Thoughts on Getting Smarter

Today, I was watching a video of Warren Buffett, on that video there is a small interview with Charlie Munger. Charlie mentioned the following German saying: “You get OLD too soon & SMARTER too late”.

This thought is just extremely powerful in life. If you can find people that get you smarter sooner, then your life should improve big time. In my personal experience, I think this is true; in fact I wish that it was sooner (meaning when I was a child).

In my earlier years, either I did not understand this or did not have the opportunity to meet smart people. It was more towards my youth when smart people started to influence me. The biggest leap was at graduate school, I was fortunate enough to meet one of the smarter persons in the world[1].

This fascinating group of people that includes professors and students help me to get smarter every day, and this has created an avalanche of resources that allows me to keep getting smarter. (One of my professors introduced me to Charlie Munger and Warren Buffett Letters)

Today, I want more and more to relate and meet with smarter people than me, as Charlie Munger said “This is the nature of life”. I find this extremely gratifying.

In summary, we must search for people that help us getting “smarter” sooner, and we must be willing to do the same to other people, so you create a “virtuous cycle” that improves our world and human kind.

On the contrary, and interestingly enough as well, I have spend big part of my life to help people getting “smarter”; and I have found both, people that wants to learn and others that don’t; I can’t answer why people will not want to get smarter earlier but for me if only one of those is willing to listen and learn faster I have done my part.
[1] The word “Smarter” not only applies to high IQ but people with high understanding of human nature and “life”

My Take on Growth

While doing valuation work it is always interesting that most of the people start thinking about future growth. The assumption of growth is interesting, because it assumes that you can look at the future very clearly. There are also people that "assume" low growth rates into their calculations, and believed that they are being conservative.

The problem with the above is that Im inclined to think that no one can actually predict what would be the growth rate in the future, at least in a precise mathematical number.

On high growth companies, many valuations include growth rates for 25%, 20% or 15% for long time. Many others utilize a two or three step DCF that includes declining growth rates at various periods of times. While this sounds mathematically correct, I do not think this is a sensible approach.

Many studies and examples tell us that very small portion (Less than 5%) of companies can growth at 15% for more than 10 years. So how can someone be sure if it’s growing at 20%, 18%, or 30%? Here is where Buffett, Munger & Graham, becomes handy.

Buffett likes businesses that he can understand and businesses where he can see 10 years from now. Graham on the other hand believed that he could not put a value of the company, and he also believed that that was not his job, but rather his job was to make sure that he will not loose money. That’s how he came up with the concept of Margin of Safety; since he could not put a precise value to a company, and then he buys with margin of safety and the rest, is up to the market. Don't remember who mentioned this but "I rather be approximately right, than precisely wrong".

So how people like Buffett, see the company ten years from now. Well, basically they don’t care about being precise, what they want is to be sure that the industry and/or the company will be there in ten years and to do this you need to make broad strategic judgments about the future. This is not about thinking if Paychex or Panera will growth 15% in the next 5 years, but rather if both companies will still in business or if the industry will be viable.

Buffett loves companies with moats, basically when discussing moats he performs a broad strategic decision. Buffett lecture to MBA students in Florida (1998) bring some light into this:


"...So I want a simple business, easy to understand, great economics now, honest and able management, and then I can see about in a general way where they will be ten years from now. If I can’t see where they will be ten years from now, I don’t want to buy it".





Based on the above, even though Buffett is the greatest mind in investing, it's impossible that he knows what will be the growth rates in the future for a company. But broadly he can make judgments about viability of an industry or a company in the future. That's the first question at trying to understand a business.... is the industry/company viable? Any moats around?

Also consider that he wants great economics now, not in the future, not tomorrow, but now!.... He does not want a rosy picture; he wants to pay for what is there now.

But if the company is viable and he can see that the company will be in good shape 10 years from now, he knows that if he pays a reasonable price, his returns will come.

There are many questions that we can draw from this: Why to worry about precision on figures?..... What's what really matter? Specific growth rates? No, only broadly strategic judgements. What’s growth? How can you be sure about growth? Is that what’s important?



