Category Archives: Competitive Analysis

Why the Study of Competitive Advantage and HAPPY NEW YEAR

Posted on December 29, 2011 | 6 comments

Life is my college. May I graduate well, and earn some honors.” –Louisa May Alcott, American writer

I will be posting almost exclusively on strategic logic as we study Competition Demystified by Bruce Greenwald (in the Value Vault, see ABOUT, http://csinvesting.org/about/) in early 2012. Now is the time to voice a complaint, comment or suggestion if you have reservations about our impending trek. Understanding financial statement analysis, studying market history and other great investors are all part of your investment journey.  The gap, I see, in the education of many is in understanding competitive advantages. There is no way around studying case studies and thinking hard about the subject.

The most profound effect studying competitive analysis, franchises, and barriers to entry as an investor has been to understand how rare structural competitive advantages really are. And the great businesses that can grow and redeploy capital at high rates are precious and difficult to find. Companies are often non-franchise, asset-type investments that an investor should buy only when there is a huge discount (read: massive disappointment, despair and disgust with the business) between reproduction and earnings power value (See Greenwald Lecture Notes here: http://wp.me/p1PgpH-23). If you are similarly influenced, you will be much more discerning in your investments. You may even invest as Buffett suggests, with a 20-hole punch-card.  Much of your investment life will be spent reading while waiting for the perfect pitch.

BUFFETT

Back to why our study of Competition Demystified is critical. Buffett is a keen student of business franchises as he was tutored by Charlie Munger when they bought See’s Candy.

(Source 1983 Berkshire Annual Report and Letter to Shareholders). Despite the volume problem, See’s strengths are many and important.  In our primary marketing area, the West, our candy is preferred by an enormous margin to that of any competitor (Regional/Local Economies of Scale).

You also alluded to getting a return on the amount of capital invested in the business.
 How do you determine what is the proper price to pay for the business?

Buffett: It is a tough thing to decide but I don’t want to buy into any business I am not terribly sure of. So if I am terribly sure of it, it probably won’t offer incredible returns. Why should something that is essentially a cinch to do well, offer you 40% a year? We don’t have huge returns in mind, but we do have in mind not losing anything. We bought See’s Candy in 1972, See’s Candy was then selling 16 m. pounds of candy at a $1.95 a pound and it was making 2 bits a pound or $4 million pre-tax. We paid $25 million for it—6.25 x pretax or about 10x after tax. It took no capital to speak of. When we looked at that business—basically, my partner, Charlie, and I—we needed to decide if there was some untapped pricing power there. Where that $1.95 box of candy could sell for $2 to $2.25. If it could sell for $2.25 or another $0.30 per pound that was $4.8 on 16 million pounds. Which on a $25 million purchase price was fine. We never hired a consultant in our lives; our idea of consulting was to go out and buy a box of candy and eat it.

See’s Candy

What we did know was that they had share of mind in California. There was something special. Every person in Ca. has something in mind about See’s Candy and overwhelmingly it was favorable. They had taken a box on Valentine’s Day to some girl and she had kissed him. If she slapped him, we would have no business. As long as she kisses him, that is what we want in their minds. See’s Candy means getting kissed. If we can get that in the minds of people, we can raise prices. I bought it in 1972, and every year I have raised prices on Dec. 26th, the day after Christmas, because we sell a lot on Christmas. In fact, we will make $60 million this year. We will make $2 per pound on 30 million pounds. Same business, same formulas, same everything–$60 million bucks and it still doesn’t take any capital.

And we make more money 10 years from now. But of that $60 million, we make $55 million in the three weeks before Christmas. And our company song is: “What a friend we have in Jesus.” (Laughter). It is a good business. Think about it a little. Most people do not buy boxed chocolate to consume themselves, they buy them as gifts—somebody’s birthday or more likely it is a holiday. Valentine’s Day is the single biggest day of the year. Christmas is the biggest season by far. Women buy for Christmas and they plan ahead and buy over a two or three-week period. Men buy on Valentine’s Day. They are driving home; we run ads on the Radio. Guilt, guilt, guilt—guys are veering off the highway right and left. They won’t dare go home without a box of Chocolates by the time we get through with them on our radio ads.  So that Valentine’s Day is the biggest day.

Can you imagine going home on Valentine’s Day—our See’s Candy is now $11 a pound thanks to my brilliance. And let’s say there is candy available at $6 a pound. Do you really want to walk in on Valentine’s Day and hand—she has all these positive images of See’s Candy over the years—and say, “Honey, this year I took the low bid.” And hand her a box of candy. It just isn’t going to work. So in a sense, there is untapped pricing power—it is not price dependent. (Source: Buffett’s 1998 Speech to Univ. of FL Business School Students)

Charlie Munger on the Mental Model of Microeconomics

Strategic logic or microeconomics is one of the mental models that Charlie Munger suggests you know cold.

http://www.tilsonfunds.com/MungerUCSBspeech.pdf

Too Much Emphasis on Macroeconomics

My fourth criticism is that there’s too much emphasis on macroeconomics and not enough on microeconomics. I think this is wrong. It’s like trying to master medicine without knowing anatomy and chemistry. Also, the discipline of microeconomics is a lot of fun. It helps you correctly understand macroeconomics. And it’s a perfect circus to do. In contrast, I don’t think macroeconomics people have all that much fun. For one thing they are often wrong because of extreme complexity in the system they wish to understand.

Case study: Nebraska Furniture Mart’s new store in Kansas City

Let me demonstrate the power of microeconomics by solving a microeconomic problem. One simple problem is this: Berkshire Hathaway just opened a furniture and appliance store in Kansas City [www.nfm.com/store_kansascity.asp]. At the time Berkshire opened it, the largest selling furniture and appliance store in the world was another Berkshire Hathaway store, selling $350 million worth of goods per year. The new store in a strange city opened up selling at the rate of more than $500 million a year. From the day it opened, the 3,200 spaces in the parking lot were full. The women had to wait outside the ladies restroom because the architects didn’t understand biology. (Laughter). It’s hugely successful.

Well, I’ve given you the problem. Now, tell me what explains the runaway success of this new furniture and appliance store, which is outselling everything else in the world? (Pause). Well, let me do it for you. Is this a low-priced store or a high-priced store? (Laughter). It’s not going to have a runaway success in a strange city as a high-priced store. That would take time. Number two, if it’s moving $500 million worth of furniture through it, it’s one hell of a big store, furniture being as bulky as it is. And what does a big store do? It provides a big selection. So what could this possibly be except a low-priced store with a big selection?

But, you may wonder, why wasn’t it done before, preventing its being done first now? Again, the answer just pops into your head: it costs a fortune to open a store this big. So, nobody’s done it before. So, you quickly know the answer. With a few basic concepts, these microeconomic problems that seem hard can be solved much as you put a hot knife through butter. I like such easy ways of thought that are very remunerative. And I suggest that you people should also learn to do microeconomics better.  END.

—

You should read the first three chapters of Competition Demystified to explain how Mrs. Bee developed Nebraska Furniture Market’s advantage.  We will review those chapters in the next several posts while delving deeply into minimum efficient scale and economies of scale.

