PT.II: How do I find the right companies and the wisdom of the Oracle?

Alright, for some of you the last bit of the title tells you a lot about my personal philosophy and mentors. For those who don’t recognize the title, it is referring to Warren Buffett, the Oracle of Omaha and one of the most accomplished investors living today. You say, well that’s great, but the dude’s a billionaire and I’m not so how does anything he does have meaning for me as I try to find a way to take control of my financial life and build a nest egg. I’m going to tell you. Warren Buffett was not always a billionaire, in fact he worked from the time he was a very young man in a number of different jobs to make money, which he invested in the market as soon as he could.

Warren would do some interesting things, like buy a six pack of coke and resell each individual bottle for a $.05 profit, he delivered papers, rented pinball machines and even created his own handicapping newsletter at the horse races. Warren took his money and invested in the market, maybe not with great results the first time around, but he also hung around the offices of the stock brokers and picked up as much knowledge as he could. Now, am I telling you to go hang out at Charles Schwab or Edward Jones and stare at computer screens? No, they would likely ask you to leave. However, if we read, study and follow successful investors we might just be able to figure out some method to their madness.

Warren Buffett is often considered what is called a Value Investor which was a school of investing created by his mentor and professor at Columbia Benjamin Graham. Ben Graham’s legacy in the investing world is still felt today as two books that he authored, Security Analysis and the Intelligent Investor are considered to be revolutionary and are still required reading in many business schools. Warren calls the Intelligent Investor the greatest book ever written on investing and if you are going to choose one of the two to read, then that is the one. Security Analysis IS important, but it’s a text book so maybe not the ideal place to start. Warren would not characterize himself as a Value Investor in the spirit of Graham so much though, he doesn’t define his style, but it has taken on the popular label of Deep Value Investor.

You may ask, well what the heck is the difference between Value and Deep Value. The crux of the distinction is this, Value Investing was built for the Great Depression, where Ben Graham would pick out companies that were trading for less than the sum of their cash and sellable property (physical items that could be sold), with the idea that if the company were to fold tomorrow he would still be able to make a profit from the sale of it. Ben would also buy 100-200 of these at a time to account for truly dead dud companies, but would still profit overall. This is Value Investing and Warren did do this for a time, but about the time he met his best friend Charlie Munger, who also was an Omaha native he took on a different perspective. Charlie told him, “It’s better to buy a wonderful company at a great price, than a great company at a wonderful price.” It may seem to be semantics, but again their is a distinction. A great company may or may not survive and prosper, and if you buy it at a wonderful price you may still make some money if it fails. A wonderful company is one that you are almost sure will succeed for reasons I will go over later, so even if you only get a great price for it, you are comforted by the fact that it will continue to prosper and bring you money over the long term. This is Deep Value investing, finding truly wonderful companies at great prices.

The question most people then ask me is well how will I know if it’s a great price. This is where I have to not take credit for the ideas, because I learned the distinctions and how to find whether it is a great company and a great price from my guru, Phil Town. He is an author, motivational speaker and hedge fund manager who teaches a style of investing called Rule #1 Investing. This name is taken from a quote by Warren Buffett that there are two rules of investing, “Rule #1 is don’t lose money. Rule #2 is don’t forget Rule #1.” It sounds tongue in cheek and may have been meant that way, but there is a simple genius to it. If you only pick companies that are wonderful and pay a great price for them, you are at best nearly certain to not lose money.

Why is it more important to not lose money than to try and gain money? Simply put, we are dealing with laws of compounding again. If you invest in a company that loses it’s value in the market by 50%, you now need the stock to rise by 100% to break even, much less start gaining money. If you look at the inverse method of choosing wonderful companies which you can buy at a price below their value, your chances of losing money and having a long fight back to start are far less. Which brings us to Charlie Munger’s four rules for choosing a great company. I will only be able to gloss over them because they are simple statements that require complex explanations for the average person, me included. This is where I will direct you to Phil Town and his daughter Danielle’s podcast, Invested the podcast, where they go into these principles in great detail and will do a better job than I ever could of breaking down the statements. It can be found on most major listening platforms, I use Spotify for it, and it’s free to listen to all of the episodes.

The greatest part of the podcast is that it is meant for beginners, Danielle starts from a place of little to no knowledge of the stock market and her dad is a freaking professional financier! She however keeps him from running past elements that are not common knowledge to the lay person as he explains. They go into detail with a lot of her questions providing the clarification I needed to start my investing journey. I learned so much about valuing and finding great companies from their work that I credit my success to them and Phil credits Warren and Charlie as well as other investors of this same cloth such as Guy Spiers, Bill Ackman, Mohnish Pabrai and others. If you were to just learn from these investors you would be set up well, however Phil does a great job of explaining the ideas and Danielle even wrote a book called Invested about her experience learning from her dad on the podcast. It’s a great read that I also recommend.

All of that aside, let’s look at Charlie Munger’s 4 principles of investing. These are from an interview given to the BBC in which he said, “It must be a business you are capable of understanding” which simply means, can you figure out everything about how that business works and not just blindly throw money at a company because someone on the TV throws out the name. A great example might be McDonalds, do you understand a company that makes and sells burgers? Probably can, however if I were to ask you to explain the revenue streams, margins and overhead of Google, you’d probably be a little less sure. We need to invest in things we are capable of understanding, because people who are knowledgeable and informed are harder to fool.

