Long-term thinkers

May 31, 2019

What Buffett’s short-termism critics don’t tell you 

There are still critics today claiming Buffett's old-school style won't last in today's “new era” of investing and that Mr. Buffett has lost his edge.

In today's climate of short-termism, the demand for immediate results makes it hard to preach Buffett's long-term style of investing. Lagging the S&P 500 Index in recent years just gives those pundits something to talk about but their arguments don’t hold any truth when evaluating Berkshire’s performance over the longer periods. If you had purchased $100 worth of Buffett’s stock in 1987 it would be worth more than $8,000 today. The same investment in an ETF tracking the S&P 500 Index would have earned you $1,700. Almost 80% less in 32 years..

Many compare Buffett's performance against bull market cycles and willingly leave out how Buffett performed during bear markets. The graph below shows that Buffett outperformed the S&P 500 Index in all of the last three bear-bull market cycles.  Berkshire lost only 41% in the 2007–2009 financial crisis, while the index fell 51%. In the 2000–2002 dot-com debacle, when the S&P 500 Index collapsed 45%, Buffett pulled off a gain of 28%. Without loading up on tech stocks, his portfolio outperformed.

Jeff Bezos - Big ideas

What we’re really focused on is thinking long-term, putting the customer at the center of our universe and inventing. Those are the three big ideas to think long-term because a lot of invention doesn’t work. If you’re going to invent, it means you’re going to experiment, you have to think long-term.

We don’t take a position on whether our way is the right way, we just claim it’s our way. Bezos quotes one of Warren Buffett's sayings, “You can hold a ballet and that can be successful and you can hold a rock concert and that can be successful. Just don’t hold a ballet and advertise it as a rock concert. You need to be clear with all of your stakeholders, are you holding a ballet or are you holding a rock concert and then people get to self-select in.” 

You can’t skip steps, you have to put one foot in front of the other, things take time, there are no shortcuts but you want to do those steps with passion and ferocity.

Interview insights

May 27, 2019
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Interview insights from Graham & Doddsville quarterly issue 

Yen Liow discusses compounding and durable businesses. 
Compounding is the most important framework in investing. Your business model, portfolio and structure should be built around it. You must find durable compounders which are businesses with a substantial and repeatable advantage that allows them to grow more briskly than the broader market.

How do you find these durable compounders? Many believe that they need the largest possible investment universe to find opportunities when in fact the opposite is true. You need to find a rich vein of repeatable inefficiency in a finite universe that you can focus on, so when price dislocation occurs you can exploit it.

Most of the market will revert to the mean over time as excess profit gets eroded away by competition. Focusing on the small percentage of stocks that resist the mean-reversion forces is where you should spend all our time and resources. These are called durable growth businesses. Durable growth businesses are often more predictable businesses because history often holds when faced with new dynamics. Businesses or industries where there is a loose link between history and the future are often defined as lower quality, as your ability to find repeatable situations is low. 

Our job is to find situations where history does hold and to constantly ensure that new dynamics and threats do not jeopardize the durability of that moat. When the moat breaks down, our ability to predict breaks down.

When your ability to predict breaks down, it is hard to know what to do with volatility. Is it an opportunity or is it risk? When your portfolio is highly durable and volatility hits, at worst you know to hold through, and at best you know to exploit it.

Q&A with Howard Marks

What are qualitative measures you use to take the temperature of the market? 
You want to assess the emotion that is prevalent in the market. When investor optimism is high, assets tend to sell above their intrinsic value.

When people are more concerned about FOMO then the fear of losing money then you must assume that prices will be high relative to intrinsic value.

When bullish prognosticators are in high demand on TV, when bullish books are written, when financial articles tout the last great time to buy before things go to the moon or when first-time fund managers easily raise funds. All these things are strong qualitative indicators of a hot market and that investor emotion is running high.

Timing the market is impossible, so to what extent can you predict market cycles if the timing is unknown?

The pattern of a cycle can be understood. We can have a sense of when we are high in a cycle or low in a cycle. We can have a sense that something will happen, but we will never know when.

If we believe a security is overvalued, we will either underweight it or eliminate it entirely from the portfolio. When a security is overvalued in our estimation it is more likely to go down then up, but we will never know when it will go down.

If overpriced meant that a stock will go down tomorrow, then nothing would ever become overpriced. In the real world, we see things go from overpriced to more overpriced to maximally overpriced. That’s how we get bubbles which proves that prices are not self-correcting.

We sometimes understand what’s going on in the market and understand its implications for the future, but we never know when these implications will take effect.

Investor behaviour

May 27, 2019
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Returns are almost never average
It seems rational to assume that stock and bond market returns would be clustered around the average with a few outliers. If we go back to 1926 we clearly see this is not the case. The average return for stocks during the 92-year period from 1926 to 2017 was 10.3%. How many times during those 92 years do you think the annual return fell between 8% and 12%? Incredibly, that only happened 6 times based on the chart below.

