Circle Of Competence Issue #14
What are you reading this week? Drop me a line and let's connect or tweet at @competence_co. Have a great week!
DEPARTMENT OF GENERAL FINANCE
Do yourself a favor and block out an hour to listen to this brilliant speech by Charlie Munger. He has such wisdom and depth of knowledge over many years of experience as Berkshire Hathaway's Vice Chairman. This speech goes in depth into the biggest psychological causes of bias and misjudgment in our every day lives and is one to revisit often. His wit and wisdom are unparalleled by anyone, even by Buffett who has admitted as much. HIGHLY recommend this link.
Great interview with Munger on trade policy with China, Elon Musk, investing philosophy, Bitcoin (which he compares to trading freshly harvested baby brains - I kid you not!), and the current political environment (he has some great wisdom here). Highly recommended!
Two examples of epic short squeezes. And wouldn’t you know it, they are in the most heavily shorted industry at the moment - retail.
Very interesting global story to be following. What is the future of the euro and eurozone? There are great arguments for both preserving and eliminating the common currency, but too often overemotional political and social trends are what decide the outcome (think Brexit!). This will be one story to follow closely.
Absolutely fantastic piece by Shane Parrish (fs.blog) on how your expectations and encouragement of others, especially in the work place, can lead to a virtuous cycle of success via the Pygmalion effect. Highly recommend this longer, but insightful article.
This is a study that was mentioned in "Quantitative Value" which I review below. It discusses global returns to equities across many markets for most of the 20th century. What stands out to me most is that the U.S. leads ALL markets for overall real returns, suggesting that when Buffett claims that the U.S. is truly the most fertile economic ground in the world, he is telling the truth. Also, there are some very interesting statistics on what happens to equity prices in real terms during war and political unrest (e.g. Japan's market fell by 95% in real terms during WWII).
Solid and detailed article on Walmart's recent acquisition of Flipkart, the Indian online retailer, by Aswath Damodaran, a well-known professor of finance at NYU Stern School of Business. He seems to think that Amazon has goaded Walmart into overpaying for a money-losing Indian online retailer just to be able to compete with Amazon's online retail success. Regardless of what the real reasons were or were not, I agree with Damodaran in one regard - paying $22B for a company that lost $1.3B in the latest year doesn't seem like a very good deal for WMT shareholders.
This is, sadly, a growing trend in today's graduate school entrants, and one that seems to me ripe for disruption. $100,000 per year for tuition? That seems more like highway robbery than an 'investment in your future.' And the worst part about it is that the government programs that loan money are backed by tax payers and give absolutely no incentive for graduate schools to reign in costs, so the ultimate burdens are borne by tax payers and students.
Is it 2007 or 2018? This smells awfully like the same thing that turned sour before the real estate bubble popped. And what is worse - these branch managers who have no skin in the game are issuing mortgages to subprime creditors that are backed by tax payers... and getting rich in the process. You could almost substitute the bankers in this situation and the graduate schools from the previous article. They are the only ones who seem to benefit from this type of scheme - not the customers or the tax payers.
Interesting site brought to me by a friend a former teammate, Chris Munnelly (thanks buddy!). Very short but eye opening read for those who continue to repeat that rising rates spell the end of the bull market. News flash - value investors could care less what rates do, they just try to buy a stream of cash flows from a business for less than they are worth when discounted at prevailing rates. Over the long run, fundamentals of businesses matters far more than short term macroeconomic fluctuations.
DEPARTMENT OF REAL ESTATE
Eddie Lampert is back at it again, but this time, it seems that he is attempting to save Sears through a complicated swap of cash for hard assets that the hedge fund can sell, while the company can use the cash proceeds to pay down some of its debt. As the article states, this kind of transaction can have multiple parties with conflicts of interest and can sometimes look a little like manipulation of debt markets. For a look into this type of transaction, I'd highly recommend my readers check out Matt Levine's column, Money Stuff, where he has covered another company (Hovnanian Enterprises) that has used this type of transaction to refinance its debt while avoiding default, to the annoyance of some of the larger investment banks:
Matt Levine's Money Stuff Newsletter is fantastic and this issue illustrates a complicated debt transaction by Hovnanian Enterprises involving some of its creditors and investment banks effectively insurance policies against its default.
