Value and Growth are Joined at the Hip

Most people think Warren Buffett is a value investor but if you want to go into the particulars, one could argue that he is primarily a fundamental investor. Buffett famously said that growth and value are joined at the hip. Both are areas of fundamental analysis.

One could also argue that many business owners would not easily understand the question if you would ask if they focus more on growth or value in their capital allocations. Business owners simply allocate capital to the projects with the highest expected IRR, irrespective of any category you might want to fit it into. 

Personally, I really like the framework put forth by the late Marty Whitman. In his opinion, there are are 5 main areas of fundamental finance: 

  1. Value Investing (limited to minority positions in public co’s) 
  2. Distress Investing
  3. Control Investing
  4. Credit Analysis
  5. First and Second Stage Venture Capital Investments

Warren Buffett, as an example, has been active in all of those categories, either directly or indirectly. Henry Singleton, as well, is someone you could not classify as a value investor specifically. He just went where he thought the highest IRR was at any given time.

Why is Chuck Royce such a Good Investor?

The title of this post is a question posed by Tobias Carlisle to his guest Micheal Green of the Logica Fund, on his The Acquirers Podcast. Micheal’s answer to this question was pretty interesting, to say the least, and beautifully formulates the investment framework of Chuck Royce and the Royce Funds.

Michael Green: “First of all, Chuck has just an incredible mind and an incredible awareness of the embedded optionality in securities. And so, his philosophy as it relates to securities selection at Royce [Funds] was that he focused on small cap stocks, but he required that they have very low levels of leverage. And the reason why he did that…I think he intuitively knew this but I don’t think certainly he was explicitly modelling it in the same way I would be forced to do.

When he recognized this, that they had option-like characteristics, right, owning a portfolio that has small cap names in it is the greatest potential to exhibit that lottery-like winner capability. And he was very agnostic between value and growth from that standpoint. Always looking for that option-like characteristic. But his simple rule was that the company couldn’t have enough leverage that would lead to aggregation or a shortening of that option duration.

So he was effectively trying to pick infinitely lived option-like assets. And he just did it extraordinary well. I mean, he had seen so many management teams and he had seen so much. I met him in 2003 for the first time and he had been running Penn Mutual Fund which was the core of the Royce universe. Which he acquired for $1 in 1974. People forget how bad things got.

There is maybe a little bit of this feeling in the active manager community today. But he was able to buy Penn Mutual Fund for $1 dollar. Because the owner, it had assets, and it had a bit of a track record. But the owner was incapable of paying directors salaries, registration fees etc. So he bought it for a dollar and then it proceeded to lose money for some time as he paid directors and others. But it turned into this extraordinary vehicle on the back of his talent. 

Tobias Carlisle: My interpretation of the Royce firm is that they seem to have a holding in every single stock I ever look at. A tiny holding. 

Michael Green: So, I think that’s true. I think that is again a reflection of Chuck’s philosophy that each of his securities represents this option like characteristics. A typical portfolio of Royce would have somewhere in the neighborhood of 160 to 300 stocks. There would be multiple portfolios.

Portfolios would typically be launched in a new fund when we thought it was a peak of a market. Which sounds counter-intuitive. Until you realize that what this actually means is that you have launched a vehicle that has an excess of cash in an environment of high valuations. And so as the markets sell off, that cash creates actually an out-performance characteristic.

So when the next cycle emerges, not only did you have cash to deploy at more attractive valuations, but you benefited from the cash component. And I mean, that type of insight. And again, I highly doubt that Chuck modeled it, but he just knew it intuitively. And that’s part of what I referred to with my respect to Chuck. I think he is probably the single finest investor I have encountered.

What’s obvious is obviously priced in…

The title of this post is a quote from a famous bond investor Jeffrey Gundlach. Gundlach is the manager of DoubleLine Capital, a huge bond fund, which has earned him the nickname the Bond King. 

It is clear to me that information that is obvious, should be priced into the market price of a public asset. This is logical. But if you abide by this logic, you should also agree with the statement that everything that is not obvious, is not priced in. 

