Jim Chanos Talks Tesla and Kidney Dialysis

I’m a great admirer of Chanos and I always try to learn something when I hear him speak. Here, an inter interview produced by Bloomberg. Two of the topics discussed, among others, were Tesla and the kidney dialysis industry.

To watch the interview, click here.

Below, two parts of the interview, the first one with a few words from Jim Chanos on the kidney dialysis industry (emphasis added).

*THE KIDNEY DIALYSIS INDUSTRY*

[12:45] Joe Weisenthal: Alright, to move it back from politics and theory for a second, I noticed you said there in your answer that you’re focused on some companies that may be in trouble with the potential rollback of the essential health care benefits. So, can you give us some insight into some specifics? Who’s vulnerable to a theoretical rollback there?

Jim Chanos: One area we would really focus in on, there’s only a handful public place, is the kidney dialysis business. I think that business is really heading for difficulties.

JW: Oh, we have a chart here of some different public companies…

JC: Oh, what a coincident.

JW: …in kidney dialysis. Amazing how that happened.

JC: There’s three of them, and I should say here that any companies that you either see a chart of or I mention, either intentionally or inadvertedly, you should assume that we are short that stock. Disclosure now done. And so, the kidney dialysis business is interesting because we have Obama care exchange insurance officials on record saying that kidney dialysis is almost single-handedly breaking the exchanges. Blue Cross of California has said that for every single kidney dialysis patient they have, they need 3,800 healthy lives to cover it. It is amazingly expensive, but not in the way you would think. In the way these companies have prospered, in a weird way, is they’re actually trying to push Medicare and Medicaid patients – where the reimbursement is much lower – into Obama care, and where they get two to three times the reimbursement rate, and under the essential health benefits factor, they gotta provide it. And so, taking an elderly person who’s on Medicare, why would they go into Obama care, right? It would costs them, an elderly person, a fair amount of money. Well, they get third parties to pay a big chunk of the premium, the former charities. And guess who donates to some of those charities? And so this is one of these sort of rent-seeking behaviours that I think is gonna go by the wayside. And I think these excess returns… one of those companies that you had up there actually has a slide in their investor dec that said 90% of their business is Medicare/Medicaid and that loses money. Ten percent of their business is commercial and that makes a 110% of their operating profit.

JW. So everybody can go search for that…

JC: Yeah, they can go search for one of those three companies. I think they quite figure it out.

Scarlet Fu: So has that gained momentum? Do you hear other people pressing the company on that? How that doesn’t seem to make sense?

JC: Well, there was a wonderful… I can’t mention networks, I know it’s no good on Bloomberg. But there was a wonderful Sunday night weekly news show on a cable network, chaired by a British guy, that actually did a 15 minutes segment about one of these companies about a month ago, and we were stunned when we saw it. We had no idea that anybody else cared. But they did a pretty good job at walking you through exactly what an issue this is.

So for all investors out there interested in the kidney dialysis industry, and for example DaVita Healthcare Partners (Ticker: DVA), a Berkshire stock investment, this might be something to dig deeper into to see whether Jim Chanos and his Kynikos is on to something here or not.

Following the chat about the kidney dialysis business is a discussion about Tesla, a company Jim Chanos has been talking about publicly before.

*THE TESLA AUTOMOBILE*

[15:49] SF: Let’s move on to another company that you have spoken publicly about which is Tesla. And as I imagined…

JC: Who?

SF: Tesla. T-S-L-A.

JC: Okay.

SF: The company is holding its annual shareholders meeting right now, so they’re probably applauding themselves for their five-year return. If you look at a chart…

JC: They’re probably launching themselves to March right now…

SF: Perhaps, perhaps. The stock has somewhat launched itself. It’s gone from less than $30 five years ago to more than $350. That’s a return of more than 1,000 percent despite the absence of consistent profits and incredible cash burn. So, Joe and I were talking about this, we know you’ve been public on Tesla for some while. What would it take for you to throw in the towel? What would have to happen for you to throw in the towel and say “I give up on this short, this is not gonna work”?

JC: I think that have to see the company actually begin to make money selling products. And I should point out that we were also short Solar City that he bought in. That one worked out a little better than Tesla. So, the fact of the matter is, that this is a company that, as you pointed out, burns a lot of cash and we think they’re gonna be burning close to 750 million to a billion a quarter for the next handful of quarters. It has not finished its Gigafactory, the batteries are made by Panasonic. But most importantly it has its big test ahead of it; the Model 3. It has been loosing money selling $120,000 cars, but it hopes to make money selling a $35,000 car, which we think it will be a lot more than that. You have an executive departure list, the only one I’ve seen longer in the last two years is Valeant’s. There just people are leaving left, right and center.

SF: It’s a freight train…

JC: Well something… I mean, I don’t know. They’re certainly… they’re not waiting around for the company of the future, the stock price notwithstanding. And so we’ll see. I mean the car is supposed to go into production in July. They’ll be competing with real companies in 2018. I noted with some interest as I got here the opening remarks by Mr. Musk were talking about transforming to an energy company, an energy solution company or something like that. So he’s trying to reposition the company as something other than an automobile company. But it is an automobile company with a money-loosing solar roof company subsidiary. In addition he’s got to raise a lot of money. Rule of thumb is it takes about 50 cents in capital for every dollar of automobile revenues. So if he’s gonna be doing a 500,000 Model 3’s and 100,000 of the Model S’s and Model X’s, he’s gonna need something on the order – that’ll be thirty some billion in revenues – he’s gonna need about another ten billion in capital to do that, and he’s gonna need it soon. So the Teslarian should just embrace themselves cause they’re gonna get the chance to buy a lot more stock or convert here I suspect in the coming months.

JW: What’s the most likely way, in your view, in which the Tesla story ends? Is it something that in the Model 3 doesn’t live up to the high…

JC: He actually starts making money. That’ll be what ends it.

JW: No, but I mean like in terms your thesis becoming validated. Would it be more of a sort of an investor strike, as in conditions changed, there’s a market downturn, people aren’t able to fund the…

JC: If the Model 3 isn’t gonna be popular, that’s gonna hurt, right. That’s the one everybody’s waiting for, the one that the average person who can’t afford an S or X and wants to be part of the Tesla revolution and if the car is a lemon I think that will be a problem. […] But at the end of the day he’s gotta make a car for the masses that is successful, so that’s what we’re gonna watch.

Some takeaways from the above talk that you may want to consider putting into your investor’s toolbox are:

  1. Are all customers contributing proportionally to the company’s profits?
  2. What’s the downside to the business from any current or future regulatory changes?
  3. How much capital is needed to support future growth (capital to revenues ratio)?
    • Who will provide the capital – debt or equity holder (any dilutive effects on current shareholders)?
    • Will the company be able to raise the capital needed?
    • How long is the business able to keep on going without further capital contributions?
  4. Does the industry in which the business operates make it possible for companies to gain and sustain any sustainable competitive advantages?

