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

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Sept. 17, 2014.  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.

Young people who do not follow the crowd can reach their full potential

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For a vivid account of early Microsoft history and the tale of how a couple of intelligent, determined youngsters, who thought out of the box and had the courage to act on their convictions, created what would become one of the most formidable companies in history, read the splendid Hard Drive: Bill Gates and the Making of the Microsoft Empire
by James Wallace and Jim Erickson.

Microsoft: leveraging and extending its competitive advantage into the future

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September 14, 2014.

My approach to investing in individual companies starts with identifying the rare companies with a sustainable competitive advantage.  While the existence of a durable competitive advantage is manifested in quantifiable features of the financial statement, the ultimate judgment of whether the current competitive advantage will last for the foreseeable future is qualitative, relying on an understanding of the nature, competitive environment and history of the business.

To adapt to an ever changing future, vigilant companies make trial investments in new related markets. The longest lasting companies are those who finally invest only in those areas in which they can maintain a competitive advantage, and hence continue to earn better than average returns on investment for the foreseeable future.   Many companies watch their once impregnable advantage decline as events shape history’s final judgment.  For example, Kodak was dominant in photographic film and in the 1970s had a 90% market share.  It then participated in the invention of digital photography and had the opportunity to integrate its own digital photo technology into PCs in the 1980s.  But Kodak did not pro-actively build a new basis for market dominance in the new markets.  Competitors caught up and passed, Kodak faded and finally filed for Chapter 11 Bankruptcy in 2012. It turns out that rare companies do the work to create bridges to future franchises, using their current market dominance to shape and outcompete in new markets.  Microsoft (MSFT) is such a company.

For the past 10 or 12 years, Microsoft has frankly been unloved by the fashionable tech media, and increasingly by the professional investing crowd.  Under this surface air of decayed greatness is an irrepressible, tenacious organism that adapts by thrusting into new territories, taking root only in areas in which it may extend its competitive advantage, and then proceeding to compete as if its life depended on it.

Recently, MSFT has put in motion a few approaches to increase its competitiveness, and these are now beginning to bear fruit.  These include low balling the price of its Windows OS;  developing its applications for cross platform markets;  partnering with 3rd party software/platform providers that may be competitors; and transitioning its market dominance to the cloud.

MSFT has used these strategies before. For example, in the early 1980’s Multiplan, the predecessor of Excel, was coded for a software emulator that would be interpreted for different OEM PCs. Thus it was sold to more than a hundred different OEMs selling to businesses, in an ultimately successful end run around Visicalc, which had locked up the retail market.  When MS-DOS was released in 1981, it was virtually given away to OEMs building IBM PC clones for a flat fee.  Clearly, MSFT viewed this as a race to sell applications (also including the programming languages that comprised its main business) as opposed to the OS.

For a vivid account of early Microsoft history and the tale of how a couple of intelligent, determined youngsters, who thought out of the box and had the courage to act on their convictions, created what would become one of the most formidable companies in history, read the splendid Hard Drive: Bill Gates and the Making of the Microsoft Empire
by James Wallace and Jim Erickson.

As announced in April at Build 2014 conference, Windows is now free to OEMs for smartphones and devices of screen size 9 inches or less, and windows now has lower processor and storage requirements. While Windows still has roughly 90% market share in PCs, the overall variegated market of computing devices has vastly increased in the last 10 years, so that Windows has less than 20% market share of that wider universe.  There are large markets for MSFT software.

OEMs have responded vigorously to this overture. For example, more than 11 (up from 3) signed up for Windows phone in the first quarter of this year.  It is important to note that since android OEMS must still pay license fees to MSFT, a $0 Windows Phone license costs them less than Android.

A lower cost Windows opens up markets on devices, as in the past, to Microsoft apps. These include both consumer oriented apps such as Xbox music, video and games, productivity apps including office 365, and services to manage devices for businesses. Over 2 years ago MSFT began writing a version of Office for iOS. When finally released in late March, it was  downloaded almost 30 million times in less than two months.  CEO Satya Nadella has articulated the vision of “Cloud First, Mobile First”, and that Microsoft will focus on “platforms and services”.  From the vantage point of BYOD, this means that businesses will use MSFT productivity applications on popular devices, on the respective different platforms, and manage mobile devices with MSFT Cloud based subscription services such as Microsoft Intune.

