Even Kings Can Be Cheap

The current research project is Anheuser-Busch InBev (“AB InBev”).  I mentioned (on Twitter) that it seemed cheap the other day.  The response was lukewarm.  That’s exciting.  Real deals don’t usually occur when everyone thinks a deal exists.

The most common complaint about AB InBev is it isn’t growing and it is still trading at 22.7x trailing earnings.  An earnings yield of 4.4% with no growth is understandably not exciting.  Especially in an industry that is fighting structural headwinds in the form of craft beer, wine, and sprits, which are  taking market share from AB InBev’s portfolio brands.  

That said, these are not new trends and AB InBev’s equity was priced 34% higher at the start of the year.  Has something fundamentally changed or has Mr. Market presented an opportunity?  Potentially neither.  It’s possible Mr. Market was irrationally excited before and the equity is still over valued! Citing the equity price decline as a basis for interest potentially induces confirmation and anchoring biases.  

Thus far I’ve only spent three full days researching this idea.  The market is in a relatively volatile period (compared to recent history, though historically speaking I’d argue this is a non event) and many “more attractive” names appear reasonably priced.  So why waste time on a no growth heavily indebted company?

Question 1: Do I Understand this Opportunity Enough to Develop and Informed Opinion About AB InBev’s Value?

In my younger and dumber years I waited in line for beer releases.  Therefore, I can appreciate craft beer’s threat to AB InBev.  This perspective also enables me to understand that the available variety of craft beer has become overwhelming.  I could buy a different IPA every week for a year and still not try them all.  It’s my view that craft will probably continue to take market share in the US, but it’s also plausible that the market has reached the shakeout phase.

Regardless of whether the craft market is currently saturated, I suspect regional winners will emerge (or already have emerged).  Some craft brews travel well, but the craft beer market is still a regional market (in my opinion). Over time AB InBev may be able to acquire some regional winners to enhance growth.  The risks to growth through rolling up regional craft beer producers are:

  • The regional winners may not want to sell to AB InBev.  That risk is somewhat mitigated by people’s desire for money.  AB InBev successfully purchased Goose Island, a strong Chicago brand at the time of acquisition.  I recently attended an event where Goose Island spoke highly of AB InBev’s hands off approach to Goose Island’s side projects.  That said, some craft beer producers are artists and  simply don’t want to sell to a large corporation.  If money were the primary driver for all industry participants 3 Floyd’s, The Alchemist, and Russian River would all be much bigger companies.  
  • Valuations could get so stretched that AB InBev won’t be able to make a reasonable return on investment.  This risk is mitigated by 3G’s success creating AB InBev.  This management team has been in the beer industry for a very long time.  They understand (a) rational acquisition multiples and (b) how to create long term value for equity in this industry.
  • Brands lose their craft image when AB InBev purchases them.  This is a serious risk.  Anecdotally, it seems as if fewer Chicagoans purchase Goose Island at bars these days.  But that may also be attributed to the explosion of craft beer options since AB InBev purchased Goose Island.  At a minimum, Chicago men are still excited for Goose Island’s BCBS lineup of beers.  See https://wgntv.com/2018/11/23/long-lines-in-lincoln-park-for-release-of-goose-island-signature-beer/.  Therefore, Ab InBev’s ownership hasn’t totally killed the brand image.
  • The AB InBev portfolio is so large that tuck in acquisitions won’t move the needle.  This is the most valid criticism of AB InBev’s US business’ growth prospects.  But I don’t view AB InBev as a US growth story.   Going forward I expect growth from emerging markets.  Importantly, I view management as capable and rational capital allocators.  Therefore I trust them to reinvest in organic emerging market growth. If the US market fades at less than 2% per annum, this investment can work. 

Question 2:  Are these people I want to align myself with?

3G has a number of portfolio companies.  Of the most prominent, Kraft Heinz draws limited investor excitement, Jim Grant hates Restaurant Brands International, and AB InBev is a “no growth” story.  So, why should I even be interested?  Isn’t this a management team that’s lost touch with where the world is going?  Don’t they cut costs too aggressively and forego the future for the present? 