By this logic, you would also have to assume that, unless every possible event is inherently obvious to market participants, the price of a public security is inevitably always wrong, since it does not account for the obvious. 

In the same vein, being a contrarian is a valuable stance, but only if there is an non-obvious truth that the market isn’t accounting for. Successful contrarians, try to approach the world from a different perspective. But they only act on it when they feel they have discovered an under appreciated possibility. 

The key is that thinking contrarian is a process, being contrarian is an action. You don’t always think contrarian, but only sometimes be contrarian.

The Efficient Market Paradox

Two economists are walking down a street, discussing the Efficient Market Hypothesis, when one of them suddenly stops in his tracks. He points to the street and says “look, there’s a $10 bill!”

The other economist looks at him with a mixture of amazement and disgust as he replies in a reprimanding tone: “Obviously, if there was a $10 bill there, someone would have already picked it up.”

What this joke illustrates is the inherent paradox of the Efficient Market Hypothesis. For markets to be efficient, they are active participants. For participants to be active in a market, there needs to be an arbitrage. In a perfectly efficient market, the arbitrage is competent away by the activity of the participants. 

The Markets are Mostly Efficient

No market is perfectly efficient. New information is constantly entering the collective perception of the market. Once information becomes obvious, it will obviously be priced in, when markets are efficient. 

WIth the internet and other technological advancement in data gathering, analytics and distribution, markets have undoubtedly become more efficient. In the early value investing days of Warren Buffett, he would read through Standard and Poor’s manuals, making mental calculations of stock’s intrinsic valuation. Nowadays, this information is readily available and calculated, practically in real time. 

In a podcast interview on the Invest with the Best Podcast, Michael Mauboussin, presented a fascinating statistic:  

I think that one of my other favorite statistics in the paper is that in 1976, there were less than 1 CFA charter holder, for every public company in the United States, and today there are 27 CFA charter holders for every public company in the United States. So a lot more eyeballs on the companies that are out there. And maybe there is clearly more dispersion in smaller midcap companies. But look, the world is just a super dynamic place. You see these value changes are quite dramatic. You think about 2020 and hardly anybody had any idea what was going to go on. It was really hard.

Degrees of Market Efficiency

It goes without saying that there are different degrees of efficiency. When you invest in big S&P 500 stocks such as Apple, Amazon or Netflix, you should be aware that there are hundreds of analysts that cover those stocks. You have to ask yourself what kind of an edge you have over those market participants. 

At the same time, there are plenty of markets and asset classes that are less efficient. There are many publicly traded stocks that don’t have a single analyst covering them. Outside of the stock markets there are all sorts of asset classes and markets where an individual can develop expertise and investment edge. Internet domains, for example, is an asset class that has a very vibrant secondary market and dedicated investors. 

There are plenty of $10 bills out there, waiting to be picked up.

Peter Lynch: “I Love Volatility”

There is this great short clip on YouTube with the legendary former mutual fund manager Peter Lynch (of Magellan Funds). In the video, Lynch declares his love for volatility and explains how he approached it: 

Volatility will occur. The markets will continue to have these ups and downs. I think that is a great opportunity, if people can understand what they own. If they don’t understand what they own mutual funds. And keep adding to it. Basically, corporate profits have grown about 8% per year, historically. So corporate profits double every nine year. The stock market ought to double every nine years.

The operative phrase here is “if people can understand what they own”. We can also invert what Lynch is saying in the video and ask ourselves what value we can provide by understanding the assets that have a volatile price?  

The Social Value of Active Investing

There’s a fantastic podcast interview with Micheal Mauboussin on the Invest with the Best Podcast, where he talks about the value that active investors bring to the market. Mauboussin says the following: 

Now, one of the things we’ve talked about quite a bit is, is there a role for indexing? And the answer is, absolutely yes. And I think for many people, that’s a very sensible solution. But that does not mean that the active management industry can go away. It’s not going to go away, because there are two things that it does that are still really important. One is price discovery, and again, indexing benefits from that positive externality, I think we can never lose that.” 

Essentially the fees paid to active management subsidize the indexing industry. And the other is liquidity. And even in these environments, we see that index people don’t trade that much. And so we need liquidity if you have it. I think those are public goods, those are vital, and those will continue to play a role. So the debate should be, what percent of the assets should be active versus passive?” 

