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The Research Process Part 2


We discussed the research process in Part 1: http://wp.me/p2OaYY-22A

Research Process Part 2

Your research process is obviously part of your investment philosophy (search, value, portfolio management, risk and you). If you are buying a non-franchise then you must buy assets cheaply since growth won’t increase intrinsic value. Or another way of approaching the problem: time is not on your side. You are dependant upon the market closing the gap between price and value. When investing in a franchise you face the difficulty in accessing the company’s sustainability of competitive advantage and how much should you pay for future growth. Hint: Not much.

You will have to spend many weeks studying your first few companies and industries to practice finding answers to your questions while learning to be an efficient reader of annual reports and proxies.  As you gain experience, you can make better assessments.  For example, say you study the title insurance business or the funeral business.  The title insurance business shows tremendous stability in return on assets but no better than normal profitability. Only one national insurance company went bankrupt in over 100 years (in 2008).  So you can have a high degree of confidence in buying below asset value that those assets will not deteriorate. But why can’t the businesses grow much or develop higher profitability? Most of the value in a title transaction comes from the originator of that transaction—the real estate broker.   Title insurance is like a local monopoly. The same goes for the funeral business.  You will notice unique aspects to various industries as you cast your net widely.

Buffett’s advice:

The Story of Warren Buffett from Of Permanent Value by Andrew Kilpatrick

Buffett rarely gets ideas from talking with other people. He gets them alone by reading and thinking. Maybe Edward Gibbon had it right: “Conversation enriches the understanding, but solitude is the school of genius.”

 How to make money 

Once Bob Woodward asked Buffett a good way to make more money and Buffett suggested investing. Woodward told Buffett, “I don’t know anything about investing.”  “Yes, you do.” Buffett said, “All it is, is investigative reporting.”

Buffett told Woodward: “Investing is reporting. I told him to imagine an in-depth article about his own paper.  He’d ask a lot of questions and dig up a lot of facts. He knows The Washington Post. And that is all there is to it.”

Buffett continues, “Bob, why don’t you assign yourself a story, get up an hour early every morning and work on a story you have assigned yourself. Now a sensible story to assign yourself would be what is the WPO worth?  Now, if Ben Bradlee gave you that story to work on what would you do for the next week or two? You would go around and talk to people (in the television business). You would try to figure out what the key variables in valuing a TV station and you would look at the four that the Post has and apply those standards to that. You would do the same thing to newspapers. You would try to figure out how the competitive battle between the Star and the Post is going to come out and how much different the world would be if the Post won that war.  All of these things are a lot easier than the problems Woodward would usually be working on. Usually people would want to talk to him but on this subject they would be glad to talk to him and then I said when you get all through with that, add it up and divide by the number of shares outstanding. All he had to do was assign himself the right story, and I assign myself stories from time to time.”

More tips

Munger: “I think both Warren and I learn more  from the great business magazines than we do anywhere else…..I don’t think you can really be a really good investor over a broad range without doing a massive amount of reading.”

Buffett replied, “You might think about picking out 5 or 10 companies where you feel quite familiar with their products, but not necessarily so familiar with their financials…Then get lots of annual reports and all of the articles that have been written on those companies for 5 or 10 years…Just sort of immerse yourself.

“And when you get all through, ask yourself, ‘What do I know that I need to know?’  Many years ago, I would go around and talk to competitors where you feel quite familiar with their products, but not necessarily so familiar with their financials…Then get lots of annual reports and all of the articles that have been written on those companies for 5 or 10 years…Just sort of immerse yourself.

Search Strategy

Most mis-priced stocks tend to fall into two categories: Either they’re well-known but hated, or obscure and unknown.   Warren Buffett seems to agree.  At the Berkshire 1999 annual meeting, he said: “If I had $100,000 to invest, I would probably focus on smaller companies because there would be a greater chance that something was overlooked in that arena.”

“If you gave me a million dollars of capital to manage, I would pretty much almost guarantee that I will make 50% a year.  I think the reason he makes that statement is he would just make 100 percent doing special situations.

Question: 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?