Generally, I like to look for ideas (a) in places that are glaringly obvious and (b) places where things don’t make any sense (thank you Adam Robinson for this advice; see Tim Ferris’ podcast interview with Adam Robinson).  In my opinion, it makes no sense that 3G is held in such high regard by Buffett and Munger but the market narrative seems so negative.  A cynic would argue Buffett and Munger only care about profit and don’t care how 3G does what they do.  But the way Charlie talked about 3G is too powerful for me to ignore.  Further, Charlie and Warren aren’t short term thinkers.  So they must think 3G is a reasonably competent long term manager and not just cost cutters. 

One of the first things AB Inbev highlights in its corporate filing is: “we are building a company to last, brewing beer and building brands that will continue to bring people together for the next 100 years and beyond.”  It’s not too often you see long term discussions from public management teams.  Too often the focus is on next quarter and guidance.  But, talk is cheap!  So I started to dig into the SEC filings of AB InBev’s subsidiary, AmBev.  This filing (https://www.sec.gov/Archives/edgar/data/1565025/000129281418003434/ambevsa20181030_6k.htm)  is a great clue showing why Buffett and Munger like 3G so much.

The filing is well written, easy to read, addresses stakeholders in the business (rather than just shareholders), separates the CEO and Chairman of the Board roles, and consistently discusses long term compensation and orientation.  That clue, combined with the Berkshire stamp of approval, and my general knoweldge of 3G, makes me believe AB InBev’s stewardship is exemplary (Morningstar agrees, for whatever that is worth).  

Question 3: Why Does This Potential Opportunity Exist

At the present time, a back of the envelope model generates an IRR of ~10%.  I’d argue a 10% IRR on a conservative model with a ~16.7x exit multiple warrants some attention.  So why does this “opportunity” present itself?  

To begin, the US brand portfolio is losing (or has lost) its cache as beer drinkers migrate to craft beer.  According to Statista, craft beer has increased its share of beer production from 7.8% in 2013 to 12.7% in 2017.  The combined effect of consumers drinking more craft beer, craft beer adding assets to the industry (which all else equal will depress profits), and a shrinking beer market (per capita consumption down from 1.23 gallons/capita in 2000 to 1.08 gallons/capita in 2016) depresses the outlook for major US beer makers.  While this concern is real, I believe the risk is somewhat mitigated by AB InBev’s (1) slightly positive U.S. volume growth last year and (2) sales mix (US sales accounted for 27% of AB Inbev’s TTM 6/30/18 sales mix). 

The second criticism is AB InBev is not growing.  I’m not sure I agree with that assessment over the long term

  1. 70% of Ab InBev’s consolidated revenues come from emerging markets.  A little more than half of the company’s Latin America (“Lat Am”) exposure is via AmBev, of which AB InBev owns ~62%.  That entity will probably grow at GDP-like rates (which are volatile in emerging markets). EBIT margins should improve at slightly higher than GDP as the company executes it’s long term value creation plan of raising prices in line with inflation while keeping cost growth below inflation.
  2. AB InBev’s acquisition of SABMiller gave the company a strong presence in Africa.  Again, I suspect this market should grow at approximately GDP with EBIT outpacing GDP for similar reasons to the LatAm region. Any premiumization of the beer category would be accretive to profits.

Both regions above should continue to grow at GDP rates due to historical (and current) birthrates.  Moreover, AB InBev should keep meaningful market share as the competitive landscape in emerging markets appears to be a distribution and cost advantage game.  AB InBev is almost 2.5x larger than its largest global competitor; Heineken (measured by volume).  That scale, combined with regional focus, should enable AB InBev to acquire emerging market customers because AB InBev should have a cost advantage.  Emerging markets consumers are very price sensitive.  To put price importance in perspective, see the graphic below:

Source: Golman Sachs, July 2018 Report

The final reason I believe people don’t like AB InBev right now is a confluence of problems with the equity performance.  AB InBev issued equity to complete the SABMiller deal, and recently (October 2018) cut its dividend in half.  That leads people to wonder whether future cash flows are now looking materially worse than when the acquisition occurred.  Moreover, shares were already underperforming the S&P before the dividend cut.  I suspect equity holders are ready to throw in the towel.

The chart below shows how many dollars of assets (less goodwill) AB InBev has historically needed to generate a dollar of operating income (“EBIT”) since 2008:

I view this measure as a reasonable way to look at the underlying franchise power of the business.  Generally speaking, AB InBev appears to be heading towards its historical franchise earnings power.  I need to dig in deeper to understand commodity pressures, LatAm concerns (which impacted American Airlines this year as well), etc.  But, the trend towards “normal” is encouraging.  (Note the spike in 2016 is a function of the SAB Miller acquisition.  The operating income benefits hadn’t gone through the income statement until 2017.)  That said, the deterioration in franchise earnings power since 2014 is concerning and warrants more attention. 

