Pilgrimage to Omaha

Subsequent to April, I traveled to Omaha Nebraska for a weekend at the Woodstock of Capitalism. I am, of course, referring to Berkshire Hathaway’s annual meeting, hosted by Warren Buffett and his Vice Chairman Charlie Munger. Buffett and Munger’s influence on me has been thorough and absolute. More than their obvious investment acumen, it is their method of thinking, their worldly wisdom, their steadfast common sense principles that continue to guide both my professional and personal way of life.

Over 18,000 people packed the CenturyLink Center in downtown Omaha. Total attendance is far above that figure, as all the overflow rooms in the Hilton Hotel across the street were fully packed as well. I woke up at 6:30am to try to secure several good seats in the arena, but alas, this vantage was the best I could do:

Warren Buffett and Charlie Munger then took questions for six hours straight (with an hour lunch break), alternating between the audience and a panel of journalists and analysts. If you’re interested, detailed notes from the meeting can be readily found online . But I’ll highlight a few insights here that were especially thought provoking to yours truly. The rhythm of their Q&A is a detailed, earnest, and sometimes long-winded answer by Warren, followed by Charlie adding a colorful sentence or two as a punctuation.

On increasing transparency on executive pay:

A: Shareholders would be harmed by more information on executive pay. Corporate CEOs’ salaries are benchmarked off of their peers, and no one thinks they are worth less than anybody else. People’s satisfaction with their earnings level is relative, not absolute. This has created a vicious cycle of upward trending C-suite salaries that cost shareholders millions every year. Munger: “We don’t want to add to the culture of envy in America.”

On See’s Candies and its significance to Berkshire:

A: Berkshire has done very well with See’s Candies, but it has not grown significantly since the ‘90s. Its main contribution has actually been opening their eyes to the power of brands. Berkshire was smart enough to buy Coca-Cola because they owned See’s – they saw the possibilities of a powerful brand. If they had not owned See’s, they may not have owned Coke. Munger: “Main contribution to Berkshire was ignorance removal. If it weren’t for the fact that we’re so good at removing ignorance, we’d be nothing today.”

On how to figure out one’s Circle of Competence:

A: Be realistic with yourself in appraising your own talents and shortcomings. Don’t be afraid to try different things to figure out where the perimeter of your circle is. Keep friends who will tell you, well, what the hell do you know about that? Munger: “If you’re 5’2”, say no to professional basketball. If you’re 350 lbs, don’t dance ballet. Competency is a relative concept.”

Miscellaneous Munger-isms:

• “If it is a very competitive business, and requires competitive abilities you lack, you should look elsewhere. I immediately decided I wasn’t going to be thermodynamics professor at Caltech. I looked elsewhere over and over and soon there were only one or two career choices left.”
• “GEICO is like Costco. They feel a holy duty to have wonderful product and a wonderful price. Companies like that get ahead over time.”
• “Frugality has helped Berkshire. I look out at the audience and I see frugal, understated people. We collect you people.”

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The purpose of attending the Berkshire Hathaway annual meetings is not to seek mind-blowing epiphanies in the art of investing. Warren and Charlie’s essential lessons stay the same, and Buffett’s increasing penchant to go on TV to give his spin on what’s happening in the world means that there are very few fresh revelations during the Q&A.

Instead, it is more akin to a pilgrimage where one renews his or her “faith” in value investing. As the market’s increasing volatility continue to shake out players who once thought compounding capital an easy game, the Woodstock of Capitalism is a nourishing reminder of the time-tested method of analyzing business fundamentals rather than their ever-shifting stock prices. Stay steadfast, and trust that the scoreboard over the long run will add up in our favor.

“The best way to get a good spouse is to deserve one. It is the same in business and investing. Behave correctly – it’s amazing how well it works.”

-Charlie Munger

Are Markets Efficient?

Last October, the Nobel Prize in Economics was given jointly to three economists, two of whom are on polar opposite spectrums with regards to their views on the Efficient Market Hypothesis (EMH). One, Eugene Fama, is the godfather of the EMH, coining the term in 1969, while the other, Robert Shiller, once wrote that the assertion of an efficient market was “one of the most remarkable errors in the history of economic thought.”

