Leon Cooperman on the Four Reasons for Selling a Stock

“I don’t ask people to do what I’m not prepared to do myself.”

—Leon Cooperman

MiB Interview: Leon Cooperman, July 4, 2015

On July 4, 2015, Leon Cooperman visited Barry Ritholtz for his Masters in Business podcast to talk some investing. Cooperman was born April 25, 1943, and is the founder and CEO of Omega Advisors, an hedge fund managing $5.2 billion as of July 31, 2016.


The Art of Selling a Stock

The following is my own transcript of the part of the interview where Cooperman discusses the four reasons for selling a stock, starting at about 59:50 and ending around 1:00:00. Enjoy.

Nr. 1: Price Appreciation

LEON COOPERMAN: If you’re a value investor and if you like something at 10 you should like it more at 9 or 8. But there are those times where something has tangibly changed, and the circumstance have changed and you gotta make a different decision. So the way I’d like to answer the question is we sell. You know, a typical question from a customer coming into our shop is; “What is your sell discipline?” Okay, and I say. We sell a stock for one of four reasons. The first and of the highest quality reason, is that we bought a stock at X ’cause we thought it was worth X plus 30 or 40 percent, and it goes up 30 percent. Nothing has changed. We sell.

BARRY RITHOLTZ: So even, even once it hits your price objective, even if there’s no change in circumstances?

LEON COOPERMAN: No after there’s no change in circumstances. So I’ll give you a perfect example. I bough 25 million shares of Boston Scientific between 5 and 6 dollars a share. We thought it was worth 12 or 13. It got there. We didn’t see circumstances had changed. We sold. Unfortunately it’s a mistake because I think it’s 18 or 19 now. Okay, but so the first reason just generically…

BARRY RITHOLTZ: Is it always a full sale or is it ever; “Well, let’s sell half of it and see what happens?”

LEON COOPERMAN: Well, it varies. Again, depending upon the company, depending upon the characteristics. And look, I’ve got a leeway of looking at charts you know.


LEON COOPERMAN: Absolutely. It’s one of the ingredients because I think the stock market is highly quality leading indicator, and you know oftentimes when it’s coming out with bad earnings and the stock has come down before the earnings, and they come away with blow-away earnings the stock is up before that. You know, the market has a way of knowing. There’s some type of secretary typing a press release for some CEO who’s got a cousin, or who’s got a wife, who’s got a relative or whatever. So the market…

BARRY RITHOLTZ: So the discounting mechanism is out?

LEON COOPERMAN: Yeah, yeah. Exactly. So the first…

BARRY RITHOLTZ: But you’re not, we would never consider you a technical analyst, or chartist. You’re not making buy and sell decisions based on… ’cause Dough said. Dough Kass said; “Ask Lee if he believes in voodoo?”

LEON COOPERMAN: No, we are deep dive fundamental investors. We work hard to dig up our information. I look at a chart because of the confirmation of what you think, and raise a question when the charts are going the wrong way. You know, because again the stock market is a leading indicator, and so stocks tend to give you some indication of what’s going on. So, the first reason we sell a stock, which is the highest quality reason. We bought something at X because we thought it was worth more than X, and it appreciates and nothing has changed, we sell.

Nr. 2: Things Not Unfolding As Anticipated

LEON COOPERMAN: Second reason we sell something is I tell my guys and gals to “Stay on top of your companies.” Not everything unfolds the way you anticipated. So talk to suppliers, talk to competitors, talk to companies. You know, follow what’s going on in the economy. If you get the sense things are unfolding differently than you anticipated, let’s sell before we get murdered. ‘Cause it’s hard to make up 20 or 30 percent losses in this kind of environment.

NR. 3: New Idea With Better Risk/Reward Characteristics

LEON COOPERMAN: The third reason we sell is that we’re not the Federal Reserve Board, we cannot print money. So sometimes you come up with a new idea that has a much better ratio of reward to risk than something you currently own. So we’ll rotate out of something that has a modest attraction to something we think has greater attraction.