Conclusion: This Idea Warrants a Deeper Dive

The past is not the future.  My thesis as of today is that management will likely invest heavily in emerging markets, use excess cash flow to reduce leverage, and focus on organic growth.  I don’t expect share repurchases or a large acquisition any time soon.  Nevertheless, I suspect AB InBev’s ROE will improve as emerging market earnings grow. 

In summary, my back of the envelope exit multiple is 16.7x earnings; compared to 20x+ since 3G purchased the company.  The IRR in that scenario still exceeds 10%.  Most importantly, I believe AB InBev’s long term competitive advantage remains in tact, despite difficult US trends.  Thus, I view the distribution of potential returns as fairly tight and my downside as limited.  Therefore, I believe this idea warrants further consideration.

Disclosure:  No position     

Cash Flow is King, But Sometimes it Isn’t

In my younger years I was too focused on hard and fast rules.  Rule 1 was cash flow is king.  Rule 2 was buy cheap.  If a company wasn’t generating meaningful cash it fundamentally wasn’t worth investing in.  I wouldn’t even consider Rule 2.  After all, a company is worth the cash it generates in the future; discounted to today’s values.  Below is a model that illustrates this concept.  Each cash flow has a 10% discount rate applied to it.

*Assumes a 10% required rate of return

You can see how much weight the early cash flows have to the calculation. Which is to say that $100 generated in “Year 1” is worth $90.91 in today’s dollars while the $100 generated in “Year 10” is only worth $38.55 in today’s dollars.  Therefore, the cash flows at the end of a 10 year model need to be substantially larger than the near term cash flows in order to be worth the same amount in today’s dollars.  This impact is exacerbated when near term cash flows are negative.   

That has always been a hurdle for me because I lack the confidence to  accurately foresee cash flows 10 years from now.  Furthermore, the required growth in cash flows caused greater uncertainty and doubt.  A negative consequence of that mental barrier/bias is I almost always missed out on growth companies because they tend to use cash while they grow.  Thus, current cash flows in growth companies are not representative of mature cash flows.  A recent presentation by Aswath Damodoran illustrated this point with this slide:

Source: https://www.youtube.com/watch?v=c20_S-QgvsA&t=2s

Damodoran highlights the cash needs of companies in different life cycles very well in that slide.  In my experience, a lot of money can be made investing during the high growth part of the life cycle (assuming you pay a reasonable price).  I believe the reason stems from the fact that the future is still uncertain so it’s still possible to have  investing edge (Note: the dispersion of future cash flows in growth companies arguably means there is more risk associated with investing in them). 

Most people can reasonably forecast the future of Coke.  Forecasting LaCroix’ future is more difficult.  Furthermore, Coke’s valuation very driven by existing cash flow rather than future cash flow.  Thus, it’s less likely to be materially mispriced because everyone is looking at the same information in the same way.  This makes buying Coke very cheap very difficult and probably limited to severe market corrections.  Waiting for those opportunities probably isn’t the best investing strategy because holding cash and waiting for a crash can cause behavioral mistakes.

I’ve learned from my mistakes and now try to look at a business or investment at the time of maturity.  I would not summarily dismiss purchasing a building during the construction phase while it was not earning maximum rent and was consuming cash while contractors completed renovations/build out.  Buying a business is no different.  

Making money investing is a difficult pursuit.  Nuance and flexibility are rewarded much more than hard rules and style conviction.  As I’ve let go of my style as a “value” investor looking for cheap cash generation I’ve begun to see opportunity in buying smaller firms at growth inflection points.  The key is determining which part of the life cycle a firm is in and analyzing that particular situation accordingly.     

Facebook: The Ultimate Attention Merchant

The business of attention capture and resale can be traced back many years.  According to Tim Wu’s The Attention Merchants, Benjamin Day began the business model of reselling attention when he started The New York Sun.  The New York Sun was the first newspaper to sell for below its cost to produce and rely on advertisers to create profitable revenue streams.  Hence, the beginning of the business model depending on selling user’s eyeballs.  

