Category Archives: Insights

Snap Inc., Not an Investment.

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Snap Inc, “the camera company” IPO’d on March 2, 2017. Snapchat is popular and useful to those who use it.  It is a prominent player in the currently expanding market in visual media on social media. Therefore, admirers of Snap products might be attracted to the Snap Inc IPO as an investment.

Does Snap meet criteria of an Amateur Investor investment?  Let’s go through them.  The first criterion of an Amateur Investor investment is the presence of a sustainable competitive advantage, such that the company sells a product that is indispensable to its users.  It is virtually certain that in 10 years the company will still be dominant in the market for its product.

Will Snap be dominant in its market in 10 years?  Let’s back up and ask a simpler question.  Will Snap exist in 10 years?  Hmm… Why not back up again and ask a different question.  Did Snap exist 10 years ago?  Of course, the answer is no.  How could we get an idea as to whether similar companies had sustainable competitive advantages?  Oops, I guess the word “had” kind of gives it away.  As chronicled in this lovely Wall Street Journal article (I recommend subscribing to and reading the Wall Street Journal, especially Business section, because its articles are simply narratives based on facts, unlike articles in some other high profile newspapers (I won’t mention the New York Times)), a number of social media wonder stocks have climbed to the height of stardom and then fizzled when least expected, not necessarily even going out with a bang.  For example, Twitter has over 319 million users, but its market value has fallen by more than half since its 2013 IPO.  Friendster back in the first decade of the 2000s had 75 million users before fading. Other somewhat less successful social networks are mentioned in the article. There is evidence that Snap does not dominate its market and is not indispensable, in that Instagram’s launch of Stories, a feature similar to snapchat, resulted in a significant slowing of Snapchat’s growth.

The second criterion for an Amateur Investor investment is that the company adapts by evolving its competitive advantage into evolving new markets.  Since Snap does not have a competitive advantage, it does not meet this criterion.

The third criterion addresses devotion to shareholders, for instance by making sure shareholders have voting power commensurate with their stock ownership, obtaining a good return on investment in acquisitions, avoiding stock dilution and so on.  In fact, the shares floated in the IPO on March 2nd do not have any voting power at all.  They are Class A shares, with no voting power.  After the IPO, close to 90% of the shareholder voting power is held by the two cofounders, Evan Spiegel and Robert Murphy. They hold all the Class C shares, which have 10 votes per share.  I didn’t even bother to look up who owns the Class B shares, which have 1 vote per share. Because Amateur investors would not be able to get ahold of those anyway.  Why does this matter?  Say in a few years (or months?) Snap decides to acquire another asset, say another company. In order to raise the necessary cash, it floats a large amount of Class A shares (only about 25% of these were sold in the IPO), thereby diluting the shares in the market and causing the price to fall.  Suppose many stock holders disagree with the wisdom of this acquisition.  What can they do? Can they vote against it as in a normal company? No, there is nothing they can do.  The founding company owners are already wealthy, they are not affected.

The fourth criterion for one of my investments is that the company must be at least 10 years old.  The fifth, that the investment is worthwhile based on the company’s past achievements, not just its hoped for future attainments.  The Sixth criterion addressed good return on investment, including low debt level, growing free cash flow, high gross margin, high ROI.  Snap has no earnings, in fact its losses of over half a $ billion exceeded its revenue of about $400 million.

In a nutshell, it is not possible to be sure whether Snap will still be going strong in 10 years.  It might, but then again, it might not.  It has no earnings.  Why take a chance speculating with your hard-earned money by buying this new company, when instead you could buy a company which you could be sure would grow and continue to be extremely strong and successful for the foreseeable future?

For inexperienced investors that feel they want to try buying something they like, I must agree that gaining some experience in the stock market, if it is with a very small amount of money that you can afford to lose, might be a way of stimulating and motivating the emotional learning process needed to learn about proper investing.  There are people who say you should not invest at all except with money that you can afford to lose.  But we Amateurs know that is nonsense.   Investment, as Benjamin Graham stated, is a purchase that upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative. There are various approaches to investing that could satisfy this definition, depending chiefly on what you, the individual investor, judge to be an “adequate”, satisfactory return.

In the Amateur Investor approach to investing, you must simply learn several important realities about businesses, the most important having to do with competitive advantage, of a durable nature.  You are looking for the company of which in 10 years it will be said “in 10 years this company will still be growing and dominating its market, and evolving and adapting to continue extending this dominance into the changing market.”

Portfolio Performance for 2016: underperformed, but businesses doing well

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Performance of my portfolio for 2016 was only 7.4%, underperforming S&P which made 9.54%. 

On 12-31-16 the relative proportions of holdings were

 

MSFT 49.9%

V 22.7%

SBUX 15.2%

CNI 5.59%

ADBE 4.98%

Cash 1.43%

 

No stock trades were made this year.

