Stock Prices are Even Less Efficient Than You Think

Within financial academia, there are three main groups of thinking regarding public equity pricing, all of which stem from the efficient-market hypothesis and depend on it to varying degrees. The strong form of market efficiency thinkers believe stock prices reflect all information that can be known about any business, including insider information, and that stock prices are wholly unexploitable for above-average risk-adjusted returns. The semi-strong form group believes prices immediately reflect public information only, given we have laws against insider trading and that it is clear insider information can give an advantage. They also believe that since stock prices reflect all public information, fundamental analysis is useless in delivering above-average returns as business values would be reflected in stock prices. Those in the weak form group believe stock prices only reflect past public information and that fundamental analysis, while studies show it is rare, may provide benefits.

All groups believe technical analysis isn’t useful in predicting future prices and/or delivering returns for investors, and academics have done a good job of falsifying the validity of charting in equities markets with many studies of past data testing typical charting techniques. On this point at least, they have come to a general consensus.

Unfortunately (fortunately), fundamental analysis isn’t easily testable given that “valuation models” as they put it, may not accurately estimate business values ex-ante, so any study would be a test of both a valuation model and the efficient market hypothesis. What this means is that proper valuation requires inputs and some degree of individual assessment, generally regarding future growth and profitability, which are unknowable or impossible to make standards on when attempting to value a group of companies. The problem is that each company needs different growth and profitability inputs, as they will all grow at differing rates in the future, and must be assessed one by one and everyone’s estimate of the proper numbers would differ, leading to different estimated values. This is why they have to test financial ratios such as P/E and P/B instead. As a result, most of the work of academia consists of theorizing on the topic as it cannot be empirically tested.

It is almost humorous that they cannot as a field of academia come to a consensus on how to value companies, given that they understand this ex-ante valuation problem but they expect that the general equities market and all of its participants can. If 5 financial academics were asked to value the same company on the basis of its future free cash flows as should be done, they will come to wildly different results yet it is believed by many that the market somehow comes to the proper or best-estimate result as a group in real-time. The present value of a firm represents the discounted value of all cash flows the firm will ever accrue, so clearly it is going to be an impossible task to get any group of people to agree on it even within a range.

To see the problem very easily, feel free to try to estimate how much money you will ever make, and then ask a family member to estimate that value, and then a friend- nobody will agree on a number and all of you will be wrong to some degree. The stock market is kind of like if everyone in the world could also estimate how much money you’ll make and they would be informed of your life and change their answers based on how you’re doing financially- some technical analysts will even change their answers based on how others have changed their answers! If you don’t even know how much you’ll make, even within a wide range, it’s clear that most of the other people who estimate won’t either. The problem is much harder for young people and the estimates will be highly inaccurate, just like the stock prices of early-stage companies, for which many things are uncertain.

In any case, it is obvious that stock markets immediately reflect only public information, but I believe the academic scale of market efficiency misunderstands how stock prices are set and change over time based on the actions of all market participants. The weak-form group is undoubtedly closest to the truth, but they haven’t publicly analyzed or protested against the many details necessary to believe in semi-strong market efficiency.

I believe the mainstream view of market efficiency harbored by most investors and consumers is somewhere between the weak and semi-strong form, with most people believing that most of the time stock prices make sense. I disagree and outline my reasoning below.

The stock market is an auction market like which any other, reflects market-clearing prices. Equilibrium prices change constantly based on changes in both supply and demand, and supply and demand are both ever changing and dependent on many variables. The variables affecting supply and demand of any stock are numerous but many of them are random, unpredictable, and subject to completely unrelated and/or arbitrary factors.

In general, it seems to be the view of most financial professionals that even if stock prices don’t reflect true value, they at least reflect the expectations of investors regarding the future of any business and therefore are close to a best estimate in most cases. There are many examples however, which invalidate the claim that stock prices are dependent only on logical expectations of the future and therefore the present value of the business and its stock price.

