The Importance Of Capital Intensity And Thoughts From Einhorn

It seems as though there has been a recent debate on going within the value investing community pertaining to ROE, ROIC and net-nets. At one hand of the spectrum we have the argument that value investors are throwing in the towel and buying anything with a high ROE while using 20+ years discounted cash flows to support their thesis. The central argument is, there is no margin of safety if one pays more than NCAV or liquidation value. At the other end of the spectrum we hear that the most profitable way to invest over the long-term is continually buying and selling assets trading below NCAV, P/B or low P/E. I do agree that assets available below NCAV, low P/B or low P/E can be profitable but we must ask ourselves why is Mr. Market willing to offer us a business at a price that values the business higher dead than alive?

According to Buffett “the risk in buying poor businesses is that much of the bargain element of the initial purchase discount may well be dissipated by the time a catalyst comes along to unlock what appeared to be the initial excess value.”

This is because 1) the market has discounted the asset for a reason, likely because the expectation is for the business to continue to destroy value as it is capital intensive in a declining industry where business metrics are deteriorating 2) The economic value the business earns is not enough to cover the cost of the capital used to generate it and 3) The company has poor corporate governance, questionable management practices and bad capital allocation.

Take a textile manufacturer as an example. This is a very simplistic example ignoring depreciation tax saving among other things. The company is currently earning $1,000 while revenues are declining (or stagnant) at $10,000 and the NCAV is $10,000.

Cash: $8000

Accounts Receivable: $5000

Inventory: $2000

Long-Term Debt: $4000

Accounts Payable: $1000

The company is selling for $7,000 or a 30% discount from NCAV and a P/E of 7. Sounds like a good deal right? Not so fast.

We need to examine the capital needs of the business. What if the company requires $1,500 a year to remain competitive in terms of maintenance capital expenditures? Simply stated, the company needs new machines and equipment to remain productive and keep costs low or face losing market share to competitors who do. Now the company has negative $500 free cash flow a year and you get your equity in the form of machinery. Keeping all variables constant in 5 years the company will have NCAV of $7,500, cash will be $5500, sales will be $10,000 (or less) and income will be $1000 (or less).

Assuming the market revalued the company along the way (@ a 30% discount to NCAV), it will now be worth $5250. The company would experience cash burn and have to make the difference through a secondary offering, debt or both in the long-term. Is this adequate margin of safety?

So what is the point? Context matters and it is imprudent to invest blindly in anything.   

ROE and ROIC arguably don’t matter nearly as much if the company is not capital intensive. The most important variables are how long the competitive advantage will continue and the rate of growth on unit volumes. Here is what Einhorn had
to say about the matter.

“I believe that it is irrelevant to worry about ROE or marginal return on capital in non-capital intensive businesses. If Coke or Pfizer had twice as many manufacturing plants, the incremental sales would be minimal. If Greenlight Capital – and here I mean the management company that receives the fees, and not the funds themselves – had twice as many computers and conference room tables we wouldn’t earn twice the fees…in fact, they probably wouldn’t increase at all. When the capital doesn’t add to the returns, then ROE doesn’t matter. It follows from this that in non-capital intensive businesses the price-to-book value ratio is irrelevant. The equity of the company in the form of intellectual property, human capital or brand equity is not reflected on the balance sheet. All that matters is how long, sustainable or even improvable the company’s competitive advantage is, whether it is intellectual property, human resources or market position.”

The place to find value in non-capital intensive companies is the earnings power. Think of Microsoft or another software company. The marginal cost associated with growing revenues are minimal, as the core infrastructure (the software) only requires small adjustments and tweaks overtime and costs pennies to duplicate. Each additional customer added or sold to actually costs less overall. Think if you could develop software for $100,000 total and sell each copy for $101 at a cost of $1. Once you achieve the break-even point of 1,000 customers, each additional customer sold to will only cost $1 or a hypothetical 10,000% ROE.

There are two main risks for non-capital intensive businesses, reinvestment risk and risk the competitive advantage will be lost. Do they return cash to shareholders? Do they attempt to diversify their revenue stream? More often than not the capital is squandered by investing in capital-intensive businesses after generating more cash than they know to do with. The blessing becomes the burden.

Let us circle back to Einhorn.