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.

Special Situations:

I am going to buy a dollar for 50 cents, and when it gets appraised at a dollar or 90 cents, I’m going to get rid of it.”  Now your returns are simply a function of how long it takes to get to convergence.  If you bought a dollar for 50 cents and sold it for a dollar and convergence took one year, you would generate a hundred percent return.  If convergence took two years, you would generate a 376% return.  If convergence took three years, you would generate a 26% return, and if convergence took four years, you would generate an 18 percent return.  So up to four years of convergence beats buy and hold.  This very simple math became obvious, and the fact is that buying great businesses is all good because you have a few more tax efficiencies and all of that.  But really the pop in terms of getting better returns on assets is first of all to sell fully priced—or nearly fully priced—assets, whether they’re special situation or net/nets and then go back and buy at 50 cents on the dollar.

To find special situations:

Let the game come to you.  You do nothing, just read and think, and occasionally, you read the paper and you will see something.

You are looking for market anomalies.  Whenever there is extreme fear in some sector, or whenever there is some big clouds over some companies, you are likely to get mis-pricing.  The question is, “Am I able to see through the clouds, and do I know the business well enough to be able to see beyond the temporary negativity of an industry or company and see what the value of the business is versus the price at which it’s being offered, and if it is enough of a delta, step in?”

The primary driver for buying the business was an ultra-cheap price and a huge discount to what it was worth.

Add your thoughts………….?

Part 2: A Professor Provides a Different Perspective on WMT

I’ve missed more than 9000 shots in my career. I’ve lost almost 300 games. 26 times, I’ve been trusted to take the game winning shot and missed. I’ve failed over and over and over again in my life. And that is why I succeed.–Michael Jordan

What is a Moat?

Moats are structural characteristics of a business that are likely to persist for a number of years, and that would be very hard for a competitor to replicate.  Management is not a moat. The best poker player with a pair of deuces can’t beat a beginner with a straight flush.

Moats are not great products, strong market share, great execution and good management.

Part Two: A Professor discusses WMT Case Study

See Part 1: http://wp.me/p1PgpH-j0

Part Two: The Professor continues his talk on Wal-Mart’s success.

First used in grocery supermarkets, bar-code scanners at retail checkout stations are now ubiquitous. Mass merchandisers began to use them in the early 1980s. Most retailers saw the bar-code scanner as a way of eliminating the cost of constantly changing the price stickers on times. But Wal-Mart went further, developing its own satellite-based information systems. Then it used this data to manage its inbound logistics system and traded it with suppliers in return for discounts.

Susan, a human resources executive, suddenly perks up. Isolating one small policy has triggered a thought. I gave a talk the day before on “complementary” policies and she sees the connection. “By itself,” she says, “it doesn’t help that much. Kmart would have to move the data to distribution centers and suppliers. It would have to operate an integrated inbound logistics system.”

Good,” I say, and point out to everyone that Wal-Mart’s policies fit together—the bar codes, the integrated logistics, the frequent just-in-time deliveries, the large stores with low inventory—they are complements to one another, forming an integrated design. This whole design—structure, policies, and actions—is coherent. Each part of the design is shaped specialized to the others. The pieces are not interchangeable parts. Many competitors do not have much of a design, shaping each of their elements around some imagined “best practice” form. Others will have more coherence but will have aimed their designs at different purposes. In either case, such competitors will have difficulty in dealing with Wal-Mart. Copying elements of its strategy piecemeal, there will be little benefit. A competitor would have to adopt the whole design, not just a part of it.

The professor suggests that WMT incorporated the bar-code scanners into an integrated process that a competitor couldn’t copy at least in the short run. When a company invents a process advantage, competitors can eventually copy that. I see WMT using a technology to lower costs within the company’s regional economies of scale advantage. Even if Kmart could lower its costs with the same technology, it was still at a disadvantage in terms of cost structure versus WMT.

There is much more to be discussed: first-mover advantages, quantifying its cost advantage, the issue of competence and learning developed over time, the function of leadership, and whether this design can work in cities. We proceed.