If a hedge fund has a large short position in a single stock but has taken losses on the position affecting the fund’s equity and/or available margin, the fund manager may be forced to close the position. Closing a large short position would dramatically increase the stock price and should increase price proportionally to the percentage of the firm’s float the short position was. This is why short-squeezes cause such a dramatic increase in stock prices- they force short sellers to cover positions and demand rapidly rises despite the fact that the short-sellers may want to keep shorting. The average expectations of the business in this case do not rise nearly as quickly as the stock price.

Executives and directors can execute and sell options in an arbitrary and random manner, oftentimes relative to their cash needs. If a firm’s executive is granted a percentage of the outstanding in the form of options and soon after liquidates it for the purchase of a house lets say, then these random transactions have each affected the stock price without regard for the value of the firm and have in total combined for a larger effect on the stock price than any of them individually would have. The options grant diluted current owners and should affect the share price in a manner proportional to its percentage of the outstanding, and the execution/sale of the stock would then increase the supply of stock without increasing demand.

If a firm’s founder and executive passes away and leaves his/her heirs with a 20% position in a public company, their arbitrary decisions will have a dramatic effect on the stock price. Once again, if they decide to sell the whole stake, the price of the firm should drop dramatically as long as demand remains constant, as they wouldn’t be soaked up at the current price, so price would drop until the market clears. Investor’s expectations of the firm haven’t changed, but the price has dramatically.

The January effect is real. More than a few studies show prices tend to do poorly in December when large funds sell in an attempt to realize losses and improve after-tax returns for that year, while January’s returns are much better as the stocks are bought up again.

A profound and obvious example is when a stock is either invited into or removed from an index. When a stock enters an index fund, suddenly demand explodes and the price of the company rises, and the exact opposite happens when they are removed from indices. Millions of unknowing investors have suddenly purchased or sold ownership in the firm and in a blink its price has dramatically changed. This, along with spin-offs, are prominent examples of transactions which affect prices for no good reason other than disinterest. The transactions just indirectly affect demand, so purchases or sales are made without regard for the present value of the company.

A last example is a technically-guided firm with high volumes making large trades based on ‘signals’ coming from the stock price chart. Their ‘signals’ are based on the purchases and sales of others and of course any transactions they make based on the transactions of others aren’t related to the value of the business but will affect price. Let’s imagine a perfect market in which investors estimate the future quite well and so prices are close enough to fair value and enter Technical Firm A. If something happens which actually changes the value and stock price of the business to its new fair value, the Technical Firm A would look at the new fair value, assume something happened from the change in price and then act on it to bring the price to a new and inaccurate price. Whatever ‘signal’ Firm A deciphered from the price change would without cause lead them to affect the price. The rest of the market could once again attempt to bring prices back to order to its previously found price, but it would continue to send ‘signals’ to Firm A to do something so that the stock price is at all times off by a wide margin.

There are infinite examples, but clearly rational expectations are not the only determinant of price and price swings. All of the above are akin to sudden and random shifts in the supply or demand of a good and affect price merely because of changes in outstanding quantity available and/or desired for unrelated reasons.

Further, the market’s expectations aren’t even the market’s expectations. Each market participant has an opinion on the firm’s future and present value given their expectations, yet each has dramatically different ownership and/or stock volume to affect prices. Therefore, when expectations are priced in, they are closer to the market’s weighted-average expectations. Investment Institution A may think a company has a great future and purchase, but if much larger Investment Institution B believes the opposite and sells at a much higher volume, then prices will decline. Investment Institution B’s opinion of course has a much greater effect on the stock price and yet it may be a misguided opinion as to the firm’s future and/or value. Investment Institution B’s selling could come from one of its funds which is managed by a single portfolio manager. Even if those two institutions disagree as to the firm’s future growth by 50% (will the firm grow at 10% a year or 15% a year for the next 5-10 years?) it could impact each investor’s estimated value of the company and their purchase/sale decisions. This would also ignore the possibility that Investment Institution B is selling for an unrelated reason and that all transactions are made based upon their assessment of the firm’s value.

