The Investor's Consigliere

Dan Duncan Obituary

In the Houston Chronicle. One of the country's greatest businessmen, he was almost unknown here in New York.

The Illegal Drug Industry

The WSJ as a great article about how the Mexican drug cartels function as a business,which is often ignored.

You can learn a lot about business by studying illegal businesses like drugs because they represent a kind of pure capitalism and because there is no annoying corporate-speak to wade through.  And it's all applicable to legitimate businesses--this one article alone touches on risk-adjusted returns, how demand creates supply, low-cost distribution channels, how to create pricing leverage with your suppliers, diversification of revenue streams, innovation and adaptation, vertical integration, and (last but not least) how government intervention in the economy often makes things worse.  It's an MBA curriculum.

Southwestern Energy: Value Investing in Real Life

One of my ongoing interests is how great value investors can be found allocating capital within companies, not just in companies' securities.  In other words, you don't have to be a money manager per se to be a value investor and many of the best value investors work in "real" companies.  If you are in the business of scouting for and identifying great value investors, you widen your universe greatly by looking at these real companies in addition to hedge funds, mutual funds, etc.

One case in point: Southwestern Energy and its leader Howard Korell, recently profiled in the FT.  Once upon a time, oil and gas exploration companies were nearly equivalent to what hedge funds are today:  a man got together a group of investors in a limited partnership, the LPs were charged an incentive fee, and the man took the investors' money and invested it in a portfolio of oil wells he thought would yield profits.  Substitute the word "securities" for "oil wells" and you have a hedge fund.

Today most oil and gas exploration is housed in corporate form, and the incentive fee compensation comes in the form of stock options and bonuses, but the idea is the same: passive equity partners (shareholders) entrust their capital to managers who use it to invest in a portfolio of exploration projects.  And wherever you have investing, you can find value investing.

The FT article indicates that Southwestern under Korell excelled at two of the basic tenets value investors hold dear:

1)  The Charlie Munger idea of virtuous (from the Latin word for "manly," a word Munger may be the last on earth to say without irony) investing being about waiting and waiting, no matter what criticism you have to endure, for a situation in which the odds greatly favor you, and then betting big once you find one, again no matter what criticism you have to endure.  That's how Munger ran his partnership, and while this approach produced great volatility and some grief, he endured it stoically.  Southwestern made a huge and lonely bet over two long years, buying up drilling rights in the Fayetteville shale.

2)  Buy things cheap.  Oil and gas leases don't trade publicly, but they do trade frequently and with pretty good liquidity.  Like stocks, they represent claims on future cash flows which are uncertain.  And like stocks, they can be overpriced or underpriced.  A good lease at a too-high price is a bad investment, no matter how much oil or gas everyone knows it produces.  Southwestern Energy under Korell pursued only those leases that promised the best returns for the price paid. 

The result was an annual return for Southwestern shareholders of 4,374% in the past decade.  If that were a hedge fund, it would be the subject of many a Manhattan cocktail party.  But since it's an oil and gas outfit in Houston, most people in finance have probably never heard of it.  Fortunately for Southwestern's long-term shareholders, the money spends exactly the same no matter what you call it.

Disclosure: No position.

Dolly Parton 60 Minutes Profile

Harvard Business School won't do a case study on her, nor will academic psychologists of success and successful entrepreneurship, and if you live in New York or have an MBA she may be something of a joke to you.  But Dolly Parton is the best businesswoman/entrepreneur/entertainer in America--better than Martha Stewart, better than Oprah, better than anyone in Corporate America. 

This 60 Minutes profile barely scratches the surface. 

Update: A profile from FT Weekend

Upcoming Natural Experiment in the Beer Industry

Long-time readers (Hi Mommy!) know I've written about the beer industry a few times in the past.  The idea is that in order to evaluate investors, you have to be able to evaluate their investments, which means you have to know a little about business.  One business that's fun to know about is the beer business.  Check out the oeuvre so far, there's no quiz at the end:

Thai Bev

Beer and Mongolia

BUD and Economies of Scale

More on Beer

Jim Koch Interview

Now check out this NYT article about Beer Lao, which enjoys 99% market share in its home market of Laos.  Beer is not indigenous to Laos, so I don't think it's the main source of liquid nourishment, nor does the country have a history of German immigrants who started their own breweries (like Argentina for instance).  It's basically for the tourists (the ones in the photo look Australian but my physiognomy is a little rusty).  Nor, the claims of Mr. Cheung notwithstanding, does it taste any different than the many other rice-based lagers sold in hot countries--trust your consigliere on this.