Whether you learn about microeconomics here or elsewhere, it is critical to apply these mental models in your business analysis.

HAPPY NEW YEAR!

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Economics and QE2 Explained with Cartoons; A Future Case Study: Amazon

Posted on December 26, 2011 | Leave a comment

The First Economist

Hayek’s Road to Serfdom

A Reader’s Digest Version–thirty pages–of Hayek’s Road to Serfdom, plus cartoons.  Hayek and Mises both predicted the inevitable collapse of socialism and fascism. http://www.cblpi.org/ftp/Econ/RoadtoSerfdom

_ReadersDigest_and_Cartoon_Versions.pdf

Quantitative Easing explained in a cartoon video. http://www.youtube.com/watch?v=PTUY16CkS-k  About five million viewers have watched this video of two bears (dogs?) asking simple questions about monetary policy.  The theory at issue here is Keynesianism  which assumes that stimuli from government, a category that includes QE2 (Quant. Easing for the second time), are beneficial. Really? Why?  If economics can neither be explained in plain English nor understood then it’s probably bunk.

For a Future Case Study on Moats

http://www.nytimes.com/2011/12/17/business/at-amazon-jeff-bezos-talks-long-term-and-means-it.html?_r=2&ref=jamesbstewart&pagewanted=print

Amazon Says Long Term And Means It By

In 1997, the year Amazon.com went public, its chief executive, Jeff Bezos, issued a manifesto: “It’s all about the long term,” he said. He warned shareholders “we may make decisions and weigh tradeoffs differently than some companies” and urged them to make sure that a long-term approach “is consistent with your investment policy.” Amazon’s management and employees “are working to build something important, something that matters to our customers, something that we can tell our grandchildren about,” he added.

But shareholders seem never to have gotten the message. In October, when Amazon reported strong third-quarter revenue growth and earnings that were pretty much what the company had predicted, but indicated it would be spending more to support continued growth, investors hammered its stock. Amazon shares dropped nearly $30, or 13 percent, to $198 a share in just one day, Oct. 25. This week they were trading even lower, at $181.

Over the years, Amazon shares have been periodically buffeted by short-term results that seem to have disappointed investors. “The stock has been bumpy,” a Morgan Stanley analyst, Scott Devitt, told me this week. “Investor trust seems to go in cycles.”

The notion that public companies should maximize shareholder value by managing for the long term is pretty much gospel among good-governance proponents and management experts. Jack Welch advanced the concept in a seminal 1981 speech at the Pierre Hotel in New York and elaborated on it in subsequent books and articles while running General Electric, when G.E. was widely lauded as the best-managed company in the country. It has been especially championed in Silicon Valley, where technology companies like Google have openly scorned Wall Street analysts and their obsession with quarterly estimates and results by refusing to issue earnings guidance.

Amazon, in particular, has been true to its word to manage for the long term. It remains one of the world’s leading growth companies and its stock has soared 12,200 percent since its public offering. In late October it reported quarterly revenue growth of 44 percent to almost $11 billion, which came on the heels of 80 percent growth a year ago. “We’re seeing the best growth which we’ve seen since 2000, meaning in 2010 and so far over the past 12 months ending September,” the chief financial officer, Thomas Szkutak, told investors in October. But operating earnings fell sharply to $79 million. While that was in line with most estimates, Amazon offered a forecast for the fourth quarter in which it said it might lose as much as $200 million or earn as much as $250 million, and even the high end would represent a 47 percent drop.

The reason Amazon is earning so little while selling so much is that it is spending so much on long-term growth. It’s opening 17 new fulfillment centers — airport hangar-size storage and shipping facilities — this year and aggressively cutting prices. Its profit margin for the quarter was just 2.4 percent, and it said it might be zero for the fourth quarter. (By comparison, Wal-Mart’s margins are 6 percent on revenue of $440 billion. )

Amazon seems to be taking customer focus to new levels, willing to run its ever-bigger global business while earning little or nothing in return. To the dismay of some, Mr. Bezos even takes a long-term view of price cuts. “With rare exceptions, the volume increase in the short term is never enough to pay for the price decrease,” he told shareholders in 2005. But that kind of thinking, he added, is “short term. We can estimate what a price reduction will do this week and this quarter. But we cannot numerically estimate the effect that consistently lowering prices will have on our business over five years or 10 years or more.” Selling at low prices may undercut profits, but they create “a virtuous cycle that leads over the long term to a much larger dollar amount of free cash flow, and thereby to a much more valuable Amazon.com,” Mr. Bezos said.

Amazon has done little to dampen speculation that it is selling its revamped Kindle e-reader devices and its recently introduced Fire tablet at a loss. Amazon simply doesn’t think like most other companies. When “we think about the economics of the Kindle business, we think about the totality,” Mr. Szkutak said. “We think of the lifetime value of those devices. So we’re not just thinking about the economics of the device and the accessories. We’re thinking about the content.” In other words, profits will come down the road when Kindle users buy content through Amazon.

“If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people,” Mr. Bezos told reporter Steve Levy last month in an interview in Wired. “But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that. Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue. At Amazon we like things to work in five to seven years. We’re willing to plant seeds, let them grow—and we’re very stubborn.”

Whatever they might say about long-term shareholder value, this is simply too much for many of today’s investors, many of whom are hedge funds, pension funds and institutions who measure their results — and earn their pay — based on quarterly benchmarks. “If you look at the average length of ownership of a stock, the period is declining,” Mr. Devitt said. “Amazon is marching to a different drumbeat, which is long term. Are they doing the right thing? Absolutely. Amazon is growing at twice the rate of e-commerce as a whole, which is growing five times faster than retail over all. Amazon is bypassing margins and profits for growth.”

For Amazon, long-term growth confers two major benefits: the kind of economies of scale enjoyed by Wal-Mart and eliminating or weakening competitors. The book retailer Borders has been forced out of business and a rival, Barnes & Noble, is struggling. Best Buy, the electronics retailer, reported this week that earnings plunged 29 percent, despite higher revenue and a surge of Black Friday sales, because the chain had to cut prices and offer free shipping to compete with Amazon. Amazon inflamed many competitors this holiday season by offering extra discounts to shoppers who took mobile devices into stores and then used them to compare prices and order from Amazon.

The revamped Kindle line and especially the new Fire tablet illustrate Amazon’s long-term strategy. “Amazon has much greater ambitions than near-term profits or margins,” Ken Sena, an Evercore analyst, said.

“Some people are griping that the Fire is sub-par,” Mr. Sena continued. “It’s not an iPad. And some investors are confused. Why would they give it away, even lose money on it? But getting it into as many hands as possible is important to them. They’ll use it to drive higher physical and digital good sales on their site. And these devices also bring Amazon deeper into the local retail opportunity, not to mention the app marketplace potential that exists. Media sales on the device are just the beginning. I think Amazon understands all these components.”

The Fire “isn’t meant to be another iPad,” Mr. Devitt noted. “It’s a device to sell Amazon content. All indications are it’s a success. It’s the most gifted item on Amazon. It’s too soon to tell, but it seems more promising than it’s getting credit for.” This week Amazon said it had sold more than a million Kindles a week for the last three weeks.

