Why You Shouldn’t Invest in a Business That Even a Fool Can Run

A post in a Facebook group called Charlie Munger Fan Club prompted me to write this note on that group. I thought of reproducing it here (with minor changes).

“You should invest in a business that even a fool can run, because someday a fool will.” Warren Buffett’s famous quote, is often misunderstood. When he spoke those words, I don’t think he meant them strictly. Some investors I know, however, disagree with me. They cite other quotes which reinforces the viewpoint.

Here is the first one, from his 2007 letter:

“A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the low- cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.

Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.

Additionally, this criterion eliminates the business whose success depends on having a great manager. Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been running their businesses.

But if a business requires a superstar to produce great results, the business itself cannot be deemed great. A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can’t name its CEO.”

Here is the second one from his 1991 letter:

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

And here is the third one from his 1980 letter:

“We have written in past reports about the disappointmentsthat usually result from purchase and operation of “turnaround” businesses. Literally hundreds of turnaround possibilities indozens of industries have been described to us over the yearsand, either as participants or as observers, we have trackedperformance against expectations. Our conclusion is that, with few exceptions, when a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.”

All of the above thoughts expressed by Mr. Buffett make many of his followers believe that superior management is irrelevant for investment evaluation purposes. And it’s easy to come to that conclusion if you go by what Mr. Buffett has said in the above quotes.

But if you go deeper, you find something else. I did, and here’s what I found.

In his 1990 letter, Mr. Buffett articulated his rationale for investing in Wells Fargo. He wrote:

“The banking business is no favorite of ours. When assets are twenty times equity – a common ratio in this industry – mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussingthe “institutional imperative:” the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.

Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly-managed bank at a “cheap” price. Instead, our only interest is in buying into well-managed banks at fair prices.”

His words “leverage magnifies the effects of managerial strengths and weaknesses” imply that whenever leverage is high, management factor is important.

Take HDFC Bank. Would you like to remain invested in HDFC Bank if it was run by a fool who doesn’t know anything about risk management and would love to learn on the job?

Which other highly leveraged industry has attracted Mr. Buffett’s interest? Well, the answer of course is the insurance industry.

Insurance uses float (other peoples’ money) which is another form of leverage. The role of management becomes terribly important in this business. That’s because its easy for a fool to under-price insurance contracts, the consequences of which will not show up in the P&L for many years.

This even more true in the Super Cat insurance business. That’s because there is little baseline information to be relied on to adequately price insurance contracts.

The same logic applies to derivatives, where leverage magnifies the effects of smart, as well as, dumb behaviour.

Imagine if one day someone like Kenneth Lay replaced Ajit jain to run Berkshire Hathaway’s Reinsurance business and its derivatives book!

Which other business models require you to focus a lot on managerial skills? Well, one that comes to mind would be a good business which operates on wafer-thin margins but still delivers an acceptable return on equity because of high capital turns and/or presence of float.

Take, for example, the case of Mclane, a Berkshire Hathaway subsidiary which is a distributor of groceries, confections and non-food items to thousands of retail outlets, the largest of them being Wal-Mart.

In his 2003 letter, Mr. Buffett wrote: “McLane has sales of about $23 billion, but operates on paper-thin margins — about 1% pre-tax.” In 2014, McLane earned $435 million on revenues of $47 billion.

In his 2009 letter Mr. Buffett acknowledged the importance of the management factor in Mclane. He wrote:

“Grady Rosier led McLane to record pre-tax earnings of $344 million, which even so amounted to only slightly more than one cent per dollar on its huge sales of $31.2 billion. McLane employs a vast array of physical assets – practically all of which it owns – including 3,242 trailers, 2,309 tractors and 55 distribution centers with 15.2 million square feet of space. McLane’s prime asset, however, is Grady.“

Running a business like McLane profitably is not easy. The wafer thin margin of just about 1% means that a small slippage in costs can quickly turn the business from being profitable to become a loss making one. And when you combine very high capital turns with operating losses, you sprint towards bankruptcy. So you have to be very very efficient to run a business like McLane. A fool cannot run a business like that successfully.

