Investing in Sustainably Advantaged Businesses - TWST Interview with Larry Coats of Oak Value

We define good businesses as those that we believe have the ability to produce predictable and growing excess cash. The predictability component is defined to a large extent by the company’s positioning relative to customers, suppliers, competitors and substitute products.

If you envision perhaps a diagram where you have a company in the middle and you have those forces — customers, suppliers, competitors and substitute products around it — you would recognize the notion that Buffett talks about in terms of a “moat and castle.” Our use of this framework is really founded somewhat in the teachings not only of Buffett and the “moat-and-castle” concept, but also Michael Porter who is a professor at Harvard and certainly a good strategic thinker. Porter also uses this competitive framework. I asked Mr. Buffett once if this competitive framework that Porter uses is essentially the same thing as his concept of “moat and castle,” and his response to me was, “Well, Porter writes books about it and I make billions, but they’re really the same concepts.”

As we look at good businesses, that’s what we’re asking. Do these businesses have sustainable advantages from an economic and a competitive standpoint so they have the ability to generate above average returns and then can they give us the predictability that we need as we look out into the future. When we get down to the valuation phase, we believe that the value of a business is defined by its future cash flows. We have to value companies looking forward as opposed to looking backwards, if you will. Good management we view as being shareholder-oriented, having demonstrated the ability to run the business and very importantly, having demonstrated the ability to reinvest the excess cash flows that the good business generates into higher-returning investments. If you can’t do that, obviously you need to return that capital to the shareholders.

Then the final piece from a philosophical standpoint is the valuation — good businesses with good management at attractive prices. We view the valuation piece in the framework of a discounted cash flow model using a five-year period and an 8% discount rate, and we’re attempting to buy businesses that we believe are trading at roughly $0.65 to $0.70 on the dollar.

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The Stock Screen

The Stock Screen - Second Quarter 2008

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Screening criteria is posted HERE.

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Confessions of a risk manager

Why did banks become so overexposed in the run-up to the credit crunch? A risk manager at a large global bank—someone whose job it was to make sure that the firm did not take unnecessary risks—explains in his own words

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The pressure on the risk department to keep up and approve transactions was immense. Psychology played a big part. The risk department had a separate reporting line to the board to preserve its independence. This had been reinforced by the regulators who believed it was essential for objective risk analysis and assessment. However, this separation hurt our relationship with the bankers and traders we were supposed to monitor.

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Spoilsports

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In their eyes, we were not earning money for the bank. Worse, we had the power to say no and therefore prevent business from being done. Traders saw us as obstructive and a hindrance to their ability to earn higher bonuses. They did not take kindly to this. Sometimes the relationship between the risk department and the business lines ended in arguments. I often had calls from my own risk managers forewarning me that a senior trader was about to call me to complain about a declined transaction. Most of the time the business line would simply not take no for an answer, especially if the profits were big enough. We, of course, were suspicious, because bigger margins usually meant higher risk. Criticisms that we were being “non-commercial”, “unconstructive” and “obstinate” were not uncommon. It has to be said that the risk department did not always help its cause. Our risk managers, although they had strong analytical skills, were not necessarily good communicators and salesmen. Tactfully explaining why we said no was not our forte. Traders were often exasperated as much by how they were told as by what they were told.
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At the root of it all, however, was—and still is—a deeply ingrained flaw in the decision-making process. In contrast to the law, where two sides make an equal-and-opposite argument that is fairly judged, in banks there is always a bias towards one side of the argument. The business line was more focused on getting a transaction approved than on identifying the risks in what it was proposing. The risk factors were a small part of the presentation and always “mitigated”. This made it hard to discourage transactions. If a risk manager said no, he was immediately on a collision course with the business line. The risk thinking therefore leaned towards giving the benefit of the doubt to the risk-takers.
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Collective common sense suffered as a result. Often in meetings, our gut reactions as risk managers were negative. But it was difficult to come up with hard-and-fast arguments for why you should decline a transaction, especially when you were sitting opposite a team that had worked for weeks on a proposal, which you had received an hour before the meeting started. In the end, with pressure for earnings and a calm market environment, we reluctantly agreed to marginal transactions.
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Over time we accumulated a balance-sheet of traded assets which allowed for very little margin of error. We owned a large portfolio of “very low-risk” assets which turned out to be high-risk. A small price movement on billions of dollars’ worth of securities would translate into large mark-to-market losses. We thought that we had focused correctly on the non-investment-grade paper, of which we held little. We had not paid enough attention to the ever-growing mountain of highly rated but potentially illiquid assets. We had not fully appreciated that 20% of a very large number can inflict far greater losses than 80% of a small number.

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Related Books:

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A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation

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Fiasco: The Inside Story of a Wall Street Trader

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The Black Swan: The Impact of the Highly Improbable

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Manias, Panics, and Crashes: A History of Financial Crises

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Speculative Contagion: An Antidote for Speculative Epidemics

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Why Technology Hasn't Saved Us From Inflation (but still can)

Technology can be a powerful deflationary force. Thanks to Moore's Law (the remarkable ability of computer technology to double in power for the same price, or halve in price for the same power, every 18 months) if you want a 50 percent discount on an electronic gadget, just wait 18 months. Or turn a service into software, and it's just a matter of time before it is free.