A third way MSFT is increasing competitiveness is by partnering with competing software service and platform providers. For the past 2 years, because there is demand for services from other providers in the public cloud, Windows Azure has increasingly accommodated services on 3rd party platforms running on Linux or from other providers such as Salesforce, SAP, Oracle and many, many others. This has produced a hockey stick upshift in Azure revenue growth.  See here for more on how Microsoft is levering its market dominance in productivity applications and services to gain market share in the Cloud, from which it wields the Cloud First, Mobile First strategy.

Microsoft: Extending its Competitive Advantage into the Cloud

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September 11, 2014. The public cloud offers unprecedented scale, low cost, and global distribution. Other than Microsoft Azure, there are two other hyper scale cloud competitors, Amazon Web Services (AWS) and Google (Google Cloud). Google Cloud is distinguished in that unlike the others, it primarily does not provide infrastructure as a Service (IaaS), that is, software running on Google Cloud must use the Google platforms. Azure represents a long term competitive campaign by MSFT that goes much further than simply matching competitors’ array of 3rd party service availability on their cloud. Compared to the other hyper scale providers, MSFT has several competitive advantages in the current watershed event of computing history, the move to the cloud. I will be discussing MSFT’s position chiefly relative to the two other hyper scale cloud companies.

  1. As Scott Guthrie, Executive Vice President, Microsoft Cloud and Enterprise group (Chief of Microsoft Azure) reiterated most recently at the September 3rd Citi Global Technology Conference, the MSFT public cloud preeminently enables computing at hyper scale. Today, clusters of datacenters are positioned in 17 regions globally including People’s Republic of China, where it is the first and so far only public cloud provider. Each region contains up to 600,000 servers housed in up to 16 data center buildings each the size of a football field. MSFT, AWS and Google Cloud are the providers of public cloud services at so called hyper scale. That being said, according to Mr. Guthrie, MSFT has datacenters located in twice the number of geographical regions as AWS and 5X that of Google Cloud. Is Amazon cutting prices to compete? This scale allows MSFT to cut prices “continually” in order to compete back.

2. MSFT operates in the hybrid cloud, running applications or services both in on premises datacenters and in the public cloud. For example, Windows Server runs in a private datacenter server, or on a server on Azure. In the hybrid cloud, on premises datacenters (the private cloud) connect with public cloud to optionally extend capacity or enjoy capability of specific public cloud computing advantages or business applications or services which reside on the cloud while preserving the private control of data and resources.

The hybrid model provides advantages because businesses that have been operating historically, are approaching the cloud from the on premises starting point and are not ready to move proprietary and otherwise sensitive data and applications to the cloud all at once and irrevocably. They do not want to be locked in.

Examples of hybrid cloud advantage include enabling services run on Azure to communicate with software and data that is still controlled within the on premises datacenter. Easyjet (largest airline carrier in the UK) keeps reservations data with passenger identities in on premises mainframes. However passengers book flights on the web site, which runs on Azure to accommodate global distribution. The hybrid application makes use of on premises and cloud data.

On premises datacenter workloads or data can be extended to platforms in the public cloud as an option. Azure provides disaster recovery solutions whereby the on premises data center is automatically backed up to Azure. This is available for physical or virtual servers on Windows or Linux, competitor VMware and others. Storage of specific subsections (tiers) of data can be optionally moved from on premises to the cloud, reducing storage costs roughly 50%. The data is moved on dedicated cables and is encrypted on site before moving to the cloud (Microsoft’s acquisition of storage companies StorSimple in 2012 and just recently InMage, play a role in these capabilities).

3. MSFT enjoys an advantage in its dominant market share in the on premises datacenters from which businesses are shifting to the hybrid cloud. Windows Server has 75% market share in business servers. Currently, 95% of businesses globally run on Windows Server Active Directory. Businesses want to use the same software on the cloud. When a virtualized Windows Server runs on AWS, MSFT receives revenue from Amazon (In fact, AWS advertises 750 free hours of virtual windows server instance per month when signing up for EC2. Thank you Amazon!). Perhaps this is contributing to growth in Hyper-V (virtual Windows Server machines) share, which is now at 30.6% and has helped grow datacenter additions, the Windows Server and System Center both up more than 40% for the year (2014 (Q4 earnings call). Here, MSFT wins through growth of either AWS or Azure.

