A new blog

Just came across a new blog. It is

http://elephantfund.blogspot.com/

Very detailed write ups on various companies. Takes the time to explain approach to security analysis. Goo read for a new investor.

More Thought On Moats: A Subjective or Objective process?

I would like to discuss the process I am going through as I try to think about how to evaluate companies moats (this is a shorthand way of describing if a company has a strong competitive advantage in its industry, Buffett says think a moat around a castle).

Essentially, I am grappling with the identification of a moat in a business. Is it a subjective or objective process, or is it both. And if it is both, which analysis comes first? To date the following is what I have considered.

I have read this



and thought it was a really great book because it provide the best explanation on how to understand what Buffett is talking about when he says stay within your circle of competence.

Buffett (or was sit Munger) has actually discussed reading a book on quotes form Einstein and I think this quote of Einstein's is what forms the basis of Buffett's circle of competence (I may be paraphrasing from my memory)

Einstein said that "everything that counts cannot be counted; everything that can be counted does not count."

Essentially to me the circle of competence is just that...there are a lot of companies that count but I simply will not have enough time to count them properly because of a lack of understanding; and there are a lot of companies that I can count but aren’t worth my time to count because while I understand the business they are not worth counting.

So I began to think how is it that will I be able to identify companies within my circle of competence that have moats, is it an objective or subjective process?

(a simple and quick way to think of the difference between objective and subjective is this: if 100 people break their leg exactly the same way we can use one objective test, x-ray, to confirm all 100 legs are broken; but if we were to ask each person to describe the pain related to the leg breaks that are the same we would get more than one single answer. That is because we can objectively identify what is causing the pain, but cannot measure how that pain is meaningful to each person)

So how does that relate to identifying whether a business has a moat of business?

Well there are objective tests to determine whether a company has a moat (some complex some simple, like using ROIC, ROE, ROA, etc, over a given period of time) but do the objective tests initially help me identify companies I should invest in. For me the answer is no.

Why?

Well I was reading some notes from one of Buffett’s annual meetings…where he questioned the idea that anyone could provide an intrinsic value analysis of each of the 1700 companies in the Value Line Survey.

Which is not to say that that it is not objectively impossible to perform an intrinsic value analysis of all 1700 companies…just that no one person can do it in a meaningful way within the circle of competence paradigm.

As Buffett has often said, he is reluctant to invest in technology stocks not because he disbelieves their value as companies; rather because he cannot form a subjective understanding of the business model in order to apply his objective testing, this even though someone could easily explain to him the business. But Buffett recognizes that Bill Gates can apply that objective testing to an area Gates understands from Gates own subjective point of view.

So this got me thinking about the whole circle of competence thing again…yes I can use objective measures to value companies and to determine moats…

But the subjective reality is that it is impossible for me to do so…if you agree that no one person has a circle of competence wide enough to encompass every company than it does not matter how accurate the objective tests is…because without first understanding from my internal subjective point of view the value of the company as a business…the objective identifiers provide no value to me.

Put a different way, as a man who has grown up in the United Sates I can easily tell you what a “yard” is (three feet) and what it measures (about the width of a standard doorway); but while I can tell you what a “meter” is a (length of measurement in the metric system) I have no idea what it measures. Therefore my knowledge of the objective “meter” has no value to me because I have no means of subjectively understanding it or measuring it (think Green Eggs and Ham, Sam I Am, Is it bigger than a house? or smaller than a mouse?).

Therefore, as a new investor I realize that objective measures can be a trap (“well this company has a low P/E, P/B, P/whatever ratio or high ROIC, ROE, so it must be a good deal”) without first understanding what it is I know, more importantly understanding what it is I do not know, finding companies that fit within my subjective knowledge base, rejecting those that do not, and only THEN applying the objective measurements to determine whether a particular company has a sustainable competitive advantage. To use the objective test without being able to articulate a subjective rationale provides a measurement to me without value. (Of course I am limiting my discussion of identifying companies which form the core of an investment portfolio; I do not mean to say that qualitative factors in and of themselves do not provide an easy way to identify stocks that will provide satisfactory return in the mid to short term).

