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John Huber
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I am the portfolio manager at Saber Capital Management, LLC, a Registered Investment Advisor that manages equity portfolios for clients using the principles of value investing and capital preservation in Graham and Buffett tradition. I am also the author of www.basehitinvesting.com (BHI), a... More
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  • Charlie Munger Comments And The Art Of Stock Picking

    Charlie Munger is not only insightful, but he's an entertaining guy to listen to. These Munger comments below were compiled by Aznaur Midov from the annual meeting for Daily Journal Corporation, a company that Munger chairs.

    I just thought I'd highlight a few comments that I thought were interesting.

    Munger talked about moats a couple times during the meeting. The first time he recited a few examples of formerly great companies that had significant competitive advantages, but due to the nature of capitalism, eventually wound up bankrupt:

    "The perfect example of Darwinism is what technology has done to businesses. When someone takes their existing business and tries to transform it into something else-they fail. In technology that is often the case. Look at Kodak: it was the dominant imaging company in the world. They did fabulously during the great depression, but then wiped out the shareholders because of technological change. Look at General Motors, which was the most important company in the world when I was young. It wiped out its shareholders. How do you start as a dominant auto company in the world with the other two competitors not even close, and end up wiping out your shareholders? It's very Darwinian-it's tough out there. Technological change is one of the toughest things."

    Munger had this story when asked to identify a moat:

    Question: What is the least talked about or most misunderstood moat?

    Munger: You basically want me to explain to you a difficult subject of identifying moats. It reminds me of a story. One man came to Mozart and asked him how to write a symphony. Mozart replied, "You are too young to write a symphony." The man said, "You were writing symphonies when you were 10 years of age, and I am 21." Mozart said, "Yes, but I didn't run around asking people how to do it".

    This was an interesting response. Moats are all the rage these days among value investors-especially Munger and Buffett disciples (a group of which I consider myself a part of as well). This is for good reason-all things equal, we'd ideally prefer to own a company with a competitive advantage (a "moat"). The problem is that it's relatively easy to identify a company that is doing well. It's much harder to look into the future and determine if said company will continue to do well. The durability of moats is much harder to identify than the moat itself. And the durability is really what is most important, since most of the time the company that is doing well currently is often priced to reflect that.

    Thus, the other problem is valuation. Munger again:

    "Everyone has the idea of owning good companies. The problem is that they have high prices in relations to assets and earnings, and that takes all of the fun out of the game. If all you needed to do is to figure out what company is better than others, everyone would make a lot of money. But that is not the case. They keep raising the prices to the point when the odds change. I always knew that, but they were teaching my colleagues that the market is so efficient that no one can beat it. I knew people in Omaha who beat the pari-mutuel system. I never went near a business school, so my mind wasn't polluted by this craziness. People are trying to be smart-all I am trying to do is not to be idiotic, but it's harder than most people think."

    Munger's comment above reminded me of the comment that he made years ago in a speech in California. In this lecture, Munger points out how important it is to think in decision trees and simple probability. He references theconcepts of two 17th century mathematicians: Pierre de Fermat and Blaise Pascal.

    In the summer of 1654, one of Pascal's friends-a gambler who was smart, but consistently lost money-came to Pascal asking for help with why he consistently lost money. This problem was interesting for Pascal, and a series of letters ensued that summer between Pascal and another mathematician, Fermat. By the end of the summer, these casual letters ended up proving to be a linchpin in the fundamentals of modern day probability.

    Munger didn't get into detail of this in his talk, but he did state how important the concept of thinking probabilistically is. And he even attributed this skill as one of the reasons for Buffett's success:

    "One of the advantages of a fellow like Buffett, whom I've worked with all these years, is that he automatically thinks in terms of decision trees and the elementary math of permutations and combinations…"

    But the main point of bringing up a couple of 400 year old mathematicians was to describe how the pari-mutuel system works:

    "Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position, etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it's not clear which is statistically the best bet using the mathematics of Fermat and Pascal."

    So the pari-mutuel system that is the stock market is fairly good at leveling the playing field between the high quality stallions and the broken down nags. Munger says a railroad company at 1/3rd of book value might not necessarily be as attractive a value as IBM at 6 times book value. Of course, it's not perfectly efficient, and sometimes the nags provide more value relative to the price you can buy them for, other times the stallions do.