I believe it is very important to analyze ROE and marginal returns on capital…but only in capital intensive businesses. It may surprise you, but I prefer at the right price capital intensive businesses with low ROEs, where I think the ROE will improve, to high-, or at least medium-ROE businesses.

The problem with high ROEs in capital intensive businesses is that it is hard to sustain the ROEs. Here, high returns attract competition both from new entrants that come with new capital and existing competitors that try to see what the better performing competitor is doing to copy it. The new capital and the copycats often succeed in driving down the superior ROEs. Really bad things happen to earnings when a 25% ROE turns into a 10% ROE.

This is why I prefer the low ROEs. Great things happen to earnings when a 10% ROE becomes a 15% ROE.”

ROE can improve three ways: 1) better asset turns, 2) better margins and 3) by adding leverage. This analysis can be performed further in depth with the Dupont method. Now is there really no margin of safety in earnings power? If you and I were to agree to a deal where you lend me money ($X) for 10-years in return for $100, how much would you lend me?

I assume it wouldn’t be $100 or even $90. It would of course depend on the opportunity cost of your $100 during the next 10-years… but is everyone’s opportunity cost the same?

If I were in your situation I wouldn’t take less than $25 representing a 15% discount rate. If you were now to offer me $80 upfront for $100 in 10-years, I would take it and think of this as a margin of safety. Here is why. First the $80 represents a 2.25% discount rate or an ability to borrow at 1% less than the current prime rate. I would then invest the money during the next 10-years and collect the difference depending on the IRR.

Discount Rate Capitalization Factor Cash Flow Net Return Break Even Borrowing
6% 1.79 $143.27 $43.27 $55.84
7% 1.97 $157.37 $57.37 $50.83
8% 2.16 $172.71 $72.71 $46.32
9% 2.37 $189.39 $89.39 $42.24
10% 2.59 $207.50 $107.50 $38.55
11% 2.84 $227.15 $127.15 $35.22
12% 3.11 $248.47 $148.47 $32.20
13% 3.39 $271.57 $171.57 $29.46
14% 3.71 $296.58 $196.58 $26.97
15% 4.05 $323.64 $223.64 $24.72

Depending on my discount rate, for every $0.01 above the breakeven borrowing rate you offer me, I will be adding to my edge or margin of safety. Because the future is uncertain, and hard to predict we demand a higher margin of safety from intrinsic value and likely blend a range of values. I would rather be approximately right instead of precisely wrong.

“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”

This brings us to the Triple play. What is a triple play? Most baseball fans will understand the sports reference but how does it relate to investing?

There are three ways to earn an investment return.

1) Revenue growth

2) Margin or inventory turn expansion leading to higher net income

3) Multiple expansion

I like to invest in companies that I think are capable of all three to maximize my overall expected return. The point of the post is there is many different ways to build wealth each with its own risks. It is up to the individual investor’s style and personality to determine which strategy (or combination of strategies) he or she pursues.

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Munger Problem: Achieve Higher Physical Volume By Increasing The Price?

Achieve Higher Physical Volume By Increasing The Price?

Question:

Now tell me several instances when, if you want the physical volume to go up, the correct answer is to raise the price?

“You have studied supply and demand curves. You have learned that when you raise the price, ordinarily the volume you can sell goes down, and when you reduce the price, the volume you can sell goes up. Is that right? That’s what you’ve learned?” They all nod yes. And I say, “Now tell me several instances when, if you want the physical volume to go up, the correct answer is to increase the price?” And there’s this long and ghastly pause. And finally, in each of the two business schools in which I’ve tried this, maybe one person in fifty could name one instance. And nobody has yet to come up with the main answer that I like.”

Answer: There are four categories of answers to this problem. A few people get the first category but rarely any of the others.

