“Ignorant men raise questions that wise men answered a thousand years ago.”
- Johann Wolfgang von Goethe
“The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long-term prospects and to those only.” - John Maynard Keynes
The quote above is from an article we recently read here which does a great job illustrating the current investment horizon of a majority of participants in the market. According to the study below, the current time a person holds a stock before selling is 1.67 years!!The article talks about the shortening time horizon of today’s investor and some of the causes of this anomaly. We’ll highlight 2 of the reasons why investors are now more prone to shorter time horizons and how a long-term horizon provides better results over time.
Institutional money managers are incentivized and forced to have a short-term horizon. Most managers have a majority of their compensation based on yearly performance and much less for long-term performance. That is not all though. Since most of the smaller individual investors invest their money in mutual funds, then funds are at the mercy of the supply and demand of the constituent investors. If overall results over the short-term are below average, then investors will pull their money out of the mutual fund. Fund redemptions will then lead to selling of investment positions. Also, many small investors chase returns and will use a fund’s previous performance as a reason to invest in a fund. If managers are able to produce above average returns over the short-term, then it is likely that they will receive more investors which then means more assets under management and more revenues. It is not any surprise that with these incentives institutional money managers are highly reliant on their short-term track record.
Small investors and institutional investors also use analysis on specific companies that are produced by sell-side analysts who are also short-term minded as well. These analysts work for firms that benefit from the extra revenue produced from constant trading, so they will provide analysis based on earnings over the next year and rarely for periods three years and beyond. Sell-side analysts could have a higher chance of getting fired if they are wrong in their earning projections, so they tend to follow other analyst projections who are also short-sighted. It is highly unlikely that sell-side analysts would change to a long-term mindset anytime in the future.
Company management teams are also generally incentivized to meet short-term goals with their stock options, so they invest their company’s internally generated cash into short-term projects while avoiding projects that benefit the long-term. By focusing on the short-term, they please Wall Street and investors who focus on the short-term. There are a small sub-set of companies with management teams that do actually have a long-term horizon because they have a sizable personal ownership of the company and many other factors. We tend to focus on these companies because the business has a better chance of producing superior performance over the long-term.
With all the focus on the short-term that means that there are opportunities for long-term investors, such as ourselves, to buy companies for fair prices and realize above average returns over the long-term. Although we are not directly incentivized per se on long-term performance with our client accounts, we are indirectly incentivized for long-term performance. First, it is our fiduciary duty to all clients to achieve the best returns over the long-term. Second, our long-term performance will lead to higher assets under management which we do get a fixed percent on. So, the greater we can grow client investments, the more money we make. We also want to differentiate our long-term performance from others with superior long-term performance. We would not be able to produce high long-term returns if we bought and sold many times incurring taxes and trading fees. We choose to defer taxes and keep trading fees low, so longer term investment periods help us achieve those goals. There is also a small supply of quality companies selling for attractive prices. It would be difficult for us to constantly find those opportunities many, many times over many years.
2. Media and Financial Reporting
Access to financial information and investment opinions has grown greatly since the advent of the internet and growth of social networking. We might expect that the extra information would lead to a market that is more efficient where prices are more accurate, however, the more information has led to more noise. The extra information could be a very great driver of the shorter term horizons. As the article highlighted, “the focus is often on short-term trading activity in reaction to market noise, i.e., what other market participants are thinking, rather than on making investment decisions based on the fundamental longer-term value of an enterprise.” Such short-term news and coverage by the media might actually lead to panic selling and could offer long-term investors opportunities to find attractively priced assets.
We have to remember that the media is incentivized on the number of eyeballs that read their reports, articles or research. The only problem is that companies rarely change dramatically in a short period of time that would indicate that it would be a time to sell. Our goal as investors is then to separate the noise, which is a majority of what we hear, with the information that could really make an impact on our long-term investment. Our investment process is designed to make us focus on the very large signals and to tune out the noise.
Since a majority of the investing public, even institutional investors, are highly reliant on meeting short-term results, they lose sight on the long-term. Investing is a long-term activity that takes patience and discipline, which is rarely found today. Companies rarely change significantly over the short-term, so all the noise from the media is useless for long-term investors. We ascribe to John Maynard Keynes’s belief that an investor would be better off in the long-term if they treated their investment purchases as they would a marriage; “permanent and indissoluble except by reason of death or other grave causes.” By doing so, we focus on the long-term characteristics of the company and have a better chance of choosing and sticking with companies that help us produce superior returns over the long-term.
