even one-time market-dominating, rapidly-growing companies eventually mature to sedate or even negative growth levels. In the early 1970s, Xerox was a high-growth, high-P/E, high-flying stock that investors loved (one of the “nifty-fifty”). Investors were right in their assessment that photocopying was in its infancy and Xerox dominated copiers with strong patent protection and a big technological lead. Xerox’s stock price in the early 1970s was a historical high for the company. That price was never met or exceeded after 30 years of growth. A buyer of early 1970s Xerox shares would have found that, while document duplication has gone through an unprecedented growth curve in the last 30 years, Xerox has come to the brink of bankruptcy. For more recent examples, one can look at the growth rate projected for Oracle, Cisco and Dell five years ago and compare it to their projected growth rate for the next five years.

If Infosys grew 50 percent annually over the next 10 years, it would have a head count of 400,000 in 2011. That is a larger headcount than IBM, Cisco and Microsoft — combined. Clearly the 50 percent annualized is way off. I’d propose that it might be reasonable (even optimistic) to assume the company grows 30 percent next year (as management has guided) followed by 20-percent growth for the next three years, followed by 15 percent growth for the next three years followed by 10 percent growth in years eight through ten. Further, let’s assume that the company is sold in 2011 for its cash on hand plus 10 times its 2011 earnings.

I don’t think I’d be too far off in speculating that the average siliconindia reader is not interested in making investments in companies like Infosys to earn a five or ten percent annualized rate of return. Presumably, the reader is looking for 15-20 percent annually (or more). We now have all the data necessary to figure out if shares of Infosys ought to be bought at $48. Table 1 shows the present value of all the future cash flow Infosys will generate under the aforementioned assumptions.

Infosys has 66.1 million shares outstanding at present. The company has an excellent stock option program for its employees. Assuming a 3 percent annual dilution in shares outstanding leads to 88.8 million shares outstanding in 2011. This yields a price of $38 per share. In other words, if all of our assumptions came true, an investor buying Infosys today at $38 per share can expect a 20 percent annualized rate of return over the next 10 years.

Ben Graham suggested a substantial margin of safety when investing in any common stock. We don’t know what the future holds. To get downside protection, Infosys should be bought at a minimum 50 percent discount (margin of safety) to intrinsic value or $19 per share. If one desired a 15 percent annualized rate of return, then one could buy Infosys for up to $29 per share with a 50 percent margin of safety. Conversely, if one were (like me) looking for a 30 percent annualized rate of return with a 50 percent margin of safety, Infosys should be bought at no more than $10 per share — a fifth of its present price. Buying the stock at $48 with a 50 percent margin of safety would yield the investor an annualized return of just 3.9 percent.

Intrinsic value is a simple concept, but very difficult to precisely calculate for most companies. The best that one can do is to make conservative assumptions and then add a significant margin of safety. The message of this article is not to suggest the price at which Infosys should be bought or sold, but rather to give the reader a simple toolset to evaluate whether to invest in any given publicly-traded company. To start, investors must have a good idea of the rate of return they’d like from a given stock. They should know the company well enough to assess its future prospects. In growing companies, one needs to remember that no tree grows to the sky. Be conservative on future growth prospects. Finally, add a substantial margin of safety.

But, one might argue, what about the value of all the intangibles of great management, brand, client base, etc.? What about the value of the terrific talent Murthy and his team bring to the table? The answer is simple. All the intangibles are very relevant, but they are the reason the company will do so well in the future. I would not be optimistic that a second- or third-tier IT services firm in India will even be around 10 years from now. American Express, Boeing and IBM all have exceptional brands and intangibles. These intangibles are very relevant to shareholders and they do lead to sustainable competitive advantages that finally trickle down to cash flow that the company generates. All of Infosys’ intangibles are fully appreciated and have been implicitly factored into its future cash flow projections. If a competitive advantage does not eventually translate into cash flow then it is not a competitive advantage that’s relevant to investors.