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But technology has been unable to offset some of the crucial supply issues around energy and food, both of which are at the core of today's inflationary quandary. Nuclear power was supposed to bring electricity too cheap to meter, but our electricity bills have never been higher. The green revolution was supposed to bring an endlessly bountiful harvest, making hunger a thing of the past, but we now have rice shortages and corn nearly tripled in price over the past year. And for all of our virtual connection via cell phones, video-conferencing and e-mail, we've increased our driving and flying to such an extent that we've outstripped global oil-production capacity, driving energy prices to all-time highs.
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What happened? Were we wrong to think that technology would deliver us from rising prices? Well, yes, but it's not technology's fault. We mostly have ourselves to blame for standing in its way.

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Related - The Long Tail: Book and Audio Book

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Known and unknown unknowns

The world’s largest machine is about to open for business. It will, however, only scratch the surface of the universe

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WELL, it is about to happen. After more than a decade, SFr10 billion ($10 billion) and a lot of nail-biting, the first protons should spin their way into the Large Hadron Collider on August 8th. These protons will only be tests. But in a couple of months’ time, when the tests are complete, the particle-smashing will begin in earnest. At that moment the LHC, as the giant machine near Geneva is known to its friends, will take the first big step into the unknown reaches of particle physics for a quarter of a century. For, although physicists have been trying to keep themselves busy on marginal projects during this period, the truth is that the last truly fundamental subatomic particles, the W and Z bosons, were found in 1983.

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The next one, unless everyone’s theories are wrong, will be the Higgs boson, a theoretical construct required to give mass to the other particles of which matter is composed. That should come quite quickly. Only if it does not will people start scratching their heads.

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But even physicists do not spend SFr10 billion in the search for a single particle. What they are hoping is that the LHC will take them way beyond the universe described by the equations which predicted the W and Z bosons and predict the Higgs, and into terra that is truly incognita. Like the creatures drawn on the edge of a medieval map, the shapes of the denizens of this land are a mixture of observation and guesswork. The existence of some is confidently predicted, and their portraits will probably prove quite accurate. Others, though, are little more than names attached to things that can, at the moment, barely be perceived.

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Related previous post (with book recommendations at end):

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At 71, Physics Professor Is a Web Star

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Bruce Berkowitz Stays In The Sunshine

Bruce Berkowitz must be disappointed that the current Olympic Games program doesn't include professional money management in the competition. If it did, the veteran stock picker's neck would be weighted down with gold right now.

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Berkowitz is CEO of Fairholme Capital Management in Miami, which oversees about $9 billion, most of it in the value-oriented no-load Fairholme Fund (FAIRX), of which Berkowitz himself is lead manager.

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The 50-year-old Berkowitz started Fairholme Fund in December 1999, and he's consistently crushed the competition. The five-star, large-blend fund has clinched the No. 1 spot in its Morningstar category for the one, three and five-year periods. Through Aug. 12, Fairholme's five-year annualized return of 16.51% bests its peers by 7.54 percentage points.

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Forbes.com recently checked in with Berkowitz to talk about his take on the market, his strategy and his top stock picks.

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Forbes.com: This has been an obviously volatile, frustrating market for investors. How do you see the market behaving for the rest of 2008 and into 2009?

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Berkowitz: There are two ways you can invest: You can try to predict or you can react. We react. We look for stressed situations and buy if appropriate.
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I hope that the market stays weak and tough and that it doesn't go up much. In the last eight years the market has done nothing, and we are up 300%. This is our kind of environment.
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Some companies have been destroyed, such as Sears, which is a big position of ours. It is a huge opportunity. It is so cheap. Everyone thinks that Sears will be worthless; meanwhile, the store generates $50 billion in revenue, significant free cash flow and has tremendous assets. So the fear, or the prediction of the death of the consumer, has allowed us to react and buy a retailer like this one.
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What is your strategy for the fund? If I was to build a stock screen like Bruce Berkowitz, what would it look like?
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We start with this basis: The only thing you can spend is cash. We want companies that generate significant cash in most times. That is how we start. We don't care much about what they make, but we have to understand it. The balance sheet has to be strong; we want to make sure there are no tricks in the accounting. Then we try and kill the company. We think of all the ways the company can die, whether it's stupid management or overleveraged balance sheets. If we can't figure out a way to kill the company, and its generating good cash even in difficult times, then you have the beginning of a good investment.
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How important is management to you?
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A bad person can cause you pain every time, no matter how good the company is. Management is important. They should have a paper trail of succeeding.
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So strong cash flows, solid assets and experienced, talented managers? Warren Buffett must be proud.
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Right, he learned from Benjamin Graham. And others have learned from him. It's a simple formula. And it works.