A quick primer: EMH is the theory that financial markets are “efficient”, and that no one can consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made. Informally, it’s the assertion that you will never stumble upon a pile of cash on the sidewalk because if such a pile existed, it would have been picked up long before you saw it.

First of all, let’s quickly disprove the idea that the market can be perfectly efficient. Assume that it is. In which case there is no reason for any active stock picker to be in business. In which case everyone is invested in index funds. In which case… how would the index themselves be priced?? It quickly becomes a paradox. The “efficiency” in markets is created by those who don’t believe it is efficient. In other words, someone’s gotta pick up that pile of cash on the sidewalk first.

However, the market is pretty darn efficient. A lot of smart people are in it, viciously weeding out the inefficiency, picking up those piles of cash almost as soon as they drop. Thus, I find it much more prudent to assume the market is efficient, assume the security I’m analyzing is priced correctly, and not to make a move unless I can credibly explain otherwise. For every buyer, there is a seller, and on balance, those who are selling likely have more experience with what they’re selling than those who are buying. Understanding your counterparty’s motive is crucial during due diligence.

Which is all to say, both Dr. Fama and Dr. Shiller are worthy of the Nobel Prize despite their seeming contradictory stances (Efficient versus Not Efficient). The question of “is the market efficient?” is an academic red herring, because the market is an interplay between both forces. Inefficiency breeds efficiency. Indeed, it is the very cornerstone of capitalism, which incentivizes human beings to be ever more productive, ever more efficient.

The added value of an active manager like Incandescent Capital is to direct capital to businesses that are, in my estimation, mispriced. We are doing our part to close the mispricing by providing liquidity to those wishing to sell the security, who can then go forth and redeploy that capital elsewhere. Meanwhile, if my assessment in the mispricing is correct and it closes, we earn a satisfactory profit on our endeavor. Although admittedly abstract, this is not zero sum over the long run. Capital incentivizes people, and the flow of capital directs how and where our innovations come from (e.g. Industrial Revolution -> steam engine; Dotcom Bubble -> Pets.com). Picking stocks may seem like an infinitesimally irrelevant cog in the global economic machine, but as Barack Obama recently mused in The New Yorker, “At the end of the day we’re part of a long-running story. We just try to get our paragraph right.”

Real Estate as Fodder for an Ode to Intrinsic Valuation

Bloomberg News recently ran a piece titled Chinese Steer Billions Abroad in Quest for Safety. The synopsis: according to New York-based research firm Real Capital Analytics Inc., the six biggest metropolitan areas in the U.S. have attracted $2.88 billion in commercial real estate investment by Chinese companies this year, up nearly 9x from $321 million in all of 2012. All this new capital has propelled some real estate above and beyond even their pre-bubble era prices.

With mortgage interest rates still near historic lows and property prices rising thanks to the gush of foreign money, real estate is feeling like, once again, a tantalizing investment for many people. “What are your thoughts on this?” I’ve been asked a few times recently, notably by folks who live in both L.A. and New York: the top two most targeted geographies for those aforementioned Chinese carrying suitcases full of cash.

Atlantic Yards in Brooklyn, New York, October 2013. Greenland Holding Group Co., the Shanghai-based builder of one of China’s tallest towers, agreed to buy a 70 percent share of the project.

Real estate, like any asset, can be valued in one of two ways: 1.) intrinsically, and 2.) relatively. Intrinsic value is a function of an asset’s cash flow generating power. Relative value is a function of the supply and enthusiasm of other buyers. It should come as no surprise that I am staunchly in the camp of #1.

A quick primer: Real estate generates cash flow through rental income, whether it’s houses or apartments or office buildings or strip malls. Revenue minus expenses equals profit, and that annual profit stream divided by the equity you put down for the real estate is your rate of return. If you put $100,000 down on a $500,000 property and earn an annual income stream of $10,000 after mortgages, taxes, insurance, maintenance, and all other miscellaneous costs, you’re earning a 10% return on your equity. You can adjust the arithmetic if, say, you’re looking at a fixer-upper that is below market prices but requires some work. The bottom line: divide cash in by cash out. It is similar to interest payments you receive from a bond, or a dividend yield you receive from a stock.