Disclosure: I have no position in any stock mentioned.

Notes & Quotes – Wealthtrack: Greenblatt Talks Investing

“I’ve been teaching for a long time and I would say that my most successful students are the ones who actually enjoy the process of figuring things out.”

―Joel Greenblatt

When I see Joel Greenblatt, for some reason, he reminds me of Benjamin Graham. I don’t really know why, but I guess it’s something in the way he behaves and talks and the wisdom he shares. And I don’t really know Graham himself much and what he looked like and the way he talked. I associate Greenblatt with Graham, let’s just leave it at that since it doesn’t really matter a lot.

Joel Greenblatt visited Consuelo Mack’s Wealthtrack on November 4, 2016. In this Wealthtrack episode discussions range from what makes a good investment, why the price you pay is crucial, return on invested capital, Warren Buffett and more.

Just to say it, my intention was not to go out and transcribe the whole interview. It just happened to be such a great one that I ended up doing it. Listening to Greenblatt when he discusses the different topics thorughout this Wealthtrack episode truly deserves the attention from every investor out there. So I hope you’ll enjoy it. And also, feel free to share it with anybody you think could learn from it.

The Secret to Investing

Consuelo Mack: Grenblatt has also written several books: You Could Be A Stock Market Genius, The Little Book that Beats the Market, The Little Book that Still Beats the Market, and The Big Secret for the Small Investor. I began the interview by asking Greenblatt to distill a lifetime of being a successful value investor. What is the secret?

Joel Greenblatt: If there is any secret I think there is in understanding what you’re doing. And most people don’t think of stocks, they think of them as pieces of paper that bounce around, and you put ratios on them or figure out difficult math problems with them. To us they’re merely owner-shares of businesses that we’re trying to value and buy at a discount. I think the people who are successful at it a) understand that, and b) really enjoy what they’re doing. I’ve been teaching for a long time and I would say that my most successful students are the ones who actually enjoy the process of figuring things out.

Consuelo Mack: So what does value mean to Joel Greenblatt?

Joel Greenblatt: Value means exactly that, figuring out what a business is worth and only buying it when it’s worth a lot less. Ben Graham said: “Figure out what something’s worth. Buy it at a big discount. Leave a large margin of safety between those two.” And that still the key to it. It’s not more complicated than that.

Consuelo Mack: You and your partner Rob Goldstein have devised a ranking system using just two variables. Is that correct? Return on invested capital and earnings yield.

Joel Greenblatt: Rob and I did a research project, and the very first thing we tested were those two concepts. Is it cheap? Does it earn a lot relative to the price we’re paying? And is it in a good business?In other words, does it deploy its capital well? So cheap was Ben Graham. His best student Warren Buffett made one little twist that made him one of the richest people in the world. He said: “If I could buy a good business cheap, even better.”

Consuelo Mack: So not just cheap? But, a good business cheap?

Joel Greenblatt: A good business cheap. And that was Warren Buffett’s little twist that helped him be so successful over time. And, we started out a project to test the concept that I’d been teaching my students, that Rob and I had been using for many years to make money, to see if we could prove those simple concepts worked very well. And the very first test we did of it ended up, I wrote a book about it called The Little Book That Beats The Market because the tests were so phenomenally good. That’s not exactly what we do now, in other words that was done, I would call that the “Not-Trying-Very-Hard-Method.” We used some crude metrics to simulate cheap and good. And those crude metrics worked so well that we said; “Well listen, we roll up your sleeve investors, we tear apart balance sheets, income statements, cash flow statements.” That’s what we do for a living. We’ve been analysing these for a long time. So, can we take these concepts and really and take them to the next level. The simple concepts work amazingly well. And so we sought out on a long project to improve on that. But, the principles are still the same.

jgbooks

Consuelo Mack: If I started tearing up a balance sheet and income statements and if I were looking for… Is my starting point return on invested capital and earnings yield? Is that… That would be my first kind of cut?

Joel Greenblatt: I think my first cut would be cheap. And that would be the earnings yield portions of what you’re talking about.

Consuelo Mack: Right.

Joel Greenblatt: You know I don’t live in Manhattan, but if I did and I had a three bedroom apartment. If it was available for $250,000, take my word for it, it would be a steal. At $50 million it would be ridiculous. The apartment, the quality of the apartment hasn’t changed. It’s the price that determines whether something’s a good investment. So you can’t invest without price.

Consuelo Mack: And the second part, the return on invested capital, that’s the good, whether it’s good or not. Could you explain how you find return on invested capital?

Joel Greenblatt: Sure. Well, the example I gave in my book, the little book, which I really wrote for my kids to explain it. I gave two examples. I said “Think about you building a store.” Well, you have to buy the land, you have to build the store, you have to set up the displays, you have to stock it with inventory. Let’s say all that cost you $400,000. And every year that store spits out $200,000 in profit. That’s a 50% return on tangible capital. Every business needs working capital, every business needs fixed assets. How well does that business convert the working capital and the fixed assets into earnings? Then I gave another example, and remember it’s for my kids. It’s another store and I call that store Broccoli. It’s a store that just sells broccoli. Not a very good idea. But you still have to buy the land, build the store, set up the display, stock with inventory. It’s still gonna cost you roughly $400,000. But because it’s not a very good idea to just sell broccoli in your store, maybe it earns somehow $10,000 a year. That would be a 2.5% return on tangible capital. So I would simply say: “I would like to own the business that could reinvest its money at 50% returns than 2.5% returns.” And if you read through Warren Buffett’s letters he doesn’t use that term return on tangible capital, but that’s what I called it in the book.

Consuelo Mack: Talk to me about your strategy of choosing stocks, specifically for the diversified long-short hedge funds that you are running now.

Joel Greenblatt: Sure. It’s probably disappointingly simple what I’m gonna tell you. But basically we look at the 2,000 largest companies in the U.S. And we rate them from 1 to 2,000 based on their discount to our assessment of value. Stock number one gets the biggest weight in our portfolio. Stock number two gets the second biggest weight. Same on the short-side. The most expensive stock relative to our assessment of value gets the biggest weight on the short side. And the second gets the second biggest weight. We own roughly a little over 300 stocks on the long side, and 300 stocks on the short side.

Consuelo Mack: So there’s 300 in each extreme?

Joel Greenblatt: Yes, they’re not equally weighted but we own over 300 on each side. And so what we have to do is be right on average. And we’re pretty good at average. We’re not always right, but we’re pretty good on average.

Consuelo Mack: And why couldn’t I just duplicate that?

Joel Greenblatt: I wrote another book it begins, it’s called The Big Secret. And it’s still a secret I say cause nobody bought it. So I’ll just tell you what the secret is.

Consuelo Mack: Yes, please do.