Any investment fund could at this moment randomly decide to buy a large stake in a tiny public company and immediately and dramatically increase its price. It is highly unlikely that the market would respond by selling an equivalent amount of stock so as to revert back to the old price, which would happen in a perfectly value-efficient stock market. It is more likely that this purchase has just randomly increased demand for the stock by the amount of shares purchased, and the stock price will as a result just be higher than what it would otherwise be. Someone could stumble upon the price and say that it is the fair price or that it reflects the market’s expectations, but if the fund sells its stake 5 years later creating a large price drop, it makes little sense to say either the purchase or sale changed the value of the business, or that they were made because of changes in the value of the business. The fund could make these purchases and subsequent sales for fun in July of each year and affect demand and therefore the stock price on an annual basis. Every July you would see a dramatic rise in the stock price and soon after a large drop, regardless of what is happening with the company.

Also related to the question of how implicit expectations of the future manufacture prices is the understanding that each investor would have to form an opinion as to the future, use those expectations to estimate the stock’s present value, and then transact in the appropriate manner based on the distance of the firm’s price from their estimate. This would be the perfect market which would render the above mentioned fund’s July transactions irrelevant as changes in price away from fair value would be reversed as everyone mechanically transacts to eliminate them. The idea that every investor cares about the current price and has compared it to some estimate of their creation is questionable. Another point is that many funds do not short stocks even if they have a pessimistic opinion of it, and so this is one example of many participants who are unable or unwilling to act on their opinion for some reason or another.

Diving into each investor’s estimates also begs the question of how they will change these estimates of value based on future information. If some new information comes out it may be meaningless to some and relevant to others. It is not as if investors all agree as to the relevance of information and its impact on pricing, because they certainly don’t.

One further point is that one’s estimate of present value is always dependent on required returns and everyone’s required returns are different. If I’ll be fine with 5% returns and you need 10% returns, I’ll pay 100% more for every company than you would, even if our expectations are exactly the same. We would have to reconcile both differences in required returns and future expectations for every market participant in order for the weighted-average to make much sense. If our expectations are different, I might expect a 5% annual return from the company at a certain price while you expect a 20% return. It starts to devolve into complete nonsense if we try to pick apart the motives of each market participant and their effect on stock prices as there are far too many factors involved.

Nearly every investor will have differing expectations to some degree, with some on the low-end and others at the high-end. There are others which may be shorting the company as well if they have very low-expectations relative to price. Clearly one of the two groups is wrong if the expectations of the short-sellers are compared to those of the firm’s most ardent supporters. The stock price reflects the opinion of neither party, but somewhere in between depending on the volumes of each party. It is also possible that if the stock has one highly pessimistic short-seller with massive volume, and many ardent but very small buyers at any price, the price could be much closer to the short-seller’s expectations than anyone else’s. If the price is closer to the short-seller’s estimate than anyone else’s, should it be said that he has a better estimate of value than everyone else because he has a larger position?

Imagine if offered a poll asking everyone how many super bowls the Denver Broncos will win in the next 50 years. If everyone had one vote, could publish the average and despite the fact that estimates could range anywhere from 0 to 10 plausibly, this would be a real averaged result. The result of this average would be meaningless but it could be said it represents the market’s expectations. If however, 1 million people had 1 vote and 100 people had 1 million votes each, then the votes of the 1 million people would become irrelevant in determining the average. If 20% of the people with 1 million votes each had estimates 50% above the future actual result (broncos fans maybe), the market average estimate would have been far too high based on the poor estimates of a select few. If the poll was done after a Broncos win and then once again after a Broncos loss a week later, the average may change dramatically and likely illogically.

The academic question of how quickly markets react to information and which information it reacts to are somewhat misguided, and the scale doesn’t reflect many of the variables that affect prices. The academic version of ‘react’ is also a misnomer and generally implies a logical and collective inference of all participants in unison. The market has the ability to react immediately to information but in an unintelligible and jumbled manner as everyone has differing incentives and opinions, which generally leads to a meaningless result.

