What Warren Buffett Wouldn’t Do

When looking for guidance from our role models we often ask “what would they do”? Maybe we should invert the question and ask, “what wouldn’t they do”?

Bloomberg does and asks what wouldn’t Warren Buffett do?

INVESTING

Don’t be too fixated on daily moves in the stock market: “Games are won by players who focus on the playing field — not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.” (from letter published in 2014)

Don’t get excited about your investment gains when the market is climbing: “There’s no reason to do handsprings over 1995’s gains. This was a year in which any fool could make a bundle in the stock market. And we did.” (1996)

Don’t be distracted by macroeconomic forecasts: “The cemetery for seers has a huge section set aside for macro forecasters. We have in fact made few macro forecasts at Berkshire, and we have seldom seen others make them with sustained success.” (2004)

Don’t limit yourself to just one industry: “There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.” (2008)

Don’t get taken by formulas: “Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas.” (2009)

Don’t be short on cash when you need it most: “We will never become dependent on the kindness of strangers… We will always arrange our affairs so that any requirements for cash we may conceivably have will be dwarfed by our own liquidity.” (2010)

Don’t wager against the U.S. and its economic potential: “Who has ever benefited during the past 238 years by betting against America? If you compare our country’s present condition to that existing in 1776, you have to rub your eyes in wonder… We will regularly grumble about our government. But, most assuredly, America’s best days lie ahead.” (2015)

Read the rest of the article by following the link below for what Warren wouldn’t do as a manager in a business.

Source:

Here’s What Buffett Wouldn’t Do, and Maybe You Shouldn’t Either (Bloomberg)

Wolves, 13Fs, Cognitive Ease, and Getting Trapped Along the Well-Worn Path

Wolves fail more often on their hunts than they succeed. As Nick Jans states in his book A Wolf Called Romeo,

Survival hinges on a brutal imperative: more energy must be gained than lost, across endless hard miles. To fail is to die.

When there is a lot of snow on the ground hunting packs travel in single file with different animals taking the taxing lead position. A well-worn path through the snow is a very attractive option for the pack. Less energy is spent forging their own path, leaving more energy to survive until the next meal.

The well-worn path through the snow can get wolves into trouble. Nick Jans goes on to tell how some of his Inupiaq trapper friends will drive a snowmobile, packing down the snow, and setting traps just off the newly made pathway.

If you’ve done any backpacking or hiking you know the appeal of the well-worn trail. When you’re out in the middle of nowhere the well-worn trail is mentally soothing. You don’t have to constantly check your map. You don’t have to constantly wonder if you’re going the right way. You don’t have to constantly keep a distant object fixed to your bearing. You just have to walk. You know many people have walked this trail before. You know that they made it safely. And you know you will too. Your mind is free to think about other things. You are in a state of cognitive ease.

Following a well-worn path also puts the wolves into a state of cognitive ease. Trappers take advantage of this. And like wolves, when we’re in a state of cognitive ease we can get into trouble. Especially with investing.

The Well-Worn Path of 13Fs

It’s 13F season. That time of year when all the large asset managers file with the SEC on what they own in their portfolio during the previous quarter. I have my list of people and funds that I follow. I use their filings as an idea generator and a study tool. When a manager I follow adds a new position and it fits into my dividend growth universe, I try to reverse engineer why it is an attractive investment. If I can reverse engineer the investment thesis, and I’m confident in my work, and the company is still cheap I may buy it.

This process takes a lot of work and produces cognitive strain.

It is far too easy to substitute the research work with the rationale that manager X bought it and manager X is a billionaire with a great track record. Therefore, I should buy this company too.

This line of thinking, the search for cognitive ease, can get investors into trouble. The most recent example is Valeant (VRX). The image below is from Whale Wisdom and it shows which asset managers held Valeant (VRX) as a large position in their fund during the quarter ending December 31, 2015. It includes some very impressive names.

From Whale Wisdom. Click image to enlarge.
From Whale Wisdom. Click image to enlarge.

All the names on that list did their homework. I hope.

The problem is the average investor or the average portfolio manager seeing all these famous names holding Valeant and then investing in Valeant too. Because how could all these famous money managers be wrong? They can when Valeant’s management is playing fast and loose with their accounting. Resulting in a restatement of earnings.

This is not to say that the average investor or average portfolio manager would’ve caught the accounting irregularities. But did they do the necessary research to build the necessary confidence in Valeant’s business strategy to invest? Probably not. And when you don’t do your own work, what do you do when you when you get caught in a trap?

Image courtesy of Stockcharts.com. Click image to enlarge.
Image courtesy of Stockcharts.com. Click image to enlarge.

When investing in a company you saw in a 13F, are you buying it because you did the research and the company is a compelling bargain? Or did you substitute it with the much easier question, “does manager X have a great track record?”

If you want to learn more about 13Fs and how to use them, Market Folly is having a sale on its newsletter dedicated to 13Fs Hedge Fund Wisdom.

Morningstar on Steve Easterbrook’s Turnaround Efforts at McDonald’s

From Morningstar’s Restaurant Rundown on what McDonald’s CEO Steve Easterbrook has been doing to turnaround the company’s operational misques.