That’s why to me identifying moats is a first and foremost a subjective identification process followed by an objective confirmation. To me, and maybe not to you, a company has a moat (or does not) because I personally do (or do not) understand the business, regardless of whether someone can try to explain the moat to me in simple terms.

Take care

Steven

Is your moat safe?

I just read an article

http://www.forbes.com/2006/05/23/eppy-awards-newspapers_cx_pm_0523notes.html?partner=yahootix

which got me thinking about moats. To me moats are not static things, they actually need care and feeding. Moats, like the tide can ebb and flow, and sometimes fail.

The article above talks about how newspapers in general were slow to respond to the internet. Instead of thinking of how to use the internet they ignored it...and now are trying to figure out how to stay as relevant in the future as they have in the past.

The best thing about the article is that it uses Target to make a point. Several decades ago when the parent company formed Target it was as a small part of a much larger company. But now the Target division IS the company.

What does this mean to a new investor like me. That in trying to figure out whether a company actually has a moat, it is also important to make sure that the castle itself is still relevant.

I mean think about the whole idea of a "moat" itself...

a moat protects a castle...but what happens if you got a 16 inch cannon which can fire a shell over and over into the castle and lay waste to it? I mean you still got a great moat..but no castle to protect.

Or think about all those forts that were placed at riverheads...they are all national monuments now because they are largely irrelvant...because they guard a passage that no longer controls the flow...everyone just went around them.

So thinking about a company that has had a moat that so far has protected it is pretty useless to me..it's helpful..but I want to think about what company (castle/fort) is going to or will in the future be able to take the necessary steps to protect the castle itself if needed.

Also it means that there are probably a lot of smaller companies which have a moat that has not been recognized. Target was there for everyone to see...most did not...I am sure some did. Figuring out the future moats (or figuring out which castles will stay relevant and/or can respond with newer moats) is the difference between Buffett, Munger, et. al. and everyone else.

Take Care

Steven

Book Review of Rule #1

Rule # 1





This is one of the most recent books on “value” investing. (As used here, my term value investing merely refers to the idea of buying a company or its stock for less than its value; as opposed to other reasons).

Remember I view everything I read through the prism of having only been a student of investing for 4 months now and therefore comment on its utility to me as a new investor. Such comments may have more or less value depending on your own experience. While I at times may offer criticism of the book it is not negative by any means; but rather constructive as the utility of the book from my point as a new investor.

With that said….

Overview
The Book
My Comments


I. Overview

Overall I think this is a very good book for a new investor. This book’s value is not found in the originality of the subject matter, the concept of paying less for what you buy has been covered by Ben Graham, Philip Fisher, and Warren Buffett for many years; but this book is original in that it provides a more accessible way for people to understand those concepts without having to read the original text.

But if for one reason or another they prove too daunting to you then “Rule #1” is a good primer substitute for the original work.

Essentially this book is very similar to Joel GreenBlatt’s Little Blue Book Book in that it provides a simple “formula” in which to find good companies and figure out if they are inexpensive.

The difference between the two is the Rule # 1 provides a more hands on way to apply the theory. Greenblatt’s book does include a theory and a system but the application of that system is dependant on the business which he provides; whereas the Rule #1 book provides a similar theory and system but allows and encourages the independent application of that system. I think both books do a good job in simplifying the theory; Rule #1 just allows a person to be less dependant on a particular information source than Joel Greenblatt’s book does* (which may or may not be a good thing for all people). Essentially Mr. Greenblatt tells you how to find good companies selling at a discount, the only problem is order to do this you have to go through his website, which may not be a negative but it fosters a dependence on him].

Therefore, I think Rule #1 should be read by ever new investor who desires a basic understanding of how to identify good companies and determine if they are selling for a “sale” price.

The Book

The Book can be divided into three separate parts. Essentially the book shows you:

How to evaluate a company as to whether it has a distinct advantage over other companies to determine if it is a “great” company that we should want to own

How to determine what a fair price for the company is on a per share basis and to figure out whether the current price allows for a margin of safety just in case we were over optimistic in our evaluation of just how good this company is

How to apply certain technical indicators to buy and sell stocks.