  1. Luxury goods: Raising the price can improve the products ability as a “show-off “item, i.e., by raising the price the utility of the goods is improved to someone engaging in conspicuous consumption. Further, people will frequently assume that the high price equates to a better product, and this can sometimes lead to increased sales.
  2. Non-luxury goods: same as factor cited above, i.e., the higher the price conveys information assumed to be correct by the consumer, that the higher prices connotes higher value. This can especially apply to industrial goods where high reliability is an important factor.
  3. Raise the price and use the extra revenue in legal ways to make the product work better or to make the sales system work better.
  4. Raise the price and use the extra revenue in illegal or unethical ways to drive sales by the functional equivalent of bribing purchasing agents or in other ways detrimental to the end consumer, i.e., mutual fund commission practices. [This is the answer Charlie likes most, but never gets]

I found the following problem to be fascinating. From my personal thoughts I was able to come up with the answer luxury goods (I have background experience at Luxottica Retail) as well as an answer that was not provided, although it does relate to number 4. The tactic I thought of (among others) is using stimuli that are addictive, nicotine, etc. to create operant conditioning while slowly raising the price as the social proof factor materializes. If the price is relatively inelastic (determined by observing behavior), the additional funds can be used to market/sell additional product, boosting revenue and creating a lollapalooza effect of marketing, price raises, social proofing, operant conditioning, critical mass, etc. The example is also relatable to pharmaceuticals.

This happened in the case of my friend Bill Ballhaus. When he was head of Beckman Instruments it produced some complicated product where if it failed it caused enormous damage to the purchaser. It wasn’t a pump at the bottom of an oil well, but that’s a good mental example. And he realized that the reason this thing was selling so poorly, even though it was better than anybody else’s product, was because it was priced lower. It made people think it was a low quality gizmo. So he raised the price by 20% or so and the volume went way up.

But only one in fifty (2%) can come up with this sole instance in a modern business school – one of the business schools being Stanford, which is hard to get into. And nobody has yet come up with the main answer that I like. Suppose you raise that price, and use the extra money to bribe the other guy’s purchasing agent? (Laughter). Is that going to work? And are there functional equivalents in economics – microeconomics – of raising the price and using the extra sales proceeds to drive sales higher? And of course there are zillion, once you’ve made that mental jump. It’s so simple.

Now let us quickly reexamine the problem with the benefit of hindsight bias and frame the questions in such a manner a physicist or algebraist would.

Invert. Always Invert. – Carl Jacobi

 

When can we lower the price and lose sales volume? How?

  • Products associated with reliability or quality, deterioration of social proof and operant conditioning overtime to competitors.

When can’t we raise the price and increase sales volume?

  • Obviously not everyone would be able to exploit such a pricing process or else the government would step in with price controls. The answer is likely to come from non-regulated or minimal regulated industries.

Of course none of these answers are definite and at best are messy and uncertain.

Why did Max Planck, one of the smartest people who ever lived, give up economics?

“It was too hard. The best solution you can get is messy and uncertain at best.”

A Diamond In The Rough: Warren Buffett Talks Jewellery

Warren Buffett (TradesPortfolio) detailed in a written letter what you should know about the business economics of the jewelry industry in general and specifically Borsheim’s. The letter was written shortly after the acquisition was made in 1989. Emphasis is my own with additional comments added throughout original excerpts. 

First WB explains very simply the economics of the existing jewelry industry.

1) high overhead

2) average margins

3) high fixed costs.

The high overhead is based on low inventory turns, a small majority (25-30%) likely coming from inventory holding costs, insurance and shrink. Another direct result of low inventory turns is the amount of capital that is “tied-up” in working capital, essentially diluting returns on capital as it sits idle in inventory.

 To begin with, all jewelers turn their inventory very slowly, and that ties up a lot of capital. A once-a-year turn is par for the course. The reason is simple: People buy jewelry infrequently, and when they do, they are making both a major and very individual purchase. Therefore, they want to view a wide selection of pieces before zeroing in on a single item.



Given that their turnover is low, a jeweler must obtain a relatively wide profit margin on sales in order to achieve even a mediocre return on their investment. In this respect, the jewelry business is just the opposite of the grocery business, in which rapid turnover of inventory allows good returns on investment though profit margins are low.



In order to establish a selling price for their merchandise, a jeweler must add to the price they pay for that merchandise, both their operating costs and desired profit margin. Operating costs seldom run less than 40% of sales and often exceed that level. This fact requires most jewelers to price their merchandise at double its cost to them or even more.



The math is simple: Jewelers charge $1 for merchandise that has cost them 50 cents. Then, from their gross profit of 50 cents they typically pay 40 cents for operating costs, which leave 10 cents of pre-tax earnings for every $1 of sales. Taking into account the massive investment in inventory, the 10-cent profit is adequate but far from exciting.”



