Saturday, 10 August 2013

Industry Practice – Investment Rationale – Wise Words from the Leading Lights (Part 1)

The Q2 / H1 figures from all global auto-companies have been released, and so as is the norm, investment-auto-motives has been investigating the 'bottom-up' intelligence gleaned from available figures relative to the 'top-down' context of regional macro trends. The former utilised in the formulation of 'Coupled Ratios' analysis, which itself seeks to graphically display the investment dynamics of the sector.

This to follow in a successive web-log.

By providing a double aspect view of Market Valuation, Profitability, Liquidity and Debt, 'Coupled Ratios' was and is an attempt to provide an improved ability for investors, from privateer to institutional trustee, to rationally contextualise and track the positions of the main automotive players, both as individuals and as a group.

Thus 'Coupled Ratios' was obviously devised so aid investment process intelligence, be it only one part of the complete jigsaw to do so. It intentionally sits as the simple 'country cousin' to the 'city slicker' that is modern-day 'quant' analysis - complex mathematical equations driving algorithmic high-speed trading.

Given that the future of capitalism rests upon mass populations' improved appreciation and trust of investment principles, there should, indeed must, be a re-assessment of those far simpler methodologies; those derived from history and understandable to even the most basically numerically literate person – from a Manhattan penthouse to a Mumbai slum.

So that an ever increasing number of people can participate in and so grow both the global investment funding pot and its very structure. And though financial hubs are indeed necessary, a notable move away from the 'ivory tower' syndrome which exists, which when inadvertently toppled by complex financial instruments only serve to damage the finance industry's reputation, the public purse from 'bail-outs' and the future financial security of the average man and woman.

However, the creation of 'Coupled Ratios' and the intent behind it are but nothing to the learning and knowledge of the investment world's past-masters.

To this end, this web-log and the next will relay in what is hopefully a concise manner the advice of those luminaries.

The following text is essentially an overtly simplified, very, very abridged version of the book 'Money Masters of Out Time' as compiled by John Train, the founder of a long established investment firm, author and contributing writer to various financial newspapers, and first published in 2000.

The persons covered in the book are:

- T. Rowe Price
- Warren Buffet and Charles Munger
- John Templeton
- Richard Rainwater
- Paul Cabot
- Philip Fisher
- Benjamin Graham
- Mark Lightbown
- John Neff
- Julian Robertson
- Jim Rogers
- George Soros
- Philip Carret
- Michael Steinhardt
- Ralph Wanger
- Robert Wilson
- Peter Lynch

It must be noted that today's far more globalised, complex and inter-connected world can be viewed as a different animal to the largely US centric world in which many of these people operated as the best of broader group who for the most part rode were able to ride portions of the American 20th century economic boom. However, such experiences should have valuable insights for those seeking to best ride global and intra-regional economic development today and into the future

[NB all quotations are paraphrases]

Thomas Rowe Price (1893 – 1983) -

“Stick with the best companies in the highest growth industries”
“Be suspect of Wall Street valuation models”

[this typically referring to the much vaunted DCF (discounted cash-flow method) which itself can be malleable to suit over-optimistic data inputs on sales etc to suit prevailing management desires. This was the undoing of the UK domestic motor industry in the 1970s, 1980s and 1990s]

“Many complex mathematical approaches create the illusion of certainty, nothing could be farther from the truth”

[the CDO sparked financial crisis obviously attests to this]

“In the post 1974 bubble world I sought-out 3 categories of investment criteria:
1. growth stocks of the future (early point in their life-cycle)
2. value stocks of established companies (at good prices though matured)
3.'mixed grille' companies (at basement bargain prices).

Warren Buffet (1930 - ), Charles Munger (1924 - ) -

“the investor should have six basic characteristics”:

A. animated by controlled greed, and fascinated by the investment process, yet don't be hurried by greed...if too interested in money it will (both metaphorically and literally) 'kill you', if not interested enough you won't go to the office. Above all enjoy the process.
B. have patience with holdings that are taken
C. think committees...”if you don't know enough to make your own decisions, get out of decision-making”
D. self-confidence and self-security should come from knowledge, without being rash or head-strong
E. recognise and accept when you don't know something
F. be flexible as to the types of businesses bought, but never pay more than the business is worth now, or its worth in due course.
“sometimes though the bell rings and you can almost hear the cash register”
“the bigger fool in the 'bigger fool theory' – accepting a bad buy and seeking to sell it on – is usually the original buyer and not the intended victim.