Nonetheless, Beer Lao is embarking on an ambitious project to expand abroad, based mostly on its cool factor.  As the above posts demonstrate, the beer market in any country tends towards dominance by a very few players.  That does not mean that an upstart cannot make huge inroads, or even topple the leader--it happend in Thailand.  I suspect that's not what Beer Lao is trying to do here though--I think it's going for a guerrilla strategy (is that a horribly insenstive pun given the country's history?) of stealing little bits of market share in those countries with huge beer markets (US, Germany, Britain, Japan) or countries whose citizens have, or are starting to have, an ethic of travel abroad (Israel, China).  Even that's hard though--Ambev tried and failed to take Brahma beer from Brazil to the rest of the world.  And Brazil, in my humble opinion, is even cooler than Laos (or if you prefer, Exhibit B.  There is an Exhibit C but this is a professional blog . . .).

Anyway, it's an interesting natural experiment.  Keep an eye on Beer Lao's progress, and also watch how its competitors react.

James Boswell Obituary

Continuing on my theme of getting investing "back to business":  In my opinion, young value investors like me spend too much time studying investors and and investing and not enough time studying businessmen and businesses. 

Here is a businessman and a business worth studying: James G. Boswell II, a California cotton baron who recently died.  Here is his obituary in the New York Times, and here is a book about him.  I can't think of a more terrible business than "American cotton farming" and yet Boswell made a great success of it.  If he'd housed it all in a limited partnership with outside investors, charged 2 and 20 and called it "Boswell Capital Management," it might have been one of the most successful hedge funds ever.

Update: Another obituary from the LA Times.

Berkshire Hathaway Letter to Shareholders

is here!  Raise your hand if you sat there clicking "reload current page" until the 2008 letter showed up. I'll have a longer commentary later, but here are some initial thoughts:

1)  Your consigliere is on record saying that value investors who venture into macroeconomics do so at their peril.  I was afraid, I'll confess, that Buffett would do just that in his letter.  But he didn't.

2)  Buffett is well-known for preaching against diversification, but states that one of goals is for Berkshire to maintain "dozens of sources of earnings and cash" and that another is to find "new and VARIED streams of earnings."  In fact, Berkshire is probably the most diversified company in the world.

3)  Kremlinology alert--I'm about to read too much into Buffett's wording:  On page 4 Buffett very precisely writes that the three large PIPE deals he made were "In our insurance portfolios."  Meaning they were funded in large part by cheap/free float.  So a 10% coupon on one of these deals is less than the return on equity to a Berkshire shareholder from doing the deal. 

4)  Berkshire's large equity put portfolio can be understood as partly a bet on future inflation, as they were written on indices that reflect nominal currency values.  There is a chart on page 206 of Barton Bigg's Wealth, War and Wisdom that I'm too stupid to know how to reproduce.   It shows that from 1932 through mid-1957, a period that included both the Great Depression and World War II, the Italian stock market enjoyed near-uninterrupted growth.  But it's a nominal index--in real terms the market fell.  But if you'd written a long-term put on that index on similar terms as the ones Buffett made, you would not have had to pay anything.  Of course Buffett must also navigate inflation when trying to invest the premium he's received on those puts.

5)  Berkshire Hathaway the stock declined 32% in 2008.  Berkshire Hathaway the company declined only 9.6%, as measured by book value.  Keep in mind that the company is now largely in the business at "borrowing" money from policyholder at very low/free/negative rates in order to invest in regulated utilities.  Those two parts of the business did very well.

More later. 

The Tyranny of Corporate Capital Allocation: Who is the Real "Investor"?

Yesterday I attended the Columbia Investment Management Association (CIMA) annual conference, a very well-attended series of panel discussions and Q&A featuring famous value investors.  It was off the record, so I can't really blog about it (FYI that was me very timidly asking David Einhorn whether his recently disclosed investment in gold contained a margin of safety). 