    Reducing the Probability for Error

    I think the stallions (the good businesses) often prove to be the lowest risk, highest probability outcomes, but this is not always the case. I've always thought generally speaking-most investment mistakes are made because an error was made evaluating the business as opposed to an error based on the valuation given the current state of the business. Of course, you could argue that a bad business (or one that gets progressively bad) turned out to be overvalued. But I'm just referring to the idea that very few serious investment mistakes come from buying great businesses at too high prices. Sometimes this happens-like buying Coke in 1998 or Microsoft in 2000. Business results at both of those companies continued to be good, but the stocks performed poorly. But usually, this type of mistake (while still a mistake) means mediocre results going forward, and not necessarily significant loss of capital. The big losses tend to come from being wrong about the business.

    So I find I spend a lot of time trying to reduce errors, and this leads me to preferring high quality businesses. And Munger and Buffett have obviously proved the merit of this idea over time. As Munger said in that same lecture:

    "And so having started out as Grahamites-which, by the way, worked fine-we gradually got what I would call better insights. And we realized that some company that was selling at 2 or 3 times book value could still be a hell of a bargain because of momentums implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual…"

    So moats are important, valuation is crucial, but thinking in terms of probability is also very important. Evaluating what Walmart will look like in 10 years will probably lead to a more predictable outcome than evaluating Facebook (note: more predictable, not necessarily better). There are no sure things, but there are probabilities, and the probabilities-unlike card games or dice-are dynamic and ever changing. It's not an exact science.

    What you're trying to do is locate what Munger calls the "easy decisions". The low risk, high probability bets. Sometimes those come from the best companies in the world with significant advantages, other times they come from off the beaten path-companies that are involved with some sort of special situation that might not have these sought after moats, but nonetheless offer significant value and low risk of permanent capital impairment.

    I think what Munger is really saying-if I can be so bold to put words in his mouth-is that identifying moats is not a science, and it's not easy to describe to someone who is asking about them. (After all, the quote above is from a speech called "The Art of Stock Picking"). Each situation is different and each company has its own set of circumstances. Despite how much we'd like to boil this down into a checklist and a simple box checking exercise, investing just doesn't work that way. It takes a lot of preparation to put yourself in the position to identify these low risk, high probability investments, and it also takes a lot of patience and discipline to wait for them in the meantime when they aren't available.

    Munger succinctly summarizes this point when he was asked at the meeting "what system do you use to identify great investments?"

    "We tend to look for the easy decisions, but we find it very hard to find "easy decisions". We found just barely enough and they had their own problems. So, I don't have a system."

    It is certainly a lot harder for Munger than the rest of us. He is 91, he's a billionaire, and he unfortunately has far fewer investment opportunities than most of us.

    But his experience is relevant, and we can take away certain aspects of his investment philosophy as we hunt for our own bargains.

    Apr 28 5:21 PM | Link | Comment!
  • Some Thoughts On The Berkshire Hathaway Annual Meeting

    I had a great time in Omaha this past weekend. I got to meet with a couple clients, reconnect with some like-minded value investors, and meet some new friends as well. And of course, being in the same building with two of the greatest investment minds in history is something special.

    I wanted to make just a few comments on a couple things in my notes from the weekend. This is by no means a comprehensive summary-and there are many things of value that I'll leave out. The post would be too long to cover everything I found interesting. So these are just a very select few things I thought I'd comment on as I was reviewing my notes this morning.

    (Please note: When I am using quotes for Buffett and Munger comments-these are quotes from my notes as I was feverishly writing on scores of notebook pages all day. The quotes capture the gist of the topic and I believe they are mostly accurate, but may not be exactly verbatim at all times.)

    On "Cost of Capital"

    "I've never heard an intelligent discussion on cost of capital." - Munger

    This was an interesting discussion. And it also contained some classic Munger one-liners.

    Both Buffett and Munger agreed that the term "cost of capital" is an abstract concept that is often used by CEO's and CFO's to justify investments or acquisitions (i.e. "We think this is "accretive" because the returns exceed our "cost of capital"). Buffett said he has sat in on thousands of these types of discussions where "the CEO has no idea what his cost of capital is" and "I don't have any idea of what his cost of capital is either".

    Buffett and Munger had a much better way to view cost of capital that I thought was much simpler.

    "Cost of capital is what could be produced by our 2nd best idea and our best idea has to beat it".

    Buffett went on to say that the "deal test is whether $1 we retain produces more than $1 in market value… not 'cost of capital'".

