Joel Greenblatt Investment mistake.

Many good investors have always encouraged the use of an investment checklist to prevent or reduce investment mistakes made. The checklist can be compiled by analysing good investors past mistakes.(There are bounds to be mistakes).

I recently read a case study on Joel GreenBlatt most disastrous mistake written by J Allen Capital Management, the mistake on Key3Media was thoroughly analysed by them and it deserves a spot in all investor checklist. http://jallencapitalmanagement.com/posts/Joel-Greenblatt-Key3Media-Case-Study.html. From that article, we can see what leads him to buy the company and what was the eventual outcome.

Lessons of the story are high operating leverage,  economically sensitive industries and a material amount of debt.

Take note of companies that have a few customers that have high margins and make up the bulks of your revenue. This can result in high customer concentration risk.(Even worse, if those customers themselves are not doing too well).

                                                                                                                                                                                                                                                        

Beware of companies that are in economically sensitive industries that have experience a recent boom ( Technology industry in 2000, housing industry in 2006-2008 and the most recent boom can be seen in the oil industry). The underlying financials been analysed are overstated because of the recent boom. Reversion to the mean will occur eventually. In fact , this is one of the mistake made by Berkshire when investing in Cort Furniture during the technology boom.

Lastly, be wary of companies that scoop up high debts during the boom industry to fuel growth.

Well each factor alone can be quite dangerous but a combination of the above can be a recipe for losing a lot of money. During the boom, you could grow your profit without increasing your operating expenses, however during the downturn, your revenue and profits could vanish but your expenses remains unchanged.  As Joel Greenblatt mentioned, ”The tremendous operating leverage benefited from in good times was a double edge sword in bad times.” The revenue vanished will impact the net profit directly.

Buffet's Nuggets

The best businesses are those “you buy once” and then no longer need to invest further capital, Mr. Buffett says. That’s one reason real estate is a good investment in periods of higher inflation. A brand is a “wonderful thing” to own in inflationary periods, he says, referencing Berkshire-owned See’s. The value of the brand rises when inflation kicks in, he says.

Utilities and railroads, which of course are major Berkshire operations, require investments that rise in cost when inflation strikes. 

The best businesses are those “you buy once” and then no longer need to invest further capital, Mr. Buffett says. That’s one reason real estate is a good investment in periods of higher inflation. A brand is a “wonderful thing” to own in inflationary periods, he says, referencing Berkshire-owned See’s. The value of the brand rises when inflation kicks in, he says.

Utilities and railroads, which of course are major Berkshire operations, require investments that rise in cost when inflation strikes. 

Key takeaways from Jamie Dimon’s Shareholder letter 2014

The banking system is a lot less risky compared previously

·         Higher capital level compared previously for most of the banks.

·         Highly liquid assets held by the banks

·         Not many complex and exotic products around

·         Higher underwriting standards

·         Many standardized derivatives are moving to the clearing houses.

Future threats to the banking industry will include

·         Ambitious large Chinese banks which has the scale and the strategic reason to compete and yet do not need to live by the same US rules that apply to the large US banks.

·         Silicon Valley companies such as lending club who is able to connect lenders and borrowers quickly.

·         Competitors in the payments industry such as Paypal and Bitcoin.

·         Cyber Security Threat.

Key changes to the banking industry

Non-bank competitors have become bigger lenders in the marketplace.

There is far less liquidity in the marketplace because of regulatory requirement resulting in low inventories of securities.

In the event of a crisis, banks are reluctant to extend credit because it utilize precious capital and in addition to the low liquidity in the market, hence the market in general could lead to increase volatility.

Investing takeway

One of the mental model to take note which is brought up by Monish Prabai.

Pay special attention to a lousy industry when it starts to undergo a period of consolidation. You will be able to see margin increases, higher pricing power etc and the overall industry doing better as a whole.

We have seen it happen in the railroads industry , the airlines industry and the SD ram industry, The common  factor will be these industries are highly capital intensive.

However, is barriers to entry required prevent further entrants from entering the industry?, For example, in the railroad case clearly there are certain barrier of entry but for the airlines and SD ram industry less so ( With sufficient capital. anyone can buy plants or planes). 

Guy spier

The sequence of research should be from the least biased point of view , The legal materials(the 10Ks, 10Q), follow by the management conference calls and lastly, the opinion of forums.

Tech industry musing

I had some thoughts after reading on Steve job biography.

Go back to some history of the tech industry. Back then, IBM was the hero making Main frame computers. As it get bigger and richer, it also got sloppy, It was the first company that came out with Xerography but the management then could not recognise it potential  That idea was taken and use by a nobody which eventually became Xerox and IBM also became bankrupt in the 90s.