Now let us think…

If we were in charge of running the businesses and tossed in as the CEO tomorrow, whatchanges would we implement, what would we leave the same?

Seriously….

What would be the optimal strategy to pursue?

At first glance, we would likely come to the conclusion we need to turn our inventory quicker, we need lower fixed costs and we need higher gross margins. What we need is a higher capital turnover ratio. (Sales / Invested Capital)

But how can a higher capital turnover be achieved?

We need to either increase the numerator (Sales) or decrease the denominator (Invested Capital), or a combination of both.

“ At Borsheim’s the equation is far different from what I have just described. Because of oursingle location and the huge volume we generate, our operating expense ratio is usually around 20% of sales. As a percentage of sales, our rent costs alone are fully five points below those of our typical competitor. Therefore, we can, and do, price our goods far below the prices charged by other jewelers. In fact, if they priced to match us, they would operate at very substantial losses. Moreover, in a virtuous circle, our low prices generate ever-increasing sales, further driving down our expense ratio, which allows us to reduce prices still more.



How much difference does our cost advantage make? It varies by competitor but, by my calculation, what costs you $1,000 at Borsheim’s will, on average, cost you about $1,350 elsewhere. This is called the “Borsheim’s Price”. There are very few instances where we are unable to offer you those great savings due to restrictions, but you will always know upfront if an item is non-discountable.



Borsheim’s charges roughly 26% less for merchandise than competitors. They are enabled to do so because of the low fixed costs (rent, property tax, insurance etc.) and huge volume (higher inventory turns, lower overhead in the form of lower inventories on hand, lower variable costs due to scalability) created through direct selling.

 Our “shop-at-home” program brings Borsheim’s to our qualified customers. Simply contact Borsheim’s to describe what you’re looking for – to any degree of detail. We will assemble selections that best reflect your wishes and send them to you. Then, in the comfort of your own home or office, you can conveniently and leisurely select the item(s) you most prefer, or return the entire selection. Our results from this “shop-at-home” program have been amazing. Customers have loved it and keep coming back for more. Each year, we send out several thousand packages, ranging in value from $100 to $500,000.”



The business economics described above are not new and can be seen when examining Nebraska Furniture Mart (1983 acquisition) and the famous Dell business model that everyone seems to relate it to. Because of the single location, roughly 5% mark-up can be forgone by the product vendor and passed onto the consumer in the form of price savings. I like to call these feedback loops or cycles, “the ratchet up effect”, essentially leading to a virtuous cycle or prosperity for the low cost producer or leader. 

 I can remember well how helpless I used to feel in a Fifth Avenue or Rodeo Drive jewelry store, where the only thing I knew for sure was that the operator had extraordinarily high overhead – and that they had to cover it in their sales priceI was also wary of the “upstairs” solo operator who operated on consignment merchandise, since that would have cost them more than merchandise bought outright, and would necessarily haveinflated their retail price.”



Key Take Away

    • In a commodity business, high inventory turns are crucial

 

    • The lower the business overhead, the better

 

    • More units sold and spread across a smaller base of fixed costs results in a higher return on capital

 

    • Selling on consignment is not usually beneficial in a commodity type business

 

    • Direct selling reduces fixed costs and increases inventory turns, if done correctly

 

    • Capital turnover ratio signifies how much $1 invested can produce in revenue.

 

    • A cost advantage is a competitive advantage susceptible to “the ratchet up effect”

 



I will write up something in more detail later in the week regarding the cost of capital, the return on capital, growth and how they are all interrelated. Thinking deeply about capital invested and the return on that capital as well as their relationship to growth is something I would encourage all investors to do routinely. Look for reasons why the ROIC is above or below average (9% is the median according to “Valuation” by Mckinsey & Company) and how the advantage is created or lost. 



“Constantly think about how you could be doing things better and keep questioning yourself” – Elon Musk


Howard Marks Memo: Dare to be Great I & II

A new memo from Howard Marks is out and is it ever great. The original post “Dare to be Great” is provided here. I would definitely suggest reading both, preferably the one from 2006 first, as it serves as an appropriate backdrop on the context in which Marks writes today. Either way, Howard provides some key excerpts from 2006 in the 2nd part, published April 8th, 2014 and provided below.