NR. 4: Change Our View of the Market

And the forth reason we sell is we change our view of the market. Okay, and you know, you can deal with futures or options for a while, but at the end of the day if you’ve gone from bullish to bearish, you want to take your exposure down to 50 or 60 percent, you gotta sell inventory. So you sell a stock ’cause you wanna get at arms way. And we did a poor job in 2008 when we missed the significance of Lehman. But by and low, those are the four reasons we sell. Price appreciation, it hit our target, we get out. Second is things are not unfolding as anticipated, get out before you get murdered. Third reason we sell is we’ve found a new idea better than the one we had. And the forth reason is we’ve changed our view of the market and we want to reduce exposure.



Svolder A: The Big Short

A Case Study of Unintelligent Speculation

Svolder’s A-share (ticker: SVOL A) today closed at SEK 243.50, down from an intra-day high of SEK 275.00. During the last twelve months the A-share reached a low of SEK 112.50 and a high of SEK 275 (Source: Avanza).


Svolder is a Swedish investment company founded in 1993 and listed on the Nasdaq OMX Nordic exchange. Svolder invests in small and mid cap listed entities. Click image below for a brief history in Swedish of Svolder (Source: Svolder).


Net Asset Value per Share as of May 31, 2016

The equites portfolio as of May 31, 2016 is shown below. As of this date, the market value of the equities portfolio amounted to SEK 1,644.1 billion. Adjusting for net debt/net receivable results in a total net worth of SEK 1,859.6 billion, equal to a net asset value (NAV) of SEK 144.60 per share (Source: Svolder).

Svolder’s equities portfolio as reported in the most recent quarterly report per May 31, 2016 was made up of the following equities (Source: Svolder).


Net Asset Value per Share as of August 12, 2016

Per August 12, 2016, Svolder reported a NAV of SEK 162 per share (Source: Svolder). The current share of SEK 243.50 is about 150.3% of NAV. At SEK 275 it’s 169.8%. A reasonable expectation would be that the share price would stay close to NAV.

One may wonder why on earth someone would be willing to pay a lot more than NAV for the A-share for a collection of marketable common stocks that Svolder currently owns? Sure, you get 10 votes for each A-share compared to 1 vote per B-share. But that looks like a very optimistic view in regards to the value of the votes connected to each A-share.


Shares Outstanding

Svolder’s shares outstanding disclosed in the 2015 annual report per December 31, 2015 was 12,800,000, consisting of 622,836 A-shares (10 votes per share) and 12,177,164 B-shares. Below an excerpt from the 2015 annual report (in Swedish).


Final Words

To wrap this up. Right now the Svolder A-share is trading at a price-level that is not supported by underlying value. I’m on the sidelines here, but when I saw this case earlier today I was just fascinated of what I was just looking at. One last question: How long will it take for the A-share to trade in line with underlying NAV? Guess we’ll have to wait and see.

For some final words, here’s an excerpt from The Intelligent Investor.

Outright speculation is neither illegal, immoral, nor (for most people) fattening to the pocketbook. More than that, some speculation is necessary and unavoidable, for in many common-stock situations there are substantial possibilities of both profit and loss, and the risks therein must be assumed by someone. There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these the foremost are: (1) speculating when you think you are investing; (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation than you can afford to lose.

Disclosure: I have no position in the stock mentioned, and no plans to initiate any position within the next 24 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. This article is informational and is in my own personal opinion, and should not be considered investment advice. Always do your own due diligence and contact a financial professional before executing any trades or investments.

Times Change and Moats Change With Them

Times change, and we change with them.

—Latin Proverb

Times Change and Moats Change With Them

In his 2005 letter to shareholders Warren Buffett discussed the topic of competitive advantage, or moats in his own words (emphasis added).

Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous.

When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as “widening the moat.” And doing that is essential if we are to have the kind of business we want a decade or two from now. We always, of course, hope to earn more money in the short-term. But when short-term and long-term conflict, widening the moat must take precedence. If a management makes bad decisions in order to hit short-term earnings targets, and consequently gets behind the eight-ball in terms of costs, customer satisfaction or brand strength, no amount of subsequent brilliance will overcome the damage that has been inflicted. Take a look at the dilemmas of managers in the auto and airline industries today as they struggle with the huge problems handed them by their predecessors. Charlie is fond of quoting Ben Franklin’s “An ounce of prevention is worth a pound of cure.” But sometimes no amount of cure will overcome the mistakes of the past.

