A Very Long Hill

Excited to announce my new eBook on getting kids started investing, its called A Very Long Hill. And it is available in the Kindle store now.

This book’s goal is to help parents and kids learn more about an incredibly important topic – how to invest for the long run, and take advantage of two of the most powerful forces in the world: time and compounding.

Hopefully this work generates some good discussions on these critically underserved areas - investment education and long term thinking. 

Investing Gems

Investing gems from some of my favorite investors - David Gardner, Lou Ann Lofton, Peter Lynch, Marty Whitman, and Charlie Munger comment on long run investing.

McCormick Spice - Almost Perfect

 What makes a perfect investment? First off, the business should be in an excellent sector, and ideally it should control a niche in that sector.

For sectors, I like how Don Yacktman looks for low cyclicality and low capex.

Getting more specific, let's check historical data - Consumer staples beats pretty much all sectors hands down. Which proves out Yacktman's most favored quadrant

Next drilling down from the sector and niche should have the ability to deliver excess returns over a very long period of time to let compounding do its work. Consumer staples is filled with lots of interesting companies and niches. But how many will continue to generate excellent returns decade over decade? The companies that sell products from older generations like Wal-Mart Coke, General Mills, and Pepsi are finding some headwinds with new generations of consumers. The consumer companies that are more on point with current norms like Whole Foods or Monster are pretty expensive. Of course, the old school brands will probably muddle through but its not always clear the profitability will be as robust as today, for example profit margins on Coke where Coke controls the brand versus profit margins on water where the barrier to entry is way lower.

But there are some areas where growth appears sustainable, for example spice. McCormick Spice is over 125 years old, and as the largest manufacturer, it dominates the spice niche. McCormick estimates the global spice market at $10B, McCormick has a 22% share of the market and is 4 times larger than the nearest competitor. If you add in the fact that McCormick produces many store brands, the combined set of brands is pretty much the whole spice aisle.

Better still, you see McCormick's brands everywhere, you see them in Walmart, regular grocery stores, and unlike most Coke/Pepsi/General Mills products you see their brands on the shelves of Whole Foods with brands like Thai Kitchen and organic lines. McCormick has pyramid of profit that lets it sell from low end to high end, not many companies can pull that off. McCormick has a B2B unit as well and customizes spices for larger companies like Frito-Lay.

How about durability of consumer demand? Well, the first IPO was a spice trading company. Don't let the IPO scare you off, gentle investor, the IPO was the Dutch East India company on September 9, 1606. The history of spice goes back to the origins of the stock market.

So McCormick operates in a sector with demand measured in centuries, dominates its niche in the favorable consumer staples sector.  Further, its got a safe balance sheet with a Debt/Equity ratio at 0.5. So why almost perfect not perfect? Well, by now you guessed it - price.

McCormick is a premium company and its priced accordingly (source- Morningstar). Its excellence is not subjective, but valuation is. its current P/E of 30 is too high for a low growth company, but at the same time even in 2008-09 McCormick still traded in the 16-17 range for P/E. There is downside protection in pepper, basil, and  mayo.

What if we use sustainable growth rate as a measure to approximate future returns? The Sustainable growth rate for McCormick can be estimated using its current 56.1% Dividend Payout ratio, and a 5 year average ROE of 24.1% which yields a Sustainable Growth rate of 10.6%. That projection dovetails pretty nice with McCormick's actual 10 year average dividend growth rate which is 10%. Assuming, McCormick can continue to deliver that dividend growth even with an expensive entry point it can work out fine for investors over long time frames. If you invested in McCormick in Nov 1, 1995 and held through to now, you earned 12.4% annualized return, and $1,000 turned into over $10,000. Run it yourself on LongRunData.

So that 1995 McCormick investor earned a tenbagger over 20 years. I would submit that investor did not take much risk at the time, no dotcom, no tech, just time. But here is an interesting side note, what do you suppose the 1995 investor paid? As we have discussed, McCormick is a stock that is never really cheap, and in 1995 the P/E was 33 which is 10% higher than today (source YCharts).

So while its difficult for a cheapskate like myself to work up much enthusiasm over a current P/E of 30, and a low current yield at 1.9%, the reality is that in the past McCormick has been able to deliver stellar long run returns even with high multiple. If long run consumer trends on spice and flavor seem durable, and if the Sustainable Growth Rate is close to what the company can deliver, then a low double digit return seems reasonably likely if you take the long view.

Personally, I would still hold out for a discount from today's price, but what is interesting to me in this analysis is that my gut reaction to a 30 P/E is to say well I guess I need to wait for a big 40% pullback or something. The history shows that instead a pretty small reduction could still potentially offer long run excellent returns. Note, this is not buy, sell or any other kind of guidance just a thought experiment on valuation and the impact of quality over the long run.

"Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result." – Charlie Munger

The Limits of the Outsider approach to investing

Often great books, even business books, do not directly translate into actionable investing concepts. "The Outsiders" by William Thorndike is one of the best business books I have read. It details the exploits of John Malone, Henry Singleton, Buffett and others, and how they built incredibly successful businesses.

Its a series of stories that elaborate on inspiring vision and execution, but there is one problem - for sure, these outsiders were wildly successful, but how can an outside individual investor recognize these companies and managers a priori to join them on their ride? Ay, there's the rub.

The exact tactics that John Malone and many others used to build their companies - massive amount of debt, continuous M&A, buybacks, and eschewing earnings - look like many of the exact things that a defensive investor seeks to avoid.

Interestingly enough one of the questions that came up when the book came out was, nautrally, so we know the historic examples of Outsider CEOs, but what current CEOs embody that approach? One of the main examples given was Michael Pearson the Outsider CEO of Valeant.

Valeant seemed to tick all the Outsider boxes - a new CEO with an unconventional approach, shaking up a staid industry, massive debt, 9x revenue growth in the last five years, a Debt/Equity ratio of 4.8,  and one acquisition after another, each one larger than the last. Most people(*) including Thorndike tabbed this as the next Outsider.

But when I tried to apply The Outsider theory in investing, as an outside, individual, non-professional investor, I found that its not so easy. Again, the very metrics I look to avoid are the hallmarks of many Outsider approaches. In fact, John Malone even mocks the lower risk approaches

“Their philosophy is low leverage, low risk and high cash payout to their shareholders,” Malone said of Vodafone. “I prefer to grow equity value.”

Who am I to argue with Malone's approach? Of course, Malone can say that with confidence, his track record speaks for itself, but what about lesser skilled CEOs of which there are many? And again, how should we recognize a Malone up front? So what works for Malone and Singleton is probably not going to work as well for an individual investor, because the difference between Malone versus Leo Apotheker and Carly Fiorina is not always obvious at the time in terms of tactics.

Now Valeant shareholders are having to wrestle with these questions. Is this a great buying opportunity, because Philidor is totally copacetic, should they back up the truck? Or is it time to run for the exits? Either way, its potentially very expensive to find out.

