Residency Wrap-Up: Lessons #3 & #4

Last post on the lessons learned over the past 5.5 years – should be relatively short. But quickly, just a brief housekeeping note…

With many thanks to @hfmlarrybird, there was a spike in views the past couple of days. I can’t express how much I appreciate those who have taken the time to read! For those reading for the first time, the Introductory posts build on each other, so it is best to start from the beginning in order to get the whole picture. As I tried to explain in the very first post (Hello, World), the site is meant to be a diary, so it will not always be the most reader-friendly. Though I do hope it gets a bit more interesting once I start posting company write-ups and reporting performance (the goal is by the beginning of Q4). Onto the final lessons (picking up at #3)…

3) LENGTHEN YOUR TIME HORIZON

“Time is the friend of the wonderful business, the enemy of the mediocre one.” – Warren Buffett

Wonderful Businesses. Buffett’s advice to buy wonderful businesses at fair prices is so simple and boring, yet likely the most powerful advice he has ever provided. Mr. Market tends to overly discount for the time it takes wonderful businesses to compound, thus their TSR tends to outperform over time. Charlie Munger pointed out in his 1994 speech to USC’s Business School that every so often the market catches on to the “wonderful business” concept and bids up prices to uneconomic levels (i.e. 1970’s Nifty Fifty, 1990’s TMT bubble) – but outside of those periods, the TSR of wonderful businesses tend to outperform over time. I would point to GMO’s piece “Profits for the Long Run: Affirming the Case for Quality” for a fantastic empirical overview of how the economics of wonderful businesses remain wonderful over time.

While the ultimate wonderful business is one that can reinvest close to 100% of its earnings at its inevitably high stated return on equity, the reality is that most wonderful businesses are too large to reinvest even close to 100% of their earnings (Buffett, in his brilliance, created the ultimate wonderful business in Berkshire Hathaway – a business with high returns on capital that has reinvested 100% of its earnings at that high return on capital for years). As such, I would define a wonderful business as one that can grow at or above nominal GDP while returning at least 70% of earnings to shareholders. Assuming an average world nominal GDP growth rate of 6%, a business returning 20% on reinvested capital could pay out 70% of annual earnings while growing at 6%. There are many puts and takes here, but it is broadly speaking what I look for.

Setting the hugely profitable large-cap technology companies aside – since nobody knows what they will look like 10 years from now – I do not believe there is a higher quality business model in the large-cap space than that possessed by Visa and Mastercard. Though lacking the overt pricing power of say Hershey, it is essentially a royalty stream on all future non-cash spending, which is virtually guaranteed to outpace global nominal GDP growth due to the massive on-going secular shift from paper to plastic. Better yet, while you have at least 8% top-line growth for years to come, these businesses will pay out close to 100% earnings. Mr. Market values Facebook, Amazon and Netflix at absurdly high multiples (multiples too embarrassing to put into words) on the hope of significant future profitability…yet he values wonderful business economics virtually guaranteed to be in place for decades to come at less than 25 time earnings!!! I am of the hope that he continues to do so in order to allow Visa & Mastercard to repurchase copious amounts of stock for years to come.

Time Arbitrage. In an investment world that struggles to see past intra-day market squiggles, zooming out even *gasp* 36 months can provide a massive competitive advantage. While the concept of “time arbitrage” is often scoffed at – since arbitrage implies a virtually riskless return – it’s exactly that…a concept. Assuming your analysis is correct, the “risk” of taking a longer view than the marginal seller seems pretty low risk, in my opinion.

This is nothing new, but I find market psychology absolutely fascinating, even if difficult to measure in real time. Probably my favorite example from the past 5.5 years that demonstrates the Fear/Greed Cycle is Greek sovereign debt. Monetarily united with but fiscally independent from its relatively financially sound Northern brethren, Greece’s sovereign creditors drove its cost of debt sky-high as the EZ danced on the edge of the break-up cliff in 2011. With debt to GDP over 150% and the inability to print its own currency, the markets rightfully assumed Greece would default. Yields reached upwards of 15% (higher?) at Greece’s nadir in mid-2012. NOT 2 YEARS LATER in April 2014, Greece came to market with 5-year debt priced at 5%, with debt to GDP projected to climb to 175%. Yes Mario Draghi swore to do “whatever it takes” to preserve the Euro – but does this yield compensate investors for risks such as the possibility: Draghi’s predecessor is not as Euro-friendly, the ECB can’t backstop a death spiral of debt to GDP, or Greece leaves the Euro and devalues? I have no idea – all I know is that in two extremely short years, greed has run just as far as fear ran the opposite direction. Hindsight is 20-20, but this example teaches how powerful a longer-than-market time horizon paired with correct analysis (think Dan Loeb in 2012…) can be.

4) DO NOT OVER-TRADE

The age-old advice of “The big money is made sitting on your assets” and “Let your winners run” nicely sums up this lesson. While in an ideal world I would check stock quotes once per quarter, in reality that is just not going to happen. As an event-oriented investor, ideas come to mind on virtually a daily basis, so it is a persistent battle to fight the urge to trim winners in order to buy something new or add to a loser (I have yet to learn that cutting losers is profitable over time – when would you ever average down?). Paraphrasing what @BrattleStCap tweeted yesterday, I am a “fool of the highest order” to think that I can expect to outperform over time jumping in and out of positions based on intra-quarter moves – the risk of missing out on a well-picked winner is far too high.

While difficult to do as a margin-of-safety-seeking, value-oriented investor, letting winners run beyond fair value is likely to meaningfully add to long-term returns. The concept of “fair value”, while absolutely vital, is a nebulous concept based on a host of relatively subjective inputs (even Buffett and Munger admit that their calculation of BRK’s intrinsic value differs, and differs considerably at times) – and when calculated by a MOS-seeking investor, it is likely to be conservative. As value investors, we average down on a stock when it is well below fair value – a  practice Bruce Berkowitz affectionately refers to as “premature accumulation” – why not average out when well above fair value? The margin of safety with the price over fair value is that you are in effect playing with the house’s money. This all sounds scientific, but is far from it – I’d call it 75% art.

 

With Residency lessons wrapped up, I will move on to outlining and detailing strategy and portfolio management in future posts. Again, many thanks to all who have taken the time to read. The more people I can have observing my process and performance the more this “diary” will act as a highly performance-oriented $10 billion LP.

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