Beginning with Q2 2016 dividends were credited to cash instead of reinvested, to build a reserve for future purchase of stocks when they should reach an attractive low price. 

The performance of my stocks in the market was as follows:

 

MSFT    +14.65%

V           +1.36%

SBUX     -6.1%

CNI        +22.67%

ADBE    +9.59%

 

Possible causes of the relatively low performance are as follows. 

In the market volatility in September 2015 and January 2016, the S&P fell 10% from its peak of 2126 on July 17 2015 to 1921 on September 4, 2015, before climbing again to a peak of 2099 in November 6, then falling 12% to 1864 on February 12, 2016.  Unfortunately, I had no cash ready to invest in order to take advantage of the attractive low prices which appeared during the dip.  That is one reason that my performance was lower than it should be.  To address this, as mentioned above I began setting aside dividends to build a cash balance to fund acquisitions at attractive prices, whenever these should appear.

Another reason was that SBUX and VISA had suboptimal years in performance, although not as businesses.  SBUX missed revenue expectations for the first threequarters of 2016, then beat in Q4.  It beat earnings in Q1, met in-line in Q2 and 3, and barely beat in Q4.  The stock price more of less followed these results.

During 2016 Starbucks began developing its strategy of “premiumization” of the Starbucks experience, with the Roastery flagships stores and the Reserve category of Starbucks stores.  The various initiatives to expand the Channel Development segment continued.  The Full year 2016 revenue rose 11% and non-GAAP EPS 17% yoy, so hardly a poor showing.  The trailing PE is currently about 30, which is approximately average for recent 10 years. The continued evolution of SBUX to strengthen its competitive advantage and adapt to new markets is intact.

VISA acquired VISA Europe on June 21, 2016, for €12.2 billion ($13.9 billion) and €5.3 billion ($6.1 billion) in preferred stock, convertible to VISA Class A stock, with an additional €1.0 billion, plus 4% compound annual interest, to be paid on June 21, 2019.  To pay for this, VISA in December 2015 issued $16 billion of senior notes with maturities ranging between two and 30 years. The acquisition was expected to be dilutive to earnings in 2016 in the low single digit range. 

Stock dilution is being offset as the $16B debt issuance is being used partly to increase stock buy backs.  The acquisition should be accretive in low single digits in 2017 excluding integration costs, and accretive in high single digit range by 2020.  The increased earnings are partly from increased efficiency:  increased scale, cost cutting efficiencies realized by integration of the businesses, and benefits related to Visa Europe’s transition from a member-owned association to a for-profit enterprise. VISA Inc. will be positioned to take on the estimated 37%, or USD $3.3 trillion, of personal cash and check spending in Europe. Europe has been an early adopter of mobile payments using NFC, expected to grow.  Visa Inc. has aggressively launched new mobile payment partnerships, platforms and products that will enable faster growth and adoption of mobile payments in Europe. This includes new tokenization services, support for digital wallets and wearables, strategic investments in other enabling technologies, ecommerce (such as VISA Checkout) and P2P payment capabilities, as well as the opening of several global innovation centers. 

VISA will be able to present a seamless experience and global capabilities to its European and international clients.  Hence the evolution of VISA Inc. to strengthen its competitive advantage as digital payments global market leader, and adapt to serve evolving markets, is intact.

 

A sensible policy for cashing and saving dividends to invest in volatile high growth stocks at infrequently occurring low prices

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1/18/2017 16:56

In the market volatility in September 2015 and January 2016, the S&P fell 10% from its peak of 2126 on July 17 2015 to 1921 on September 4, 2015, before climbing again to a peak of 2099 in November 6, then falling 12%  to 1864 on February 12, 2016.  I did not have a source of cash with which to take advantage of some really attractive bottom prices in stocks, specifically ADBE.  I resolved to find a way to take advantage of the low prices which appear in market dips, as purchases made in teeth of market terror are key to producing the most outstanding returns.

The purchase additional stocks for the portfolio must be funded either from the sale of current holdings or from cash kept for the purpose (I do not consider the use of debt to be a sound option).

There are various arguments against the sale of current holdings to simultaneously fund new purchases.  The decision to buy is driven by the identification of a prospective purchase that is currently found at an attractive, low price, or where business prospects for the company appear to be more promising in the immediate future.  Meanwhile, to optimize return, the company that is sold to fund the purchase would be judged to have less promising prospects and hence likely to fall in price, either because it is currently judged to be overvalued,  or because business prospects appear uncertain in the near future.  But there is no particular reason that the advent of an attractively low price in the target purchase would coincide in time with an attractively high selling price in another holding.  Rather, one may be faced with the prospect of selling a stock at a merely reasonable price to enable the purchase of a stock which is found to be hopefully at a nadir.  Unfortunately, the decision can potentially be wrong on both sides, that is, the price of the target purchase may subsequently fall even more, while the sold stock may subsequently continue to rise.