Sanjay Bakshi's excellent lecture on Klein vs Kahneman distills decision making down to Klein's expert insights versus Kahneman's mistake avoidance. Individual investors already have major implicit advantages - time and patience, not sure they need more, because they can harvest satisfying returns simply from time and patience assuming they can avoid mistakes.  In my view, bravery is required to capitalize on your view of what scenario Valeant is in at present. Bravery can yield great results when you are right, but patient quality offers a better margin of safety the rest of the time.

* Well, one person did not: "Valeant is like ITT and Harold Geneen come back to life, only the guy is worse this time." - Charlie Munger (March 2015)

Dwelling on Quality

In an oped in the FT two years back, Nick Train asks a great question - "what is the right price for quality shares?" That's a deceptively important and potentially difficult problem actually.

Its important because of Munger's three laws of investing

Its a potentially difficult problem because while most intermediate investors can recognize a bargain price and they can recognize high quality, the intersection of the two is problematic. Take a company like Diageo, its P/E is 20 right now. For a cheapskate like myself that is a bit on the high side. On the other hand, its a high quality franchise. For one example its Return On Equity has ranged between 32-48% for the last decade. But because the market is not generally stupid, it never gets classically cheap. The last time it was in bargain territory was 2008 (when everything was) when the P/E was down to 14.

So what to do? Sit on cash for a decade or two waiting for that one opportunity? Or pay up a bit for higher quality.

Nick Train: "...should Diageo’s shares really be trading at 20 times historic earnings? 

Any discussion of these issues has to begin with an acknowledgment of the fundamental investment attractions of these shares – which are self-evidently great. I would contend that more investment weight should be placed on the excellence of a business than its valuation. 

It is easier to be certain that Diageo is a great business than it is to decide whether or not it is overpriced on 20 times earnings, or still cheap on 15 times. The excellence is not debatable; the valuation discussion is worryingly arbitrary. So, I tend not to worry about valuation unless truly egregious levels are struck – say a price/earnings ratio of 30 times or more. "

Morgan Housel did some digging on this topic, he went back to 1995 and looked at what P/E would you pay for an 8% return. Interestingly enough, many of the higher priced companies (on a P/E basis) had excellent returns, and many apparently cheap companies just stayed cheap or outright floundered.

In the Adventure of the Copper Beeches, Sherlock Holmes said, "Crime is common. Logic is rare. Therefore, it is upon logic rather than upon the crime that you should dwell." There are plenty of cheap stocks, even today, however the number of great companies that can compound over decades is very small. That kind of quality is rare, but it is knowable with investigation. Therefore, in the case of price and quality, the investor should dwell on quality.

Book Review: Tren Griffin's "Charlie Munger - the Complete Investor"

A key question I had going into reading Tren Griffin's new book "Charlie Munger - The Complete Investor" was - what would the work add to the previous books on Munger? I am happy to report that the book is an excellent addition to the family of Munger books.

"Poor Charlie's Almanack" by Peter Kaufman is one of my favorite all time books, its a compendium and includes lengthy speeches from Munger. It is unique.

"Damn Right" by Janet Lowe is not nearly as well known, but it covers some useful biographical material on Munger's life. It also explains a key component as to why Munger is worth studying. Buffett is a prodigy and became a millionaire very early on. Its hard for most people to relate to whiz kids who have astonishing success from very early ages. We can all admire Buffett, Gates, and Mozart. We can draw many lessons, but its not always as relatable. Damn Right shows in a lot of detail how Munger worked his way through some tough personal periods including a divorce and did not achieve great financial wealth until much later in life. Overcoming these challenges is something that everyone can comprehend.

"Seeking Wisdom" by Peter Bevelin puts Munger's thought processes into a historical context of thinkers from Charles Darwin to Michel de Montaigne. It shows you certain habits that you can improve your thinking and avoid common errors of judgement.

I had many takeaways from all of these books and the numerous transcripts available on line, so I had a bit trepidation picking up Griffin's effort. What would Griffin add on a life that is well covered from many perspectives? Like Poor Charlie's Almanack, The Complete Investor contains a diverse array of Munger's wit and wisdom. Like Seeking Wisdom, The Complete Investor shows how Munger's analytical process fits into a larger context.

The Complete Investor goes on to tackle a couple of areas that are fundamentally new. Note, as I am reading I fold pages so that I can revisit, the middle part of the book is chock full of things worth revisiting.

The two areas that I see where Griffin broke new ground were first in assembling Munger's ideas into an investing context. It sounds a bit crazy, but Munger is such an original thinker that the previous books focused mainly on his thought process. Griffin's book deftly brings together incisive quotes from Munger, decades apart, into a tossed salad where each idea slots into a business and investing context.

The other area is my favorite chapter, "The Seven Variables in the Graham Value Investing System." I spent a fair bit of the early part of the book a bit perplexed by how Griffin continually referred to Munger in the context of a Graham value investor. One key insight I have learned from Munger is how he helped move Buffett away from the strict bargain basement Graham school of cheap stocks and towards wonderful businesses at fair prices. So it was initially disconcerting for the early stage of the book to look at Munger mainly in a Graham context.

But that made the Seven Variables work all the more enjoyable because Griffin brings that evolution into clear focus. To summarize the seven variables that Griffin distilled from Munger's work I have chosen one of my favorite quotes. Again, what is interesting to me here is that Griffin's work is the first attempt that I have seen by someone attempting to pull together an investing framework based on Munger's thinking. That alone makes the book very useful.

To give you an idea on this important chapter, I have copied the variables that Griffin distilled below along with my favorite Munger quote (of the several that Griffin includes and comments on in the section). Notice the progression. The first two variable are old testament Graham, and then Griffin shows how Munger builds upon that foundation to a new, quality at a reasonable price style.

First Variable - Determining the Appropriate Intrinsic Value of a Business
"There are two kinds of businesses: The first earns 12 percent and you can take it out at the end of the year. The second earns 12 percent, but all the excess cash must be reinvested - there's never any cash. It reminds me of the guy who looks at all of his equipment and says, "There's all of my profit." We hate that kind of business." - Charlie Munger, Berkshire Annual Meeting, 2003

Second Variable - Determining the Appropriate Margin of Safety
"Ben Graham had this concept of value to a private owner – what the whole enterprise would sell for if it were available. And that was calculable in many cases. Then, if you could take the stock price and multiply it by the number of shares and get something that was one third or less of sellout value, he would say that you’ve got a lot of edge going for you. Even with an elderly alcoholic running a stodgy business, this significant excess of real value per share working for you means that all kinds of good things can happen to you. You had a huge margin of safety – as he put it – by having this big excess value going for you." - Charlie Munger, USC Business School, 1994

Third Variable - Determine the Scope of an Investor's Circle of Competence
"Warren and I have skills that could easily be taught to other people. One skill is knowing the edge of your own competency. It’s not a competency if you don’t know the edge of it. And Warren and I are better at tuning out the standard stupidities. We’ve left a lot of more talented and diligent people in the dust, just by working hard at eliminating standard error." - Charlie Munger, Stanford Lawyer, 2009

Fourth Variable - Determining How Much of Each Security to Buy
"I always like it when someone attractive to me agrees with me, so I have fond memories of Phil Fisher.  The idea that it was hard to find good investments, so concentrate in a few, seems to me to be an obviously good idea.  But 98% of the investment world doesn’t think this way." - Charlie Munger Berkshire Annual Meeting, 2004

