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.

2015 a year of realization, refocus, and anti-diversification

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Amateurinvestor beat the market soundly in 2015. The 1 year return was 23.7%; 3 year: 22.1%; 5 year: 21.6% and 10 year: 15.3%. The S&P 1 year return in 2015 was -0.73%. As of 1-5-2016, S&P 3 year return was 11.2%, 5 year return: 9.58%, 10 year return: 4.70%. Therefore I have approximately doubled the S&P returns for 3, 5 and 10 years.

The relative proportions of my holdings are as follows:

MSFT 48.75%
CNI 4.6%
SBUX 19.7%
V 24.7%
ADBE 1.4%

The portfolio is rather focused, in fact the number of stocks dropped from 8 at the beginning of the year to only 5 stocks today. I would like to share some thoughts regarding my sale of 2 companies this year, Cerner (CERN) and Intuit (INTU). I sold these because I realized their purchase was a mistake.

I bought Cerner in October 2013 at $57.75. Cerner is the largest dedicated digital medical records software provider, has an impressive gross margin and a business with a high proportion of recurring revenue and switching costs. I bought it because it has an impressive record of growth for over 35 years. It provides a software platform is a critical part of its client’s business operations. It has staying power and seemed to have a durable competitive advantage. At the time I bought it, I owned just 6 stocks, which seemed to me to be very few, even for a focused portfolio. It seemed wise to diversify into a new strong company I had found. I had a few small doubts at time of purchase. At the time CERN had risen because of recent success in agreements to sell its software and services to major medical centers, particularly Intermountain Healthcare in Utah. I knew it was richly valued. In addition, it regular buys shares to compensate for share based compensation, but still manages to continually increase its share count, which casts doubt on its dedication to shareholder value. Unfortunately, events have shown that because of its high valuation, any miss in analysts’ earnings/revenue estimates are met with a drop in the stock price. There has been some loss of important customers to competitors recently which casts a little doubt on the invincibility of its moat. I decided to sell on August 10. At this point I was uncertain how well it would recover from the market instability of that time. Moreover, I was provoked by a quarterly revenue miss. Overvalued stocks with evidence of weakness in their franchise do not do well in market downturns. I sold at $65.40, at a modest gain, so the damage was limited. On Jan 6, 2016, CERN was at $57.9.

My error in this case was a failure to understand the Cerner business well enough either to a. be convinced that its earnings would continue to grow safely in spite of current overvaluation and related vulnerability to temporary downturns, or b. realize that it’s competitive advantage and dedication to shareholders were lacking and therefore not good enough to earn a place in my portfolio.

Underlying this mistake is a more fundamental and common error, that of impatience. I could have simply taken the necessary time to analyze the company before buying. Had I done so, CERN would have been available at a little less than $50 several months later in May 2014. In any case, the allocation at the time of purchase was approximately 0.8% of the portfolio, so the damage was bound to be limited. I cautiously limited my allocation because of my trepidation regarding valuation and other factors mentioned above. In fact, one might ask what was even the point of investing such a small amount in this company. To this I can only reply that I acted from intuition instead of analysis. The advantage of this is that it certainly limited the damage caused, while adding experience. The avoidance of serious mistakes is an important part of investing success.

Upon reflection, I note that I cautiously limited the size of my allocation, and also that I feel a needed a deeper understanding of the company, and that I could have been more patient. We will revisit these points later.

Intuit is an apparently attractive business, with a dominant share in small business accounting software, and market leading shares in retail DIY tax software and professional accountant tax software. As are Cerner, Microsoft (one of my favorite investments) Intuit was a survivor of the early 1980s boom in computing. As with Cerner, it seemed to be a judicious addition of a long lasting company with clear competitive advantages to my portfolio of so called eternal companies. I bought it in February 2015 at $91.00. It seemed somewhat overvalued but I attributed this to the well-established strength of its franchise. It has introduced Quickbooks Online, a cloud based version of its dominant Quickbooks small business accounting software. Other than Turbo tax, the market leading consumer tax software, the other anchor of its competitive advantage is (was) Quicken, software for home finance management.

