It’s often the case that investors buy into a company that has a terrific economic franchise, one that allows it can charge a premium price and achieve high ROCE, and then, a few years down the line profits start to decline. The world has moved on.
Whether through technological change making competing ways of delivering a service or producing a good, or whether through social change reducing demand your favourite firm can no longer attract customers and still achieve the old profit margins. This is the way capitalism works: creative destruction over and over again. Just drive around a town built in the Victorian era. Here in Leicestershire we have old textile factories, in Stoke you see the remnants of famous potteries, and on the Tyne, shipbuilding yards. In our own time we’ve seen the decline of the high street as a portion of shopping moves online; and the numbers of high street travel agents and insurance brokers have fallen. Newspapers have had a hard time of it, as have producers of paper car manuals. Now we are seeing the combustion-engine based industry and fossil fuel power producers under threat, as well as the landline phones and linear TV. We need to keep up to date. We need to continually challenge our assumptions regarding the durability of a business model – some sectors are much less vulnerable to change than others, but all must be watched for signs of attack. Charlie Munger was recently asked about his experiences in helping Berkshire Hathaway to grow over the last 60 years. What had surprised him, and how he used some of those surprises in his quest to become a “better learning machine”? He replied: “Some of the things that surprised me the most was how much dies. The business world is very much like the physical world where all the animals die in the course of improving all the species, so they can live in niches and so forth. All the animals die and, eventually, all the species die. That’s the system. “When I was young, I didn’t realize that that same system applied to what happens in capitalism to all the businesses. They’re all on their way to dying, is the answer, so other things can replace them and live. It causes some remarkable death. “Imagine having Kodak die. It was one of the great trademarks of the world. There was nobody who didn’t use film. They dominated film. They knew more about the chemistry of film than anybody else on Earth. And, of course, the whole damn business went to zero. “Look at Xerox, which once owned the world. It’s nothing compared to what it once was. Practically everything dies on a big enough timescale. When I was young, it was just as obvious then, [but] I didn’t see it for a while. “Things that looked eternal and had been around for a long time, I thought would likely be that way when I was old. But a lot of them have disappeared. Practically everything dies in business. None of the eminents last forever. “Think of all the great department stores. Think how long they were the most important thing in their little community. They were way ahead of everybody in furnishing credit, convenience in all seasons, convenience back and forth using the same banks of elevators and so forth [over] multiple floors. It looked like they were eternal — and they’re basically all dying or dead. Once I understood that better, it made me a better investor.” “To have IBM have the huge position it once had in terms of utter dominance and, now, it’s just one of the also-rans. It’s still an admirable place. I’m sure they still have a lot of talent left in IBM, but it doesn’t help. You die even though you’re talented and hard-working.” Prof Glen Arnold now offers a Managed Portfolio Service at Henry Spain Investment Services under which clients’ portfolios contain the same shares as his (write to Jackie.Tran@henryspain.co.uk)
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It seems that there are a lot of investors around who follow people like Warren Buffett into companies that have strong economic franchises. Indeed, they often buy-in years after Warren has bought. This seems particularly true of well-known consumer brand companies, e.g. Coca-Cola or Kraft Heinz.