Fifth Variable  - Determining When to Sell a Security

"There are huge advantages for an individual to get into a position where you make a few great investments and just sit back and wait: You’re paying less to brokers. You’re listening to less nonsense. And if it works, the governmental tax system gives you an extra 1, 2 or 3 percentage points per annum compounded." - Charlie Munger, Damn Right, 2000

Sixth Variable - Determining How Much To Bet When You Find a Mispriced Asset

"We came to this notion of finding a mispriced bet and loading up when we were very confident that we were right." - Charlie Munger, USB Business School, 1994

Seventh Variable - Determining Whether the Quality of a Business Should be Considered

“Grahamites ...realized that some company that was selling at 2 or 3 times book value could still be a hell of a bargain because of momentum implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual or other, or some system or other. And once we’d gotten over the hurdle of recognizing that a thing could be a bargain based on quantitative measures that would have horrified Graham, we started thinking about better businesses. We’ve really made the money out of high quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money’s been made in the high quality businesses. And most of the other people who’ve made a lot of money have done so in high quality businesses.” -Charlie Munger, USC Business School, 1994

(Interestingly enough the chapter called "The Seven Variables in the Graham Value Investing System has an eighth variable)

Eighth Variable - Determining What Businesses to Own (in Whole or in Part)

“The difference between a good business and a bad business it is that good businesses throw up one easy decision after another. The bad businesses throw up painful decisions time after time.” - Charlie Munger, Berkshire Annual Meeting, 1997

In the spirit of Munger I have nothing to add to these variables. 

As to the book, the above example shows exactly how Tren Griffin takes a broad range of Munger's ideas and assembles them to compose a set of the key insights on the investor's decision tree.

The Joys of Hunkering Down

Its been a crazy week in the market, but it has been another quiet week in Lake Wobegon. Usually, people think about hunkering down in the winter time, but Josh Peters has a great quote on the pullback (emphasis added)-

Glaser: The pullback was caused by a lot of things--everything from concern about China to the Federal Reserve. Do any of these concerns lead you to think there could be dividend cuts on the horizon or weakness in the real economy, or are these just things that are impacting the market but not the businesses themselves?

Peters: Nothing new has emerged on that front. I still think that, in looking at the energy sector, you have to be concerned. You want to make sure that you're on very high ground and that you've got companies with very strong balance sheets so that they can afford to have their earnings and cash flow drop significantly for a period of time without having to force a dividend cut.

Outside of that area, we're still at a pretty high level of profitability across the board. Where payout ratios are generally higher tend to be in the more stable industries--like your REITs, like your utilities, like your staples. So, overall, the backing for dividends in most of the market still looks pretty good. The question that arises is, "Does this presage some recession that, even if it starts in China or in some other emerging market, rolls around the world and eventually drags the U.S. down with it?"

This is why I try to stay hunkered down all the time and why the bulk of my portfolio--typically 75%--is going to be in very defensive names like the ones we've already been talking about. I reserve some of my portfolio for more cyclical names. I own Chevron (CVX)--that falls in the cyclical category. Wells Fargo (WFC)--a bank, to me, is cyclical. Industrials are cyclical. But even in those cases, I feel like I'm getting the sufficient protection, as well as long-run total-return prospects, that make owning those stocks worthwhile. The rest of it, I really want to be able to trust those cash flows and trust the dividends and even continue to grow the dividends even in the downturn. That's a standpoint that has served the strategy very well over more than a decade now. 

Indeed, why not stay hunkered down all the time?

I wrote about some research via John Authers and SocGen that showed that patient quality investing beats the market and that patient value was better still. However, most people do not work in finance, they have jobs and lives. And so this is a case where second best (quality) is beats first (value) when you have a job. Monday was a prime example.

I know a few folks got great bargains on Monday am, kudos to them. I would have been very excited to buy Visa in the lows 60s, for example. Here is the thing - I was too busy to act on it, because I am not a full time pro I missed the brief window.

Here is another point, I know a handful of folks who got great bargains on Monday, but I know multiples more who spent the weekend worrying about their portfolio. You know what? You only get a few dozen Augusts. Do you really want to burn any time on an August weekend fretting? No. How much time would you spend worrying about whether people are going to still eat Cheerio's between Sunday and Monday? I will round it down to the nearest digit - zero.

So value is great when it works, but quality is a fantastic plan B, you may be a step behind the great value investors, but you will still have a fair chance to beat the market and enjoy your summer weekends, too.

To Sleep Well at Night Buy Businesses Not Sardines

The wild gyrations in markets brought to mind a mindless species - sardines. Specifically, the story that Seth Klarman shared:

“There is an old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The teller said, “You don’t understand. These are not eating sardines, they are trading sardines.” Like sardine traders, many financial-market participants are attracted to speculation, never bothering to taste the sardines they are trading.”

People freaking out about prices is not new. But these people have the wrong end of the stick. The whole point of investing is that you are a business owner. Being an owner means having the fortitude to hold through cycles to achieve long run excess returns. 

The headlines are predictably apoplectic, but context is severely lacking. Let's say you own McCormick Spice, the world's number one spice maker with sales all across the globe. They pay a low 2% yield but they grow it each year and raised it by around 2.5x in the last decade. Its reasonable to assume there are decades of growth ahead of McCormick. After all, people love spices and the origin of the stock market all the way back to the Dutch East India company. That shows you the longevity of people's taste for spice.

Just like pretty much everything else, McCormick shares traded down over the last few trading sessions. McCormick now sells for $77/share. About a week ago the shares were around $84/share. Examples like that are what makes people panic. But should they? 

$84 was an all time high for McCormick. So at today's price we are talking a 10% discount to an all time high. How many business owners would readily give up their company which has excellent, long run sustainable demand just because it was valued 10% lower than a week before? 

Zooming out is usually a good idea in situations like this, here is a long run chart for McCormick

Gee that does not look too bad.

If you invested $1,000 in McCormick Spice in 1995, you would have $12,183 today. Its compounded at 13.2%. No genius insight required, just the idea that people like spice. Sure the market can get spicy at times too, but that is not a reason to run for the exits if you like the companies you own.

Sonho Grande (Dream Big)

Two years back, Buffett recommended the book "Dream Big", the story of 3G Capital, which I finally got around to reading. When Buffett recommended it he was referring to 3G's involvement in the Heinz deal and how much he liked doing business over the years with Jorge Paulo Lemann. Since then, 3G spearheaded deals with Tim Horton's and the Kraft Heinz merger. I figured it was finally time to read the book.

Its not an investing book, more of a business history and all the of the history leading up to 3G is covered in detail. Since they started in Brazil there was a lot I did not know about the founders, and I suspect it will be new to most US investors. 3G has a much bigger name now controlling so many well known North American and global brands, its a fair question to ask, how did a few people from Brazil with no particular advantage pull of this feat?