It might be an interesting exercise for the reader to calculate the intrinsic value and future return expectations of all the stocks in their portfolios. The results will probably be surprising. Investors would be well served to look for great businesses within their circle of competence and then calculate intrinsic values for those businesses based on their annualized return expectations. The data would call to take a pass on most companies. Occasionally, however, Mr. Market will throw out a fat pitch. You know what to do then.

After closing in the aftermath of the Sept. 11 tragedy, stocks plummeted the following week — with the Dow over 14 percent! As one would expect of a rational market, companies like American Airlines, Smith & Wollensky Restaurants, and The Four Seasons Hotels all took major hits to their pre-Sept. 11 market caps. However another important event took place. Federal Reserve Board Chairman Alan Greenspan reduced interest rates by another 0.5 percent, bringing the prime rate to a seven-year low.

As amazing as it sounds, there is a set of businesses for which both the WTC tragedy and Greenspan’s rate cut are positive events. Under the rational/efficient market hypothesis, these stocks should have gone up when the market reopened on the 17th, because it is pretty clear that their future profitability just got better. Is that what happened?

Let’s examine a few of these publicly-traded companies. Stewart Enterprises (STEI) is the second largest company in the “deathcare” industry worldwide. Stewart has about $700 million in annual revenues and owns about 700 cemeteries and funeral homes in nine countries, with the bulk of them in the United States. With $325 million in debt tied to the prime lending rate, Greenspan’s action will increase Stewart’s earnings by about two cents annually.

As a result of the events of Sept. 11, their revenue or operating profit are not expected to decline at all (they may have increased). Thus, net-net STEI should have had a price increase of at least $0.20 over its Sept. 10 close. Stewart closed at $7.15 on Sept. 10 and at $5.85 on Sept. 24. In percentage terms, the Dow was down 14 percent during the week, while Stewart was down more than 18 percent! Nearly every single Dow stock is going to report significantly lower earnings as a result, while Stewart will be reporting higher earnings, yet it lost nearly a fifth of its market cap. How much sense does this make?

Let’s move from the morbid subject of death to the relatively more uplifting subject of medical diagnostic services. Radiologix (RGX) is a company that develops and manages radiology and medical imaging centers. RGX operates 124 centers in 18 states. The company has about $250 million in annual revenue and a market cap of $121 million ($6.20 a share) as of Sept. 10. In addition the company has $160 million of debt that is tied to the Fed discount rate and LIBOR. The 0.5 percent drop in interest rates had the impact of increasing EPS by about $0.05 annually and should have led to a $0.30-0.60 increase in the share price. On Sept. 24, after a steady decline throughout the week, RGX ended at $5.25 — a decline of more than 15 percent!

I cannot find a correlation between the events of Sept. 11 and the intrinsic value of RGX. Why did RGX lose 15 percent of its market value in the week following Sept. 11, when it should have increased five to 10 percent?

From death and MRIs, let’s move to the more colorful world of retail. Liquidation World is an impressive operation based in Calgary, Alberta, Canada. From its start in 1987 through 2000, sales have grown from less than C$1 million to C$165 million, with no decline in sales in any single year. Since 1992, net profit has grown every single year and they have about 90 stores (up from one in 1987). The company specializes in buying merchandise from other retailers and e-tailers that have obsolete or excess inventory, bankruptcy or distressed situations, receiverships, closeouts, etc. They go in and buy great stuff at pennies on the dollar and then put it in their outlets and do what Sam Walton preached: Stack it High and Let it Fly! You get the picture.

When Silicon Valley was reeling from its dot-com bust and all the e-tailers were going under, Liquidation World had many teams working overtime in California and all over the U.S. getting the best stuff from these e-tailers at super-distressed prices. All of those VC losses were their gain!

On Sept. 10, LIQWF was changing hands at around $6 a share. In the wake of the tragedy, it dropped to $5.30 — a 12 percent decline. LIQWF’s prospects for picking up excess inventory, etc., only improved after the tragedy as several retailers are driven to the brink of bankruptcy with declining sales and consumer confidence. In addition, most of its outlets are in Canada. Canadians feel significantly less threatened and traumatized than the general U.S. population by the events of Sept. 11. So, the best that I can tell, Liquidation’s prospects and profitability only improved. Why did it lose 12 percent of its already modest value?