Once other newspapers caught onto the idea they specialized in certain niches and adopted the business model. According to Wu:

“We’ve already seen the attention merchant’s basic modus operandi: draw attention with apparently free stuff and then resell it. A consequence of that model is a total dependence on gaining and holding attention. This means that under competition,the race will naturally run to the bottom…[to] whatever stimulus…engage[s] what cognitive scientists call our ‘automatic’ attention as opposed to our ‘controlled’ attention…[This]…poses a fundamental, continual dilemma for the attention merchant – just how far will he go to [harvest attention.]”  The Attention Merchants by Tim Wu @ 16. 

The more things change, the more they stay the same.  The obvious difference today is the scale at which the attention capture and advertising distribution changed.  In the past there were regional barriers to distribution.  Today, the only barrier to distribution is a company’s ability to capture the incremental user.

The risk to attention exploitation is customer revolt.  Historically people have lobbied government to step in.  Again, to quote Wu, “when audiences begin to believe that they are being ill-used –  whether overloaded, fooled, tricked, or purposefully manipulated – the reaction can be severe and long-lasting enough to have serious commercial consequences and require a significant reinvention of approach.” Id. @ 21.  Without users there is no attention to merchandize.  As of November 2018 that risk feels particularly heightened with Facebook.

If this risk materializes and customers revolt the business erodes and dies; like My Space and AOL. If the users leave then other users have less incentive to stay because the network shrinks.  In that scenario Facebook’s inventory becomes less valuable to advertisers.  Therefore, the value of Facebook’s platform depends on the user base connecting with each other. 

The most important investment question: Will People Leave?

The key investment question is whether Facebook’s current negative publicity cycle results in users disengaging from the platform.  A recent Pew Research study suggested people were deleting the Facebook App en masse.  Subsequent company released user metrics put that report in doubt.  It’s possible for both things to be true.  Facebook doesn’t report engagement through its app.  Rather, the company reports daily and monthly active users (DAU and MAU, respectively).  Thus, it is possible for someone to continue accessing Facebook, Instagram, or WhatsApp but not do so through the app. But I disgress…

To begin to answer the sustainability question its important to understand users access Facebook only when they are infront of a screen.  Facebook is an immense beneficiary from smart phones making screens accessible all day.  Moreover, data plans have enabled consumption on the go.  Today, the average person looks at their phone 39 times per day.  Irresistible by Adam Alter @ 14.  People’s screen time addiction is so powerful that the mere presence of a smart phone is disruptive to people’s ability to concentrate. Id @ 16.

How sustainable is this trend?  46% of people say they couldn’t bear to live without their smartphones.  Id. @ 27.  80% of teens check their phone every hour (Snapchat tends to dominate this cohort’s social media usage).  Id at 28, parenthesis added. Only 24% of people spend less than two hours in front of their smartphones every day. Id @ 15.   It seems as though screen usage isn’t going away anytime fast.  That said, a transition to another media consumption medium would be a direct threat to Facebook’s business.

Why Do People Choose Facebook, Instagram and WhatsApp?

The next issue is to identify what factors enable Facebook to capture people’s attention when they look at their phone. 

Facebook gives people a platform where they can feel heard and be a part of a group.  Therefore, it can be a good tool to satisfy people’s fundamental needs of friendship, intimacy, family, and sense of connection. An even more utopian view of the Facebook platform could surmise that those feelings lead to fulfilling higher human needs of increased self-esteem, recognition, and status.  A dystopian view is the platform enables spreading hate speech, entering filter bubbles, and elevating trolling.  Regardless of the view point, a key psychological insight driving Facebook’s success is tribalism. 

When Facebook began it was only available at select colleges.  If you’ve ever been to a nightclub (or just thought about your high school days) you may remember not being part of the “cool” kids.  There is an intense desire to be a part of the cool crowd. Please see the movie Mean Girls for an entertaining analysis of this desire.  The exclusivity created a buzz around the product that made it different from a site like My Space.  So as it rolled out around the country students signed up in droves. Finally, college kids everywhere could be in the cool crowd.  Merely being in Facebook was joining a tribe and it signaled that you were part of the “in crowd.”  

As time passed further subtribes emerged as people became “Friends” and joined groups.  The creation of tribal identity is very powerful, especially when combined with Facebook’s like and comment features.  Why?  Because people within a tribe are more likely to “like” each other’s posts (social proof and reciprocation tendencies drive this behavior). And likes are the secret sauce.