Its easy to see why Buffett appreciates doing business with 3G. They are at the same time quite successful and very focused on discipline and results. They are also modest. My favorite quote in the book is at the end. When the author approached Lemann with the idea to write a book, he did not think they were worthy. Lemann said "All we did was copy a little from Goldman Sachs and a bit from Walmart. Nothing more than that." That's a pretty big understatement from a firm that controls beer across Latin America, Anheuser-Busch, Kraft Heinz, Tim Horton's, Burger King, and a lot more besides.

One key to success is a major focus on costs and zero based budgeting, managers have to fight every year to justify budget items. The mantra is that costs are like fingernails, they have to be trimmed regularly. This mantra is playing itself out at Kraft Heinz right now, the cuts go way beyond jobs - no free cheese sticks for employees, employees can't bring competitors food for lunch, printing on both sides of the paper, and so on. The goal for Kraft Heinz is to take out $1.7B in costs by 2017.  The book does a good job showing that this is not new to 3G, this playbook is their DNA and it has evolved for decades.

They have a strong culture where they look to find and empower PSDs - Poor, Smart, and Deep Desire to get rich. 3G's process has identified many of these folks over the years, such as Carlos Brito, and once they are able to find them, the recipe basically is to give them the playbook,  keep costs way down, latitude to operate, and big incentives to deliver. Brito came from nothing, worked his way up to CEO of Anheuser-Busch and ended up with 0.18% of the company's shares after delivering on the aggressive performance metrics set for him.

The culture is high on meritocracy and low on formality. Beto Sicupira comes to the office in scruffy jeans and a backpack. "the simplest guy in the whole world." Like Berkshire and Walmart, results matter, puffery doesn't. People matter, Oscar Telles still is involved in the new employee orientation, to ensure the culture stays consistent.

Selecting the right kinds of businesses to invest in matters with this approach. 3G buys low cyclicality, low capital businesses like consumer staples firms. These companies are ideal for the 3G approach, if you tried the same playbook at another firm, it might not work nearly as well.

One criticism is that 3G does not do a lot of traditional innovation with product launches and such. I am not sure if that is that big a deal. Look at P&G, GE and other firms that spent the last decade acquiring, now they are shrinking brands as fast as they can. 3G has run this focused playbook for a long time. In reading the book I was left with the distinct impression that it would be no fun at all to compete against these guys. When your competition can sustain a cost advantage it probably means they also have an advantage in focus and in customer service. That's what Sam Walton and Hunter Harrison figured out.

Like Berkshire, 3G does not do grand strategic plans.  When 3G originally started in the beer business they looked around Latin America. The richest guy in Venezuela was a brewer. Same with Colombia, same with Argentina. They thought - they can't all be geniuses, it must be the business model that is good.  That is where the genius of 3G lies, finding simple, scalable businesses and focus on them. Then get the right people, give them room to operate, excellent incentives and give them room to run. Its a  recipe that has delivered and should continue for years to come.

Use an Investing Strategy that Any Idiot Can Use

Great recommendation from Harold Pollack that your investing goals should fit on a standard 4x6 index card. Simplicity has a quality all its own.

One of my investing mantras is based on an old Peter Lynch quote, invest in businesses that any idiot can run, because one day one will.  This nugget of investing wisdom has kept me out of a lot of trouble. Not that there are not great managers out there, obviously there are. For example the highly enjoyable book "The Outsiders" describes the huge gains investors enjoyed from the managerial feats and capital allocation wizardry of the likes of Buffett, John Malone, Dick Smith, and others. What investor wouldn't want to have those kinds of managers working for them?

Well one problem is that very often you only know who the great managers are after they have been wildly successful. That means two things, first many of the gains are in the rear view, and second that the manager however good they may be, now operates with a larger base which equals less opportunities.

Another problem with seeking great managers and many of the ones described in The Outsiders, is the techniques that they use are indistinguishable a priori from incompetents and crooks. For example, John Malone built one of the great track records in history, however he did it based on massive debt loads and continuous M&A. If you built a portfolio that focused on finding companies that have huge debts and lots of acquisitions, you may find a Malone, but you probably end up with HP and worse. That's my basic problem with looking to invest in great managers, the chain saw, in the hands of a skilled professional, is a great tool for clearing forest. In the hands of a newbie you lose (your own) limbs.

So my twist on the Lynch rule is that individuals should use an investing strategy that any idiot can use, because one day one will.

My index card starts with four elements taken from Charlie Munger, who is clearly not an idiot (6 min mark):

1. Buy things you understand

2. Moat - Ensure there is a durable competitive advantage

3. Management integrity and ability 

4. Price matters, don’t overpay

Because I am not as smart as Munger, I use a few more checks to further idiot proof my process

5. Safety - Balance Sheet, earnings cyclicality

6. Quality Income - Free Cash Flow, dividend yield

7. Dividend Growth - ability to grow dividend over time

I think that leaves me enough room on the index card for a small drawing. Don Yacktman's recent talk at Google described a useful, simple concept to use forward rates of return so that you analyze a stock similar to a bond. The process identifies investing candidates with low capital requirements and low cyclicality as the best starting place.

The other quadrants like Low Capital plus high Cyclical or Low Cyclical plus High Capital can house interesting opportunities, but must account for these risks. I think this sums it up well. Don Yacktman is clearly not an idiot either, he has one of the best track records of performance of any big mutual fund manager over multiple decades, and stacks up well next most any other manager. But the key distinction is that however skilled Yacktman is following his basic process does not require any particular genius insight to buy PG, Coke, and Pepsi and hold them for 20 years.

Now I just need an index card! What is on your index card?

A Dozen Things I Learned from Todd Wenning About Investing

Todd Wenning is leaving Morningstar for another post in the investing world. Not sure if he will be able to post as much going forward, so this seems a good time to summarize the lessons I, and I am sure many others, have learned from his work.

1. Importance of Dividends
Dividends are everywhere now, but Todd has been writing about dividends for a long time. A lot of what I learned about the importance of dividends comes from Todd's work. These include focusing first on the moat, which is more important than the dividend itself, signs of what companies to avoid, and minimizing transaction costs.

2. Think Different
Most guidance on dividends includes the safety check for how sustainable the dividend is. These guidance pieces almost always point you in the direction of the Payout Ratio. This is a good indicator to check, but its based on earnings. Todd points out that free cash flow is the more important metric for dividend investors.

"Many companies and investors primarily focus on earnings cover (earnings per share/dividends per share or net income/dividends paid). As such, earnings cover is also important to consider, but "earnings" are simply an accountant's opinion of the company's profits and not necessarily a good measure of cash flow. In fact, a company can have sufficient earnings cover but negative free cash flow cover.

Because dividends are paid in cash, we want to use a metric that helps us measure cash inflows and outflows. That's what the free cash flow cover metric can do.

Free cash flow is how much cash flow is left over each year after the company has reinvested in its business. Think of it as spare or surplus cash flow. It's from these surplus cash flows that dividends, buybacks, debt repayments, etc. are funded."

3. Think Small
Morningstar is a great service with a lot of useful information. However it has one gap - lack of small cap coverage. The fundamental construct that Morningstar uses to assess companies' durability is the economic moat. For sure, there is a good case to be made that the moat concept is just as relevant to a small cap as it is to J&J. Todd wrote a series on Small Cap Moats, that uncovered lots of interesting smaller companies from WD-40 to Badger Meter, there are a lot of interesting ideas in this space.