The public equities markets are mostly efficient, but not fully efficient. Events like Sept. 11 tend to widen the efficiency gap – as shown by our three examples. In times like these, Mr. Market gets severely depressed and can only think about doom, gloom and uncertainty.

Investors who use times likes these to make investments in a few great businesses and make these investments meaningful portions of their portfolio for the long haul can take advantage of these inefficiencies. With his occasional mood swings, Mr. Market offers a wide array of great businesses on “clearance sale” for a few weeks every few years. This is a good time to take advantage of Mr. Market.

Last year, former Harvard professor Amar Bhide wrote “The Origin and Evolution of New Businesses,” a book based on hundreds of interviews with Inc. 500 CEOs about the elusive beast known as entrepreneurship. His conclusions are counter-intuitive and should be required reading for would-be entrepreneurs and investors looking at everything from startups to public equity markets.

Bhide’s research showed that virtually all startups fall into two categories: marginal startups (e.g., hair salons, lawn care, etc.) and promising startups (e.g., Microsoft, HP, etc.). Marginal startups have low uncertainty, low investment requirements and low likely profit. Promising startups have high uncertainty, low investment requirements and low likely profit. However, both types have two things in common: they are low risk and arbitrage oriented. This is contrary to the myth that entrepreneurs are risk takers. When Gates dropped out of Harvard and started Microsoft, his opportunity cost was very low. He was not worth much in the job market. But, had Microsoft failed, he could have simply returned to Harvard to finish his degree. He faced uncertainty and ambiguity, but not risk (see figure 1).

Risk Reward Equation

Consider the example of a skilled hairdresser who notices that there are no salons within a 24-mile radius of her town. She scrounges up her savings and opens a little salon with very basic infrastructure. Her risk of failure is quite low because people need to get their hair cut and they are driving at least 24 miles.

Because of the compelling proposition, she soon gets a steady and growing clientele. She has virtually no risk because, if the venture fails, she simply goes back to working at another salon. The upside is better than working at another salon, but it’s unlikely that she’ll end up on the Forbes 400 as a result. Essentially, she’s engaged in arbitrage. The arbitrage “spread” is the 24 miles between her and the next salon. As she gets busy, another venturesome hairdresser leaves her job and opens a salon 12 miles away. Then another opens three miles away, and so on. Eventually, the market becomes efficient and net changes in salon chairs match population changes.

When Gates and Allen launched Microsoft in 1975, their only product was an 8080 BASIC compiler that ran only on an Altair computer. At the time, they were the only ones serving this small niche. Similarly, HP started with an audio oscillator for which there was very limited demand. Both companies essentially were acting as arbitrageurs in their respective markets. They were collecting the “spread” until other entrants show up. Neither had a grand plan to get them to where they are today. They simply were trying to be resourceful and survive.

Arbitrage by definition is low risk and typically a return slightly higher than the risk. If gold is quoted in London at $275/ounce and $280/ounce in Frankfurt, arbitrage players quickly jump in buying in London and selling in Frankfurt till the spread eventually equals transaction costs.

But an astute investor — whether looking to invest in Microsoft in 1975 or in our salon when it still enjoys the 24-mile advantage — is not usually looking for an arbitrage spread. Buffett succinctly says: “The key to investing is … determining the competitive advantage of any given company and the durability of that advantage.” Our salon has a wonderful competitive advantage when it starts, but that advantage is not durable. Hence it would make a poor investment. Similarly, the barriers to entry for others to create a BASIC compiler for the Altair were essentially nonexistent (see figure 2).

The good news for entrepreneurs and investors is that the arbitrage spread can occasionally last for years. Given enough time, some durable barriers to entry may be created such as brand, scale or a loyal customer base. Nonetheless, Bhide’s research clearly shows that the business model of the overwhelming number of startups is straight arbitrage. Any sustainable competitive advantage is nonexistent at the time of startup.

Both Microsoft and HP would have failed Buffett’s durable competitive advantage test in their early days. To scale, both jumped from one niche to the next without much planning or analysis. Any one wrong jump would have done them in.