Nearly 15 years after Amazon’s public offering, it’s safe to say that Mr. Bezos and his colleagues have realized their goal of creating a company to tell their grandchildren about. But one of these days Amazon has to deliver on its promise of higher margins and profits, however long term that may turn out to be. “To many investors, long term is a year,” Mr. Devitt said. “For Bezos, he’s looking at a 10- to 20-year time line. When he says long term, he means 2020 or 2030.”

Now from http://ycharts.com/  Amazon: Free Shipping and Low Prices Don’t Add Up To a Moat By Jeff Bailey

The smartest guy in financial journalism, James B. Stewart, earlier this month in his Saturday New York Times column, praised Amazon (AMZN) for taking the long view in building its business and criticized the company’s critics for failing to appreciate the company’s steadfastness. (See above.)

Amazon revenue continues to rise spectacularly. Its profits, however, have fallen, as margins are squeezed by aggressive product pricing and surging use of the company’s popular free-shipping option. So, the question seems to be, will those strategies help Amazon build what Warren Buffett would call a moat – a protective fortress around its business that long-term allows it to reap substantial profits and build value?

Stewart, author of several fabulous business books, including “Den of Thieves,” about the late-1980s Wall Street scandals, and a Pulitzer Prize winner for his work at the Wall Street Journal, is such a well-regarded thinker about companies that we at YCharts were forced to stop and consider his point of view; he’s not just another pro-Amazon tout.

We have regularly written that we view Amazon as overvalued and have marveled at how its recent growth has made it less profitable, not more so.

The critics have certainly influenced Amazon’s share price in recent months.

Amazon.com Stock Chart by YCharts

Yet the PE remains in the 90s, and this for a company with a plunging and razor-thin profit margin.

Amazon.com PE Ratio Chart by YCharts

Stewart’s admiration of Amazon certainly makes sense if you’re an Amazon customer. The service is wonderful, and like so many American shoppers during this holiday season we have ventured into actual stores very few times because shopping online – from Amazon and its many imitators – is so much easier. That change in consumer behavior seems to suggest a moat is forming. But does the moat encircle Amazon protectively, or is it instead a moat encircling bricks-and-mortar retailers into a market-share-losing ghetto?

The brutal price-comparison ethic Amazon unleashed on the book business years ago helped it take huge market share. But it also rendered the book business less profitable for all players. And as that ethic unfolds across product categories – aided most recently by Amazon’s Price Check app – results at Amazon and Best Buy (BBY) would suggest the greater transparency on pricing is helping consumers, but not so much retailers.

Running Borders out of business, sadly for Amazon and other booksellers, didn’t make the book business more profitable again. Rather, the pricing model Amazon brought to the market seems to have rendered book retailing a crummier business. And it’s also unlikely that consumer electronics and the other categories Amazon is transforming will, once a few large competitors go bust, miraculously become more profitable. There isn’t a shortage of players in any of these markets and the consumer behavior Amazon helped spur – constant price shopping, demanding free or reduced-priced shipping – would seem impossible to reverse.

The Wall Street Journal recently noted the toll free shipping is taking on retailers’ profits. The Journal, noting Amazon’s shrinking margins, said, “Free shipping has likely played a meaningful role in this, although the company hasn’t detailed the cost.”

Actually, Amazon does detail the cost in its 10-K filings (page 26). Its net shipping costs – total shipping costs minus what Amazon collects from customers for shipping – totaled $1.39 billion in 2010, up 63% from $849 million the prior year. Total sales were only growing by 40%. So net shipping costs were equal to 4% of sales in 2010, versus 3.4% in 2009. That trend may have accelerated during 2011, and could largely explain why profits have fallen.

The strategy Stewart lauds is doing a bang-up job of boosting revenue. And consumers love Amazon’s service. But it’s hard to see how the company is going to fatten its margins when competition remains fierce; consumers have been taught to demand low-low prices (and free shipping); and beyond elegant technology, Amazon’s main tools for attracting consumers are both margin killers — low-low prices and free shipping.

Certainly the Kindle is an attempt to build a moat around Amazon’s book business. Selling the devices at what has been reported as a loss suggests the company sees future payoff from Kindle-owning consumers downloading their reading (no shipping expense here) exclusively from Amazon. But in the more general merchandise categories that increasingly make up Amazon’s sales, it’s hard to see how to insert such a loyalty device.

Stewart’s argument seems in part based on the notion that, forgoing current profits, Amazon must be managing for the long term. But if your very pricey stock is reliant on spectacular revenue growth, a cynic might reason that a strategy of adding sales — even if they’re increasingly less profitable (or money-losing) – appears short-term and somewhat desperate.

Amazon management is smart, as is Jim Stewart, and investors could be inviting ruin by shorting Amazon shares. But to us, the company hasn’t made a persuasive case that it’s building a moat – just that it’s delivering great service and selling stuff cheaper than the next guy.   End.

Let’s revisit our study of whether Amazon has a competitive advantage or not after we finish our study of Competition Demystified (in the VALUE VAULT).

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Misery, First Solar (FSLR), Invert

Posted on December 22, 2011 | 6 comments

Johnson spoke well when he said that life is hard enough to swallow without squeezing in the bitter rind of resentment.  Charlie Munger

“Invert, always invert,” Jacobi said. He knew that it is in the nature of things that many hard problems are best solved when they are addressed backward. –Charlie Munger

How to Guarantee Misery in Your Life

Below are tips from the great and the not-so-great on how to guarantee misery and second-rate achievement in your life.

Johnny Carson says,

  1. Ingesting chemicals in an effort to alter mood or perception;
  2. Envy, and
  3. Resentment.

John Chew pleads: Meet my Ex.    http://www.youtube.com/watch?v=i5OlolbLXvw.    Not to be watched if squeamish.

Charlie Munger intones:

  1. Be unreliable. Do not faithfully do what you have engaged to do.
  2. Learn everything you possibly can from your own experience, minimizing what you learn vicariously from the good and bad experience of others, living and dead.
  3. Go down and stay down when you get your first, second, or third severe reverse in the battle of life.
  4. Avoid thinking creatively about problems. Never invert.

First Solar

Now to put our lessons to the test…

I read the news this morning…Oh boy. –The Beatles.

This morning I read a Bloomberg story discussing First Solar’s attractive valuation following its recent selloff.  Also analysts have rekindled takeover chatter. “First Solar is still profitable,” a Kaufman analyst explains. “So you are buying the best in the industry at a discount price. Certainly for both GE and Siemens (SI), it would diversify their energy platform.” FSLR trades at 60% of book value and 5 or 6 times trailing earnings.

If the Kaufman analyst said that to me, this is exactly how I would respond. http://www.youtube.com/watch?v=6eXFxttxeaA

Why?  What is the strategic thinking you would need to do before considering this as an investment?

How could you have avoided this house of pain before the price drop?

 

http://ycharts.com/:

Subsidy Orgy Ending, First Solar’s Hangover is Just Beginning By Jeff Bailey

Ever been to a sporting event where, during a break in the action, they wheel out that clear booth, stick some poor sucker from the crowd inside, and cash is blown into the enclosure for a brief period of shameless money-grabbing?