Based on what I wrote above and other stuff I have read on this subject, I do not think Mr. Buffett meant it literally when he said “You should invest in a business that even a fool can run, because someday a fool will.”

If you read between the lines you find that there have been several occasions — and I just cited three)— where without a highly competent manager in place, Mr. Buffett would never have invested in the business.

We should look at the whole picture and carefully observe what Mr. Buffett does, not just what he says. And, to my mind, he has never invested in a business where he felt the incumbent management was foolish. Nor, in my view, would he like any of his businesses to be eventually run by a fool.

The Mohnish Pabrai Lecture @ MDI

Mohnish Pabrai delivered a wonderful talk in my class at MDI in December 2014 which you can see from here.

My favorite part of the video is when Mohnish talks about how he used what he had learnt while practicing value investing lessons to create and run his Dakshana Foundation. Over time, Dakshana has produced a stupendous track record. According to the Foundation’s Annual Report for 2013

Since inception in 2007, the IITs have accepted 631 Dakshana Scholars (out of a total universe of 1288 Dakshana Scholars) – a success rate of 49%. Not too shabby – considering that the IITs accept under 2% of applicants. In 2014, out of 259 Dakshana Scholars who took the IIT entrance test, 167 made it – a success rate of 64.4%. 

Wow!

Mohnish invited a few Dakshana Scholars to attend his talk. Their presence and interaction with Mohnish made the experience all the more memorable and enriching.

The Sunil Agrawal Lecture Video and Slides

On 28 Jan, 2015, Sunil Agrawal, Chairman and MD of Vaibhav Global Limited delivered an inspirational talk to my students at MDI about his journey as an entrepreneur. Displaying extraordinary candor, he talked about the story of his ups and downs and what he has learnt over the last 35 years.

You can watch the video playlist from here and his presentation slides from here.

Before Sunil delivered his lecture, I had written a teaching note for my students which you can get from here.

 

 

62-Bagger and Counting: An E-commerce Business That Actually Makes MONEY But Almost Didn’t

Here is a teaching note I prepared for my students before tomorrow’s guest lecture by Sunil Agrawal, CEO of Vaibhav Global Limited in my class at MDI.

Disclosure: I own shares in VGL. This note is not a recommendation to buy VGL’s shares. Rather, it’s a document I have written to help you understand what I liked about VGL. To be sure, there are many things to not like about VGL. There isn’t enough time to list them all. In any case, you should assume that I am biased and I could be wrong. I have been wrong many times in the past.

The Ajit Isaac Lecture Video

The Ajit Isaac Lecture Video is ready. You can view it from here.

It would be best to read my teaching note on Ajit and his presentation slides before you see the video.

Enjoy. And Learn.

The Ajit Isaac Lecture Presentation

Ajit Isaac, CEO of Quess Corp (formerly known as IKYA Human Capital), a subsidiary of Thomas Cook India Limited (which is a subsidiary of Fairfax Financial Holdings Limited) delivered a fantastic lecture in my class today.

Ajit Isaac in my class

Ajit Isaac in my class

Ajit spoke from his heart to my students about his journey as an entrepreneur and how he grew his business from a one-room operation in 2007 to having 90,000 employees in 2014. He also covered topics such as how he thinks about businesses, the role of extreme focus, how he has build Quess organically and inorganically (his track record in M&A is fabulous), how important is integrity, how he thinks about profitable growth without taking unnecessary risks, and his aversion to debt and how the cultures at Fairfax and Quess compliment each other.

He also took great efforts to explain the fundamental economics behind each business vertical in Quess. My introductory slide before Ajit started addressing my class was this one:

Introductory Slide # 1

Introductory Slide # 1

That one word is “FOCUS”

Introductory Slide # 2

Introductory Slide # 2

I cited a wonderful book, titled “The Little Book of Talent,” and the first advice of its author, Daniel Coyle is that you should stare at who you want to become.