Joel Greenblatt: The secret is really patience is in really short supply. I give a few examples in that book, one of them is really telling. I looked at the top performing managers for the decade of 2000 to 2010. I looked at the top quartile managers, the ones who ended up with the best records.

Consuelo Mack: That’s after the tech crash?

Joel Greenblatt: Yes, 2000 to 2010. Inclusive of the tech crash.

Consuelo Mack: The “lost decade” some people call it.

Joel Greenblatt: Right, the market was actually flat during those period. But the top quartile managers, here are there stats. 97% of those who ended up with the best records spent at least three of those ten years in the bottom half of performance. Not a surprise, but it’s almost everyone.

Consuelo Mack: In the same decade?

Joel Greenblatt: In the same decade. 79% of those who ended up with the best ten-year record spent at least three years in the bottom quartile of performance. And here is the stunning statistic. 47% of those who ended up with the best record spent at least three of the ten years in the bottom decile of performance, meaning they were in the bottom ten percent. So you’re pretty sure that none of their clients actually stuck with them to get the good returns. And to beat the market you have to do something little different than the market. You gotta zig and zag a little differently. But clients are not very patient. I also wrote a study about institutional investors. Two actually academic studies, and both studies concluded the same thing. There is only one metric you need to predict the institutional cash flows. And that metric is “How did the fund do last year?” If it did well it gets all the inflows, if it didn’t do well it gets all the outflows.

Consuelo Mack: Where were you during that decade? I mean, did you meet those statistics? Where you… I don’t know, how many years were you in the bottom decile, or bottom ten percent?

Joel Greenblatt: Sure, we did measure it. We had a year, I would say our worst years were 1998 and ’99 during the Internet Bubble.

Consuelo Mack: Sure.

Joel Greenblatt: The market didn’t agree with the way we were valuing companies. And then the market plummeted in 2000, it wasn’t that we became geniuses all of a sudden. We were doing the same things we were doing in 1998-99 when it wasn’t working. And we got paid of in 2000 when the market became more sane.

Consuelo Mack: What are a couple of the cheapest companies right now that you’re holding?

Joel Greenblatt: Well, there’s one called Towers Watson. It’s a cheap company. It really does all kinds of work for companies, keeping track of their employees and everything else. And it’s a very steady business, and now with the health-care reform I think they’re gonna have continued growth going forward. So that’s a nice business. VeriSign registers most of the domain names in the United States.

Consuelo Mack: So that’s another one that’s again one of the cheapest two by your evaluation?

Joel Greenblatt: Sure, it doesn’t have a lot of growth. It’s still growing about 5% a year, but it’s a very steady income, big cash flow generation. So it’s a, you know, good and cheap.

Consuelo Mack: Right. And what’s the turnover in your portfolios these days?

Joel Greenblatt: Well the way it works is that, you know, if we buy the company at the biggest discount to our assessment of value. Here is value and here is price. Companies on the little cheap… if I’m right in what I tell my students, companies are on a little journey towards fair value over time. And as a company moves towards fair value over time, it’s not as cheap as it used to be. It still could be very cheap, but not as cheap. So we’ll sell some of it down and reinvest that cash in companies that are cheaper. So that’s our process. But if you start at the beginning of the year in our long book, we probably have about 45% of the same names at the end of the year. But their allocation in the portfolio may change.

Consuelo Mack: Right. And I’m gonna ask to the flip side of that. So what are some of the most expensive names in that universe of 2,000 companies that you’re looking at?

Joel Greenblatt: Well Twitter is a company that has a lot of users but not a lot of revenue and a lot of cash flow. And you know it’s losing money, so that’s not usually a good thing. You know growth has slowed down so it’ll be curious to see if they could turn that into a good business model. Zynga is a game company that loses lots of money and probably has seen its heyday. So that’s another short that we have. And generally we’re looking for things that are earning very little or losing money and destroying capital as they do it.

Consuelo Mack: What’s wrong with the old-fashioned way of value investing of just going long, of just buying companies that are really cheap and good?

Joel Greenblatt: Sure, there’s nothing wrong with that and for many years we pursued that.

Consuelo Mack: Right.

Joel Greenblatt: I think perhaps part of your question would be: “Why do most people who go out, especially professional mangers to go out to beat the market, fail?” And I think they have very diversified portfolios of companies, and it’s very hard to know in dozens, or 30, 40, 50, 60 companies very well and know them better than other people. So I think the way to go about it, following that kind of strategy, would be much more… at least one of the ways, would be in a much more concentrated strategy, keeping to what you know very very well and those companies are usually far and few between. So usually a handful of companies, and most managers don’t stick to just a handful of companies. It’s to volatile for their investors. They’ll have to underperform a lot of the time, so people don’t really pursue that strategy. But if you’re goal is to beat the market, that’s a good one.

Consuelo Mack: And speaking of running a concentrated portfolio, Gotham Capital the hedge fund that you co-manage with your business partner from 1985 to 1995. It did have a very heavily concentrated portfolio, I mean six to eight names I read somewhere. Why did you take that approach to begin with? Why be that concentrated?

Joel Greenblatt: Right. That’s a great question. And it really goes to the answer I just said. We couldn’t know companies very very well if we had to know 50 of them. We might have to go through 50 or 100 companies to find those six or eight that are at the biggest discount to our assessment value. But what comes with such a concentrated portfolio is that every few years and or two of ideas you wake up and they haven’t worked out, and you might loose 20 or 30 percent of your net worth in those few days. And if you have outside investors they are not too pleased about that. If you’re working with a partner like a have, Rob Goldstein, we understand what we own, we understand that’s it’s just at a bigger discount if we haven’t changed our opinion, and so we’re willing to stick with it. But not many people would. The problem with, I think, giving money to idiosyncratic stock pickers is that I think investors don’t know the logic that really leant behind each investment. All they really have are the numbers, the results.

Consuelo Mack: Right.

Joel Greenblatt: And unfortunately returns in the last 1, 3, or 5 years have very little to do with the next 1, 3, and 5 years. But that’s all people look at, so that they’re giving money to the people who have just performed the best, then they’re taking money from the people who have performed the worst. That’s actually not what’s going on. What you wanna look at is process. Are they evaluating and valuing businesses in a disciplined and effective way?

Consuelo Mack: Is there some Greenblatt golden rule or approach that enables you to invest in this, again it’s a very focused portfolio that got you these 30 or 40 percent annualised returns when you were running Gotham Capital?

Joel Greenblatt: Well sure. I actually wrote a book of war stories, things you looked at, You Could Be A Stock Market Genius. Probably one of the most poorly worded titles ever. But in it I tried to really explain how we go about doing things. So it was a compilation of war stories. And one of the things I said in there was: “If you don’t loose money, most of the other alternatives are good.” So that’s one thing to think of. But mostly the book was about special situations investing. In other words, looking for things that are a little bit of the beaten path, they’re a little complicated, or just a little different then what other people are looking at. Company going through extraordinary changes. Something little odd, something little complicated, something a little different. So I would not say to get those type of returns we had to be the world’s greatest analysts. We just had to look under a few different rocks where other people weren’t looking at the time. But it still all comes down to being able to value a business and buying it at a discount. It’s just that, why not turn the edge in your favour and look at places that other people aren’t.