The global boom in government subsidies to the solar panel industry went something like that, and one can see the brief and frenzied joy of that period in First Solar’s (FSLR) up-and-down stock chart, with today’s price a steep 90% or so below the peak.

The good times were good. Malaysia was handing out huge tax holidays for manufacturers, so First Solar built plants there. Germany seemed intent on covering every roof with solar panels, paid for in part by government subsidy, so First Solar sales were huge there. And not to be left out, the U.S., during its giddy economic stimulus days, offered cash grants for solar installations. Party on.

But, as with past alternative-energy orgies, the good times must come to an end. Goodbye to First Solar’s market cap of $20 billion. Jimmy Carter’s Public Utility Regulatory Policies Act of 1978, known as PURPA, led to tens of billions of dollars of alternative energy projects, including some early and costly solar. But paying above-market electricity rates to subsidize the projects became so costly that PURPA was eventually curtailed.

Poor politicians can’t help themselves. They love stuff like solar and wind, which generate manufacturing and construction jobs and makes everyone involved seem so with it. More efficient energy projects – like ones that reduce consumption – are by comparison so boring, even if they make more sense.

Last week, in announcing reduced earnings projections for 2011 and 2012, First Solar’s CEO Mike Ahearn said, “we are recalibrating our business to focus on building and serving sustainable markets rather than pursuing subsidized markets.” Investors can count on thinner margins and all the hassles and expenses that go with building and operating huge energy projects. And solar remains a relatively expensive way to make power. Unless the brent crude oil price chart goes to $200 a barrel.

In the meantime, the stock is bound to look super cheap by some measures. A trailing PE of 5, of course, suggests some big adjustments ahead to the E.

But it won’t be until 2014, Ahearn said in a statement, that First Solar’s will “earn substantially all” of its revenues from non-subsidized markets. So the results until then are nothing to make long-term bets on. The last of the party is still winding down. End.

Thoughts on First Solar and Competitive Advantage

OK, I am not saying First Solar is not a buy at any price, but what did the Wall Street “analysts” not analyze.

Studying competitive advantage will help us as much in avoiding a house of pain as in finding profitable investments.

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Readers’ Questions: Buffett Compounding $1 Mil. and Why Should an Investor Learn Austrian Economics

Posted on December 21, 2011 | 10 comments

Readers’ Questions

Rather than email a reply, I thought sharing with other readers might be helpful.

A reader writes: Your emphasis on capital compounders raises a question in my mind. WEB (Buffett) famously said that if he was running a million bucks, he could get returns of 50% per year. If you reverse engineer this statement, you have to think he would be investing in the following: small caps, special situations, and catalysts.

I don’t think you can get those kinds of return with capital compounders. Thoughts?

My response: Good point. By the way, any future questions that you have for Warren can be answered here: http://buffettfaq.com/.  An organized web-site of all of Buffett’s articles, writings, and speeches organized by subject, source and date–an excellent resource for Buffaholics.  Buffett said he could compound a small amount of money at 50% as he mentions below:

Interviewer to Buffett: According to a business week report published in 1999, you were quoted as saying “it’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.” First, would you say the same thing today? Second, since that statement infers that you would invest in smaller companies, other than investing in small-caps, what else would you do differently?

Buffett: Yes, I would still say the same thing today. In fact, we are still earning those types of returns on some of our smaller investments. The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts. It would perhaps even be easier to make that much money in today’s environment because information is easier to access.

You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map – way off the map. You may find local companies that have nothing wrong with them at all. A company that I found, Western Insurance Securities, was trading for $3/share when it was earning $20/share!! I tried to buy up as much of it as possible. No one will tell you about these businesses. You have to find them.

Other examples: Genesee Valley Gas, public utility trading at a P/E of 2, GEICO, Union Street Railway of New Bedford selling at $30 when $100/share is sitting in cash, high yield position in 2002. No one will tell you about these ideas, you have to find them.

The answer is still yes today that you can still earn extraordinary returns on smaller amounts of capital. For example, I wouldn’t have had to buy issue after issue of different high yield bonds. Having a lot of money to invest forced Berkshire to buy those that were less attractive. With less capital, I could have put all my money into the most attractive issues and really creamed it.

I know more about business and investing today, but my returns have continued to decline since the 50’s. Money gets to be an anchor on performance. At Berkshire’s size, there would be no more than 200 common stocks in the world that we could invest in if we were running a mutual fund or some other kind of investment business.

  • Source: Student Visit 2005
  • URL: http://boards.fool.com/buffettjayhawk-qa-22736469.aspx?sort=whole#22803680
  • Time: May 6, 2005

So the Wizard of Omaha agrees with you that returns are probably to be found in small caps where greater mis-pricing on the downside and upside can occur. The problem you have is paying higher taxes on short-term (less than one year and a day) gains and reinvestment risk.  Once you sell you have to be able to find other attractive opportunities to redeploy capital.  Special situations like liquidations may give you high annualized returns but the positions may only be held for four months until the investment is liquidated.

Investing in a Coca-Cola may give you high risk adjusted returns but not 50% annual returns because of its side and lack of reinvestment opportunities. Unless you find an emerging franchise which is quite difficult, then if you hold Coke for years, you will eventually earn the company’s return on equity.

This writer organizes his investment world into franchises and non-franchises. With non-franchises you are hoping to buy at enough of a discount to asset value and earnings power value to generate attractive returns. A catalyst like a special situation or corporate restructuring may increase the certainty and lessen the time needed to close the gap between price and your estimate of  intrinsic value. Often, with non-franchises you do not have time on your side. You must buy at a huge discount to have a chance at 50% returns.  These opportunities may be limited to micro-caps with large discounts  partially due to illiquidity issues.

By the way, I am a big fan of small cap special situations, and I plan to post my library for readers, but we have to go step-by-step in posting material.

The reasons I want to focus on franchises are the following:

  1. A study of franchises will teach us about investing in growth which is difficult to value.
  2. Studying competitive advantages will hone our skills in business analysis making us better investors.
  3. Knowing that a company is not a franchise is also important, because–then with no competitive advantage–the company must be managed efficiently. We know what to look for in management activity. Diversification would be a warning signal, for example.
  4. Investing in franchises can be quite profitable if bought at the right price. Say 3M (MMM) at $42 back in 2009 was purchased, then you would be receiving today about a 5.5% to 6% dividend with growth in cash flows of 8% to 10% or more, then in a few years you will have a 14% dividend yield leaving out any rise in share price. You compound at a low base while you defer taxes and reinvestment headaches. I think Buffett receives double in dividends each year more than the original purchase price of Washington Post.  MMM_35
  5.  The biggest gap today in industry and company research is the lack of interest or knowledge in analyzing competitive advantage. Rarely do you ever see an analyst focus on barriers to entry in their valuation work. My hat is off to Morningstar, Inc. because their stock research is geared toward franchises. Many managements have no idea what are structural competitive advantages are. Often, they say their company’s competitive advantage stems from “culture.”
  6. Finally, you want to avoid Hell. Hell is paying a premium for growth for a non-franchise company. Look at Salesforce.com (“CRM”) as an example for today. Full disclosure: I have held short positions in CRM.   Thanks again for your question.