To identify good companies the author takes you through a multi-step system. The best way to understand it would be to use the link I have on the right to the Phil Town blog and read the last year or so of blogs which uses examples and case studies to show how the concepts are applied. Essentially, you must understand the business and it must be reasonably stable and growing.

I think the book simplifies the process of identifying a great business a bit too much in that of the three steps this one is the hardest to do in my opinion. My opinion is based on the fact that the ability to forecast how the economy may or may not change and that effect on a particular business is the ultimate question. Using the past to demonstrate the soundness of a company today may demonstrate that it is great today and yesterday; but the application of the past to the future is a process that requires caution and more than a bit of humility to understand the limitations of one’s own ability to predict the future.

But as far as explaining the concept Mr. Town does a good job of communicating it to someone with no prior exposure.

To determine a fair price for a company Mr. Town also provides a simple way to perform a discounted cash flow analysis (which is a way to determine the future value of a business today looking into the future). Mr. Town does a good job of is trying to show the new investor that you do not need an advanced understand of math to figure out the present value for a company. The book also does a good job explaining the concept of margin of safety.

The final part of the book is perhaps the most original for a new investor. Mr. Town articulates the idea that several decades past Mr. Market was the collective conscious of millions of investors acting at once. In the last two decades Mr. Town points out that the actions of individual investors has been replaced by mutual funds.

In essence the book argues that mutual funds/institutional investors ARE the market (Mr. Town calls them the Big Boys) now because in many issues they collectively own 30-70% of a companies common stock. Mr. Town believes that the advantage little investors have over the big boys is that we can enter or exit a position much more easily then they can.

In essence in order to maintain an orderly market a mutual fund will have to take 3 weeks or so to accomplish its move. Therefore, when a Big Boy decides to act us little people need to get out of the way in Mr. Town’s opinion.

How do we do that? Well Mr. Town uses three technical indicators which he believes can signal when a stock is going to move up or down.

Prior to the book being published I posted on Mr. Town’s blog on how and why the indicators might work. This is not to say that they do work, just to show that they might be worthy of further study.

You can read it at

http://philtown.typepad.com/phil_towns_blog/2006/02/
getting_out_of_.html


Essentially the indicators are used to avoid losses and to book profits.


My Thoughts

As stated I thing that the book does a real good job of simplifying the Graham/Buffett style of value investing in identifying good or better companies that are selling at a discount. I also think Mr. Town does a good job of not boxing the new investor into having to use one data source or subscribe to one service. Mr. Town does a great job of explaining what he recommends but shows how to get the necessary information for free.

On the other hand I think that new investors should be very cautious when projecting what will be a good business in 10 years. This is the most tricky part to me and one that requires a lot of thought.

Also the use of the technical indicators is bound to be a controversial topic among value investors. In a bull stock it may be a great way to book profits on the highs and reenter on the dips, but in a bear market for that particular stock getting in and out may be tricky for the average person. It also goes against much of what Buffett has said, not that his is the final opinion, but it should not be ignored.

Also trading increases the friction costs of broker fees and if applicable taxes.

The use of indicators though is somewhat interesting because he is not advocating using the indicators as a means to determine whether you should buy a stock; but as a means to determine when the “insiders” are making a move up or down and to get in or out before they finish the move.

I see a lot of talk and posting about what Buffett or Fund Manager X is buying…(see gurufocus.com as an example)…essentially people want to know what the successful investors are doing or thinking… there is really nothing wrong with that because it is simply studying success. So when ever Buffett, et. al. discloses a new or exited position (usually in a quarterly report) everyone looks at it to see what’s going on…

And a lot of times they all follow each other because they don’t want to get left out in the cold (the I am safe in a crowd thought process, as long as I do as good as the other guy I am okay) or the company ios one that has been on value investors rader for a while (Dell Tyco for recent example)

What Mr. Town has done is offer a theory on how to anticipate what the money mangers are going to do in real time based on their limitations on size….

For instance lets you have determined that company X is a good company that you understand and feel can predict what its current value is with a margin of safety. Assuming that it is selling with a suitable MOS (fair price is 50 selling for 25) should you buy it now?