A variation of this strategy is to sell a stock that seems overvalued, or is expected to fall in stock price, in order to build up a cash reserve to fund purchases of a stock in the future, rather than simultaneously.  The problem with this strategy is that it  based as it is on prediction of the future, a sketchy enterprise at best. 

Indeed, the problem with any approach based on predicting the future of stock prices is that stock prices do not necessarily reflect current business events in the company in question at all.  They may rather reflect the market’s shifting reaction to those events, in turn driven by entirely distinct and distantly related social or economic forces.  Because of this, a stock that seems overvalued, and thus a likely candidate for harvest, may continue to rise into regions of continued overvaluation if social or economic sentiment looks favorably upon it, against conventional rational business expectations.  In this case, the sale price would be regretfully too low, too soon. Or in fact one may decide the stock should after all have been held for the long term.  Conversely, the tide of market sentiment may tumble a stock even though the company is prosperous, producing regret that one did not harvest at the previous peak.

One characteristic of my investing approach is the attempt to recognize and understand the emotional currents underlying  investing decisions.  By doing so, one can steer a course that is free of emotional hazards to sound investing decisions.  In the present case, awareness (perhaps not fully conscious) of the shakiness of one’s predictions about future prices is likely to cause anxiety which interferes with rational trading decisions.

One cannot change a future outcome that one does not control, either before it happens, or after it has happened.  But since no one else can either, failure to do so does not impair one’s performance relative to other investors, that is, relative to the market.  What one can do is first, avoid the chances of making an error, while maximizing the chances of better results, and second, minimize the emotional influences which interfere with sound investing decisions. 

A different strategy is to build up cash reserves to fund stock purchase.  In the absence of new cash, the only possible source of these is stock dividends credited to cash instead of reinvested.   These have a few advantages as a source of cash.  First, the cash is contributed regularly, at a range of different stock prices, so that no bet is made that a particular price would have been the optimal selling price.   Thus, one avoids the chance of making a large error in choosing a sale price which may turn out later to have been the wrong one.  no specific decision must be made to sell a treasured holding, with the accompanying distress.  This will minimize the emotional turmoil which leads to hasty, ill thought out decisions.

There are thoughts pro and con this strategy.  Crediting dividends to cash means they will not participate in the hopefully continued rise in the stocks they were contributed from.  In order to make this strategy worthwhile, one needs to buy new investments at a low enough price, or to achieve a high enough return on investment, so that this will compensate for the time of missed returns before the cash was invested.

Purchasing at a discount from the long term stock growth rate is crucial to maximize the chance of a good outcome.  If the stock fits criteria for the portfolio, none of which depend on short term market action, then its long term growth rate should approximate that of the portfolio.  The cash that is held pending the new stock purchase has a return of 0%.  Let us assume that the stock to be purchased would have a certain price at the time of purchase, if the stock was adhering continually to the long term portfolio growth rate ( R ), and call this P (r).  Let us assume that at the time of purchase, the stock has fallen so that it is discounted in price P (r).   In order for the cash invested in the new purchase to attain the portfolio ( R ), then the discount from P (r) at which the new stock must be purchased must equal the time the cash was held, in years, t (cash), multiplied by ( R ).  The illustration below shows this for a stock bought with cash that has been held for one year.

stock-discount-chart

For cash held for less than a year, then the discount from P (r) would need to be relatively less, while still enabling the stock to attain the same portfolio ( R ).  One source of error in purchasing stocks, especially volatile high growth stocks, is failing to patiently wait for an adequately low price.  In my proposed strategy of using accumulating cashed dividends to fund new stock purchases, the fact that the cash balance builds up slowly as dividends are contributed, is an incentive to wait for an adequately low price so as to generate returns at least equal to ( R ).  This is because frequently making small investments which use up the accumulating cash, if made at a discount to P (r) which is less than t (cash) times ( R ), will result in subpar long term returns.

There remains one question: if the stated goal of a rational policy of accumulating cashed dividends and reinvesting them, is to merely match the long term growth rate of the portfolio that would be attained if the dividends had been automatically reinvested in their respective stocks in the first place, then what is the point of hoarding the dividend cash in the first place?

The reason is as follows:  some stocks seem to have a higher expected growth rate because of the strength of their business and market expansion.  However once this is well recognized by the market, the stock in question becomes chronically highly priced, and is rarely available at an attractive price.  However, these stocks can yield great returns if they can indeed be found cheaply.  And, inevitably they sooner or later do fall in price.  In fact, when a company from which the market has high expectations (ADBE), meets a setback, it is generally swiftly punished and its stock falls more than would be the case for a company with a solid business but from whom the market has more conventional expectations (Philip Morris International).  This type of company might be termed a Volatile High Growth Stock. The above strategy of accumulating cashed dividends to take advantage of these infrequent opportunities can then in fact lead to overall increased returns.