This jives with what I have seen and heard from multifamily investors - that pricing is getting tight and rents aren't keeping up. As rates rise, it will be interesting to see what happens with all of the new supply coming online in major metro areas.
DEPARTMENT OF STARTUPS AND TECHNOLOGY
It is often noted how Buffett has avoided most high-tech stocks and investments due to his lack of understanding, but that has changed as of late with his investments in Apple stock and... almost Uber? What is most interesting in this situation to me is how he wished to structure the investment - a convertible note not unlike the one he structured with Goldman Sachs during the financial crisis in 2008 where he got preferred stock and warrants. Clearly, Buffett was not taking an equity only directional bet on Uber, but was rather looking to make an investment in a company that was down on its luck after numerous PR blunders and needed a bit of both actual and reputational capital. However, the deal did not come to fruition because the CEO of Uber did not wish to give up as big of a piece of the company (after conversion to stock) as Buffett wanted in return for his capital.
Great article on new digital only insurance company backed by Amazon. Could amazon move into the digital insurance arena in the next 5 years? Very possible given that this would certainly fit within the Amazon fly-wheel digital model.
Bezos’ ambition is off the charts but will be an extremely interesting process to watch him compete with Elon Musk’s Spacex in the private space industry. After all, his vision for a moon industrial complex seems more easily attainable than a colony on Mars (Spacex) at the present moment.
I've always thought that it is ridiculous to ride around in a 2,000 lb. metal box for a few blocks just to go to work or to go downtown. City dwellers need a new mode of transportation that isn't so congestive and so, well, wasteful. Enter the shared electric bike and scooter networks. This will be an interesting trend to watch for congested metro areas.
The Robots are coming to medicine.
DEPARTMENT OF BOOKS
Wonderful book by Wesley Gray (Founder and CEO of Alphaarchitect.com) and Tobias Carlisle (author of "Deep Value" and "The Acquirer's Multiple" which I reviewed last week). This book is broken into six parts, with the first part introducing the reader to Joel Greenblatt's Magic Formula (read "The Little Book That Beats The Market" if you do not know what this is - highly recommend this book, even though the research couldn't be replicated from it) and other measures of quantitative value investing metrics. The next four parts go into detail on a myriad of different metrics to help investors find out whether or not a business is in financial distress, whether it manipulates earnings, whether it has an economic franchise, how cheap it is relative to other companies, and how to combine these various metrics into a workable investment screen. The last part combines these metrics into a model that is backtested and picked apart rigorously by the authors to support their performance claims.
Overall, this book taught me the importance of examining a company's books for earning manipulation and financial distress, where to look for the best investment ideas, and reinforced the need for an investment checklist to eliminate careless mistakes. I highly recommend this book for anyone who is interested in learning more about quantitative value investing in general and has a basic knowledge of financial metrics.
DEPARTMENT OF PODCASTS
I would highly recommend this episode for people looking to get a start in real estate investing. It has some very inspirational stories as well as solid tips for getting started in real estate investments. Highly recommend for newbies!
DEPARTMENT OF LETTERS
This week I decided to finish Charlie Munger's letters to his shareholders at Wesco Financial from 1983-2009 and take notes with this question in mind: What makes Charlie Munger such a brilliant businessman?
Let's start with a little history. Before his days as Wesco's Chairman and Berkshire's Vice Chairman, Charlie developed commercial real estate in California successfully in joint partnerships and was also a successful corporate attorney at Munger, Tolles, & Olsen. He also averaged a ~19% annualized return from 1962-1975 in his hedge fund Wheeler, Munger & Co. He parlayed his majority stake in Blue Chip Stamps which he bought for $24M (representing almost 61% of his hedge fund investment assets at the time) into successful investments in See's Candies (99%), The Buffalo Evening News (100%), and Wesco Financial (80%).
What is interesting is that his investments into these three companies were wildly successful over the next 40 years, despite a 67% decline in the market value of Blue Chip Stamps from 1972-1974, which caused a 50% drop in Munger's hedge fund holdings. He wound up his fund in 1975 to concentrate on his larger stakes in Blue Chip, See's, Buffalo Evening News, and Wesco. His investment, alongside Buffett's, in Blue Chip for $24M essentially bought him 3 other businesses - See's Candies (which has outstanding economics), Buffalo Evening News (which performed well into the 1990's until new types of media put pressure on the business model), and Wesco Financial (which became a large financial insurance subsidiary within Berkshire Hathaway).
