Posts By: Geoff Gannon

Relative Regret

To Focused Compounding members:
One of the most difficult things for investors to deal with is to watch other get richer faster than you. In the stock market, the same choices are available to everyone. So, if someone is up 20% this year, they are up 20% purely on a collection of opportunities you passed on. Two things make this even tougher for the people reading this memo. One, you judge yourself on your relative results versus a benchmark like the S&P 500. Two, you judge yourself on a yearly basis. Even if your process is superior to that of most other investors – there’s a decent chance you’re lagging this year. Does that mean you’re a failure as an investor? Is it even realistic to set the bar as high as beating a benchmark each and every year?

Let’s think about this another way. Let’s remove the idea of you from this analysis. Instead let’s imagine we are evaluating not an investor but an investment strategy. And, to make this easier, let’s set the pace horse a lot slower. Investing in the S&P 500 is not a bad strategy long-term. What is a bad strategy? Putting 100% of your savings into a commodities basket month after month. History shows that holding a basket of commodities indefinitely barely keeps up with inflation. So, if you continue to make a 100% commodities wager month after month for the rest of your working life you are almost certain to underperform the person who makes a 100% S&P 500 index wager month after month for the rest of his working life. In fact, based on the very long-term past record the annual real edge your neighbor would have over you if he invested 100% in a stock index fund and you invested 100% in a commodities basket would be greater than the house’s edge on a single game of baccarat, blackjack, roulette, or craps.

To simplify this hypothetical, let’s say you get only one investment choice your whole life. Instead of picking specific investments as the years go by – you only get one choice at the start of this 30-year period. And that choice is a strategic choice. You can either pick the 100% stocks strategy or the 100% commodities strategy. You can’t switch. Will there be years in which you regret taking the 100% stocks strategy? In a sense, yes. A basket of commodities will – in some of the next 30 years – outperform a basket of stocks. Yet, to say you would – in those years – actually regret your initial choice of the 100% stock strategy is like saying a casino would rather be the player than the house. If the casino knew the future of each hand, each night of play, etc. – I guess you could say that. However, what exactly is it that an investor is actually regretting in his poor relative performance years? He’s regretting not switching strategies from a long-term superior strategy to …

Anything Times Zero

To Focused Compounding members:
Since I read “Fortune’s Formula” and “A Man for All Markets” this past week, let’s talk blackjack. In blackjack, the player has an advantage over the casino if he’s counting cards. A card counter can bet nearly the minimum when he suspects the rest of the deck has cards unfavorable to him in higher proportion than a fresh deck and he can bet nearly the maximum when he suspects the rest of the deck has favorable cards in a higher proportion than a fresh deck. Applying this to stocks, let’s say you’re convinced Wells Fargo is a safe bank and Bank of the Ozarks is a risky bank. You have $10,000 to invest in bank stocks. These are the only two bank stocks you know anything about. You have one question: what happens if instead of taking your $10,000 and putting $5,000 into Bank of the Ozarks and $5,000 into Wells Fargo you instead put $1,000 in Bank of the Ozarks and $9,000 in Wells Fargo. You still start off with $10,000 worth of bank shares, but now you are acting like a card counter – betting nearly the maximum when you think the rest of a deck (Wells Fargo’s future) is favorable and betting nearly the minimum when you think the rest of deck (Bank of the Ozarks’ future) is unfavorable. How important is your decision to split your money 10/90 in favor of Wells Fargo?

Let’s say the chance of Wells Fargo stock going to zero in any one year is 0.5% and the chance of Bank of the Ozarks going to zero in any one year is 5%. Over a single year, a bigger annual upside – especially in the form of a quicker catalyst – can make up for a stock being 10 times riskier. Stocks are volatile. And any extra chance of a 50% pop in the stock’s price this year could overcome a 4.5% difference in the rate of catastrophe. So, if you frame your own investment lifetime as lasting only a single year – the math says it’s perfectly fine to bet as much on Bank of the Ozarks as on Wells Fargo. Catastrophic failure is not a big deal over one year. And you’ve promised yourself you’ll only play one hand. You’ll buy both Wells and Bank of the Ozarks today and sell twelve months from today no matter what. Whatever result you get won’t compound. That makes failure cheap. And if there’s some upside catalyst you see for Bank of the Ozarks this year – that catalyst could overcome the 4.5% greater chance of catastrophe this year. But, that’s framing the choice as a one-year bet. Buffett has owned Wells for 27 years. So, let’s ask: what is the difference between a 99.5% annual survival rate and a 95% annual survival rate if you’re committed to letting each bet ride for the full 30 years? Now failure isn’t cheap. It’s expensive, because it kills compounding. If you …

Value Trading – Does It Ever Make Sense?