Another reader:

First I would like to thank you for the quality work you are doing. I am new to Austrian economics and I would really appreciate if you can walk us on how to get started and how is it different from other Keynesian and mainstream economics. I, also, want to know why Austrian economics would be more valuable to value investors than other schools. I also wonder why we have not been taught about Austrian economics in school and why it’s not taught.

My reply: Oh boy, you are asking for an all-night discussion. I came out of school having studied Keynesian economics (Samuelson’s text-book, http://en.wikipedia.org/wiki/Paul_Samuelson) because that is what American Universities taught back then and still do about economic theory. Imagine studying geography and being told that the world was flat, yet once in the real world ships were circling the globe.  What I experienced in real life (raging inflation with high unemployment in the late 1970s) completely contradicted Keynesian theory.  Also, the conceit of central planning, having the government intervene, made no sense. How could bureaucrats in Washington, DC allocate resources in Alaska better than an entrepreneur, say, in Alaska?  The only economists that predicted the Great Depression and the collapse of the Soviet Union and Eastern Europe BEFORE the events occurred were the Austrians, von Mises and Hayek. So I read, Human Action by von Mises, and became hooked. The world of booms and busts, inflation, deflation and capital formation started to make sense. But I had to UNlearn a lot of nonsense.

See how flawed Keynesian prediction has been vs. American history: http://www.youtube.com/watch?v=6XbG6aIUlog. Bernanke in 2005 discussing housing vs. the Austrian view. http://www.youtube.com/watch?feature=endscreen&NR=1&v=x2qr5cSln3Q. Bernanke’s confident ignorance is terrifying.

As an investor you must understand how man operates in an economy allocating scarce resources to better his condition or lesson his unease. Only Austrians–from what I know–have a coherent theory of the business cycle and the structure of production. But then you may ask, “If Keynesianism is such a repeated failure, then how come it is still prevalent today?” Think of human motivation. If you are a politician, what better cover to weld power than Keynesian theory?   Constant intervention to “help” is your guide.

Successful investors who are considered Austrians because they study/follow the precepts of Austrian Economics): http://www.dailystocks.com/forum/showtopic.php?tid/2623

Noted investors who use Austrian Economics:

George Soros is the legendary investor who started Quantum Fund in the 1960s and is a multi-billionaire as a result of some winning macro trades. Soros’ prescription for healing broken economies cannot be mistaken for Austrian Economics, but Soros’ analysis of markets as expressed in his books seems to borrow a lot of influence from the Austrian Economists.

Jim Rogers is acknowledged as one of the most successful investors of all time. Making an early start when he was in his twenties, he was able to build a huge fortune with an initial investment of just $600 by the time he was 37. A firm believer in Austrian economics, he advocates investing in China, Uruguay and Mongolia.

Marc Faber was born in Switzerland and received his PhD in Economics from the University of Zurich at age 24. He was Managing Director at Drexel Burnham Lambert from 1978-1990, and continues to reside in Hong Kong. He is famed for his insights into the Asian markets, and his timely warning about market crashes earned him the name of Dr.Doom. In 1987 he warned his clients to cash out before Black Monday hit Wall Street. In 1990 he predicted the bursting of the Japanese bubble. In 1993 he anticipated the collapse of U.S. gaming stocks and foretold the Asia Pacific Crisis of 1997-98. A contrarian at heart, his credo has always been: “Follow the course opposite to custom and you will almost always be right.”

James Grant, a newsletter writer who publishes “Grant’s Interest Rate Observer” is also a follower of Austrian Economics. He is a “Graham & Dodder” too. Go to www.grantspub.com

Ron Paul, a Republican Congressman for the Texas State, is also a believer of Austrian Economics.

Interestingly enough, Howard Buffett, the father of Warren Buffett is also an Austrian Economics follower. His son, Warren, however, seems to be more inclined to the Keynesian method of healing broken economies as opposed to the strict and rigid ones espoused by Austrian economists. Warren Buffett did acknowledge in a recent TV interview that one will have a hard time finding a paper based currency that appreciates in value over time. (All fiat currencies have been debased to worthlessness.)

Austrian Economics vs. Keynesianism

What is Austrian Economics http://mises.org/etexts/austrian.asp

http://mises.org/daily/4095   Hayek vs. Keynes Rap video and discussion. http://mises.org/daily/3465    The Austrian Recipe vs. Keynesian Fantasy.

A recent civil debate between an Austrian economist and a New Age Keynesian.  http://board.freedomainradio.com/forums/t/32178.aspx

Free School in Austrian Economics

If you REALLY want to learn Austrian economics, the lessons couldn’t be laid out better for you than here: http://www.tomwoods.com/learn-austrian-economics/.   Start with Economics in One Lesson by Hazlitt.

And if you want to interact with professors you can go to the Mises Academy here: http://academy.mises.org/.   Don’t go by what I say, but by what YOU think after delving into the material. Does it make sense? Forget political labels of Right-wing, Democrat, Liberal, and Conservative; think of how the world works.  I hope that helps partially answer your question.

The same reader asks another question:

I have another question related to Bruce Greenwald book, Competition Demystified. In his book he mentioned that if the company has no competitive advantage then strategy is irrelevant and the course of action should be efficiency. However, following this argument, investors would have avoided many companies during the journey to become industry dominant player.

Correct me if mistaken, but I don’t think you have read the entire book yet. Greenwald will talk about entrant strategies from the point of view of the incumbent (crush an entrant) to an entrant (how to gain a foothold profitably against an incumbent). Greenwald will also talk about cooperation between incumbents.

If you want a more detailed description of emerging franchises–though I suggest you read it after Greenwald’s book–read Hidden Champions of the 21st Century by Hermann Simon.

I can promise you that one of the reasons for Buffett’s success is his amazing understanding of competitive advantages in his investments.  As a business person understanding strategy is critical.

Here is a question.  You own a chain of very profitable movie theaters within a 150 mile radius of a major city. These theatres are spread about 5 to 20 miles from each other and are nicely profitable. You have economies of scale in hiring, securing first-run films, buying condiments, etc.  You awake one morning to find that another large regional theater chain from 800 miles away wants to open a theatre near one of your 29 theatres.  What response might you offer to send a strong message not to enter this market?  A paragraph is enough.

Thanks for your questions, you make me work hard.

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Greatest Company Analysis, Studying Franchises and More………….

Posted on December 20, 2011 | 3 comments

“The average person can’t really trust anybody. They can’t trust a broker, because the broker is interested in churning commissions. They can’t trust a mutual fund, because the mutual fund is interested in gathering a lot of assets and keeping them. And now it’s even worse because even the most sophisticated people have no idea what’s going on.” –Seth Klarman

I’m passionate about wisdom. I’m passionate about accuracy and some kinds of curiosity. Perhaps I have some streak of generosity in my nature and a desire to serve values that transcend my brief life. But maybe I’m just here to show off. Who knows? –Charlie Munger

Best Company Analysis

Several experienced investors (including charlie479) have called the lecture in the link below one of the best company analysis ever done. A Charlie Munger speech about worldly wisdom in solving the problem of building a trillion-dollar business almost from scratch.  http://www.scribd.com/doc/76174254/Munger-s-Analysis-to-Build-a-Trillion-Dollar-Business-From-Scratch

Analysis of a Franchise: Linear Technology

An analysis of Linear Technology’s franchise characteristics: http://www.valueinstitute.org/viewarticle.asp?idIssue=1&idStory=109

Do you agree with the above analysis? The five companies below are considered by some to be franchises. Build a database of franchise companies to eventually purchase at the right price for you. Write down what you think are the sources of competitive advantage. Can you arrive at a ball-park value?  If not now, then set aside for future reference. Note the level of ROIC, operating margins, use of excess capital, growth and investment needed for growth and the history of returns.