4. Another advantage is MSFT’s dominant share in commonly used productivity applications. Purchasing Office and related productivity applications as a service running on Azure (Office 365) relieves businesses of the cost of maintaining datacenters, gaining the agility to increase or decrease usage with work load fluctuation, while increasing security and availability globally. Moreover, this move to software as a service is more profitable for MSFT. The reduction in revenue to datacenter IT service provider is replaced by new revenue to MSFT. Obviously, AWS does not compete in widely used business productivity apps and Google is competing from well behind.

Recently MSFT has made a concerted effort to make its productivity apps available on other mobile platforms such as Android and iOS, increasing market share of the MSFT apps. For instance, two years ago development of Office for IOS began, finally released in late March and downloaded almost 30 million times in less than two months. Once a business moves to Office 365, its users are managed via Active Directory and the devices are efficiently and securely managed using Windows Intune (for which there are over 10,000 paying corporate customers since release in late April 2014) within the Enterprise Mobility Suite. Yes, that means all those iOS and Android as well as Windows devices. This is another point of competitive advantage for MSFT, in that the device business (with relatively low gross margins) is intrinsically less attractive than the type of mission critical software with switching costs that MSFT is using to manage the devices and enable them to be productive in a secure way.

The ability of services run on Azure to accommodate various cross platform devices at incredible scale was exampled in the largest content streaming event in history, the Sochi Winter Olympics. Content was streamed via over 6 million app installations cross platform on mobile devices, and over 500 million web pages were viewed with more than 25 billion requests to Windows Azure virtual machines.

MSFT dominance in historical productivity services and apps means hybrid cloud represents an extension of MSFT’s durable competitive advantage into the future. Here MSFT is leveraging its franchise in office to extend its competitive advantage to the cloud, in a way that competitors cannot. By enabling customers to keep managing their data flexibly and continuing to use established management software, MSFT is keeping the high margin productivity software business as customers gradually transition to the cloud with software as a service (Saas) such as Office 365. Meanwhile, MSFT is competing with AWS and Google Cloud by lowering prices in infrastructure as a service (Iaas). AWS and Google have fewer high margin businesses to move to the cloud.

5. For the past 2 years, because businesses demand services from providers other than Microsoft in the public cloud, Windows Azure has increasingly accommodated services on 3rd party platforms running on Linux or from other providers such as Salesforce, SAP, Oracle and many, many others. These disparate services and platforms can be accessed on Azure via a single sign on credential using Active Directory, allowing businesses to efficiently and securely manage access to services by staff worldwide. In fact, 3rd party platforms or services are easily managed within a graphical user interface. As Azure accommodates the platforms and services that are demanded in global business, this has produced a hockey stick upshift in Azure revenue growth.

6. Emerging classes of applications on the cloud include business intelligence (BI) and machine learning. (ML). In BI, cloud applications can process large amounts of data from MSFT and non-MSFT platforms running in Azure and present it in useful ways to the customers. This was demonstrated using Salesforce in the recent WPC 2014. In machine learning, amounts of data that are too large or physically separated to process on the business’s own datacenter are analyzed in the cloud to make predictions. For instance, a retailer might upload data from customer purchase behavior to be analyzed in Azure ML, to guide targeted email marketing to target offers based on predicted next purchases. Machine Learning is the basis for the newly announced Delve, which provides up front display of the most relevant information for the user within Office 365, thereby keeping track of relevant events and new information from the entire enterprise for the user. BI and ML are being introduced to the widely used applications within Office to integrate the power of cloud computing to enable more complex questions to be answered simply, in everyday business.

Recent revenue growth in Azure and related software is a result of the ability of Azure to enable innovative agility, scale and distribution to Microsoft software applications that have switching costs with captive customers. Even though Microsoft has not been the first to the public cloud, it is succeeding because of previously existing competitive advantages. Moreover, openness to 3rd party platforms and applications enables access to novel markets.

Over 57% of Fortune 500 companies are now deployed on Azure. Synergy Research Group reported that in the second quarter of 2014, Azure revenue grew three times faster than the other hyper scale cloud providers: MSFT at 164% yoy, AWS 49%, Google 47%. In the 2014 Q4 Earnings Release \ it was announced that Commercial Cloud revenue (Azure) had grown 147% since the year previous Quarter, at a run rate of over $4.4B. The attractions of the cloud (low cost, scale, agility, global reach) are helping MSFT applications. Over 25% of global businesses have now licensed Office 365.

