Notes on long term thoughtful investing

Category: Charles T Munger

Attitude towards investing > your investing approach

One thing that never stops surprising an experienced investor has to do with divergent perspectives which people operate within the markets. And this is despite the fact that all of these participants have one common objective – to earn adequate returns while minimizing the risks, overtime.

There are believers of ‘technicals’ who earn money through reading stock price movements and then there is this broad group of ‘fundamental’ investors who differ amongst themselves with respect to the horizon one employs. All of these fellows wholeheartedly believe what they do is best way of earning money within their defined circumstances.

A mutual fund manager who earns a fixed fee over assets under his management tries to attract as many investors as possible. And given that most of these lay-investors go by near term performance for choosing between the wide array of funds, fund managers take upon themselves to ‘maximize’ their short term performance. Key thing to note is that such fund managers make money off their investors and not necessarily for their investors. Making sustainable above average returns, while controlling for risks, deploying a myopic focus on near term results is just improbable. This has what experience and in-depth studies conducted over a long periods have shown.

Differing attitudes towards long term investing

It would be unfair to say that investing approaches differs only with respect to their horizons. In fact, within the long term bucket, there are further multiple classifications depending upon willingness and patience levels of the practitioner. Not every long term investor would feel good about owning something (or atleast evaluating) with a 5-7 years kind of horizon.

Add to this the fact that each investor has his own sweet spot where some may be comfortable with just 7 securities in the portfolio while others may feel safer with 20-25 names. Preferences of such type has a significant impact on ones security selection process. Hence, expecting a ‘consensus buy’ within the like-minded group of people is little too much. But one needs to be cognizant about where does the differences lie. You don’t want to end up owning companies run by crooks just because it is trading at inexpensive terms. Here, chances are one may under estimate risks since they aren’t as clear as the returns which the excel sheet is showing.

Another place where investors with similar horizons and portfolio concentration could differ is with respect to one’s preference for good ‘quality’ companies over others. Quality would mean companies which makes 20%+ return of networth, has high free cash generation, enjoys some sort of a competitive advantage and are governed ethically.

Here, quality seekers would be more wiling to pay up a fair price for such businesses versus an average business which is trading at a substantial discount to its fair value. And it sometimes seems as if they are content with the moderate internal growth compounding which these established companies usually do. But such an approach helps them to keep chances of permanent loss of capital to its minimum.

Which of these approaches is the best?

Answering this question with the approach one practices regularly would be like deluding oneself!

More than any specific approach, what would help an investor is to keep an open attitude towards investing. This is to say that investing is an art which only improves with complete dedication, over time. If you see something work really well that you initially believed would not, it might help to stop and introspect. Was it luck? or was it a low probability event kicking up? or just a temporary outcome of an irrational market? But if someone with a very long track record of doing things you thought is not possible, it might help to learn something from him or her. Proponents of efficient market hypothesis still consider Berkshire’s track record as an ‘outlier’ thereby allowing themselves to ignore the methods with which it has earns those exceptional returns

Personally, I had a notion early-on that investing into equities is inherently speculative. But after coming across Buffett’s biography accidentally, it showed me its not. And given the generosity of Mr Buffett with respect to sharing his learning through his talks and letters, in a short span in time one moves from being a dis-believer to become a disciple of life long learning.

Studying the duo Buffett & Munger would tell one the intellectual openness they have applied all through their career. Munger thought that he could be a more successful investor than a lawyer and he switched despite coming from a background which would suggest otherwise. And in their initial years, both of them started as ‘bargain hunters’ i.e. looking to buying companies trading at below its book value and then selling it off over a couple of years. It was only after a decade long practice when the bargain pool dried up and they were almost like shutting down shops (Buffett had actually shut down his partnership firm) they realized that investing into companies with competitive advantages could be even better than bargain investing. Imagine how it is to believe in something totally opposite to what you have done every day till the age of 40!

And if these are too old an example, here is another one which suggests that they haven’t impaired their openness even today. Berkshire is a major investor in US airlines and Apple despite the duo saying on record almost for a half a century that airlines are the worst assets to own and most of the technology companies are not investible for someone with 5-10 year kind of horizon given the inherent intensity of change in tech. They were even successful to convince Bill Gates into this line of thought 2-3 decades back!

Its not to say that these are not well thought of investments or that Berkshire is ‘barrel scratching’. Each of these decisions have seen some deeper thoughts go into the same. Of course, they could be wrong in their thesis but the key to learn from this is to never stop, as Mr Munger would say, ‘killing your own best ideas’.

Ideas or approaches are not something to be treasured – they ought to be challenged from time to time. And if they still pass those harsh tests of time, only then are they worth committing to yourself!

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.