As Rameet Chawla said, “[They are] our generation’s crack cocaine. People are addicted.  We experience withdrawls.  We are so driven to get this drug, getting just one hit elicits truly peculiar reactions.  I’m talking about likes.”  – Rameet Chawla, founder of Lovematically, as quoted in Irrestistible @ 128. 

Every time someone logs onto Facebook and sees a red icon indicating that they got likes/comments on their posts their brain releases dopamine.  The dopamine released causes the brain to want, desire, seek out, and search.  It reinforces the impulse to visit Facebook’s properties.  But why do so many people seek the dopamine hit on a daily basis? 

In Irresistible, cited throughout this post, Adam Alter set out to determine that answer.  He found the answer in an odd place.  In 1971, Michael Zeriler, a psychologist, set up an experiment to see how pigeons respond to stimulus.  The experiment required pigeons to press a button in order to receive food.  During his experiment Zeriler altered the amount of times a pigeon had to press a button before receiving food.  Zeriler found that pigeons feverishly pecked the “feed” button when they received a relatively consistent but not guaranteed reward (50-70% of the time).  They were less interested in the button when the reward was guaranteed. See Irresistible from 126-127.

And herein lies the genius of the like button, comments, and notifications.  No one knows whether and how much feedback they are getting on any given Facebook post, Instagram upload, or WhatsApp message string.  The feedback loop is uncertain and has the potential to release dopamine and satisfy base human desires.  Facebook’s properties capture people’s screen time as they feverishly check to see whether people “like” us and whether the world is passing us by. 

A Nod To Charlie Munger

One of the best speeches I’ve ever read is Charlie Munger’s Psychology of Human Misjudgment.  In it he outlines what he believes are the reasons people make poor/irrational decisions.  These are what I believe are the pertinent psychological forces further driving Facebook usage: 

  • Liking/Loving Tendency – Humans care what people think about them and a desire to get more people to like them.  People go to Facebook and Instagram and share their life.  Voila.  Likes galore.  Or they head over to WhatsApp and feel connected to their text chains.  These platforms enable engagement with otherwise tenuous relationships.  Much of the time that affirmation feels great, even if it comes from a tenuous relationship. 
  • Disliking/Hating Tendency – The opposite of the liking tendency is the tendency to seek conflict.  Look at the human races’ history of war.  A more common illustration of the disliking/hating tendency takes place seemingly everyday as politics is difficult to escape.  The need to feel heard in a cultural war drives traffic to Facebook, in my opinion.
  • Envy/Jealousy Tendency – Humans seem unable to avoid situations that leave them envious.  Instagram and Facebook are fantastic places to feel envious.
  • Excessive Self Regard Tendency – Most people suffer from overconfidence.  They assess their ability and prospects too highly.  Facebook and Instagram are the best platforms to showcase how fantastic a person’s life is.   
  • Lollapalooza Tendency – The tendencies above, when together, can create exponential effects.  I’d go add that the issues identified in Irresistible compound the effects even further.  Facebook understands these principles and created its algorithm to exploit them. 

The current narrative is Facebook’s properties are harmful to its users, disintegrate public discourse, and people don’t trust the company.  I have no idea whether the sentiment accusations are accurate (what people say is different from what they do).  Even if they are true, history can offer some clues about how this all may play out.  Did people trust cigarette companies after the 1980s?  Are Coke and Pepsi “good” for you?  No and no. Yet, the companies continued to perform well.

Habit and addiction are very hard to break.  I believe many people are addicted to Facebook and its properties.  Which is why I don’t think Facebook was lying when it reported the following stats:

Source:  https://www.sec.gov/Archives/edgar/data/1326801/000132680118000067/fb-09302018x10q.htm @ page 25.
Source: https://www.sec.gov/Archives/edgar/data/1326801/000132680118000067/fb-09302018x10q.htm @ page 26.

Those stats might be somewhat inflated because of fake accounts.  That said, I believe they are on a like for like basis.  Which is to say I suspect the number of fake accounts randomly fluctuates and the reported numbers convey an accurate trend.  Some people, myself included, were surprised about Facebook’s lack of customer attrition given the negative news cycle.  For the reasons cited above, combined with data that disproved my original thesis, I now suspect Facebook’s customer usage trends continue.  

Which brings me to my final investing point.  Change your mind when the facts change.  And remain open to changing your mind again.  