Based on demand we have reinstated our newsletter and have the next installment available. For those that are not familiar, our first newsletter dug into the business economics and moat around Platform Specialty Products. Although our investment ideas are for the long-term, since our original issue on February 13th, PAH’s share price has increased 24% and the company annouced a significantly accretive acquisition.
Our new issue goes over the following:
Many of us succumb to habits that actually have a large effect on our investment process and lead to our long-term investment returns. These habits tend to not add value, but we continue to do them. We feel there has been little written on bad investment habits and how to modify them, so this newsletter focuses on how to identify and modify those useless habits. We also describe ways to apply discipline to our investment process to become better investors. These ideas can be applied to many other aspects of one’s life which could improve your quality of life as well.
Our in-depth company analysis digs into a foreign company that we consider as a hidden champion that has been slowly chugging away, year after year, keeping up with the changes, surviving and profiting. This company is the market leader of an industry that has been around for hundreds of years and is unlikely to change much in the next decade. The company is trading at a fair price while the overall industry is on the cusp of further growth. The company also benefits from an owner operator that has performed well over decades and has only the long-term in mind.
If you are interested in getting your hands on this newsletter you can either contact us or click here.
I remember reading Graham & Dodd’s Security Analysis years ago and learning a great deal from the book. My only gripe I had was not having access to the annual reports of the companies that Graham mentions in his examples. This isn’t a negative against the book, but I knew I was not getting the full effect of the lessons he was teaching without having access to the reports he was referring to. I’m sure other investors who have read the book probably have felt the same way.
Since I have found sources that do have some of these historic annual reports, I think it would be beneficial for us to check some of them out to add some color to the examples that Benjamin Graham brought up Securities Analysis.
The first example I’d like to examine in Wright Aeronautical Corporation which Benjamin Graham made a mention of while making a point about analytical judgments on the stock market’s behavior.
“Let us take an example from the field of common stocks. In 1922, prior to the boom in aviation securities, Wright Aeronautical Corporation stock was selling on the New York Stock Exchange at only $8, although it was paying a $1 dividend, had for some time been earning over $2 a share, and showed more than $8 per share in cash assets in the treasury. In this case analysis would readily have established that the intrinsic value of the issue was substantially above the market price.”
Are we missing something else here? Rarely do stocks trade for such discounts without some problem or looming uncertainty. Of course, back in the early 20′s the stock market was inefficient, but there must be other problems the company was going through.
In 1921 Wright Aeronautical Corporation had produced $2.4 million in income from contracts with the War and Navy Department of the United States, had $2 million in backlogged orders, but Graham did not point out a few large uncertainties that could have led to a depressed stock price. The War Department had recommended to the Department of Justice that a suit should be brought against Wright to recover $4.7 million in alleged overpayments which it publicly announced on Jan 26th. The War Department had with held $1.18 million in payments connected to the allegation, but Wright and their counsel argued that the allegations were false and that the $1.18 million with held from them should be paid back. By the time the annual report for 1922 was issued there still had not been a proceeding. The market must have been extremely pessimistic about a potential lawsuit and rightfully so since a $3.52 million payment would have eaten up the company’s $1.1 million in cash and marketable securities while causing the company to take on significant debt. Of course Graham’s point is still clear that the market was over reacting to the potential lawsuit.
The other uncertainty, as Benjamin Graham pointed out, was that the aviation industry was in its infancy and the market, and the world, had yet to experience the true potential of aviation in war and in commercial applications. The 1921 annual report stated that the aviation industry was slowly growing. The Air Services of the US Army had been experimenting with dropping bombs from planes, but using planes for such functions still looked to be far in the distant future. Commercial aviation projects at the time were also benefiting from the excess surplus stock piles from the Army and Navy, so an investor in 1922 could have also been turned off by the short term prospects of Wright Aeronautical.
Even with these uncertainties, for $8 a share the intrinsic value of Wright Aeronautical Company was much higher.
He then goes on to say:
“Again, consider the same issue in 1928 when it had advanced to $280 per share. It was then earning at the rate of $8 per share, as against $3.77 in 1927. The dividend rate was $2; the net-asset value was less than $50 per share. A study of this picture must have shown conclusively that the market price represented for the most part the capitalization of entirely conjectural future prospects – in other words, that the intrinsic value was far less than the market quotation.”