    Classic Munger: "Cost of capital is stupid." He went on to say that Warren's test is the best way to view capital allocation and reinvestment opportunities within a business. "It's simple: We're right and they're wrong".

    We've heard Buffett discuss this "$1 of value for $1 of retained earnings" test plenty of times, but it really helps to hear its common sense logic reiterated. Buffett said that they are "always thinking in terms of opportunity costs". Thinking in this manner, rather than some model that can be manipulated in a spreadsheet, is a much more productive way to analyze investment opportunities within a business.

    Munger once used this idea when referring to stock investments in general. He basically said that whenever they were looking at a stock, he would compare it to Wells Fargo. His thought process was: if it's not a better value than Wells Fargo, then just buy more Wells Fargo.

    I personally view "cost of capital" as similar to DCF models. They both use numbers that appear to be provide precise and accurate information but in reality can be easily manipulated to achieve the desired result.

    Takeaway here: Set up a simple decision tree. Think in terms of simple opportunity costs. Look at whether a business is producing more than $1 of market value for every $1 retained-don't use "cost of capital".

    See's Candies

    "See's main contribution to Berkshire was ignorance removal." - Munger

    I don't recall the specific question, but Buffett and Munger began talking about the early days of their investment philosophy evolution-specifically their newfound and developing interest in quality businesses that could produce high returns on capital and consistent free cash flow.

    Munger said that "we were pretty stupid when we bought See's" and in fact "we were just barely smart enough to buy it". He is bluntly describing how they were willing to nearly walk away from See's because of their unwillingness to pay up for the business. They of course did pay up (although from my calculations still were still buying it for a pretty low earnings multiple), and more importantly, they began learning about the power of this type of business (one that produces much more cash than is needed and one that can grow without sizable investments).

    "I always understood brands, but there is nothing like owning one." - Buffett

    Munger said that if they didn't buy See's, there is a very good chance that they never would have bought Coke a decade and a half later. This demonstrates the power of compound knowledge. At first they had no interest in paying what seemed to be a premium for franchise businesses, but Munger convinced Buffett to buy See's, and in the process of owning that investment they almost serendipitously discovered the power of a business model like See's.

    Munger describes this process as "ignorance removal". It allowed them to remove their rigid focus on metrics and begin to view value in a much more comprehensive way, paving the way some of Berkshire's most significant home runs and-perhaps more importantly-presumably reducing many would-be errors of commission.

    On Circle of Competence

    "If you just keep learning things, eventually something will work." - Buffett

    This was a classic Buffett teaching moment. He basically said that to develop a circle of competence he would do the same thing that he did when he was 23. He said he would look at lots of companies to learn about them.

    He said that if he wanted to learn something about the coal industry, he would go around and talk to 8 or 9 coal executives, and ask them about their business models and their competitors. He implied that one can achieve an enormous amount of knowledge by talking to management and people who understand the industry better than you do.

    On Intrinsic Value

    "A bird in the hand is worth two in the bush".

    I had a reader ask me to define intrinsic value last week. I'll let Buffett define it here, as he does in Berkshire'sowner's manual:

    "Intrinsic value is the present value of all cash that will be distributed from now until judgment day".

    We hear that definition a lot. Buffett said that intrinsic value has really become equated to the value that a private business value. It's a relatively simple concept-how much cash will an owner receive from the business in the future? What is the present value of that future cash?

    We are trying to determine: Are the two birds in the bush (future cash flow) worth more than the bird in the hand (the cash required to buy the business)?

    He said that Graham would have focused on more quantitative aspects of a company to determine the future cash that could be withdrawn from the business. Conversely, Phil Fisher would have focused on more qualitative aspects to determine the same thing. He basically said that the objective is to lay out money now to receive more money back later. "That's the point of a business". Put cash in, get cash out. He said that Ben Graham and Phil Fisher would agree that the value of a business is based on this "cash in-cash out" idea.

    He also implied that determining intrinsic value is an art form. He said that if he and Charlie were to write down their intrinsic value estimate of Berkshire, they would probably be within 5% but wouldn't be within 1% of each other.

    On Conglomerates and General Investments

    "It's not a bad business plan to own a bunch of great businesses."

    The question was related to conglomerates but Buffett and Munger used it as a way to espouse some of their general wisdom on investing in general.

    They started by saying that most conglomerates fail because of financial engineering (issuing stock at 20x to buy at 10x-Buffett likened this process to a chain letter). This practice doesn't create long term value. The key is to buy great businesses and focus on earning power, not engage in financial engineering.