Linear:                      LLTC 25 Year    LLTC_VL

Balchem:                  BCPC_35 Year   BCPC_VL

Applied Materials: Charts 35 year AMAT  AMAT_VL

Analog Devices:      ADI_35 Year  ADI_VL

Intel:                         INTC_35 Yr   INTC_VL

Now is the time to dig into the Value Vault and read, Competition Demystified by Bruce Greenwald. A study guide is offered here (Thanks Sid): http://competitiondemystified.com/index.htm

Be the Best

To be the best, you will need to have character, be independent and tough like Joker: http://www.youtube.com/watch?v=gYxEIyNA_mk&feature=related

You will need to develop your skill in understanding and recognizing franchises. Eventually you will show skill like this: http://www.youtube.com/watch?v=HwtMPdMFXQA&feature=related or take it to the hoop like Jordan: http://www.youtube.com/watch?v=U17x7gJ33bY&feature=related

I have never held a ball in my hands, but even I know Jordan is practicing magic not basketball–but, then again, he almost didn’t make his high school team.

 A Good Data Source

Accounting, business studies, and data here: http://mgt.gatech.edu/fac_research/centers_initiatives/finlab/index.html

Freedom vs. Tyranny

A satellite view of tyranny vs. freedom: North vs. South Korea    http://mjperry.blogspot.com/2011/12/legacy-of-n-korean-dictator-kim-jong-il.html

Answer to Economic Question Posed in previous post

The European Central Bank (“ECB”) is offering euro zone banks loans of up to 3 years on Dec. 21 at a rate of 1%. A Wall Street/City of London Whiz can buy Spanish paper at plus 2% on money borrowed from the ECB at 1%. Brilliant! This is going to deluge the Euro zone with money and become extremely bullish for the Euro zone markets and price inflationary.  How else do central bankers know how to deal with a financial crisis. Print.

A viewpoint of America’s involvment in the Euro crisis: http://www.thedailybell.com/3379/Ron-Paul-Beware-the-Coming-Bailouts-of-Europe

Have a good evening.

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Current Events Economic Question and More……..

Posted on December 20, 2011 | Leave a comment

Franchise Studies

There are some readers here who are only interested in the nitty-gritty of individual companies. They study the accounting and the competitive advantages of their companies. That is good. Those readers will become good investors.  Later today, I will post the world’s greatest analysis of a company. And we will begin our study of franchises and competitive advantage.

I think we all need to see the mountain top to know what to strive for. I will put the cart before the house by posting 5 franchise companies with a short description of their alleged competitive advantages.   Within four months we will have about 100 companies in our data base.

We will also begin discussing the case studies in Bruce Greenwald’s excellent book, Demystifying Competition.  Please go to the Value Vault (just email aldridge56@aol.com with VALUE VAULT in the subject line, and I will email you a key–please use the materials for your own use) and read this book a few times, take notes and think about the cases.

Economics Question

Now, there may be other readers who are actually interested in Austrian economics and are also value investors.  For you I pose a question, “Why is it NO SURPRISE to see the markets higher this morning and what is the ECB actually doing?  Answer to be posted this afternoon.

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Strategic Logic Quiz, Review of Austrian Economics, and What about Tomorrow?

Posted on December 16, 2011 | Leave a comment

The three biggest achievements of the Cuban revolution are health, education, and low infant-mortality rates, and that its three biggest failures are breakfast, lunch, and dinner. — Government Worker, Habana, Cuba.

Strategic Logic Quiz

Last week, I promised the greatest business analysis ever done.  See here: http://wp.me/p1PgpH-cs

A reader, Logan, gave a strong hint for the solution.  Before I post the answer, let’s try another question.

Use Munger’s multidisciplinary thinking or Professor Greenwald’s strategic logic to find an answer to the following problem: The Cuban dictatorship collapses and property rights are restored. You have been given the job to develop a business in Cuba with barriers to entry.  You must build a business with the strongest combination of competitive advantages. What business would you choose, why and how would you build barriers to entry? How many advantages can you design for development? If you come up with a sensible plan, you will be given $5 million to start.

Two hints: the business can not be involved in cigars or tourism (like hotels or restaurants). A reading of Cuban business history would lead you to an answer, but I presume many have little knowledge of that history.

Tip: A great way to learn about businesses is to read corporate history or the biographies of business leaders.  You will sense how a business grows and develops advantages or loses them.

Austrian Economic Review

What are the markets telling us? Deflation has gold and commodities selling off?   I don’t think so. Never predict, but here goes………The Fed and the ECB both have the ability to print money and exchange good collateral for bad collateral with banks. What do central banks know how to do? What motivates central bankers? What are the monetary aggregates telling us?

The dollar is weak: http://scottgrannis.blogspot.com/2011/12/dollar-is-still-very-weak.html#links

Keeping an eye on longer-term investors: Insiders are long-term bullish. http://www.marketwatch.com/story/those-bullish-corporate-insiders-2011-12-07

Place facts into a coherent theory

How do we place facts into context? A rap video of Hayek (Austrian Economist) vs. Keynes (An Interventionist)http://www.youtube.com/watch?v=d0nERTFo-Sk

Bernanke vs. the Austrians during the housing bubble:http://www.youtube.com/watch?feature=player_embedded&v=MnekzRuu8wo

What confidence do you have in Bernanke’s planning ability or in bureaucrats controlling our monetary system?

Inflation today: http://www.economicpolicyjournal.com/2011/12/exposed-why-krugman-smoothed-inflation.html

Note the unusual bond yields.http://scottgrannis.blogspot.com/2011/12/bond-yields-are-out-of-whack.html

MF Global is an example of our Ponzi financial system in action: http://lewrockwell.com/french/french143.html

Murray Rothbard wrote, “If no business firm can be insured, then an industry consisting of hundreds of insolvent (banks) firms is surely the last institution about which anyone can mention ‘insurance’ with a straight face. ‘Deposit insurance’ is simply a fraudulent racket, and a cruel one at that, since it may plunder the life savings and the money stock of the entire public.”

Our Media

The videos below reinforce the need to read original documents or to speak to people who are actually involved in an industry or sent to war rather than believing our press. Excuse the political connotations.

A savage spoof of the media and our government that hits closer to the truth than I would like! Hitler reacts to Ron Paul’s Rise in the Polls: http://www.youtube.com/watch?src_vid=fFbc3sHl3Ic&annotation_id=annotation_162843&feature=iv&v=5ScPXDRcIfc

War and the importance of understanding history: http://www.youtube.com/watch?v=I8NhRPo0WAo&feature=youtu.be  Note that many against war are the folks who actually have experienced it.