Consuelo Mack: Do you have a special situation that you’re investing in now? That would exemplify your approach?

Joel Greenblatt: Well frankly, what we’re doing now in a very diversified approach is valuing businesses. And so about six years ago Rob and I my partner, we looked at each other and said… picking, doing an intensive work on just a handful of companies is a full-time job. Covering a whole universe of research universe of stocks, a few thousands of stocks, even with a nice analyst team and a very talented analyst team, is also a full-time job. And we couldn’t do both, and so we decided to go all-in here. And part of it was that it was a little bit different than what we had been doing for several decades. The other part was that there’s a number of ways to make money. One is to be very concentrated in something you know well. And that’s what we had done for a long time. And the other is to be right on average. The benefits of what we’re doing now is that, as I told you before, if… when we owned a stock portfolio of 6 to 8 stocks and two of our investments weren’t going our way, we might wake up and loose 20 or 30 percent of our net worth. Today with a more diversified portfolio our bad days are 20 or 30 basis points of underperformance. And so for most investors, the reason we decided to take outside money in again is our other approach was probably not appropriate for most investors really can’t take the kind of volatility that of that concentrated approach. And the best strategy for most people is the one they can stick with.

Consuelo Mack: Tell me why you and your business partner decided to close the Gotham, the heavily concentrated Gotham Capital fund, and give the money back to investors–the outside investors.

Joel Greenblatt: Sure. We had a great record for 10 years. So we opened up in 1985 and at the end of ’94 we had built up a great ten-year record. And we had done well enough to keep our staff and continued to run our money while returning  outside money. Part of it is that we didn’t wanna peg the principle our way of what we know how to do well. So we as your assets rise, Warren Buffett said; “The fat wallet is the enemy of high investment returns.” And so as you raise more and more money it becomes more difficult to get high returns.

Consuelo Mack: Especially in a very focused portfolio, or?

Joel Greenblatt: Yeah, especially in a very focused portfolio. At least that you have many more alternatives, as you run more and more money, and Buffett runs you know probably a $100 billion or so, you can’t look at a number of the smaller situations that you could before. And even if you could, you couldn’t put a lot of you money, a big percentage of your money in those. So I think we should start in the way of keeping our hurdles pretty low. You know, being able to look at more choices is usually better, and so we wanted to. And it was a very concentrated portfolio. So it was a combination of those things. And we really enjoy what we do.

Consuelo Mack: Explain the long-short strategy, and why you think over the long term that’s better than just being long.

Joel Greenblatt: Sure. Well, if you’re able, when you’re a long and short, long you’re picking the cheapest companies you could find. The ones that are at a discount. The ones you think could give you good returns over time.

Consuelo Mack: You are as a value investor?

Joel Greenblatt: Yes. And on the short side you’re gonna pick expensive companies that you think will come down over time, meaning they are overpriced, and the market will realise that they’re overpriced and come down over time. If you’re good at doing both you have two ways of making money. One on the stocks you like the best, and one on the stocks you like the least. So what we’re trying to construct is something that makes it easier to be a contrarian value investor. Buy things people don’t want, short things that people love to death at the moment. And that’s potentially a volatile market. We’re trying to make it as diversified and easy to take as possible. So it’s always tough to be a contrarian, and we’re trying to make it as painless as possible. It’s not always successful, but that’s the goal.

Consuelo Mack: How do you justify, I guess from a value investor perspective, the fact that you are investing in so many companies? They all can’t be the best. Doesn’t that bother you at all, I mean, you’re dealing now with numbers in supposed to individual companies that you know inside and out?

Joel Greenblatt: Sure. No, it’s a great question. The big picture is we’re excellent on average. We’re not right every time, we’re right most of the time however. And that’s all we need to be when we have 300 names. On average we get it right. And some things are inherently uncertain. A lot has to do with what’s gonna happen in the future. It’s been shown that Wall Street analysts aren’t particularly good at doing that. But when we’re using our metrics of valuation, both cheap and good, on average they work quite well over time.

Consuelo Mack: Last question. The one investment for a long-term investment diversified portfolio, I ask each of our guests what that should be. Obviously none of our guests can recommend their own founds. So what would you have us all own some of in a long-term diversified portfolio?

Joel Greenblatt: Well, number one for tax reasons, ETFs are a great structure meaning you don’t pay taxes until you sell them. So if you bought an ETF, a share in an ETF today and held it for twenty years, when you get dividends you’ll pay taxes on that but you won’t pay any taxes, it’s almost like a retirement account. You don’t pay taxes, if they’re well-structured, until the twenty years ahead when you sell them. I wrote a book saying that market-cap weighted indexes aren’t really the smartest way to go about investing

Consuelo Mack: Because?

Joel Greenblatt: Well, because for market-cap weighting, what that means is that you buy more of the bigger companies. The ones with the higher prices. And if a company is overvalued, what you tend to do is buy more of it because you’re being the ones at the highest prices. If a company is bargain-priced your owning less of it. So it’s really a systematic way to do the wrong thing at every stage. And that cost you about 2% a year. So your alternatives would either go to an equally-weighted index, an equally weighted S&P 500 and those work. And you make plenty of errors and you make them randomly so you get the 2% back, that you make the mistakes with a market-cap index. You could buy a fundamentally weighted index or what I would prefer is a well-structured value index but in form of an ETF so you have the tax advantages. And for most people most funds don’t beat the market over time. So the advice to buy an index, despite what I do for a living, is quite good. Just you should buy the right index.

Consuelo Mack: Joel Greenblatt, thank you so much for joining us from the Gotham Funds. It’s been like taking your class at Columbia Business School. We really appreciate it.

Joel Greenblatt: Thanks so much for having me. Appreciate it.

Links

 

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.

LeonForbes

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.

BARRY RITHOLTZ: You do?

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.

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Jim Chanos on Idea Generation Through Pattern Recognition

“…we’ve tended down through the years to see that a lot of our ideas fit certain broad themes.” —Jim Chanos

Podcast: Jim Chanos on the Art of Short-Selling

A few days ago I was lucky to find another great interview with Mr. Chanos, this time from FT Alphachatterbox released on April 25, 2016. In this interview Jim Chanos is asked a question about idea generation and pattern recognition:

Getting back into the general sense of where ideas come from, are there kinds of patterns that you look for? What are the sorts of things, whether it’s capital structure of a company or management that sets off alarm bells?

