Thursday, March 22, 2007

Value Delusions and Strategic Thinking

One of my great mentors in life was my partner, Doug in a previous investment partnership. His goal in “managing” this business was to ensure that all of us had some time on our hands. Like most young people who were trying to make partnership, I was working my butt off attempting to bring in a raft of new investment ideas. With a universe of securities that literally covered the earth outside of Canada, it was tempting to build a shopping list of value oriented ideas. Screening for low P/E’s, low P/BV’s, low P/CF, high ROE, high ROIC etcetera seemed like the intelligent thing to do. Yet, it always seemed to me that much of what I was doing was far too obvious, far too rule of thumb, far too plug-and-play investing. The discipline itself was helpful in that it kept me from doing too many stupid things (Doug may have felt otherwise.) But what seemed obvious and rudimentary didn’t really involve much thinking. It was merely a cookbook approach. I was successful in being asked to join the investment partnership, but I was more of a proponent of disciplined analytics than a critical thinker or outstanding investor.

There is great wisdom in backing away from the task at hand and to re-assess. Much like the old IBM mantra of “THINK,” it is important for us to chill, to breathe and to think. One of the worst mistakes we make in investing is to do something without thinking it through entirely. Doug’s contribution to my becoming an investor was his insistence that I take some time to think things through. Trading requires instant analysis and can be very instinctive and gut-based. It takes cognition to invest. That takes time away from a computer screen, away from a phone, and away from CNBC.

Great investors have strong analytical disciplines that are second nature. But much more important than that is an ability to ask the right questions. Investing involves much more than the ability to recite endless data about a company’s history. It is the ability to understand why a business is successful or otherwise. It is the ability to distinguish facts from opinion and even more important than that, is the ability to avoid the “halo effect.” Rather than succumb to hyperbole and hype found in much “research,” great investors attempt to improve their powers of critical thinking. Cheapness in and of itself can frequently be a value delusion...presents excellent “value,” but at best, likely to stay there.

Most of us spend insufficient time thinking about the underlying keys to a company’s performance. The better blogs speak to value and the best refer to competitive advantage. Unfortunately, at least in my view, most of investment blogspace is completely irrelevant to understanding a business.

There is far more to successful investing than following a specific series of steps. In a recent McKinsey Quarterly article, Phil Rosenzweig, a professor of strategy at IMD in Switzerland outlines his views on business strategy and the halo effect. A great investor should think like a great business strategist in my view.

“If success could be reduced to a formula, companies would not need strategic thinking but could rely on administrators to tick the right boxes and ensure that formulas were followed with precision.” Rosenzweig highlights the fundamental uncertainty in the business world. None of us can accurately predict a customer’s response to a new product or service with 100% accuracy. None of us can predict the actions of an old or new competitor to our actions. Consequently, all of us need to approach investment or strategic problems as interlocking probabilities.

Charlie Munger has spoken in awe-struck tones about Buffett’s ability to “think in decision trees.” As investors we can improve the odds by considering these kinds of external factors...industry forces, customer trends, and the nature of competition. Our internal analysis should focus on the capabilities and resources of the business as well as its risk preferences. I think we make a great mistake when we believe we understand the value of a business in absolute terms without considering the odds, chances, and trade-offs.

Another great Rosenzweig observation, “A business’s performance is fundamentally relative, not absolute. Success and failure depend not only on a company’s actions but also on those of its rivals. A company can improve its operations in many ways-better quality, lower cost, faster throughput time, superior asset management, and more-but if rivals improve at a faster rate, its performance may suffer.”

Isn’t this the issue with US automakers? Despite much improved product quality, improved safety, better inventory management, etc, the more that the Big 3 moved ahead, Japanese and Korean manufacturers moved ahead faster. In absolute measures of productivity and assessment of product, the Big 3 made enormous absolute improvements. But in a relative sense, the “behinder” they got. Little wonder that the absolute performance provided their shareholders little comfort.

Value investing is based on a premise that one is buying assets at a discount to their intrinsic value, the great teaching of Benjamin Graham. But the determination of intrinsic value is premised on understanding competitive advantage, the competitive landscape, understanding the odds of success, and determining the probabilities of these interlinked outcomes. These complex judgments are pivotal for managements to build a successful enterprise but are also necessary for investors to build successful portfolios.

My worst mistakes in investing have come from not fully appreciating the competitive threats to a business and in buying “absolute” rather than “genuine” value. Absolute value often is termed value cigars. Few businesses have unlocked the secrets of sustained greatness. Scrutinize your holdings carefully to understand the competitive threats that are ever-present. Critical and strategic thinking will improve your portfolio performance.

Sunday, March 18, 2007

Geoff Gannon Survey-Please Help!