In September 2006, I wrote a memo entitled Dare to Be Great, with suggestions on how institutional investors might approach the goal of achieving superior investment results. I’ve had some additional thoughts on the matter since then, meaning it’s time to return to it. Since fewer people were reading my memos in those days, I’m going to start off repeating a bit of its content and go on from there.

About a year ago, a sovereign wealth fund that’s an Oaktree client asked me to speak to their leadership group on the subject of what makes for a superior investing organization. I welcomed the opportunity. The first thing you have to do, I told them, is formulate an explicit investing creed. What do you believe in? What principles will underpin your process? The investing team and the people who review their performance have to be in agreement on questions like these:

  • Is the efficient market hypothesis relevant? Do efficient markets exist? Is it possible to “beat the market”? Which markets? To what extent?
  • Will you emphasize risk control or return maximization as the primary route to success (or do you think it’s possible to achieve both simultaneously)?
  • Will you put your faith in macro forecasts and adjust your portfolio based on what they say?
  • How do you think about risk? Is it volatility or the probability of permanent loss? Can it be predicted and quantified a priori? What’s the best way to manage it?
  •  How reliably do you believe a disciplined process will produce the desired results? That is, how do you view the question of determinism versus randomness?
  •  Most importantly for the purposes of this memo, how will you define success, and what risks will you take to achieve it? In short, in trying to be right, are you willing to bear the inescapable risk of being wrong?

    Passive investors, benchmark huggers and herd followers have a high probability of achieving average performance and little risk of falling far short. But in exchange for safety from being much below average, they surrender their chance of being much above average. All investors have to decide whether that’s okay. And, if not, what they’ll do about it.

    The more I think about it, the more angles I see in the title Dare to Be Great. Who wouldn’t dare to be great? No one. Everyone would love to have outstanding performance. The real question is whether you dare to do the things that are necessary in order to be great. Are you willing to be different, and are you willing to be wrong? In order to have a chance at great results, you have to be open to being both. 

    Dare to Be Different
    Here’s a line from Dare to Be Great: “This just in: you can’t take the same actions as

    everyone else and expect to outperform.” Simple, but still appropriate.

    For years I’ve posed the following riddle: Suppose I hire you as a portfolio manager and we agree you will get no compensation next year if your return is in the bottom nine deciles of the investor universe but $10 million if you’re in the top decile. What’s the first thing you have to do – the absolute prerequisite – in order to have a chance at the big money? No one has ever answered it right.

    The answer may not be obvious, but it’s imperative: you have to assemble a portfolio that’s different from those held by most other investors. If your portfolio looks like everyone else’s, you may do well, or you may do poorly, but you can’t do different. And being different is absolutely essential if you want a chance at being superior. In order to get into the top of the performance distribution, you have to escape from the crowd. There are many ways to try. They include being active in unusual market niches; buying things others haven’t found, don’t like or consider too risky to touch; avoiding market darlings that the crowd thinks can’t lose; engaging in contrarian cycle timing; and concentrating heavily in a small number of things you think will deliver exceptional performance.

    Dare to Be Great included the two-by-two matrix and paragraph below. Several people told me the matrix was helpful.

    Of course it’s not that easy and clear-cut, but I think that’s the general situation. If your behavior and that of your managers is conventional, you’re likely to get conventional results – either good or bad. Only if your behavior is unconventional is your performance likely to be unconventional . . . and only if your judgments are superior is your performance likely to be above average.

    Continue Reading 

Aside

Q&A with Michael Shearn of Compound Money Fund

Michael Shearn founded Time Value of Money, LP, a private investment firm, in 1996, to devote his attention to selecting and researching stocks and private investments. He launched the Compound Money Fund, LP, a concentrated value fund, in 2007. Shearn serves on the Investment Committee of Southwestern University, which oversees the school’s $250 million endowment. He is also a member of the Advisory Board for the University of Texas MBA Investment Fund.

 

Michael is the author of “Using an Investment Checklist: The Art of In-Depth Research.”

 

Question: Hey Micheal, it’s great to have the opportunity to ask you a few questions!

I have three, but they’re all on completely different topics so I’ll make them separate comments. First one:

With the subtitle of your book being “The art of in depth research” (purchased the Kindle version today by the way, can’t wait to read it!), and the reviews all confirming that your approach is pretty exhaustive, do you think it’s possible for the average every day guy to successfully pick stocks given very limited time to do research? This debate gets brought up very often here; how many hours would you say need to be devoted to researching a company before an idea can be turned into a good investment?