Thinking more on what I posted in my previous email. I re read Greenwald's thinking on growth. This brings us to a very, very important lesson, for those (like me) that have been "bewitched" by the darlings of growth. Predicting growth is not what seems to be.

Basically Greenwald mentioned the following:

"It takes both high rates of growth, relative to the maximum rate of R, and high levels of profitability, relative to the cost of capital R to generate large levels of growth related value."


Based on the above statement, value created by growth depends on two factors:

1) The profitability of the incremental capital employed. ROC / C;

2) How fast the franchise grows.

If we take Greenwald's formula, trying to detect growth can be an impossible task for any investor.


Let's assume the following numbers for a particular company:

G= 10%

R = 12%

ROC = 25%

Where:

G= Growth

R = Cost of Capital

ROC = Return on Capital

M = Multiple to current earnings power for no growth.

Greenwald's formula is

M = 1-(G/R)(R/ROC)/1-(G/R)

The above numbers give you a multiple of EPV of 3.6. So, if Earnings with no growth equals $100M then the value of the enterprise with no growth equals $800M, then if the company grows at 10% for long period of time, then the value of the enterprise should be 3 times the value of no growth of $2.4B.

But what happens if the company only grows at 8% for long time? The value of the enterprise should be only 2 times or $1.6M (this is a $1B miss in your calculation for only 2% miss on growth)

What happens at 5%? Value drops to $1B...

So, here is why growth needs to be taken not as a precise figure, but only as a margin of safety; Too much variability into results. I guess we can assume safely two things: 1) the industry is viable? 2) If yes, Barriers to entry? Are there any sustainable competitive advantages? The rest is to obtain growth for free.

I think that if we are able to find a company, valued at normalized earnings power assuming no growth. And the company prospects are to keep growing, that should be our margin of safety, providing that ROC can be maintained.

Lesson - Dont pay for growth, unless you understand the business extremely well and know why it should be worth more. Like Greenblatt said" You do not have to go trough life doing that (referring to paying up for growth). I think is harder to do, because you have less room for error.... its hard to do because you can screw up." (See Benjamin Graham below)


Benjamin Graham in an interview back in June 3, 1955 named “How to handle your Money” stated the following when asked about growth:

A Growth Company is one which a) will be expanding its business and its profits at more than the average rate, and b) will in the course thereof be investing a large part of its profits back in the business.

Q: When you get into the growth stocks, you get into a situation where a man needs a great deal of knowledge?

BG: I think so. But even it’s hard to tell how good your knowledge is; because growth stocks lead to the future, and you don’t really ever have any knowledge of the future. You may have a more expert guess that the other man, but it stills a guess. And many mistakes have been made in buying growth stocks on the theory that the future will duplicate the past.

Q: In trying to buy something for long term growth, you ordinarily have to recognize, one that you are taking a chance and, two, you perhaps have to sacrifice income along the way in order to achieve a long term growth. Isn’t that ordinarily the case?

BG: Yes. The chance is basically related to the point that you pay a higher price for a security in terms of its past and current earnings and dividends than you would for non growth securities, and there is always the possibility of disappointment. The company would have to be better than the average company to justify the price you pay for it. Maybe it won’t be, but you think it will.

Pavlovian Conditioning, Operant Conditioning & Coca- Cola

I recently bought Poor Charlie’s Almanack, which is a review of Charlie Munger life. The book is structure similarly as Poor Richard’s Almanack by Ben Franklin. For those interested in the understanding Charlie’s multidisciplinary approach, I highly recommend to buy a copy.

In the book, there is a speech given in July 20, 1996. The name of the speech was Practical Thought about Practical Thought? This speech is a great example of what is Charlie approach about. It gives a clear example of how to think of Coke as a great investment assuming you were in 1884. Even though he gives various examples of multidisciplinary approach I will discuss just one of them “Pavlovian Conditioning” and how it relates to Coke.

For those not familiar with Conditioned reflexes, let me briefly explain what Pavlov did.

