Some Thoughts on Investing - Part 1

I was reading Warren Buffett's letters to shareholders from the 1970s and came across a performance measurement ratio he used when evaluating the performance of Berkshire's performance - Operating Income on Beginning Equity Capital.  The rationale behind not using earnings increase year over year is that "there's nothing particular noteworthy in a management performance combining a 10% increase in equity capital and a 5% increase in earnings per share. After all, even a totally dormant savings account will produce steadily rising interest earnings per share each year because of compounding. "

To better understand this, I wrote a simple business scenario and compiled the financial statement by myself.

Let's say we started a juice business with $2000 bank loans and $3000 equity capital (3000 shares with $1 par value). We then bought 4 juicers for $250 each and other fixed assets (such as desks, chairs, credit card processing machines) for another $2,000. Our beginning balance sheet will look like

Cash              2,000
Juicer             1,000
Fixed Assets:  2000
Total Assets:  5,000

Bank Loans:  2,000
Equity:           3,000
Total L+E:     5,000

Here are the assumptions:
We can sell 30 cups per day, or 10,950 cups per year
Sale price is $5 per cup.
Cost of sales is $2 per cup.
Rent Expense is $12,000 annually
Utilities and Electricity is $2,400 annually
Interest expense rate is 5%, or $100 annually.
Juicers and fixed assets are depreciated straight-line using 5 years, which means depre exp= $600 annually.
Other expenses: $100
Tax rate: 30%

Our Income Statement will look like:                    

Sales :                             $54,750
Cost of Goods Sold:          21,900
Gross Profit:                      32,850

Rent expense:                    12,000
Utilities and Electricity:         2,400
Depreciation Expense:            600
Interest Expense:                    100
Other Expense:                       100
Total Operation Expense: $15,200

Income from Operations:  17,650

Income Taxes:                    5,295

Net Income:                     12,775

Earnings per Share:            4.26


Our Balance Sheet will look like this:

Cash:                        $15, 375
Juicer (net)                        800
Other Fixed Assets:          1600
Total Assets:              $17,775

Bank Loans:                  2,000
Equity:                         15,775
Total L+E                    17,775



Our key ratios and stats for year 1 are as follows:

1. Gross Profit Margin: 60%
2. Operating Margin:  32.2%
3. Net Margin:  23%
4. BV per share: 5.26
5. Return on Beginning Equity: 426%
6. EPS: 4.26

Now, assuming in year 2, we didn't not buy new juicers and all other information stay the same. Our income statement will look exactly the same, our balance sheet will look like this:

Cash:                       $28,750
Juicer:                             600
Other Fixed Assets:       1,200
Total Assets              $30,550

Bank Loans:                 2,000
Equity:                       28,550
Total L+E                 30,550


Our key ratios and stats for year 2 are as follows:

1. Gross Profit Margin: 60%
2. Operating Margin:  32.2%
3. Net Margin:  23%
4. BV per share: 9.52
5. Return on Beginning Equity: 81%
6. EPS: 4.26

In year 3, again, we didn't not buy new juicers and all other information stay the same. Our income statement will look exactly the same, our balance sheet will look like this:



Cash:                       $42,125
Juicer:                             400
Other Fixed Assets:         800
Total Assets              $43,325

Bank Loans:                 2,000
Equity:                       41,325
Total L+E                 43,325


Our key ratios and stats for year 2 are as follows:

1. Gross Profit Margin: 60%
2. Operating Margin:  32.2%
3. Net Margin:  23%
4. BV per share: 13.78
5. Return on Beginning Equity: 44.8%
6. EPS: 4.26

This scenario unfortunately did not give me a better understanding of Return on Beginning Equity Capital. However, I accidentally stumbled onto the following implications based on this exercise:

1. This scenario essentially illustrates a business model with low reinvestment (capital) need, high fixed cost, high cash flow generation, and high ROA and ROE in prospering years. We may see situations like this in Retail and For-Profit Education industries a lot.
2. This business model will do extremely well in booming years because once you covers fixed cost, every sales dollar will add to the bottom line. On the other hand, this business model is extremely cyclical as high operating leverage will magnify the impact of decrease in sales.
3. A great business with this business model should have pricing power and can differentiate its product. A perfect example is See's Candy.
4. Non-controlling stockholders may not do as well as owners, especially if the equity interest is purchased at a later stage. Even though BV will increase every year, EPS is stagnant. Mathematical illustration is as follows:

If we use book value as a proxy of intrinsic value:
Year 1: Both BV and IV increase by 81%.
Year 2: Both BV and IV increase by 44.75%
Year 3: Both BV and IV increase by  31%
........
Year 10: Both BV and IV increase by 10.82%
.....
Year 20: Both BV and IV increase by  5.2%

Here we are subject to the law of diminishing returns. While the early equityholders enjoy fabulous returns in early years, later equityholders may face only mediocre return. This may be the case for Abercrombie and Fitch.

5. In order for the business to grow earnings per share, the owners must have the courage and determination to make investment that will generate returns in excess of cost of capital.   The best business will be able expand by opening more stores, expanding to new markets or increase prices of the products consistently. Urban outfitters, Coca Cola and See's Candy are good examples.

My Stockfolio-Malaysia Stock Analysis: Li Lu sharing his Value Investing Strategies

My Stockfolio-Malaysia Stock Analysis: Li Lu sharing his Value Investing Strategies: This past weekend was the Berkshire Hathaway (NYSE:BRK.A / BRK.B) annual shareholder meeting. At one point during the Q&A, a questioner ...

The 2013 Pilgrimage - Part 2

6:30 am, May 3rd, Friday. My alarm had been snoozing for a few times. I had a sound sleep after yesterday's  value investing fest. Nine more great speakers today, including Howard Marks, one of the greatest thinkers and investors. Looks like it was going to be another great day. 

The first speaker today is Barnett Helzberg, founder of Helzberg Diamond, a subsidiary of Berkshire Hathaway. He talked about what he learned before selling to market and the entrepreneurship mentoring program. My biggest takeaway from his presentation is his insight on retail. When asked about what he thinks is most important in the retail business, he said management quality and business culture. Retail is essentially a people business, if you have bad management and bad culture, it will ultimately reflected in sales and profits. He said the retailers he admires the most are Nordstrom and  Costco. 