Who Fails?

Most companies, however, are unable to keep successfully jumping from one arbitrage opportunity to the next and thus wither away. The ones that choose not to jump (like our salon) remain small. U. S. government data indicates that 60 percent of the million annual startups fail in the first six years. More importantly, the overwhelming number of survivors remain small.

Durable competitive advantage is usually the result of unpredictable and rare random events, like IBM’s call to Microsoft to sell them a PC operating system when Microsoft had never built an operating system before and did not have one to sell. These events have no pattern and cannot be forecast when a startup is being formed. They happen to a very small minority. Once a startup has acquired a durable competitive advantage, and investors get an opportunity to buy in well below intrinsic value, backup the truck.

Because entrepreneurs are arbitrageurs, they constantly watch companies with durable advantages. They then try to find a way to carve off a piece of that advantage for themselves. Durable competitive advantage is an anomaly and quite rare. When the Coca Cola Company started it had a unique product that delivered high value to its customers. The drink was wildly popular.Concocting Coca Cola was not rocket science and soon enough numerous other “colas” emerged. These new arbitrage players offered lower prices or entered markets that Coke had not yet entered. In time, hundreds of “cola companies” with names similar to Coca Cola had popped up. Most folks would ask for Coca Cola and vendors would freely serve any other brand they were selling. Coke was in a fix until its brilliant lawyers sued all the competitors and their vendors — driving them out of business. Pepsi, based in Canada, escaped and today is Coca Cola’s primary competitor.

Thus, the Coca Colas and the Microsofts of the world are under constant attack by thousands of entrepreneurs trying to make inroads.

In another fascinating book, “The Living Company,” Arie de Geus noted that the average life of a Fortune 500 company is less than 50 years from birth to death. The Fortune 500 represents the businesses that are able to take advantage of some aberration and build durable competitive advantage.

Investing in most startups is akin to gambling. The odds do not favor the investor. Hence it is necessary invest in them at substantial discounts to intrinsic value with a Ben Graham “margin of safety” to realize a good return within the first few years.

Conventional investing wisdom says that one needs to concentrate investments when amassing wealth and diversify when preserving wealth. Most successful entrepreneurs at some point have 90+ percent of their wealth tied up in a single company. They are in wealth amassing mode and represent the extreme of asset concentration. Ironically, most entrepreneurs are quite comfortable with their non-diversified assets.

Young people with several decades until retirement mainly want to amass wealth, not preserve it. But how do you do that if you are not an entrepreneur? Charlie Munger points out that the first step to wealth is to spend less than you earn from the outset. As you generate savings, the most logical choices are to invest either in individual stocks or mutual funds or both.

Mutual funds has been one of the most rapidly growing industries for the last two decades. The number of funds has mushroomed to more than 8,000; assets under management have grown consistently to several trillion dollars over the years. This, despite the fact that six out of every seven funds lag the performance of the S&P 500 index over time. The industry is one of the only ones I know of where even if you perform poorly, you still continue to grow revenues and profit!

If the objective is to amass wealth, then mutual funds are not the answer. Regulations do not permit funds to invest more than five percent of assets in a single stock. Thus, at a minimum, any fund has at least 20 stocks. In practice, virtually all mutual funds have hundreds of stocks with no single one being more than two to three percent of the portfolio. Any portfolio with hundreds of securities has a very high probability of under-performing the market and an infinitesimal probability of outperforming it. I find it difficult to find more than four to six winners in a year. I don’t know how a fund manager can find 200 winners. There is very good logic behind the 5 percent rule: it protects investors from big losses. The side effect is that it pretty much guarantees mediocrity.

The best way to sum up mutual fund investing is the following quote from Warren Buffett, taken from the 1996 Annual Report of Berkshire Hathaway:

“…The best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results delivered by the great majority of investment professionals.”