Why do investors underestimate their vulnerability to bias? 

Below are five (of many) possible explanations:
Overconfidence: Our belief that we are better than others is probably the most obvious explanation; this issue is exacerbated for professional investors as there is undoubtedly a selection bias into fund management roles toward those with exaggerated levels of confidence in their own capabilities.

Cognitive dissonance: Whilst the overconfidence explanation focuses on how we perceive ourselves relative to others, cognitive dissonance is focused on how we judge ourselves internally.

Too complex / too difficult: It may simply be a case that dealing with personal biases is too difficult.

Personal narratives: When objectively and dispassionately observing another person’s investment decisions it is often easy to identify the potential biases that are likely to be influencing their judgment.

The sales message: Perhaps the reticence of professional investors to engage with their own bias is related to a general reluctance to acknowledge mistakes.

None of these potential justifications are a reasonable excuse for understating our own behavioural limitations or failing to actively mitigate them. Given how few genuine edges are available in the investment industry, it is baffling that this one remains widely neglected.

Weekend catch-up

Your weekend Edge catches you up on this week's most interesting charts, articles, and musings to hit our desks and inboxes. Click here to view our complete archive.

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Loss Leaders
Below are companies with the largest losses at IPO. They are ranked by trailing EBITDA.

A poor guide to future performance (Link)
This chart shows US-listed companies (>$1B) that had IPOs since 2000. They are grouped based on their 1-day price change on offering day ("pop"). Many of the companies with large price increases on the first day had large declines subsequently. It's clear that the direction of first-day moves is irrelevant for determining a stock's future performance.

German chipmaker Infineon Technologies soared 127% on its launch day but it is now trading at about 50% of its IPO price. Shares of Mastercard which actually declined on opening day in 2006 are now up over 6000%.

Advice from Warren Buffet on IPO's (Link)
At the most recent Berkshire annual meeting Buffet went on to explain how he and Munger have not bought shares in an IPO since 1955, when they bought 100 shares of Ford. Buffet believes buying new offerings during hot periods in the market is not something that the average person should think about at all.

Buffett reminds investors that just because a strategy works for one investor doesn't make it a good idea. He says, "There always can be scenarios in which a company goes on to grow in price post-IPO. I mean, there was a pair of dice at the Desert Inn one time many years ago - they had them in a little case - that came up 32 times in a row - 4 billion to 1, maybe a little bit over. So you can go around making dumb bets and win. It's not something you want to take as a lifetime policy, though. I worry much more about the things that I do than the things that I don't do. I missed all kinds of opportunities in my life. You just want to make sure that you're on the side of the house when you bet rather than bet against the house."

Buffett advises investors to think about the reasons they're investing in a company at a certain valuation.

McDonald's reinventing the drive-thru (Link)
McDonald’s drive-thru times have steadily increased over the last 5 years. Back in 2012, the average customer spent 189 seconds in the drive-thru. In 2018 the average customer spent 273 seconds. Of the brands studied in 2018, the average was 234 seconds. Many blame the increase in times on technology advances and menu complexity.

In 2019 McDonald’s announced it was finally taking steps to improve drive-thru speed. To help with this effort McDonald’s announced it was spending $300 million to acquire Dynamic Yield. This startup based in Tel Aviv provides retailers/fast-food chains with algorithmically driven "decision logic" technology. When you add an item to an online shopping cart, it’s the tech that nudges you about what other customers bought as well. This was McDonald’s largest purchase since it acquired Boston Market in 1999.

The technology acquired by this acquisition will give McDonald’s the ability to create a more personalized experience by varying outdoor digital drive-thru menu displays to show food based on time of day, weather, current restaurant traffic, and trending menu items. It can instantly suggest and show additional products to a customer’s order base on their current selections. Chief executive officer Steve Easterbook said that McDonald’s has already begun rollout of the technology. It’s up and running in 700 drive-thrus across the U.S.

In regards to speed, the platform uses data collected based on current restaurant traffic and then starts suggesting items that make peak times easier on restaurant operations and crews.

How Daigous are still going strong in China (Link)
Daigous are China’s personal shoppers who specialize in importing lower-priced luxury goods from the West. Daigous, pronounced dye-go, literally means “representative purchasing” and refers to merchants who source and re-sell products even if they are not authorized distributors. These agents smuggle luxury goods into China by mislabeling or incorrectly claiming the actual value causing widespread cases of tax evasion. China’s government has had enough and enacted new laws in early 2019 that threaten to upend the entire Daigous business model.

After the new law was enacted, headlines claiming “Daigous business is dead” flooded Chinese media and social platforms. 