What they often forget to do is ask a simple question: What is the price, and does that price offer a good margin of safety? So, when Warren bought the share was standing on price earnings ratio of say 15 – quite high for a value investor, but justified if good growth can be expected. He often buys at a time when some event or temporary poor trading period has lowered the price to provide a margin of safety. But the would-be emulators pile in when times are good, and millions of investors think that these companies are great. Of course, the shares by then are trading on PERs of 30, 40 or more. All conception of margin of safety has evaporated. Do not expect exceptionally high returns from such knee-jerk copying. Charlie Munger, the person who most influence Warren Buffett into buying into these excellent businesses at times when there share prices are low said recently “The trouble is you will find, when you get into those good businesses in a place that’s picked over and analyzed…if it’s really a great business, it’s at least 25x earnings and maybe 30x or 35x or something. That makes it much harder because if something goes wrong, you can lose a lot of your investment. “Of course, that’s what makes investment so difficult, the fact that good businesses don’t stay cheap. They’ve got to somehow recognize a good business before it’s recognizable as a good business. That’s very hard to do. “Some people get good at it, but not many. 95% of the people who are America’s professional asset managers, I wouldn’t want working for me…I think it’s that hard. I think you need to be in the top 5% to have a reasonable chance. It’s very difficult.” (Charlie Munger at February 2023 meeting of Daily Journal) Challenge for the day: Can you recognize a good business before it’s recognizable as a good business? Do you spend sufficient time and have sufficient tools? Prof Glen Arnold now offers a Managed Portfolio Service at Henry Spain Investment Services under which clients’ portfolios contain the same shares as his (write to Jackie.Tran@henryspain.co.uk) As you know, we value investors spend a tremendous amount of time trying to thoroughly understand the businesses we put money into. This has a number of aspects, including:
Business or managers? A question frequently asked of value investors is “When you’re evaluating a company for a potential investment, what do you place the most emphasis on — the business or the management? Here is Charlie Munger, “We like the business great first. Then, second, we want a great manager. But we have not made a huge success by investing in great managers who take over lousy businesses. That is not the way we rose. If you’re a lousy manager, you really need a great business.” He added ““Don’t bail away in a sinking boat if you can swim to one that is seaworthy.” Can a great business be run by a lousy manager? Warren and Charlie invested over $1.3bn in Coca-Cola shares over the seven years to 1994 via Berkshire Hathaway. Those shares are now worth $25bn. The dividend received by Berkshire in 2022 alone was $704m. Because it was such a great economic franchise with terrific competitive advantages which could be sustained through periods of poor management Munger concludes that great businesses can be run by lousy managers and still thrive in the long run. He recalls: “Sometimes. Coca-Cola was run for years by a man with very severe mental impairment. The directors just assumed he was drunk and let him stay there year after year. Now, that’s my idea of a wonderful business — you can be mentally defective and run it pretty well. That was Coca-Cola in its heyday.” That is quite some test for the shares in your portfolio: could the company be run by someone who is mentally defective and still retain its franchise? This hurdle is too high because you would end up with too few companies to be sufficiently diversified, but it’s nice if you can find a few of these amazing companies in an investing lifetime to put into a portfolio – but only if you can buy at the right price, so a lot of patience is required. Prof Glen Arnold now offers a Managed Portfolio Service at Henry Spain Investment Services under which clients’ portfolios contain the same shares as his (write to Jackie.Tran@henryspain.co.uk) Investors should expect to make many mistakes – expect this, accept this, and still function:
Charlie Munger on the subject: “It’s natural to have decisions in each individual life that don’t work very well. We live in a world of sin, sorrow, and misdecision. That’s what human beings get to cope with in their days of life. I don’t expect the world to be free of folly and mistakes and so forth — I just hope that I’m invested with people who have more good judgment than bad judgment. I don’t know anybody who’s right all the time.” (February 2023, Daily Journal AGM) So how do you make fewer mistakes?
“If you have good judgment, your life will work a lot better than if you have bad judgment. You get good judgment gradually over time, partly by making bad judgments and having them work out poorly. My counsel has always been to start trying to be better and keep trying to improve all of your life — and you’ve got about half a chance. If you don’t do that, you’ve got no chance.” (February 2023, Daily Journal AGM) You’ve got to do the hard miles to get to the starting line of good judgement Charlie Munger: “I used to say I could only teach what the other person almost knows. Then I can just [push] him over the brink when he’s hanging on the edge. But if a guy is not within miles of even starting, I never succeed. In removing idiocy, I have a 100% failing talent. I have never succeeded.” (February 2023, Daily Journal AGM) An example of Munger’s learning process (at the age of 99): He was asked this question at the Daily