The second speaker today is David Rofle, a portfolio manager from Wedgewood Parters, a Saint-Louis based investment advisor. David talked about GEICO's history and Warren Buffett's investment history with GEICO, which reminded me of Tom Russo's speech from yesterday. For each new policyholder, GEICO will show approximately a loss of $250 in the first year but the present value of future premiums will be a net gain. Buffett told management at GEICO just to grow the business even though each new policy holder that was put on the books cost an enormous amount of losses the first year. They had high net present values and you've seen the history.The result: the number insured at GEICO, because of Berkshire's willingness to show the losses up front, have grown from just under a million policy holders to almost ten million. And his spending to drive that growth that just burdens operating income up front has grown from $30 million a year to almost $900 million. The fact is by spending up front, having the elasticity, the willingness, to burden your income statement and then getting the results in the future is a very nice trade off. GEICO is a great example of the capacity to suffer and discipline. David also talked about how Wedgewood Partners adheres to Buffett's 20 punch card philosophy and only invest in the 20 best ideas, resulting a ultra-low portfolio turnover. I asked David a question on how to utilize footnote information in the valuation process. He brought up a good point: Use footnote as a filtering tool, if you can't understand the footnote, simply don't buy the stock or sell the stock if you already own it. That's why they sold AIG back in 2008 because they could not understand the footnote. 

Then came Scott Phillips from Lauren Templeton Fund. His topic is the Templeton touch. Sir John Templeton is, without doubt, one of the best investors of all time yet his investment philosophy is not widely understood by the investing public. Buying at maximum pessimism is one of the doctrines I stick to but it is psychologically very difficult to do so when you almost have to go against everyone at that point. A case in point is JC Penney. Almost everyone thinks it is a dying business and stocks have dropped precipitously after the 2012 full year earnings release. When you hear media and almost everyone else is talking about the possible demise of JC Penney, it is certainly not easy to go against the crowd and voice a different opinion. 

The fourth speaker is Michael Shearn, author of the book "The Investment Checklist."  I have read his books three times and learned enormously. However, how to incorporate all the information from the checklist into the valuation process still baffles me. Luckily Michael answered my question inadvertently during his presentation, "the fair value derived from the checklist is dynamic, if you have a change in management, if will impact the valuation. " This is a great point. As human beings, we are all subject to the conservatism, confirmation bias and status-quo bias, the combination of which creates a massive psychological barrier  for us, as investors to absorb new information of the companies we invested in and make changes to the dynamic fair value accordingly. The most important thing, as Howard Marks would put it, is to be vigilant to structural industry or company-specific changes. 

The last speaker before lunch break is Ryan Floyd, founder of the Barca Capital. He talked about his investment in emerging markets and the power law. The key takeaway ties closely to Nassim Taleb's book of "Fooled by Randomness" and "Black Swan." Fat tail event does happen all the time. Right after he invested in a bank in Ivory Coast, a civil war broke out and the value of his investment tanked 40%. My thoughts on this is, the lower the probability of a certain event happen (inherently true for black swan events), the larger the possible loss and there is no way you can build this in a quantitative model. How do you hedge the risk? Don't be greedy and don't leverage. 

After Ryan's presentation, we took a lunch break. I talked to Jeff Stacey, a BRK meeting veteran and Richard Russo, Tom Russo's nephew over lunch time. Jeff talked about how BRK's meeting has evolved over time. 

The highlight of the day is Howard Marks. He doesn't give public presentations very often so his arrival grabbed everyone's attention. Howard's topic is the human side of investing. Here's a link to the detailed notes:

http://www.gurufocus.com/news/218106/howard-marks-the-human-side-of-investing

The 2013 Pilgrimage - Part 1

It is 8:00 pm on Wednesday May 1st, 3 days before the Berkshire Hathaway 2013 Shareholder Meeting. I am at the Atlanta Airport, waiting with great excitement for my flight to Omaha, NE that departs in an hour. This is only my second pilgrimage to Omaha. Last year's meeting was certainly mindbogglingly amazing so I decided to make it an annual event. I found out that there's a Value Investing Conference right before the meeting and many highly admired value investors such as Tom Russo and Howard Marks are speaking at the conference. Therefore, I decided to make this year's trip a little more than just the shareholder meeting.

My flight departed on time. I spent most of the time reading books. " It looks like we are getting some snow tonight at Omaha, ladies and gentlemen." The captain announced about 30 minutes prior to landing. "Great," I thought to myself. "Now this trip is going to be epic. Who would have thought you will get snow in May."

The plane landed a bit earlier than scheduled and I could see the snow outside. It's going to be a wild ride to the hotel. We got out of the plane around 10:30 Central time. Omaha's airport is relatively small and somehow it gives you a very warm feeling. Walking towards baggage claim, I saw a picture of the young Warren Buffett with the words "Invest in Yourself" right next to his picture. He is exactly right and that's why over 35,000 fellow value investors flock to Omaha this year. A six-hour meeting with the "Oracle of Omaha" is one of the best learning opportunities you can ever imagine as a value investor. 

At the end of the hallway is a big screen with a picture of Omaha with the following words: "Welcome, Berkshire Shareholders." Suddenly I felt like I was home and it's awesome. I quickly grabbed my luggage from the carousel and hopped on a taxi right outside the airport. The driver is from Togo and has been living in Omaha for more than 10 years. My taxi driver from last year was also from Africa. I started to think that there is something magical about Omaha that keeps Buffett here.