Geoff Gannon of fame is a terrific blogger and a disciplined investor who I respect a great deal. He has done considerable work on market valuations over time and is hoping to complete a survey of his audience as to their expectations for the total return expected from the S&P 500 over the next ten years.

Geoff does thorough and thoughtful work. His plans to publish an investing newsletter that reflected his critical thinking were set aside largely because he was having difficulty finding ideas with an adequate margin of safety. Reminiscent of Buffett returning capital to his limited partners when opportunities were lacking.

Please take time to answer the poll to help Geoff broaden his survey. The survey is on the right hand side of the page. Noth Geoff and I would appreciate it!

Geoff's Link

Friday, March 16, 2007

Falling Out the First Storey Window

I have been absent from the blogosphere for about a month, having spent some two weeks involved in teaching some CFP (Certified Financial Planner) candidates in investment as well as my first and foremost responsibility, my clients. As well, I continue to pursue the successful completion of a private placement deal that has occupied my time for the better part of a year. Rather than waste your time and mine with banter or drivel, I would rather provide more thoughtful commentary since I believe that is what you deserve and I hope to deliver.

Since the February 27th fall in the Shanghai market, there has been some contagion in markets around the world. Like Butterfly theories of the global economy suggest, popping of speculative bubbles elsewhere in the world can have a profound effect on other markets. The psychology of speculation and sudden awareness of misallocated capital creates fear and destroys rational thinking. As is usual, the break in the Chinese market had no specific trigger, no new revelation, and no single disturbing statistic that prompted this change in thinking. As is also usual, most internationally bound capital starts seeking domestic shelter.

There is minor evidence of chastened thinking. One of my favorite brokers had turned down my firm’s global investment unit trust in January because it was too conservative and reflected economies with insufficient growth. He pointed out a chart showing Japanese and European economic growth at the low end of world growth forecasts and well below that of BRIC economies. My investment trust is down a fraction; his choice is down about 9%. Now, I learn that he is calling me in for a separately managed account for one of his “aggressive” accounts who has become interested in safety of principal.

For the most part, there is a fair amount of complacency and “seen this before” attitude in capital markets. Most of the “Average Joe” investors that I have spoken to seem to believe that the market always comes back and over the long run, you can’t lose. I spoke to one high net worth fellow yesterday, a fellow with most of his invested wealth in hedge funds who believes that he faces little risk with his Blackstone managed private equity funds. Perhaps, we in the investment industry have done too good a job in teaching people not to panic. Perhaps, we are all deluding ourselves as to the risks.

I have always maintained a truism that the economy per se has nothing to do with the stock market, the biggest factor is what price you pay and what level of profitability you are attaching yourself to. Historical profitability is an important factor in analysis but of far more importance is a sense of the competitive advantage period. Finding companies that can earn substantial profitability behind the protection of a sustainable competitive moat is always the mission. Being able to do so when the world is dying to get out is the tactical advantage we seek.

I had hoped for better prices. Ordinarily, I love to be in the position of sifting through wreckage following a substantial correction. Unfortunately, the Chinese “accident” was more of a scrape or a fender-bender than a full-fledged crash...a fall out of a first storey window. The grave-dancer in me would love to see a little more stormy weather hitting the emerging markets. Streams of income from risky third-world countries provide insufficient compensation at this point to warrant the risk. But streams of income from highly leveraged companies in a private equity pool also should demand higher compensation. Fear and a sense of terror do not seem to be out there. Fear is the main source of superstition as Bertrand Russell said and taking advantage of it can be one of the best elements in buying great stocks cheaply.

Risk aversion unfortunately tends to get thrown out the window by higher rather than lower prices, by exotic instruments rather than traditional ones, and by mystery and intrigue!

Risk aversion was defenestrated in the Internet phase of 1999 and 2000. Despite wonderful opportunities that existed in the decent stocks that were being dumped to provide the fuel to accumulate the crap, the desire for more risk overwhelmed most investors. Boring and decent was traded for excitement and lure. On the other side of the bubble, fear overwhelmed many investors. Of all passions, fear weakens judgment the most.

The willingness to undertake new, unproven, and risky investments remains very high at the moment. The skepticism and apprehension that ordinarily causes vacillation and reluctance in many investors also seems to have gone by the wayside. In short, when it comes to hedge funds, to private equity funds, and to buyout funds, the usual insistence on high risk premiums is absent and the willingness to accept greater risk is strong.

Mr. Market has provided us with a few bargoons in the interim. I like Legg Mason (LM) at current levels and continue to believe that 3M is cheap following the value-enhancing buyback that management proposed shortly after we published our recent note (we are not so arrogant to believe that this action was in any way other than fortuitous timing) I am also intrigued with Barclay’s Bank (BCS ) at current levels. I will write up my views on Barclays shortly.

Disclaimer: I, my family, or clients have a current position in LM, MMM, and BCS.

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