What are some great sources of investment opportunity? Source include stock market correction or panic like a bull-to-bear market switch, industry recession, business calamity, war, or structural changes? The perfect buying situation is when a stock market correction or panic is coupled with an industry recession or an individual business calamity or structural changes or war.

   Recessions signal the start of great buying opportunities, for the value investor with spare cash available. Recovery time from a recession is generally anything between one to four years and during this time there are excellent buying opportunities. During recessions the manic-depressive Mr. Market goes into panic mode and out of fear offers to sell great companies often at single digit PEs. The true value investor understands that during a recession period everyone gets hurt, but the strong survive while the weak are removed from the economic landscape. Sticking to intrinsic value calculations and focusing on business fundamentals, while ignoring manic price fluctuations, allows the value investor to pick up fantastic businesses at bargain sale prices.

   Recessions are so important to the value investor we will discuss it further. George Soros, the famous macro investor, observed business boom-bust cycle markets so often during his career he formulated a graphical model of it and constructed his own market theory he called reflexivity. In his market theory he does not specify the cause of such boom-bust cycles, but he speculates that they always have a political element. Government economic intervention as the cause of business cycles has been extensively written about by various authors, including those from the Austrian School of economics. They write that an extra market force (in the case the central bank of a country) can initiate an artificial, or unsustainable, economic boom. They further write that a money-induced boom contains the seeds of its own destruction, i.e. the market upturn, must by the logic of market forces set in motion, be followed by a downturn.

   When markets, or the economy as a whole, are not performing optimally politicians can interpret this situation as a threat to their elected positions. If they do, they will often take corrective action to rectify the situation before it becomes a political issue during election time. One of the popular methods of stimulating economic activity is to increase the money supply. This expansion of the money supply leads to lower interest rates. In turn lower interest rates generally lead to an overconsumption in the market as well as lower discount rates (i.e. lower cost of debt thus lower weighted cost of capital). These lower discount rates in turn lead to increased business valuation calculations, or valuation inflation, and increased malinvestment to the valuation inflation.

   Over-consumption and lower cost of debt leads to increased revenues, allows businesses to expand, and leads to greater profits. This process can very easily lead to a speculative bubble, i.e. from price increases due to valuation increases, to increased investor enthusiasm, to increased demand, and hence further price increases. When a bubble starts forming, substitutes for business fundamentals start to justify the politically motivated economic boom. Therefore, as fundamental data no longer justifies the boom, market participants replace fundamental analysis with fundamental substitute analysis that will support the boom. These substitutes are always consistent with the perceived new economic conditions driving the boom (e.g. stocks are values at multiples of revenue, not earnings, and growth is funded by selling stock, not executing sound business plans). This leads to a situation where a substantial gap between market behaviour, or speculation, and fundamentals forms and widens.

   This ever widening gap however cannot continue indefinite and at some point the market has to correct, it has to abandon the substitutes and re-establish fundamentals. This does not happen however before the last marginal investors in the market buy in. As the old saying goes: what the wise man does in the beginning, the fool does in the end. This final marginal buying further fuels the gap and is the boom’s final push. At this point the politicians have to cool down the market bubble in order to avoid a market crash. Interest rates are raised to reduce consumption and increase discount rates, which causes valuations to decline and malinvestment to halt.

   Now the actual fundamentals start to decline as a result of lack of buying and together with rising interest rates the fundamental substitute’s starts to deteriorate. This deterioration starts the investment liquidation cycle and marginal short selling. This market behaviour feeds off itself resulting in mass selling. This triggers investors to take a so called flight to quality that involves liquidating perceived risky investments in favour of government securities or precious metals to preserve the balance of their portfolios. This process typically continues until the true fundamentals decline below pre-bubble levels. As Warren Buffett says: a pin lies and wait for every bubble, and when the two eventually meet, a new wave of investors learn some very old lessons.

   At this point malinvestments are liquidated and recovery of the market can begin. Fundamentals and market conditions reconcile again and economic growth can again begin. There is however the chance of recession or depression, based on the severity of the crash. Therefore, often this phase is met with a new wave of government intervention in order to shorten the duration of the correction cycle and fuel economic growth.