Our managers focus on moat-widening – and are brilliant at it. Quite simply, they are passionate about their businesses. Usually, they were running those long before we came along; our only function since has been to stay out of the way. If you see these heroes – and our four heroines as well – at the annual meeting, thank them for the job they do for you.

But, as sure as times change, the same goes for moats. So, if you manage to identify a moat that you may even assess as sustainable, remember that nothing lasts forever, not even wide moats (at least I’d say that’s the most probable and likely outcome if you were asked to make a bet on any given business).

As an example, let’s take a look at the newspaper industry and how it has changed during the latest decades.

Newspapers in the ’70s: Moat-Widening

Thanks to a reader of the blog, I was made aware of an article published back in 1977 in the Wall Street Journal and entitled The Collector: Investor Who Piled Up 100 Million in the ’60s Piles Up Firms Today. In this article the author wrote about Warren Buffett’s taste for cash-generating newspapers with moats:

Warren has been largely restricting himself to companies which he feels offer some protection against inflation in that they have a unique product, low capital needs and the ability to generate cash. Warren likes owning a monopoly or market-dominant newspaper to owning an unregulated toll bridge. You have relative freedom to increase rates when and as much as you want.

To read the WSJ article, click here.

Newspapers Today: Moat-Erosion

Going back through the years and the letters to shareholders written by Warren, we find an extensive discussion about the state of the newspaper industry in his 2012 letter (emphasis added).

We Buy Some Newspapers . . . Newspapers?

During the past fifteen months, we acquired 28 daily newspapers at a cost of $344 million. This may puzzle you for two reasons. First, I have long told you in these letters and at our annual meetings that the circulation, advertising and profits of the newspaper industry overall are certain to decline. That prediction still holds. Second, the properties we purchased fell far short of meeting our oft-stated size requirements for acquisitions.

We can address the second point easily. Charlie and I love newspapers and, if their economics make sense, will buy them even when they fall far short of the size threshold we would require for the purchase of, say, a widget company. Addressing the first point requires me to provide a more elaborate explanation, including some history.

News, to put it simply, is what people don’t know that they want to know. And people will seek their news – what’s important to them – from whatever sources provide the best combination of immediacy, ease of access, reliability, comprehensiveness and low cost. The relative importance of these factors varies with the nature of the news and the person wanting it.

Before television and the Internet, newspapers were the primary source for an incredible variety of news, a fact that made them indispensable to a very high percentage of the population. Whether your interests were international, national, local, sports or financial quotations, your newspaper usually was first to tell you the latest information. Indeed, your paper contained so much you wanted to learn that you received your money’s worth, even if only a small number of its pages spoke to your specific interests. Better yet, advertisers typically paid almost all of the product’s cost, and readers rode their coattails.

Additionally, the ads themselves delivered information of vital interest to hordes of readers, in effect providing even more “news.” Editors would cringe at the thought, but for many readers learning what jobs or apartments were available, what supermarkets were carrying which weekend specials, or what movies were showing where and when was far more important than the views expressed on the editorial page.

In turn, the local paper was indispensable to advertisers. If Sears or Safeway built stores in Omaha, they required a “megaphone” to tell the city’s residents why their stores should be visited today. Indeed, big department stores and grocers vied to outshout their competition with multi-page spreads, knowing that the goods they advertised would fly off the shelves. With no other megaphone remotely comparable to that of the newspaper, ads sold themselves.

As long as a newspaper was the only one in its community, its profits were certain to be extraordinary; whether it was managed well or poorly made little difference. (As one Southern publisher famously confessed, “I owe my exalted position in life to two great American institutions – nepotism and monopoly.”)