Again the promise of higher returns by a high growth stock is only likely to be fulfilled if the purchase price is low enough.  On this inarguable basis,  a sound strategy might be to buy the target stock with half of the available cash when it reaches a % discount from the previous 52 week peak, that is equal to the 10 year growth rate for the portfolio ( R ).  Should the target stock fall to 2 x ( R ) from the same previous peak price, then the remainder of available cash will be invested in it.

This strategy may not be perfect, for example it may result in only half of the available cash being invested in the target stock at an attractive price. On the other hand, it preserves the chance for purchase of at least some of the target stock at the truly great price of a 30% discount to previous peak. This approach should at least preserve the average portfolio growth rate from damage caused by ill-advised purchases.  Meanwhile, If the target stock is one with growth rate relatively higher than the average for the portfolio, this should raise the portfolio performance.

 

Bought more ADBE in 2016; reflection upon the emotional aspect of the trade

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On January 11, 2016 I sold 6.5% of my MSFT stake to buy ADBE.  I thus somewhat more than tripled my stake in ADBE, which nevertheless made up only 5% of my portfolio as of 12-31-2016.

The timing and pricing of this trade was as follows.  In August-September 2015 the market sold off by 10%, then recovered, only to sell of by approximately 12% in January 2016.  ADBE had bottomed on 8-24-2015 at 75, down 13% from its previous peak at 86 on 8-17-2015.  It then rose again to peak  at 95 on 12-29-2015 before falling 22% to nadir at 74 on 2-9-2016.

 I bought ADBE at 88 on 1-11-2016,  down less than 8% from the 12-29-2015 peak of 95.

In fact, since 1-11-2016 MSFT is up 20-83%, ADBE up 19.56% as of 1-18-2017.

But MSFT pays a dividend of 2.35% currently,  That trade isn’t looking too impressive. Bear in mind of course that the prices of both fluctuate, so on a different date, the assessment would be different.

Had I bought at the nadir of both stocks with MSFT at 75 and ADBE at 74 on 2-9-2016, since than ADBE up 46.24, MSFT up 26.89 not counting dividend, as of 1-18-2017.

adbe-msft-2016-chart

The rationale for the trade was that ADBE is a high PE stock with expectations of high future growth which have become well recognized by the market. This type of stock rarely trades at an attractive, relatively lower purchase price. I wanted to increase my holding of ADBE and wanted to take advantage of a lower price. I still agree with the decision to increase my holding of ADBE, but obviously I totally missed the true opportunity for a better price. 

This episodes proves again two timeless investing truths.  First, it is true that valuable and expensive stocks will be available at a better price, if you can only be patient.  Second, if you feel impelled to do something less you run out of time, just again, be patient. In fact using more time to decide will result in a better outcome.  This is not the only time that it would have been more profitable for me to wait for a better price.  In fact it is a recurring theme. 

But upon reflection, I find that this conventional lesson only probes one layer of this experience.  A distinct lesson is provided by considering the emotional aspects of the trade.

First, I felt I was missing out by not owning more of ADBE, a wonderful company with an insurmountable competitive advantage in its business (digital media) which it is strengthening, while building a second business (digital marketing) which looks likely also to have a sustainable competitive advantage.  This created a sense of urgency to trade.

Second, since I held no cash, I needed to sell another holding to buy more ADBE.  All of my 5 stocks are treasured holdings.  Part of holding such a concentrated portfolio is the nagging thought that perhaps I should be more diversified, at least within my 5 holdings.  This added to the anxiety surrounding the trade; on one hand, I should trade into ADBE, on the other hand, I was reluctant to sell my other holding.

the emotional aspects of investing must be explicitly embraced and addressed, rather than just suppressed.  Same as in the rest of life.  Remembering that good investing is a model for a fruitful life, lived to its fullest potential.

In perspective, the sum of money used for this trade was a very small proportion of my portfolio , less than 3%, as to make only a small difference at best.  This suggests that instinctive fear led me to avoid putting a healthy proportion of my portfolio on an investment.

Regarding strategies to reduce the roil of emotions interfering with sound trading next time.  One suggestion is to create a relatively fixed, preplanned trading strategy.

For instance,  wait until it is reduced 10% from the peak and use half of the money available for the sale.  Then use the rest when or if the 20% discount is reached.

This assumes that you really want to own the company.  If it is a new investment that may not have the same conviction as a better understood, long term holding, then waiting for the full 20% discount is probably best.

Second, in order to isolate the decision to purchase from the reluctance to sell a current holding, it would be helpful to have a source of cash for new purchases.  This is the topic of a subsequent post. 

The lesson to be learned from this episode is not just that patience is a virtue in investing.  For the barrier to patience is often posed by the emotions impelling a trade.  One cannot simply make one’s emotions disappear.  I for one, have been successful in making them disappear so far, and I am surely not alone. 