   The second of our ideal buying opportunities is linked to business calamity. Sometimes great companies make mistakes which cause them to lose money. This creates concern in the market and their share price reflects this by declining sharply. This in turn represents a great contrarian buying opportunity. The value investor has to determine whether this is a passing calamity or irreversible damage. A company with an identifiable competitive advantage almost always has the financial durability to survive calamity. Deciding whether the calamity is correctable is important. Even more important is whether the calamity affect’s the competitive advantage of the company, in which case the investor should not consider investing. Often just one division of a company suffers a calamity, but affects the entire company. If the investor believes that management can fix the calamity or that the other divisions, with the competitive advantage, can save the company then the investor should consider investing if the price is right.

   The final opportunities arise with structural changes and world events like war. Structural changes in a company, like mergers, restructuring, and reorganizations, can often affect earnings negatively and thus negatively affect the share price thereby creating buying opportunities. War, or the threat thereof, will send stock prices tumbling. The uncertainty and great potential for disaster will send fear through the entire market triggering a mass sell-off and a hoarding of cash and safe commodities like gold. This in turn disrupts the entire economy and creates great buying opportunities for the value investor who can determine which companies will recover from the ones that won’t.


Be extraordinary!
Myles Rennie

Contrary to popular management belief, there are only a few types of competitive advantage. Examples of sustained competitive advantage are rare to say the least. The simplest form of advantage is created by government when it grants a license to one or more companies to engage in some kind of business with potential entrants deterred by law. Other forms of competitive advantage stem from the basic profit equation: revenue less costs equals profit. This equation highlights two key elements to profits, namely costs and revenue. Some companies have a cost or supply advantage and some a revenue or demand advantage.

   Cost or supply advantages are only sustainable if the company possesses production techniques or products that other companies or new entrants cannot match. These could include patents, or specialized know-how (known as a downward sloping learning curve), or access to cheap resources like labour or capital. Note that technology could create a cost disadvantage, i.e. where a newcomer sets up with the latest technology, and erode any incumbent advantage.

   Customer demand advantages happen when a company has access to customers that a potential entrant or existing competitor cannot match. For the competitive advantage to persist, customers must in some way be captive to these companies, and there is a limited number of ways this can happen. Habit is the most powerful of these. High search costs, i.e. the costs in searching for an alternative supplier, is another advantage and generally apply in local situations with local companies or companies with comprehensive product ranges and great customer satisfaction ratings. The final demand advantage is companies that have products with high switching costs like the case with banks and complex systems, e.g. computer systems. This advantage relies on the time, money and effort required to switch from one supplier to another.

   The final, and generally most durable competitive advantage, is a combination of economies of scale (on the supply side, with high fixed costs relative to variable costs and stable unit variable costs) with some form of demand advantage. In order for economies of scale to constitute an advantage the demand advantage must provide the company with a dominant share of the market. The demand advantage can be small and still matter. Even with only a minor demand advantage, economies of scale will translate a slightly superior market share into lower costs, higher margins, and higher profitability, while attracting a larger share of newcomers into the market. A company with economies of scale, but without a demand advantage, should fiercely protect its markets share. Once its market share starts to erode, the underlying cost advantage shrinks with it. Economies of scale are often linked to companies with a disproportionately large regional market dominance or product-line dominance. When these companies spread across other regions or other products the economies of scale advantages often shrink or disappear eroding its competitive advantage.

   Another marker to look for in identifying companies with a competitive advantage is price increases. Companies with a competitive advantage have the ability to raise prices aggressively and often. Whether a supply, demand, or patent advantage, the strategy is to reinforce the advantage while making full use of pricing opportunities.

   Reproducibility is another factor that differentiates economies of scale as a competitive advantage. This is based on superior production systems, but lasts only as long as the underlying technology does (which is at most a couple of years). The same thing happens with captive customers, they eventually disappear over time. Consumer franchises that are sustainable over decades must have a competitive advantage in recruiting new customers as well as retaining existing ones (i.e. very high demand preferences like Coca-Cola) combined with economics of scale.

   An identifiable and structural durable competitive advantage only exists where a company benefits from barriers to entry that keep out potential competitors or insure that if they choose to enter, they will operate at a competitive disadvantage relative to the company. Successful value investors remain within their circle of competence, where their knowledge of markets, industry, and companies, allows them to identify with certainty competitive advantage. If not these investors are just more punters, taking fliers rather than making investments.