By this logic, you could also posit that as an active investor the best way for you to add value is to find areas where you can add value by pricing the securities in question (research, know-how, etc), especially in securities where (or time when) liquidity is scarce.

If God was the Only Active Investor

In active investing the investor aims to outperform an index. In passive investing the investor aims to match or track the performance of an index. 

Now imagine if God was the only active investor in a theoretical market. 

God is all knowing, so he knows all the future cash flows of all the investments available in the market. Since he is the only active investor and all other investors mimic him, all the investments in the market will be priced based on their discounted future cash flows. As such, all the investments will have exactly the same expected return. 

There are two fundamental problems with this thought exercise:

  • If God knows the future cash flows, then he’s not taking any risk. If God isn’t taking any risk, what discount factor should God use? The rate of inflation? 
  • If God is the only active investor, then who is he buying from? If God is the only investor that sets prices and all other investors are trying to mimic his returns, then all the other investors would want to buy when God buys and sell when God sells. Does this mean that no orders will be matched?

Leverage + Arbitrage

I like reading books on business history and biographies of business people. One thing that I feel is often a common thread in there stories is that substantial wealth creation often seems to stem from some combination of leverage and arbitrage.

I’ll elaborate. Often, the initial businesses are created around some sort of arbitrage. The arbitrage might be that the entrepreneurs have some information or ideas that others don’t. But an arbitrage usually doesn’t sustain. Once the word is out the trade gets crowded, which in turn erodes the profitability.

Some arbitrage are more sustainable than others and cane be ridden for longer. And I suapect that there are plenty of business people out there that found powerful arbitrages to take advantage of and did so for a long time. The reason we never heard about them, is because they were constrained. They were not scalable. They couldn’t not be levered.

If you have an arbitrage, however, that is defensible and has the potential to be leverad to a larger scale, you have the components of substantial wealth creation.

Here are a few examples:

  • Sam Walton realized that by buying cheap and pricing low, he would create operating leverage, by maximizing inventory turns. He realized that the big stores would not go to smaller towns, an opportunity that he was able to arbitrage for a very long time.
  • Kirk Kerkorian built his initial wealth through a unique albeit limited arbitrage. After WWII, Kerkorian borrowed money to bid on surplus bombers which he picked up abroad and flew home. At the time, there was a shortage of jet fuel and Kerkorian was able to sell the remaining fuel in the bombers’ fuel tank. Selling the fuel raised enough money to repay the loans he had taken. He essentially got the planes for free.
  • Sam Zemurray made a fortune in the banana trade. In his early days, he took advantage of a brilliant arbitrage opportunity. When banana cargo came to New Orleans, bananas that were spotted were deemed unfit for the travel to metropolitan locations and were discarded at the port. Zemurray bought the ripe bananas very cheaply and sold them locally to grocers within a day of New Orleans. To get the bananas to grocers fast, he leveraged the train system.

What is Inflation Anyway?

I feel like we have made inflation deceptively simple. We have this exact number for it. The Bureau of Statistics will declare something like “last month, the inflation was 2.46%, annually adjusted.” It will do so with an number that is so precise that at will have at least two decimals, implying the surgical accuracy employed to get to that particular number.

We don’t seem to ask ourselves how we come up with these number, do we?

Do We Even Know What Inflation Is?

The great Milton Friedman did not have even a shadow of a doubt: “Inflation is always and everywhere a monetary phenomenon.” Well, here is what the equally great Robert Solow said about Milton Friedman: “Another difference between Milton [Friedman] and myself is that everything reminds Milton of the money supply. Well, everything reminds me of sex, but I keep it out of my papers.”

In Japan they have been expanding the money supply for decades. They can’t seem to produce inflation, no matter how hard they try. If we ask the European Central Bank what inflation is, they say something like “inflation occurs when there is a general rise in prices.” (They will also ask if you have seen the inflation monster and offer you to watch a cartoon about price stability).

If inflation is just general rise in prices, then why do prices rise or fall? Most would say, because changes in supply and demand. Don’t prices of products and services tend to drop over time? How do we even measure this?