Well if the big boys come to the same conclusion and want to buy a million shares they will take 3 weeks to do it…and other big boys will see the move and do it to…and what MR. Town believes is that when this happens we can see it using certain technical indicators and get in front of it…

The same thing goes for negative movements …Company X might be announcing earnings in a month…we can read about the estimates. but that’s it…

Well the big boys eat, drink, and party (so to speak) with the people who do know (CEO, CFO, COO, etc) and they will get a “whisper” at the club or the golf course…and if a big boy is bailing on a stock (or buying) pre announcement we may see it, using Mr. Town’s selected indicators, because the big boy will have to start the move a few weeks out…

So the little guy like me might not get the whisper directly but if I pay attention I might see it anyway…

If you go back to my post on Mr. Town’s blog you will see what I mean

As you can read from Mr. Town’s blog doing this sounds simple but takes a lot of practice. So as a new investor the idea intrigues me but no system is perfect and I do not have the resource or skill to determine or backrest Mr. Town’s use of the indicators over a wide number of stocks. I would say to anybody to tread very lightly in the use of technical indicators.

So as a new investor I would recommend this book for the following reasons:

If you are not sure how to figure out what is a great business then this book provides a good simple way to think about it

If you are not sure of how to do a discounted cash flow analysis then this book provides a good introduction

And if you have ever wondered if you could use technical indicators to make money than this book talks about that and gives you some ideas

but this book like all books is a starting point for further research.

If you are having a hard time reading Benjamin Graham’s work or understanding what Buffett means than this book could serve to help you get into other works. But this book should not be the last book you read on investing (if there ever is such a book). And you should also read a lot of material form Graham and Buffett as well as others regarding the merits of technical trading even if it has a value basis.

Also just reading Mr. Town’s blog will be great as well or will serve to fill in some gaps he could not address in the book.

Overall this is a good book to get if you are just starting out or find Graham et. al. a little to in-depth at this point.



Take Care

Steven

Another Good Blog

There is a blog that I have mentioned before as a good blog

http://gannononinvesting.com/

(I call it GOI for short) but I have not really talked about why. Now I will.

Geoff Gannon is the publisher of the above blog as well as the producer of podcasts, and the writer of a quarterly newsletter. The blog and the podcasts are free; the newsletter is a paid subscription. I have been reading his blog since I just about started investing...I think I found it sometime in January from Shai's blog (link on the right) regarding a discussion of whether value investing and technical analysis can coexist.

Anyway the blog is a straight blog on value investing, which is not to say there is not a discussion of growth, but that it is a blog on fundamental/quantitative analysis of companies.

GOI does not try to mix any sort of TA or momentum into the value investing paradigm. GOI is all about helping me learn how to find companies with reasonable growth prospects selling at a discount to their intrinsic value using several metrics.

The beauty of GOI is it discusses the complex in a way that is simple to understand. That is not to say that GOI is a simple blog...in fact the points made are often so subtle that one must re-read a blog in order to clearly grasp what has been said. It is just very well written in language even someone like me (only investing since 12/05) can understand. GOI just does a real good job of explaining complex topics in a way which new investors like I can follow along.

The blog does many things well...it does posts on current news...reviews other blogs...provides links to relevant websites...and does in-depth value analysis.

The in-depth analysis is the best part. If you are new like me and struggling to understand how to evaluate a company, what an evaluation looks like, and the things that go into it, GOI sets it all out for you…(GOI has done analysis of LXK, JRN, OSTK, and a few others since the blog started in 12/05).

If that was not enough, GOI also gas a glossary/encyclopedia of investing terms. So when you are reading one of GOI’s posts, if he uses a specific term or investment metric that you are not to sure of, GOI provides a hyperlink to the glossary so that you can understand what he is writing about (for instance the definition of free cash flow). This is very helpful to a new investor.

I have waited this long to write about GOI because I wanted to see what the Gannon Quarterly Newsletter (GQN for short) was all about. The GQN is the subscription newsletter I mentioned at the beginning of the post. After reading GOI for a couple of months, I decided to take a chance and buy the GQN for 1Q 06 (as the name of the publication is the gQn, it is published at the end of each Q with more in-depth discussion of specific companies added or subtracted from the GOI portfolio).