Be extraordinary!
Myles Rennie

Benjamin Graham's favorite allegory was that of Mr. Market. He said that Mr. Market turns up every day at our door offering to buy or sell his shares at a different price. Often, the price quoted by Mr. Market seems plausible, but often it is ridiculous. We are free to either agree with his quoted price and trade with him, or to ignore him completely. Mr. Market doesn't mind this, and will be back tomorrow to quote another price. The point is that we are better off not being concerned with Mr. Market’s often irrational behavior except when we can benefit from it.

   If Benjamin Graham is right, if market prices are frequently nonsensical, then we would be foolish to use price as a sole indicator of performance. Although this is true, the majority of the investment industry is focused only on price. If prices go up, most investors assume something good is happening, and if prices go down they assume something bad is happening. I prefer not to base my actions on the ups and downs of market prices.

   This problem is compounded by the foolish habit of evaluating price performance over very short time periods. Not only do most investors depend on the wrong thing, i.e. price, they also look at it too often. I believe this price based, short term mentality is a flawed way of thinking. I don’t check stock quotes every day and I don’t buy and sell at the snap of a finger.

   I do not want to participate in the senseless short term game of chasing performance, measured totally by price. There is considerable pressure on portfolio managers to generate short term performance numbers. These numbers attract a lot of attention and are praised by financial reporters. This fixation on short term price performance attracts a lot of new deposits into the top performing funds. I do not believe that focusing on short term performance is sustainable. Shareholder wealth in businesses is created over time and therefore I expect my investments in great businesses to follow this trend. I believe that any other approach all but guarantees underperformance. Warren Buffett states that we have to drop our insistence on price as the only measuring stick, and we have to break ourselves of the counterproductive habit of making short term judgements.

   My approach opens itself up to short term underperformance. Shahan showed that investors focusing on short term performance will inevitably achieve it, but at the expense of long term results. I accept that in order to achieve long term results I have to be indifferent to short term performance. Examining portfolios managed by Buffett, Munger, Ruane, Simpson and Keynes shows that on average their portfolios underperformed the S&P500 26% of the time during the lifetime of the fund. Munger and Ruane’s portfolios respectively underperformed the market 36% and 37% of the time, with Carlie Munger trailing the market by 37 percentage points at one time. These superinvestors all experienced trailing performance at one time or another, some having to endure years of trailing the market.

   I therefore know I could be trailing the market for some periods of time. If I know that price is not a good measure of performance I have to define an alternative. Here I follow Warren Buffett’s lead. Just like Buffett I believe that my economic fate will be determined by the economic fate of the businesses I own. I believe that shareholder value and operating results are the correct measures of performance. I let the economics of the business dictate whether I am increasing or decreasing the value of my holdings. I believe, like Buffett, that the market will at times ignore business success, but eventually confirm it.

   In conclusion, I believe there is a strong correlation between the operating earnings of a company and its future share price, given the appropriate time horizon. In other words, the longer the time period, the stronger the correlation. Warren Buffett says that a strong business will eventually command a strong price. He does caution that the translation of earnings into share price is both uneven and unpredictable. Benjamin Graham gave the same advice saying that in the short run the market is a voting machine but in the long run it is a weighing machine.

   My investment horizon is measured in years and I am in no hurry to affirm what I already know is true. What is important to me is that the intrinsic value of my investments is increasing at a satisfactory rate.

Be extraordinary!
Myles Rennie

Both value investing and focus investing aim to keep portfolio turnover very low. The turnover ratio describes the amount of activity in a portfolio. For example, if a portfolio manager sells and re-buys all the stocks in the portfolio once a year, or half the portfolio twice, the turnover ratio is 100 percent. Sell and re-buy everything twice a year, and you have 200 percent turnover.
   My investment philosophy includes a simple principle: once a stock has been properly selected and has proven itself, it is only occasionally that there is any reason for selling it at all. Therefore, I prefer a low turnover approach to investing. This approach has two additional benefits:
  1.      It works to reduce transaction costs
  2.      It increases after-tax returns

   On the average mutual funds generate between 100 percent and 200 percent turnover ratios per year. Studies have shown that funds with low turnover ratios outperform funds with high turnover ratios by as much as 14 percent over a 10 year period. The bottom line is every time you trade it costs money, i.e. add brokerage costs, which works to lower your net returns.