Over the years, almost all cities became one-newspaper towns (or harbored two competing papers that joined forces to operate as a single economic unit). This contraction was inevitable because most people wished to read and pay for only one paper. When competition existed, the paper that gained a significant lead in circulation almost automatically received the most ads. That left ads drawing readers and readers drawing ads. This symbiotic process spelled doom for the weaker paper and became known as “survival of the fattest.”

Now the world has changed. Stock market quotes and the details of national sports events are old news long before the presses begin to roll. The Internet offers extensive information about both available jobs and homes. Television bombards viewers with political, national and international news. In one area of interest after another, newspapers have therefore lost their “primacy.” And, as their audiences have fallen, so has advertising. (Revenues from “help wanted” classified ads – long a huge source of income for newspapers – have plunged more than 90% in the past 12 years.)

Newspapers continue to reign supreme, however, in the delivery of local news. If you want to know what’s going on in your town – whether the news is about the mayor or taxes or high school football – there is no substitute for a local newspaper that is doing its job. A reader’s eyes may glaze over after they take in a couple of paragraphs about Canadian tariffs or political developments in Pakistan; a story about the reader himself or his neighbors will be read to the end. Wherever there is a pervasive sense of community, a paper that serves the special informational needs of that community will remain indispensable to a significant portion of its residents.

Even a valuable product, however, can self-destruct from a faulty business strategy. And that process has been underway during the past decade at almost all papers of size. Publishers – including Berkshire in Buffalo – have offered their paper free on the Internet while charging meaningful sums for the physical specimen. How could this lead to anything other than a sharp and steady drop in sales of the printed product? Falling circulation, moreover, makes a paper less essential to advertisers. Under these conditions, the “virtuous circle” of the past reverses.

The Wall Street Journal went to a pay model early. But the main exemplar for local newspapers is the Arkansas Democrat-Gazette, published by Walter Hussman, Jr. Walter also adopted a pay format early, and over the past decade his paper has retained its circulation far better than any other large paper in the country. Despite Walter’s powerful example, it’s only been in the last year or so that other papers, including Berkshire’s, have explored pay arrangements. Whatever works best – and the answer is not yet clear – will be copied widely.

In a the recent Politico Playbook interview Warren Buffett shared his bearishness on newspapers.

Buffett is bearish on newspapers:
“Newspapers are going to go downhill. Most newspapers, the transition to the internet so far hasn’t worked in digital. The revenues don’t come in. There are a couple of exceptions for national newspapers — The Wall Street Journal and The New York Times are in a different category. That doesn’t mean it necessarily works brilliantly for them, but they are a different business than a local newspaper. But local newspapers continue to decline at a very significant rate. And even with the economy improving, circulation goes down, advertising goes down, and it goes down in prosperous cities, it goes down in areas that are having urban troubles, it goes down in small towns – that’s what amazes me. A town of 10 or 20,000, where there’s no local TV station obviously, and really there’s nothing on the internet that tells you what’s going on in a town like that, but the circulation just goes down every month. And when circulation goes down, advertising is gonna go down, and what used to be a virtuous circle turns into a vicious circle. I still love newspapers! You’re talking to the last guy in the world. Someday you’ll come out and interview me, and you’ll see a guy with a landline phone, reading a print newspaper.”

The table below shows how advertising revenue has declined between 2003 and 2014. A slide that most likely is going to continue.

As summarized by The 13th annual Pew Research State of the News Media Report about the current state-of-play when it comes to newspapers:

It has been evident for several years that the financial realities of the web are not friendly to news entities, whether legacy or digital only. There is money being made on the web, just not by news organizations. Total digital ad spending grew another 20% in 2015 to about $60 billion, a higher growth rate than in 2013 and 2014. But journalism organizations have not been the primary beneficiaries. In fact, compared with a year ago, even more of the digital ad revenue pie — 65% — is swallowed up by just five tech companies. None of these are journalism organizations, though several — including Facebook, Google, Yahoo and Twitter — integrate news into their offerings. And while much of this concentration began when ad spending was mainly occurring on desktops platforms, it quickly took root in the rapidly growing mobile realm as well.

In hindsight, everything looks pretty clear, right?