Summary:
The emerging generation of cloud driven apps brings the power of hyper scale computing to everyday business applications. But the path to that new era runs from on premises datacenters through the hybrid cloud. MSFT is using its dominant market position in productivity apps to forge a strong share in IaaS hosting 3rd party platforms and becoming a one stop shop for enterprise software. Over a period of likely more than a decade, MSFT can bring businesses to MSFT platforms in the cloud as a PaaS provider, to cement its control of business “plumbing”, the standards for business processes. Then, it will control its economic future in the public cloud. An investment in MSFT represents a part ownership in this massive future market. In 20 years when we say, “business today runs on the cloud”, to what extent will this imply, “runs on MSFT software”? Notwithstanding, surely there will always be partners as well as competitors at all levels.

Finally, where does this leave us regarding a purchase decision? I will not add an exhaustive valuation analysis of MSFT here. In fact, for years the investing community has had low enthusiasm for Microsoft and therefore valuation of MSFT is relatively safe.

MSFT had Free Cash Flow (FCF) of over $26B in 2014, with FCF/sales of over 30%. The lowest such ratio in the past 10 years was 27%, in the teeth of the recession in 2009. PE is 17, midway between the high PE of 25 and low of 9 in the past 10 years. One of my favorite valuation measures is also extremely simple: Cash Return. This is the cash a company generates, as a percentage of its capital, both equity and debt. Cash Return equals FCF plus interest expense divided by enterprise value. Enterprise value (EV) is market cap, plus debt, minus cash. EV is in fact the price an investor would need to pay to purchase the entire company. According to Morningstar, MSFT Cash Return is 8.5%. Excellent, considering this is a company with clear competitive advantages that should continue to generate an above average return on its investments well into the foreseeable future as it has in the past, without important changes to its capital investment requirement.

Why Book Reviews?

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July 27, 2014.

I am reluctant to spend time learning how to invest successfully, solely for my own benefit.

I have benefitted from my attempts to teach others, in that teaching successfully requires that one articulate ideas lucidly, whether in spoken conversation, or in writing. And I do aspire to write truthfully.  So, teaching others helps me in that journey. 

There is also the ethical aspect. Just as I helped myself and my family by investing, I may perhaps touch others, who might discover the opportunities and gratification of the investing approach to life. Others may benefit so immensely from understanding that investment is fundamentally, the allocation of your resources, to preserve and grow your capabilities, maximize your potential. And your truly maximal potential will be as directed by your talents and intentions, no others.

I have learned by reading accomplished investors. Their writings are a crucial starting place and continuing education, and it is natural and important that I point my readers to this material. I have read every book I review. My reviews are my personal take on the book, not taken from elsewhere.

How we invest: distinguish fear and opportunity, insist on great companies, ignore wall street.

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latest twitter pic7-9-14
Amateur Investor blog describes an approach to investing which can be executed on a part time basis, but hopes to beat average market returns.

Without question, Amateur Investor stands on the shoulders of giants. I came to investing relatively late in life, awakened by the cataclysmic power of the markets in the tech bubble of 2000. I embarked on a period of study and discovery of investing. I found that the greats of value investing possessed the antidote for the carnage that was the bursting of the tech bubble. Beginning with the greats of value inviting, including Warren Buffet, his teacher Benjamin Graham, and many other investors and writers, I iteratively honed my own approach.

I will take Benjamin Graham’s definition of investing as a minimal definition of investing as opposed to speculation:

“An investment operation is one which upon thorough analysis promises safety of principle and an adequate return. Operations not meeting this are speculative. ”
The fact is, successful Amateur investment requires more considerable studying, reading than the complete novice might desire. The possible exception to this is investment by the formula of Volume Cost Averaging.

And yet in my own experience various things have become apparent:

First, the investor who is prepared to spend a few pleasantly enlightening hours per week learning how to invest, and who has the requisite psychological approach, can obtain better than average results.