In August 2015, again at a time of market turmoil, Intuit management made some capital allocation decisions which shook my confidence in their competence, namely the decision to divest Demandforce and Quicken. Intuit had acquired Demnandforce, an email marketing company for small businesses, in 2012 for $423.5 million. Intuit thought to integrate it with Quickbooks. 3 Years later, CEO Smith explained the abrupt decision to divest this recent acquisition made for over 10% of its 2012 revenue at the related investor presentation. He matter of factly stated that Demandforce and QuickBase [another business divested at the same time) are great businesses, but they do not support the QuickBooks Online Ecosystem and both serve customers that are up-market from our core small business customers.” When asked by an analyst to address Intuit’s record of acquisitions, he stated “many of the larger ones have not gone well”. “…We have a mixed record in terms of bolt-on businesses, new businesses that may not plug-in directly with QuickBooks or tax businesses…” and promised that management had developed a “set of criteria that [future acquisitions] have to meet”. In other words, he was promising that 32 years after its founding in 1983, Intuit would begin to ensure acquisitions make sense for the company before purchase. Obviously these words are not those of a CEO of an eternal company. Quicken was one of its original businesses at the founding and was providing over 20% of revenue in FY 2014. I was surprised by the decision to divest this instead of adapting it and continuing growth.

The poorly planned capital allocation into Demandforce and the abrupt divestiture of Quicken gave me the impression that Intuit management may not be able to adapt successfully to future markets. I had bought in February 2015 at $91.02 and sold in September at 89.26. I found it difficult to pinpoint where I went wrong here. Intuit seemed to be a sound and strong business, providing necessary products which had market leading shares. Perhaps if I had read more of the past financial reports, I would have discovered other episodes of poor acquisitions. Perhaps I should have simply observed its progress over enough time to get a more detailed impression of how it functions. Prior to its purchase, I had considered Intuit to be a strong business with an economic moat which was akin to those I owned. I actually sold shares in Visa and Starbucks, both of which were highly valued by conventional measures such as cash return, to buy Intuit. As happened with Cerner, I felt I lacked deep enough understanding of the company and its management, without which I was vulnerable to nasty surprises.

In the case of both Cerner and Intuit, I felt surprised by adverse company events, and retrenched back to my long term holdings. Therefore, 2015 was a year of realization, that buying companies which seem to be good businesses, and even to have a durable competitive advantage, is not enough. they must be observed to dominate their markets for the foreseeable future, and be observed to demonstrate management competence and respect for shareholders over some time, until one is convinced.

But how is one to judge when the evidence is enough to justify buying and holding forever? Sometimes the clue to a solution to a life problem can be found in a careful reflection upon the experience, and asking the question, “how did it make you feel”. This is because the correction solution is only correct if it is the right one for yourself. In the case of investing, as Benjamin Graham stated, “the investor’s chief problem, and even his worst enemy, is likely to be himself” (Intelligent Investor). The investor will need to be comfortable holding his security in the face of inevitable market fluctuations. In this case, as previously noted, I reflected that I did not feel I had a profound enough understanding of the company to feel comfortable holding in the face of a market downturn. The solution then is to wait and continue to analyze the company until I feel I know it well enough to be able to commit, or not. There are also cases of companies which are actually worthy, but seem overpriced, in which case one would wait for a market downturn even after having come to understand the company sufficiently.

This process of coming to understand the company is not purely intellectual. For example, I doubt a simple analysis of financial statements prepare one for Intuit CEO Smith’s rather absurd explanation of his failed acquisition of Demandforce. I believe rather than one must experience the company as much as is possible via its communications, perhaps its products, and by communicating when possible with clients, customers, employees. One must build a relationship with the company, until one feels one can trust it. This is actually what the legendary investor Philip Fisher (author of the book Common Stocks and Uncommon Profits) termed “scuttlebutt”, the flow of information he held indispensable for analyzing a growth stock.