The goal of the Small Cap Moat series is one that resonates with individual investors:

"identifying smaller firms that exhibit moatworthy characteristics and are run by skillful management teams. This is a promising combination for any company to have, but it’s particularly attractive for smaller companies with long growth runways, as they have the ability to compound shareholders' capital at high rates of return over long periods of time."

4. Look Outside the US
Investors should not limit their holdings to the US. Many companies in general, and dividend payers specifically exist out side the US. Go where the opportunities are.  Further some of the more interesting investors to follow are outside the US, for example Neil Woodford. Todd uncovered a number of Woodford quotes I really like this one:

"In the short-term, share prices are buffeted by all sorts of influences, but over longer-time periods fundamentals shine through. Dividend growth is the key determinant of long-term share price movements, the rest is sentiment."

5. Make Tools  
Churchill said we make our buildings and then they make us. The same is true in investing. We make our analytical tools and our tools make our portfolios. Todd published the Dividend Compass tool which is a great way to analyze the key data to dividend investors and monitor changes.

6. Separate Income Investing from Value Investing
Like a lot of people, I came into dividend investing thinking about it as a subspecies of value investing. I like both styles of investing, but unless we are talking about 2008-11 timeframe its pretty hard to find great bargains on dividend payers.

Todd's post Income Investor Manifesto gets to the heart of this distinction:

"a high yield can sometimes be indicative of an undervalued stock, but the objective of a pure income strategy differs from value investing in that its primary focus is to generate a growing and sustainable stream of dividends. Capital gains are an important, yet secondary concern. For value investing, the opposite is true -- indeed, companies don't necessarily need to pay a dividend to make it an attractive investment to a value investor.

Further, income investing has a distinct research process that focuses on a company's ability to sustain and increase its dividend. Where value research typically begins with a company's balance sheet and growth research starts with the income statement, dividend research commences on the cash flow statement.

From the cash flow statement, for instance, we can determine free cash flow coverage, earnings coverage, how the company approaches dividends versus buybacks, debt repayment trends, acquisition trends, and more.

This analysis is critical in determining a company's dividend health and therefore the cash flow statement is the necessary starting point for dividend research."

7. Be Long Term
Lots of people "talk" long term, but its even more important for dividend investors. Further, individual investors do not have many advantages, but the ability to be long term is one absolutely one. Buying high quality + high yield and holding for the long term really works. Todd says it well-

"Individual investors, on the other hand, don't have to worry about underperforming in a given year and can thus maintain a patient and long-term focus. You can hold a large cash position or take a contrarian position, for instance, and give your thesis a few years to play out without worrying about investors pulling money out of your fund."

8. What to Avoid
Todd advises to ask yourself these questions before investing:

• What do I know about this stock that other investors don't? 
• Does this company have a sustainable competitive advantage? 
• If the stock loses 50% of its value over the next three years, what happened? 
• In two minutes, can I explain to a friend how this company makes its money?
• When will I sell this stock?

Not only are these solid questions to ask, they also get to get to a critical issue - mistake avoidance. Asking these questions helps to ensure that that you have a margin of error in your own thinking process.

9. Learn from Your Mistakes
Mistakes are inevitable, learning from them is not. One way to try and learn is to first recognize your mistakes and identify where it went wrong. Todd revisited his purchase in Tesco that did not work out.  Buffett also got burned on Tesco. Interestingly enough I was looking at Tesco around the same time, and the thing that convinced me not to invest was the metrics that Tesco showed on Todd's Dividend Compass tool.

Suffice to say, the world in general and investment world in particular is rife with people talking about their success and ten baggers, but the mistakes get somewhat less review.

In the case of Tesco, Todd summarized the key lessons learned:

• When you find yourself making a lot of excuses for a company’s missteps, it’s time to reevaluate your investment thesis. Remember, you don’t work for the company and there’s no reason to spin bad results in a positive light. Call them as you see them. 
• If a company holds its dividend flat after years of steady growth, it’s likely a sign that the competitive landscape and/or company’s strategy has changed. The board and management are clearly not confident in their medium-term outlook. Something is up. 
• When figuring out when to buy or sell a stock, don’t concern yourself with which investors are also buying or selling the stock. Fund managers with large assets under management can have very different investment criteria and objectives than you and I do. They can also make mistakes like anyone else. 
• Forget the price you paid for the stock. The question you need to answer is, “Would you buy the stock today?” Anchoring is a powerful behavioral bias. To combat anchoring, write down your original thesis and periodically review it and update your assumptions. Has anything materially changed? 
• Even a solid research process can have a poor outcome. On average and over time, a good process should yield better results, but on a case-by-case basis this isn’t always true. Learn from the poor outcome and move onto the next investment.

10. Share Ideas
Harold Edgerton developed a number of ground breaking technologies, including high speed strobe, and ran one of the major labs at MIT. His motto was ""Work like hell, tell everyone everything you know, close a deal with a handshake, and have fun."

There are a lot of investment analysts out there, but not many share as much insight and tooling as Todd has. I suspect that like Shelby Davis observed years ago, there is a lot of value to the person sharing because it forces more rigorous thought. Virtuous cycle.

11. Process Matters
I think processes are unlikely to automagically turn up huge ideas, but what processes are very good at is mistake avoidance. That matters in any kind of investing, but mistake avoidance matters even more in dividend investing. If you are a biotech investor you know going in that you will flame out half the time, but you have some huge upside on the ones you are right on. In dividend investing, you are not going to see the huge upside this decade, so you have to stay in the game and avoid losers.

Todd's good process traits:

Stoic: It can endure both good and bad short-term outcomes without getting emotionally swayed in either direction.

Consistent: It doesn't adjust to current market sentiment and sticks to core competencies. 

Self-critical: The process is periodically reviewed, includes both pre-mortem and post-mortem analysis on decisions, and is refined as needed. 

Business-focused: Rather than rely on heuristics like "only buy stocks with P/Es below 15," a good investment process focuses on understanding things like the underlying business's competitive advantages (if any) and determining whether or not management has integrity and if they are good capital allocators.

Repeatable: A process gets more valuable with each application -- insights are gained, deficiencies are noticed, etc. 

Simple: The less complex, the better. If you can hand off your process to another investor without creating significant confusion, you're on the right track.

12. Simplicity and Patience Win
Processes are great at limiting errors, but what about finding excellent ideas? Search strategy should seek out different ideas. But what are we really searching for? The answers have less to do with advanced math and more to do with investor behavior:

Investment + good company + right price + patience

Without the investment, for instance, nothing else happens. I know this is obvious, but bear in mind that only about half of American households own stocks at all. Not everyone is taking that first step and planting the seed.

It's also a matter of where the seed is planted. Just as rocky soil wouldn't allow a tree to grow to its full potential, investments in poorly run companies will likely struggle over long periods of time. Instead, look to own good companies -- that is, firms with durable competitive advantages and strong financials that are run by able and trustworthy management teams. It's these companies that will give your investment the best chance to grow over the long-term.