Now the question becomes, is that rate of return satisfactory for you? To evaluate, you have to take into consideration the risks involved. Namely, how good is your tenant base, and if you have turnover, how easily will you be able to replace them? If you took a gamble on an older property, how much will it cost for an up-to-date remodel, and more importantly, how confident are you in the estimated costs? There is less risk owning a piece of property in Manhattan where the vacancy rate is 2%, versus owning something out in a desolate suburb hit hard by the subprime bust. Perhaps for the less-risky former, you’d be willing to settle for a 5% return with the possibility of escalating rents in the future. For the much-riskier latter, you may not want to take anything less than a 15% return. At this point it boils down to personal investment goals and your opportunity costs. But this very analysis is the core of intrinsic valuation. Kudos to all who practice this.

Relative valuation, on the other hand, is much simpler. Hey, what did someone pay recently for something similar?

I suppose there’s nothing wrong with relative valuation, provided that the “someone” you’re making comparisons with actually did an intrinsic valuation you can piggyback off of. But herein lies the danger that manifested during the financial crisis. After a while, amidst the feverish buying and flipping, piggybackers end up piggybacking off of each other. Responsible investors actually concerned about intrinsic value couldn’t win a bid and simply left the market. Rates of return turned negative. But who cares, right? I can always flip the property to someone else in six months for 50% more than I paid for it!!

That works… until it doesn’t. We lived through the painful bursting of that phenomenon just a few short years ago. Stunning news: real estate prices do decline. So, the answer to what I think about the re-burgeoning real estate market is: it depends on the intrinsic value of each deal. It may mean doing more work to understand the demographics and economics of the area you’re looking to invest in. It may mean getting outbid by people who don’t care about rates of returns. It may mean watching a property you were outbid on doubling in six months for no apparent reason other than there was someone else willing to pay twice as much for it. Stay steadfast, because, again, relative valuation works until it doesn’t. Once prices depart from a sensible intrinsic value, you’re playing musical chairs. You’re no longer investing, you’re speculating. Speculating can be fun and sometimes profitable, but, like a nagging nun, I feel obligated to remind you that you should only speculate with money you can afford to lose.

However, if you are patient and opportunistic and get your intrinsic valuation right, you won’t care if the music stops and the market crashes. You’ll bank your cash flows and earn your returns regardless of what’s going on. Indeed, you may even hope for a crash then, which would allow you to parlay your cash flows into new investments at fire-sale prices. That has been the simple blueprint of every great real estate investor, nay, every great investor, period, ever. What Ernest Hemingway once wrote about going bankrupt also applies to getting rich in investing: “Gradually, then suddenly.”¹

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[1] The original line, in The Sun Also Rises: “How did you go bankrupt? Two ways. Gradually, then suddenly.”

The IPO of Twitter: To Buy or Not to Buy

Media coverage of Twitter’s IPO has reached fevered proportions. It is easily the most hyped IPO since Facebook. The question I’ve gotten often lately is: are you going to buy it?

The short answer is no¹. Twitter, in my humble opinion, using any conservative method of valuation using publicly available financial figures, is overvalued. By a lot. You may think a Ferrari is a really great car, but would you buy one for $1,000,000 (assuming you can afford it)? Probably not. Price is what you pay, value is what you get.

That seems like an obvious thing to point out, but it gets complicated because 1.) the true intrinsic value a company, especially a rapidly growing tech company like Twitter, is unknown, and 2.) the fractional and liquid nature of stock markets stir gambling instincts like no other. Imagine if the aforementioned Ferrari is a limited edition model, and you can buy and sell 1/100,000th of it for $10 a share with the click of a button. Maybe a small voice deep within you will say, If I can buy this for $10 but sell it for $11 tomorrow, who cares what it’s really worth?