Well I actually took no chance because the GQN met or exceeded my expectations. As it is copyrighted material I really can not go into specific details or quote passages to you (I do this not as a way of teasing you at all, it is just that I respect the author’s desires) but the newsletter is professionally printed, well organized, with graphs and charts as well as meaningful statistics and analysis (essentially each company reviewed is given a one page stat sheet similar to what you might see at Value Line with an accompanying in-depth 8-12 page analysis). GOI also offers a general market commentary as well.

While the company analysis would be well worth the price paid, the true value to me so far is that in reading the general commentary GOI has provided to me a way to think about investments I had not previously thought. Essentially he has helped me understand better what is value investing and what is not (it may sound simple to say but being able to repeat something is not the same as identifying it, e.g., taking medication is easy; knowing what medical problem exits is the hard part). For that alone I feel I got my money’s worth.

Now I must state that over the last few months I have emailed GOI with specific questions which he has always had time to respond to. So I have had “personal” contact (I say that within the confines of the internet, i.e., exchanging emails, as opposed to the non-internet world contact of sharing a cup of coffee for example) with GOI and have not been a passive reader. But I have not ever received anything of value from GOI other than that which everyone else has received, which is his writing on investing at GOI.

Anyway GOI is on my short list of blog’s that I must read. A new investor can do very well just starting at the beginning of his blog posts in December 05 and reading straight through to get a good handle on value investing. Of course reading offline books will always be helpful, but GOI provides a good resource to read, learn, and ask questions. As far as the GQN goes, I think it provides very good value for the money I spent and can recommend it, but a new investor can also do just fine reading GOI. I recommend you check it out.

Take care

Steven

The Best Investment...

The best investment...is you. Or so says Warren Buffett at the last annual meeting accorfding to OID's most recent edition.

What he is talking about...well Buffett says he meets a lot of young adults (probably all those college students from undergrad Business and MBA programs) and many of them he is willing to give $100,000 for 10% of their future earnings..thereby valuing them as a "business" investment that will produce a milion bucks (and probably more) over their life times.

Why does he do this....because at the heart of it..all investment is about investing in people. So Buffett beleives that the best thing you can do with your money is invest in yourself.

What does that have to do with your own persoal investments...for me plenty.

It is the old saying of give a man a fish..or teach him to fish...

Before you figure out what comapny and its people to invest in...take some time and invest in yourself. Read some books on investing, learn how to read financial statements, do a discounted cash flow analysis, etc. Believe me..if your just starting out it will pay off.

We are all CEO's of companies called our families....most of us get a paycheck (revenue or sales of our time) spend money on gas, clothes and food to get that paycheck (cost of goods "our time" sold) spend money to aquire things that will help us keep on making that paycheck like a house, car (capital expenditures) ...i could go on but I think I made my point.

After we pay all the bills we got some money left over..thats the eps ...the decison then is where to distribute it...do we reinvest it into ourselves...and grow our business...or distribute it as a dividend to spend or save?

well for me...Before you figure out what company and its people to invest in...take some time and invest in yourself. Read some books on investing, learn how to read financial statements, do a discounted cash flow analysis, etc. Believe me..if your just starting out you are probably going to get a better return on your money by investing in yourself and growing your knowledge base than you will rushing into investing....or askign someone else to make the decisons for you.

Once you have spent enough time to learn about investing you will get to the point where you will find that you will not be able to acheive any more growth in your knowledge base at a high rate of return (the law of diminshing returns apply here as well...the more you learn the less there is to learn easily...) you will find than that you will have a better use of your money by investing in other people and the companies they run...

I am not saying that you should ever stop growing your knowledge...my point is that when you are starting out like I am it is pretty easy to learn something because you can pick up just about any book on investing and learn something pretty quick...so you might be better off buying a $20 book than a $20 stock...your ROI maybe higher...

once it is not so easy to learn something... your knowledge is no longer a growth stock but a divdend paying stock... than focus on investing those divdends in the stock market...and keep on learning to enhance those invested dividends...

Once you start thinking about yourself as a CEO of a company it gets alot easier to understand what Graham said (and Buffett takes to heart) when he talked about sound investing is most sound when it is business like.

Hope this all helps. Take Care.

Steven