The trick is being able to continuously evaluate businesses and industries and identify any data that may indicate a coming, or ongoing, moat-erosion. But that’s some topic for another post.

Even though this blog post was about the past, the key take-away from it is that moats change, and we gotta be aware of this and make the best we can out of it we look into the unknown future. At least if we’re hunting for, and investing in, companies supposed to enjoy sustainable competitive advantages.

“Of all the ‘old’ media, newspapers have the most to lose from the internet.”

—The Economist


The Buffett/Munger Investment Checklist

“When investing, we view ourselves as business analysts—not as market analysts, not as macroeconomic analysts, and not even as security analysts.”

—Warren Buffett, Letter to Shareholders, 1987

The Buffett/Munger Investment Checklist: A Framework for Business Analysis and Valuation

How to go about when performing a business analysis, and what to look for in doing so, is nothing but the holy grail of investing. A business analysis could be carried out in a number of different ways. You just have to make sure that you have a way that works for you, a process for analyzing and evaluating businesses that is continually updated along the way as you learn about new facts and circumstances.

When building your own framework for business analysis, you should always remember to keep things simple, since it most likely will tend to get hard enough anyway in the end. Also, you don’t have to come up with your own stuff, you are perfectly free to use everything there is from great men that’s come before, as Charlie Munger noted when he said: 

I believe in the discipline of mastering the best that other people have figured out. I don’t believe in just sitting down and trying to dream it all up yourself. Nobody’s that smart.

To set the scene to sort of create an investing map to follow it’s worth considering what Warren Buffett once wrote:

In our view, though, investment students need only two well-taught courses—How to Value a Business, and How to Think About Market Prices.

To be able to value a business, you have to understand the business. And to be able to say that you understand a business you would likely want to know about its products/services and revenue sources, operating leverage, financial leverage, competitive position, industry characteristics, etc. These questions all belong to the first section of the Buffett/Munger Investment Checklist, i.e., understanding the business.

When you understand a business and its management, and have evaluated the long-term prospects as favorable, the next step is to value the business, i.e., come up with an estimate of intrinsic business value that is to be compared to the current market price of the business. If you manage to, and have the luck, to check each of the four main parts of the checklist, you most likely have an investment worth making.

In his 1977 letter to shareholders Warren Buffett explained his and Charlie’s process for analyzing and evaluating businesses.

We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price. We ordinarily make no attempt to buy equities for anticipated favorable stock price behavior in the short term.  In fact, if their business experience continues to satisfy us, we welcome lower market prices of stocks we own as an opportunity to acquire even more of a good thing at a better price.

So, already back in 1977 Warren Buffett laid out the checklist that he and Charlie go through when evaluating a business. This will serve as a good starting foundation for anyone who wants to build their own investment checklist. Each checklist point could then be expanded to included a number of supporting sub-questions needed for coming up with a conclusion about the “main” checklist question being evaluated.

From the above quote and discussion, keep in mind the foundations of our Buffett/Munger Investment Checklist:

  1. Understand the business
  2. Favorable long-term prospects
  3. Operated by honest and competent management
  4. Very attractive price

To make it easier to remember the top four checklist points, memorize the acronym “UFOV.” That’s easy to remember, right? It’s just “UFO” plus a “V.”

As always, when talking about the subject of checklists, make sure to use them in an appropriate wat and also remember Warren Buffett’s words that “A checklist is no substitute for thinking.”


“Take a simple idea and take it seriously.”

—Charlie Munger

Peter Thiel’s Stanford Lecture Nr. 5: Competition is for Losers

«Escaping competition will give you a monopoly, but even a monopoly is only a great business if it can endure in the future.»

—Peter Thiel, Zero to One

Let’s Go to Class: Peter Thiel on Competition

Click here for slide deck.

A transcript of class nr. 5 is available here.

Also, Blake Master’s notes from the Thiel classes can be found here.

* * * * * * * * * * * * * *

«If I do my job right, this is the last class you’ll ever have to take.» 

