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?