Prices will oftentimes be in a wide range around a decent guess as to the present value of any stock, but particularly when the firm’s future results are difficult to predict given uncertainty in the industry, the potential of some technology or product, the stability of the industry, or when it is difficult to know how long rapid growth of a company can continue for, the range of expectations can vary wildly. Technology in particular can be extremely difficult to assess as it is rapidly changing. How long a firm can grow at above average rates can be impossible to know, just as when the rapid decline will occur can also be cloudy. Most investors wouldn’t even be able to agree on a ballpark estimate of how long many firms will operate for. For some companies a plausible guess could be anywhere from 10 to 100 years+, and if expectations of growth differ, the difference in valuation can be remarkable. There are many things which cannot be known as to the near future, even by the world’s experts in some fields. In most cases, I do not think it is possible to know most things about even the very near future, not to mention the long-run. Does anyone know exactly how the world and everyday life will change in the next 5-10 years?

All of the above points questioning market rationality apply in ‘normal times’, meaning in periods of average liquidity and without crises. We have to, of course, also add to our equation the factor of random shocks to both equity demand and supply leading to massive reductions in liquidity as everyone wants to sell which happens each recession and rapidly reduces average stock prices. Prices generally revive within 1-3 years after a recession, but they change dramatically simply because demand temporarily plummets at the same time that supply skyrockets and so prices take a while to reach their previous levels. Along with that, there is also the impact of miscellaneous crises such as weather and politics which may or may not affect business values but can make investors feel as if they have or will have some impact on value, so they have the capacity to wildly affect prices either for valid reasons or no good reason at all. Of course in some cases it may not be possible to know to what degree the reasons are valid or not.

I’ve used the chart below in another article, but it was created by Robert Shiller in 2013 to assess differences between price and value for the S&P 500. The blue ‘Present Value’ line is the actual value of the S&P 500 using all future dividends discounted to that point in time, whereas the red line is the price of the S&P 500. If you could perfectly predict the value of every company in the index, any point on the blue line represents the price you would be willing to pay for a share of the index based on interest rates at the time. If you buy above the line, you will get below-average returns, and if you buy below it you will get above-average returns.


The chart cannot necessarily invalidate any claim regarding the determinants of stock prices, but it shows how wildly they fluctuate in comparison to company values. Particularly in recessions when liquidity completely dries up and prices plummet, values haven’t changed much at all. The companies were of course the same as they were prior to any crash. The present value of a company includes all future years it will ever have, so one year of poor results in reality does little to that value. There are also boom years where prices remain far above fair values for years, even over a decade on end.

If you notice the end of the chart, the red line drops and converges on the blue. This is because those years are very close to the date of the chart creation in 2013 and so do not and cannot accurately describe future dividends. The years 2000 on in this chart would likely all need to be revised in the future.

If we are to believe that stock prices merely reflect expectations of the future, then expectations must change wildly. 1920, 1929, 1932, 1937, and 1942 are quite a ride and between each year mentioned either expectations changed wildly (without good cause), or other factors such as random drops in demand occurred. Between 1937 and the end of 1942, the market crashed, regained most of its losses, and once again crashed. Those were of course tenuous and difficult times in which prices were affected dramatically by political policy and liquidity, but nonetheless the value of the S&P 500 was slowly increasing through those years.

The random liquidity factor also has to be examined to some degree, as thinking about massive drops in liquidity as exogenous shocks outside of the control of all investors is almost certainly fallacious. Recessions undoubtedly occur with regularity and seemingly at random, but the reactions to them through the changes in stock prices shown above cannot be valid. Investor expectations may be highly volatile and ever changing during these periods, but they are unlikely to be rational. If this is a world where emotions don’t affect prices, then there would have to be constant and major errors in logic. The expectations of the future would in these periods have to be wildly incorrect and fluctuating to a very high degree. Margin and leverage play some factor via forced selling, but I don’t think they are the fundamental driver of stock sales and the extent of the price declines in these times.