One question struck me in particular.  A young man (I think his first name was Omar) asked one of the panels how, being capital allocators themselves and knowing how hard it is to do well, they evaluate the capital allocation ability of the managements of the companies in which they invest.  The panelists, almost all of whom names you would know and who profess to follow in the steps of Graham and Buffett, either misunderstood the question or chose not to answer.  Which is a shame, because because the question is all-important.  Here is how I would have answered:

That's a great question, Omar.  It may be the most important question a modern value investor asks himself.  A little arithmetic will illustrate what I mean.

Let's say your goal in life as an investor is to earn 15% per year over the long term, which would be truly outstanding.  Broadly speaking your ability to earn this 15% depends on three factors:

     a) The size of the discount to intrinsic value at which you're able to purchase an investment.

     b) The growth in intrinsic value of your investment during the time you own it (or more strictly speaking, the additional growth in intrinsic value over and above what's already reflected in the price of the investment).

     c) The time it takes for either the discount to narrow, or the IV to grow.

Factor c) is hard to predict--that's why you try to invest with a margin of safety.  Let's focus then on the first two factors.

Back in the day, when Ben Graham and Walter Schloss were doing their thing, there really was such a thing as a 50-cent dollar.  That is, you could look for something worth 100 that was trading for 50, hold it for five years, and earn your annual 15% without any intrinsic value growth whatsover.  That is, it's worth 100 today and it will be worth 100 in five years. 

At the risk of speaking famous last words, today there are very few true 50-cent dollars available, especially for those managing larger pools of capital.  The value investor who wishes to earn his 15% must therefore get some help from the growth in intrinsic value of the companies in which he invests. Suppose you can only find a 67-cent dollar, i.e. something trading at a 1/3 discount.  If you hold it for the same five years as above, and you want to earn your 15%, then the discount to IV must go away and the IV must grow at an annual rate of 6%, which, as it happens, is about the rate Corporate America as a whole grows annually on average.

By now you see the relationship:  The greater the growth rate of an investment's IV during the time you own it, the less of a discount you have to buy it at in order to earn your required return.  If your company is a true cigar butt (e.g. a company with a hidden portfolio of bonds) generating no capital to allocate one way or the other, then you have to find a 50-cent dollar, which is hard work.  If your company's ability to allocate capital is just about average, then you only have to find a 67-cent dollar.

But what if your company's ability to allocate capital is above average?  What if your company has the ability to grow its IV at 10% annually?  In that case, you need only find an 80-cent dollar in order to earn 15% per annum over five years, assuming the discount narrows to zero.  An investor who only has to find 80-cent dollars rather than 50-cent dollars has a much easier time of it, especially today. 

You may have noticed that I'm equating "the ability to grow intrinsic value" with "the ability to allocate capital."  That is on purpose.  With very few exceptions, a company's ability to grow its intrinsic value over time is basically equivalent to its ability to allocate capital.  The growth in IV tracks closely the amount of capital added to the enterprise over time, which in turn depends on how much capital the enterprise generates, how much it retains, and the return on the capital generated and retained (and reinvested, etc. etc.), which in turn is what we mean by "the ability to allocate capital."  I can think of only three exceptions to this rule.  One is companies like Ebay that benefit from network effects--once they get their mousetrap going, it grows without their having to add more capital to it.  Another is companies like Dell in its heyday, who have such good working capital dynamics that their customers essentially provide the capital needed to grow.  The third is companies that can simply raise prices year in and year out, like newspapers once upon a time. 

So a company's ability to allocate capital well is hugely important to the modern investor.  It's what I meant by the title of this post.  We the value investors of today, the owners of passive minority stakes in companies, are essentially hostages of the "real investors" upon whom we depend to earn our required return: those making the capital allocation decisons at the companies themselves.

I have yet to answer the question asked.  All I've done is remind everyone how important it is (much more important than the guy who asked about gold's margin of safety).  So how then do you evaluate the ability to allocate capital?

The first thing to realize is that the ability of a company to allocate capital well, unfortunately for those who believe in the Great Man theory of business, depends to a great extent on the industry a company is in.  With very few exceptions, public companies must reinvest the capital they generate in something similar to what they already do.  If you are in the horse and buggy industry, you can be the best CFO in history and it won't matter--your ability to allocate capital won't lead to much growth in intrinsic value.  Conversely, if you're in a fast-growing industry with stable market shares, you've got the capital allocation wind at your back (think of Coke in the late 80s).  Most companies are somewhere in the middle--figuring out exactly where is part of your job as an investor.