Pavlov's experiment & Conditional Reflexes

“The most famous example of classical conditioning involved the salivary conditioning of Pavlov's dogs. Pavlov's dogs naturally salivated to food. Pavlov therefore called the one-to-one correlation between the unconditioned stimulus (food) and the unconditioned response (salivation) an unconditional reflex. If a tone (generated by a tuning fork, for example) was reliably sounded for a few seconds before food, however, the tone eventually came to elicit salivation even when the tone was presented alone. Because the one-to-one correlation between the conditioned stimulus (tone) and the conditioned response (salivation) involved learning, Pavlov referred to this relationship as a "conditional reflex". The conditional reflex (food-related behavior elicited by a stimulus that has been reliably paired with food) is said to be developed through classical conditioning.

The origins of the two reflexes are different. The food (unconditional stimulus) causing salivation (unconditional response) reflex has its origins in the evolution of the species. The tone (conditional stimulus) causing salivation (conditional response) reflex has its origins in the experience of the individual organism.” (Source: Wikipedia)

Operant Conditioning

According to Wikipedia “Operant conditioning, also called "instrumental conditioning", involves the modification of behavior due to the consequences of behavior. When a response or act is followed by a reinforcing consequence, the future probability of the response increases. When a response or act is followed by a punishing consequence, the future probability of the response decreases. Operant conditioning is generally associated with B.F. Skinner (1938, 1953, 1957). During reinforcement and punishment, the behavior of an organism is changed by the experience of the coincidence of the response and consequence (some would say the contingency between the response and consequence). The organism (or the response) is thus said to have been conditioned.

A typical example of operant conditioning in the laboratory would be a comparison of the response rates of rats under two conditions. In the first, rats are allowed to press a lever with no programmed consequence. In the second, rats are allowed to press a lever with the result that each lever press is immediately followed by giving the rat a small portion of food. Generally, the rate of lever pressing is higher in the second condition. It is then said that lever pressing was reinforced by the presentation of food, or that the response-contingent presentation of food strengthen lever pressing.”

Basically, you create stimuli and you will have a desire response.

Back to Charlie, he challenge us to describe to a Venture Capitalist how to make a $2trillion Dll business from 1884 to 2034, and we have 15 minutes to describe our plan how to achieve this out with basic knowledge of freshman courses (assuming 1996 knowledge) but back in 1884, and assuming we do not nothing about what happened in the future (Got it!).

He first asked us to start any solution to a problem by simplifying “no brainer” decision. The first one is that in order to achieve a $2 trillion business we must rely on a strong trademark. This will lead us to understanding the essence of the business in academic terms. In psychology 101, we are going into a business of creating and maintaining conditioned reflexes. “The Coca- Cola trade name and trade dress will act as the stimuli, and the purchase and ingestion of our beverage will be the desired responses.”

At first Charlie will use Operant Conditioning from which will try to accomplish two things… “…maximization of rewards of beverage ingestion and minimize possibilities that the desire reflexes (as Pavlov’s Dog) will be eliminated by operant conditioning by proprietors of competing products”.

As we know there are two types of operant conditioning a) with rewards b) with punishment…clearly we want to use rewards such as: Food value in calories, Flavor, texture & aroma, stimulus (sugar & caffeine) Cooling effects, etc.

Munger will go explaining also the effects on publicity… and how it relates to Pavlovian conditioning; he gives an example on “Men’s brain yearns on the type of beverage held by the pretty women he cant have”, this will parallel when the “Dog salivated at the bell it cant it”. Thus, beverage must be associated with in consumer minds with all things customers like or admire.

He goes further to utilize Pavlovian effect in texture, color and flavor… such as making Coca- Cola appear like wine and to have carbonated water to seem like Champagne. With all this we ensure maximization or rewards; but there is a pending question: how does Coca-Cola ensures that these reflexes will not be eliminated by operant conditioning by our competitors? Well, the answer is availability. Coca-Cola must be available everywhere. As he goes to mention: “…a competing product, if it’s never tried, can’t act as a reward creating a conflicting habit”.

Charlie speech really goes into the heart of Worldly Wisdom… drawing several concepts from other disciplines to apply them into our real world. This is the purpose of this blog, that we all share ideas on how to acquire and use Worldly Wisdom.