 I woke up the next day after a sound sleep. It was white outside, like it was still January. I called the taxi driver from last night and he took me to the UNO business school, where the Value Investor Conference is held. I checked in and took a seat in a conference room. First thing I noticed was that there are many people from outside of the U.S, maybe half of the participants are from another continent. Many Spaniards, Aussies, Canadians, South Africans and Brazilians. Robert Miles, the organizer of the conference, gave a brief welcome speech and told a few jokes that ignited a good amount of laugh. Then he introduced the first speaker, Jeff Matthews, author of the internet book "Secret in Plain Sight." It is an interesting book with some very good insights. Jeff opened up with an anecdotal story about how he found out about Dr.Pepper in a small town in Texas then he talked about what he thinks is the most important yet highly ignored secret of Buffett's success- the quality of shareholders. I thought that was a remarkably good point. In the world of investment, during a market crisis such as the recent meltdown from 2007-2009, if you don't have quality investors who shoot for the long run and are less concerned with the near term volatility, you will be doomed by the velocity at which investors withdraw from the fund. When the panic is wide spread, the best way to survive is to have investors who perceive the wide-spread panic as buying opportunities as opposed to the end of world. Yet in the financial world, very often (maybe 90% of the time) money and greed are the drivers of hedge fund or mutual fund managers. If your goal is to get rich fast, you use leverage and you bet big. As we've seen from the collapse of LTCM and other quant funds during the crisis, the ending is often devastating. Investors in those funds had a quick build up of wealth, which evaporated even faster during a so called "25 sigma event". Jeff talked about how his investors stayed with him during the downturn and that made it much easier for the fund to avoid liquidation of loss positions due to withdrawal of funds. 

The second speaker is Ivan Martin-Aranguez, a portfolio manager of the Santander Fund Asset Management from Spain. His topic is "The Case For Spanish Equities." Since most investors will have a home-bias, meaning they only invest in the equity market in the country he or she resides in, it was interesting to hear why the Spanish market can be attractive given different market dynamics such as "less analyst coverage" and " more family-controlled companies." 

The last speaker of the day is Tom Russo, who in his word, is a value investor I highly admire. His topic is " The Capacity to Suffer," which he had presented several times in the past. He shared his favorite story about Charlie Munger. During an interview, someone asked Charlie how he feels about Warren getting all the attention and credit and Charlie said, "well, some people do the talking and some people do the thinking. " This story got a good laugh from the audience. Tom went on to talk about the capacity to suffer. He mentioned that his No.1 question to the management of the companies he invested in is "are you spending enough?" A company can suffer from a prolonged period of paper losses from investing for the long run and Wall Street does not like that but a culture to suffer for the long run is critically important to build a great company. A case in point is Nestle double down on its investment in Russia during the Russian ruble crisis. They built more facilities and made acquisitions when everybody fled Russia because they wanted to avoid booking short term losses in their income statements. Now Nestle is benefiting from a $2 billion a year business in Russia. Another case is Buffett's holding of $50 billion cash before the crisis and willing to suffer short term under-performance when the market shot up. Then when the crisis came, he was able to secure some special arrangement with Goldman Sachs and GE with the cash on hand.  The capacity to suffer is extremely hard mentally, especially when everyone else around you is benefiting from short term gains and you look like an idiot. But the capacity to suffer is also often one of the most important qualities that separate the best from the mediocre. Tom brought out another interesting point, which I have never thought about- margin of safety comes from not only the price you pay, but also from the competitive advantage of the business you invested in. Does P&G offer a good margin of safety at the a seemingly hefty valuation? Yes, and obviously the margin of safety does not come from the price. If it's not the price that gives you the margin of safety, then it must come from the competitive advantage of the business that offers sustainable growth in the future. This is one of the best lessons I learned from the conference. 

After Tom's presentation, Thursday's session came to an end and we were all going to the Omaha Marriott for the CFA dinner which features Mario Gabelli. During the shuttle ride to Marriott, I met an investor from California. He told me he made millions of money during the tech bubble from a few hundred thousand dollars capital and got wiped out after the tech bubble busted. He went in the market and made millions of money again during the housing bubble and got wiped out during the financial crisis. So over the last 15 years his wealth had gone through a roller coaster ride. He went from a middle class worker to a multi-millionaire, and back to a middle class worker and again to a multi-millionaire and then back to where he started. I have not experienced a wild ride like and I cannot imagine what it is like to experience something like that. But his story reaffirmed my belief that not losing money is extremely important in achieving superior returns. This is a big idea that often falls into oblivion in practice. Here is a mathematical illustration: 

Assuming we have investors, Mr. Quantmania and Mr.Valuemania.

Mr. Quantmania started with $10,000 dollars. He leverages up and compounds it for 4 years at 50% per year. In 4 years, his $10,000 will turn into approximately $50,600 pre-tax. That is an admirable achievement on an absolute return basis. Now assuming the market turns into a chaos in year 5, like it did in 2002 and 2008, and Mr.Quantmania suffers a 80% drop in value, his investment now only worth about $10,100 pre-tax at the end of year 5, or approximately 0.2% compounded annually.

Mr.Valuemania also started with $10,000 but he does not use leverage and does not invest in fad stocks. His return is 20% per year for the first 4 years and he loses 20% in year 5. His $10,000 will turn to approximately $16,600 pre-tax at the end of year 5, or approximately 10.6% compounded annually.

There are a few observations we can glean from this imaginary scenario (even though we've seen similar real stories during 2002 and 2008).

1. Mr. Quantmania's cumulative return, prior to the downturn, is 406.25% pre-tax whereas Mr. Valuemania's cumulative return, prior to the downturn is only 107.36%.After the downturn, Mr. Quantamania's return is essentially flat whereas Mr. Valuemania is still up more than 65%.

2. Mr. Quantmania's 80% drop, wiped out almost 100% of his cumulative gains from the 4 years prior to the downturn whereas Mr. Valuemania's 20% loss only reduced his cumulative gains from the 4 years prior to the downturn by 38.6%.

3. Over 90% of investors will choose Mr. Quantmania's fund at the end of year 4 over Mr. Valuemania's fund.

4. Over 90% of money managers will copy Mr. Quantmania's strategy at the end of year 4.

5. A bigger percentage gain is needed to compensate for the same absolute dollar loss. Or inversely, a smaller percentage losses will wipe out a larger cumulative percentage gains, other things equal. Mathematically speaking, a 5% loss will wipe out a 5.26% cumulative gain; a 20% loss will wipe out a 25% cumulative gain; a 30% loss will wipe out a 43% cumulative gain; a 40% loss will wipe out a 67% cumulative gain and a 50% loss will wipe out a 100% cumulative gain. 