 

Answer: I personally believe it is difficult to do anything well in a limited amount of time. Although I will say if you can focus 2-3 hours a day on research without interruption (no email, phone calls, distractions) then you can closely match the time that most investment professionals spend on actual research – if not more. One of the dirty secrets of the investment management industry is that most investment professionals do not have time to research a lot of businesses because they have to spend their time building their business (money raising, client relations, operations, etc.) Therefore, if you can develop the habit of being able to focus on a daily basis on stock research then you will be quite surprised at your outcomes.

As far as how much time it takes to determine if something is a good investment or not this is difficult to answer because it varies by your experience level in investing and the number of mistakes you have made and more importantly your ability to learn from your mistakes. Therefore, the answer is that it depends on you and your experiences. The best investors have failed many times and have learned from these experiences so on the next investment they learn what to look for or more importantly what to avoid. For example, one of my first investments went bankrupt so I learned about the importance of avoiding highly leveraged businesses.

Question: Do you recommend that retail investors develop their own investment process or adopt one from a pro?

If an investor decides to create their own do you have any advice about how they should go about doing that?

Answer: I think you should learn as much as you can from the pros such as Warren Buffett because they can help you short-cut the process and more importantly you are in a position to better recognize and learn from an investment mistake. In other words, you need to learn the principles of making successful investments from the pros and then go out and apply them on your own. There is no better teacher than making your own mistakes but the key is to not waste them or let them get you down. The key is to learn from them.

As far as creating your own there is no thing as an original idea. In other words, no one can sit in a room and come up with an idea in a vacuum. They have to be constantly studying others in the industry who have had long-term success and try to extract the time-tested principles and lessons learned by those people. Where people go wrong is studying the wrong “pros” such as those who have recent success or in trying to copy others exactly the same way. The key is to formulate what works for you. For example, I used to copy other investors and looked at investing in distressed assets because I saw some pros were successful at this but frankly I did not enjoy this that much and never got very good at it. For me, learning about management teams is something I really enjoy and is the niche I have carved in the investment world. The big benefit to the investment world is that there are so many niches and methods to make money. The key is to learn which one you enjoy the most and then get busy learning as much as you can about it-whether it is qualitative or quantitative investing.

 

For each investment some questions on the checklist are more important to answer than others. For example, if a business has debt then it is critical for us to answer the questions on debt but if it has limited or no debt you can just ignore this question. The checklist is therefore meant to be flexible.

 

The strategy I have learned to use is to improve my ability to judge management teams. When you are investing for the long-term you have to be partnered with the right people because if not time works against you instead of for you. I would say spend some time learning how to identify great management teams. A great starter is the book by Robert Miles “Warren Buffett CEO” because it profiles many of the different CEOs that run the subsidiaries of Berkshire Hathaway.

 

They are all in completely different industries yet they share many of the same qualities and characteristics. Another book is Sam Walton’s autobiography Made in America which I think is terrific in helping you understand what are the qualities inherent to a great manager. I would then study what makes a bad manager by reading a book such as Bethany McLean “Smartest Guys in the Room” so you can learn who to avoid and what are the characteristics of these managers.

 

Question: What was your experience running a fund, and how does that contrast to what you’re doing with Southwestern? Do you think that endowment management or something similar could be a decent alternative to hedge funds for someone who is really passionate about the industry?

 

Answer: Endowment management is focused more on picking asset classes or investment firms rather than picking individual stocks so it is a different skill set. I believe you have to choose one or the other.

As far as your first question I would start off by saying that you are lucky to have found your passion in life (not many people do). Second, you have identified what you don’t want (a firm that does not value work/life) so you can now more quickly determine whether an investment firm meets your criteria or not.

I would personally avoid those firms that do not value work/social life balance (i.e.most hedge fund firms in New York). Investing is a long game and you never want to be burned out or be at a firm that is more interested in how much you work rather than the quality of your research. I personally believe it is critical to have balance and the opportunity to step back and see the big picture in investing. The best investors spend a lot of time analyzing an investment but then step back on the investment for a couple of weeks to get perspective on all of their prior work. It is an iterative process and having balance in life helps you be more productive.