Entrepreneurial Alertness

A podcast on finding opportunity: http://www.economicpolicyjournal.com/search/label/The%20Robert%20Wenzel%20Show  Scroll down to the second or third show.

Adapt or Die: Be Creative and Sell your Skills http://www.lewrockwell.com/north/north1073.html

Old (2007) but detailed Longleaf Interview:  http://www.palmerstongroup.com/articles/2007july/interview.html

Interesting Blog from a former Wall Streeter: Reading Fiction will Make You a Better Investor: http://interloping.com/

Have a great day and weekend.

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Readers Discuss charlie479

Posted on December 15, 2011 | 5 comments

No victor believes in chance. – Friedrich Wilhelm Nietzsche

Thanks to contributions from two readers, Chai and “TC”, who analyzed charlie479–the author of these case studies:http://wp.me/p1PgpH-cg, http://wp.me/p1PgpH-dc and http://wp.me/p1PgpH-cT we can learn what they gained from the cases.

Please excuse the light editing. Chai says,

Three key distinct lessons stand out. First, the key to long-term wealth creation is to invest in compounders i.e., stocks that can grow profitably and preferably with high pricing power and operating leverage and hold on as long as possible. Time would do the compounding magic. While investing in short-term oriented special situations may give you a return uplift you will still face capital reinvestment risk to find another good investment for redeployment of capital.

Secondly, great performance results come from investing in compounders at a valuation as low as possible. Compounders are rare but not cheap, true compounders are even rarer. This means you have to be willing to look at ugly situations (e.g., European stocks now?) or try to identify and recognize the sources of competitive advantage of the companies before anyone else (sometimes maybe even before the management themselves recognize the potential).

Thirdly, it’s crucial to always go to primary sources: 10k, Merger Proxy etc. and not to rely on secondary sources media to gain true informational advantage.

Questions

Separately while I am still trying to catch up on the material on Value Vault and your site, a few questions while reading this interview came out are:

(1) How concentrated should a portfolio be i.e., how should you size your portfolio? I know ultimately it would have to be dependent on your risk appetite / temperament (and perhaps if you are a fund manager, your investors expectation) etc. but would be keen to learn your perspective on this. If you use a 5-stock or 10 stocks approach, how do you rank various investment opportunities to take into consideration of non-quantitative consideration such as business quality aside from pure risk-reward /upside-downside ratio?

My reply: Prof. Greenblatt uses the example of the man who inherits $1 million and he has to invest it within 50 miles of where he lives. He wouldn’t put $1,000 in 1,000 businesses. He would walk around looking to put $100,000 to $200,000 in 5 to 10 businesses–the best businesses at the lowest prices he could find. If you can find great businesses at attractive prices then 6 to 8 positions diversify out 83% to 88% of the market specific risk. If you have only 6 positions then each position is 16.67% of your portfolio. If you get the following results over two years:

$16.67

$0.00

$16.67

$5.00

$16.67

$8.00

$16.67

$25.00

$16.67

$34.00

$16.67

$66.68

$100.02

$138.68

$136.89

 cagr 17%

Most could not stomach the volatility in each stock but overall the portfolio does well. You really have to be unlucky/bad to get a goose egg or lose more than 50%, but your winners are what drive the returns.  Buying these compounders that can redeploy capital at high rates is nirvana, but exceedingly difficult and rare to do.

All investing involves context. But you have to choose a philosophy and method that fits you.  And you also must know the nuances with the approach. Charlie479 is buying companies that can compound their capital by both being very profitable and by redeploying their capital at high rates. Since these are difficult to find and buy he owns few of them and holds them to allow the compounding to work.  For example, I believe Morningstar (Morn) is one example, but the price is too high for my understanding. But I do want to invest as much as possible in these—even no more than 4 or 5 if they have all the signs of a good investment.

But if I was buying net/nets then I might own 5 to 10 companies in a sector—playing a numbers game. If I am buying stable franchises I might by 20 to 25 names because I have no edge other than price.  Also, I have to be quick to sell if the price closes my estimate of intrinsic value because then my return is only the return on equity over time. I am taking a long record of stability as my benchmark rather than my edge in understanding of how long the company can maintain its competitive advantage. I assume the company will hold onto it while I am an owner (the odds favor the strong) but I will be wrong occasionally, of course, as franchises (Nokia, Newspapers, radio) get breached or destroyed.

(2) The issue of price vs. business risk. What should one do when share price drops by 25%, 50% of 75%? What if you re-examine the investment thesis and the business risk seems to stay intact, do you double up your stake – given it’s a better bargain now? Do you sell out- perhaps partially as prudent measure just in case your analysis is wrong? Or to stay put?

Reply: All answers rely on context. Are you right or wrong? If you are wrong then you go down with the ship. What specific areas do you have to understand to know that you are wrong?  Certain businesses are much riskier operationally then others (selling steel vs. soap). If the assets are solid and the company has no debt and the reason the price is dropping is due to mismanagement (earnings power value below asset value) and you know a strong activist value fund taking a large position, then perhaps you can double up. But, again, what are your choices? Perhaps while this is happening there are even better opportunities elsewhere? Or the tax loss is a good asset to have against an equivalent gain in another new position.   There are so many variables, a precise answer is impossible.

Charlie Munger would tell you, “The importance of knowing what you know and don’t know. There is a lot of wisdom in this remark from Eitan Wertheimer: “I had a big lesson from Warren: the use of the word discipline…We learned very quickly that our most important asset is our limitations… the second thing we understand is that when we respect our limitations we don’t suffer from them anymore.”

(3) Cash portion of portfolio. What shall be the cash % a portfolio should have? I see that both charlie479 and Seth Klarman routinely set aside 25 – 30% cash. I would have thought instead of letting the cash sitting idle, it could be better deployed by upsizing into existing positions given these positions are well researched?

Cash allows them future optionality. Also, they allow for being wrong. You never know.  Cash can build up because you sell one position or part of it and you can’t redeploy the capital at the prior discount to intrinsic value thus you wait until an opportunity arises and you don’t do anything stupid with cash burning a hole in your pocket.

I will ask Confucius, Buffett and Dwight Schrute (the Office) to help with your question.

In no particular order of wisdom:

Dwight Schrute– The secret to investing is not being an idiot (15 second video) http://www.youtube.com/watch?v=yVqhxMEf1jc&feature=related

Confuscius: “The superior man, when resting in safety, does not forget that danger may come. When in a state of security he does not forget the possibility of ruin. When all is orderly, he does not forget that disorder may come. Thus, his person is not endangered, and his States and all their clans are preserved.”

As Buffett said (about absence of the need to invest all the time): “You only have to do a few things right in your life as long as you don’t do too many things wrong.” Also, Seneca said, “The mind must be given relaxation; it will arise better and keener after resting.”

I wish I could give you easy rules to follow, but investing is an art more than a science and the biggest part of your investing success is YOU. Spend time thinking about your inherent flaws as well as the next 10-K.

“TC” comments on the charlie479 interview

Prior to even being interested in the stock market, charlie479 developed two excellent traits for successful investing – he was confident in his ability to solve problems, and he questioned conventional wisdom.