“be a genius of sorts” (in whatever sphere) [presumably to confirm intellectual capability]
“possess a high degree if intellectual honesty”
“avoid any significant distraction”

“recognise that only a few businesses are truly exceptional”, their characteristics are:

1. good return on capital without accounting gimmicks of lots of leverage
2. they are understandable, and what motivates all stakeholders from stockholders to management to staff and to suppliers
3. they see their profits in cash
4. they have strong franchises (ie branding) and so have pricing power
5. they don't take a genius to run
6. earnings are predictable
7. not natural targets of regulation
8. low inventories and high turnover
9. owner-orientated management
10. high rate of return on inventories and plant (ie high utilization)
“the best business is a royalty on the growth of others, requiring little capital itself”..this essentially meaning that it directly benefits from the growth of others with little in-house expenditure.

“bad business include”:

1. retail (ironic given that aspects of Berkshire Hathaway's growth included the former),
2. bet the company situations (eg aircraft makers),
3. farm-related enterprises (given long inventory cycle of the crop year, possibility of crop failure, and upfront farmer's costs),
4. dependence upon research and development (seeing R and D costs as a problem not a strength).
5. debt-burdened companies
6. 'chain letter' businesses (geometric growth requiring ever more cash)
7. dishonest management
8. long-term service contracts

Buffet previously espoused that one should “avoid smokestack American industries requiring continuous massive investment, many of them are in trouble because of strong competition, over-regulation, rising labour costs etc”..”the symptom is that to stay in business requires more money than can be be retained out of reported earnings after paying reasonable dividends on the new stock and interest on the new bonds that they constantly issue”.

[NB this was of course long the case for GM and Chrysler of old prior to Chapter 11 bankruptcy, and indeed a 're-mortgaged' Ford, and still arguably is in the long term inside the US even with recent complete 'write-down' re-births. Hence far far greater reliance upon EM regions able to replay the early 20th century American industrial model in the 21st century; the new headwinds being EM political and socio-economic demands of those countries].

“understand at least basic accounting principles, the bedrock of investment analysis...without it the investor cannot understand the discipline, let alone find where the truth lies...understand changes to accounting methods (eg meaning if a switch from LIFO vs FIFO) etc.

“be aware the dangers of management stock options, which is detrimental to the external stock-holder's income, the manager then gains from the upside but not exposed to any (possibly self-induced) downside in the businesses fortunes”

Buffet's co-operator Charlie Munger similarly sets out 8 principles:

1. specialisation often produces very good business economics
2. advantages of scale are important
[NB these the corner-stones to Germany's global-reach Mittelstand businesses]
3. technology business improvements must serve the shareholder before customer
4. investors should figure where they have an edge and stay there
5. 'bet big' when the the right moment comes, otherwise never
6. a significant discount means more upside and a greater margin for safety.
7. buy quality even if its costs more
8. low turnover reduced taxes and increases returns

John Templeton (1912 - 2008)

The ten principles:
A. portfolio diversification across various sectors
B. search many markets for companies selling at a fraction of their true value
C. be sector specific and country specific
D. hold flexible viewpoint(s), see past the .surface'.
E. understand the negative importance of 'expropriations'.
(this being the impact of constraints that destroy investment value, such as price controls)
F. be detached from crowd psychology (typically enthusiasm vs desperation)
G. question business management about competitor capabilities
H. use all cost-efficient available intelligence sources
I. don't trust rules and formulae
K. the four universal criteria are:
- p/e ratio
- operating profits margin
- liquidation value
- growth rate and earnings consistency.

Richard Rainwater (1943 - ) -

A seemingly rarer type of long-term investor, who would essentially scenario-plot the expected future, imagine the 'shape' of what a 'perfect type' of company would take and then seek out current companies which approximated the notional ideal.

Having found a company of that ilk, he would become an activist investor, working as investor / consultant / merchant banker so as to re-mould the company into his envisioned version.

Strategy elements:
“I'm interested in large industries and companies that offer products the whole world needs”...

A. target a major industry in disrepute and ripe for change
B. Identify a particularly attractive company or sector target within that industry. This he refers to as the 'double-play', gaining at company and sector structural levels.

...and “companies which has a long-term sustainable advantage, or 'impregnable business franchise'”

C. find a “world-class player” to run the show, rather than personal hands-on management.
D. never enter an investment alone, creation of a partnership with trusted colleagues and specific industry experts
E. improve the risk-reward ratio through financial engineering

[NB though in this present new era, because of the leverage effect which snowballed the financial crash, financial engineering has become problematic, though the long low interest environment will no doubt unfortunately regenerate this approach].

Paul Cabot (1898 - 1970s)

Long passed and an elder statesmen of the investment community, this passage of the book starts with his election to JP Morgan's board as a young man and describes him as “the dean of institutional community in Boston for many decades”, having run Harvard University's endowment fund for 17 years and at State Street Management.