 

The key is to constantly uncover rocks and keep looking. I had an intern once who said that he wanted to travel to third-world countries to look for investments and he dedicated a lot of time to identifying all of the investment firms that specialized in emerging markets. He then looked for articles on these firms to understand what their investment approach was and looked at their historical investments. He would then call the manager with the benefit of knowing a lot about the firm and ask them more pointed questions on how they applied their investment methodology of investing in emerging markets and asked if he could be of value to them. He eventually got the job he was looking for so yes, it can be done but like anything in life it requires a lot of legwork. Good luck on this endeavor!

 

Question: What is your opinion of the overall usefulness of “Wall Street” and the investment management industry? Of course people always trot out the “more efficient allocation of capital” argument, but do you think that Wall Street is really benefiting the economy as much as they are taking away from it by using up talented engineers and physicists and statisticians or screwing people on shady CDO deals and all that?

 

Answer: I agree with your premise that the investment management industry as a whole does not create a lot of value and that it mainly serves the personal interests of those who manage the money. As a mentor once told me “the money is not made in New York, it is sent to New York where it is chopped up in fees”. That being said this argument can be applied to any industry or profession. In my opinion there are always a limited number of shining stars in any given profession or industry. For example, in physics Richard Feynman is a great star but there are many examples of physicists who are only interested in getting published or being lauded by their peers instead of creating new and valuable ideas. On the whole though your argument is extremely valid for Wall Street in particular. I don’t know if I could argue that it is taking away talent from other professions because those who enter Wall Street tend to be more interested in making money so I don’t know if Einstein would be taking a job on Wall Street because his interest was always more on ideas than in making money. I am still in the process of formulating this opinion though…

 

Question: We’ve had a big debate around here recently regarding high frequency trading. Do you have any thoughts on the matter?

 

Answer: I believe it is the next big shoe to drop (i.e. scandal) in the securities industry. If you look at the total fees spent on buying and selling securities on all exchanges 10 years ago such as the NYSE, NASDAQ it was in the $2-3 billion range but with the advent in high frequency trading this amount has been multiplied by 10 times so it therefore is more expensive to buy and sell securities today than it was in the past because these high frequency trading firms are front-loading most transactions. Mutual funds and other institutions have been complaining about the increased cost for some time and prosecutors are finally starting to listen so there will definitely be more regulation in the future in this area.

 

Question: What books have been most influential for you in your career? Are there any that you’d recommend that may have flown under my radar (i.e. something outside the typical “Intelligent Investor”, “One Up On Wall Street”, “Margin of Safety” classics)?

 

Answer: I recommend the book Antifragile by Nassim Taleb because if you can adopt the mind frame of always looking for optionality in your investments then you will put the odds of investment success in your favor. What I mean by optionality is that if you invest in a highly leveraged firm then the future outlook for a business is more narrow because the management team is often forced to make short-term decisions that are detrimental to the long-term health of a business.

 

The reason for this is that the high debt does not give them many options on what they can do. Think about how a management team would not be able to commit to losing money on research and development on an important project that could be profitable 3 years from now because they must instead focus on making interest and principal payments on the debt. What I like about the book is that it helps you adopt this mental framework in investing of always looking for businesses that have lots of optionality which are businesses that will not be severely impacted by things such as downturns in the economy or black swans.

 

Question: Could you give us a brief overview of your checklist? Is it a list of yes or no questions, or metrics, or what?

 

Answer: The questions help guide you on deepening your understanding of a business and its management team. The key to investing in anything is having an understanding of what the future cash flows of the investment will be. The only way to do this is to examine a business from a variety of perspectives. You want to know if a business has some type of competitive advantage that protects its cash flows or whether it is one that a competitor can easily come in and under price them. Sometimes, you have a great business but if the management team is not good then the cash flows will not grow.

 

Witness how both Coke and Microsoft which are great businesses have not created much value over the last decade or so. Most of this is due to not having the proper management in place. So instead of being a yes or no response it is more of why do we believe the management team is competent or has integrity? Are the products good for customers and why? Is the CEO product (Steve Jobs at Apple) or sales (Balmer at Microsoft) focused? If the business disappeared tomorrow what impact would this have on the customer base? The questions help you understand the stability of cash flows today and how they are likely to change in the future.

