Introduction
For
the week that ended Friday one could focus on short-term price movements or
long-term investment thinking. As my week evolved I did both, which produced
positive, but disjointed conclusions.
Short-Term
Price Actions
On
Thursday prices fell supposedly in reaction to political events. As an analyst
and portfolio manager trained in the school of contrarianism, I saw the reason
for the decline differently. For some time I have been aware and have commented
on the price gaps in the performance of the three main individual security
price indices; Dow Jones Industrial Average, Standard & Poor's 500, and the
NASDAQ composite. In each case the index had two days when prices
through the day were measurably higher than the high price achieved the day
before. This price gap phenomenon rarely happens and most of the time a
subsequent price action fills the gap before the market resumes its prior
trend. In earlier blogs I had warned about this probability. Further, I quoted
a knowledgeable market analyst who was expecting a 5% correction.
On
Thursday the two price gaps in the two senior indices, DJIA and S&P 500
closed both gaps. By far the strongest index this year, the NASDAQ closed one.
I would expect in the fullness of time the remaining price gap will be closed.
Historically when the bulk of traders focus on the political issues of the day (in
contrast to the financial inputs) their emotions are a bad guide to future
investment price performance.
A less followed sign is the Confidence Index published by Barron's each week. The index focuses on the difference in yields between the highest corporate bonds and those of intermediate quality. In the week ending Friday,
compared to the prior week, high quality bonds yielded 3.22%, down 17 basis
points whereas the intermediate credits yielded 4.27%, down only 13 basis
points. This suggests that in the week high quality bonds were considered
better value than the higher yielding intermediates. Often this is considered a
bearish sign for equities as bond buyers are opting for lower risk securities.
In
assessing the value of these two observations it is important to understand
that the judgments expressed are based on a feeling for the historical odds and
not certainties. As noted in my earlier blog posts there are no pure laws of
economics that guaranty the same level of certainty as found in physics. One
should assign perhaps a 90% certainty to your favorite economic laws. Most so
called "investment laws" would be considered successful if they were
correct 70% of the time. Using a technique I learned at the racetrack, I multiply these ratios
(0.9 x 0.7 = 0.63). This suggests to me that I would be happy if my analysis
was correct 63% of the time. I can improve my dollar return by weighting some
decisions compared to others.
General
Sun Tzu
Other
than the Bible no other text has been used more to teach the military than Sun
Tzu's "The Art of War. Considering the importance that we are
putting on the rapid progress of China it is very wise for us to remain
conversant with China's greatest military scholar. Friday I was refreshed in my
knowledge of the general's thoughts when good friends of mine who are life long
investment experts on Asian investing gave me a book by Jessica Hagy, The
Art of War Visualized: The Sun Tzu Classic in Charts and Graphs.
Since
in many ways competitive investing follows the equivalent precepts as
successful military warriors, I am going to apply the same principles to
investing. There are five particular strategies that the General recommended.
1. Victory can be achieved through measurement,
estimation, calculation and balancing
chances. (In investing it is important to measure accurately what is there and
even more important what is not there; e.g., BREXIT and the Republican swing,
as well as incomplete financial statements.) These are some of the times when
good estimates are critical which makes it essential to know how much reliance to place
on calculations of the future. In discussing the short-term data above I
showed one possible way to calculate different levels of uncertainties. All of
these and other factors need to be weighed in conjunction to determine whether
the odds of success are sufficiently high to undertake the risk to achieve
victory.)
2. Always be prepared to attack and always be
prepared to defend. (Opportunities will always occur without warning.) A good
investor must be able to quickly shift to an aggressive mode and just as
quickly shift into defense. Most investors have too little in the way of reserves
to dramatically "juice" returns, particularly if they are reluctant
to sell or reduce less favorable positions in the new opportunity context. In
terms of defense we all need to part with some of our least loved positions
regardless of tax implications.
3. There are dangers to be avoided:
recklessness, cowardice, hasty temper, and rich appetites. (Many will find it
difficult to react wisely to the
opportunities due the dangers listed. As is often the case we can be our own
worst enemy. The General called for sound discipline at all times.)
4. Do not feel safe and be a good generalist full
of caution. (Quite possibly the biggest
risk to our wealth is a feeling that we are safe. We are not on the outlook for
possible problems, most of which won't materialize, but some or one can be like
a hole below our boat's waterline. This can be caused by our bad navigation or an
enemy torpedo, Perhaps at least mentally we should practice fire drills as well
as abandon ship actions.