    Keys to successful conglomerates:

    • Common sense business principles
    • Good capital allocation
    • Focus on earning power, not stock promotion (issuing stock to make investments)

    Buffett said that "our goal is to buy really good businesses that can grow over time and that have great managers".

    Charlie added that there are two main differences between Berkshire and the failed conglomerates:

    • We can buy stocks
    • We don't feel the need to always be doing something

    This last point is underrated. Berkshire doesn't have to deal with limited partners who have expiring lock up periods (thus demanding shorter term results). They can sit on piles of cash as long as they want and wait for the proverbial "fat pitch". This is incredibly valuable when things become distressed.

    On Identifying Winning Businesses in "Disruptive" Times:

    • "We stick to businesses where we can identify the winners". Buffett discussed his classic and simple idea that he likes to look for businesses where he can imagine the earnings being much higher 10 years from now.
    • He and Munger try to stick to businesses that have slow changing characteristics (likely will be providing the same basic product or service in 10 years that they are currently providing). He mentions that all businesses go through changes, but he tries to invest in ones where change is happening slowly and over time.

    Final Thought

    There were many other interesting topics broached during the 6 hour Q&A session. One book I added to my ever growing Amazon wish list is Dream Big by Cristiane Correa, which is about Jorge Paulo Lemann and 3G Capital, the firm Berkshire partnered with to buy Heinz. Buffett spoke very highly (and very often) on Saturday about 3G and how he believes they are incredibly talented managers.

    As I continue perusing my notes, there are many other thoughts, but they'll have to be reserved for future posts.

    Have a great week!

    May 06 1:17 PM | Link | 6 Comments
  • An Exercise On Thinking Differently And A Great Business

    I came across an excellent presentation that I wanted to share because it sparked some thoughts. It is not about a current-or even prospective-investment, but one that exemplifies the art of thinking differently.

    I spend a fair amount of time reading annual reports about businesses that I have no intention of owning. Typically, these businesses are high quality companies that-although maybe too expensive to offer attractive investor returns-are great entities to study and learn about. Studying businesses that have a history of compounding their value (and their owner's equity) over time can help you develop a blueprint of sorts-things to look for in an effort to find such businesses when they are more attractively priced, smaller, or otherwise more unknown.

    Quality Business Characteristics

    A friend and I were discussing some of the ideal things we like in businesses. Valuations aside, we all like high ROIC, ample reinvestment opportunities, great management, etc… When thinking about what I like in a business, I always start with simple business models. I like toll bridges. I like parking garages in attractive downtown locations. I just was reading about a business I like that is the largest provider of ATM machines and other point-of-sale products (and the recurring revenue associated with many of these products) for restaurants, retailers, and convenient stores. I like simple models. It's easy to understand why these businesses are profitable, sustainable, and predictable.

    Those are nice businesses to own. The owner of a strategically located parking garage will do quite well over time. One thing I want to mention in more detail-maybe the next post-is pricing power, something Buffett called "the single most important" aspect of a business. Even though the parking garage owner might have limited reinvestment options for his sizable cash flow, he does possess pricing power.

    At the top of the post, I mentioned I like to read about great businesses and great business models-even if they are stocks that I really have no intention of owning. Amazon is one of these businesses. (Don't leave, keep reading).

    Much to Learn from AMZN's Model

    It is now 13-f time, and I always enjoy reading through what other respected value investors are doing. About this time last quarter when I was reading through my 13-f list, I was quite surprised to see Amazon listed as one of Tom Gayner's stocks that he was buying. He actually began buying it about a year ago, and has purchased very small amounts each quarter since. It's a tiny position, but regardless of the size, I was surprised to see AMZN enter his portfolio. So I casually began thinking about it here and there, perusing through annual reports. I actually really enjoy reading the AMZN reports, and would encourage investors to check them out.

    The stock isn't cheap, but the business model can teach us a lot about the importance of scale, efficiency, pricing power, capital allocation, and great management with ownership mentalities and long term horizons.

    Of course, it is with great trepidation that I reference Amazon on these pages here at BHI, as it perennially trades at ungodly prices when using traditional value metrics that most of us look at. But fear not, I don't own Amazon, and I don't necessarily intend to-although I'm always aware of one of Ben Graham's famous quotes which I'll paraphrase: "For almost every business, there is a price at which it could be purchased, and a completely different price at which it should be sold."