Journal’s 2023 meeting: “You’ve said that you should destroy at least one good idea that you have each year. What good idea did you destroy in 2022 and anything in 2023 so far?” CM: “The idea that I destroyed — it wasn’t a good idea, it was a bad idea. When the internet came in, I got over-charmed by the people who were leading the online retailing and I didn’t realize it’s still retailing. It may be online retailing, but it’s also still retailing. I just got a little out of focus and that made me overestimate the future returns from Alibaba. I have never [had to eliminate a mistake] twice. I keep rubbing my own nose in my own mistakes, like I’m doing now, because I think it’s good for myself.” [Munger invested heavily in Alibaba] (February 2023, Daily Journal AGM) Warren Buffett, too, rubs his nose in his mistakes in order to keep learning He said recently: “Over the years, I have made many mistakes. Consequently, our extensive collection of businesses currently consists of a few enterprises that have truly extraordinary economics, many that enjoy very good economic characteristics, and a large group that are marginal. Along the way, other businesses in which I have invested have died, their products unwanted by the public. Capitalism has two sides: The system creates an ever-growing pile of losers while concurrently delivering a gusher of improved goods and services. Schumpeter called this phenomenon “creative destruction.” (Warren Buffett, 2023) It's important for investors to know the history of business mistakes too. One example is IBM’s failure to capitalise on its position as the leading mainframe computer company as the world of computing evolved. Charlie Munger put it well recently: “Everybody makes mistakes. I’d say one of the most interesting things that happened in my lifetime was the rise of IBM and the fall of IBM. IBM was the most admired company in America for most of my young life. They just marched from triumph to triumph to triumph and, in the last ten or fifteen years, they’ve slipped and they’re falling back in relation to other people in their field. As the Apples and the Googles and so forth came ahead, IBM just kind of missed the boat. I think that’s almost inevitable. Kodak missed the boat of the change to digital photography, too. “I’ve heard Bill Gates say that it’s almost the rule that [when] a really disruptive technology comes along, the incumbents screw up their reaction to it. It’s hard to change your ways when they’ve been successful for a long time and go into a totally different way of behaving and thinking.” (February 2023, Daily Journal AGM) Prof Glen Arnold now offers a Managed Portfolio Service at Henry Spain Investment Services under which clients’ portfolios contain the same shares as his (write to Jackie.Tran@henryspain.co.uk) Cryptocurrency “isn’t even slightly stupid, it’s massively stupid” says billionaire investor1/4/2023 Charlie Munger had some ripe words to say about cryptocurrency when he addressed a meeting as director of Daily Journal recently (Charlie is Warren Buffett’s business partner and made his billions by choosing his investment carefully over a six decade stretch – and he is still making money and giving good advice aged 99).
Here is what he said: “Naturally, people like to run gambling casinos where other people lose. The people who invented this crypto crappo, which is my name for it, sometimes I call it crypto crappo and sometimes I call it crypto shit. “It’s just ridiculous that anybody would buy this stuff. You can think of hardly nothing on Earth that has done more good to the human race than currency, national currencies. They were absolutely required to turn man from a goddamn successful ape into a modern successful humans and human civilization, because it enabled all these convenient exchanges. “So if somebody says I’m going to create something that sort of replaces the national currency, it’s like saying I’m going to replace the national air. It’s asinine. It isn’t even slightly stupid, it’s massively stupid. “It’s very dangerous and the governments were totally wrong to permit it. I’m not proud of my country for allowing this crap — what I call the crypto shit. It’s worthless, it’s no good, it’s crazy, it will do nothing but harm, and it’s anti-social to allow it. “The guy who made the correct decision on this is the Chinese leader. The Chinese leader took one look at crypto shit and said not in my China. And, boom, there isn’t any crypto shit in China. He’s right and we’re wrong. There is no good argument on the other side. I can’t supply it. “It’s totally, absolutely crazy stupid gambling with enormous house odds for the people on the other side — and they cheat in addition. It’s just crazy. “That is something that there’s only one correct answer for intelligent people — just totally avoid it. And avoid all the people that are promoting it.” Personally speaking, when I look at crypto I see nothing there – not a stitch of clothing on the emperor at all. When you are buying nothing in the hope of selling that nothing to another person…well, that is not investing. Prof Glen Arnold now offers a Managed Portfolio Service at Henry Spain Investment Services under which clients’ portfolios contain the same shares as his (write to Jackie.Tran@henryspain.co.uk) |
Glen ArnoldI'm a full-time investor running my portfolio. I invest other people's money into the same shares I hold under the Managed Portfolio Service at Henry Spain. Each of my client's individual accounts is invested in roughly the same proportions as my "Model Portfolio" for which we charge 1.2% + VAT per year. If you would like to join us contact Jackie.Tran@henryspain.co.uk investing is about making the right decisions, not many decisions.
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