A better approach may be to 1. analyze the source of the emotions.  In my case, my rush to trade and poor decision making was not simply from a greedy rush to chase a hot stock.  By understanding the source of the feelings, you can know how to neutralize them.  2. have a strategy to avoid a repetition. For example, I will trade at specific target reductions in price, and not worry about trading until then, merely watching the market prices regularly.  I know my portfolio is sound as is, there is no urgency to trade unless it is actually at an attractive price.  3.  have a source of cash  for purchases.  Again, this point will be the subject of a different post.

In sum, the emotional aspects of investing must be explicitly embraced and addressed, rather than just suppressed.  Same as in the rest of life.  Remembering that good investing is a model for a fruitful life, lived to its fullest potential.

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Essential Criteria of an Amateur Investor investment.

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edited 4-4-2016
1.  Sustainable Competitive advantage defending or growing market share in its specific market.  This is the sine qua non of our investment choices and the foundation of our approach to investment.  The company with a competitive advantage is rare.  It is marked by the ability to increasingly attain returns on investment above its cost of capital, and above those of its competitors.  A competitive advantage might be made durable by low cost/high volume leadership among competitors; barrier to market entry of competitors; product differentiation/switching costs to customers.  The company with a sustainable competitive advantage sells an indispensable product.

2. No competitive advantage truly lasts for ever. Hence, a related critical facet of the competitive advantage feature is that management consistently anticipates or reacts to changes in the market or competitive landscape by finding profitable ways of extending the company’s competitive advantage into new markets that are tangibly related to its current markets. That is, the company adapts and evolves to perpetuate its competitive advantage by extending it into the evolving new markets.

3.  Evidence of devotion to shareholders by its capital allocation, manifested in the following ways
stock buybacks to reduce share count
avoiding excessive dilutive stock compensation
obtaining good returns on investments in acquisitions
aligning reward and performance of management and employees to reward shareholders and long term company performance
allowing shareholders to have voting power commensurate with their stock ownership.

4  Common stock of publically traded company based in U.S. or other relatively transparent legal environment with respect for property rights, at least 10 years old.

5. The investment worthy activities of the business are demonstrated in the record of its past and present achievements, not in the hoped for future.

6.  quantitative evidence of ability to obtain returns on investment above cost of capital, such as low debt level, growing free cash flow, high free cash/revenue, high gross margin, high ROE and ROI.

Management must defend and extend competitive advantage

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The first criterion for an eternal investment is the presence of a durable competitive advantage.  This means other companies are not able to compete with the company in its markets.    But there a critical second two aspect of this feature. An impregnable competitive advantage by itself is not enough to confer everlasting earnings growth.  A second critical facet of this feature is that management consistently anticipates or reacts to changes in the market or competitive landscape by finding profitable ways of extending the company’s competitive advantage into new markets that are tangibly related to its current markets. As technology evolves to change markets and create new markets, the company adapts to meet new demands. Otherwise, other so called “disruptive” companies will meet the demands of those new markets. in some cases, new technology can abruptly threaten a company’s product with obsolescence. Then, the company must either change its business to adapt to the new market, change to serving a market related to its original product, or fold. The cash built up through its current strong franchise, and expertise in serving the current market, should give the company a head start in adapting to change. But in order to execute this, management must maintain a culture which detects looming changes, proactively develops new initiatives and enforces profitability. Indeed, it is management culture that establishes dominance in different, evolving markets over the history of a long lived, “eternal company”. The continuation of a company’s competitive advantage into the future is not guaranteed, but shaped by management culture.

One might say that no competitive advantage is truly eternal.  The foreseeable future inevitably gives way unforeseen innovations.  Competing companies use these to erode the formerly dominant company’s market share.  Undoubtedly this does occur, and recently there is much talk of “disruptive innovation”.  In many cases the problem may be more that management of company A does not efficiently enable utilization of novel tools to maintain its domination.  Or, does not imaginatively envision how the new tools can be used to extend its markets. This might apply to Microsoft in the years between 2000 and 2014, when it seemed to focus more on maximizing profit from the windows, office, server franchise, rather than expanding into new markets for its software afforded by digital readers and mobile phones. In fact, arguably Microsoft’s own management which impaired its revenue growth, as much as the strength of Apple or Google.  In other words, it is not that android or iOS phones have destroyed the market for Microsoft Office products, far from it.  Rather, they have created a large new market for mobile computing, a market related to Microsoft’s market for its productivity software.  And Microsoft has failed to extend its dominance into this new, related market.  In 2014, in a vigorous departure by new CEO Nadella, Microsoft began making a concerted attempt to forge into the market for mobile productivity software, for example by releasing Office for iOS and Android.  More interestingly, work on this software had begun under the previous CEO Balmer.  But more interestingly still, the strategy of creating Microsoft applications for other companies’ platforms had been heavily utilized in earlier Microsoft history, so it was actually part of the engineering and management culture.

AmateurInvestor 15.4% 10 yr return beats S&P (5.2%), Berkshire Hathaway (8.69%) for Oct 2015.