Despite a country-wide government crackdown and social media ban, the Daigous industry has remained curiously strong. Chinese customers still rely on Daigous based in Europe to get the latest, limited-edition products from top brands, since they still see on average 30% higher prices on those items in China. The Daigous market is far from dead, contrary to what Chinese and Western media had predicted.

How is Aldi upending American supermarkets (Link)
Running a supermarket in America has never been harder. Online shopping and home delivery are changing the way people buy their food. In this environment how is Aldi thriving and growing in America?

Aldi has more than 1,800 stores in 35 states and is on track to become America’s third largest supermarket chain behind Walmart and Kroger, with 2500 by 2022.

There secret is their ultra low prices. The company strips down the shopping experience passing along savings to its customers. For example, Aldi only stocks around 1,400 items compared to around 40,000 at traditional supermarkets. Aldi claims its prices are up to 50% cheaper than traditional supermarkets, and independent analysis by Wolfe Research shows its prices are around 15% cheaper than Walmart on a basket of the 40 most commonly bought supermarket goods. 

Adapting to consumers

Get the Edge - Click here to view an archive of investment education, daily musings, book recommendations and more.

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McDonald's reinventing the drive-thru (Link)
McDonald’s drive-thru times have steadily increased over the last 5 years. Back in 2012, the average customer spent 189 seconds in the drive-thru. In 2018 the average customer spent 273 seconds. Of the brands studied in 2018, the average was 234 seconds. Many blame the increase in times on technology advances and menu complexity.

In 2019 McDonald’s announced it was finally taking steps to improve drive-thru speed. To help with this effort McDonald’s announced it was spending $300 million to acquire Dynamic Yield. This startup based in Tel Aviv provides retailers/fast-food chains with algorithmically driven "decision logic" technology. When you add an item to an online shopping cart, it’s the tech that nudges you about what other customers bought as well. This was McDonald’s largest purchase since it acquired Boston Market in 1999.

The technology acquired by this acquisition will give McDonald’s the ability to create a more personalized experience by varying outdoor digital drive-thru menu displays to show food based on time of day, weather, current restaurant traffic, and trending menu items. It can instantly suggest and show additional products to a customer’s order base on their current selections. Chief executive officer Steve Easterbook said that McDonald’s has already begun rollout of the technology. It’s up and running in 700 drive-thrus across the U.S.

In regards to speed, the platform uses data collected based on current restaurant traffic and then starts suggesting items that make peak times easier on restaurant operations and crews.

How Daigous are still going strong in China (Link)
Daigous are China’s personal shoppers who specialize in importing lower-priced luxury goods from the West. Daigous, pronounced dye-go, literally means “representative purchasing” and refers to merchants who source and re-sell products even if they are not authorized distributors. These agents smuggle luxury goods into China by mislabeling or incorrectly claiming the actual value causing widespread cases of tax evasion. China’s government has had enough and enacted new laws in early 2019 that threaten to upend the entire Daigous business model.

After the new law was enacted, headlines claiming “Daigous business is dead” flooded Chinese media and social platforms. 

Despite a country-wide government crackdown and social media ban, the Daigous industry has remained curiously strong. Chinese customers still rely on Daigous based in Europe to get the latest, limited-edition products from top brands, since they still see on average 30% higher prices on those items in China. The Daigous market is far from dead, contrary to what Chinese and Western media had predicted.

How is Aldi upending American supermarkets (Link)
Running a supermarket in America has never been harder. Online shopping and home delivery are changing the way people buy their food. In this environment how is Aldi thriving and growing in America?

Aldi has more than 1,800 stores in 35 states and is on track to become America’s third largest supermarket chain behind Walmart and Kroger, with 2500 by 2022.

There secret is their ultra low prices. The company strips down the shopping experience passing along savings to its customers. For example, Aldi only stocks around 1,400 items compared to around 40,000 at traditional supermarkets. Aldi claims its prices are up to 50% cheaper than traditional supermarkets, and independent analysis by Wolfe Research shows its prices are around 15% cheaper than Walmart on a basket of the 40 most commonly bought supermarket goods. 

The IPO game

Get the Edge - Click here to view an archive of investment education, daily musings, book recommendations and more.

_________________

Loss Leaders
Below are companies with the largest losses at IPO. They are ranked by trailing EBITDA.

A poor guide to future performance (Link)
This chart shows US-listed companies (>$1B) that had IPOs since 2000. They are grouped based on their 1-day price change on offering day ("pop"). Many of the companies with large price increases on the first day had large declines subsequently. It's clear that the direction of first-day moves is irrelevant for determining a stock's future performance.

German chipmaker Infineon Technologies soared 127% on its launch day but it is now trading at about 50% of its IPO price. Shares of Mastercard which actually declined on opening day in 2006 are now up over 6000%.