—Peter Thiel

Additional Reading

New Mauboussin Paper: Thirty Years

“But great investors do two things that most of us do not. They seek information or views that are different than their own and they update their beliefs when the evidence suggests they should. Neither task is easy.”

―Michael J. Mauboussin, Thirty Years

Thirty Years: Reflections on the Ten Attributes of Great Investors

Credit Suisse’s latest report is out: Thirty Years – Reflections on the Ten Attributes of Great Investors

“Perhaps the single greatest error in the investment business is a failure to distinguish between the knowledge of a company’s fundamentals and the expectations implied by the market price.”

  • The world of investing and business has seen a great deal of change in the past 30 years.
  • This report shares thoughts on the ten attributes of great fundamental investors.
  • Accounting is the language of business and you need to understand it to appreciate economic value and to assess competitive positioning.
  • Investors face a slew of psychological challenges. Perhaps the most difficult is updating beliefs when new information arrives.
  • Position sizing and portfolio construction still do not get the attention they warrant.
  • The substantial shift from active to passive management has profound implications for the investment industry.


Ten Attributes of Great Fundamental Investors

The top ten attributes discussed in the paper are:

  1. Be numerate (and understand accounting)
  2. Understand value (the present value of free cash flow)
  3. Properly assess strategy (or how a business makes money)
  4. Compare effectively (expectations versus fundamentals)
  5. Think probabilistically (there are few sure things)
  6. Update your views effectively (beliefs are hypotheses to be tested, not treasures to be protected)
  7. Beware of behavioral biases (minimizing constraints to good thinking)
  8. Know the difference between information and influence
  9. Position sizing (maximizing the payoff from edge)
  10. Read (and keep an open mind)

See here for a collection of links to other Mauboussin papers.

Peter Thiel on the Characteristics of Monopoly

”The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”

—Warren Buffett

”ESCAPING COMPETITION will give you a monopoly, but even a monopoly is only a great business if it can endure in the future.”

—Peter Thiel, Zero to One

Are you buying an asset or a franchise?

Let’s start with some thinking about investing, what you buy, and why you buy it.

In the end, for any single investment you’ll make, it’s all about the risk and inflation adjusted after tax return on invested capital net of any expenses. When you invest you are giving up money that could have been used to buy goods or services today, with the aim of (hopefully) receiving more in the (unknown) future.

One critical questions to consider and answer for each business you invest in is: “Are you buying an asset or a franchise?”

In his 1991 letter to shareholders Warren Buffett provided a definition of a franchise:

An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company's ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise's profitability, but they cannot inflict mortal damage. 

In contrast, "a business" earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management. 

(Source: Warren Buffett, Shareholder Letter, 1991)

What Buffett calls “a business,” is what I earlier named an “asset.” In theory, what Buffett calls “a business” is a business that does not have a sustainable competitive advantage, i.e., no moat, and thus is not able to earn any economic profits, i.e., a return on invested capital (ROIC) above its cost of capital (COC). The invested capital (assets) in a business like this does not generate any excess value since ROIC equals COC, and the business is only worth the value of its assets.

In contrast, a franchise is a business that earns a ROIC above its COC, and in a situation like this the earning power of the business will result in a intrinsic value exceeding the value of the assets. For this to be sustainable, and for you to go on and base your valuation from the future earning power of the business, there must be some characteristics of the business that makes it possible to defend these excess profits from any competitors that will try to take these profits away. A wide moat (sustainable competitive advantage) will make sure this does not happen—then the next question to consider is the durability of the moat, i.e., how long the business will be able to defend its excess profits. If there is no moat, incumbents have no advantage over entrants and all excess profits will be competed away—maybe not in the short term, but it will happen over the long haul.

A stock selection framework when trying to answer this question—see image below—was originally published in The Manual of Ideas: The Proven Framework for Finding the Best Value Investment, written by John Mihaljevic.

Depending on your answer to the question (asset or franchise), there are two different ways when approaching your analysis: (1) asset value analysis or (2) earning power analysis. When looking at a franchise, that is, a business enjoying a sustainable competitive advantage (or a moat with lots of piranhas in it) the analysis will focus on the earning power of the business.