Charlie learned early on that investing in high quality, undervalued equities and allowing them to compound over many years was far superior (both in terms of excess return and the required effort) to the analysis and investing he was doing in his day job).

Charlie resonated with Buffet’s twenty punches philosophy. He realized (separately) that finding high quality companies at low valuations did not occur often, and portfolio concentration allowed him to take full advantage of his best ideas while acting a filter on those that did not make the cut. Buffet’s quote was reassuring to him, that yes, taking a 25% position in your best idea does not make you crazy, it makes you intelligent!

Charlie focuses much of his effort on the qualitative side of his analysis – knowing the industry well and a deep dive on the competitive advantages and their sustainability at the company level. I get the impression he would first identify a high quality company by its quantitative factors – high ROIC relative to peers, high margins, etc. but would then thoroughly explore the qualitative causes of this advantage. A critical component of his best ideas was that they could reinvest their cash flows and earn similar high levels of return on large amounts of capital – i.e., a long and wide runway.

What I learned:

It is nice to see someone investing successfully with a model of extreme concentration. Buffet and Greenblatt preach it, but Charlie proves once again it can be done.

In my opinion, the best part of a concentrated portfolio is that, with fewer investment decisions, I can devote more time to finding more ideas, or doing non-investment related things. A common complaint I hear from fellow investors is they don’t have enough time to find good ideas. Portfolio concentration fixes this problem.

I love his analogy of investors jumping from fire to fire, trying to determine if the stock is worthy of investment, while he seems to do his preparation well ahead of making a buying decision. This sounds like what people do who are following the 52-week low list. Right out of Buffet’s playbook, he follows many high quality companies on a regular basis and reads 10-ks consistently – two of his investment examples showed this (7-10 years of following I believe). I can picture him thumbing through a 10-k asking himself “is the competitive advantage still present? Does the company still have a long runway for reinvestment?”

If Charlie is able to find these type of companies at low prices, it means the market does not always see the true competitive advantages underlying a company – even if you can know their presence from a quantitative standpoint. Having an absolute understanding of a company’s competitive advantages is an edge over the market, and the confidence to load up when the price is right.

I hope you found my report satisfactory!

My reply: Yes, excellent insights and thanks for sharing your thoughts. You noticed charlie’s inquisitive, skeptical mind and his disciplined habit to read original documents like 10-ks not broker reports.  Also, this investor thinks deeply about what creates and sustains an excellent business. Well done.

I  will post a few more case studies of charlie479 as good examples of an investment thesis.

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Qualitative Competitive Advantages

Posted on December 15, 2011 | Leave a comment

If you were given a government monopoly that a majority of the US population had to use, could you ever go broke?  You need to understand that different types of competitive advantages confer different strengths and durability.

A government monopoly that use force (fines/imprisonment) is less durable than a natural monopoly created by customer captivity through consumer choice and economies of scale (coca-cola, Microsoft’s operating system).

If ever there was a lesson in why the government is not efficient, it is here: the power of incentives.

http://townhall.com/columnists/jeffjacoby/2011/12/11/email_isnt_killing_the_post_office/page/full/

Email Isn’t Killing The Post Office

  • Dec 11, 2011

IT’S GROUNDHOG DAY at the US Postal Service: time once again for the familiar laments about how the agency’s financial losses are surging, how demand for its services is plummeting, and how officials have no choice but to close local facilities, raise the price of stamps, and reduce delivery standards.

Last week the Postal Service announced plans to cut $3 billion in costs by slowing down first-class mail service and eliminating about half of the country’s 461 mail-processing centers. That would mean an end to next-day delivery of first-class mail. Although that might not seem like much of a threat for something already thought of as “snail mail,” the Postal Service has insisted for decades that 95 percent or more of local first-class mail is successfully delivered overnight. When the new standards take effect next spring, two-day delivery will become the new overnight, even for mail that’s just traveling down the street.

If all this sounds familiar, you aren’t hallucinating.

“In 1990, the Postal Service launched a nationwide plan to intentionally slow down mail delivery,” policy analyst James Bovard wrote in his 1994 book, Lost Rights. First-class letters were already taking 20 percent longer to reach their destination than they had in 1969, but Postmaster General Anthony Frank assured Congress that the reduction in delivery standards would “improve our ability to deliver local mail on time.” In the weird logic and language of the American postal system, the key to success was to give the public less for its money.

The more things change in Postal World, the more they remain the same. In the 1960s, a stunning 83 percent of the agency’s total budget went to wages and benefits. Three decades later, after billions of dollars had been spent on automation, labor costs still accounted for 82 percent of the budget. And in 2011? “Decades of contractual promises made to unionized workers, including no-layoff clauses, are increasing the post office’s costs,” The New York Times recently reported. “Labor represents 80 percent of the agency’s expenses, compared with 53 percent at United Parcel Service and 32 percent at FedEx, its two biggest private competitors.”

That things have been getting tougher for the Postal Service, nobody disputes. With the ubiquity of e-mail, text-messages, social media, and online bill-paying, the volume of mail entrusted to the post office has been sinking for years. In a study published last year, the Government Accountability Office noted that first-class mail, the Postal Service’s most profitable business line, had declined 19 percent from its peak in 2001, and was expected to fall another 37 percent by 2020.

The Internet Age may be wreaking havoc with the post office and its mail-delivery business, but what industry in America isn’t going through the same wrenching experience? And not many institutions enjoy the benefits that federal law confers on the Postal Service: It pays no income or property taxes, it’s exempt from vehicle licensing requirements and parking fines, and it has the power of eminent domain. Most significant of all, it has a legal monopoly on the delivery of mail: The federal Private Express statutes make it a crime for any private carrier to deliver letters. The only exception is for “extremely urgent” letters, and even those may be delivered by a private company only if it’s willing to charge a much higher rate than the Postal Service would have charged.

They don’t have a legally binding monopoly, unlike the US Postal Service. Yet they’re thriving, while the post office is struggling to stave off bankruptcy.

Yet with all its privileges, the Postal Service is struggling, while UPS and FedEx flourish. Why? Because they have something invaluable that the post office lacks: Competitors.

“We have a business model that is failing,” Postmaster General Patrick Donahoe said last week. It’s true. But it was true long before e-mail came along. What is killing the post office is the lack of genuine, head-to-head competition that forces vendors to compete for customers by pushing quality up and holding prices down. Only in a government-sheltered monopoly like the Postal Service would labor costs remain as bloated as they have, year in and year out.

More than a decade into the 21st century, there is no reason why mail shouldn’t be delivered by multiple enterprises, each one competing for market share and goodwill by providing consumers with a valued service. In nearly every other area, after all, Americans embrace competition. With competition comes accountability. And only when the Postal Service is accountable — only when its customers are free to take their business elsewhere – will the endless round of excuses and losses and service reductions finally come to an end.

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Case Study #3 of an Excellent Investment Thesis

Posted on December 13, 2011 | 8 comments

You should read this case to see the depth of thinking this investor puts into his company analysis.

You will also gain from rereading the case as your understanding of competitive analysis and investing improves.

Learning is often an itinerant process; you have to circle back and review and reread to gain better understanding.

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