Recommended Reading:


The Importance Of Entry Price

When is an investor most likely to permanently lose money?  When he/she enters an investment.  Therefore, investors should be extremely cautious before entering an investment.  In theory this sounds nice, but in practice the fear of missing out (FOMO) can cause investors to buy too early.  

Some basic math shows the risk of buying at elevated prices.  I recently looked at Adobe Systems Inc.  I haven’t done enough work on the company to have informed opinion about the success of their recent acquisitions and whether management is capable.  That said, I am used to their Adobe branded products because I use them frequently.  Therefore, I understand Adobe’s core product is fairly integral to a business setting and they are priced on a subscription basis.  

Wall Street loves subscriptions because they tend to reduce churn and increase revenue certainty.  Consumers tend to renew subscriptions (sometimes without even realizing it), tend to not request their money back once billed, and cannot defer purchases because a company simply bills their credit cards.  Therefore the existing revenue streams of subscription companies are very likely to continue.  Furthermore, price increases tend to be easier to pass on to consumers since there is less sticker shock (many consumers don’t even check their subscription bills). 

Another thing Wall Street loves is software companies.  Why?  Because once a software company gets traction with customers there is minimal incremental capital to signing up the next customer.  Therefore, most of the additional revenue becomes cash flow to the business.  Thus, once a software firm achieves a minimum viable scale each additional customer becomes immensely valuable (assuming the cost to acquire that customer is less than the lifetime value of the customer). 

Adobe is subscription based and has hit scale.  Therefore, Wall Street loves it.  I decided to take a look because there has been a sell off in tech stocks lately.  Below is a very simple back of the envelope model I built.

I built the model assuming that Adobe continued trading at roughly 30.2x free cash flow.  I decided to increase Adobe’s buyback ratio over time and allowed for free cash flow growth in excess of GDP growth.  These are reasonable assumptions because Adobe probably won’t need all the cash it generates and should be able to raise prices.   

This seems reasonable so far, but the results rest on the assumption that Adobe will continue to trade at 30.2x free cash flow.  Is that reasonable?  Perhaps.  The current yield on 30 year treasury bonds is roughly 3.4%.  The current yield on Adobe is 3.3% (1/30.2; the inverse of the free cash flow multiple).  So, investors are willing to accept slight less free cash flow yield than risk free bonds today because they deem Adobe’s growth and earning certainty worthy of that bet. It’s important to stress that Adobe currently trades at a lower cash flow yield than risk free assets. 

Interest rates have been depressed for a long time now.  I have no idea whether they will continue to stay at these levels or not.  But, its reasonable to ask what happens if rates revert to their long term average of ~4.5%.  For purposes of this illustration lets assume that happens over the next 3 years.  The investment result is below (assuming Adobe trades at a similar yield to 30 year bonds). 

In the example above the business performs exactly as it does in the first scenario.  However, the multiple contraction decreases a shareholder’s 5 year return from 35.3% to 9.0%.  In that scenario, a shareholder would earn less than 2% per year.  That return is certain to reduce a shareholder’s purchasing power over time.  

Therefore, identifying a business worthy of investment is a necessary but insufficient condition to becoming a good investor.  Tradeoffs must always be made.  Bad businesses will sell at extraordinarily cheap prices at times.  They may be worth buying.  Conversely, good businesses selling at extraordinarily high prices may not be worth the risk of wealth destruction.  Reasonable minds can differ about which companies to buy and sell.  But price and risk must be a critical part of the discussion.  

Thoughts Post Malone

I recently attended Liberty Media Day.  I’ve known about John Malone for a long time, but never saw him in person. A couple things stick out in my mind:

  1.  The importance of a long term mindset
    • Dr. Malone talked about where he sees the media and cable industries going. His vision, as I interpret it, is the cable companies and the wireless companies eventually merging.  In the meantime he believes distribution companies should focus on incorporating Netflix and Amazon’s product offerings into their distribution channels. So, in Malone’s ideal world the cable company would drive traffic to Netflix and Amazon and receive a referral fee.  It’s an interesting concept but Netflix and Amazon aren’t suffering from a customer acquisition problem.  Therefore, I don’t know how receptive they would be to this proposition.  Regardless, Malone turned down an offer for his cable company at a substantially higher value than it trades at today.  He seems unfazed as he believes over the long term Charter will create more value than the offered price.  
    • Malone started his career at a smaller cable operator.  He left McKinsey to take a shot at building a company.  The company was called TCI and the road to success was uncertain at best.  That said, he stayed focused on his goal and thought strategically about the long term despite the short term outlook.  Today he has significant influence over a legitimate media empire that contains SiriusXM, Live Nation, Formula 1, Discovery Communications, Charter Communications, Trip Advisor, The Atlanta Braves, and he is the largest land owner in the US.  Time plus focus can accomplish astonishing things. As Tony Robbins says, “People overestimate what they can accomplish in a year and underestimate what they can accomplish in 10 years.”
  2. Some management teams just win. 
    • Listening to John Malone and his CEO, Greg Maffei, it’s pretty clear they are playing chess and the other guys are playing checkers.  Malone’s control of the entities enables Maffei to take a long term outlook.  Contrast that to AT&T, which has a substantial asset base but also has the pressure of meeting quarterly earnings estimates and worrying about a substantial dividend payout.  The guys at Liberty and their companies have a structural qualitative advantage AND the skill to exploit that advantage.  Those are situations I want to align myself with.  See also Berkshire Hathaway, Markel, Brookfield Asset Management, Constellation Software.
  3. Setting Yourself Up For Success Matters…A LOT
    • Liberty Media issues tracker stocks.  Tracker stocks are derivatives that are used to highlight the business value of the business segment within Liberty Media.  I never understood why people were comfortable owning them.  Now I have a better understanding.  Malone uses tracking stocks because he likes the entities under one umbrella because “there are antitrust and tax benefits on intercorporate dealings.” To begin, its pretty astonishing to hear him say that out loud.  Second, it’s exactly how Buffett thinks about antitrust and tax as well.  But Buffett doesn’t say anything like that publicly.  Tax avoidance is a large part of why Malone is so wealthy.  Lesson: set yourself up for success on the front end in order to take advantage of long term success.

In closing, I didn’t know what to expect from “Liberty Day.” I knew other people loved Malone and Maffei, but I never understood the following.  After watching them for a day I began to understand why people follow them so closely.  I intend to read everything I can get my hands on to better understand how they see the world.

The Same Investment Mistakes Occur Everywhere In Life: The Too Hard Pile

The more I look at different “deals” the more I get convinced everyone is looking at the same stuff in different wrappers.  My first home purchase was located at the corner of Division and Clybourn in Chicago.  It was a very cool property with an incredible view of Chicago.  In fact, it probably had the best views of the city I’ve seen.

Why was I able afford it?  Because it had a massive downside.  The home was located near Cabrini Green.  See https://en.wikipedia.org/wiki/Cabrini%E2%80%93Green_Homes

I was betting on Cabrini Green coming down and the neighborhood drastically changing.  I figured even if I paid a little too much for the property the neighborhood would change so much that the price I paid would look like a bargain.

So why was this “investment” unsuccessful?  For starters, the global financial crises came and development completely stopped.  I probably should have known the housing market was phony when I could get a loan as a law student and provide no documentation.  But, at the time I wasn’t able to think the way I do now.  So let’s put the greater housing market in the “outside of my control bucket” for now.

More importantly, I was the dumb money.  I should have done more research to figure out whether the neighborhood changing was a realistic expectation.  Once I moved into the home I learned that my alderman and the alderman for the low income housing across the street were different people.  That means they were serving different masters. Therefore, they had different incentives.

Those incentives are massively important in a city like Chicago.  Alderman have a ton of power.  That was a fact that I could have known but didn’t even think to look into.

Which leads me to comment on the most important piece of advice Warren Buffett has ever given: create a too hard pile.  I am fairly confident in my ability to see a home in an existing neighborhood and determine whether that home is a reasonable value.  What I am not comfortable with is my ability to determine (1) which neighborhoods will gentrify and (2) the rate they will do so.  Therefore, an investment that requires gentrification by a certain date should be “too hard.”

For the longest time I thought Buffett said things were “too hard” when he couldn’t really understand them.  But, can’t Buffett understand almost any business concept?  Yes.  So how do 90% of the things he looks at end up in his “too hard” pile?  Because their success is too difficult to determine.

At the moment I believe the common stock of General Electric is incredibly cheap.  In fact, I think it’s quite possibly the deal of a lifetime.  Yet, Buffett isn’t buying.  Why? I believe there are issues within the entity he thinks are “too hard.”  I suspect he looks at some of the business lines and views turning them around in a similar vein to how I should have viewed the potential gentrification of my first neighborhood.