The Power of Incentives

I just finished to read a new book called "Freakonomics" by Steven Levitt & Stephen Dubner. Levitt is not the typical economist, he looks at the world in a different way; he uses economics to explain human behavior. The book was written based on few fundamental ideas, I would mentioned two:

a) Incentives are the cornerstone of modern life

b) The conventional wisdom is often wrong (But not always!)

He goes to mention that understanding incentives is the key to understanding about any riddle.

In chapter one, he examines an example of late pick ups from a daycare center. According to Levitt there are three types of incentives: social, moral & economics. The moral pressure to pick up children by the scheduled time was proving inadequate, and late pickups were becoming a business problem for the daycare center. To encourage better promptness, the administrator introduced a small fine for tardy pick ups. If parents were 10 min late they would pay $3USD per child for each incident. The fee would be added to the parents monthly fee.

After the fee was enacted the number of late pick ups went up! double the original number. According to Levitt, this incentive substituted an economic incentive ($3 penalty charge) for a moral incentive, the guilt that parents were supposed to feel when they came late. For a few dollars each day , parents could buy off their guilt... Furthermore, the small fine send a signal to the parents that weren't such a big a problem.

After couple weeks the daycare administration decided to take away the penalty fee, but the number of late pick ups did not went down. Now they could arrive late, pay no fine and feel no guilt.

By now you may have already guess that the solution was a larger penalty fine... large enough that parents really wanted to avoid the payment of the fee.

In October 2003, Charlie Munger gave a speech to the undergraduate students of University of California, Santa Barbara, he posed a problem to the students where a tire store chain in the Northwest has succeeded over fifty years (Les Schwab tire store chain)... Les Schwab started competing first with Goodyear, then competition was with the great discounter's such as Costco and Sam's Club... and Schwab still remains. (Note, the owner has no education at all)

Charlie answered on how Les Shwab accomplished it's success by mentioning that they must have done a lot's of things right, but among the best things was that the company harnessed what Mankiw calls the "superpower of incentives". He must have a very clever incentives structure driving his people.

Just give it a second thought on this concept... and you will find that everything that we do in life is based on some sort of incentive. That's the way that we learned since we were children... if you get A's you get a prize, if you disobey your parents you get grounded.

Isn't it possible then that what Levitt saids about incentives "understanding incentives is the key to understanding about any riddle." can helped us to understand the world that we live?

The Eighth Wonder of the World

Albert Einstein is alleged to have called compound interest one of the most powerful forces in the universe. Charlie Munger considered compound interest as one of the key models in our tool kit.

I found an interesting blog from Michael Moe, posted in May 2005 (ThinkEquity Blog) about compound interest. Below is a portion of his post...

"...we can benefit from the magic of compounding identifying companies that will grow their earnings at a high rate for a long time and hold on for the ride.

An important concept to appreciate as a growth investor is the power of compounding growth. While when it comes to growth companies, where the bulk of their future earnings lie ahead of them, the perception of valuation risk crowds out investor interest in future earnings potential. This said, a few simple math examples may help to underscore the power of growth.

The Power of Long-term Compounding

In 1626, Dutchman Peter Minuit purchased the entire island of Manhattan for $24 from the Wappinger Indians. In other words, for what it would cost to order a bagel and cafe latte at a midtown hotel today, Monsieur Minuit owned the entire Big Apple.

While there are many outside of Gotham that would look at neither as a bargain, our point is to demonstrate the power of compound interest over time. Compound interest has been called the "eighth wonder of the world" and, with the help of the "ninth wonder of the world," the HP 12C, we can calculate whether Peter Minuit got a good deal or not.

Obviously, the key variable to determine the answer is interest rate that we apply to the $24. Or what we could have earned in an alternative investment.

The difference between a 5% return and a 10% return isn't a simple doubling but a compounding that becomes staggering over time. If the $24 was invested at 5% interest over the past 377 years it would have grown to $2.3 billion today, implying a good price given Rockefeller Center sold for $1.9 billion in 2000.