Advice from Warren Buffet on IPO's (Link)
At the most recent Berkshire annual meeting Buffet went on to explain how he and Munger have not bought shares in an IPO since 1955, when they bought 100 shares of Ford. Buffet believes buying new offerings during hot periods in the market is not something that the average person should think about at all.

Buffett reminds investors that just because a strategy works for one investor doesn't make it a good idea. He says, "There always can be scenarios in which a company goes on to grow in price post-IPO. I mean, there was a pair of dice at the Desert Inn one time many years ago - they had them in a little case - that came up 32 times in a row - 4 billion to 1, maybe a little bit over. So you can go around making dumb bets and win. It's not something you want to take as a lifetime policy, though. I worry much more about the things that I do than the things that I don't do. I missed all kinds of opportunities in my life. You just want to make sure that you're on the side of the house when you bet rather than bet against the house."

Buffett advises investors to think about the reasons they're investing in a company at a certain valuation.

Weekend catch-up

Your weekend edge - catch up with this week's readings:

Get the Edge - Click here to view an archive of investment education, daily musings, book recommendations and more.

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Great investors are investment philosophers (Link)
Think back to your education. Remember your university or secondary school days. What did you learn then that you still use today? Does any of it help you in your professional life? Many could claim that nothing they learned at university helps them at their job today. If you’re in finance how could your chemistry skills of calculating the polarization of sodium D1 help with investing?

If we think about this further many of us could claim the best skill we developed in university was how to solve problems. Famous mathematician, Carl Jacobi once said: “Invert, always invert.” He said that many complex problems can be solved if you invert them and think about the solution you want to find and then work backward to your current situation. When you do that, you often find the quickest and most effective solution to seemingly intractable problems. In mathematics and physics, this inversion technique is applied all the time, but seldom is it used when assessing business problems or new investment opportunities.

Research analysts and fund managers typically have been trained in finance and learned everything about financial statement analysis and know every little detail about the companies they cover. Many of these fund managers are interviewed on television and usually share their “wisdom” on why they love growth or income stocks or why they think rates will be hiked or not. Put another way, they talk their book. Are they good problem-solvers or are they just book smart?

How do people like Warren Buffett, Howard Marks or Benjamin Graham stand out? They don’t focus on any of these technical details. They think about the fundamental long-term drivers, and they have developed investment techniques that can adapt to a broad range of problems to understand the underlying market dynamics. These are investment philosophers.

A lesson on compounding (Link)

Many young people find it very hard to stick with a long-term savings plan. For many, it’s likely your savings will trump your investment gains for the first couple of decades. And then, all of a sudden, your investment returns take over once you’ve built up a decent-sized nest egg.

Let’s pretend someone starts out saving 10% of their salary from age 25 to age 65. They start out making $40,000 and that salary grows at 3% a year (with inflation). Let also assume they earn a 6% annual return. Here is the math:

By 40, they have saved over $80,000 with the overall balance growing to $125,000 from investment growth. This means that 65% of the balance comes from saving alone. As years go by that ratio begins to flip. 

By age 65, the contributions from saving equal 31% of your portfolio and 69% come from your investment growth on 6% annual growth. Small gains can add up over time even though it may not feel like it at the moment.

Less is more: Chick-fil-A (Link)

Founded in 1967 by entrepreneur Truett Cathy, Chick-fil-A’s signature item has been its breaded chicken-breast sandwich and its relatively simple menu is what makes it stand out. Five decades later, the closely held company this year is poised to become the third-biggest U.S. restaurant chain by sales. Sales from Chick-fil-A’s restaurants have tripled over the past decade, reaching $10.2 billion in 2018.

What’s their secret? It's their slow and steady, quality over quantity approach. This combined with their focus on ensuring all customers, employees, and restaurant operators are treated with care and respect. Among U.S. restaurants that serve chicken, Chick-fil-A’s market share rose to 33% last year from 18% in 2009, while the market share of Yum Brands Inc.’s KFC chain fell to 15% from 29% in that time.

Since, 2015, Chick-fil-A has been the top-rated fast-food restaurant on the American Customer Satisfaction Index. This is in large part due to their restaurant operators who help assure consistent food quality and service. The average McDonald’s franchisee owns half a dozen stores while most of Chick-fil-A franchisees own one.

America's favorite supermarket: Wegmans (Link)

Wegmans Food Markets is a Rochester-based regional grocery chain with just over 90 stores and reported $8.3 billion in sales. Founded in 1916, this family-owned company is under the leadership of the 3rd and 4th generations of the Wegman family. The spirit of family extends to its customers, employees and into the community. It's not surprising that it's the most beloved supermarket in the US. According to the Harris Reputation Ranking survey, Wegman’s has the best corporate reputation among visible US businesses. In 2019 Wegmans beat out # 2 ranked Amazon.

There are many things that Wegmans does well but most of all they believe in putting employees first. They believe that in order to be a great place to shop, they must first be a great place to work.