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My portfolio beat the market this year as well as for the past 10 years. I also beat the 10 (8.69%), 5(10.92%), 1(-8.77%) and YTD (-10.49%) returns of Berkshire Hathaway (Brk.a).  Just saying.

This year’s outperformance is partly due to a realization that the focused portfolio is focused for a reason.  In late 2013 and early 2014 I added some stocks which seemed to fit the criteria to be an Eternal Company, but I could not explain fully why they did.  I did this because owning no more than 4 stocks (V, SBUX, MSFT, PM) felt a little unsettling.  I felt that stringently requiring that they manifestly exhibit the required criteria seemed unrealistic, given that so few companies with these qualities exist.  And so I acquired some more companies, described below, and later sold them. Performance will have been improved by pruning  these companies.

The good results were also related to investments in new additions to the portfolio  which have become permanent investments and have contributed to growth.

In 2015 my portfolio ended with 5 stocks, V, SBUX, MSFT, ADBE, CNI.

This chapter resulted in a few lessons learned.  In the search for Eternal Companies, possibly it is difficult to be adequately motivated to research the company unless you have an ownership stake.  I am reminded that the ValueAct Capital hedge fund acquires a small stake in prospective investments after having done preliminary research, and then continues to perform intensive investigation sufficient to enable a profound understand of how the company makes money and the issues facing growth, before making a definitive investment.  ValueAct is a focused fund.  I suppose I will need to find a way to be more conscientious about researching new opportunities.

The reality that there are very few qualified Eternal Companies does not mean that  investments made in companies that fail to qualify as such will still be as good.  Rather, the dearth of Eternal Companies means an investment strategy focused on these will indeed result in a relatively focused fund.  There is no way around this.  Having proved this more fully to myself, I now feel more content remaining with my exclusive selection of companies.

Another lesson is that I am still capable of making errors.  Fortunately, I am scrutinizing my own execution fully enough to correct errors before they cause serious damage.  Conversely, I am still capable of learning.

Here may lie the most important lesson. Namely, that I can improve the way I invest.  What tools might be best to address the issue at hand, that of picking a company which does not demonstrably meet the required criteria?  One tool might be to write out the reasons justifying investment, as well as any weaknesses with the company, prior to buying.  The narrative would cover a checklist of criteria critical for a good investment. Judgement regarding the criteria is gained by reading, as well as experience. The final analysis should be subject to a critical reading, in which the key assessment can be characterized as asking the question, “does this investment jump out at me as an obvious great investment?” There should be no doubt.

What are the most important qualities of an Eternal Company?  First, the existence of a durable competitive advantage.  This means other companies are not able to compete with the company in its markets.  Second, management consistently  anticipates or reacts to changes in the market or competitive landscape by finding ways of extending the company’s competitive advantage into new markets in a profitable way.

Note that this is entirely different from simply using its financial strength in a attempt to establish a foothold in markets which are entirely new to the company.

Below is a comparison of my returns with those of some renowned value investing mutual funds.

Fund/index Expense ratio (%) 10y (%) 5y (%) 1y (%) Ytd (%)
S&P 500 5.12 11.75 1.06 1.46
Amateur Investor   15.4 22.4 22.0 21.14(as of 11-25-15, est.)
Oakmark Select Fund (OAKLX) 0.95 7.68 14.67 -2.08 -1.08
Sequoia Fund (SEQUX) 1.0 7.28 12.14 -7.71 -8.68

Data is taken from Morningstar.

Following is a brief outline of the qualitative changes to the portfolio in the last couple of years. The companies I bought and subsequently sold at minimal loss – to  – modest profit were as follows:   Fomento Economico Mexicano (FMX, the Mexican Coca Cola bottler and owner of the Mexican convenience store chain Oxxo); Ebay (EBAY, operator of the online auction platform, online conventional merchant marketplace and PayPal, the latter subsequently spun off); Cerner (CERN, the largest dedicated electronic medical records provider); Intuit (INTU, with a dominant market share in desktop personal finance software with Quicken, small business accounting software Quickbooks, as well as growing businesses in consumer electronic tax returns with TurboTax.

I discovered two companies which have become permanent investments.  One is a true Eternal Company, Canadian National Railroad (CNI, one of the seven remaining class I railroads in North America, has the lowest operating ratio of any rail on this planet, and other features that enable it to grow by focusing on growing their customer’s and their own business as opposed to competing on price).

The second addition to my portfolio is Adobe (ADBE software dominates the market for creative professionals, Adobe is now increasing profitability as well as market by shifting from permanent to subscription licensing in the cloud, and in a related market has created software to manage digital media campaigns which is growing in dominance.

Finally, I sold, with some sadness, an Eternal Company for which growth in earnings has recently become stunted partly by a slowing of its market growth, and in addition by the effect of the strong dollar, since its earnings are all outside  the US: Philip Morris International (PM, which has the strongest portfolio of cigarette brands outside the US and is innovating in reduced risk cigarettes).  It cannot match the growth of my other stocks.