Importantly he heavily criticised the mutability of large educational endowment fund trustees who could be convinced to change their typically conservative stance by excessively exuberant influences in what rightly appeared to him as the late phases of an economic and business cycle.

His personal investments included only 'good grade' municipal bonds where local administrators has a sense of local responsibility.

“realism and care”...”I've only got confidence in older men who have been through depressions, recessions, wars and all the rest of it”.

Philip Fisher (1907 – 2004) -

Apparently a man of simplistic behaviour who abhorred superfluous administration.

General perspectives:
- not a lot of 'good' investments, just a few outstanding ones
- companies with outstanding business management and technical leadership
- understood manufacturing, avoided financials
- concentrate on growth from intrinsic worth
- only sell for one or more of three reasons:
a) you made an appraisal mistake
b) the company ceases to qualify under same appraisal method
c) if a better opportunity elsewhere arises
- mature companies fine if:
1. able to maintain low cost production
2. constant cost-cutter across the business
3. innovation culture
- do not throw away the investor advantage of valuable knowledge gained about certain companies in favour of comparable scant knowledge regards new companies
- do not sell because you think the stock is too highly priced, or because it has gone up a lot.
- a truly great company grows indefinitely
- act conservatively to make capital grow in a practicable manner
- recognise mature companies past their prime relative to their more dynamic younger international competitors.

Fisher believed that 'outstanding companies' enjoyed two aspects;
A. characteristics of the business
B. quality of management

A. business characteristics:
- growth from both existing and new products
- high profit margin
- high return on capital
- effective research (management and technical)
- superior sales organisation
- advantage of comparative scale
- valid 'franchise' (brand power)

B. management quality:
- high integrity
- conservative accounting methods
- accessibility for investors
- long range outlook
(at the expense of quarterly earnings as required)
- excellent financial controls
- multi-disciplinary skills
- specialist knowledge associated to specific industry
- good personnel policies (staff and management)
- continuous programme of cost cutting

Other issues recognised were:
- exceptionally high profit margins attract new competitors, often better to have a small competitive edge plus a high turnover, so leaving little competitive incentive.
- greedy managers are likely to issue themselves new stock options when the company exists valued 'under book' during lean business and economic periods, only to grow, then achieve 'price to book' or over because of market sentiment, without the management having fundamentally altered the companies general shape or directly improved its natural health, yet able to cash-in on their stock options. This seen as extracting innate value from previous and recent external share-holders.
- management that pursues short-term goals whilst talking 'long-term language', this seen via short-term creative accounting, which “borrows from the future to boost near term results”.
- viewed that institutional investors soon recognised such traits and so effectively 'capped' the innate long-term valuation of the company concerned.
- the all too typical over-optimism of annual reports...”the officers of a company seem to view the report as a form of advertising”

Three stage company analysis:
1. view all publicly available material
2. use the 'scuttlebutt', that is industry forums (events to grapevine)
3. company visits

“A company best serves its investors by management following a constant, predictable dividend policy”
“Higher dividends means lower corporate re-investment, and a lower long-term growth build-up of value...which investment is all about”

Benjamin Graham (1894 - 1976)

Seen as the grand-daddy of 20th century investment, influential through his 2 primary publications, his career greatly assisted when made a partner by the age of 25, and forming his own investment pool in 1926.

However, as a mathematics enthusiast and so a near purely numbers-driven quantitative analyst, he was perhaps overly reliant upon just the numbers and far less appreciative of the macro-trends.

“have the ability to say no to apparent opportunities, many times over if necessary”

“diversification is important, a singular investment might go wrong, but that effect buoyed by a the range of others, a type of pro-active insurance”

“a holding may fail to be an investment and thus mere speculation because the analysis, the safety or return is lacking”

“the market pays no attention to reality during periods of speculative enthusiasm”

“The fact that other people agree or disagree with you makes you neither right nor wrong. You will be right if your facts and reasoning are correct”

“seek-out 'bargain issues', companies selling for less than their current net asset value - “cigar butts”

“it always seemed ridiculously simple to say that if one can acquire a diversified group of common stocks at a price less than the applicable net current assets alone – after deducting all prior claims, and counting as zero the fixed and other assets – the results should be quite satisfactory; they were so in our experience for over 30 years”

“sometimes the patience needed is quite considerable”.

“yet in times of gloom, as any practicising securities analyst knows, you always have any opportunities”.

Six methods used by Graham's fund:
- buying of stocks at two-thirds or less of their net current assets
- buying companies in liquidation (80% + hence of making 20% return annually)
- risk arbitrage: playing both buy and sell sides of an acquisition
- “convertible hedge”: buying a convertible bond or preferred stock whilst simultaneously selling the common stock it converts into.
- buying control of a company selling for less than its worth to force realisation of the assets
- “hedged investing”: buying long one security and short another to balance-out.