Answering this question Jim Chanos provided a list of six broad schemes that he admits a lot of Kynikos Associates’ investment ideas fit into. The six schemes are:

  1. BOOMS THAT GO BUST. “…we’ve tended down through the years to see that a lot of our ideas fit certain broad themes. One I mentioned is the booms that go bust, where you just get these credit-driven asset manias and the asset can’t service the debt. Usually that ends in tears.”
  2. TECHNOLOGICAL OBSOLESCENCE. “The internet’s been a great wealth creator, but it has destroyed lots of business plans and lots of moats, and we keep our eye out. And that’s, for us, an ongoing source of ideas. It’s amazing how the analog-to-digital revolution just continues to find new businesses to decimate. And we’re mindful of that. It’s the Schumpeterian view of capitalism.”
  3. CONSUMER FADS. “…you see Wall Street over and over and over again just extrapolating out single product companies with hockey stick growth, whether it’s George Foreman Grills or Nordic Tracks or Cabbage Patch Dolls or FitBits or whatever it might be. ‘This time it’s different. Everybody’s going to have five.’ And it rarely is.”
  4. GROWTH BY ACQUISITION. “Another area would be growth by acquisition. We’re just drawn like moths to the flame, I guess, to companies in crummy businesses that decide to tell the Street that they’re actually growth companies by buying the growth. Typically this leads to the temptation of playing acquisition accounting games in terms of valuing the assets and/or spring-loading by having the target companies hold off business in the interim period between the announcement of the deal and the closing of the deal so they look better once you fold them in. And so we love those kinds of stories, the rollups, or as they’ve been deemed, the ‘platform companies’.”
  5. ACCOUNTING GAMES. “Then there are just pure outright accounting stories, where we just find a company that’s just completely playing legal or illegal accounting games to obscure the reality of what’s going on.”
  6. SILLY TRADES. “…then finally, any time we can sell $1 for $2 because the market gives us some silly trade, we’ll do that till the cows come home.”
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Jim Chanos on Shorting Herbalife and Valeant

“A stock can be a better short even though it’s gone down, it can be a better long even though it’s gone up if you’ve got new information.” —Jim Chanos

Podcast: Jim Chanos on the Art of Short-Selling

Whenever Jim Chanos speaks I’d like to listen. I have come to appreciate the way he explains things and how he attempts to take on and analyze different kinds of businesses from a fundamental investor’s view. It’s always interesting to hear what he has to say on businesses, industries, and countries etc.

A few days ago I was lucky to find another great interview with Mr. Chanos, this time from FT Alphachatterbox released on April 25, 2016.

The excerpt below contains a discussion about Herbalife where Mr. Chanos shares his and Kynikos reasoning and decision-making that came out of their analysis of the risks and rewards at the time (emphasis added).

MATT KLEIN: So I want to take a moment to actually look at a specific example I think might be relevant to this question, which is Herbalife. It’s a company that certainly got a lot of attention. It’s dropped out of the news recently, but some people, like Bill Ackman, were saying it was a complete scam, other people were saying it was good and were buying it. You were shorting it at one point and then I saw you said you’d exited the short after Ackman gave his presentation. You said the price was no longer compelling in terms of what the upside return would be for you. Can you walk through a little bit how you did that calculation and came to that decision?

JIM CHANOS: Well, so we were short Herbalife, and when Bill put his first report out the stock was down almost 50% in a matter of days. And at that point we just determined the risk reward had changed dramatically. That unless we felt the FTC or someone else was going to immediately move to crimp their business, that two other multi-level marketing ideas that we were also short – which didn’t move as much, they were only down a little bit – actually were much better uses of our capital at that point.

Further on into the interview Mr. Chanos talks about Kynikos short-position in Valeant in connection to a question about how Chanos and Kynikos works to generate new investment ideas.

MATT KLEIN: One of the things you mentioned earlier is the importance of your colleagues or partners and your staff for generating ideas and doing research and managing risk. Can you give some more sense of what is it everyone does and how you pick them, what the value is to the organisation as a whole?

JIM CHANOS: Our model’s a little bit different than a lot of investment management firms I believe, in that one of the things I find interesting about our business is that one of the most essential parts of the process, idea generation, most investment firms hand that responsibility to the youngest, least experienced people on the staff. The portfolio manager will put pressure on the junior analyst to come up with ideas for him or her to evaluate. And I think that’s really, really asking a lot. Particularly on the short side, where you have some of these other barriers like the borrowability and so on and so forth. The rebate structure. And in our view we would rather have the partners head up research and the portfolio managers spend some time on the ideas. And we have analysts who will say: “I think we ought to be looking at something”, but before they do a deep dive, we take a shallow dive and just make sure that this looks interesting from someone who’s got a number of years of experience in doing this and can immediately see something doesn’t look right. Valeant is a good example. That’s a name we’ve been short now for a couple of years, and the first time I looked at this company, before we handed it to our very able pharmaceutical analyst, I immediately at a research meeting said: “This looks like Tyco.” In terms of not the business itself but the frantic nature of the acquisitions, and a CEO who was just hell-bent on buying companies and making them fit no matter what.

And again that was a gut check kind of reaction, but it was also pattern recognition, having seen these sorts of things before. And having a person running a company to please Wall Street can really be problematic, and even on the first pass through you would see that with a company like Valeant, and that’s why it was so exciting and why I then insisted that we spend a lot of time on it, because it just seemed to… For a couple of us on the team who are a little bit older than the others, we saw parallels to some of the great rollups of the late 90s and early 2000s. So I think that was helpful for us.

MATT KLEIN: Speaking of Valeant, there’s a couple of interesting things there. It’s a pretty strange company. The traditional model of pharmaceuticals is you spend a lot on research and you fund yourself with equity and you have cash because your earnings are going to be lumpy. You have hits and then they die out. And Valeant is the opposite. They have a ton of debt, they spend nothing on research. Their model is essentially they buy a drug someone else has already invented and they try to raise the price. How they get people to overpay is an interesting question they’re now getting in trouble with.

There’s a thing there that’s interesting in terms of the personality of the executive there and at another company that you had a lot of interesting experience with, Enron. I’m not going to say that McKinsey is the cause of either one, but it’s interesting that these are both veteran McKinsey consultants who were beloved by the industries and respected who then came in to run these companies. Initially were very successful, at least on the surface, became very rich doing it. Is this something that people should – is this an automatic signal for you, when a consultant goes into the chief executive role?

JIM CHANOS: Well I’m always wary of accountants who become CEOs too. That’s always a bad sign for me. I don’t know about that, but I do know when I see a mindset, and when you see the mindset, the company is a black box and Valeant has had some of that… Valeant also, one of my partners pointed out that Valeant, in terms of a narrative or a parallel, also resembled Worldcom. Because you had this iconoclastic guy, Bernie Ebbers, and he was apart from his other executives, and again it was this rapid, rapid deal making with questionable numbers and then open feuding with his own executives toward the end of the Worldcom story. So there’s a couple of parallels in there. And then I saw Tyco. So Valeant within confines of a few different opinions at our shop looked like Tyco, Enron and Worldcom. You’re probably on the right track if you’re a short seller if it reminds you of not only one of those, but three of those.