Good companies should also be purchased at the right prices, of course, just as an apple tree needs to be planted in the right type of climate. As I noted in this post, an investment can be made in a good company and held patiently, but if it was bought at too dear of a price, it won't yield as much as the same company bought at a discount.

The final step is the trickiest one of all. Having the patience to hold a single investment for more than a few months isn't easy, let alone a few decades, yet you wouldn't tear down a tree for not producing bushels full of fruit right away, would you? It's only over longer periods of time that both yield great rewards."

As Todd is moving on to other things, I am glad I took the time to distill a lot of lessons I have learned from his work. I am also glad that even though he may not post as much, these are lessons that do not have an expiration date and so individual investors like me can leverage them for a long time down the road.

How to Lie with Statistics

This is a book that two of my favorite people report that they give as their holiday gift of choice. Bill Gates recommends it on his summer reading list. After finishing How to Lie with Statistics, I can see why.

Just on the craft part of writing, the book is a great example for how to communicate important but dry concepts in an engaging, entertaining way.

"Permitting statistical treatment and the hypnotic presence of numbers and decimal points to befog casual relationships is little better than superstition. And it is often more seriously misleading. It is rather like the conviction among the people of the New Hebrides that body lice produce good health. Observation over the centuries taught them that people in good health usually had lice and sick people very often did not. The observation itself was accurate and sound, as observations made informally over the years surprisingly often are. Not so much can be said for the conclusion to which these primitive people came to from their evidence: Lice makes a man healthy. Everybody should have them"

Huff's book is written in a tongue in cheek way as if the reader wants to use stats for a tool to fool other people, of course plenty of people do do this. It can be hard to tell the difference. The current age has so much data, but far less quality analysis and consequently we have very little information relative to data we are awash in.

"It's all a little like the tale of the roadside merchant who was asked to explain how he could sell rabbit sandwiches so cheap. 'Well' he said 'I have to put in some horse meat too. But I mix 'em fifty-fifty: one horse, one rabbit.'"

Anyone who has tried, say, Kona coffee and Kona coffee blend can relate to this. Statistical models are often wielded to distract from important points. As Sherlock Holmes said "there is nothing more deceptive than an obvious fact."

As to investing, we need look no further than dividend yield to see a great example of misleading stats. Once a yield gets too high, say triple the current S&P yield, you are generally in "sucker yield" territory. The company that says its going to payout 8% dividends today should not be taken at face value, and in fact it should be looked at as a negative, because once you look at the quality metrics you are likely to find the company will have a hard time delivering on that number.

The last chapter should be required reading for any citizen, frankly, as a self-defense mechanism in the so-called information age. Its a set of rules for how to talk back to a statistic, always ask:

• Who says so?
• How does he know?
• Did somebody change the subject?
• Does it make sense?

I might add to this list - how can you test this to see if the trend holds or not? The reason I see this book as required reading is that people with agendas are wont to throw out stats to prove their point, if you do not ask these questions you miss important points. 

I will give Mr. Huff the last word:

"Encephalitis cases reported in the central valley of California in 1952 were triple the figure for the worst previous year. Many alarmed residents shipped their children away. But when the reckoning was in, there had been no great increase in deaths from sleeping sickness. What had happened was that state and federal health people had come in in great numbers to tackle a long-time problem: as a result of their efforts a great many low-grade cases were recorded that in other years would have been overlooked, possibly not even recognized."

Markel Brunch Notes

I spend most of my time in investing looking for excellent dividend growth opportunities. However, there are two exceptions to this. One is Berkshire Hathaway, why should investors want a dividend from a company that has Warren and Charlie reinvesting the cash? The other exception is Markel.

I have been attending the Markel annual brunch in Omaha since about seven years ago. When I first started going, there were maybe 50-60 people in a small room like you might have for a regional sales meeting. Not so much any more, now its in the many hundreds.  The investing world seems to have caught on to what they are doing.

The meeting is the day after the Berkshire meeting in Omaha. Mohnish Pabrai mentioned that when he got started investing he was surprised that in an industry with thousands of funds, no one was copying Buffett and Berkshire. Likewise, Steve Markel, Tom Gayner, and the gang at Markel noticed that you could clone not just the investment approach, but the overall business model.

To recap, Berkshire is a three legged stool that starts with cash coming from insurance. Buffett really made his name by reinvesting the float intelligently into stocks (not just bonds like most insurers). The third leg is wholly owned businesses like See's Candy, Burlington Northern and many others, which now eclipse the stock part of Berkshire.

Markel has been successfully cloning the first two parts of this model for many years. The insurance operation regularly turns in excellent performance.  Over on the investment side, the past 15 years, Tom Gayner's stock portfolio has returned 11.3% versus the S&P 500's 4.2% performance. Really just those two legs of  the stool comprise a fundamentally quality operation. However, recently Markel has added the third leg - wholly owned businesses - through Markel Ventures. This collection of varied companies (everything from channel dredging to Belgian waffle makers) has been very interesting to watch unfold.  From the Annual Letter:

"From the start in 2005 when we purchased 80% of AMF with its roughly $60 million in revenue, Markel Ventures ended 2014 with revenues of $838.1 million and Adjusted EBITDA of $95.1 million. Markel Ventures now stands as a real, and meaningful contributor to the wealth creation underway at Markel Corporation.

Markel Ventures does two things for Markel. One, it gives us another option for capital allocation decisions. Secondly, it makes a bunch of money. As one frame of reference for that statement, consider Markel Corporation 10 short years ago. In 2004, we earned underwriting premiums of just over $2 billion and underwriting profits of $72 million. While the language used to describe underwriting profits from insurance operations, and cash flows from non-financial businesses, are different, it’s not that hard to translate. Underwriting earnings are generally comparable to Earnings Before Interest Expense, Taxes, Depreciation, and Amortization. They equal the acronym EBITDA. In 2014, the Adjusted EBITDA of Markel Ventures, which also excludes a non-cash goodwill impairment charge of $13.7 million, totaled $95.1 million. This stuff is starting to add up."

There is a more complete set of notes from the annual brunch meeting here, but I wanted to share my observations as well:

* The last question of the day was the best and most insightful. The question was - "what do you want Markel to become." Tom Gayner confirmed what I think a lot of long time Markel followers thought when he said - "we want Markel to be one of the world's great companies. That's what we want to be when we grow up." That's a heady statement and it was a great way to close out the meeting. When you step back from it, it makes sense. After all Markel has in place all three legs of the Berkshire model in place. Berkshire is indisputably one of the world's great companies. Now Markel's own snowball is rolling, why not aim high?

* Commenting on Markel Ventures, Steve Markel said that like Berkshire they want to buy well run businesses. They do not want to parachute in people to fix them. (Makes sense - Hard to imagine insurance people fixing a dredge or waffle making business)

* When Markel bought Alterra, they took on investments that were mainly in bonds. They are working their way towards more stocks, currently the combined portfolio is around 50% stocks, and could trend as high as 80% eventually

* You get a good sense for the culture at these events. Markel CEO Alan Kirshner says its ok to make mistakes, just don't make the same dumbass mistakes. Steve Markel described a key to Markel's strength as - "we don't believe our own bullshit." Steve Markel said that if you were the kind of person to sell off Markel shares when you got them to buy a boat, you probably wouldn't fit in.