Introductory Slide # 3

Introductory Slide # 3

“If you were to visit a dozen talent hotbeds tomorrow, you would be struck by how much time the learners spend observing top performers. When I say “observing,” I’m not talking about passively watching. I’m talking about staring—the kind of raw, unblinking, intensely absorbed gazes you see in hungry cats or newborn babies. We each live with a “windshield” of people in front of us; one of the keys to igniting your motivation is to fill your windshield with vivid images of your future self, and to stare at them every day. Studies show that even a brief connection with a role model can vastly increase unconscious motivation.”

“The key to effective engraving is to create an intense connection: to watch and listen so closely that you can imagine the feeling of performing the skill. For physical skills, project yourself inside the performer’s body. Become aware of the movement, the rhythm; try to feel the interior shape of the moves. For mental skills, simulate the skill by re-creating the expert’s decision patterns. Chess players achieve this by replaying classic games, move by move; public speakers do it by regiving great speeches complete with original inflections; musicians cover their favorite songs; some writers I know achieve this effect by retyping passages verbatim from great works. (It sounds kind of Zen, but it works.)”

Ajit is a great role model for a future generation of entrepreneurs and value investors. He is worth staring at.

Introductory Slide # 4

Introductory Slide # 4

You can get a copy of Ajit’s excellent presentation from here. I will post the video soon after I get it from MDI. An earlier teaching note I had prepared on this lecture can be downloaded from here.

Disclosure: I own shares in Thomas Cook India Limited, which is the holding company of Quess Corp. This is not a recommendation to buy TCIL’s shares.

Teaching Note on Ajit Isaac: A Cash Generating Machine called 1-800-5000

Ajit Isaac, CEO and co-owner of IKYA Human Capital (which was renamed as Quess Corp Limited a few days ago) will be addressing my students at MDI on 9 January. In order to help students prepare for that class, I made a teaching note for them. You can get it from here.

Disclosure: I own shares in IKYA’s holding company, Thomas Cook India Limited (TCIL). This note is not a recommendation to buy TCIL shares.

Who Will Bail Shale?

A few days ago, I quoted The Economist in a tweet:

A friend of mine saw it, and mailed me:

Hi Sanjay, I just saw your tweet on the above. I have been following this sector quite closely and can claim that I have a P.hd on it because I have managed to lose money on it :) 

Nothing concentrates your mind when your head gets handed to you.

That said, I have been following these articles and been thinking of the point which Buffett has made about economics — always ask, “And then what?”

Most of these articles talk about weak balance sheet of Shale oil companies and the need for the various OPEC countries to balance their budgets. This kind of thinking almost seems to be equivalent of wanting to a earn a specific level of income based on the expenses rather than based on what one’s skill is and what the market will pay.

I have invested in a few smaller oil and gas companies and have been following them closely. Some of my observations: 

  • The marginal cost of oil is not a uniform number and varies from well to well. That said, this number is constantly going down as the industry gets more efficient. As oil is a commodity, I would assume that the price has to tend to the marginal cost of production (highest to meet the incremental demand).
  • Most shale companies have large unexplored land and a 10+ year inventory. As they get more efficient, I would think that the overall cost could remain flat even as they use up the better fields (this is an assumption).
  • Even if some companies are over leverage, the worst that will happen is that they companies will either file for bankruptcy or liquidate. However the resource and the cost to produce does not change. At worst a new player which is better leveraged comes along. So in the medium term, if even OPEC manages to drives out some players, the new ones will come with a better capital structure.
  • Some of this has already happened in the natural gas space, where the prices dipped below cost of production and are now back up. As soon as the prices spiked in early 2014, the production came roaring back. I think the same could happen in oil the moment prices cost $80/barrel.

I will stop now :) ..What are your thoughts ?