Let us get some more color on why the market was so exuberant with Wright Aeronautical in 1928.
The aviation industry was booming from commercial and Government demand. Wright’s development of an air-cooled engine cracked the safety and reliability problems that aircraft engines had with water cooled engines which were inhibiting the success and wide spread use of airplanes. By 1928, demand for Wright engines was extremely high and did not have a large potential lawsuit on their hands like in 1922. Demand was so high that Wright had to significantly increase their manufacturing capacity to meet with the demand. The company increased their fixed assets by roughly $4 million or 224% financed by selling 50,000 shares @ $100.
In 1927, 250,000 shares were outstanding which equated to $3.77 per share, so that means that the $8 a share the company earned in 1928 was with 20% more shares outstanding compared to 1927. So, Benjamin Graham’s example only shows that Wright Aeronautical’s earnings rose 116% while in actuality earnings rose by 160%. A quick reverse DCF calculation on the $8 in earnings shows that the market was expecting 24.6% compounded growth over the next 10 years with a 15% discount rate. Remember the stock market was booming and the Dow had risen from 150 to 300 in 1928, so Wright Aeronautical’s price surely reflected the irrational exuberance of the market.
Benjamin Graham’s above example is a perfect illustration of how Mr. Market’s mood can greatly swing in either direction with the same company at different times and how investors should view the situation. The market generally has a reason for these moods swings which usually get in the way of people’s judgment. Reading Graham’s examples without the background of the company seems like the analysis is simple and easy, yet standing in the shoes of an investor during the time shows that other unknowns and possibilities could have clouded an investors judgment. Investors stand a better chance if they use more analytical judgments. I feel the more we look back at the past, the more we can learn.
What are long term investors interested in? For me, I’m interested in finding companies that can compound returns and maintain high profit margins well into the future. Lumpy returns are not bad, nor are small obscure companies, but the main idea is to find companies that can sustain and grow their profits. I want companies that can take on competition and evolve. Such characteristics will allow a company to compound it’s capital, which will equal compounded returns for investors that hold on for the long-term. I’m willing to buy these companies for a fair price or whenever possible for much lower than a fair price. If price is not such a big issue, then quality is extremely important. Having an ability to distinguish quality gives us an edge over other investors who are either too numbers oriented or focused on the short term. How do we measure quality? What wisdom can we draw on?
Warren Buffett likes to compare a business’ competitive advantage with a moat that would defend a medieval castle from intruders. Several things like patents, brands and other barriers can provide a defense for companies allowing them to sustain their competitive position and profits, which would equal a moat. Buffett has said that he likes to find companies with a very large moat with extra defenses such as piranhas and crocodiles to keep intruders at bay. I think that this analogy is wonderful and has helped many investors mentally conceptualize some hard to define qualitative characteristics of great companies, but I think another analogy might enhance our perception of a businesses’ competitive advantage. Businesses need to evolve to compete and sustain their advantages well into the future. We can imagine that a moat around a castle could shrink, grow, have ferocious animals added to it or disappear altogether. In reality, a moat around a castle rarely evolved in size and the castle the moat protected rarely changed in size either. Of course castles and moats are obsolete these days. For me it is hard to analogize an inanimate castle and its moat with a living growing company and its ability to defend itself from competition.
An analogy that could better help investors conceptualize a companies’ competitive advantages, while also helping us keep in mind that evolution is needed for survival, would be to look at nature. To me a business is more like a living organism that grows and evolves. When I say organism, I’m referring to the species of an organism and its survival over time. Not all species are able to survive for significant periods of time while some can. A number of different factors might lead to a species’ extinction such as competition with a “better” fit species or the environment changed and the species was unable to adapt. The species that are able to survive for significant periods of time are able to evolve and adapt to changes in their competition and their environments. Companies also need to compete successfully with other companies to ensure their survival. Those companies also have to be able to adapt and evolve with the changes in their industries and the environments that they compete. In nature, as well as in markets, the main theme is survival of the fittest. Long-term investors can benefit from the study which species have been able to survive for long durations of time as well as those that quickly became extinct.
First, before we get further into our discussion let’s imagine mother nature made a bet with you. Mother nature says that she can predict which species is more likely to survive and adapt another million years and believes that you cannot. The stakes are high because if you are right, then mother nature will make sure your future children will be taken care of. If you are wrong, then mother nature will see it that they have difficulties.