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Jean-Marie Eveillard - Value Investor Insight - May 30, 2008

JME: For the past 30 years we’ve sort of floated in style between Ben Graham and Warren Buffett. Graham’s approach is static, quantitative and focused on the balance sheet. There’s no attempt to look into the future and judge the more qualitative aspects of the business. He’d love the Japanese net-nets today, for example.

Buffett’s major idea was to also look more qualitatively for those few businesses with apparently sustainable competitive advantages, where the odds were fairly high that the business would be as successful ten years from now as it is today. In those situations, one makes money not so much from the elimination of the discount to intrinsic value, but more from the growth in that intrinsic value.

When I started out in 1979, both in the U.S. and Europe, there were many Ben Graham-type stocks to uncover after the dismal stock performance of the 1970s. As we grew and markets changed, we’ve moved more to the Buffett approach, but not without trepidation. If one is wrong in judging a company to have a sustainable competitive advantage, the investment results can be disastrous. With the Graham approach, the very large discount to static value minimizes that risk. Overall, I’d like to believe we’ve learned well from both Graham and Buffett and that we own securities that would attract each of them.

Most of the time the short-term outlook stinks for the companies we end up buying, for company-specific or cyclical reasons. The best opportunities tend to be when the company now facing a lousy short-term outlook was not long before considered a darling of growth investors, and when the problems are now perceived to be more permanent. If you think those problems aren’t really permanent, you can make very attractive investments if you turn out to be right.

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Value Investor Insight
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Oaktree - Howard Marks: Letter to Clients

Of the two things I think are most wrong about American business, the worst is short-termism. (The other is the ability of executives to thrive while their companies do poorly.) Companies are rewarded for short-term success and penalized for short-term failure, whereas few people ask about the long term. The only thing that matters is “What have you done for me lately?” A lot of this emanates from stockholders.

In a memo several years ago, I listed a few phrases that have sunk into obscurity over the course of my career. They included “fiduciary duty,” “preservation of capital” and “dividend yield.” Another is “long-term investor.”

Most investment managers are measured against a benchmark every quarter and expected to add value. Some clients have their fingers on the trigger, ready to axe a manager who underperforms for a year or two. For this reason, managers sit with their own fingers on the trigger, ready to dump a stock or bond whose short-term performance lags. And company CEOs whose securities are laggards are likewise on the hot-seat, with boards that rarely support executives who disappoint Wall Street.

Too many people think of the long run as nothing but a series of short runs. The way to have the best five-year investment record, they think, is by sequentially assembling the twenty portfolios that will produce the best performance in each of the next twenty quarters. No one wants to invest in a company that may lag until long-term investments pay off down the road. They’ll just sell its stock today, assuming they’ll be able to buy it back later.

Understanding this, companies face great pressure to emphasize short-term results. What might they do in response?

• Maximize revenues (perhaps by stuffing pipelines and offering discounts that accelerate future sales into the present).
• Minimize expenses in slow-to-bloom areas like research and development.
• Borrow to buy back stock, because debt capital is cheap and equity is expensive (despite the fact that equity provides safety and leverage amplifies risk).

Do you want your companies doing these things? Probably not. But do the collective external pressures force companies in these directions? Absolutely. The things that maximize profits in the short run often serve to decrease profits and increase risk in the long run, but they can be mandatory these days.

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GMO - Jeremy Grantham: Q2 Letter

In the meantime, we are living increasingly beyond our means, and Mr. Market is about to help us reconsider our behavior. This century will likely see the end of the Industrial Revolution and the age of “limitless resources.” Higher prices and (hopefully) voluntary improved behavior will together usher in the post-Industrial Revolution phase of limited resources and frugality. We will all modify our behavior and probably quite fast. We will all re-adopt Yankee virtues (or Yorkshire virtues, I might add) of “waste not, want not,” and get accustomed to using our brains instead of our hydrocarbon brawn.

The prices of commodities are likely to crack short term (see first section of this letter), but this will be just a tease. In the next decades, the prices of all future raw materials will be priced as just what they are: irreplaceable. Oil, for example, will never again be priced on the marginal cost of pumping a marginal barrel from some giant Saudi oil field, as has been the practice for most of the last 100 years of oil production. Real cost is always replacement cost and oil, a precious feedstock for chemicals and fertilizers, simply cannot be replaced. Using marginal cost as a substitute was ignorant and conducive to wasteful consumption of scarce energy resources. It also enabled us to put our collective head in the sand and ignore the growing need for an enlightened long-term energy and climate policy.

Relatively quickly, in 100 years or so, we will run out of oil, underground water, and most non-fully-renewable resources. At current rates, we will do it very, very fast. A major complication now, though, is that we have been brainwashed by repetition to reject this whole idea as irretrievably pessimistic and defeatist, and just well ...thoroughly un-American.

One of the most unfortunate features of our sustained ability to overcome presumed limitations by applying technology is in the dangerous overconfidence it has given us, particularly in our casual and profligate use of resources. Starting now, higher prices will steadily overcome our optimistic assumptions and change our wasteful behavior. We must remember that, after all, in the wolf story, the wolf finally comes.

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