The company has a new CEO. What is he doing to get the company back on track?

Hottovy: The most interesting things that Steve Easterbrook has done since taking over are changing the organizational views about accountability and being more customer-centric. Those things give us conviction that a turnaround is possible.

Easterbrook reorganized the company into four segments based on the maturity and the competitive position of their markets, which has also led to rapid improvements in the level of communication and cohesion among executives, franchisees, and suppliers.

This has been most apparent in what the company’s calling its international lead markets, which are Australia, Canada, France, Germany, and the United Kingdom. Innovations there are establishing a blueprint for more sustainable growth across the entire system.

For example, in France they’ve rolled out what they call the full restaurant model, which combines a number of different ordering technologies, whether it be kiosks or touchscreens, or just even at the counter. They’ve got a number of ways to customize burgers, chicken sandwiches, and salads. Then, there is also the in-restaurant experience, whether it be Wi-Fi, pickup at the counter, or table delivery. The full restaurant model has done really well in that market. It’s a success that could be brought to the United States.

In the United States, what’s important is that the company has decided that it’s not a one-size-fits-all market. What works in Chicago may be different from the Northeast or the West Coast.

Then, there is the recent launch of the all-day breakfast platform. It’s not necessarily the all-day breakfast platform doing well that’s got me excited. It’s the fact that they were able to roll that out from a test market to nationwide in just over six months. That’s something that we hadn’t seen under the previous management team, where it was a much more drawn-out process. Sometimes, we’d see products either delayed or outright canceled. That quick time frame gives me confidence that this can be a much more nimble company.

Source:

Restaurant Rundown (Morningstar Advisor)

Always Invert

“Invert, always invert”

It is a phrase coined by the mathematician Carl Jacobi and made famous by Charlie Munger. When you want to solve a difficult problem take the inverse.

It is the first thing that came to mind when reading about survivorship bias and where to armor allied bombers during WW2.

In World War 2 the allied nations had a problem, they were losing too many aircraft. At the most dangerous times of the war the odds of coming back were a coin flip.

The Navy decided that the best solution would be to add armor to the planes, but could only add so much, and didn’t know where to put it. They took this question (how much armor to add and where) to Abraham Wald, a mathematician working on the war effort. Wald applied his models to places where the plane hadn’t been shot.

This took everyone aback. Why armor where the planes hadn’t been hit?

Wald reasoned that if some planes were able to return after being shot in certain places, other planes had not been able to return after being shot in the inverse of those places. Wald found the survivorship bias in looking at only the planes that made it back.

Source:

Survivor Bias in WW2 Airplanes, NBA players, & Mutual Funds (The Waiter’s Pad)

How Sustainable are Signet Jewelers’ Revenue and Dividend Growth?

For the last 5 years, Signet Jewelers (SIG) has outperformed the S&P 500 by a wide margin.

From Yahoo! Finance. Click image to enlarge.
From Yahoo! Finance. Click image to enlarge.

More importantly to us, Signet Jewelers has grown their quarterly dividend by a compound annual growth rate of 17% over the last 5 years.

From S&P Capital IQ. Click image to enlarge.
From S&P Capital IQ. Click image to enlarge.

Signet currently yields 0.85% which is low. However, low yields haven’t stopped us from investing in dividend growers like Visa (V) and MasterCard (MA). We’re more interested in Signet’s ability to keep growing their dividend at a high rate.

Issues raised this weekend in Barron’s by Herb Greenberg and Donn Vickrey of Pacific Square Research question the quality of Signet’s recent growth.

Vickrey: Their core U.S. business has always had a pretty significant reliance on credit. But about 18 months ago, they made a change to their “credit decision engine”—their words, not mine—and somehow it enabled them to increase the number of people they are loaning money to.

Your report says “credit participation” went to an all-time high of 63% of sales.

Vickrey: And immediately after that, their comp-store sales received a nice boost. The company says they haven’t changed their credit standards, but they admit that the credit mix has changed. Low-quality borrowers are borrowing more than higher-quality borrowers.

 

According to Pacific Square Research, Signet has also changed the way it measures underperforming loans and how it recognizes revenue. Two more red flags.

Vickrey: The majority of companies that offer consumer financing use what is called the “contractual method” for deciding whether a loan is nonperforming and subject to being written off. If your payment is $100 and you pay $100, you are OK. But Signet uses the “recency method”; even if a client pays less than $100, the company decides whether to call it nonperforming.

When you do use the recency method, it tends to understate your nonperforming loans. And even though they are using the recency method, charge-offs increased like 23% over the trailing 12 months. Then, right about the time their change in their “credit decision engine” anniversaried, exhausting the benefit to comps, they made a change to revenue recognition for their extended service business.

The issues raised have Signet boosting revenue with unsustainable one-time accounting gains. Future growth compared to its recent past will be tough. The worst case is Signet has expanded too much credit to too many risky borrowers. If these borrowers start defaulting at high rates it would harm the company. Both scenarios affect Signet’s ability to grow its dividend at a high rate.

Signet’s payout ratio is 16% so the dividend is protected but there are too many red flags for us to be interested in Signet as a dividend grower. There are always other opportunities.

Source:

Alibaba: Digging Into the Numbers (Barron’s)