What species come to mind? What qualities would you look for? Would you look for the smartest, fastest, strongest or laziest species? Those qualities do not necessarily ensure an organism’s ability to survive. To give an example just imagine what it would have been like when Tyrannosaurus evolved into their 40 foot high frames. They were large, ferocious and did not have a predator. They dominated their era on earth and survival of the entire species probably seemed inevitable. Thankfully, for us homo sapiens it did not play out that way. We can walk down the street and not worry that we will run into a Tyrannosaurus. So, the Tyrannosauruses of today might not make it another million years. On the flip side, who would have guessed that the slender, small homo sapien would be the most dominant force in the world 195,000 years ago. If we were to draw a comparison with businesses like this today maybe Facebook and Twitter would come to mind. They seem like the are dominating the social media world today, but will they?
Currently, the longest surviving species that is known is the Horseshoe Crab which has been able to survive for nearly a half billion years or approximately 445 million years according to current archeological records. This is an extreme feat of accomplishment since multicellular animals first appeared in our current fossil record about 600 million years ago. Surely it would be beneficial if we could find companies that could adapt and survive like the Horseshoe Crab has.
So what are the characteristics that have allowed the horseshoe crab to thrive while the Tyrannosaurus has gone extinct? The Horseshoe Crab is an organism that has interesting characteristics that are not found in other species and we feel might be some of the reasons the species has survived so long without much need to evolve. The Horseshoe Crab is nearly identical to its ancestors that date back not millions but hundreds of millions of years ago.
The first defense that the Horseshoe Crab has is its hard exoskeleton and the design of its body. The exoskeleton covers its spider like appendages and body making it difficult for predators to attack. Such a design means that there are no current predators that hunt the Horseshoe Crab and it is likely that if there once were a predator, that they are no longer in existence. For companies to survive they need to have a form of protection which can be found via patents, brands, customer switching costs and other high barriers to entry. The more barriers that a company has, the better their defense system and the fewer predators that target them.
Horseshoe Crabs also benefit from the area which they live in. Horseshoe Crabs live in coastal shorelines which are not full predators that would get Horseshoe Crabs (like Whelks or Eels that , however, humans use Horseshoe Crabs as bait for Eels and Whelk fishing. That means that the area of habitat is important for the survival of a species. A company that focuses on areas that are not within the cross hairs of a larger competitor with greater financial resources will also have a greater ability to survive. We are talking about small niches. Think of Games Workshop the makers of small plastic and metal figurines that are used for table top battles. Most of the large toy companies are in the business for selling plastic figurines for a profit and try to do so with scale, but the small table top battle niche is too small to ever move their financial needles. So, it is very unlikely that Mattel or Hasbro would ever enter this niche even though both companies are respectively 43 and 25 times the size of Games Workshop. A small niche then becomes a better area to survive within.
Another interesting characteristic of the Horseshoe Crab is their diet and their ability to adapt to changes in their environment. Horseshoe Crabs are omnivorous scavengers eating almost any kind of organic matter, feeding upon small worms, bivalves, mollusks, algae and dead fish. Having a wide variety of consumption options means that Horseshoe Crabs have not relied on one or a few sources of food. Having such a concentrated reliance on one type of food with many competitors could spell trouble for a species. It is likely that this characteristic has evolved over time but that is just my hunch. Companies compete for customers and preferable terms from suppliers. That means that a company that is not highly reliant on a certain market, a particular customer and supplier has a higher likelihood of surviving and maintaining their profits.
Horseshoe Crabs are also ecological generalists and have great abilities to adapt to environmental change. Whether it be wide fluctuations in salinity levels (found in the oceans where they live) or wide ranges in oxygen levels, the Horseshoe Crab can handle the changes. A business that also generalizes with an ability to adapt to a wide variety of changes will also be able to survive many different changes in competition, demand and operating environments. A great example of a company that was able to adapt was the Kimberly-Clark Company back in the early 1970’s. The company’s main focus was on newsprint and coated paper, but the then CEO Darwin Smith decided to sell the mills because the future prospects were destined for mediocrity. They used the proceeds to invest into the consumer paper-product industry which had far better prospects but higher competition. Kimberly-Clark succeeded and today is at the top of the top of the consumer paper-product industry. If Kimberly-Clark were still selling coated papers, then it is highly likely the company would not have produced the returns that it has been able to achieve.