In the beginning of the book Mihaljevic describes the stock selection framework as follows.

Figure 1.2o outlines an approach that may be able to handle, at least in principle, the vast array of equity investment opportunities available in the public markets. Although the following framework may not be practicable for most small investors, it does illustrate how we may think about security selection if we adopt the mindset of chief capital allocator.

The stock selection framework begins by asking whether the net assets are available for purchase for less than replacement cost. If this is not the case, we exclude the company from consideration because it might be cheaper to re-create the equity in the private market. If the equity is available for less than replacement cost, then we consider whether it is so cheap that liquidation would yield an incremental return. If this is the case, we may consider liquidating the equity. In the vast majority of cases, an equity will trade far above liquidation value, in which case we turn our attention to earning power.

Once we focus on the earning power of a going concern, the key consideration becomes whether the business will throw off sufficient income to allow us to earn a satisfactory return on investment. Many related considerations enter the picture here, including the relationship between net income and free cash fl ow, the ability of the business to reinvest capital at attractive rates of return, and the nature of management ’s capital allocation policies.


From Zero to One, or Asset to Franchise

Zero to One, written by Peter Thiel, is a book about ”how to build companies that create new things.” The book is based on a course that Thiel held about startups at Stanford in 2012, and ”the primary goal in teaching the class was to help [his] students see beyond the tracks laid down by academic specialties to the broader future that is theirs to create.”

As always, there is no one formula to find. Instead, there are principles.

”The paradox of teaching entrepreneurship is that such a formula necessarily cannot exist; because every innovation is new and unique, no authority can prescribe in concrete terms how to be innovative. Indeed, the single most powerful pattern I have noticed is that successful people find value in unexpected places, and they do this by thinking about business from first principles instead of formulas.”

Zero to One is about a few things to consider in building a business from the start. Although the book focuses on venture capital and startups, it’s worth reading for everyone interested in business analysis and investing. Why? It discusses the difference between a great business, a business with a sustainable competitive advantage (or “monopoly”), and and businesses that doesn’t enjoy any competitive advantage at all and is bound for a hard struggle for any profits available in a highly competitive market (in theory, the cost of capital since economic profits are competed away).

The value of a business today comes from the cash inflows and outflows that can be expected to occur during the remaining life of the asset discounted at an appropriate interest rate. So, when thinking about the value of any business, future cash flows is highly critical, and at the same time highly uncertain.

One section in the book is called Monopoly Characteristics and devoted to a discussion of what characteristics (i.e., competitive advantages) to look for in a business. Thiel starts by asking a central question:

”What does a company with large cash flows far into the future look like? Every monopoly is unique, but they usually share some combination of the following characteristics: proprietary technology, network effects, economies of scale, and branding.”

Further Thiel notes that:

”This isn’t a list of boxes to check as you build your business—there’s no shortcut to monopoly. However, analyzing your business according to these characteristics can help you think about how to make it durable.”

Characteristics of Monopoly to Look For

Thiel asks and discusses a critical question when it comes to businesses and investing: “What does a company with large cash flows far into the future look like?” This is pretty close to the one-million dollar question. But Thiel also provides a discussion of the different characteristics to look for in our analysis of different businesses. According to Thiel “[e]very monopoly is unique, but they usually share some combination of the following characteristics: proprietary technology, network effects, economies of scale, and branding.”

Below each one of the different characteristics is summarized with all of the quotes below taken from the book.

Monopoly Characteristic Nr. 1: Proprietary Technology

Definition: “Proprietary technology is the most substantive advantage a company can have because it makes your product difficult or impossible to replicate.”

Two different ways: (1) invent something completely new, or (2) radically improve an existing solution.