6. Knowing implication 5 above, investors should focus on not losing money and if loss of capital is inevitable, limit it to 20% if you can. 

I think I have a better understanding of Mr. Buffett's Rule Number 1 now. It is indeed very simple but not easy. We ended the night with the CFA dinner featuring Mario Gabelli. My biggest take away from the keynote speech is that an investor has got to be able to back up his or her thesis quantitatively, something Mr. Buffett routinely and habitually does and yet vastly ignored by his followers. For example, Mr. Gabelli stated that if you invested in a 5 carat diamond ring 50 years ago, your compounded annual return will be 4.5% whereas if you invested with Mr. Buffett 50 years ago, your compounded annual return will be close to 20%. Now you have an investment thesis backed by quantitative evidence. The best illustration, of course comes from Mr. Buffett.

“I will say this about gold. If you took all the gold in the world, it would roughly make a cube 67 feet on a side…Now for that same cube of gold, it would be worth at today’s market prices about $7 trillion dollars – that’s probably about a third of the value of all the stocks in the United States…For $7 trillion dollars…you could have all the farmland in the United States, you could have about seven Exxon Mobils, and you could have a trillion dollars of walking-around money…And if you offered me the choice of looking at some 67 foot cube of gold and looking at it all day, and you know me touching it and fondling it occasionally…Call me crazy, but I’ll take the farmland and the Exxon Mobils.”

During another interview at a different time, Mr. Buffett said the following

The value of all that gold at today's prices would be about $10 trillion.

As for its merit as an investment, Buffett observes the following:
The cube of gold will produce nothing in the next hundred years (or, for that matter, thousands of years).
The cube of gold will not pay you interest or dividends, and it won't grow earnings.
You can fondle the cube, but it won't respond.

If you had $10 trillion sitting around, Buffett further observes, instead of buying the cube of gold, you could buy all the cropland in America ($400 billion-worth) and 16 Exxon-Mobils. And you would still have $1 trillion of "walking-around money."

Over the next hundred years, your cropland and Exxon-Mobils would produce trillions of dollars of dividends (the size of which would be adjusted for inflation), and you would still have them at the end of the century, at which point you could probably sell them for vastly more than the $9 trillion you bought them for.

So, which investment would you choose?

For the cube of gold to be the smarter investment, Buffett observes, you would have to be convinced that you could persuade someone else that the cube of gold would be an amazing investment at your asking price. Because that's the only way you can ever make money in gold—if there's someone out there who is willing to buy it from you for more than you paid for it (and pay enough to offset the costs you have incurred from storage and insurance in the meantime).

Meanwhile, your cropland and Exxon-Mobils would likely keep throwing off tons of cash even if the market for them completely dried up.

Note that the value of all the gold and the number of Exxon-Mobils you can buy with the value of gold are different as the first interview took place during 2011 and the second interview took place during 2012. Did Mr. Buffett calculate these numbers by himself? Not all of them, at least not the length of the side of the cube that holds all the gold in the world.  You can get that information from websites such as:

http://www.numbersleuth.org/worlds-gold/

  Ditto to the value of all the cropland in America. Mr. Buffett probably remembers it from his readings. However, the secret is, in my opinion, to put the total value of gold into a comparative fashion quantitatively such as the number of Exxon Mobil you can purchase. The underlying thought process centers around opportunity cost. It all boils down to what else you could have invested when allocating capital. "Intelligent people make decisions based on opportunity costs," says Charlie Munger. This is another Mr. Buffett' secret that is often neglected. 

Back to my hotel, I already could not wait for tomorrow.

2013 Berkshire Meeting Notes Compilation

"Overall I would advise any young person who wants to manage or invest money to have an audited track record as early on as possible,"

"To attract money, you should deserve money... Record is a product of sound thinking."

Munger says most people start with friends and family. "It's hard to do when you are young and that's why they start so small."
Warren: You'll see it again, not necessarily in housing. Humans make the same mistakes again. People get fearful when others are fearful. You saw it in money market funds. I've often thought, if I owned a bank in a two-bank town, I'd hire extras to line-up in front of the other guys bank. But then, the extras would come over to my bank, after the other one went down. This is an area where Charlie and I have an edge. We don't get caught up in what other people are doing. We learned that over time, maybe. When we see failing prices, we think it is time to buy. We don't own on margin. Don't get out on a limb. Leverage is tempting when things are going up. Leverage was a huge part of housing.

Q: What would you tell your 30 year old self?
Munger: Be boring, stay rational and work where you are turned on. I've never done well in a job I didn't enjoy.

Q: if buying shares in the 20 best companies in the United States would be better than investing in an index fund.

Buffett: The results would probably be similar. Then he launches into a bigger point: there are professional investors, and then there are amateurs who invest. Being the former requires a lot of work and research, which many, many amateurs don’t have the time or inclination to do.

The main problem for most people, he says, is “trying to behave like a professional when you aren’t spending the time in the game needed to be a professional.”

Q: What identifies fraudulent financial statements?
Warren: It varies over the years. We can't identify 100%, 90%, 80%... but people give themselves away. In poker, its called tells. We try to assess the individuals that we're dealing with. We don't think we can assess everything accurately. But we try to be right when we make a buy. In looking at financials, for example, in insurance, you can see things done with lose reserves. Before offering stock to the public, reserve would mysteriously go down. I've seen how promoters act. You can spot certain people that are playing games with the numbers. I can't give you a 40-item checklist.

Munger's assessment of BRK's competitive advantage is a template for its success - Recruit well, buy well, and let people do their thing. Stay rational - easy to say for a little while, but so many get sucked into irrationality due to the weight and time and probably intense public scrutiny.

What BRK does is not unique or are they the only one who does so. In the book, "Outsiders," which showcased 7 or 8 highly successfully run businesses that are run by outstanding CEOs, that handily beat market and industry returns during their tenure, also employed the tricks that BRK practices! So these practices is similar to how the trick of value investing can be attributed to the village of Graham & Doddsville. No luck but skill!