With fifteen minutes to go, I let the discussion wind down. They have done a good job analyzing Wal-Mart’s business, and I say so. But, I tell them, there is one more thing. Something I barely understand but that seems important. It has to do with the “conventional wisdom”—the phrase from the case I put on the whiteboard at the beginning of the class: “A full-line discount store needs a population base of at least 100,000.”

I turn to Bill and say: “You started us out by arguing that Walton broke the conventional wisdom. But the conventional wisdom was based on the straightforward logic of fixed and variable cost. It takes a lot of customers to spread the overhead and keep costs and prices low. Exactly how did Walton break the iron logic of cost?”

I push ahead, putting Bill into a role: “I want you to imagine that you are a Wal-Mart store manager. It’s 1985 and you are unhappy with the whole company. You feel that they don’t understand your town. You complain to your dad, and he says, ‘Why don’t we just buy them out” We can run the store ourselves.’ Assuming Dad has the resources, what do you think of his proposal?”

Bill blinks, surprised at being put on the spot for a second time. He thinks a bit, then says, “No it is not a good idea. We couldn’t make a go of it alone. The Wal-Mart store needed to be part of the network.”

I turn back the whiteboard and stand right next to the boxed principle: “A full-line discount store needs a population base of at least 100,000.” I repeat his phrase, “The Wal-Mart store needs to be part of the network,” while drawing a circle around the word “store.” Then I wait.

With luck, someone will get it. As one student tries to articulate the discovery, others get it, and I sense a small avalanche of “Ahas,” like a pot of corn kernels suddenly popping. It isn’t the store; it is the network of 150 stores. And the data flows and the management flows and a distribution hub. The network replaced the store. A regional network of 150 stores serves a population of millions! Walton didn’t break the conventional wisdom; he broke the old definition of a store. If no one gets it right away, I drop hints until they do.

When you understand that Walton redefined the notion of “store,” your view of how Wal-Mart’s policies fit together undergoes a subtle shift. You begin to see the interdependencies among location decisions. Store locations express the economics of the network, not just the pull of demand. You also see the balance of power at Wal-Mart. The individual store has little negotiation power—its options are limited. Most crucially, the network, not the store, became Wal-Mart’s basic unit of management.

In making an integrated network into the operating unit of the company, instead of the individual store, Walton broke with an even deeper conventional wisdom of his era: the doctrine of decentralization that each kettle should sit on its own bottom. Kmart had long adhered to this doctrine, giving each store manager authority to choose product lines, pick vendors, and set prices. After all, we are told that decentralization is a good thing. But the oft-forgotten cost of decentralization is lost coordination across units. Stores that do not choose the same vendors or negotiate the same terms cannot benefit from an integrated network of data and transport. Stores that do not share detailed information about what works and what doesn’t can’t benefit from one another’s learning.

If your competitors also operate this kind of decentralized system, little may be lost. But once Walton’s insights made the decentralized structure a disadvantage, Kmart had a severe problem. A large organization may balk at adopting a new technique, but such change is manageable. But breaking with doctrine—with one’s basic philosophy—is rare absent a near-death experience.

The hidden power of Wal-Mart’s strategy came from a shift in perspective. Lacking that perspective, Kmart saw Wal-Mart like Goliath saw David—smaller and less experienced in the big leagues. But Wal-Mart’s advantages were not inherent in its history or size. They grew out of a subtle shift in how to think about discount retailing. Tradition saw discounting as tied to urban densities, whereas Sam Walton saw a way to build efficiency by embedding each store in a network of computing and logistics. Today we call this supply chain management, but in 1984 it was as an unexpected shift in viewpoint. And it had the impact of David’s slung stone.

Compare this discussion with Greenwald’s analysis of WMT in Ch. 5 of Competition Demystified. Do you agree with the professor that WMT has a network effect?

Hint: You are most likely to find the network effect in businesses based on sharing information (Amex), or connecting users together (Ebay, CME), rather than in businesses that deal in rival (physical goods). Of networks there will be few.

Cost advantages matter most in industries where price is a large portion of the customer’s purchase criteria.