 

Sometimes, the questions help you understand that you really don’t understand an investment and therefore should avoid it or they can help you understand what areas you need to further research by those questions you are not able to easily answer. This often can tell you the potential risks you face in an investment.

 

Question: What would be the sub-categories on your investment checklist? Currently on my own I have:

1) Risks 2) Costs and Cost Structure 3) Units (Capacity, Elasticity, SSS, Volume, Pricing power etc.) 4) Management/Insiders 5) Balance Sheet 6) Competition 7) Income Statement 8) Compensation 9) Cash Flow 10) Products/Services (Switching Costs, revenue mix, reoccurring etc.)

all with about 5-10 more specific questions below for a total of about 85 questions. Is this too much?

I am not sure If I am missing any big themes and would love to hear your opinion.

The 2nd question being at what age did you “break into” the industry and what would you recommend someone wishing to create a partnership should do if they are under the age of 30. Is the CFA an ideal achievement?

The 3rd question being, what would be the first 3 questions you ask yourself in terms of your investment checklist?

 

Answer: No – it is not too many questions because you will not have to answer all 85 questions in each investment that you make. For example, if a company has no debt you can ignore 5) balance sheet but if it is a business with a high fixed cost base then you have to pay attention to 1) Risks, 2) Costs and Cost Structure way more than the others. You weigh the questions for each particular investment you make and also for your experience level. When I first started it was important for me to ask more questions because I was learning more about investing but as I made investment mistakes and my judgement was being formed I learned what questions were more important to ask for a particular investment (which is a process that is always ongoing). The list should be comprehensive because it brings certain things top of mind and makes sure that you are not forgetting to ask what could be a very important question or you can learn what you don’t know by the questions you are unable to easily answer.

 

As to your 2nd question I broke in right after college because I frankly could not get a job at an investment management firm because I did not have any distinguishing background that would pique their interests. I later learned that when I applied to New York firms that these firms were looking more for pedigree (what school I went to) and since I went to a small liberal arts school in Texas with limited name recognition in New York I did not stand out in any way so I started doing analyst research work for an individual investor basically for peanuts but I was doing what I enjoyed. As far as forming a partnership you need to determine how many people will invest with you in your close circuit such as friends and family because it will be extremely difficult to get outsiders to trust you so you have to focus on those who already trust you first. I don’t believe the CFA is an ideal achievement but if you are raising funds from institutions then it becomes a “must have” so depends on the type of investor base you are targeting.

 

The first three questions we ask is 1) If the business disappeared tomorrow, what impact would this have on the customer base? 2) What is the background of the CEO? Are they sales focused or product focused? and how did they rise in the organization 3) Is this a business that we would be interested in learning more about – in other words can we sustain interest learning about this business over a long period of time. For example, we avoid banks because I frankly am not interested in them and therefore will never be good at analyzing them. So the top questions are geared towards our investment style and what our criteria is for an investment which has been developed over time.

 

I remember when I first interviewed with firms that I was focused on selling myself. When I got to the other side (I was interviewing others to hire them) I realized how wrong I was. The key is to ask the interviewer questions to determine if the firm is one where you can add value. I remember interviewing one applicant who kept asking me specific questions on how we did things and then commented on whether he thought he could add value to our process. This made the candidate stand out from all of the other people who were focused on selling themselves.

 

When you don’t have pedigree you need to have something that demonstrates you can add value to a firm such as a thorough investment report on an investment that highlights how you think about investing and your process. Your investment does not have to be successful but it has to highlight your thinking. In other words, let the actions (your report) speak rather than words and then genuinely try to figure out if you can add value or if it is frankly a firm or people you would be interested in working for.

 

I would avoid firms where the HR department interviews you for a job instead of the person you will be working for. If you get an interview with the person you are potentially working for ask them what their expectations are of you and what you could bring to the table. What is it they are trying to accomplish by hiring you. Then be genuine about whether you fit this criteria and be honest if you don’t.

 

I have many examples where I told potential clients that I would not be a good fit for them and they ended up referring me to others who were so being authentic and not trying to fit the criteria of someone else is key. You will eventually self-select where you belong and if you lie about it or try to fit the criteria you will end up paying the price down the road. I hope this answers your question?


[Bonus] Michael Shearn on How Assess Company Management and Talks About Investment Checklists