Exploring a company which seems promising, and might rise in value, while waiting to feel fully comfortable enough to commit before buying, is difficult for two reasons. First, it requires patience. Inevitable, one is afraid of missing a low price. Second, it is surprisingly difficult to be motivated to really experience a company, to form a relationship with it, unless you have an interest in it. This may lie behind the investing approach of the excellent hedge fund ValueAct Capital. The investment staff study a company until it seems to be a good bet, then buy a small share and continue to follow it until they know it well enough to feel they know how it makes money, and what to expect from it. They then deepen the relationship by buying a stake large enough to command a board seat, and continue becoming part of it. Perhaps by buying a small stake in a company, I can be motivated to follow it closely enough to understand it better. Seen in the light of these thoughts, perhaps my cautious forays into new additions to my portfolio may not be faulted too much, but in fact be considered a necessary step to taking the time to come to know a company. And by limiting the size of initial investment, I limited the damage caused by errors. But the benefit is that this might be a way to actually discover new gems. Such was indeed the case with Adobe, a small investment I made which was turned out to be a wonderful investment.

Finally, 2015 was a year of anti-diversification, the acceptance that there are truly few companies which have exhibited the qualities of an eternal company in a lasting way, and acceptance that there is no need to diversity just for its own sake. In 2015 I sold Visa and Starbucks, which I had owned for years, and which I knew where companies with very strong franchises, to buy a new company, INTU, which I was less familiar with. Having corrected this error, my portfolio was whittled down to 5 companies. This time, I feel happy with the small number.

But again, reflecting upon this retrenchment back into my small collection of investment gems, I find that the high degree of comfort I have with my existing portfolio, continually reinforces the reluctance to invest in new companies. As my understanding of and satisfaction with my exclusive set of existing investments grows, this sets a higher bar for new companies to meet. And this may actually be an anti-diversification mechanism by which focus investing reinforces its own success.

The restaurant experience builds the brand, and the packaged product monetizes it.

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One strategy of competitive advantage is to afford a unique experience that is preferred by the customer.  Food or beverages are good examples of the type of product that can represent this type of familiar, sought after experience because they are intimately experienced by the user, and can become part of the customer’s personal life habits.  In order to possess a competitive advantage the food or beverage must be of a quality unique enough so that it cannot be easily duplicated.  In order to possess pricing power, the quality must be both unique and recognized as being outstanding.  For food/beverage purchased in a restaurant, the atmosphere, clientele and location of the restaurant are part of the experience.  The restaurant environment is controlled to convey a specific experience and this strengthens the consistent branded experience.   Lacking this complex tool to control the customer experience, the packaged beverage industry is extremely competitive.  Brands fight to establish a vivid appeal based on their packaging or advertising.

However, the packaged beverage industry can have relatively high margins.  Assuming the product’s appeal can secure pricing power, margins can be healthy for what is essentially a relatively cheap product based on commodities (sugar, coffee, flavorings…) with some degree of intellectual property in the recipe.  Meanwhile, the restaurant bears the costs of real estate which can be high in sought after locations, as well as costs of the retail operation which are relatively high, particularly for fresh or very high quality product.  So the packaged product is relatively profitable, but struggles to make more than a fleeting connection with the customer.  Meanwhile, the restaurant can foster a bonding experience with the target customer, but bears the costs of real estate and the retail operation.

What if a company could have both appealing restaurants which served delicious and excellent beverages and foods, and also widely marketed packaged products?  The restaurant experience could establish a bond with the customer.  The relatively higher margin packaged product could benefit from the bond that was forged in the more deliberately pleasurable experience of the restaurant.  This bond could never be duplicated in the grocery, supermarket or convenience store aisle.  The company would therefore have a competitive advantage over rivals who do not have that restaurant experience brand building mechanism.  It is said that Brand confers a competitive advantage.  In fact a strong Brand results from a superior product, including the experience by the customer of the product.  What a  strong Brand does make possible is pricing power.  In the present example, the unique restaurant experience enables pricing power for the packaged product. 