Xerox too also became bigger and richer.  Success too spoilt Xerox. They were also the first company that came out with some graphical interface which is an idea 5 years ahead of its time or something however their management failed to recognize its potential and cast it aside as some lousy project. However, its potential was not lost on Steve jobs and Bill gates which capitalise on the idea and when on to create what is known as the Window OS.And we also know what happen to Xerox eventually.

All these big companies were the intial guys to come out with the next best thing. but they fail to take risk, reinventing themselves, their status quo bias and had their best ideas snatch out right from their nose.

Good management is off paramount importance in a tech coy.

Well HP started off been an instrument company, turn into calculator company and than a computer,printers company.

Key things to take note when investing in tech coys, firstly to be able to detect industry shifts, secondly ensure that the management guys are not bozos.

Apple musing.

Steve jobs always believe in end to end control of the product. All the way from the design, make their own software, hardware and their own stores to deliver the products. The culture is to have the designers, engineers and marketeers collaborate together which is different from the rest of the other tech coys. It seems that this culture promote innovations and reduce bureaucracy. 

Key Takeaways

On growth.

Earnings growth happens three ways and they are of vastly different quality. The best kind of growth is organic top line unit growth. Companies that grow by doing more of whatever they do are the most valuable. Investors, can, should and do pay up for this kind of growth.

The next best type of growth is through margin expansion. Margin expansion is good. It rarely requires additional capital. Whether it comes from pricing power, economies of scale or cost cutting it is nice. The problem with margin expansion versus, unit growth, is it isn’t open ended. Most businesses can only improve margins to a certain extent. Eventually, they can’t push price, they operate at optimal scale and there is no fat left

The third way, and least valuable, to create earnings growth is by leveraging the balance sheet. Sometimes this passes as top line growth through acquisitions or excess capital investment. Sometimes it comes from leveraged recapitalizations through one means or another or incrementally over time through share repurchases. However achieved, this form of earnings growth is least valuable. Not only is it inherently unsustainable – the growth rate, not the earnings – in that companies can only leverage to a certain degree, but such growth should be rewarded with a shrinking p/e multiple as the risk to the enterprise grows and the cost of equity correspondingly should increase.

It is true that sometimes the market doesn’t recognize the distinction and rewards this growth with an undeserved rich multiple. However, that is a difference between what the market should do versus what it does do. Smart investors can make the distinction and avoid paying up for situations like these where higher growth comes with higher risk.

On Health care companies. Key checklists to take note

• Does the company deliver better quality care than someone can get anywhere else?
• Does the company deliver a net savings to the overall health care system?
• Does the business produce high returns on capital, have growth potential, and have shareholder friendly management?

On the 3 types of businesses

Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag

Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and 

continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all. 

But if a business requires a superstar to produce great results, the business itself cannot be deemed great. 

(A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can’t name its CEO.) 

Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no 

rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly 

great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large 

portion of their earnings internally at high rates of return. 

 Let’s look at the prototype of a dream business, our own See’s Candy. The boxed-chocolates 

industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn’t grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last forty years. Indeed, I believe that See’s, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry’s earnings. 

 We bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million.  Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories. 

 

Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. 

In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire 

 There aren’t many See’s in Corporate America. Typically, companies that increase their earnings from $5 million to $82 million require, say, $400 million or so of capital investment to finance their growth. That’s because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments. 

 A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is, to follow through on our example, nothing shabby about earning $82 million pre-tax on $400 million of net tangible assets. But that equation for the owner is vastly different from the See’s situation. It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google. 

 One example of good, but far from sensational, business economics is our own FlightSafety. This company delivers benefits to its customers that are the equal of those delivered by any business that I know of. It also possesses a durable competitive advantage: Going to any other flight-training provider than the best is like taking the low bid on a surgical procedure. 

Nevertheless, this business requires a significant reinvestment of earnings if it is to grow.

When we purchased FlightSafety in 1996, its pre-tax operating earnings were $111 million, and its net investment in fixed assets was $570 million. Since our purchase, depreciation charges have totaled $923 million. But capital expenditures have totaled $1.635 billion, most of that for simulators to match the new airplane models that are constantly being introduced. (A simulator can cost us more than $12 million, and we have 273 of them.)

 

Our fixed assets, after depreciation, now amount to $1.079 billion. Pre-tax operating earnings in 2007 were $270 million, a gain of $159 million since 1996. That gain gave us a good, but far from See’s-like, return on our incremental investment of $509 million. 

 Consequently, if measured only by economic returns, FlightSafety is an excellent but not 

extraordinary business. Its put-up-more-to-earn-more experience is that faced by most corporations. For example, our large investment in regulated utilities falls squarely in this category. We will earn considerably more money in this business ten years from now, but we will invest many billions to make it. 

 Now let’s move to the gruesome. The worst sort of business is one that grows rapidly, requires 

significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. 

 The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it.