* Incentives and metrics came up - Gayner pointed to Exxon's vesting policy which is spread out over ten years as a good model. He also said that rate of book value change is the "Least worst" way to measure management success in Markel's case.

In 2005, Markel's Book value per share was $176/share. Today it is more than triple that at $564. Considering the turbulence of the past decade, the three legged stool not only weathered the storms, Markel thrived.

Neil Woodford BBC Interview

Neil Woodford does not get covered all that much in the US, but there is a lot to like about his approach. Todd Wenning's excellent Income Investor Manifesto post really gets at the heart of the subtle yet crucial difference in the Income investor approach compared to value investing and growth investing schools.

Todd's post clarifies the strategic difference very well. I would add one other factor - its a far easier approach for investors aka humans, to use. A colleague whose work I admire set up his portfolio to invest in very boring, yet essential dividend growth companies. The companies performed well and he has beaten S&P for several years. But the true value revealed itself recently when sadly there was a major family event and he was unable to closely monitor his portfolio. Yet the companies plugged away just fine. This point is lost on a lot of people - there are many things way more important than investing. Your personal and work lives will intervene, and you will very often not have time or inclination to process random events. Tesla may be a great company, but do you want to have to dig through the car fire issues when work is crazy or a major personal event comes along?

In general, a simple hedge against all that is to go for patient quality. Find companies that do not require a twitchy sell finger, hovering over every monthly report, and are unlikely to produce a lot of unclear decision sets.

Woodford's fund just completed its first year, and it thumped the market with a 21% return. The old school ways still work. Its worth noting that US investors can easily clone Woodford's approach.

Recently, Woodford was interviewed on BBC HardTalk here are some snippets:

[Buffett says if you don’t feel comfortable owning something for ten years, then don’t even hold it for ten minutes] 

Woodford: I couldn’t agree more, that’s the right philosophy. My investment holding period in my old firm was way beyond ten years. It was as high as fifteen years at one stage…My discipline is to focus on the long term

[So that’s the enemy of faddishness in investing then, because if you are thinking in those 15-20 year chunks of time, then what is hot today is really irrelevant to what you are doing]

Woodford: Yes. And having a very clear discipline on valuation. Making sure you don’t overpay for an investment. I think there are plenty of very good companies that will make very bad investments because the valuation reflects that they’re very good companies. My philosophy is to marry a very strong investment discipline of focusing on valuation with that long term approach.

[Where are the best places to put money today?]

Woodford: 70% of the earnings of UK companies come from non-UK sources. So where the companies are located doesn’t necessarily guide you to where the earnings and cash flows accrue from. So you can get a very internationally exposed portfolio by just investing in the UK. So to some extent I think more about what are the industries and the companies rather than do want to be in emerging markets or Latin America or North America or Europe or whatever. That’s always been my approach.

--

Woodford points out one of the key risks in Income Investing - overpaying.To build on Todd Wenning's manifesto that distinguishes income investing from value and growth:

I suggest to add another row- Key Risk

• Value Investors
• Key Risk - Value Trap
• Income
• Key Risk - Overpaying for quality
• Growth
• Key Risks - insert litany...how much time do you have?  

This further illuminates the appeal of patient income investing. Plenty of things can go wrong with growth investments and you have to watch closely how events unfold to tell the difference between a hot new thing and a flash in the pan. Value investing is filled with companies that could turnaround but for different reasons never do. The key downside in Income investing - overpaying - is one of the easier risks to avoid in that the earnings and cash flow based valuations based against historical norms can give investors very useful clues.

The Key Skills required show some variation too. For Growth investors, its about trendspotting. For value investors its contrarian insight or variant perception. For Income Investors its largely buy quality, i.e. don't overpay, and then sit on your ass for long periods (decades) of time.

How Worried Are You?

A friend asked me this week, given that you hold stocks how worried are you about a crash or major correction? Charlie Munger was asked a similar question during 2009, and his answer came to mind - "zero."

There is good evidence why that's the case. For investors who are heavy into cyclicals, biotechs, nanotech, tech tech, and all manner of flavor of the month (Michael Kors is hot, oh wait its not), there probably should be some concern. After all, there are plenty of risky stocks. Does that mean "the market" is risky? I do not think so, at least for some corners of the market where defense is prized over offense. So to the evidence, here is the ten year dividend returns for the WMD portfolio members.

Do I think the prices in the stock market are overdue to pull back by a double digit percentage? Sure. I thought it was overdue last year, too. But we just saw a massive pullback in 08-09, which was smack in the middle of the chart above. You know what? Its pretty hard to spot the impact looking at the dividend returns from wide moat companies.

The ability to pay dividends through a crisis like 08-09 is in itself a margin of safety, it shows the company's cash flows are stable, and the cash is useful to an investor who may be able to reinvest it at better prices. Its not to say that investors should be smug, the going in proposition with this type of investing is avoiding mistakes after all, its not swinging for the fences. Will the markets pull back? Sure, but like Buffett says - predicting rain doesn't count, building arks does.  Wide moat dividend payers are as close to an ark that can weather 08-09 storm  as an investor can reasonably expect to find. The quality companies not only manage through but come back even stronger, because they can reinvest through the crisis and take advantage of bargain prices.

The Detective and the Investor

One of the first books I read when I started learning about investing was Robert Hastrom's "The Warren Buffett Way." Hagstrom is a writer who excels at seeing connections and finding patterns.

As a fan of detective stories in general and Holmes in particular, I was happy to uncover a Hagstrom book from 2002, called "The Detective and The Investor." Its out of print now, but easy to find copies on Amazon. If you like investing and detective novels then you will enjoy it, because Hagstrom finds a lot of common thought processes from great detectives  and investors.

There is a chapter dedicated to the specific techniques of the three main subjects that Hagstrom covers: Poe/Dupin, Conan Doyle/Holmes, and Chesterton/Father Brown. Each chapter then links what the investor can learn from the methods of the detective.

Hagstrom draws out the Habits of Mind from the great detectives:

• Auguste Dupin
• Develop a skeptic's mindset; don't automatically accept conventional wisdom
• Conduct a thorough investigation
• Sherlock Holmes
• Begin an investigation with an objective and unemotional viewpoint
• Pay attention to the tiniest of details
• Remain open minded to new, even contrary information
• Apply a process of logical reasoning to all you learn
• Father Brown
• Become a student of psychology
• Have faith in your intuition
• Seek alternative explanations and re-descriptions

Hagstom skillfully traces the evolution of the detective novel, which he says begins with Poe's Dupin. The book shows how each of the three detectives refined the craft of the detective and brings new methods to the table. Each of these prove useful to investors as well.

Dupin shows the value of plodding detective thorough investigation (Hagstrom calls this the document state of mind) when combined with the tenacity to dig out as many facts as possible. This is done both by confirming and disconfirming observations. The most talented, productive people that I have worked with are the ones who work the hardest at beating up their own ideas.

Holmes has many qualities of successful investors. To cite one example, Holmes works at determining the underlying factors of what appears as self-evident. Holmes says "There is nothing more deceptive than obvious fact." That quote immediately brings to mind Charlie Munger's - "every time you see the word EBITDA, you should substitute the word ‘bullshit’ earnings.”