Some people probably though I was running a Ponzi scheme, Buffett said of his early days investing other people's money. "Didn't you manage to scrape together $100,000 from your loving family?" Munger asked. Buffett said they might not have loved him immediately after. In sum, however, Buffett said, young people wishing to make a living as investment managers should develop an audited track record and start slowly. Munger said do as Buffett did and start with family money.

Warren: I don't understand the moat around IBM as well as Coca-Cola. I'd have more conviction around Coca-Cola or Wrigley or Heinz. But, I feel good enough about IBM, and I put a considerable amount of money in IBM. Nothing precludes IBM and Microsoft both being successful. I like IBM's financial policy. Its hard for me to think of things that could wrong with BNSF. I could think of things that could go wrong. IBM has big pension liabilities -- it's an annuity business on the side. The liabilities and assets seem equal, but the liabilities are more certain.

Warren: The example of used in the past is, "The Meek will inherit the Earth, but will they stay Meek?" You'll notice that I don't tell our newspapers who to endorse to for president. When I write that , I'm trying to box in my successor. We don't want a CEO using Berkshire as a power base. We want it to be run for shareholders.

Charlie: Sometimes somebody becomes CEO, who has the characteristics of a famous Californian CEO about whom it was said 'he could strut sitting down'

Charlie: A lot of them aren't being fraudulent, because they're deluded. They believe what they're saying.

Warren: Berkshire is an usually rational place. We know what we want to accomplish. We've benefited from a long-run. We've avoided outside influences that pushed us places we didn't want to go. Insurance should be run rationally. Other insurers have had Wall Street pressure to increase premiums. At National Indemnity, we decreased premiums 80% -- I doubt another company answering to external pressure could do that. We have no external pressure, and that's a great way to operate. We don't have outside criticism, and there is no reason for us to do something stupid in insurance. We were major writers of natural catastrophe insurance years ago when the prices were good. We don't do it today because the prices are right. We didn't leave the market, it left us. We won't price at $0.90 for a probabilistic loss of $1.

Charlie: Sometimes it's pretty obvious. I was once introduced to a man who wanted to sell us a fire insurance company. One of the first things he said to us - with a thick accent... Eastern European, I think - said, it's like taking candy from a baby. He said, 'we only write insurance for concrete structures that are underwater'

Charlie: On the subject of Warren's operating methods. We didn't know when we started out that you shouldn't make a lot of decisions when you're tired, or that making a lot of decisions is tiring. We didn't know that consuming caffeine and sugar was helpful for decision making (laughter). It turns out that this is an ideal way to sit where Warren sits. He didn't know that - he just stumbled into it.

Charlie: I have nothing to add... but I do think knowing the edge of your own competency is important. If you think you know more than you do, you're in trouble. Works particularly well in matrimony.

Warren: but you know that BNSF will carry more carloads in 10 or 20 years. There will be no substitutes. There will be 2 railroads in the West, 2 railroads in the East... It's not complicated, they have assets... It's silly to ignore what you know because of things you don't know. Any sort of normal (new, in-between, old, etc) doesn't mean anything to us. If you get a good business, and the price is good, you'll do very well over time. If you try to time the market based on forecasts, you'll make lots of money for your broker.

Warren: We will get a decent rate of return (on the newspapers). Most newspapers were bought as corporations or partnerships, so we get to write-down the intangibles, which affects after-tax returns. Everything that we've seen to date indicates that will meet or beat 10% returns.

Buffett: the consolidation in the airline industry is interesting to watch, but he's not looking to invest. Airlines have very high fixed costs but very low marginal costs. Too much temptation to sell that last seat at a low price. If we ever get down to one airline with no regulation, then it will be a great business.

Munger: It's hard to create a new railroad, easy to create a new airline.

Charlie: I cannot remember an important decision that Warren made when he was tired. He sleeps soundly. He eats what he's always eaten.

Warren: We don't look at forecasts. We have never made a decision on a stock on a macro forecast. We don't know what things will look like. So why spend time talking about something you don't know anything about. So we talk about the businesses. I like Bill Gross. But it doesn't make a difference to me what he or any economist thinks about the future.

How do you not ruin your children, a shareholder asks?

Buffett: "More kids ruined by parental behavior than inheritance. Your children learn through your actions. It is important and serious job. The amount of money left by rich person is not determining factor how children turn out."

Buffett: There is virtually no correlation between book value and intrinsic value. Investors should care about intrinsic value. In Berkshire's case, book value is used as a very understated proxy for intrinsic value. At 1.2 times book value, Berkshire would be willing to buy back a lot of stock.

Warren: Todd and Ted, working under a 2/20 arrangement, if they put the money in a whole in the ground, would make a $120m each this year. Not exactly an arrangement you don't want to think about ahead of time.

Charlie: The arithmetic attracts the wrong sort of people.

Charlie: Letting in Greece into the EU is a lot like using rat poison as whipping cream - an exceptionally stupid idea. It's not a responsibly capitalistic country... a place where people don't pay taxes and committed fairly straight fraud to get into the EU.

Charlie:There's a reason why all that stuff is in the bible that you can't covet your neighbour's ass... it's a terrible thing to do. How much fun can you have being envious... it's the only sin there's no fun in.

Buffett: Generally speaking if you have a chance to buy a wonderful business, you probably should stretch yourself (on the price) particularly if a company can invest new money at very high rates of return.

Charlie: We're in a different mode now. That has a great lesson in that if we'd kept our earlier molds, if we'd never learned. We wouldn't have done so well. The game of life is a game of learning.

Munger: "You can't make a lot of money just knowing what is going on now."
Buffett: "And you can lose a lot of money thinking you will know what is going on tomorrow."

Buffett: Some jump out at you. A lot of it is based on figuring out how promoters act. They generally give themselves away. If you have doubts, forget it.

Charlie: When you multitask like young people do, you're unlikely to do anything well.

Buffett "When people get scared, they get scared in mass. They get greedy in mass. Confidence come back individually."

Warren: Whenever you hear people talk about concepts, for instance, country by country ideas, they are probably better at selling than investing.

Munger on the Fed's policies (low interest rate) : Well they had to hurt somebody, and the savers were convenient.