Sustainable competitive advantage drives the choice of investment. CNI: a toll bridge investment on steroids.

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Competitive advantage does not mean a company earns high returns on capital just because the management is smart. It means that competitors are not able to match its returns on investment. There may be a barrier to market entry, or switching costs for customers are relatively high. The company with competitive advantage can sell its goods at prices well above its cost of sales, without fear that competitors will flood the market and attempt to undersell it. This is reflected in healthy gross margin that is sustained over an extended time, and steady or increasing returns on capital investment.

In the metaphorical toll bridge investment, customers must pay to use the company’s product in order to obtain something they demand. In the literal example of a toll bridge, customers must pay for access to the bridge to a destination. Assuming the demand to reach that destination is persistent enough to justify building the unique bridge, the shares of the company are bid up because of the durability of this demand. The problem with toll bridge investments is that unless demand to reach that destination continues to increase, the company shares will not continue to rise over time. Since the company management recognizes this, it will likely pay a dividend in order to keep investors, as long as earnings continue to support it. Assuming there is no alternative bridge, the company’s competitive position is hard to attack, and management does not have to be world class. Earnings do not rise any faster than economic growth at the bridge destination, the stock price will reflect this. In an attempt to increase earnings more quickly, Management may allocate some income to attempted expansion into other markets, but there it does not possess a competitive advantage and will do no better and possibly worse than competitors who are dominant in those different areas. An example of this is Hawaiian Electric (HE), a regulated electric utility that supplies virtually all power on the Hawaiian Islands. Its growth is limited to the growth of power demand on the Islands.

What if over time demand for reaching the destination not only increased with growth of the most stable economies in the world, but also with the growth of the most rapidly growing economies (thus growing at a rate exceeding the average growth of the world GDP)?

What if the company had exclusive use of 2 toll bridges, with different markets clamoring for access to them? What if the management in fact did not merely rely on the advantaged position afforded by their non-reproducible franchise, but was driven by a historic struggle for economic survival to run the most cost efficient toll bridge possible, therefore focusing its capital allocation on improving its transportation speed and the capacity of its bridges? What if management was systematically incentivized to grow return on invested capital, earnings, free cash flow, and expected to purchase ownership in the company?

What if the toll bridge investment was Canadian National Railway (CNI)?

Competitive Advantage is at the intersection of Market Need and the Company’s Unique Ability Supply It.

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Focus is crucial In order for a company to build a competitive advantage (the same might be said for a person). A company must first recognize the potential advantage, and focus in order to capitalize on it. A competitive advantage is at the intersection of the most urgent market need and the unique ability of the company to uniquely supply that need. Efforts are focused on developing that ability, and ignoring other less rewarding aspects of the company.

Adapting to focus on meeting the current market needs therefore builds the company’s competitive advantage. But the market does not remain static. In order to continue dominating markets that change, the company will need to develop new strengths. The source of strength at one stage can be used to build new sources of strength. Hence, the company must adapt again. Over time, evolution occurs and the degree and nature of change can be striking.

The story of the early Microsoft is a good example of this. In 1975, Bill Gates and Paul Allen had a competitive advantage in that had high IQ’s and had worked extremely hard to develop their programming skills, devoting most of their time to that end since the age of 13. At that time, the most practical computers available were termed minicomputers. These were smaller, more physically more practical than the mainframes which had hitherto dominated computing. Minicomputers were pioneered by companies like Digital Equipment Corporation. The programmer communicated with using a keyboard, generally remotely. Different users would book on the remotely located minicomputer. Bill and Allen had spent essentially all their otherwise unoccupied time learning use mini-computers since high school and had faced a constant battle to find time on a shared minicomputer. They realized that computing power would be valuable if it was available on computers conveniently located at the user’s location, whether home or office. Processors were becoming cheaper, smaller and more powerful, so in theory it seemed computers would follow to make this vision possible, although the established computer hardware companies were sticking to more developed markets. So they were aware of a possible new market opportunity which would match their strengths.

In 1975, Ed Roberts in Albuquerque NM had a company called Micro Instrumentation and Telemetry Systems (MITS), selling electronic equipment. In 1969 he moved it out of his garage and focused on selling kits to build calculators. He was wiped out by Texas Instruments’ and others’ entry into the market in early 1970s. Roberts shifted to using the new micro-processors, introduced in 1971 by Intel, to create computers that were small and cheap enough to be used by a single hobbyist. This new chips enabled the entire CPU to be contained on the single small chip. Roberts sold a kit to make a portable computer using the 1974 8080 Intel chip. The computer was called the Altair, the term “personal computer “, was coined by Roberts.

It was the Altair that appeared on the cover of Popular Electronics Magazine in January 1975. Paul Allen spotted it at the newspaper kiosk in Harvard Square while visiting Bill. They realized this was an opportunity to apply their programming abilities with a future market.