And it’s interesting because what made the stock attractive to the bulls was its new way of doing business. R&D’s terrible. It doesn’t yield anything. That was the new mantra. So why do it? Why don’t you selectively buy drugs that seem to be overlooked and then run them through this sausage grinder of your reimbursement model and derive all this value that others are just leaving on the table? And that was my first problem. Because it was just this easy to raise prices 800% and get reimbursed, why wouldn’t everybody do that? Why wouldn’t the guys who owned the drugs not do that? That’s the first thing that I couldn’t get an answer on. And we now know why. In Pearson’s own words from his January 2013 conference call: “Well, there are ways even if a payer refuses to pay for a script [prescription], there are ways to get paid.” I’m paraphrasing, but that was a real warning sign for us that these guys were going to play somewhat fast and loose. Then he came up with the idea, well I’m going to buy drugs, so that’s my R&D in effect. So every other drug company that’s spending 16% of sales on R&D or 15% of sales on R&D, Valeant’s spending 2% or 3%. And the difference is meaningful, number one. Number two, of course Pearson would have you add back any purchased R&D amortisation that was running through the income statement, because of course drugs don’t last forever. They do have lives. And he was buying things sometimes with relatively short lives. And in any case no drug has more than a 20 year patent.

So if you were rational about this, if he bought $40 billion worth of companies, you might want to set aside $2 billion a year – at least – to replenish that portfolio over time. And that would be the equivalent of your R&D expense. Well, no, he wanted you to add back any amortisation and he called that his proforma cash earnings per share. And Wall Street dutifully pointed out: “Oh, that’s great, because it’s noncash.” And we pointed out: “Well, yeah, but take a look at Hewlett-Packard and some of these other companies that have had to buy companies to keep their revenue growth just constant. That’s the same as maintenance capex. In the drug business, that’s the same as maintenance R&D.” So he got Wall Street for a very short period of time to have its cake and eat it too by how he had them evaluate the company, and now I think people are beginning to see through that, of course. So a lot of these rollups, they truly have to get Wall Street to believe that two plus two equals five, for a short period of time. When in fact the way they do deals, two plus two is often 3.5.

MATT KLEIN: The Valeant trade, I’m curious more on the specific timing. Now the share price has gone down tremendously from its peak, but there was a period when it was going up by…

JIM CHANOS: It went up 100% on us.

MATT KLEIN: Right. How is that…?

JIM CHANOS: We started in the low 100s and our first blended set of average prices was somewhere around 130. So, yes, it got our attention. It doubled first.

MATT KLEIN: You mentioned the way that Valeant was creating an alternative pro forma accounting metric that was popular with Wall Street. One of the things that I’ve been reading a lot recently is this growing gap between the official…

JIM CHANOS: GAAP [generally accepted accounting principles] and “GAAP”, yes.

MATT KLEIN: Right, the “GAAP gap”. And it seems like it’s mostly coming down to treatments of things like one-offs and stock based compensation, which sounds familiar from 15 years ago. Is this something that we should be aware of in general? Are there legitimate reasons why this could be happening?

JIM CHANOS: Well, there are always legitimate reasons why you can break out something on a line out. Doesn’t always mean it’s legitimate to give the management the benefit of the doubt if common sense belies what they’re telling you. So it’s a problem. I teach a course on the history of financial market fraud, and usually trying to ferret out when companies are playing games with their numbers, as many do, takes some digging and some figuring out. What’s so amazing about the past five or six years is they lay it all out for you. And then they just tell you: Disregard it. So whether it’s stock based compensation, which of course is compensation…my favourite is the annual restructuring charge. There are companies now that have been charging off charges every single year for nine, ten, 11, 12 years. And sometimes every quarter. And Wall Street dutifully takes that out, to which I keep pointing out: “It’s happening five years in a row. Seems like it’s recurring to me.” But Wall Street gives them the benefit of the doubt for the fact that they break it out on a line item. And this has been going on for a while now, and the problem with it, Matt, is that now the disparity between the so-called operating EPS [earnings per share] and the GAAP number, I think it’s getting close to $30 a share for the S&P [index of large American companies]. I think the trailing 12 months’ now are somewhere in the high 80s and I think the operating number is somewhere in the 115, 116. And people say: The market’s not so expensive. I’m always raising my hand and will say: Depending on what? On the $88 it certainly is expensive. But we’re going to disregard that bad stuff. And then of course I love the people that say: “Well, but of course that’s energy. Energy’s down, you’ve got to take that out.” And I say: “Well, what about when energy goes back up? Are we going to take it out then?”

But again Wall Street is always a glass half full kind of place. But in this case it’s been interesting to us just how obvious some of these things are that they want you to disregard. Valeant was a master at that. This pro forma cash EPS, which by the way was just multiples of its real cash flow, was just one for the ages.

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John Malone: Shareholder Letters, CNBC Interview and Cable Cowboy Excerpt

“It’s not about earnings, it’s about wealth creation and levered cash-flow growth. Tell them you don’t care about earnings.” —John Malone

Liberty Media Shareholder Letters

Click image to download a collection of John Malone’s shareholder letters from 2001-2014.

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John Malone: Scale very important in media space (full interview)

Click image below to see the CNBC interview, from Thursday, 12 Nov 2015, with Liberty Media Chairman John Malone.

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Cable Cowboy: John Malone and the Rise of the Modern Cable Business

For an excerpt from the book Cable Cowboy about John Malone—see here.

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Mario Gabelli on Private Market Value and Evaluating Investments

“Always keep your portfolio and your risk at your own individual comfortable sleeping point.” —Mario Gabelli

Mario Gabelli, Chairman and CEO of GAMCO Investors, Inc., joined the 18th episode of Wall Street Week, where he talked about, among other things, his view on private market value and how to evaluate investments.

Transcript below is my own.

Gabelli on Private Market Value

Gary Kaminski: You pioneered this idea of intrinsic private market value idea of investing. What does that mean in terms of looking at businesses?

Mario Gabelli: Well, that’s a great question. It basically go back to when I started the firm. I would sit down and write a great idea on a great stock, and somebody would say: “I buy any stock.” So I came up with the idea, saying look if a company is publicly trading, what is it worth if you and I chipped up to buy it? At the time it was called both strap financing, which became leveraged buyouts which is private equity today. So we talked about if a company is publicly traded, what would it be worth if it went private, that is private market value. What will make us surface the value? The spread between what it’s trading for, and what’s it’s worth. And one of the first reports we wrote on that subject was a company in Buffalo, New York, called Hodai [not really sure if I got the name of the company correct], and Henry Kravis picked the price, the stock was $23, I think it was $25 don’t hold me to that, I said it was wort 37 to 39. Henry Kravis buys it, and that was a good example.