Charlie: You can have a CEO who's 9 out of 10 on almost everything, but some deep flaws too.

Buffett: Four or five times in the average lifetime, you will see incredible opportunities in the equity markets. You need the mental fortitude to take advantage of them.

Buffett: Individuals tend to get excited about stocks at the wrong time.

Charlie: The railroads consolidated, grew their profits and what did we do? We missed it. It's conceivable that Bill Miller is right. It goes into my 'too hard' pile.

If you try to time the market based on forecasts, you'll make lots of money for your broker.

Buffett on bubbles: "It works for a while. Your neighbor gets richer because he goes along. The bandwagon is hard to resist. We just don't give a damn. If they can make a lot of money day trading, good luck to them."

Munger: "We are boring and trite. Keep plugging, stay rational. The old virtues."

Charlie Munger's life advice: "It's trite, but the old-fashioned virtues still work."

Charlie and I have simple lives. We do what we love. We both like to read a lot. Charlie likes to design buildings

Strayer Education - Quality Educator For Sale

The for-profit education industry has been beaten down considerably in the recent past. I am almost sure that many value investors have done some research in this section of the market in search for bargains. There are numerous articles on companies such as Apollo, ITT Education, Career Education, Corinthian Colleges, Capella University and etc. Most articles conclude that for-profit education stocks are cheap based on valuation metrics but the regulatory risks are also very high. I will not repeat what has been widely known by the market participants. My thesis is built more on the qualitative analysis. 

I started my research on the for-profit education a few months ago. My goal was to find a company that combines quality and value in the for-profit education industry. My initial list includes Strayer Education, ITT Education, Apollo, Career Education, Corinthian Colleges and Capella University. After reading some 10ks, earnings call transcripts and articles, I've narrowed it down to Strayer Education and Capella University. I eliminated the others mainly based on qualitative issues. For example, while reading Apollo's annual report, I noticed that management claims that Apollo has "aligned our admissions practices to better support our students's success by eliminating enrollment measures as a factor in the evaluation and compensation of our admission advisory teams."  This sounds like a good intention. However, new regulation specifically states that "a school participating in Title IV programs may not pay any commission, bonus, or other incentive payments to any person involved in student recruitment or admissions or awarding of Title IV program funds, if such payments are based in any part directly or indirectly on success in enrolling students or obtaining student financial aid." If a management team blatantly writes misrepresenting statement in the annual letter to shareholders, I don't think there is much integrity in the business. Other examples include ITT Education's abysmal reviews from its students, Corinthian Colleges' officials' engagement in a no-holds-barred campaign to drive down their schools' rates by pushing former students to obtain temporary forbearance and deferments on their loans. The for-profit education industry is one in which greedy management can take advantage of the underprivileged students even though education in general is supposed to have noble intention.  No wonder the regulators have been more stringent. Unsurprisingly, on a quantitative level, such as manifested by the cohort default rate, schools with questionable management also score very low. The 3 year cohort default rate for the 2009 class is 26.4%, 28.8% and 34% for for Apollo, Corinthian College and ITT education whereas for Strayer and the Capella, the rates are only 13.9% and 9.70%. 

The more research I've done, the more Strayer Education stands out from its peers, both from a qualitative perspective and quantitative perspective. So after months of research, I've decided to select Strayer Education within the for-profit education industry as my recommendation. 

Business Description:

Strayer Education, Inc. was founded in 1892. Strayer University is an institution of higher learning that offers undergraduate and graduate degree programs in business administration, accounting, information technology, health care, education, and public administration at over 60 physical campuses. The Company is a for-profit post-secondary education services corporation. Its mission is to make post-secondary education achievable and convenient for working adults in today's economy. It works to fulfill this mission by offering a variety of academic programs through its wholly-owned subsidiary Strayer University, Inc., both in traditional classroom courses and through Strayer University Online. Strayer University makes post-secondary education accessible to working adults who were previously unable to take advantage of higher education opportunities. Strayer University provides access to higher education to working adult students. Marketing activities include direct mail, Internet marketing, marketing to its existing students, print and broadcast advertising, student referrals, and corporate and government outreach activities. Strayer University maintains booths and information tables at appropriate conferences and expos, as well as at transfer days at community colleges. It has a total of 92 campuses in various stages of growth. As an institution of higher education accredited by Middle States and operating in multiple jurisdictions, Strayer University is subject to accreditation rules and varying state licensing and regulatory requirements.

Quality of Business:

Strayer Education's moat fundamentally comes from a top-notch management team. The current Chairman and CEO Robert Silberman (will step down as the CEO but will remain Chairman of the Board), worked as the COO of Cal Energy, which was owned by Berkshire Hathaway, before he was recruited as the CEO of Strayer Education. He has done a remarkable job building up Strayer Education's moat in the for-profit education business. In his book The Investment Checklist, Michael Shearn enumerated various instances where Robert Silberman showed integrity and great leadership. Here is an excerpt from the book,  "When Robert Silberman took over as CEO of Strayer Education in 2001, he said he was not going to focus on any of the metrics that generally drive public company valuations, such as revenue growth, operating income growth and margin expansion. The only thing that was going to drive real sustainable long-term value of owners was the intangible value of Strayer University and the to increase the intangible value, you increase the level of learning outcomes."  

Strayer's annual reports also stand out from those of its peers. Each year's annual report contains a reprint of the Strayer's Business Model from the 2001 letter to shareholders, which clearly outlines

• What Strayer does
• How Strayer's business model generates both reported net income and owner’s distributable cash flow, and 
• Strayer's strategy to increase the intrinsic value of your investment in Strayer Education. 

Robert Silberman also writes letters to shareholders every year and his writings are vastly different from the CEOs of Strayer's peers. The letter starts with the past year's result, detailing both challenges and accomplishments. Unlike his peers, Silberman goes in depth to analyze the reasons behind the challenges and accomplishments so that shareholders can get a clear understanding of the overall picture. Here is an example from the 2011 letter in which he offers his insights on the decline in student enrollment, which is very different from the public perception.