The last and most intriguing characteristic that is highly likely to have aided in the survival of the Horseshoe Crab as a whole species is their blood. A horseshoe crab’s blood has a certain protein found in its blood cells that detects the smallest trace of bacteria and when bacteria is spotted clots trapping the bacteria. This special blood clotting mechanism stops problems from happening and is sought after by pharmaceutical companies. A company’s internal culture when composed of talented individuals with the appropriate incentives is a good recipe for keeping the company on track and not becoming susceptible to internal problems. Cultures that emphasize thinking like an owner and entrepreneur are most likely to have the appropriate controls in place to allow the company to run at full bore while preventing problems. Berkshire Hathaway is a company with the right culture composed of talented individuals who are highly competent. Warren Buffett and Charlie Munger know that it is best to find individuals who are top talent and run their companies as if they owned 100%. Buffett knows that his subsidiary managers are much better at running their operations without him interfering, and his time is much better spent at allocating the company’s capital.
Which species would you choose to survive the next million years?
Thinking of a company’s competitive advantages as a moat is very helpful and fits well as a buzz word in conversation, but we think a Horseshoe Crab better allows us to conceptualize a company’s competitive advantage, ability to adapt and survive. We will continue to find other species of animals that have survived and see if they are similar to Horseshoe Crabs or if we can gain further insight. We will also look at the species that failed quickly.
To sum up, a Horseshoe Crab company is one that:
- Has plenty of defense in the form of patents, high switching costs, long term relationships with customers, brands and other high barriers to entry.
- Has a dominant position within their industry. Small niches might be better.
- Has a wide variety of client relationships and does not rely too heavily on one customer or supplier.
- Has the ability to adapt to a changing environment even if re-invention of the company is necessary.
- Is composed of highly talented and competent individuals and internal culture emphasizes owner operation.
- And might not be the most popular, most aesthetically pleasing industry or exciting industry but gets the job done and does it well.
I’ve recently talked about some mnemonic tools that should be beneficial in building the lattice work of worldly wisdom. Memory palaces help provide the container which to hold the data and the major system to help translate some of the data to put into those palaces. We will go over many other tools to help us in our journey, but I feel we need to step back again to figure out what information we need to put into those palaces. Again, we are trying to build worldly wisdom.
Wisdom is found not in just one area but in many seemingly unrelated subject areas. People often do not realize how related some of the subject areas can be. Apple’s dominance in the app world can be tied to its extensive app-ecosystem, which is almost exactly the same as a dominant ecosystem in nature. Nature can teach us about business which can teach us about investing. It’s necessary to figure out which subjects we need to learn about. I have mapped out what I believe to be important areas to focus on below. Now I could have mapped out every subject matter of every area but that would be a waste. As Charlie Munger has stated before, we do not have to know each subject area at the granular level to build wisdom because only a few main ideas hold the most freight. In the mind map below, I included what I believe to be the major content areas along with the sub-categories that hold the most freight for a healthy life which would benefit investing. This is not an exhaustive list but gives us a point of reference. As we go along, other areas might jump to my attention that are important which I will then be writing about.
My challenge will be to take the 8 larger wisdom subject areas and put each one of them into their own memory palace. Since each one of these areas starts from a bird’s eye view to more detailed areas, I’ll do the same with my memory palaces. I can picture looking from the moon back at the earth and seeing 8 different areas which I have lived or traveled to. The only difficulty might be finding a number of palaces in each of those places that I can remember very well. I’ll keep readers up to date on my progress and I’d be curious to hear how other readers associate specific palaces with each subject.
Warren Buffett often quotes numbers from historic annual reports such as the number of cases Coca-Cola sold in 1938 and has said he’s read every annual report of Bank of America since 1950. Its safe to assume that he’s read almost every annual report in existence for the companies he has owned. Its a little unfair, however, because other investors have limited to no-access to historic annual reports, yet I feel that reading as many historic annual reports are absolutely necessary to building one’s investment wisdom. The SEC database only goes back to 1994, but the corporate world did not begin in 1994; there is a whole century of corporate reports that people do not have access to.
How nice would it be to get the data from Coca-Cola’s 1929 annual report online? Or have the ability to click a button and get a summary of the events found in Wells Fargo’s 1986 annual report? Or have access to a database that aggregates the income statement data each year for Disney from 1950 – 1960? Sounds like a fantasy world, right?
Well, I have a vision to create such a place and fortunately have access to a never ending supply of old annual reports. Keep checking back here for more updates on this project.