Article by DAVE ROTTMAN

I would like to discuss and elicit feedback from our community on the topic of value trading. What I mean by value trading is the purchase and sale of stocks in a shorter time frame than traditional long-term investing, where the buy and sell decisions are driven by the exact same fundamental analysis, margin of safety standards, and owner’s mentality that traditional long-term value investors utilize. In other words, I would like to discuss the idea of a business-oriented investment strategy coupled with the willingness for a short investment holding period in certain situations.

Theory

To start, I will simplify the investment landscape by categorizing all stocks into two buckets: slow growers and compounders. Slow growers are businesses where the intrinsic value does not grow especially rapidly, and compounders are businesses where the intrinsic value does grow rapidly. All things equal, purchased at an equivalent price to value (P/V) ratio, compounders should outperform slow growers over long holding periods. This makes intuitive sense, because a large portion of the return in investing in slow growers is the narrowing of the P/V gap, whereas the large portion of the return in investing in compounders is the value itself actually increasing. This is what Charlie Munger is getting at when he said:

“Over the long term it’s hard for a stock to earn a much better return than the business that underlies it earns. If a business earns 6% on capital over forty years, you’re not going to make much different than 6% return, even if you buy it at a huge discount. Conversely, if a business earns 18% on capital, you’ll end up with one hell of a return long term, even if you pay an expensive looking price.”

With that in mind, all things equal it makes sense that an investor would prefer the P/V gap to close as quickly as possible for slow growers more so than for compounders. Further, an investor who is open value trading would be more likely to trim or sell investment in slow growers rather than compounders, because with compounders there is a higher risk of selling too early, not getting back in, and missing out on the value creation that occurs for years to come.

This brings me to the practical considerations of value trading. If, as value investors, we buy businesses whose shares are available at large discounts to intrinsic value, and those shares subsequently rise quickly in price, should we hold onto those shares until the gap narrows further, or should we consider selling (at least some of the investment) and reallocating the capital to other attractive businesses with a larger price-value gap, assuming we can find such businesses? Do long-term buy and hold investors at times hurt their returns by simply holding stocks that bounce up and down, with the P/V gap narrowing and widening over time, even as the value may march steadily upwards?

I suggest that in some situation we should be willing …

Efficiency vs Reliability

Friday, May 25th – Pandora A/S (PNDORA) by LUKE ELLIOTT
Friday, May 25th – GameStop (GME) by VETLE FORSLAND
Sunday, May 27th – “Value Trading – Does It Ever Make Sense?” by DAVE ROTTMAN
To Focused Compounding members:
Two different Focused Compounding members are to blame for this week’s memo. One is Dave Rottman who wrote an article entitled “Value Trading – Does it Ever Make Sense?”. The other is someone I was talking to this week on Skype. The discussion on Skype centered on the idea that I had said somewhere before that I thought it was possible to achieve 30% annual returns. What I think I meant by this – because I’ve said it elsewhere – is that an investor who puts together a run of 30% annual returns is like a Major League player batting .400. Over a career length period of time 30% annual returns are the highest you’re likely to see. Warren Buffett roughly did it over the years he ran his partnership. Peter Lynch roughly did it over the years he ran Magellan, and Joel Greenblatt did even better at Gotham from 1985-1994. A period of 10-15 years is basically the length of a professional athlete’s career. So, we could say Buffett, Lynch, and Greenblatt were 30% annual return career hitters.

Imagine that you – a very good, but not a truly great value investor – are running a portfolio that has chugged along at 20% a year for the last 15 years. You know that other investors at other times – Buffett, Lynch, and Greenblatt – ran portfolios that chugged along at 30% a year for almost as many years as you’ve been going at this. So, you know your portfolio is running at only two-thirds of its optimal efficiency. Where is the “waste” so to speak? Why aren’t you doing 30% a year? I can think of 4 possible reasons. One, you are making mistakes they did not. Two, you are using less leverage. Three, you are putting less into each stock you own. And four, you are owning each stock longer than they did. A portfolio running at optimal efficiency would be: 1) Free from human error, 2) Leveraged, 3) Concentrated, and 4) Have a high turnover. Why would it have a high turnover? Because the portfolio manager would have more ideas than money. This is also why it would use leverage. The question of leverage brings us to the difference between efficiency and reliability. An investing system that is maxed out for efficiency will – in any given year – achieve the highest return. On the other hand, an investing system that is maxed out for reliability will last the greatest numbers of years. Compound results are a combination of efficiency and reliability. The article published this week on Focused Compounding argues that – if a value investor has enough good, reliable businesses to invest in that he knows very well – he should (like Allan Mecham does) constantly be …