Gary Kaminski: So the idea, just so that the viewer understands. So if you we’re using your money to buy a business to get it as a publicly traded entity, it’s a privately owned business, it generates revenues, it has earnings, you’re borrowing money to basically buy that business. You’re trying to figure out at what point you can get an acceptable rate of return for buying that business, total enterprise value.

Mario Gabelli: Right, in today’s terminology, forty years later it would be what would private equity pay to buy a public company to take it private, knowing full well as strategic, that is a corporate buyer having synergies right, would pay more.

Gabelli on Evaluating Investments

Anthony Scaramucci: We’ve know each other for a long time. I’ve seen you take a piece of paper and write down a couple of numbers, and on a back of an envelope make a decision on a stock. Tell viewers how you are capable of doing that.

Mario Gabelli: Well, there’s a little of hard work. It’s like that fellow Jordan sinking a put with a lot of pressure, just missing by one and winning a tournament. You just basically gather the data, rate the data, project the data, interpret it. Then communicate it, but that’s our culture. It’s really the notion of compounded knowledge, accumulated knowledge of a specific industry. Wall Street would call that, Buffett would call that, the core competency. What’s our circle of competence, what’s the value of a business. So you take something as simple as yoghurt. You gather the data on a global basis. How big is the yoghurt market? How big is the U.S. yoghurt market? What are the trends and consumption of yoghurt? Who is producing your good? Who would want to be in the production of yoghurt? What’s good about yoghurt? And then look at the company, you look at General Mills and you read the annual report, you read the chairman’s report, you go to the balance sheet first, not the income statement, balance sheet. And then we go…

Anthony Scaramucci: Why go to the balance sheet?

Mario Gabelli: Because we like to see what’s the downside.

Gary Kaminski: So it’s once again accounting as the language of business. You look at companies, you look at businesses.

Mario Gabelli: The question is how can I predict as an analyst, as a portfolio manager, as a business guy. How can I predict five years from now with somebody would be willing to pay for my cash flow for that company.

Click on image below for the 18th episode of Wall Street Week with Mario Gabelli.

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To learn more about Mario Gabelli, check out Value Walk’s Mario Gabelli’s Resource Page.

Go here for annual reports from Gamco Investors.

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.

Guy Spier on Checklists for Investors

“A checklist is a way of managing your own mind and guarding against your own proclivities, so it needs to be based on this kind of self-awareness.” ―Guy Spier, The Education of a Value Investor

TEOAVI1Investment Checklists and Surgeons

In The Education of a Value Investor Guy Spier discusses the subject of checklists, and how to develop and use them in investing. This is the main subject of chapter 11―An Investor’s Checklist: Survival Strategies from a Surgeon. Spier shares some of his own insights and his view of checklists as a tool to prevent investors from making mistakes.

What’s the Use in Using an Investment Checklist?

Let’s consider a few points before moving on, to get a quick refresher on the subject of investment checklists, and why a checklist could serve you as an investor good in your investing process.

All quotes below are taken from Guy Spier’s book as referred to above.

Who? An investment checklist for you yourself as an investor.

“…it’s important to recognize that my checklist should not be your checklist.”

What? An investment checklist containing broader categories (“including themes such as leverage and corporate management”) made up of individual checklist items (such as “has this management team previously done anything self-serving that appears dumb?”).

“…design checklist items that would help to prevent us from repeating […] mistakes.”

When? As a tool to be used before we make a final decision to buy or not buy into a certain business.

“Before pulling the trigger on any investment, I pull out the checklist from my computer or the filing cabinet near my desk to see what I might be missing.”

Where? As an integral part of your ongoing investment process, and as a tool in your business analysis and investing.

“The checklist is invaluable because it redirects and challenges the investor’s wandering attention in a systematic manner. I sometimes use my checklist in the middle of the investing process to deepen my understanding of a company, but it’s most useful right at the end as a way of backstopping myself.”

Why? Minimize the probability of permanent loss of capital. Our mind sometimes plays tricks on us and we better watch out and do our best to mitigate these so-called biases (or heuristics) that affects our decision making. As Warren Buffett once said: “Rule No. 1: Never loose money. Rule No. 2: Never forget rule number one.”

“The brain is simply not designed to work with meticulous logic through all of the possible outcomes of our investment decisions.” 

“The goal in creating a checklist is to avoid obvious and predictable errors.”

“…the items on [pilots’] checklists are designed to help them avoid mistakes that have previously led to plane crashes. In investing too, the real purpose of a checklist is to serve as a survival tool based on the haunting remembrance of things past.”

An Investment Checklist as a Way to Avoid “Cocaine Brain”

Spier talks about a certain problem, a mental state that he refers to as the “cocaine brain” and explains as…

“…the intoxicating prospect of making money can arouse the same reward circuits in the brain that are stimulated by drugs, making the rational mind ignore supposedly extraneous details that are actually very relevant. Needless to say, this mental state is not the best condition in which to conduct a cool and dispassionate analysis of investment risk.”

To keep it simple. Each checklist item you chose to put up on your checklist, you include for one reason, and one reason only. That is, to avoid the cocaine brain mental state, and to make your best effort in trying to make sure not to break the two rules mentioned above by Buffett.

Checklist Items: The Warren Buffett Way

The Oxford Dictionaries defines the word “Checklist” as:

A list of items required, things to be done, or points to be considered, used as a reminder. (Source: Oxford Dictionaries

As any checklist, an investment checklist is often made up of individual checklist items, that together constitute broader categories, that in turn form the checklist as a whole. Let’s look at an example to see what these broader categories may look like, by looking at a well-known quote from Warren Buffett taken from his 1977 letter to shareholders, where he lays out four things that he looks for in a business (emphasis added).

“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 priceWe 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.”

The quote above contains four points (or broader categories): 1) an understandable business, 2) favorable long-term prospect, 3) honest and competent people, and 4) an attractive price. For each one of these points one needs to determine what factors (individual checklist items) to consider to be able to reach a conclusion. Another quote from Buffett could give some advice on what to look for when evaluating management (emphasis added).

Passion is the number one thing that I look for in a manager. IQ is not really that important. They need to be able to work well with others and the ability to get people to do what you want them to do. I’d say intelligence, energy, integrity. If you don’t have the last one, the first two will kill you. All you have is a crook who works hard. If a person doesn’t have integrity, you want them dumb and lazy.” (Source: Buffett FAQ)

And how could you find the information you need to make a judgement call like this? Again, let’s turn to Buffett for some advice (emphasis added).

“Almost everything we learn is from public documents. I read Jim Clayton’s book, for example. There is adequate information out there to evaluate businesses. We do not find it particularly helpful to talk to managements. Often managements want to come to Omaha to talk, and they come up with all sorts of reasons, but what they really hope is that we become interested in their stock. That never works. The numbers tell us a lot more than the managements. We don’t give a hoot about anyone’s projections. We don’t want even want to hear about it.” (Source: Buffett FAQ)

Checklist Items: A Few Examples from Guy Spier

In the book Spier gives a few examples of different kinds of checklist items in connection to different case studies that he goes though to show the reader the reasoning behind how he derived the items in question.