After  reviewing  all  the  data,  I  believe  that  the  most significant factor behind Strayer University’s extended decline in new student enrollments during 2011 must have  been  the  sustained  level  of  distress  across  the economy, and specifically the markedly higher level of unemployment in our target student population. Real unemployment in this country among 25–50 year olds without  a  college  degree  was  a  devastating  22%  in 2011, up from 6% in 2008. It is even higher in some of  our  newer  geographic  markets  in  the  industrial Midwest. We  know  from  surveying  our  students  that the large commitments of time and finances necessary to  succeed  in  our  undergraduate  academic  programs are  often  too  daunting  for  those  adults  who  have  no steady  means  of  income  (particularly  those  with dependents). We also know from our surveys that most of  our  undergraduate  students  have  contemplated returning  to  college  for  upwards  of  two  years  before making the final commitment. They have had to truly “screw  their  courage  to  the  sticking  point”  before actually enrolling. Therefore, in many ways, there is a lag factor to the effect of serious economic disruptions on our new student enrollments. As I have written in this letter  in  the  past,  while  some  level  of  economic insecurity  does  indeed  drive  working  adults  back  to college, sustained unemployment does not, at least not to Strayer University. 

Silberman also summarizes the capital allocation results from the prior year and lays out the plan for next year .Capital allocation is extremely important for any business yet rarely does a CEO of a public company present the result of prior year's capital allocation in a shareholder-friendly way. This transparency by Silberman is another indicator of management quality.

At the end each year's annual report, Strayer's Heritage reprinted from the 1912 student catalog is always attached. This section speaks the character of the business. Below is the full catalog:



This catalog was written with a view of setting before the men and women of this community some of the advantages of a business education, and of acquainting them with the superior facilities of this school for giving high-grade business training. 

The courses have been designed and presented to meet the needs of the business office of today. The teachers are men and women who are specialists in their respective subjects. The school rooms have been chosen and equipped with special reference to light, comfort and sanitation, so as to make it an ideal place for study.

We ask that the public, in determining which school it shall attend, to consider the facts in connection with this school, as are outlined in this catalog and supplementary literature. It is twenty years old. It has grown steadily  since  the  beginning.  It  attributes  its  growth  to  correct  ideals,  careful  management  and  successful, enthusiastic, and rapidly increasing alumni.

While it is essential to its success that a school should give thorough instruction in the subjects that comprise its courses, yet the school that does  only this, falls short of its full mission. The development of those traits of character which make for reliability in business and good citizenship are the peculiar province of the school as well as the home. This school, then, has nothing in common, can have nothing in common, with those so-called business schools offering cheap and superficial courses. Such courses, while inexpensive, and possibly of short duration, cannot result in anything but disappointment in the end.

This  school,  then,  stands  for  high  ideals,  it  courts  investigation,  welcomes  comparison,  and  stands by  its  promises.  It  is  a  school  to  which  you  may  attend  with  the  knowledge  that  you  will  be  in  pleasant surroundings, will be accorded fair treatment, and will be given thorough and painstaking instruction.

Finally, in presenting this catalog, we want to thank a discerning public for its support, and assure it that we shall endeavor to continue to merit the bountiful confidence it has heretofore placed in us. 


Regulatory Compliance:

Regulatory compliance is the biggest perceived risk in this industry. Although this risk is high for companies like Corinthian, Career Education and ITT Education, Strayer is probably one of the best positioned companies in the for-profit industry and I think it is a good thing that regulators are spending more time and effort addressing the questionable practice by a lot for-profit educational companies. Strayer's risk of non-compliance is very low in my opinion. The most recent 3 year Cohort Default rate is 13.9%, well below the 25% threshhold and the revenue% from Title IV loans is only 76%.

Also, as noted in the 2012 annual report,

Senator Tom Harkin (D-Iowa), Chairman of the U.S. Senate Committee  on  Health,  Education,  Labor  and  Pensions (HELP). Senator Harkin’s committee staff conducted a two year investigation into tax-paying, investor-funded post-secondary  educational  institutions  and  concluded that, “Strayer’s  performance  is  one  of  the  best  of  any institution  examined,  and  it  appears  that  students  are faring well at this degree-based college.” 


For the last three years the Department of Education has reviewed the regulations that govern how for-profit universities qualify to receive the proceeds of Federal student loans as tuition revenue.
The Department ultimately adopted a number of new regulations, the most important of which (the “Gainful 

Employment  Regulation”)  measures  the  earnings  of 

graduates of for-profit universities and compares those 

earnings to the debt levels the graduates incurred to 

finance  their  education. There  is  a  rather  complicated

process for measurement, and the first full measurement

year  was  not  slated  to  be  until  2012,  but  the 

Department released in 2012 “illustrative” data for all 

for-profit  universities  for  the  year  2011,  so  as  to  give 

these universities an early look at their compliance. I am 

pleased to report that using the illustrative 2011 data, all 

of Strayer University’s programs passed the Gainful 

Employment  Regulation  with  flying  colors.  Although 

the regulation has since been declared invalid by a U.S.  

District  Court,  and  the  Department  has  not  yet 

announced its plans going forward, we remain confident 

in our ability to run our university in compliance with 

what we believe to be the Department’s intent.  

Valuation:

Based on my observation and understanding of the business, Free Cash Flow is probably best metric to be used to value Strayer Education. FCF per share was $3.93 10 years ago, peaked at about $10.45 during 2011 and dropped precipitously to just above $5 per share during 2012. On a statistical basis, if we take the lowest price of Strayer stock in the past 10 years,  divided by FCF per share, the average P/FCF using the lowest price is about 14.  If we take the highest price of Strayer's stock in the past 10 years, divided by FCF per share, the average P/FCF using the highest price is about 25.  Where does the P/FCF stand now? It's about 10 times, or more than 20% lower than the historical average using the lowest price during each of the past 10 years. Looking out 5 years, if the industry stabilizes and unemployment drops, Strayer can earn $8 FCF per share and apply a 14 times multiple, we get $112 per share. 133% higher than current price and ~18.5% compounded annually.