Since index funds are the way to go to preserve wealth, should one invest in a few stocks directly to build wealth? When Warren Buffett ran his Buffett Partnerships he rarely made an investment in his portfolio with less than five or 10 percent of assets. Once in the 1960s he invested 40 percent of the Buffett Partnership funds’ assets in a single stock: American Express. Buffett’s partner Charlie Munger has an even more extreme perspective. He feels that three to four stocks are all that are needed to have a stellar portfolio. It reminds me of a former CEO of Coca Cola, Woodrow Wilson. He was once asked by an analyst if it was a good time to sell Coca Cola stock. Wilson responded, “I don’t know. I’ve never sold any.” Till today, the Wilson Foundation has never diversified. Over 90 percent of its assets are in Coca Cola stock. Needless to say, its returns have trounced the overall market. Charlie strongly endorses the Wilson Foundation’s perspective on non-diversification. The Buffett Foundation will inherit more than 99 percent of Buffett’s estate and it too will be 98+ percent concentrated in a single holding: Berkshire Hathaway.

So should investors build their own portfolios? I can’t resist another Buffett quote from the same annual report on the subject that sums it up succinctly:

“Should you choose … to construct your own portfolio, there are a few thoughts worth remembering. Intelligent investing is not complex, though that is far from saying that it’s easy. What an investor needs is the ability to correctly evaluate selected businesses. You don’t have to be an expert on every company or even many. You only have to be able to evaluate companies within your circle of competence. The size of the circle is not important; knowing its boundaries, however, is vital.”

The key point in Buffett’s quote is that while intelligent investing is simple, it’s far from easy. Over the last five years, 90+ percent of funds have lagged the S&P 500. The Odean and Barber study (done at the University of California at Davis) covering 78,000 individual investors showed that, on average, individual investors also lagged the market. My own experience with individual investors concurs with the results of the study. Most individuals would do better with index funds.

Investors who take the time to study and then only invest in a few outstanding businesses that they think are available well below their intrinsic value (see siliconindia article on intrinsic value in the July 2001 issue) and then hold those great businesses for a long time will come out ahead on their journey to wealth. However, there are only a few of us who have the discipline, analytics and patience to follow this approach.

To sum up, most managed mutual funds will lag the market. Index funds are a good way to preserve your wealth but not make you rich. And individual stock picking is a loser’s game for most investors. To make matters worse, Buffett predicts that the U.S. stock market will only deliver a four to six percent annualized rate of return over the next 10-15 years. I agree with Buffett’s thesis. So the next decade will be a disappointing one for most investors.

To close on a somewhat positive note, I’d like to add that a few professional investors have consistently beaten the market following Buffett style of focused value investing closely. I’d recommend that the reader stick to index funds or investigate investing with managers like Marty Whitman (Third Avenue Value Fund), Bill Ruane (Sequoia Fund), Mason Hawkins & Stanley Cates (Longleaf Partners), Bill Nygren (Oakmark Fund) and Seth Klarman (Baupost Fund). They have all delivered results that have been vastly superior to the indices and have a focused investment style with limited securities in the portfolio.

Isolating Incentives: Where Are The Carrots Aligned?

Incentives: There is much to be said about incentives and how they influence our individual and collective actions, for better or for worse. It was incentives that unfortunately helped cause the last recession, extravagantly compensating Moody’s credit analysts by quantity (piecework) of rated ABS, MBS and CDSs. Quality of work deteriorated and everything was quickly rated AAA even though it shouldn’t have. Without the credit rating agencies’ blessing, banks would not be able to sell the securities and pension funds unable to buy, suppressing a large portion of both demand and supply.

Real Estate Commission Example

A great example examining the influences of incentives is real estate agents. (There is provided below a quick three-minute video from “Freakonomics.”) Essentially, the real estate agents are influenced by quantity or “closing time” as opposed to looking out for the house seller or buyer, achieving the highest or lowest closing price regardless of closing time.

We can also all think about the typical example of the stock broker who has an incentive to turn our portfolio for commission, inducing us to trade/gamble our hard-earned savings. Fund managers have an incentive to hug the index to keep their job, continually collecting fees from AUM. Established (wealthy, schloarly or political) people are more risk averse, as they have a position to protect and plenty of options. People in poverty or that are not established have fewer options and thus are induced to be risk seeking. The list is endless.