Second, he or she can obtain these much more efficiently by focusing on common stocks of companies which have certain attributes which allow them to earn better than average earnings for a prolonged period of time. Moreover, they progressively increase the ratio of their gross margin over time. I call these Eternal Companies, because they perpetually put their growing earnings to use strengthening the Company in a self-reinforcing virtual cycle, alongside growing benefits to shareholders

Eternal Companies are wonderful, but they are no mystery, and can be identified by a due examination of available financial statements, consideration of the economics of their business, industry and the company’s position in it, and other FACTS.

A key advantage over those will not beat the market, is the Amateur Investor learns to distinguish economic FACTS form wishful thinking. Coming to terms with the compelling reality of actual costs has the effect of drastically thinning the universe of investing opportunities , allowing one to focus on the rare Eternal Companies. The Amateur Investor finds that professional analysts often say “YES”, when they mean “I DON’T ACTUALLY KNOW, NO ONE DOES, but I will say yes because it sounds much better”.

Accepting the need to be emotionally comfortable with the investment is crucial. Because only with confidence in the Company can the Amateur Investor himself endure the vicious downturns in the market which are a central reality of investing. Indeed, particularly for Eternal Companies, it is these otherwise anxiety provoking market fluctuations which make possible the purchase at a relatively low price. This is one crucial key to above average returns in the long run.

By focusing exclusively on these rare companies, the Amateur is able to much more efficiently and contentedly concentrate and deepen his knowledge of his beloved eternal companies. A deep knowledge reinforces confidence, contributes to peace of mind.

Confidence and peace of mind in the Eternal Company investment enables the Amateur to hold the investment for a long time. Eternal Companies earn better than average earnings over a prolonged period of time. In order to realize the benefit of this economic power, compounding returns must be allowed to operate for as long as this economic power continues. Thus, psychological comfort with the investment unlocks the final step to realizing the potential of Eternal Company investing.

Truly,

Amateur Investor.

Header picture: view of Manhattan from Hudson River across George Washington Bridge and Upper New York Bay.

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Manhattan was originally home to the Lenape Native Americans. In 1524 the Florentine Giovanni da Verrazano became the first European to sail as far as Upper New York Bay, and named it after his patron – the King of France’s – Sister. But it was almost a hundred years later that Manhattan’s destiny began to take shape, when corporate raiders of The Dutch West India Company arrived far afar to map the area, with more tangible goals in mind. In 1624 the New Netherlands was established, based on fur trading, and the island of Manhattan was purchased from the natives for approximately $1000 in 2014 USD. The Manhattan enterprise was founded by the Dutch West India Company in order to serve shareholder interests (“tend to the benefit of subscribers”). This focused people’s efforts in productive directions. For instance, when the colony political leader Peter Stuyvesant tried to ban Jewish financiers in the 1650’s, he was corrected by the corporate leadership. Shareholders, including some important Jewish shareholders, demanded the earnings that increased economic activity would bring. The right thing was what would secure long term growth in earning power. Growing the financial industry in Manhattan would grow its competitive advantage.

Manhattan’s competitive advantage was its geographic location with excellent harbor, which attracted the most dynamic elements of the growing Colonies, United States, and a continuous stream of immigrants. This quality strengthened as trade volume and diversity vastly increased with the development of Canal transport to the growing Midwest, later rail and increased shipping. From the beginning, its status as a trade center translated into bleeding edge financial innovation. While becoming a financial center, a large diversity of occupations were attracted to the island.

In 1975 accelerated overspending led NYC to the literally violently teetering brink of bankruptcy. But it was saved, by temporarily chastened unions, bond holding banking interests, and pressure by a nervous US government and foreign financial and government interests, who feared a wider banking crisis. Simply put, New York had to be saved in order to preserve its financial advantages: it was indispensable.

With a renewed devotion to the pursuit of the free market, New York City boomed in the 1980s, 1990s, and 2000s, as Wall Street ascended to new heights of paramountcy, financial wizardry and notoriety, with the customary subsequent tumbles from sun drenched elevations, and temporary regrets.

Today, Manhattan continues as a financial center, as well as a center in many other areas. The reason it endures goes beyond tangible volumes of transactions. The quality that emerges from the interaction humans in a wide range of socioeconomic, cultural, ethnic, national, aesthetic, and many other types of diversity, is propinquity. Propinquity, closeness to each other of distinct entities, or people. If you want to access the potential and the fruits of the entire planet’s resilient, resourceful, dynamic individuals, you can come to New York.