Their first task in seizing this opportunity was to promise Ed Roberts they would create a version of basic that would run on the 8080 chip and be able to run calculations. Roberts did not take them seriously. Many enthusiasts had phoned him and made similar claims, hoping to score a contract. He told them all that whoever produced a working product first would get the deal.

The young men did what was required to overcome the obstacles involved. No one had ever written a version of BASIC for a personal computer like this one, since this was indeed the first one. They did so, with the help of fellow student Monte Davidoff. The young men did not even have an Altair to program on. Allen located a manual for the 8080 chip, and created basically an emulator on the PDP-10 microcomputer they used at Harvard. He saw this could be done because of previous work he had done with Gates in high school. Gates wrote the required version of BASIC that would run on the 256bytes of memory it contained. Davidoff wrote the portion that worked with mathematical calculations. Allen flew to Albuquerque at the end of Feb 1975 to show (to everyone’s amazement) that they had written software that could perform on the Altair.

The next step was follow through to turn this creation into a product that would sell. They wrote versions of BASIC that used more memory, and debugged. This required continuous work. Allen joined MITS as software director. Allen’s work colleagues at Honeywell, where he wrote “assembly code for a niche market machine” made clear they thought he was embarking on a foolish distraction, and assured him his job would be waiting for him when he regained his senses. Gates moved at the end of his sophomore year and eventually dropped out of College. They brought Davidoff and an old colleague Chris Larson.

Thus, the partners’ strength in terms of programming skill and agility, and extreme commitment to the task, combined with their focus on the one opportunity to feed a new market which they and apparently no one else were willing to pursue, gave them the start of a competitive advantage.

Demand for the relatively new personal computers was red hot on the part of hobbyists and amateurs. While no established computer related companies initially planned to create PCs using the new microchips, demand for the Altair was huge and MITS quickly became profitable. Micro-Soft, as it was initially called, was clearly supplying an urgent market need by writing versions of BASIC, the most practical and widely used programming language for everyday computer applications, for the Altair in its various models as well as other personal computers as they appeared.

What did Allen and Gates focus on in their new company? Software had hitherto been written by hardware companies for use in their computers. Now, Allen and Gates were writing BASIC and selling it to be used on computers made by someone else. Allen and Gates signed a contract with MITS whereby MITS would pay them per copy royalties for BASIC. In addition, 50% of software sold without hardware, and of software sold to other hardware makers (OEMs). The concept of selling software for people to use in this way was novel, many users copied the Altair BASIC without paying and revenues were initially poor. Gates, the more ebullient of the two, worked to establish the precedent of expecting to get paid for the hard work of writing software partly by writing hard hitting editorials in new magazines devoted to the novel computers. The custom of buying software took hold, without which the Micro-Soft business plan would not be viable.

Within a year of the emergence of Altair, MITS began to be superseded in the market by other companies building superior hardware, and soon new personal computers were being introduced each month. Eventually established companies such as GE and NCR came in. Micro-Soft (Paul Allen came up with this name) wrote versions of BASIC for each new OEM. Their strategy was to sell it cheaply enough to discourage OEMs from developing their own software. Micro-Soft became the software developer for the PC industry, and they continued making sure to provide BASIC for every new microcomputer on the market. In 1977 they added Fortran, a language used in scientific research and engineering, and then others such as COBOL.

In October 1976, Micro-Soft was registered as Microsoft Inc. in New Mexico, and moved into modest offices on Central Avenue, a humdrum low rent commercial neighborhood. Here is a plaque at the sight of the original Microsoft office. The building they originally occupied has since been replaced.

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In 1977, prominent brand name companies entered the personal computer market. The TRS-80, Commodore PET and Apple II arrived. These were altogether more usable, with keyboards, monitors and graphics. MITS did not grow and adapt quickly enough to compete with these larger corporations. Microsoft parted ways with MITS after enduring an arbitration process, and proceeded to establish the standard software tools for PC’s. Microsoft provided BASIC for RadioShack’s TRS-80, the most popular PC that year. Apple could not produce an acceptable BASIC tool and licensed a 12Kbyte version from Microsoft. Computers became steadily cheaper and more powerful.

One weakness with this business plan, was that significant work was required to produce a software language for a specific new PC. The development of CP/M, an operating system developed by Gary Kildall of Digital Research, meant that if hardware providers could make their machines support the OS, then software tool providers could write for the OS instead of having to reengineer a programming language version for every single new processor or machine.

In time, 1980 to be precise, the then king of computer companies, IBM, would ask little Microsoft, as the provider of the most widely used programming language tools (while IBM had a version of BASIC, they knew Microsoft’s version was more popular with programmers), to provide programming languages for the new IBM PC they were secretly planning. Oh, and Microsoft was expected to provide an operating system as well to go along with the package. But that is part of another chapter, which occurred after the company had moved from desert Albuquerque to the Pacific Northwest, home for the founders.