My reply:

  1. Anytime one invests in any business involved in extraction of stuff from under the ground or the sea, or from the sun, or wind, one needs to wear the skeptical hat. There are huge perverse incentives to over-state reserves. Mark Twain’s quote is the appropriate default position: “A mine is a hole in the ground, with a liar on the top.” :-)
  2. Even if you are very confident about the reserves, you still have to predict the future price of the commodity. Doing that accurately and consistently on multiple occasions, is beyond anyone’s capability. When oil was at $10 “experts” said it will go to $5 and when it was $140, they said it was going to $200.
  3. When you buy the stock of such a company, then you are implicitly predicting the price of whatever it gets out of the ground, even though you are not making those forecasts explicitly.
  4. There will be all kinds of experts who will sound extraordinarily persuasive with theories like “peak oil” blah blah. Lots of people will believe them and maybe the experts would be right for a while. But then almost all experts will be right for a while. And then they will be wrong.
  5. The value of an Oil company is vastly different when you use a $5 future oil price scenario than a $200 future oil price scenario. They way to not handle this inherent variability in potential future value is by using scenario analysis. That would be functionally equivalent of a man who cannot swim trying to cross a river that has an average depth of 5 feet while he is 6 feet tall. He forgets that the range of depth is between 4 feet an 12 feet. And drowns. Ignoring the range of possibilities is foolish. And in the oil business or any business which involves extracting suff from under the ground, that range is huge. [TALEB]
  6. People will continue getting things out of the ground well after it stops making economic sense. Maybe they have perverse incentives in place. Maybe they like playing Russian Roulette with their competitors. There are all sorts of reasons people will continue to do things for a long time which appear to you to be stupid and dumb. You must not expect the prevalence of sanity across the world in any commodity industry as part of your investment thesis.
  7. In any commodity-type business, it’s not possible to be a lot smarter than your dumbest competitor. [BUFFETT]
  8. Investing in such situations makes sense, if you have enormous staying power. That is, you have no debt and you have lots of patient capital that will never be withdrawn from you at the wrong moment. You’ll also need the capacity to bear pain for a long time which includes the pain of seeing other people who invest in businesses that buy commodities but sell branded products get rich in environments when commodity prices are high or low. Most investors do not fit into this class of investors. I certainly don’t.

The Amit Wadhwaney Lecture

My friend Amit Wadhwaney, whom I have now known for almost a decade, and who until recently was Portfolio Manager with Third Avenue Managment, delivered an excellent talk to my students in MDI. Here is the link to the video:

And a link to his slides:

https://db.tt/klYLAtT7

Amit’s style of value investing is quite distinct from mine (he focuses on net asset values, I focus on moats). One of the things I had told Amit was that by now, my students at MDI were probably fed up of hearing about moats from me and he should not use the “M” word in his talk. Rather, he should talk about his own style of value investing. He did that brilliantly, of course, and ended up using the “M” word only a couple of times!

As you watch Amit speak (sometimes you’ll have to strain your ears a bit— Amit is so soft spoken that even the microphone had to strain its ears to hear him), you will witness his adventures in value investing in multiple countries ( the example about his investing in Pakistan was my favourite) and how  bottoms up, macro-myopic investing into “safe and cheap” businesses works in the long term.

A great way to learn from Amit is to read his letters written to the shareholders of The Third Avenue International Value Fund. In almost every letter, he picks up a topic related to value investing and puts down his thoughts on esoteric concepts like “Catalysts, Value Traps and the Like,” “Holding Companies in the Fund,” “Some Thoughts on Buy Discipline,” “Sell Discipline Revisited,” “Accounting Substance or Accounting Form,” and “Some Thoughts on Uncertainty.” I have enjoyed reading those letters over the years and I am sure you too will. You can get them from:

http://www.thirdave.com/reports/third-avenue-funds-letters-reports-archive/

Amit learned value investing from his teacher Marty Whitman— the legendary value investor who founded Third Avenue Management and who has authored many excellent books on value investing. My favourite is “The Aggressive, Conservative Investor“. Marty sent me a signed copy of this marvellous book in mid 1990’s when I had written to him as a student.

Both Marty and Amit have influenced me a lot in developing my own investment philosophy. By studying Marty and Amit, I have ingrained in my own investment thinking, important concepts like OPM (Other People’s Money), OPMI (Outside Passive Minority Investors), Resource Conversion, Positive Cash Carry, and the Primacy of Balance Sheet.

I have learnt much from Amit and I hope this video will encourage you to do that too.

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