Notes on long term thoughtful investing

Month: August 2017

Strong but questionable form of competitive advantage

Charlie Munger in one of his speeches described a test he has performed at a number of US schools –

I have posed at two different business schools the following problem. I say, “You have studied supply and demand curves. You have learned that when you raise the price, ordinarily the volume you can sell goes down, and when you reduce the price, the volume you can sell goes up. Is that right? That’s what you’ve learned?” They all nod yes.

And I say, “Now tell me several instances when, if you want the physical volume to go up, the correct answer is to increase the price?” And there’s this long and ghastly pause. 

And finally, in each of the two business schools in which I’ve tried this, maybe one person in fifty could name one instance. They come up with the idea that occasionally a higher price acts as a rough indicator of quality and thereby increases sales volumes. (luxury goods)

And nobody has yet come up with the main answer that I like. Suppose you raise that price, and use the extra money to bribe the other guy’s purchasing agent?

He further says –

One of the most extreme examples is in the investment management field. Suppose you’re the manager of a mutual fund, and you want to sell more. People commonly come to the following answer: You raise the commissions, which of course reduces the number of units of real investments delivered to the ultimate buyer, so you’re increasing the price per unit of real investment that you’re selling the ultimate customer. And you’re using that extra commission to bribe the customer’s purchasing agent.

You’re bribing the broker to betray his client and put the client’s money into the high-commission product. This has worked to produce at least a trillion dollars of mutual fund sale

The Principal – Agent Problem

The concept which Munger wants us to grasp through this small extract is that of agency problem. This is where mental models of ‘conflict of interest’ & ‘incentives’ collide to give rise to this particular behavior. Its not only highly profitable for its exploiters – it is pretty much legal and goes unnoticed most of the times.

In order for this thing to work, three things are required:

(i)  Presence of an ‘agent‘ or someone who acts on behalf of the payer. Essentially acting like a middle men between seller and the buyer.

(ii) Complexity, such that payer or the buyer is unable to understand things on his own. And hence has to invariably rely on such agents

(iii) Absence of stringent regulations. This means that agents are free to deviate and seek to further their own self-interests over that of their clients.

These three combined creates an opportunity for profit seeking capitalists to go for not-so honorable means to generate excess returns by overcharging their customers and sharing part of those proceeds with the agents.

Personally if you ask me, such businesses are painted with those darker shades of grey. It is certainly not commendable kind of work which they do. And those excess commissions which are paid to the agents makes the entire transaction highly inefficient.

Some Examples

Pharmaceutical Companies: Doctor is the last person we would like to argue about anything. Whatever he or she says, to us it is like writing on the wall. And we know that it is upon them where most of the marketing efforts of the pharma companies goes. By paying them commissions based on prescriptions they make, branded pharma companies have successfully earned excess returns for decades. More in so in case of ‘branded generics’ (which is certainly a paradoxical term in the first place)

Financial Services: Here again ignorance of a lay person is exploited by sellers of financial products like brokers, insurance agents and mutual fund distributors. To their unsuspecting clients, they are ‘advisers’. And to the fund houses or institutions whose products they sell, they are called as ‘distributors’. Their principal business is earning commissions. You can imagine where would those money-minded guys like their clients to put their money.

Just like these, there are hundreds of other businesses which have made excess returns over decades by excessively relying on incentives and over charging the end user.

Notes for the investor

(a) Such overcharging can go unnoticed for decades. Many a times clients are indifferent since the magnitude of such overcharging could be meaningless for them in the overall context (think low ticket, but highly important items like medicines).

However, regulators could spring up a surprise anytime. And in a country with as low purchasing power as ours, it is not as difficult for the government / regulators to justify some of its acts.

(b) Also, with improvements in technology, alternative channels are opening up which not only does away with those agents but also removes information disparity between buyers and sellers. For example, its very easy today to figure out generic versions of branded drugs today with just a click of the button. There are websites available which compares financial product offerings across several players in the industry. Till sometime back, it was almost unthinkable!

(c) Another thing to remember is that these excess profits have a disproportionate impact on a company’s bottom-line if a company has mix of regulated products as well unregulated ones forming its sales.

For example, assume a pharma company which has about 10 products forming bulk of its revenues. Now, assume that in 8 out of those 10, it makes a meager 10% margin at operating level. Whereas, for other 2 newly launches products, it makes about 50% margins. The result – it makes around 18% margins.

Now, if for some reason, say due to regulatory push, it is forced to bring down those 50% margins to 10%, the overall profit margins come down from 18% to 10% – almost like halving it! And given that markets uses profitability as a metric to value these companies, market cap would follow a similar journey.

Such examples are far from fantasy. Numbers of many branded pharma companies would convey this story when DPCO came into force couple of years back.

Also, many US exporting generic pharma companies which saw handsome rise in their margins due to back-to-back ‘block buster’ drug launches over last 5 years have also started to see pressures on their margins. Number and magnitude of potential block buster drugs have been declining since some time. (Remember the coveted ‘patent cliff’?)

Having too few products generating super-normal profits can put an investor in a tight spot when margins for those fortunate products starts to normalize.