A great quote by Steven Levitt from “Freakonomics” holds true now more then ever while the global bankers (BOJ, BOC, PBOC, FED, ECB, BOE) are holding the golden carrot, artificially creating demand for the lower end of the yield curve, systematically suppressing interest rates. This pushes investors all over the world to reach further up the risk curve for an equivalent return they may have earned otherwise. Historical risk adjusted returns (theoretically) suffer.

“An incentive is a bullet, a key: an often tiny object with astonishing power to change a situation.” – Steven Levitt

Warren Buffett (TradesPortfolio) and Charlie Munger have been advocates of understanding incentives, the biases they cause and have talked numerous times about incentives over the years. Thinking about the incentives involved in a typical situation is a form of inverting the situation, examining it from the other parties’ point of view. Usually, identifying incentives is a great way to avoid a toxic situation or to partake in an enriching one.

So Why, As an Investor Could This Be Beneficial?

Well think about management’s ownership and how this may benefit you. We have all heard the phrase “aligned incentives” but what does it mean? It means that the parties involved are striving towards a similar incentive or goal with reciprocity as the targeted outcome. These are the situations (as investors and business owners) we want to be involved in.

But take the incentives of a management team facing fraud allegations (think Enron’s Jeff Skilling), willing to fight until the bitter end. Not only is their job at stake, but personnel criminal charges are also a possibility.

Identifying where incentives are aligned can be difficult, but if or when a plausible scenario is identified where incentives are aligned in a positive manner, it is best to ride the wave, so to speak.

One personal example of my own that comes to mind is JPMorgan (JPM).

Jamie Dimon bought roughly $20 million worth of JPMorgan shares in the summer of 2012 after the London Whale loss. This instantly caught my attention because I knew it was a large loss (cut the stock 25%) and Dimon already owned a large portion of stock. With the $20 million purchase he was putting his money where his mouth was when he told the Street it was a one-off situation. From what I can recall from my research, he had a net worth of $200 million at the time, most in JPM common shares. The new purchase represented a 10% net worth bet on a horse that he would be jockeying.

The point is, I purchased 200 shares the next morning at $33 (it went to $30 or $31) doing absolutely no research other than on Jamie Dimon’s compensation and incentives, reading the 2011 annual report, and seeing JPMorgan was valued under B/V after a quick balance sheet examination. I sold the shares shortly after in the fall of 2012 for just shy of $40 or a 20% return in three months. The moral of the story: Ride the bigger fishes’ currents, it is a lot less work.

Stock options that are awarded can also be influential incentives behind the company’s performance (or GAAP-reported performance). Stock option induced incentives can create short-term thinking and a desire to achieve analysts’ estimates, sacrificing long-termshareholder value because the ones with the options have no skin in the game, hence one of the reasons Warren Buffett is not fond of (and does not issue) options but pays bonuses in cash on a pay-for-performance basis.

Executive Compensation 

The following is an excerpt from Buffett (TradesPortfolio) regarding executive compensation and identifying executive incentive structure, i.e. compensation.

Too often, executive compensation in the U.S. is ridiculously out of line with performance. That won’t change, moreover, because the deck is stacked against investors when it comes to the CEO’s pay. The upshot is that a mediocre-or-worse CEO – aided by his handpicked VP of human relations and a consultant from the ever-accommodating firm of Ratchet, Ratchet and Bingo – all too often receives gobs of money from an ill-designed compensation arrangement.

Take, for instance, ten year, fixed-price options (and who wouldn’t?). If Fred Futile, CEO of Stagnant, Inc., receives a bundle of these – let’s say enough to give him an option on 1% of the company – his self-interest is clear: He should skip dividends entirely and instead use all of the company’s earnings to repurchase stock.