5. An experienced General is never bewildered. Once
some level of activity is commenced it is easier to accelerate or decelerate
than to start to move from a standing stop. I am a believer, at times, of making
partial commitments and at other times full actions. Often the key to an
investment decision is not the action itself but how it positions a person or
portfolio for subsequent steps.
How Sun Tzu Might Have Viewed the Actions of Berkshire Hathaway
and Sequoia Fund Through Alphabet, Amazon and
Apple
One is
always at risk of misinterpreting or over simplifying by abbreviating some
of The General's thinking. For this
exercise I am only going to
focus on his first step to victory through calculation and his fourth,
balancing chances. Almost all of the named securities (Alphabet, Amazon, and Apple) are owned by me or close relatives.
However, the purpose of the ensuing observations are not meant to be taken as
any form of recommendation. For those who are interested in converting the
observations into actions, I will be happy to discuss my views tied to your
specific needs, “off line.”
Berkshire
and Sequoia share the same source of inspiration, Warren Buffett. Not
surprising over the years they have owned some of the same stocks derived from
their own work. The three highlighted stocks were recently discussed in
investor meetings. The reason to focus on these three specific stocks is that
it revealed their thinking.
Alphabet,
the parent company of Google, was well known to both. Mr. Buffett’s view is one that was under its nose as it was
extensively used by Berkshire’s subsidiary GEICO. It was just not in its
universe, which is strange as GEICO is so advertising-centric (both they and I
owned Interpublic one of the largest global advertising complexes recovering
from very poor results). As it wasm't looking at Google, it was not in the
calculation. This is similar to those who were following the polls prior to the
BREXIT and Trump votes in analyzing data, perhaps the most important task is
identifying what is not there.
To some degree Sequoia
also had a calculation failure. Sequoia quickly grasped the advertising power
that the Google search engine produced. However, it needed a
"kicker" to be added to its calculation. The kicker was
"AI" or artificial intelligence. Sequoia believes that Alphabet is
"by far" the leader in AI, which it may be. My problem is that the current level of earnings from AI products or augmented services has not
been revealed. In this particular case the lack of numbers on the AI effort was
probably a factor in its balancing of chances.
Amazon is another
example where the two intrinsic value investors disagreed. Because of
Berkshire's operating experience it had some doubts that Jeff Bezos could
succeed in the highly competitive distribution business. If he could succeed, it doubted that the same mentality that could build a highly successful
distribution business could aptly handle the technologically challenging task of developing a
commercial cloud business. I suggest that the financial analysts in Berkshire
focused on the financials which showed robust revenue growth and marginal
reported profits. Sequoia saw that the financial statement hid the internal
process of taking substantial operating profits and reinvesting them into the
cloud. Further, Sequoia probably saw that the keys to the success of Amazon's
distribution business were based on highly automated warehouses and tightly
controlled transportation. However, Sequoia like many of us, were captured by its collective experience. Bill
Ruane the founder along with Rick Cunniff often focused on buying stocks
"at the right price" and thus they did not buy as much as they should
have as the price of Amazon went up.
Apple is another
example where these two investment groups came to different conclusions based
on their research methodologies. Sequoia in calling on Apple's management,
could not get them to speculate what handset sales would be three years in the
future, so they passed. Again the words of its founder were a hurdle. Bill
said that they understood potato chips not computer chips. Berkshire only recently viewed Apple as a consumer not a
technology company. They focused on both the "eco-system " that Apple
was growing and the potential use of its technology and related skills in
substantially new product categories not yet on the market. Interesting that
both Berkshire and Sequoia want to invest in companies that have competitive
advantages, which is often translated into unique products or services. Sequoia
will sacrifice future growth for competitive advantage. Berkshire under Charlie
Munger's prodding is more attracted to growth at a fair price. Apple effectively used the General's formula of balancing chances.
Bottom Line
As with all
"school solutions" there is no guaranty of success. While the odds
improve with a well thought out plan, nothing beats good execution. Thus, when
we pick mutual fund and separate account managers we pay attention to both
their investment philosophy and their history of good executions. More often
than not good executions are the results of front line troops. That is the
lesson that I learned as a US Marine Officer where it was my job to develop a
plan of action and inform my senior non-commissioned officers of the plan and
the logistics, communication, and heavy arms support, but let them carry out the
mission as they saw how to do it. The same principle works at the racetrack.
While I did not see the running of the Preakness the two horses that were
leading coming into the homestretch had a good plan, but a third horse had a
better execution and thus won the race.
As you can see I am
always learning and hope to do so all of my intellectual life.
What are the sources of
what you have been learning recently?
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A. Michael Lipper, CFA
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