My former professor at NYU Stern, Aswath Damodaran, has taken a stab at estimating the intrinsic value of Twitter and published his thought process here:
http://aswathdamodaran.blogspot.com/2013/10/twitter-announces-ipo-valuation.html

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[1] Not even a few shares “just for fun”, which is literally the reason several people have told me with a completely straight face.

It’s long and fairly technical, but I’ll boil it down for you²:

1. The most important assumption in valuing a rapidly growing company is just how rapid its revenues will grow. Professor Damodaran assumes 55% for the next five years before tapering down to a 2.7% perpetual growth rate by year ten.
2. Revenues are nice, but as shareholders, we care about profits. Professor Damodaran assumes operating profit margins will increase linearly to 25% over the next ten years.
3. For companies to grow, they have to reinvest, which will delay the time when shareholders actually get to enjoy the fruits of excess profits. For now, all excess profits are plowed right back into R&D. Professor Damodaran assumes Twitter will have to spend $1.00 to generate $1.50 in new revenues.
4. All that stuff in #1-3 is risky. What returns might investors demand to take on such a risk? Professor Damodaran assumes 11.22% based on the recent price action of stocks in comparable industries.
5. Given the above assumptions, Professor Damodaran thinks Twitter is worth $17.36 per share.

That’s pretty much it in a nutshell. Notice that incredible assumptions that must be made, e.g. neck-snapping 55% annual growth, disciplined execution of business operations to generate a high profit margin, and continued innovation to drive such growth into an uncertain future. Out of such rough estimates comes a comically precise number: $17.36.

Before this spirals into a full blown lesson on academic valuation, I’ll stop here and let those who are truly, insatiably curious dig into the link above and/or give me a call where I promise I am happy to nerd out with you to as granular a level as you’d like.

The broad takeaway should be obvious. So much of the value of Twitter is guessing what the future will entail. True – in investing, it’s impossible to not incorporate a guess of the future, but some things are easier to guess than others. For example, it’s easier to assume millions of people will keep buying Coke than to assume Twitter will figure out a way to sell ads effectively and profitably and at scale and won’t be mooched away by future competition. In 1999, people³ happily assumed companies like eToys and Pets.com and Webvan and Amazon would similarly enjoy rocket-powered growth and bid all of them up into multi-billion dollar valuations. Today, only a little over ten years later, only Amazon is left.

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[2] My qualifications, for your edification, are that I got an A and an A- in the two classes I took with Mr. Damodaran.
[3] Really smart, Ivy League educated people getting paid enormous sums of money.

Predicting stuff is really hard. Most of the time, it’s just guessing, especially as you lengthen the duration of your prediction. You want as many handicaps as you can get on your side: amount of cash in the bank; proven revenue model; unconquerable strength of brand; special situations bound by clear catalysts; tangible assets, etc., etc.

Twitter has none of those. Brand strength… maybe. But it’s not “Twitter” the company, per se, that its users are loyal to, it’s the network of people and their followers. Can you be reasonably assured that something cooler won’t catch the fancy of people in the next ten, fifteen years? If you say yes, would you have applied the same argument to MySpace back in 2004?

This is not meant to be a knock on Professor Damodaran’s conclusion of a $17.36 per share fair value. The value of Professor Damodaran’s exercise is the process, not the assumptions. All investors should apply their own assumptions. It’s what makes a market a market. And if you’re reasonably assured of them and your output is $17.36 per share, then you should buy the stock if it’s falls below that price.

It might be a while, though. TWTR traded above $40 on its first day. Now, if you think 55% growth, 25% margins, etc, are aggressive assumptions to achieve a $17.36 fair value, imagine what assumptions you’d have to make to double that. Yeah, exactly. It is highly probable that the current marginal buyer of TWTR is simply gambling. Nothing wrong with that, I suppose, but I’d rather not do that with the money that my clients and I will rely on to retire in the future.

“Remember that just because other people agree or disagree with you doesn’t make you right or wrong – the only thing that matters is the correctness of your analysis and judgment.”

-Charlie Munger

Steve Jobs

On Wednesday, October 5, at 7:49 EDT, my inbox flashed.

