Month: September 2019

The key to investment success is to buy wonderful businesses. Like many great truths, it may seem obvious, but it is not. As Warren Buffett would put it: It is far better to own a wonderful company at a fair price than a fair company at a wonderful price. 

The philosophical father of value investing, Benjamin Graham, taught Buffett that price is what you pay, and value is what you get. But the emphasis of Graham’s teaching was on buying cheap companies and assets, while the idea of the quality of the business was not focused upon. Graham would love to buy companies well below their liquidation value. But unless you were a liquidator, you might need to wait a long time for the price to equal value, and you might need some kind of event for it to happen. 

If you were to buy a business with very high earning power however, and it would keep returning high returns year after year, the returns of the business will ultimately be the returns of the shareholders. A good business tends to increase its earnings yearly, and thereby increasing its value over time. A bad business has a high chance of getting less valuable further down the road, and consume a lot of the owners’ capital over time as well. While time is the enemy of a bad business, it is the friend of a wonderful one.

Joel Greenblatt, who ran Gotham Capital and averaged an annual return of +40% for two decades, shared some insights during an interview about how hard it is not only to pick a good manager, but also to stick with him. Even with Joel’s performance his investors would find it really hard to stick with him, and he felt it was easier to manage his own money after a while.

Joel started the interview saying that even Warren Buffett says most people should stick with index funds, and he agrees with him. But Buffett doesn’t index himself and neither does he – how come? The answer: If you don’t know what you’re doing, the safest thing to do is index. By periodically investing in index funds, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.

If you on the other hand are a know-something investor, Buffett suggests that you should focus on your best ideas.

According to Joel Greenblatt stocks aren’t pieces of paper that bounce around that you put fancy ratios on. Stocks are pieces of ownership in a business, that we try to value and buy at a discount. Investing in stocks is really about valuing businesses and try to buy them at a discount. In doing so, the best strategy, says Greenblatt, is the one that makes sense and that you can stick with.

If you can’t value businesses on your own then you have an alternative to find a manager with a good investing process and sticking with that. The problem is that sticking with a good manager is really hard to do. Human nature tends to work so that we pile in and pile out at all the wrong times. For example the best performing mutual fund in the U.S. in the period of 2000 to 2010 managed to gain an average annualized return of 18 percent. The market was flat in that period so that was pretty good. But the average investor managed to lose 11 percent a year by moving in and out at all the wrong times. After the market went up they piled in, and after the market dropped they piled out. And after the fund outperformed they piled in, after the fund under-performed they piled out. They thereby turned an average gain of 18 percent into an average loss of 11 percent. The example shows that it’s really hard to handle volatility for an investor, and to stick with a good manager even if he has a good process. 

Another study Greenblatt did turned out that about half of the managers in the top quartile performing institutional funds over a ten year period spent at least three years in the bottom performing decile. How many do you think would stick with them?

The problem is that people tend to look at the returns of the last few years to determine whether they should start following the manager’s fund. But according to Greenblatt the last 3-5 years don’t determine the outcome of the following years. What you need to do is look at the manager’s investment process instead. 

Most fund managers don’t want to pick stocks that look like they won’t make a good return over the next three years. But that’s where the opportunities are according to Greenblatt; that’s why you’re getting the stocks at a discount. 

If you’re a stock picker you should focus on time arbitrage; buy undervalued stocks by doing good valuation work, and wait for the market to agree with you.

Buffett was asked: “What piece of advice would you give to people who are looking to succeed in business?”

He answered: “By far the best investment you can make is an investment in yourself. For example communication skills. Many students take advanced degrees and learn complicated formulas. If they just learned to communicate better, both in writing and in person, they’d increase their value by at least 50%! If you can’t communicate, it’s like winking at a girl in the dark… nothing happens!

It’s relatively easy to learn, but it’s hugely important. And if you invest in yourself, nobody can take it away from you!”

Warren Buffett was asked in an interview in the spring of 2019 how closely he is following his biggest stock investment, Apple. The interviewer mentioned that people are concerned that Apple hasn’t released any new products lately and so on, and asked what Buffett thinks about that.

Buffett quickly answered: “Well, if you have to follow the company closely, you shouldn’t own it!” “Really!?” the interviewer said surprised.

Buffett continued: “If you buy a farm, do you go to the farm every day or every other week to look at it? Do you check closely how far the corn has grown, or do you worry about if this is going to be a year of low prices, or of high prices, and whether exports are affecting your earnings?”

“It doesn’t grow faster if I stare at it. It doesn’t help to cheer at it. I know there is going to be some years when prices are going to be good, and there are years when prices aren’t going to be good. I know there will be years when yields are better than others.”

“I don’t care about economic predictions. I do care about whether the farm is well tended to, and whether productivity is increasing over the long term. If you owned the best auto dealership in town, would you go in everyday and check how many customers drop in?”

He summarized: “Things are going to be different in a business day to day, and year to year. You shouldn’t buy the business if the day-to-day is important!”

If you’re concerned everyday about how the business is going and you feel you have to follow it very closely, perhaps you do not own a wonderful business?

The successful investor Joel Greenblatt once told a story about when he was asked to teach a 9th grade class about the basics of investing and how the stock market works. He had shortly before tried to teach the same to a group of surgeons. When the men’s questions after the presentation were in the lines of “The stock market was up 2 % yesterday – what do I do about that? And, “Oil is down $2 – what should I do?”, he figured he had failed his presentation to the intellectuals.

He then thought about what he could do to not crash and burn in the presentation for the kids, so he walked in to the class the first day, and he handed out a bunch of cards. He also brought a big jar of jelly beans, and he handed around the jar, told the kids to try to count the jelly beans, and figure out how many they thought were in the jar, and then write their estimate on their own card one by one.

It turned out that the average guess that the kids wrote down on their cards was 1771 jelly beans. There were 1776 in the jar, so that was a pretty good average estimate.

Before he told them their average estimate, he went around the room, one by one, and asked them to tell out to the class what their guess was. The guess when he went around the room was 850 jelly beans on average.

He explained to the class that the second guess was the stock market.

Everyone knows what they just read in the paper, what the guy next to them said, what they saw in the news, and they are influenced by everything around them – and that’s how the stock market works!

The cold calculating guess, when they were counting rows and trying to figure out what was going on, that was the better guess. That’s not the stock market, but that’s where Joel sees the opportunity that the stock analyst has to do well in the stock market if he does good valuation work.