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Circle Of Competence Issue #12

Department of General Finance

Wonderful overview of what it takes to purchase a small, privately held operating business. This article talks about the offer process, due diligence process, financing and closing process, and the operating process at a high level. I’d highly recommend this one!

Excellent article about Robert Smith, the private equity tech titan and founder of Vista Equity Partners, and the systems he has in place to coach the software companies in his portfolio from acquisition to exit. Highly recommend this article.

John Huber, portfolio manager of Saber Capital and one of my favorite writers about investing, lays out his big takeaways from the Berkshire Hathaway annual meeting. I enjoyed his honesty about the investment management business and its obsession with short term results.. In my opinion, and clearly John's opinion as well, the biggest advantage an investor can have is long-lasting, steely-eyed, icy-veined patience. Without it, you get sucked into the short-term game everyone else is playing. And that doesn't produce long-term results. As Buffett once famously said, "No one wants to get rich slowly" - meaning most folks simply don't have the patience and resolve to be in this game.

Shout out to Richard Miller, an up and coming analyst currently working at Morgan Stanley in the Financial Institutions Investment Banking Group (and a great friend of mine) for sending me this piece.

Necessity is the mother of invention - and insurance companies need a leaner cost structure for two reasons: competing more effectively against competitors to gain market share and increase float, and also to achieve better margins on the premiums, since their potential investment returns have dropped due to low interest rate policies. One stat caught my eye immediately:

"Big property and casualty insurers give away too much revenue (and potential profit) to a whole network of companies that help insurers deal with clients and claims. About 60 cents of every dollar of premiums gets paid directly or indirectly to these companies, according to forthcoming research by Oliver Wyman."

What an interesting turn of events. All I can say with regards to sports betting is that if people want to bet on sports, they'll find a way to do so, regardless of its legality. This will no doubt be a political issue in upcoming elections for state and federal level representatives.

Department of Real Estate

One can only imagine how raw the debate got over this new measure in California which requires all new construction to have solar panels on the roof to reduce carbon based emissions. In what is already an extremely expensive real estate market, is this policy wise or not so much? Time will tell.

Department of Economics

Fairly interesting, but brief, explanation of what occurs after a yield curve inverts both in the US and globally. Long story short, both US stocks and bonds suffer within 12-18 months after a yield curve inversion.

Department of Technology & Startups

A fascinating dive into the biggest companies attempting to bring autonomous vehicles to the mainstream. Some companies even seem poised to bring level 4 autonomous vehicles (ones that don’t need human intervention) to market later in 2018 pending regulatory approvals and safeguards.

Is it any wonder that a company charging a flat fee ($9.99) monthly for customers to consume a product as much as they wish (movies), while paying variably ($5-$10) for each product consumed (movies), is in dire straits? Seems like investors have subsidized many customers' movie pleasures, without much of a return. When a company has such fantastic customer growth at such a terrible rate of cash burn, what options does it have but to raise more equity? It certainly has bargaining power with the theaters because it is bringing a lot of business to the flagging movie theater business, but at an incredible cost to equity holders. Will MoviePass find a profitable business model or go the way of the Dodo?

EdTech has always interested me because it is, fundamentally, trying to disrupt a multi-millennia model of education using the internet and basic computing technology that is ubiquitous in the modern world. OpenClassrooms is not only offering degrees online (like Udacity, Coursera, among others), but is also partnering with companies who pay the company to train new/future employees. Said company gets employees for a fee, OpenClassrooms collects revenue and builds brand/network, and prospective student gets a job. All parties win.

Department of Letters

1985 Letter

Munger writes extensively in this letter about the dangers inherent in the Savings & Loans industry that were years ahead of the early 90's S&L crisis. He makes his stance clear: it was highly irresponsible to insure these institutions and their depositors as the managers grew at all costs by offering sky-high interest rates on deposits just to attract more funds and used the deposits to fund ever growing loan portfolios with riskier and riskier credit quality. As interest rates were increasing rapidly in the early 80's, he wisely chose to sit on the sidelines as many S&L's granted high interest accounts just to expand depository funds available for lending. The section detailing his opinions on the excesses of mortgage lending in the S&L industry reads like a prelude to the 2007-2009 real estate crisis. The root causes were somewhat the same - excess leverage.

Wesco Reinsurance division was started with $45M in equity from Wesco Financial under the direction of Warren Buffett at Berkshire Hathaway, who owned 80% of Wesco at the time. Wesco Reinsurance immediately reinsured 2% of Berkshire Hathaway's subsidiary Fireman's funds premiums from 1985-1989, effectively giving them 2% of the company's book of business. It is interesting to note that Buffett used Munger's company, which he owned 80% of, to reinsure the Fireman's fund's book of business. It generated over $60M in premiums during 1986, available for investment purposes for Wesco. Seems to me that this was a move to get Munger's resources into the insurance industry.

Another little nugget that continues to show up in the reinsurance business letters I've read is that this business serves a highly commoditized product - namely, peace and security in the form of money paid out for an specific (bad) event occurring. So, what form of competitive advantage can be gained in the industry? Munger and Buffett often write in their letters about how the financial strength of Wesco and Berkshire Hathaway is their biggest advantage. In the reinsurance industry, returns can be wonderful for years due to very long-tail risks (low probability, high cost events). However, when the proverbial lightning strikes and many reinsurers become insolvent due to catastrophic events, the remaining players' not only pick up the pieces of competitor's books of business but their financial brands improve in the eyes of their clients and customers.