Noted by 1939 that “hedged investing” was to precarious to continue.

Indeed, for the average retail investor, only the first method is still periodically available, since the others have become so professionalised.

Undervalued assets were key, he didn't care what the company did or whether the management were capable, simply the level of under-valuation, hence very happy with liquidations.

By the 1970s his theorems had become adopted as core techniques for all professional and good amateur investors, so the competitive advantage seen to be diminished.

He then proposed a much simplified approach based on:

1. purchase of common stock at less than working-capital value, or net current asset value, giving no weight to plant and other fixed assets, and deducting in full all liabilities from current assets.
2. purchase of common stock at seven times reported earnings over previous 12 months

“at bottom it is a technique by which true investors can exploit the recurrent excessive optimism and excessive apprehension of the speculative public”

with in 1976, building on previous standing:

A. purchase of common stock at less than two-thirds of net current assets giving no weight to fixed assets and deducting all liabilities in full, and thereafter sold at 100% of net current assets
B. the company should owe less than it is worth
C. the dividend should be no less than two-thirds of AAA bond yield.

Selling points:
1. after the stock has gone up 50%
2. if the dividend is omitted
3. if earnings decline that make current price is 50% over new target price

Interestingly Graham stated that it is perhaps irrelevant if the investor knew nothing about the company being selected, he had such faith in the numbers

[NB in the 2000 edition John Train ends the synopsis of Graham by rightly stating that the overly simplified 'all numbers approach' is overtly hypothetical, and that a mix of 'deep numbers diving' (bottom-up) and macro-appreciation (top-down) would return and has become the norm].

Mark Lightbown (1963 - ) -

By 2000 Lightbown had earned a reputation as the EM investment manager, amongst those operating in a 'classical style' of stock-picking, not just EM mass-buying as seemed the case in the late 1990s after the Asian Tiger Economies crash.

His interaction came with recognition of the potential in South America, Chile specifically given its richness in natural resources: copper, timber, agriculture and fishing; after the Allende-Pinochet era.
- focus on 'true worth'
- derived from market capitalization, including and excluding debt.
- compare results to sector peers
- review against self-calculated (not market set) valuation.
- if attractive, set a price range for stock purchase

'True Worth':
- determine the FCF (Free Cash Flow)
- preferred method is to use operating profit plus depreciation and amortisation, then subtract the amounts required in plant and equipment and additional working capital to maintain the expected growth rate.
- this determines whether the company will still spin-off cash to its owners, or if it will instead demand fresh equity to support growth.
“the aim of every business is to create economic goodwill”, ie to grow its innate value.
- determine at which stage or aspect of the business true added value arises

“ I seek management able to grow the business on incremental invested capital”.
“management must have 'intellectual integrity' (ability) to appreciate the future”.

Macro and micro viewpoints:
- EM countries must have aligned President and Congress to support pro-capitalist reforms
- a country must see beyond its natural resources base, to trade and 'people-soft' activities
- indigenous population must want to save and invest, so create a virtuous domestic cycle
- a large trade surplus can be viewed as strong 'national savings'
- homogeneous population with no of few ethnic rivalries, toward common goal.
- educated and aspirational population
- good savings to investment channels, esp for all new infrastructure
- a basic legal and technical system to permit capital movement
- existence or arrival of a stock exchange
- little / no government intervention
- low and stable tax rates
- deregulated labour force
- structural reformation is easier in a country of 'manageable size'
- extracting useful information about a company from its competitors is problematic
- get to know the owner-capitalist of the company, s/he has the same problems
- good companies penetrate far corners of the country, so good distribution channels
- the substantive reality of 'siphoned goods' into the hands of criminal groups

“don't wholly believe local sources of information, even investment 'professionals' get a feeling for how things really happen you should travel extensively by public transport around the country that you are interested in...sniffing around the countryside and provincial cities is far more instructive than worrying about the latest opinion helps you build a mental model of how different components of the country local newspapers likewise”

“the ultimate prize in EM investing is to find a medium-sized company with a solid position in its economy that is on the way to becoming a big company, and eventually a regional or world-class company”

“critical to EM regions is assessment of competitive forces, whether the true market strength of a company is because of its own capabilities” (possibly having acquired competitors) “or because a multi-national has not arrived”

“be patient”

“if you buy a good company that is a valid takeover candidate, you're sitting there when a big multi-national makes an offer”.

To Follow -

A summary of John Train's perspectives on:

- John Neff
- Julia Robertson
- Jim Rogers
- George Soros
- Philip Carret
- Michael Steinhardt
- Ralph Wanger
- Robert Wilson
- Peter Lynch