    Good, if Not Cheap

    So certainly at some price, I'd love to own Amazon, as it is-in my opinion-one of the greatest companies in existence. But the purpose today is to share some brief thoughts on a specific aspect of Amazon's quality that is important-namely an owner operator that thinks and acts for the long term benefit of owners. My thoughts on AMZN today were sparked by an excellent presentation I came across over the weekend by Josh Tarasoff of Greenlea Lane, a value investor who happens to own this forbidden fruit.

    My reaction to seeing a recommendation for AMZN at a value investing conference is similar to when I noticed it in Gayner's portfolio. I was surprised. But nevertheless, it rekindled my energy to begin paging through some of the old AMZN annual reports again.

    Every value investor knows Amazon's P/E is in the stratosphere. Some investors have made the case that their high P/E is actually inflated due to the massive amounts of expenses they incur-all in the name of "future revenue". My very general interpretation is that Amazon is basically advancing expenses-paid for with current cash flow-that would normally be reserved for next year, or 2016, or beyond. They are incurring these "future" expenses today in an effort to expedite their already incredible revenue growth, building out massive infrastructure that will support even greater sales volumes.

    At some point, this will stop and the expenses will slow down to match revenues, and the real (i.e. normal) cash flow will rear its pleasant head, and the multiples will come crashing down (or maybe the stock will continue rising). I really have no idea when this occurs, but reading through the 10-K's, and studying this business, I do believe this is part of what's happening there. Amazon is actually understating their true earning power-which is the opposite of what often occurs in the more common situation among the more GAAP-conscious, Wall Street pleasing managers.

    The Importance of Long Term Oriented Managers

    As I said, I really enjoy reading the reports. Bezos makes it clear that he is an owner minded manager with a long term horizon. He has no interest in what Wall Street says or thinks, and he is completely focused on generating long term shareholder value. To borrow a quote from the presenation, which can also be found in Bezos' 1997 shareholder letter,

    "When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we'll take the cash flows."

    This is one of my favorite new quotes, and it would behoove shareholders of every company if their managers would post this quote on their office wall, internalize it, and implement the corresponding behavior. It's kind of the anti-activist style of "profit now, ask questions later".

    By the way, despite the fact that many of these noisy activist investors are successful in driving stock prices higher in the short term through massive cost cuts and buybacks, I'm very unconvinced of how much true value they are adding for long term owners.

    Bezos runs AMZN like it's his family business that he intends to own for generations, without a care toward what outside judges think of his short term performance.

    Regardless of whether AMZN is ridiculously expensive or not, I think studying the business and reading the annual reports really help create a blueprint for what kind of manager we'd ideally like to partner with as shareholders.

    Long Term Orientation Plus Favorable Economics Means Growing Owner's Value

    Of course, long term thinking on its own means nothing if not combined with advantageous economics. And Amazon also has plenty of those. They basically beat every other retailer because they can afford to operate with the lowest markups and the slimmest of margins. Basically, their incredible economies of scale means they can spread their costs across an ever growing number of customers, which translates into lower prices, which begets more customers, creating even greater scale, and the cycle continues, etc…

    Their business model is interesting, and I might write another post or two on some things I've picked up fromreading through the old reports. I was recently inspired this weekend after reading Josh's presentation, which was excellent. Josh also has some absolutely brilliant things to say regarding pricing power, which got me thinking, and might make a nice summary post on its own.

    Beware of Your Biases

    As an aside: Consider your internal reaction when you first saw that I was talking about Amazon. Maybe you had no reaction… but lots of value investors have an immediate negative reaction because of the high valuation. I used to have this same reaction whenever I came across something on Amazon. But seeing Gayner buying it made me open up my mind and begin to approach it with curiosity, which is a much better mindset for learning. The closed-mindedness that many exhibit with AMZN prevents the brain from being able to consider facts in an unbiased way, and thus stunts the development that can take place by studying a model as successful as Amazon's.

    Again, I really have no opinion on the stock, and like many value investors, I also find that even after adjusting expenses to try and estimate normal earning power, it still seems that a lot of future growth is built into the current price. I am unsure if this future has been properly discounted or not, but regardless of AMZN's value or lack thereof, I've enjoyed occasionally reading about the company and I thought Josh's presentation did a great job at succinctly summarizing most of AMZN's strengths.

    I may or may not ever own the stock, but I'm happy to continue reading the reports as they come out each year if nothing else.

    Here's some relevant links:

    Tags: AMZN
    Mar 03 12:28 PM | Link | Comment!
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