To put each checklist item below in the proper context, I urge everyone to check out Spier’s book and to read each of the case studies. In this post I will just briefly quote the questions as examples of what a checklist item could look like.

The first case study called “The Man Who Lost His Cool” is about the author’s investments in different for-profit education companies. Here the reader gets two checklist items that seem to belong in the corporate management category.

CHECKLIST ITEMS

“Are any of the key members of the company’s management team going through a difficult personal experience that might radically affect their ability to act for the benefit of their shareholders?”

“Also, has this management team previously done anything self-serving that appears dumb?”

The second case study is called “A Tortuous Tale of Tupperware,” and it’s about the Tupperware Plastics Company. This investment turned out to be a failure, and a failure that failed slowly. The reason? Because “…there was too much competition, and the high price of its products had become a serious obstacle to growth.” In this case, Spier concludes that he “…failed to ask the most obvious question: does this product offer good value for money?” Spier further concludes that “This misadventure taught me an invaluable lesson: I want to invest only in companies that are a win-win for their entire ecosystem.” With ecosystem Spier refers to “the value chains.”

CHECKLIST ITEM

“Is this company providing a win-win for its entire ecosystem?”

In case study number three “What Lies Beneath?” Spier goes on to discuss his investment in CarMax―“the Wal-Mart or Cotsco of secondhand cars.” CarMax business is heavily dependent on the company being able to provide its customers with financing, since without financing customers won’t be able to buy a car. In other words, debt markets was (and is) of utmost importance for CarMax’s business model. So, what happened? The financial crisis happened, and customers were not able to obtain the credit needed to buy a car, and as a result sales dropped and the stock price dropped too.

Spier’s greatest insight from his CarMax investment was that the “…situation taught [him] how critical it is to discern whether a business is overly exposed to parts of the value chain that it can’t control.” 

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“How could this business be affected by changes in other parts of the value chain that lie beyond the company’s control? For example, are its revenues perilously dependent on the credit markets or the price of a particular commodity?”

The fourth, and the last, case study is “How I Lost My Balance.” This case study is about a food company called Smart Balance (since renamed Boulder Brands), and about the author’s “narcissistic hubris” that led him to pay too high a price for the business.

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“Is this stock cheap enough (not just in relative terms)?”

“Am I sure that I’m paying for the business as it is today—not for an excessively rosy expectation of where it might be in the future? Does this investment satisfy me psychologically by meeting some unmet personal need? For example, am I keen to buy it because it makes me feel smart?”

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.

Sequoia Fund Investor Day Transcript 2015 (Ruane, Cunniff & Goldfarb)

“Any time you look at an investment, you want to look at what percentage of its market it has and how big it can get.” ―Rory Priday

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Sequoia Fund Investor Day Transcript 2015 (Ruane Cunniff & Goldfarb)

Ruane Cunniff & Goldfarb recently released their Sequoia Fund investor day transcript for 2015.  I picked up the link to the transcript via Market Folly, and it’s a great read.

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The transcript lays out the Q&A session where Sequoia Fund’s investment management team discusses their thesis and outlook on numerous portfolio companies, including Valeant, Google, Mohawk, Idexx, Fastenal, Rolls Royce, TJX, O’Reilly, and many more.

While you read it, think about how each person in the investment team thinks about the companies and how their reasoning goes about why a business is good or not, and what kind of things they focus on in coming up with an investment thesis.

At the end of the second quarter, Sequoia Fund’s top holdings were:

S1This really is an interesting read in its entirety given their candidness about assessing their positions.

Sequoia Fund investor day transcript for 2015

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.

Tom Gayner Talks at Google, Part III

This is the last part of my posts about Tom Gayner’s talk at Google. See here for part I and here for part II.

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The Q&A session in Tom Gayner’s talk at Google starts at 26.36 and last for about half an hour. Below is the first question about how to evaluate management.

Question #1 – Evaluating Management

“So you mentioned evaluating management, you think about character and integrity. First question is, how do you actually, specifically evaluate that? And for us that can actually interact with management of companies, and we just look at prices and stuff like that, how do we actually go about figuring that out?”

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Answer #1 – Evaluating Management

“Well again, I’m looking around the room and I’m seeing that I’m older than you, but I’m married, and I’ve been married a long time. Just by show of hands, some of the people who are married? A bunch of you. How did you decide who you’re going to marry? You dated. And what’s the point of dating? It’s not really to see a movie, or go to a restaurant or ballgame or roller skating, or whatever you did. It’s really to spend time with somebody, to see if their values overlap enough with yours, that you’ll be able to get along for a long period of time. That’s the whole point of dating.

And with management teams, and people running businesses, in effect, what I’m doing, is analogous to the idea of dating. It’s trying to find people running these businesses where our values, at least in the worlds of commerce, overlap enough that I’m happy for them to have the responsibility and authority to run that business as they see fit.

Now you mentioned a limitation, that you suggest that I’m able to get an appointment and see people who run business and interact with the managers, and to some degree, that’s true. But at the same time, I really spend a lot more time reading about people, and using the exact same resources that you would have access to as well. So I read the annual reports. I read the proxy statements. I read magazine articles. And I try to think and just sort of look, and get a gut feel and make some judgement and discernment about whether these people are acting in a way that’s reasonable and makes sense to me.

And your calibration is going to be somewhat different than mine. You’re just different. All of us are going to set those things that we think are important and where we think the bounds of behavior should be differently. Because we’re all different, but you have them. And I encourage you to think about things in that dimension, because one of the things you’ll find is, you’ll make a judgement. Your judgement will not be perfect, but by virtue of the times you get it wrong, when make an error, you’ll learn something. It’s like, ooh, I don’t like that so much. And that will be a marker to you, that the next time you see it, you will be sensitized to it and it will help you make better judgements.

In looking at you guys, when I first started in the investment business, I have a wonderful mentor namned Ned Reynolds. And this was a gentleman who’s probably 70 years old and I was brand new in the investment business. And he was a very interesting character, and it’s not like he was formally my mentor, he was nice. He was kind and he was just helpful to people. And one day I happened to be standing next to him on a hot, summer day in Richmond, Virginia. And not much was going on. We were just sort of, market was open, and in those days, you didn’t have the CNBC with the ticker tape, but you actually had a physical ticker tape in a brokerage office, so it would create this sort of hum and drone of this tape going by. And he was standing there. And he had his arms folded like this, and he really wasn’t engaged in conversation with me. He was standing by my side, was not making eye contact, but I had been in the business for three months at this point. And he said, Tom, the secret to success in the investing is lasting the first 30 years.”

There are a few more question, all worth listening to. Click image below to listen.

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