  • Invent something completely new: “Google’s search algorithms, for example, return results better than anyone else’s. Proprietary technologies for extremely short page load times and highly accurate query autocompletion add to the core search product’s robustness and defensibility. It would be very hard for anyone to do to Google what Google did to all the other search engine companies in the early 2000s.”
  • Radically improve on an existing solution: “Or you can radically improve an existing solution: once you’re 10x better, you escape competition. PayPal, for instance, made buying and selling on eBay at least 10 times better. Instead of mailing a check that would take 7 to 10 days to arrive, PayPal let buyers pay as soon as an auction ended. Sellers received their proceeds right away, and unlike with a check, they knew the funds were good. Amazon made its first 10x improvement in a particularly visible way: they offered at least 10 times as many books as any other bookstore. When it launched in 1995, Amazon could claim to be “Earth’s largest bookstore” because, unlike a retail bookstore that might stock 100,000 books, Amazon didn’t need to physically store any inventory—it simply requested the title from its supplier whenever a customer made an order. This quantum improvement was so effective that a very unhappy Barnes & Noble filed a lawsuit three days before Amazon’s IPO, claiming that Amazon was unfairly calling itself a “bookstore” when really it was a “book broker.”You can also make a 10x improvement through superior integrated design. Before 2010, tablet computing was so poor that for all practical purposes the market didn’t even exist. “Microsoft Windows XP Tablet PC Edition” products first shipped in 2002, and Nokia released its own “Internet Tablet” in 2005, but they were a pain to use. Then Apple released the iPad. Design improvements are hard to measure, but it seems clear that Apple improved on anything that had come before by at least an order of magnitude: tablets went from unusable to useful.”

Examples: Google, PayPal, and Amazon.

Rule of thumb: Must be “at least 10 times better than its closest substitute in some important dimension to lead to a real monopolistic advantage.”

Monopoly Characteristic Nr. 2: Network Effects

Definition: ”Network effects make a product more useful as more people use it.”

Examples: “For example, if all your friends are on Facebook, it makes sense for you to join Facebook, too. Unilaterally choosing a different social network would only make you an eccentric.”

Rule of thumb: “Network effects can be powerful, but you’ll never reap them unless your product is valuable to its very first users when the network is necessarily small. … Paradoxically, then, network effects businesses must start with especially small markets. Facebook started with just Harvard students—Mark Zuckerberg’s first product was designed to get all his classmates signed up, not to attract all people of Earth. This is why successful network businesses rarely get started by MBA types: the initial markets are so small that they often don’t even appear to be business opportunities at all.”

Monopoly Characteristic Nr. 3: Economies of Scale

Definition: ”A monopoly business gets stronger as it gets bigger: the fixed costs of creating a product (engineering, management, office space) can be spread out over ever greater quantities of sales. Software startups can enjoy especially dramatic economies of scale because the marginal cost of producing another copy of the product is close to zero.”

Rule of thumb: ”Many businesses gain only limited advantages as they grow to large scale. Service businesses especially are difficult to make monopolies. If you own a yoga studio, for example, you’ll only be able to serve a certain number of customers. You can hire more instructors and expand to more locations, but your margins will remain fairly low and you’ll never reach a point where a core group of talented people can provide something of value to millions of separate clients, as software engineers are able to do.”

Examples: ”A good startup should have the potential for great scale built into its first design. Twitter already has more than 250 million users today. It doesn’t need to add too many customized features in order to acquire more, and there’s no inherent reason why it should ever stop growing.”

Monopoly Characteristic Nr. 4: Branding

Definition: ”A company has a monopoly on its own brand by definition, so creating a strong brand is a powerful way to claim a monopoly.”

Rule of thumb: ”Beginning with brand rather than substance is dangerous.”

Examples: ”Today’s strongest tech brand is Apple: the attractive looks and carefully chosen materials of products like the iPhone and MacBook, the Apple Stores’ sleek minimalist design and close control over the consumer experience, the omnipresent advertising campaigns, the price positioning as a maker of premium goods, and the lingering nimbus of Steve Jobs’s personal charisma all contribute to a perception that Apple offers products so good as to constitute a category of their own.”

Competitive Advantages Framework

I have written about the subject of competitive advantages earlier, and put together the “Competitive Advantages Framework” as a way to keep the most important parts in one and the same place. As we noted earlier, there is no single formula, instead there are principles to guide us in our analysis and understanding.

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.