Once in charge at Wesco, Charlie set to work improving Mutual Saving's and Precision Steel's operations and used each company's excess cash flows to invest in equity securities and other operating businesses as opportunity allowed. Berkshire Hathaway, 80% owner of Wesco Financial, also invested in Wesco's business by starting a reinsurance operation in the mid 80's, where some of Berkshire Hathaway's subsidiaries could lay off risk to Wesco's reinsurance business and allow Wesco to participate in their premium volumes (which generated investment 'float' for Charlie to invest). This insurance operation would go on to be a major force in generating funds for investment for Munger at Wesco.
In 1987, he along with Buffett, invested in Salomon convertible preferred stock which yielded over 9% dividends and were convertible into common equity if the stock traded above a certain price. He would make more investments of the type in Gillette, USAir, and Champion International - all of which would be converted into common equity after receiving substantial dividend payments and sold for big profits (except Champion where he sold the convertible preferreds for a profit). He bought a 4% position in Freddie Mac in the late 80's and compounded his money twenty times over.
He also bought a few more businesses as the years went on. The first was New America Electric, which was an electronics manufacturer. Munger made the mistake of paying too much for a business that was at peak earnings and in a tough industry. The next business was Kansas Bankers' Surety which insured banking institutions in the Midwest. This company would be rolled into Wesco's insurance operation and continue to add to the investment float over the years. The last business, CORT Furniture, no doubt had its seal of approval from Warren Buffett due to his pleasant experiences with Nebraska Furniture Mart (which still pumps profits out today). However, with this purchase, it is clear that Wesco paid too much for a business that was at its cyclical peak and that didn't perform well in recessions.
When it was all said and done, Munger compuonded book value at roughly 12% from 1983-2009 and turned Wesco into a multi billion dollar conglomerate. So, with all of this said, what makes him such a strong businessman? Here are my eight thoughts from reading through his letters (supplemental notes below) and watching countless speeches and interviews of Munger:
1. The brilliance in his 'latticework of mental models' view of the world is unmatched. He is able to string together the big ideas from all major disciplines and apply them in situations outside of their normal areas to new situations. Shane Parrish has a great link here on what I mean by mental models.
2. The brilliance in understanding what the MAJOR driver(s) are of a particular scenario and paying very close attention to them. To see this, I highly recommend you read the 1990 annual letter where Munger lambastes the then-current legislative environment for savings and loans institutions and then offers certain cures for the industry's problems.
3. The brilliance of grasping the simple and not the esoteric. As Einstein said, genius is taking something complex and making it simple.
4. The brilliance in his ability to do nothing when nothing is required. One of the benefits of having patient shareholders and capital as his partners is that "When there is nothing to do, we are very good at doing nothing." Sometimes doing nothing is better than lots of activity, especially in the stock market.
5. The brilliance of his ability to recognize what kind of exponential value a powerful economic franchise would add to a business over time.
6. The brilliance of his mastery of psychology as shown in his speech (linked to above) on misjudgment allows him to understand what types of biases are inherent in every investment opportunity and to adjust his decision making accordingly.
7. The brilliance of him being a lifelong learning machine and voracious reader. As Munger always said,"in my whole life, I have known no wise people who didn't read all the time."
8. The brilliance of his ability to change his mind when he finds the facts support a new opinion. Too many people paint themselves into corners, whether it be political opinions or investment ideas, and stick to them long after facts have proven them otherwise. Charlie, on the other hand, is a master at constantly reevaluating his fundamental assumptions and opinions based on the facts.
Supplemental notes on (most) Wesco letters from 1983-2009
1987 Letter Notes (page 40)
Salomon investment - $100M @ 9%, convertible into common equity at $38 per share or more in 1987 after the massive stock market crash and operating losses at Salomon (classic strategy of protect downside and participate if the upside happens).
Quote from letter: "When Wesco's parent corporation acquired control, Wesco's activities were almost entirely limited to holding (1) some surplus cash, plus (2) a multi-branch savings and loan association which had many very long-term, fixed-rate mortgages, offset by interest-bearing demand deposits. The acquisition of this intrinsically disadvantageous position was unwisely made, alternative opportunities considered, because the acquirer was overly influenced by a price considered to be moderately below liquidating value. Under such circumstances, acquisitions have a way of producing on average, for acquirers who are not quick-turn operators, low to moderate long-term results. This happens because any advantage from a starting bargain gets swamped by effects from change-resistant mediocrity in the purchased business. Such normal effects have not been completely avoided at Wesco, despite some successful activities, including recent investment in General Foods."