Finally, as I noted in Week 10 reading, savings and loan institutions as well as steel warehousing and metal work businesses are not particularly high return on capital businesses and typically are not associated with economic moats. Charlie made this clear in his 1985 letter that while he was looking for such high return businesses at reasonable prices to purchase outright, that they were hard to come by. And thus his quote at the end of the letter (emphasis mine):

"Wesco is trying more to profit from always remembering the obvious than from grasping the esoteric (including much modern "strategic planning" and "portfolio theory"). Such an approach, while it has worked fairly well on average in the past and will probably work fairly well over the long-term future, is bound to encounter periods of dullness and disadvantage as it limits action. Moreover, this approach is being applied to no great base position. Wesco is sort of scrambling through the years without owning a single business, even a small one, with enough commercial advantage in place to pretty well assure high future returns on its capital. In contrast, Berkshire Hathaway, Wesco's parent corporation, owns three such high-return businesses."

1986 Letter

Not much to report in this letter, other than general updates for Mutual Savings & Loan, Precision Steel, Wesco Reinsurance, and Bowery Savings Bank (a recapitalized distressed bank in which they invested a minority equity position in 1985). It was pretty impressive however, how big of a difference the reinsurance business made on the bottom line from just one year of operations - it contributed over 55% of normal net operating income in 1986 vs. -5% in 1985. This illustrates the lumpiness of reinsurance as a case in point.

In this letter, Prem Watsa highlights his portfolio companies' shortcomings:

- Return on equity of 4.1% (measly by Fairfax's historical standards).

- Fairfax stock sold for less than book value for over 15 months but allowed Fairfax to repurchase shares at prices immediately accretive to shareholders.

- Large insurance losses mostly stemming from newer US operations in Ranger, Crum & Forster, and TIG ($588M in 2000 alone).

- Total underwriting combined ratio of 116%, a far cry from cost-less float (100% or better).

Even with unfavorable results, Fairfax has compounded book value by 37% from 1986-2000 and recorded an 18.2% ROE over that time period, not to mention a stock that compounded at 33% (close to book value) over the time. It is refreshing when management (Prem Watsa in this case) is highly transparent about their business, especially when things go sideways. Who wouldn't want a partner that is honest 100% of the time?

The last tidbit I noted was their low exposure to stocks (~6%) in their insurance float portfolio due to the high valuations back in 2000 as well as their discussion of some of the internet company stock blowups of the dot com bubble (AOL -54%, Amazon -80%, Yahoo! -86%, VerticalNet -92%, Red Hat -94%, and the list continues).

Department of Books

This is a quick and easy read, however the idea presented in the book is powerful. The major thesis of the book is simply that, over time, a portfolio of the cheapest stocks ranked by acquirer's multiple (the multiple calculated by dividing enterprise value by normal operating earnings), outperforms not only the market, but also a basket of stocks with great returns on equity at relatively cheap prices (see Joel Greenblatt's book, "The Little Book That Beats The Market" to understand what his 'Magic Formula' is all about - wonderful businesses at a fair price).

The key idea is not that buying cheap companies on an 'acquirer's multiple basis' beats the market, but that it also beats Joel Greenblatt's algorithmic attempt at Warren Buffett's 'great businesses at a fair price' approach (The Magic Formula).

Buffett always says that he'd rather buy great businesses (high return on capital with a solid competitive advantage) at fair prices rather than fair companies at great prices. The Acquirer's Multiple turns this thesis on its head by showing with back-tested data that in fact, it doesn't matter as much what type of business you're buying, but how cheaply you buy it relative to its operating earnings.

All in all, this is a wonderful book and a wonderful place to start learning about value investing strategies in the stock market. I highly recommend it!

I thoroughly enjoyed Guy Spier's honesty in this book. He laid out his journey in a very open manner, describing in detail his transformation from a self-described Gordon Gekko wanna-be to a more enlightened version of himself after stumbling upon Benjamin Graham's 'The Intelligent Investor' and Warren Buffett's principles for business and life. Not only does he describe his life transition, but he also goes fairly in-depth into what he believes it takes to fully realize self-potential as and investor and person. It shows how the principles of Graham and Buffett and other value investing legends have had far reaching effects beyond simply enriching their shareholders. I won't spoil all of the details, but would highly recommend this book to someone who is searching for a better way of doing business.

Department of Podcasts

In this episode of the Investor's Podcasts, Preston and Stig talk to Jim Rickards and he has some very compelling things to say about Bitcoin and why it won't work out as the dominant cryptocurrency in the future:

- the power consumption in the future is too great to support utility as a transaction based currency and only increasing in usage

- the transaction speed vs. traditional networks' speeds is simply too slow and needs to be sped up by orders of magnitude

- there are better alternatives that significantly improve on Bitcoin's shortcomings in these two key areas

I won't spoil the rest of the podcast, but he also delves into his opinions on the Trump tax cuts, stock buybacks, and where markets are headed from a macroeconomic perspective. Wonderful, and short, episode!

What are you reading this week? Drop me a note and let's hear your thoughts! Also, feel free to tweet at @competence_co. Have a great week!

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