The second thing to realize is that over the course of a few years, a company will make many many capital allocation decisions, all of which are available for you to investigate and judge.  You can start in the obvious place, the financing section of the cash flow statement, and evaluate the dividend policy.  If the company is earning a lower return on capital than Corporate America as a whole, why isn't its dividend higher?  Conversely, if the company has a high return on capital (and on the marginal capital it retains), why does it pay a dividend at all?  In the same section, evaluate the share repurchase/issuance decisionmaking: Is the company buying back overvalued stock?  Is it issuing undervalued stock?

Then you can move up to the investing section of the cash flow statement.  Are capital expenditures leading to gains in IV, or are they simply needed for the company to stay in place?  Have the company's acquisitions turned out well?  In the operating section you can look at working capital management, an often overlooked consumer of cash for growing companies (and another reason why EBITDA - capex is an incomplete measure of cash flow).  Think of a retail location with fast-growing same-store sales.  If those sales come at the expense of even faster-growing receivables and inventory, the company may not be deploying capital well.

That's six capital allocation factors so far: dividends, share repurchases, share issuances, capex, acquistions, and working capital.  All of them represent capital allocation decisions in management's discretion, and with a little work you can figure out how good these decisions have been.

But don't stop there.  Many capital allocation decisions show up on the income statement.  When a company like Coke spends heavily on advertising, accounting treats it as an expense but you should really think of it as a kind of capital expenditure, a discretionary decision to allocate capital in a particular way.  Soon after Berkshire Hathaway acquired full control of GEICO in 1995, it stepped up spending on advertising.  Not only that, but GEICO thinks about the productivity of its paid advertising by also keeping close track of unpaid advertising, i.e. word of mouth referrals and customer retention.  A new customer you acquire when their friend tells them about the company is a customer you don't have to acquire yourself.  A customer who renews his policy with you because he's happy is a customer you don't have to reacquire through advertising.  All of this comes under the heading of "ability to allocate capital."  When Goldman Sachs steps up headcount and compensation expense, it's also allocating capital by "investing" in talent.  And like all capital allocation decisions, it is subject to evaluation--does it increase the intrinsic value of the company over time or not?

Billionaire Liu Family of China

Nice NYT article about the Liu family, one of China's richest.

I've created a new category for this post, called "Investor-Owner-Operators."  Great investors exist along a continuum, call it the "investor/businessman" continuum.  At one end are completely passive investors, who are not really businessmen at all.  Most hedge fund managers fall into this category.  One small step over are so-called activist investors, who try to have some managerial influence over their investments.  Then come private equity and venture capital funds, who not only allocate capital to businesses but take an active role in their management via board seats and selecting the operating executives.  All the way at the other end of the spectrum are the pure businessmen whom nobody really thinks of as investors at all but in fact are, because capital allocation is part of their job.  I've written before that Sam Walton was one of the greatest investors of all time, even though no one calls him that.  The point of thinking about it in terms of a continuum is not to say one way is better than another.  It's simply to recognize that great investment records--sustained success in allocating and reallocating capital at high returns--are found in various places, and the student of investing unnecessarily limits his universe by defining the term "investor" too narrowly.  It's also to underscore the importance of "looking through" in investing.  Too often institutional investors forget just how many layers of capital allocation exist (each taking their cut out of the ultimate return) in one investment.  An endowment that invests in a hedge fund of funds is really allocating capital to someone (the FoF manager) who in turn is allocating capital to someone (the underlying hedge fund manager) who in turn is allocating capital to someone (company management) who in turn is allocating capital.  That's why even the most institutional of institutional investors, in order to succeed, must know something about evaluating businesses.

I place the Liu family into a category in the middle of the continuum, which I call the "investor-owner-operator."  I think of this category as the ideal, the perfect melding of all the various functions of a capitalist.  Buffett goes in this category, as does Phil Ruffin, whom I recently wrote about.  If I were an institutional investor who, like Yale's endowment, allocated capital to external money managers, I would consider investor-owner-operators to be almost a separate asset class.  Why pay 2 and 20 to a hedge fund manager to allocate your capital for you when someone like Warren Buffett or Leucadia or Li Ka-shing does exactly the same thing for much less, and often does it much better?

Richest South Africans

Just in time for the holidays, another list of rich people, this time from South Africa.  Thank you Santa.