1988 Letter Notes (page 50)
Incredibly in depth discussion of Federal Savings and Loan Insurance Corporation's insolvency and what the preconditions were for such large scale losses in the S&L industry. I wouldn't do it justice to write the details here, as Munger has done in this letter, but suffice it to say that there were incentives for S&L institutions to compete for ever more deposits using higher rates of interest paid to depositors, and then invest these funds into ever riskier loans, expecting the FSLIC to insure them if (when) losses occurred. And low and behold, these losses did come to fruition, and were born by taxpayers in large quantities (billions).
Interesting discussion of 80% acquisition of New America Electric where Munger and Buffett invest alongside an owner-operator (the CEO who retains 20% ownership of the company), which has been their preferred method of private investment over the years.
1989 Letter Notes (page 71)
Interesting to note in this letter are the new convertible preferred stock investments in Gillette Company ($50M at 8.75%, convertible at $50/share), USAir Group ($12M at 9.25%, convertible at $60/share), and Champion International Corporation ($23M at 9.25%, convertible at $38/share). I remember reading about these investments Buffett made in his annual shareholder letters, so it is clear that he and Munger worked together to make these investments.
I really like this particular type of investment because it is a "heads I win, tails I don't lose too much" type of investment where the risk/reward ratio is very positively skewed. It essentially gives the buyer a high yielding fixed income instrument with an out-of-the-money call option on the underlying stock. So it has the protection of equity capital in the capital stack, but also offers significant upside, should the company continue to perform well fundamentally.
Finally, Munger highlights his embarrassment from New America Electric's first year of operation where it earned a meager $168,000 or 1.6% on purchase price in the prior year. It is always interesting to follow mistakes of the investment greats like Buffett and Munger to learn where they took a wrong turn. This operation's troubles stemmed from a consolidation to new facilities, which seems transient rather than permanent in its effect on earnings power. However, after reading several more letters, it seems that Wesco paid up too dearly for a company at peak earnings in a fiercely competitive industry.
1990 Letter Notes (page 90)
Munger writes a long diatribe against the then-current legislation in effect that attempts to address the Savings and Loan industry problems after the large insurance losses to the FSLIC in the late 80's. I won't even begin to detail his long list of potential solutions to the ailing industry, but they are well worth the read for their policy implications both then and now. He ends his diatribe with a nod to Buffett:
"This eccentric, who heads Berkshire Hathaway, Wesco's parent corporation, believes for some reason that accumulated wealth should never be spent on oneself or one's family, but instead should merely serve, before it is given to charity, as an example of a certain approach to life and as a didactic platform. These uses, plus use in building the platform higher, are considered the only honorable ones not only during life but also after death. Shareholders who continue in such peculiar company are hereby warned by our example in writing this section: some of the eccentricities of this fellow are contagious, at least if association is long continued."
1992 Letter Notes (page 117)
Wesco effectively ended its engagement in the savings and loan industry and rearranged its organization to allow for "a lower cost operation, with higher investment flexibility."
1993 Letter Notes (page 126)
This year marked the year of Wesco's entry into the super catastrophe reinsurance business ("super-cat"), when National Indemnity (another Berkshire Hathaway Subsidiary) ceded part of its reinsurance book to Wesco's insurance operation. Munger has an interesting discussion on the economics of catastrophe reinsurance in this letter.
1996 Letter Notes (page 161)
Wesco Financial's reinsurance division purchased Kansas Bankers Surety Company for $80M in an all cash deal. KBS specialized in insurance products tailored to midwestern banks, including directors and officers indemnity policies, bank employment practices policies, and deposit insurance.
1997 Letter Notes (page 171)
Salomon was merged into Traveler's Group Inc., which caused the unrealized gains in their common and preferred stock holdings in Salomon to be recognized at a large profit.