Charlie then tells us, “It must be a business with some intrinsic characteristics that give it a durable competitive advantage”, this is commonly known on Wall Street as a MOAT. We want to invest in companies that are going to be around for a long time, not a flash in the pan. We want companies that have some reason people choose to go to them over their competitors, that is where MOATs come in. I won’t go over all of the various types but will mention three that are very common and easy to understand. First is brand, if I say tractors the likely brand you think of is the green John Deere, it’s almost synonymous in the mind. Second is price, this is where Walmart stays in the lead of retail stores, because they can undercut everyone’s price through their business model whether you like them or not. Third is called a Switching MOAT, this is essentially a company that is so difficult to move away from that people may ignore better products because of the trouble it would cause them to switch. Two great examples are Microsoft and Apple, we literally divide the populace into Mac people or PC people. This is because each type of person usually finds their preference and would rather die than go to the other. There are several others, I encourage you to search the internet or listen to Phil’s and Danielle’s podcast to learn them all and get better explanations.

Next Charlie wants us to find a situation where, “The business should have management with integrity and talent.” Now Charlie uses the word must a lot, but here it’s a little softer statement, why? Mainly because of two reasons, one is that we have no idea exactly how management will behave until a situation arises. We can look on paper and see some things that make us trust the management, but when crisis hits, the human factor manifests and we have no real idea how they will react. Second is that it can be the least important factor of a business, obviously we want to try to avoid bad management if we know they are bad. If we are investing and holding our positions for the long run though, there will be change in the management guaranteed. Warren said it best, “I always invest in companies an idiot could run, because one day one will.” We cannot hope that companies owned for a long period of time will have great management teams, the odds just aren’t in our favor, so we find companies so wonderful that even bad management can’t kill them.

Last Charlie says, “Finally, no matter how wonderful it is, it’s not worth an infinite price. We have to have a price that makes sense and gives a margin of safety considering the normal vicissitudes of life.” This is crucial because this is the key area where can make sure we don’t lose money. Charlie and Warren talk about buying dollar bills for 50 cents. Phil calls it buying $10 bills for $5 dollars and refers to it as the margin of safety. Which is essentially we want to buy companies for half of their value in 10 years time. So with a lot of research and a little bit of math, we work out a price we can expect the business to be worth in 10 years and pay half of that. That process covers Charlie’s normal vicissitudes of life, which may be my favorite Charlie saying ever. Essentially even if the worst were to happen it should still be covered because we only paid half of what the company is worth.

I will be honest, this takes a lot of very good companies off of the table. The way Value Investors see companies value is different than looking at the stock price. I could go into the differences between Efficient Market Hypothesis and Value Investing, but I will try to boil it down. Efficient Market Hypothesis theorizes that all stock prices are the value of the companies because with all information about the companies factored in, that price is the value of the company. Value Investors would disagree, and the fundamental difference comes down to the human factor. They will state as Graham did long ago, that sometimes rational people do irrational things which do not reflect the underlying value of a company. This was played out very clearly in the dot com bubble burst back in 2000. Stocks were trading for 100s to 1000s of times their earnings, and eventually the people who bet that someone else would pay more for it were wrong and many people lost money because the companies could not bring in enough revenue to justify the price.

I’ve mentioned some resources here to look at for how to find great companies, in addition to Phil’s website http://www.ruleoneinvesting.com and invested the podcast there are a number of videos and websites that talk about value investing free on the internet, just search it and look for videos that talk about Warren or Ben Graham and stay away from the simple sounding “this one trick will earn you all the money you want.” This style of investing takes work, but my path through it has been fruitful and I have done very well by sticking to it as best I knew at the moment. I made some mistakes, some of which even worked out, but overall look for value, don’t chase the fads and you will be much better off in the long run.

Also consider buying the indexes if you are unsure of your ability to buy individual wonderful companies, it’s basically what advisors do and it’s cheap. It provides a broad diversification, whereas Deep Value Investing or Rule #1 investing focus on a small number of wonderful companies. It’s really all about the work that you put in. I will reference all of the people mentioned in this post in some way or another as many have written books that I have found helpful to my own practice of investing and who I follow on a regular basis and look at their portfolios for ideas.

It may sound hard, and while I’ve stated several times there is a lot of work to do, it’s really not all that hard once you learn it. You are going to go through the phases of competence, but you will progress and as you understand more and more the world of investing will open to you in a magical way. It is truly exciting and amazing as the clouds over your eyes lift and you see the underlying practice of investing and gain confidence in your decisions. Second, when going through those principles from Charlie, if you don’t understand a company or can’t find the information to value it easily, put it in the too hard bin. Warren does it, Charlie does it, every great investor in this field does it and they do it A LOT. Warren even calls Charlie Munger the “Abominable No-man” because of how often he turns down investment ideas. Warren himself puts most opportunities into the too hard bin. He didn’t invest in tech stocks besides IBM until deep into the 2000s because he couldn’t understand how to figure out if they were wonderful companies and he’s best friend with Bill Gates for crying out loud! They take vacations together and play bridge!

I only understand probably one in fifty businesses I look at personally, and of those even fewer make it past the valuation tests. This is frustrating and leads to a lot of inactivity, but the knowledge that you only have to be right a few times in your life provides a semblance of balance. You won’t see every Amazon or Facebook coming, but there’s nothing to say that you won’t find the next Whole Foods or Costco or Netflix if you can do the homework on it. Don’t gamble on the market by throwing the dice blind. Do the homework and get yourself a pair of (figuratively, DO NOT DO SOMETHING ILLEGAL TO WIN) loaded dice, so that when you do roll you know you will win. Because at the end of the day we all like to win and we all hate to lose money. Next time I will be continuing on with how in the world do you even buy a stock? Till then, I’ve got velociraptors to herd!

-Daddicus Rex

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