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FINANCIAL TIMES Breaking News
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Apple says Steve Jobs has died, aged 56
Apple says Steve Jobs died on Wednesday, aged 56, after a prolonged battle with pancreatic cancer

Just like that, I found out¹. It was simple, succinct, powerful. Social networks exploded with R.I.P. tweets. Is there another billionaire CEO out there that would elicit such an outpouring?

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Tech Stocks Philosophy

For self-coined Value Investors, there is a palpable stigma towards one particular business industry: technology. This was never more exemplified than during the tech boom of the new millennium, when the NASDAQ composite peaked at over 5,000 (today, the index slogs along at the low 2,000s, a mere 40% of what it used to be a decade ago). All the new million- and billionaires were affiliated with technology, be it entrepreneurs like Mark Cuban or stock pundits like Henry Blodget. And over there in the dunces corner, growing a paltry 0.5% in 1999 compared to the Nazz's 85%, was Warren E. Buffett, sitting on his $36 billion wealth comprised of boring country names like Coca-Cola, Washington Post, and Wells Fargo, while being sandwiched at #2 by Microsoft kids (Gates, #1, $90B; Allen, #3, $30B; Ballmer, #4, $20B) on the Forbes 400.

I promise, this is not yet another W.E.B. post. At least, not intentionally.

Despite being, by all accounts, best buds with Bill Gates, Buffett staunchly refused to invest one red cent of Berkshire's in technology stocks (although he has admitted buying 100 shares of MSFT in his personal account just to keep track of it). The rationale was from the same scripture: buy what you know, stay within your circle of competence. Buffett's humble spin on it was he did not understand technology, him being a dinosaur from the Depression era, and could not predict where the MSFTs and CSCOs and INTCs would be 10, 15, 20 years from now. The unspoken truth was, if Buffett, capitalism's foremost genius, couldn't figure it out, no one could.

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Reconciling Experiences

With each passing day, it appears increasingly obvious a "generational bottom" was put into the broad market on March 9th. Even though it's only been three months, it feels like an eternity ago. (By the way, how cool is it that this blog, so aptly named, was started one day after the exact bottom?)

I think it's instructional to reflect on how the market felt, versus how it feels today. This is a good old fashioned melt-up. The action is choppy, but you let a week or two go by and almost everything is higher. There is a persistent bid underneath during every sell-off. Three months ago, the floor felt like it was falling. If you buy, you are down 10% in a heartbeat. The proverbial falling knife was sharp and accelerating.

I've made a nice haul off the bottom, despite the occasional slash wounds. But since then I've pared back a lot of my positions, and days like today create performance anxiety. I feel like too much of my assets are in cash and bonds. The names on my watch list are melting up, while my cash sits, devalued day by day.

I've become a victim of the persistent bid.

Cramer is making a lot of noise about this being a new bull market. This certainly feels like bull market action. Meanwhile, I'm cognizant about the macro economy, which remains at 9-10% unemployment. The trick is to understand that the two are not perfectly correlated. They're not even closely correlated. They are eventually correlated, if you look at a chart that spans decades. It's why Ben Graham calls Mr. Market a voting machine in the short run, and a weighing machine in the long run. Or, as Keyenes puts it, the market can stay irrational for longer than you can stay solvent. Bottom line: I don't know what to make of this current market, whether to buy or sell. Performance anxiety be damned--I'll stay conservative.

One thing we know for sure: the bargains are gone. Risk has been repriced rationally. Go back to my Oversexed Guy In A Harem post, and compare the prices of the bargains I listed then and their prices today. WCC: $15 vs $26, BOOM: $7 vs $21, IPHS: $8 vs $16, ACMR: $1.40 vs $3.50. These are huge gains in a span of three months. We may not see something like this again for many, many years.

So the main takeaway is to reconcile our experience of then and now. Investing can be a complicated game, but in many ways it is fundamentally simple, as it is tied inexorably to human behavior. Remember what it felt like back then, in times of panic, and in retrospect, how easy it would've been to make so much money. Be fearful when others are greedy, and be greedy when others are fearful, says Buffett. It is that which is perhaps his most famous and oft-repeated quote, and not some archaic or complicated formula only decipherable by genius.