It is worth noting that Munger discusses his investments in convertible preferred shares of Gillette, Salomon, USAir, and Champion International. His investment in Gillette cost $40M, but after conversion to common equity, was worth $321.4M at the end of 1997. He and Buffett made four investments of the type: Salomon, Champion International, Gillette, and USAir. Their Salomon (then Traveler's) and USAir holdings were worth $119.3 more than their original cost (not including dividend payments in the interim) at the end of 1997. Finally, they made $4.2M after taxes on the sale of their Champion International Corporation convertible preferreds (not including dividends).
1998 Letter Notes (page 182)
Citigroup was merged with Traveler's, and Wesco became a holder of Citigroup convertible preferred shares.
1999 Letter Notes (page 192)
Wesco purchased 100% of CORT Business Services Corporation for $384M in cash. CORT was a leading furniture rental and sales company. Interestingly, 60% of the purchase price was 'goodwill' or the accounting entry that occurs when acquiring a company for more than stated book value. Clearly Munger thought that this represented a company with a durable economic franchise. If we back out of the numbers, we can see that CORT earned roughly 30% on book value of shareholders' equity pretax ($384M purcase price x 40% = $153M estimated book value, $46M / $153M = ~30%). However, as I soon found out, this would be too rosy of an expectation going forward.
2000 Letter Notes (page 200)
Wesco's position in Freddie Mac common shares that was bought in the late 80's for $72M was sold in 2000 for approximately $1.4 billion. Wesco made roughly 20 times their money pretax on the investment, and netted $852M after taxes. This works out to roughly a 28% compounded annual return over 11-12 years since Munger loaded up on Freddie Mac. As Munger always preaches, "few bets, big bets, infrequent bets."
2002 Letter Notes (page 216)
CORT furniture's fundamentals have declined precipitously from 2000 to 2002 with operating income down from $46M in 2000 to $2.1M in 2002. Perhaps they bought it at a cyclical high in fundamentals?
2003 Letter Notes (page 226)
CORT furniture's fundamentals continued to slide, reporting a $6.3M operating loss, while insurance operations reported profits, but declines from 2002.
2004 Letter Notes (page 235)
CORT's fundamentals rebounded with a $5M operating profit. Still, this is far below the $46M in 2000 when Wesco bought the business for $386M.
2005 Letter Notes (page 244)
CORT's business rebounded even more to $20.6M in operating earnings, and overall operating earnings were up to $77.9M from $47.2M in 2004.
Wesco recorded $216M in gains on sales of securities, but the entire amount was due to Gillette's merger with Proctor & Gamble, whereby Wesco received shares of P&G for their interest in Gillette.
2006 Letter Notes (page 253)
CORT's business continued to expand, recording $400M in revenue and $26M in operating profits. It seems that Munger purchased the company at a cyclical height in its earnings cycle and the general macroeconomic cycle, just before the internet bubble burst in 2000 and 9/11 happened in 2001.
Wesco Financial's Operating Income from 1983-2009
1983 - $8.4M ($2M in securities gains)
1984 - $10M ($13.1M in securities gains)
1985 - $8.3M ($41.5M in securities gains)
1986 - $11.9M ($4.5M in securities gains)
1987 - $16.6M ($1.2M in securities gains)
1988 - $23.5M ($1.6M in securities gains)
1989 - $24.4M ($5.9M in securities gains)
1990 - $25.0M ($.391M in securities gains)
1991 - $22.8M ($5.8M in securities gains)
1992 - $22.5M ($.147M in securities gains)
1993 - $20.3M ($1.1M in securities gains)
1994 - $24.6M ($.16M in securities gains)
1995 - $30.2M ($4.3M in securities gains)
1996 - $30.7M
1997 - $38.2M ($62.6M in securities gains)
1998 - $37.6M ($33.6M in securities gains)
1999 - $45.9M ($7.2M in securities gains)
2000 - $70M ($852.3M in securities gains)
2001 - $52.5M
2002 - $52.7M
2003 - $39.9M ($34.7M in securities gains)
2004 - $47.4M
2005 - $77.9M ($216.6M in securities gains)
2006 - $92M
2007 - $93.4M ($15.7M in securities gains)
2008 - $77M ($4M in securities gains)
2009 - $54M
Total of $1.05B in operating income, $1.3B in securities gains ($2.3B total) and an increase in book value from $124M to $2.5B from 1983-2009. Compounded book value by roughly ~12% over 26 years.