Remember, there is no requirement to play a game you don’t understand and/or want to get involved in.  No is a perfectly fine answer.  Get in the habit of saying this is “too hard.”  It will help your results over the long term.

 

The Evolution of a “Value” Investor

I have a tendency to need to make my own mistakes.  I wish I could learn from others more quickly, but it seems as though personal experience is my only reliable teacher.  So, it is with some hesitancy that I have to admit that only recently have I understood the growth investor’s mindset.

I initially got interested in investing when my grandmother’s friend, John Runnette, sent me The Intelligent Investor, The Battle for the Soul of Capitalism, and Common Sense on Mutual Funds.  Mr. Runnette must have had a sick sense of humor because 2 of those books are written by John Bogle, who founded Vanguard.  The other, written by Benjamin Graham, is the layman’s version of Warren Buffett’s bible.

My personal experience left me thinking there is no way markets are rational.  I lived through the 1999-2001 period and John sent me those books in 2009.  Thus, I was in the middle of watching the second gut wrenching crash in a decade.  Therefore, the idea of a market portfolio was inherently unacceptable to me because I “knew” that was a silly idea.  Surely, the “enterprising investor” as Graham described him/her could outperform those silly indexers.  Right?  Well, it turns out this is a very difficult game.

My dad likes to say “I knew all the answers and then the questions changed.”  That is how I am beginning to feel about investing.  That said, the fundamental tenant of viewing a stock as a part ownership interest in a business AND paying a reasonable price for that interest will never go away.  What I’ve learned over time, however, is the previous sentence is far more nuanced than it may appear.

What is a reasonable price to pay?  The answer to this question depends on a number of factors, but the most important components are whether the business (1) is growing or shrinking and (2) requires additional investment to grow or shrink?  Please see the post on The Importance of ROIC and Growth for more information.

A business that is both growing and doesn’t require additional investment should grow in value over time.  In fact, that growth is likely exponential assuming the ability to grow continues over time.  Therefore, you can pay a lot more for the existing business because the growth in value will probably bail you out.  In the long term, if you identify a company like this early enough in its lifecycle then its hard to see a scenario where you will lose much money (especially if you repeat this process a number of times).

I have made serious errors is investing in companies that are in decline but they are selling at “discounts” to my estimate of what they are currently worth.  The problem with these situations is the business value is eroding over time and the value can decline below your entry price.  While I believe there is merit to the strategy of buying these kind of companies (see Tobais Carlisle’s book Deep Value), I think the only suitable approach is through an ETF (the cost effective option; Toby is releasing the ETFs with ticker symbols ZIG and ZAG shortly) or very diversified portfolio.  This is because the stratefy depends on mean reversion and requires a large number of bets to work.  Any one “cheap” business losing its value can go to $0.

It took me a very long time to realize that cheap relative to today’s value is not the only definition of value investing.  Further, it took me a long time to realize that cheap relative to today’s value tends to realize investment results via an investment “rerating” or increasing in market value.  This creates a problem because there are many times those investments don’t have too much organic growth (though they can).  Therefore, when the investment increases to an investor’s estimate of its true value that investor needs to sell and find the next idea.  The downsides of that approach are the investor (1) pays capital gains and (2) has to find the next idea.

Therefore, an investor can find him/herself with too much cash relative to what they would prefer.  Having too much cash may not sound like a problem.  In practice, however, having cash can create the feeling of needing to deploy it.  That feeling has led me to make mistakes (this is a common problem).

All of this is to say that my approach is now to attempt to limit my investible universe to companies that have long growth paths in front of them and don’t require much incremental capital to grow.  I will always be attracted to “underpriced” situations but hope to spend much more time looking for great businesses that can grow and trade at reasonable prices.  Easier said than done…

Recommended Reading/Viewing:

100 to 1 in the Stock Market:  https://www.amazon.com/100-Stock-Market-Distinguished-Opportunities/dp/1626540292

Chuck Akre Talks At Google: https://www.youtube.com/watch?v=O38I7QIc_eQ

Deep Value: Why Activists and Other Contrarians Battle for Control of Losing Corporations https://www.amazon.com/Deep-Value-Investors-Contrarians-Corporations/dp/1118747968

Tobias Carlisle Talks at Google: https://www.youtube.com/watch?v=1r1vJZ80Z7I