   Another important economic advantage of low turnover funds is the postponing of capital gains tax. The more you turn the more you increase your tax liability. Every time a stock is sold, and a capital gain is realized, the capital gains tax is incurred. Therefore, not only does any new stock purchased have to outperform the stock it replaced, it has the anchor of outperforming the capital gains tax associated with the stock it replaced as well. Few investors realize this, but taxes are often the biggest expense that they face.

   When a stock appreciates in price and is not sold the increase in value is unrealized gain. No capital gains tax is owed until the stock is sold. I prefer to leave the gain in place, allowing my investments to compound more forcefully. Warren Buffett calls this “an interest-free loan from the Treasury.” Interestingly, but counter intuitive, is that the greatest tax damage to a portfolio occurs at the outset of turnover and then diminishes as turnover increases. A study by Jeffrey-Arnott showed that, at a 25 percent turnover ratio, the portfolio incurs 80 percent of the taxes that would be generated by a portfolio turnover ratio of 100 percent. Therefore, I am mindful of my turnover ratio even though it’s in the low range. My target turnover ratio is somewhere between zero and 20 percent. 

Be extraordinary!
Myles Rennie

There are good reasons to exit an investment position. The best reason to liquidate a position is when someone wants to buy a home, pay school fees, etc. These personal reasons to sell stocks are all reasonable and not considered here. Liquidation of an investment position, as far as I am concerned, is only motivated by a single objective – to obtain the greatest total RAND benefit from the investment capital available.

   I believe there are three reasons for the sale of a common stock. These reasons are purely financial and never personal. The first reason is obvious. This is when a mistake has been made in the original investment and it becomes increasingly clear that the factual information, i.e. simplicity of the business, durability of competitive advantage, quality of management, and good economic position, of the investment is, by a significant margin, less favorable than originally believed. Managing these situations requires self-control and the acknowledgement of your mistake.

   The second reason to sell a stock is when, over time, the underlying company changes and no longer qualifies in regards to my investment criteria set out in valuation of a common stock to about the same degree it qualified at the time of purchase. For this reason it is important for me to keep close contact, and up to date, on all the activities of all my investments all the time.

   The final reason to sell a stock seldom arises and will be acted upon only when I am very sure of my facts. I don’t time the market, I price the market. Therefore, in order to exchange one position for another the new position should present similar or better business simplicity characteristics, an equal durable competitive advantage, and similar quality of management as the existing investment. It further has to present better price to intrinsic value economics, as well as better growth prospects, than the current investment. Only if these factors are all applicable and in favour of the new investment, including the effect of capital gains tax on the investment returns, will one position be sold to enter a new position.

   Good investment opportunities are rare and there is always the risk that the new opportunity has been misjudged. Therefore, before selling a good holding in order to get a still better one, the greatest care will be taken in trying to evaluate all elements of the situation. In closing, my investment philosophy includes a simple principle. This is that once a stock has been properly selected and has proven itself, it is only occasionally that there is any reason for selling it at all.

Be extraordinary!
Myles Rennie

My investment philosophy starts with a very simple statement “I invest, I don’t speculate”. The difference can be considered subjective, but I see a clear distinction between investment and speculation. Firstly, an investment approach relies on a well understood, analytic philosophy designed to deliver superior investment returns over time. Speculation on the other hand relies on spotting trends, taking chances, and does not consider capital protection. My investment approach looks to find businesses that are easy to understand, have a durable competitive advantage, have high quality management with a lot of integrity and energy, and finally sells at a price that is below its intrinsic value. From this it is clear that my investments returns are not based on chance, it is based on a fundamental analysis of both the balance sheet and the earnings power of the underlying asset. I look toward these valuations to justify the price I pay for owning a share of the asset.

   I do not look at share prices every day or every week. I invest based on business fundamentals. The business fundamentals of a solid business do not change on a daily or weekly basis. Therefore, if I considered a company good enough to invest in yesterday, I am pretty confident that company will still be good enough today and tomorrow. Most people however look to the market to guide them when making investment decisions. When I, on the other hand, consider investments I ignore the market completely because I believe the market to be manic depressive, behave irrationally, and be driven by the human emotions of fear and greed. Therefore, I choose not to use the market to instruct or guide me, I choose to use the market to serve me. I prefer to take advantage of the ups and downs of the market, to my advantage, rather than the market taking advantage of me.

   My investment approach is a combination of value investing and focus investing.

Be extraordinary!
Myles Rennie