In the Father Brown chapter, Hagstrom shows how Buffett's famous Coca Cola purchase occurred at a time in 1988 when Coke was selling at five times book value, a below average dividend yield and an above average P/E. Where was the buy signal? Yet Buffett found it, put in $1 Billion and it led to one of the best investments of his career. Though the raw numbers did not show it, Buffett, like Father Brown, saw that things are not always as they seem.

Its a unique book on two of my favorite topics, so its hard to have too many quibbles. Some of the analogies and linkages are a bit of a stretch, but that is unavoidable in this type of writing, and the main points that connect the analytical toolboxes are expertly linked. Chesterton's work went well beyond detective novels and it may have been interesting to hear more about his other work as a logician. But these are minor points, like licorice this book is not for everyone, but the people who like it will like it a lot. If this is the kind of book that you will like, you already know it by now. I think its a hidden gem.

Dividends Give Management Discipline and You a Seat at the Table

A quote from Stephen Chazen the CEO of Wide Moat Dividend portfolio holding Occidental Petroleum underscores an important attribute for dividend investors.

“I think dividends—if there is a religious activity here, I think that’s it. It provides discipline to the management. Otherwise you print shares, do all sorts of wealth-destructive things. The dividends give you discipline.”

Investors always want to know not just that they are buying a piece of a business, but that they as an outside investor have a seat at the table, a voice in the overall direction. At the same time, the companies need a mission statement. For a company like Facebook its about identifying leading technology trends which can justify the massive purchases like Oculus and Whatsapp.

For companies that prioritize dividends its far simpler - maintain and increase the dividend. So any use of cash by management must be judged by that yardstick. That means in turn that when management evaluates the numerous options that any company has, it has to clear the hurdle that it would be able to continue to pay its dividend and increase chance for dividend growth down the road. So outside investors are present, not in person but virtually, in any major capital allocation debates.

I am sure that outside investors factor in on some level to most companies, whether they pay dividend or not, however its not always clear where shareholders fit versus management growth plans, incentive schemes, or corporate flavor of the month. In the case of dividends, we outside investors get our own line item on the Cash Flow statement- Cash Dividends Paid. We're first class citizens not an afterthought.

That's no guarantee that the right decisions will be made and there could be some cases where dividend growth should be put on the back burner for some period of time (in my view GE's current restructuring is an example here). Still the fact that dividends paid to outside investors represent a line item every quarter, year over year, that is expected to maintain and grow, this fact represents a distinctly different type of company-investor relationship.

In the case of Occidental this has proven to be profitable. Given the oil price crash, Shell and Chevron both had to borrow to pay their dividend, and they both had to hold the dividend steady because they do not have the cash flow for dividend growth. On the other hand, this week Oxy managed to increase its dividend by 4%. Shell and Chevron are both engaged in behemoth efforts with BG and Gorgon respectively, the much smaller Oxy is going the opposite direction, selling off its assets in Middle East and North Africa, and instead transforming into a pure play on its best asset the Permian. For investors, simplicity and focus often trump grand plans, especially when the company's management uses dividends as a filter for ideas.

The Surprising Link Between Jeff Bezos and Neil Woodford and What It Means to Dividend Investors

On the surface it appears that Amazon and Jeff Bezos are worlds away from anything a dividend investor would care about. After all, Amazon struggles to even show earnings, much less pay a dividend. But remember the first rule of investing, you are buying a part of a business, and Bezos has built a formidable business.

Here's the killer business insight from Bezos that should be a hallmark for long term and dividend investors (emphasis added):

"I very frequently get the question: 'What's going to change in the next 10 years?' And that is a very interesting question; it's a very common one. I almost never get the question: 'What's not going to change in the next 10 years?' And I submit to you that that second question is actually the more important of the two -- because you can build a business strategy around the things that are stable in time. ... [I]n our retail business, we know that customers want low prices, and I know that's going to be true 10 years from now. They want fast delivery; they want vast selection. It's impossible to imagine a future 10 years from now where a customer comes up and says, 'Jeff I love Amazon; I just wish the prices were a little higher,' [or] 'I love Amazon; I just wish you'd deliver a little more slowly.' Impossible. And so the effort we put into those things, spinning those things up, we know the energy we put into it today will still be paying off dividends for our customers 10 years from now. When you have something that you know is true, even over the long term, you can afford to put a lot of energy into it."

So here we have from the most unlikely source, a true blue, original dotcom, that even today struggles to show earnings, worlds apart from the staid world of dividend investing, yet Jeff Bezos has nailed one of the single most important things to dividend investors - staying power.

After all, the stock market prizes current yield, and it is hard to get excited about current yield at 2.5-3% range for blue chips like Clorox, Coke or Pepsi. But at the same time, the stock market misprices long run dividend growth and its easy to get excited to invest in a business that can compound and quadruple their dividends a decade out. 

For that to happen, then the operative question becomes Bezos' - what will not change ten years out? Will consumers still want beverages, candy, and salty snacks? Will they prize convenience (delivered by global supply chains)? Will there be more stuff to clean? Will they respond to ads?

These kind of questions should factor into any style of investing, but I would suggest that they are more relevant for a dividend investor than any other type. Long term focus is a hallmark of successful value and growth investing, but they can do quite well by defining long term as 3-5 years, meanwhile dividend investors see the best payoffs then plus years out.  A five year dividend investment could look something like this - 3% starting yield with low double digit growth rate (good luck finding one of these today, this is just for illustration purposes). So at five years your 3% may be yielding 6% on cost. Not bad, but its much more interesting to see where it can go next, and can you get it into a double digit yield on cost territory? 

Someone like Mohnish Pabrai can find great value investments that have a good shot at doubling inside of five years. Dividend investors can likely approximate that if we simply look at yield. However since the starting yield is so low, the yield must double twice say 2.5% x 4 before things get interesting. But once they do get there, a 10% yield on cost in a business that with a wide moat is a snowball rolling down hill. That's about as good as it gets for a dividend investor. 

The key ingredient in that is not yield or even dividend growth rate, its finding what won't change. Morningstar's Heather Brilliant says it well - ""The persistence of excess returns is much, much more important than the magnitude of excess returns"

Utilities, long the core engine in dividend investors portfolios are perhaps the ultimate example here - hard to be more basic and essential than electricity and heat. Looking at one of the all time great dividend investors portfolio, Neil Woodford, what do we see? We can learn from what he does and what he doesn't.

Woodford famously avoids banks (perhaps what he sees is that what wont change is bankers' ability to blow up at least once a decade?). The main sectors in Woodford's portfolio all have one thing in common - sustainable, long run demand - Pharma, Consumer defensive, Utilities, and Defense/Industrials. These all lack glamour, but have clear long run demographics and reasons to think that the healthcare, electricity, and defense will be as relevant a decade on as they are now.

Judging by the amount of ADD in the world, smartphoness Tweets et al, I'd say long term orientation, itself, is likely to be as rare ten years from now as it is today. So to sum up, think like Jeff Bezos, invest like Neil Woodford.