We can also use the P/S multiple as revenue fluctuate less than FCF and earnings. Again, on a statistical basis, if we take the lowest price of Strayer stock in the past 10 years,  divided by revenue per share, the average P/S using the lowest price is about 3.6.  If we take the highest price of Strayer's stock in the past 10 years, divided by revenue per share, the average P/S using the highest price is about 6.64.  Where does the P/S stand now? It's about 0.9, or more than 75% lower than the historical average using the lowest price during each of the past 10 years. Even if revenue per share stays the same at $50 per share and assume things revert back to the mean in 5 years, Strayer should be trading at $180 per share, 275% higher than the current price and ~30% compounded annually.


Strayer does look cheap from a statistical perspective. However, as Robert Silberman has candidly mentioned in the most recent annual report, things may very well not get better in the next several years. In this case, the return can be expected from shares repurchase (which is increased to $150 million). Assuming the shares are repurchased at $50 per share, resulting in a 3 million share (27% of total shares outstanding) shrinkage to 8 million shares outstanding, with  $57 million FCF, the per share FCF will be ~$7. Apply a 14 times multiple, we get $98 per share, or 15.5% compounded annually for 5 years.


Conclusion: At $48 per share, Strayer is a good combination of quality and value in the for-profit education industry.

Disclosure: Long STRA.

The Pareto Principle and Investing

The Pareto Principle states that 80% of the results, outputs, or rewards, are generated from only 20% of the causing inputs or efforts.

The implications for investing:

1. 20% of our best stocks will probably generate 80% of our overall profit.
2. 20% of the time we spent doing research usually generates the 80% most useful information.
3. 80% of the time we spent doing research is likely not very productive.

The above implications can be very  discouraging for investors who have never thought about applying the Pareto Principle to their investment research. In fact, I wrote this article because I was truly disappointed and bothered by the feeling that most of my time spent doing fundamental analysis is not targeting the most important things. Why? Because I often forget to write out the most important thing first before I even start my research. This article is trying to address implication 2 and 3 above.

 My investment research routine is

1. Research company background, read the most recent 3-5 10Ks and 10Qs of the company and those of its competitors to answer every question on my checklist.
2. Gather 10 years of financial statements and build the valuation model.
3. Calculate intrinsic value and  margin of safety.

I usually spent about 90% of the time performing step 1 and step 2 above. The intrinsic value and margin of safety calculation are the most important things but it usually takes about 10% of my time. Well, you can argue that step 1 and step 2 above are necessary as they build the foundation for step 3 but step 1 and step 2 frequently incorporate a lot of assumptions and each one of them may impact the ultimate result in step 3. Garbage in and garbage out. The majority of the information I gather in step 1 and step 2 end up being inconsequential. Therefore,  it's not the quantity of time you spend that will ultimately determine the quality of your research, it's the quantity of time you spend addressing the most important things that really matter.

Here is a most recent example. I have been digging into the for-profit education sector and have spent a massive amount of time just to gather all the financial data and incorporate them into the valuation model. I've also read the 10Ks for Strayer Education, Apollo, Capella and Career Education. However, just like someone driving around in a strange city without navigation, I wondered around for a while, lost and still not getting to the point. I read all the business description, all the risk factors and the regulatory environment but still have not put all the piecemeal information together in a meaningful way because I have already spent so much time and I feel justified to delay the ultimate intrinsic value calculation. To quote Michael Bauboussin "Most people do not find it natural to match ideas from their mental database to tricky situations in the real world. Our brains are not wired for the process of moving from preparation to recognition. Indeed, typical decision makers allocate only 25% of their time to thinking about the problem properly and learning from experience. Most spend their time gathering information, which feels like progress and appears diligent to superiors. But information without context is falsely empowering. if you do not properly understand the challenges involved in your decision, this data will offer nothing to improve the accuracy of the decision and actually may create misplaced confidence. "

He is exactly right. In doing fundamental research, we often gather information for the sake of gathering information, which feels like progress and create misplaced confidence because we tell ourselves that we spent a lot of time doing research and therefore, we should have confidence in our thesis. This fallacy is very dangerous, especially in the world of investing yet so many of us have been ignorant to it. In my opinion, the best way to cope with this is to begin our investment process by asking ourselves what are the most important things.

With regards to the for-profit education sector, the most important things are:

I.  How likely is an institution not in compliance with the regulation and can the institution go out of business if not in compliance?  Specifically, what is the institution's compliance status with regards to:

• Cohort Default Rate
• The 90/10 Rule
• Incentive Compensation
• Gainful Employment

1.  At least 35% of students are in satisfactory repayment status with respect to their federal student loans three to four years after entering repayments. 
2. If the annual loan payment of a typical graduate of the program for all debt incurred by the graduate for the program does not exceed 30% of the average or median discretionary income in the third or fourth year after graduation; or
3. If the annual loan payment of a typical graduate of the program for all debt incurred by the graduate for the program does not exceed 12% of the average or median annual earnings in the third or fourth year after graduation; 

II. Is the headwind that the for-profit education sector facing structural issue or cyclical issue?

III. If the headwind is a cyclical issue, what will enrollment level be once things return to normal?

IV.What strategies are being executed to address both the current headwind and future development?

V. Given I-IV, what is the intrinsic value of the business?

I am absolutely not indicating we should abandon hardcore fundamental analysis. Diligent fundamental analysis is what defines value investors. What I am suggesting in this article is that before we start our research, we should take the time to define our focus points in our research. Once we lay out the most important things, we can direct our research to address them first. Once we've answered all these vital questions, we can dive into other things.Warren Buffett once said: The chain of habit is too light to be felt until it's too heavy to be broken. The habits we cultivated as teenagers inevitably affect how to behave as adults. In investing, in order to not lose money and generate superior return, we have to be cognizant of the habits we cultivated when we were young that could inherently lower the quality of our research and hence, the potential return of our investment. It takes time and can be against human nature to step back and question ourselves but that's how we become better over time.

By the way, here are two  much better articles on similar topic from Geoff Gannon.

http://www.gurufocus.com/news/212478/5-things-i-look-for-in-a-stock

http://www.gurufocus.com/news/197914/whats-your-research-process



As always, I welcome all constructive criticism.