 

Summing it up

To sum up, investors which are lured into these companies need to be cognizant about the following:

(i) Such businesses work till the time they are ‘under the radar’. Best thing to hope for them is that they never too much attention (especially of the negative type)

(ii) Sometimes, if 2 out of 10 products of a company is sold via such means, you could be sure these 2 products would account for a significant chunk of profits. And the impact of these two going would be huge. This point is more relevant for pharma companies selling ‘branded generics’.

(iii) Assessing sustainability of these is challenging. Hence, never fail to look at alternative scenarios where you put together probability of profit erosion and magnitude of erosion. In the world of technology in which are living, many of those information dis-symmetries between buyers and sellers are slowing going away.

Finally, it may not be the most honorable way to earn money as an owner. In words of Mr Munger, it is akin to spending your life ‘selling something you would never buy’.

It is sort of an inefficiency with capitalism (and our ignorance) has allowed to foster over really long time period of time.

 

Capital Cycle Investing: Figuring out the Fade Rate

Reading about how other successful investors have, over the years, threaded their path ends up uncovering some fresh insights. And even if many a times these insights are not as ‘ground breaking’ as others, these offer interesting perspectives to look at existing realities. They helps us by way of broadening our worldly understanding of the events around us.

For example, Graham’s way of looking at market fluctuations have added a new dimension to our understanding about market movements. No longer are we avoiding volatility. Rather, we are seeking to reduce the chances of permanent loss of capital. And volatility, in many ways, is a core driver of our overall returns.

Similarly, Buffett’s calling to sometimes pay up for certain kind of businesses has helped us to embrace entities with hard to replicate advantages. His concept of ‘circle of competence’ has ensured that losses due to one’s ignorance are minimized. And Munger’s system of multi-disciplinary thinking promises us of reaching places which otherwise was unthinkable.

Left upon us, harvesting such deep in-sights would have easily taken a lifetime of trial and errors. As Newton once said we are truly ‘standing on the shoulders of giants’.

 

Capital Cycle way of investing

Recently, I was reading ‘Capital Returns’ – an impressive collection of essays written by Marathon Asset Management over 2004-2014. In one of its chapters, they discusses their core investing framework. It goes like this:

Marathon looks to invest in two phases of an industry’s capital cycle. From what is misleadingly labelled the “growth” universe, we search for businesses whose high returns are believed to be more sustainable than most investors expect. Here, the good company manages to resist becoming a mediocre one. From the low return, or “value” universe, our aim is to find companies whose improvement potential is generally underestimated. In both cases, the rate at which a company reverts to mediocrity (or “fade rate”) is often miscalculated by stock market participants. Marathon’s own experience suggests that the resultant mispricing is often systematic for behavioural reasons.

This chart conveys the above para beautifully –

Capital Cycle approach to investing

Capital Cycle approach to investing

Notice that they do not get themselves tied with the conventional way of ‘growth vs value’ investing way of thinking. At times, they become growth investor without paying up for growth and at other times they turn into value seekers. At both the times their expectations are higher than that of the market which presumably is on the pessimistic side.

 

Expectations Investing Vs Capital Cycle Investing

One can draw parallels between this and ‘expectations investing’ which Michael Mauboussin has effort-fully explained us over the years. Essentially, he says that successful investing is about figuring out those situations where market’s expectations are pessimistic than what a rational mind would expect. And also avoiding those where expectations are going through the roof!

But at one place this theory diverges from mainstream investing. While expectations investing could be applied to every kind of company, capital cycle approach deals with more or less those areas where rules of capital cycle applies. That is to say that franchise companies where in excess returns do not converge to average rate of return over very long periods are more or less left out of the investing universe. Guys at Marathon refer to them as situations where in ‘capital cycle breaks or cease to operate’

In a way, this theory excludes those fertile hunting grounds based on which Buffett has built $450Bn worth Berkshire over more than half a century!

Another point at which this theory departures is that on number of stocks to be held within a portfolio. Marathon says that they are looking to bet on an industry which looks well placed to benefit from a cyclical upturn. Hence, while individual companies matter, but what they are more concerned is with their portfolio’s exposure to a particular sector.

Invariably, this means that although their ideas may be concentrated on few events unfolding at the industry level, their portfolios are diversified. Nothing wrong in this. Only problem is that the effort required to be spent on managing a portfolio goes up as the number of stocks in it goes up. Those nagging company specific issues does consume our limited ‘mind share’

What compounds the problem further is that there are limited number of sectors in an economy and each of these are not investible at all points in time. That means one needs to look at multiples countries and multiple sectors there in. This widens the landscape sufficiently. However, it also means that now one is dealing more often in unfamiliar terrain. And getting one well acquainted to each of these is not easy. Also, dealing with multiple currencies has its own set of challenges.

Ability (and conviction) to concentrate on a limited number of stocks is advantageous in multiple ways.

Despite all of the above differences, capital cycle approach is worth understanding and Marathon’s collection of essays are worth reading. Given the challenges they face, the efforts they undertake while investing in broader geographical markets and their experiences there in are worth meditating.