Let’s assume that under Fred’s leadership Stagnant lives up to its name. In each of the ten years after the option grant, it earns $1 billion on $10 billion of net worth, which initially comes to $10 per share on the 100 million shares then outstanding. Fred eschews dividends and regularly uses all earnings to repurchase shares. If the stock constantly sells at ten times earnings per share, it will have appreciated 158% by the end of the option period. That’s because repurchases would reduce the number of shares to 38.7 million by that time, and earnings per share would thereby increase to $25.80. Simply by withholding earnings from owners, Fred gets very rich, making a cool $158 million, despite the business itself improving not at all. Astonishingly, Fred could have made more than $100 million if Stagnant’s earnings had declined by 20% during the ten-year period.

Fred can also get a splendid result for himself by paying no dividends and deploying the earnings he withholds from shareholders into a variety of disappointing projects and acquisitions. Even if these initiatives deliver a paltry 5% return, Fred will still make a bundle. Specifically – with Stagnant’s p/e ratio remaining unchanged at ten – Fred’s option will deliver him $63 million. Meanwhile, his shareholders will wonder what happened to the “alignment of interests” that was supposed to occur when Fred was issued options.

A “normal” dividend policy, of course – one-third of earnings paid out, for example – produces less extreme results but still can provide lush rewards for managers who achieve nothing.

CEOs understand this math and know that every dime paid out in dividends reduces the value of all outstanding options. I’ve never, however, seen this manager-owner conflict referenced in proxy materials that request approval of a fixed-priced option plan. Though CEOs invariably preach internally that capital comes at a cost, they somehow forget to tell shareholders that fixed-price options give them capital that is free.

It doesn’t have to be this way: It’s child’s play for a board to design options that give effect to the automatic build-up in value that occurs when earnings are retained. But – surprise, surprise – options of that kind are almost never issued. Indeed, the very thought of options with strike prices that are adjusted for retained earnings seems foreign to compensation “experts,” who are nevertheless encyclopedic about every management-friendly plan that exists. (“Whose bread I eat, his song I sing.”)

Getting fired can produce a particularly bountiful payday for a CEO. Indeed, he can “earn” more in that single day, while cleaning out his desk, than an American worker earns in a lifetime of cleaning toilets. Forget the old maxim about nothing succeeding like success: Today, in the executive suite, the all- too-prevalent rule is that nothing succeeds like failure.

Huge severance payments, lavish perks and outsized payments for ho-hum performance often occur because comp committees have become slaves to comparative data. The drill is simple: Three or so directors – not chosen by chance – are bombarded for a few hours before a board meeting with pay statistics that perpetually ratchet upwards. Additionally, the committee is told about new perks that other managers are receiving. In this manner, outlandish “goodies” are showered upon CEOs simply because of a corporate version of the argument we all used when children: “But, Mom, all the other kids have one.” When comp committees follow this “logic,” yesterday’s most egregious excess becomes today’s baseline.

Comp committees should adopt the attitude of Hank Greenberg, the Detroit slugger and a boyhood hero of mine. Hank’s son, Steve, at one time was a player’s agent. Representing an outfielder in negotiations with a major league club, Steve sounded out his dad about the size of the signing bonus he should ask for. Hank, a true pay-for-performance guy, got straight to the point, “What did he hit last year?” When Steve answered “.246,” Hank’s comeback was immediate: “Ask for a uniform.”

(Let me pause for a brief confession: In criticizing comp committee behavior, I don’t speak as a true insider. Though I have served as a director of twenty public companies, only one CEO has put me on his comp committee. Hmmmm . . .) 

Avoid Excessive Top-Heavy Compensation Structures 

As we can see, identifying outright ownership is an important variable to isolate as it directly aligns with our position, direct ownership through common shares. Stock options, hidden conflicts of interest (consulting fees, kicked to self owned subs or friends), salaries, bonuses and other “perks” can be examined with a search on the Internet and proxy statements (specifically DEF 14A).

If we find incentives are not aligned and compensation is abused at the expense of shareholders, it is time to flip the next rock and move on. If we find incentives are aligned it is time to dig deeper or buy a stake in the business. For the rest of 2014 and beyond let us all practice identifying incentives and inverting situations we face whether investing related or personal, proverbially standing in the shoes of others.

“I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. Never a year passes that I don’t get some surprise that pushes my limit a little farther.” – Charlie Munger