Human Nature is the Ultimate Hidden Fee

Tuesday, May 15th – Box (BOX) by Jayden Preston
To Focused Compounding members:
In an interview this week with Barron’s, Vanguard founder Jack Bogle cited stats that showed the average investor’s annual return from index funds was 8.4% from 2005 to 2017, from actively managed funds it was 7.2%, and from ETFs it was just 5.5%. ETFs and index funds are invested in much the same things. So, investors are charging themselves a 2.9% annual fee in the form of bad timing. The same Barron’s article quotes BlackRock’s Larry Fink as saying: “..long-termism is better than short-termism. But people need financial instruments for different reasons.” This is the common argument for the existence of ETFs, long-short hedge funds, etc. But, it’s wrong. We’re talking about a drag of 3% a year between investors staying in a representative sample of U.S. public companies and investors trading in and out of those same assets. This past week, Andrew and I announced we’ll be handling managed accounts. People who have called in have mostly wanted to talk about the fee. I like a 2.5% fixed fee because the math that matters is easy for me to do in my head. We should only accept money when we feel we can still beat the market by more than 2.5% a year after taking on that sum. Different kinds of investment vehicles have different kinds of hidden fees. These fees often add up to more than the amount you’re actually being charged. I spent a good part of last week warning Andrew about the performance drag we’d experience if we either: 1) Held more stocks or 2) Managed more assets. Both would create big performance drags. For ETFs, the hidden fee is bad timing. Investors want the freedom to trade in and out of an ETF. And that freedom costs them 3% a year. For accounts like Andrew and I will be running – the hidden fee is size. I guarantee you you’ll be better off when we are running $1 million instead of $10 million or $10 million instead of $100 million. Andrew and I won’t be better off. But, you will be. Here’s the thing. When money managers charge a percent of profits, they like to say their interests and their clients’ interest are aligned. But, the truth is that the manager’s interest and the client’s interest are never aligned on the one question that matters most: “Should we gather more assets?” The bigger a fund gets, the worse its performance will be. The more an investor trades in and out of ETFs, the worse his performance will be. Hidden fees like these often add up to more than the actual fee you’re charged. Whatever fees a fund is charging you, it’s going to be very hard to overcome the hidden cost of either high turnover or a large amount of assets to actively deploy. Small, active funds can work well. And giant, inactive funds can work well. Everything in between that tends …

Goodness vs. Soundness

Tuesday, May 8th, Industrial Logistics Properties Trust (ILPT) by George Baxter
To Focused Compounding members:
Ben Graham wrote: “Confronted with a…challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY…all experienced investors recognize that the margin of safety concept is essential to the choice of sound bonds.”

Note the word I bolded: “sound”. As I sat down to write this memo, I thought immediately of chess. Can a good chess move be an unsound chess move? Can you win a game because you made a move that actually gives you a negative margin of safety? We know you can. After playing a game of online chess, humans often have a computer chess engine analyze their game. At each point along the way, the computer evaluates the position and states the advantage for black or white in terms of hundredths of a pawn. The computer can also suggest “lines” – or series of moves – where the game would have worked out differently. So, a computer can tell you what move your opponent should have made and whether or not you had a real advantage under “best play”. A move that wins against a human with limited time to think but would fail against a computer with infinite time to think may not be a bad move – but, it is a speculative move. The English word speculation comes from a Latin word – a language Graham knew well – that basically means “to look out for”. A speculation is future focused. It depends on stuff you have to look out for. In chess, to judge whether or not your speculative move was a good one you can look at the result of your game. However, to judge whether or not your speculative move was a sound one you have to sit down – perhaps with a computer, but certainly with a lot of time – and analyze what would have happened had a different move been played in response. Perhaps Graham’s most important quote on the topic of margin of safety is this one:
“The function of margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future.”
A sound move is one that works well enough whatever your opponent plays. A sound investment is one that works well enough whatever the future holds. But, just as some “unsound” chess moves work more often than not when playing against a human – some speculations have awfully good odds.

This brings us to Entercom (ETM). Last week, this minnow that swallowed the whale called CBS Radio was the subject of an excellent write-up by Vetle Forsland. A lot of members have asked for my comments on the stock. And a lot of members are clearly excited by the opportunity. Here’s the thing: If I had to come up with one and only one “line” that is most likely to be played out over the next few years, it …