At a 10% return however, the $24 doesn't just double the 5% return, or to $4.2 billion, but magnifies it to $97 quadrillion!

At the foundation of our investment philosophy is that over time, share prices are nearly 100% correlated with earnings. Hence, our objective is to identify companies that can grow their earnings at a high and sustainable rate and hold on for the ride.

In the world of investing, few stocks have accomplished the returns of Peter Minuit, yet, consider that Microsoft went from a $500 million market cap company at the time of its IPO to nearly $400 billion today by growing its earnings at approximately a 40% compound annual growth rate over the past 17 years.

The trick, of course, is that it is almost impossible to grow at a rate that high, for that long of a period, as the laws of compounding cause growth to diminish with size. Bearing this out is the fact that there are fewer than 30 companies that managed to grow their earnings in excess of 20% annually during the past 10 years out of a universe of more than 12,000 companies!

1¢ Doubling Every Day or $10,000 per Week

To illustrate the power of the doubling effect, suppose you were offered a job as a consultant for a month and you had your choice of being paid $10,000 per week or a penny the first day, and having it double every day for the remainder of the month. Easy choice right?

At $10,000 per week, you would make $40,000 for the month. On the other hand, making a penny the first day, two cents the second, four cents the third, eight cents the fourth, and so on, you actually end up making over $10 million by the 31st day."

He also give us a model to use called the "rule of 72"; where if you divide 72 by the interest rate you will find the number of years that your investment will take to double. i.e. If your interest rate is 15% it will take you 5 years to double your investment.

Now our challenge is to get this model in our head and try to applied it to the real world. Remember what Julian Huxley (biologist) said "Life is just one relatedness after another".

Last Best Chance - NTI

Last Annual Shareholders Meeting at Berkshire Hathaway, CEO Warren Buffett did mentioned about him being worry of Nuclear and Bio threat. He also mentioned that he's been working diligently to reduce the exposure in all Berkshire Insurance subsidiaries.

During the meeting he did recommended a video produced by the Nuclear Threat Initiative (NTI). Warren called it "a fictional but not fanciful" scenario. I got interested and ordered it.

Last Best Chance mentioned that " Nuclear terror is the most potentially devastating threat facing the world. The most effective way to prevent it is to lock down nuclear weapons and materials at the source, in every country and facility that has them"

Based on the latter, the NTI believes that the only way to stop terrorist groups to get a nuclear weapon is through the security of materials; such as uranium. NTI believes that is easy for terrorist groups to build a nuclear weapon than to get the raw material. Thus, they urge government's to take actions to secure them and lock them down.

I suggest you go to www.lastbestchance.org and get a free copy of the video.

What is Worldly Wisdom? (Charlie Munger thoughts)

For those who are not familiar with Charlie Munger's Worldly Wisdom, I attached below link to a speech given by him at the USC Business School (1994)...

http://www.paladinvest.com/pifiles/MungersWorldlyWisdom.htm

Just a final quote from Charlie T. Munger: " Acquire Worldly Wisdom and adjust your behavior accordingly. If your new behavior gives you a little temporary unpopularity with you peer group... then to hell with them."

Charlie Munger's "Independence"

Today was the day that I finally understood Charlie Munger's words about why he wanted to get rich. His answer was "independence"!.

At age 22, I got the opportunity of an explosive growth career... My career growth was not due to high IQ or because "my uncle" helped me to escalate the corporate ladder. Neither it was because of a stike of luck or any fortune teller wisdom. Today, I finally understood why. The reason: I was not afraid. Not afraid of making mistakes, not afraid that I may step in someone's powerful toes. I was "independent".

Long time ago, I read Charlie's words... I read them, they clicked in my head but never in my heart; until today.

Today, I realized that I was not independent anymore... Yes, I know we all think we are independent, but how can we be independent if we are still depending on our employees salary?. I also noticed that my career has not been growing at the same rhythm as before... The reason: Now I take more conservative steps, I'm not as aggressive as before, now I care about what my bosses think... In short, I'm afraid.

Nevertheless, today is a different day... Today is the day that I finally understood Charlie Munger.