This is a strategy that Starbucks is using to continue developing its brand experience, while building out a relatively high margin packaged good product that will extend Starbucks sales far more widely than would be possible merely by increasing the number of its restaurants.  Of note, roughly 80% of coffee is drunk out of restaurants, at home.  This market must be addressed with packaged coffee and coffee beverages. 

There is another issue with relying solely on a strategy of expanding the base of restaurants in order to grow sales.  A high rate of restaurant expansion risks impairing the quality of the experience, through poorly trained staff or mediocre product.  In order to maintain the quality experience which is crucial in order to nurture the relationship with customers, the quality of the restaurant experience must be preserved and itself nurtured.  The restaurant experience builds the brand, and the packaged product monetizes it.

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.

Philip Morris Intl., for the first time, an actually better product, and better for you!

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Like everything else, competitive advantages are not everlasting. Even the strongest company must sooner or later defend its business against competition. Moreover in a changing economy presenting threats and opportunities, it must adapt by extending its market dominance into new markets or modifying its products and brand to meet new market needs. Philip Morris International Inc. is successfully taking on such a challenge, and is likely to gain market share as a result. Read more.

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.

Amateur Investor 10 year annualized return (14%) beats S&P (8.12%) in September 2014.

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As I have learned more about investing over the past 14 years, my performance has improved, giving me some confidence. In view of this outperformance, I may hope my experience may be of use to others. First of all, this performance shows that an individual investor, spending some hours per week reading and thinking, can beat the market as well as some respected paid professionals (see below).

Personally, I did not have the opportunity to learn about investing until relatively late. It is worthwhile for young people to learn about investing for two principle reasons. First, investing in securities can secure your financial position and afford you the liberty to pursue opportunities that would be much more difficult without available funds to invest in them. Second, investing is in essence, making choices about allocating capital. In learning about how companies go about growing successfully by investing in themselves or by making acquisitions, the investor can learn how to select ways of spending his or her time which will yield the best return in investment. If your parent tells you to study hard because it will be worthwhile, that is one thing. If, based on your investment self-education, you can foresee a good outcome from making certain investments in yourself, then that is entirely more convincing.

The approach that leads to this outcome is based on a few principles. Avoid overpaying for hot stocks. Pay for companies that have a strong business and a long history of the same. Train yourself to ignore market fear, so as to buy those strong business while others are selling them. Know your businesses so you can keep in mind why your contrarian decisions are justified.

A comparison of my returns with those of some respected value investing mutual funds:

Fund/index Expense ratio (%) 10y (%) 5y (%) 1y (%) Ytd (%)
S&P 500 8.12 15.93 19.99 8.93
Amateur Investor   14.00 22.10 25.90 11.90
Oakmark Select Fund (OAKLX) 0.75 8.75 22.50 32.55 11.13 (as of 6/30/14)
Sequoia Fund (SEQUX) 1.02 8.67 19.13 18.45 0.91 (as of 6/30/14)

Note that mutual fund returns are before fees. The expense ratios are noted.

Of course I have some advantages relative to the commercial mutual funds. For me, there are no panicked mutual fund investors demanding that I sell at the bottom of the market in 2009. I can have an extremely focused fund. I can truly ignore the crowd of media and Wall Street with its questionable advice.

Nevertheless this performance is not bad, for an Amateur.

The above information comes simply from my account site online at Vanguard. The mutual fund and index returns are obtained via Vanguard and Morningstar respectively. As I find the time, perhaps I will provide data regarding dates of purchases, sales, and holdings, so as to provide some historical basis and explanation for this performance.

For now, I will note that the portfolio is extremely focused. There is one main portfolio and two much smaller ones. The total number of stocks is 7.