How to Measure Inflation?

This seams to me an exceptionally tricky undertaking. If inflation is supposed to measure changes in the price of the stuff we buy over a period of time, what happens when we start buying different stuff over time? Our behaviors and preferences are constantly changing? Imagine a lab scientist that has to test his experiment on rats one day and then repeat the experiments with hamsters.

Do you see the problem here? The stuff we buy is not constant. Take mobile phones for example. How can you realistically measure the inflation in mobile phones from one year to another? Or even, how do you compare the price inflation of mobile phones to a period 20 years ago, when there were no mobile phones?

What about all the stuff we don’t pay for yet derive some benefit from? How do you factor in the change in cost of consuming Google searches into any inflation measurement? Should you measure the increase and decrease in paid ads displayed with organic searches? 

And there there are substitute products. If pork rises in value, relative to beef, you might be inclined to consume more beef and less pork. But the baskets of goods and services will take that into account.

So next time, when you see an inflation number with a couple of decimal points. Ask yourself how it was measured and how accurate that measurement could be.

How to Value Your Job

The worst career advice that you get from people is when they say stuff like “you need to take control of your career, you need make sure you get what is coming to you, no one is going to care about you the way you do, so you need to make sure you fight for all of this stuff”, etc, etc. Those are all terrible advises. 

Your job, whatever your job is, is to add value to your employer. It is not your job to try to extract value from your employer and try to get as much of it into your pocket. Rather, your job is to add as much value as you can for the employer and then you can capture some of that value. 

Contrary to what most people think, being underpaid is a very powerful position to be in. Because, if you are adding more value than you are costing then it means also means that you are a very valuable employee. And if your employer is rational, you are going to be treated well.

Nobody has ever gotten fired for creating too much value for their employer. And nobody keeps a job very long if they are getting paid more than they are worth. 

This text was adapted from a podcast interview with legendary investor Bill Miller on Master in Business. The whole podcast is well worth the listen

Repugnant Markets | Alvin Roth on Trading Kidneys

A repugnant transaction is an economic term that describes an exchange between people that is generally perceived as morally or ethically wrong. These transactions fall outside of regular market mechanisms, hence the term repugnant markets. The repugnant nature of these transactions, cause these markets to be structurally inefficient. 

Examples of Repugnant Markets

  • Organ transplants
  • Child surrogacy 
  • Prostitution 
  • Recreational drugs

Whether a market is considered socially repugnant in not a binary definition. At the same time, what people consider to be a repugnant transaction can change over time and across cultures. Some transactions that are considered repugnant, are also illegal. Some are not.

Matching Markets

When you think about markets, the first examples that come to mind will be something like stock exchanges, farmers markets or auctions. In all these examples, the transaction is impersonal. If you want to buy a stock on the New Youk Stock Exchange, you simply need to place an order through a stockbroker. In fact, anybody can place a bid. 

Many markets are, however, personal. These markets are called matching markets. In order for a transaction to take place, a buyer and a seller need to be matched. A good example of this is the labour market. If you are in the labour market, you can’t simply choose a job. You need to match with an employer who is looking for someone who matches your skillset. 

Repugnant Transactions

In a matching market, price is not the only mechanism. For a matching market to be repugnant, it means that other people feel that it should not be allowed to engage in the desired transaction. 

Alvin Ross, the economist who coined the phrase, formulated the concept of repugnant transactions when studying kidney transplants. It is against the law almost anywhere in the world, to buy and sell kidneys for transplantation. Yet there is a black market for kidneys, which means that there are instances where individuals are willing to transact in kidneys, while people, in general, feel that it is immoral to do so. 

Alvin Roth on Repugnant Markets and Forbidden Transactions

In the following lecture, Nobel laureate Alvin E. Roth will investigate the nature of and reasons for repugnance with its implications for the design of markets. Why is it forbidden to sell and buy organs? Why is the exchange of kidneys that leads to many successful transplants allowed in some countries such as the US, but not in others like Germany? Which markets or transactions we allow, affects the choices that people have?

Watch the lecture and learn more:

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