It seems that changes in expectations of the future of the top 500 companies in the U.S. from -50% to 100% and back again in a few years time would be a poor explanation of the changes in price. It also breaks any claims of the rationality of stock price volatility in both booms and recessions and given that investors still make decisions in these periods out of free will, for whatever reason they change their minds rapidly. Unfortunately, prices never seem to stay near fair value for long, rather they are always significantly above or below and moving far too quickly. Equities markets are fickle to say the least.

At best it could be said the market is mistakenly changing expectations based on short-term phenomena and just constantly overshooting the distant future based on what the economy and each business is doing in the present, but it seems much more plausible to say that it is simply irrational and born out of emotion (not that imagining a constantly linear economy based on recent results is logical anyways). Many forget that growth will not continue forever at the peak of a boom and they also forget that losses will subside at the bottom of a recession. That effect is likely emotional rather than having anything to do with expectations of the future.

So if we were to try to sum up this article so far and market efficiency in general, we would have to say something close to the following:

In most times with normal liquidity, stock prices will be affected both by the market’s weighted-average expectations of the future, which may or may not be properly baked into prices, as well as random and unpredictable transactions which do not relate to the value of companies. Prices will generally be too high in good times and too low in bad times, possibly due to misguided expectations and they will change rapidly without good cause and almost always overshoot. Whether due to mistakes in reasoning or emotion run rampant, at nearly all times stock prices are incorrect and moving while business values grow slowly.

That statement would of course assume investors are transforming their expectations of companies into numerical estimates of value in normal times. The chart used the top 500 largest companies in the economy in each year, and we would have a tougher task trying to assess what is happening if we looked at the historical prices of 1000 smaller companies.

To say however, as many do, that because the largest companies in the stock market are followed by many, their prices will reflect good-enough estimates of value and/or logical expectations of the future as to be unexploitable would be an extremely difficult claim to stand by when put to the test.

Within the group of those who believe it is possible to exploit market pricing, I am likely at the very far end in terms of disbelief in market efficiency if we are discussing its ability to create logical prices. Market prices are always incorrect to some degree (incorrect meaning the stock will deliver returns implied by its price far outside a normal range of required returns), they change too often without cause, and the changes in most cases tend to either relate to non-value factors (random buying/selling) or inexplicable changes in expectations. Further, if you are in boom times most companies will be priced too high and in a crash nearly every company will be priced too low. You could have just randomly picked stocks out of a hat in early 2009 and done very well.

The market responds immediately to news that may be relevant and of course the price perfectly reflects supply and demand at any point in time. However, stock prices and their movements are clouded by random transactions, the irrational/emotional whims of participants, dramatic changes in liquidity, as well as the differing opinions, motives, and assessments of all parties and as a result often does a poor job of reflecting fair expectations of the future as prices reflect the muddled confluence of all these factors.

To conclude, I’ll post below a passage from Keynes’ General Theory of Employment, Interest and Money in which he writes on market activity. It’s a few pages from the book and is a long passage, but worth the read.

“In practice we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The essence of this convention—though it does not, of course, work out quite so simply—lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change. This does not mean that we really believe that the existing state of affairs will continue indefinitely. We know from extensive experience that this is most unlikely. The actual results of an investment over a long term of years very seldom agree with the initial expectation. Nor can we rationalise our behaviour by arguing that to a man in a state of ignorance errors in either direction are equally probable, so that there remains a mean actuarial expectation based on equi-probabilities. For it can easily be shown that the assumption of arithmetically equal probabilities based on a state of ignorance leads to absurdities. We are assuming, in effect, that the existing market valuation, however arrived at, is uniquely correct in relation to our existing knowledge of the facts which will influence the yield of the investment, and that it will only change in proportion to changes in this knowledge; though, philosophically speaking, it cannot be uniquely correct, since our existing knowledge does not provide a sufficient basis for a calculated mathematical expectation. In point of fact, all sorts of considerations enter into the market valuation which are in no way relevant to the prospective yield.

Some of the factors which accentuate this precariousness may be briefly mentioned.

(1) As a result of the gradual increase in the proportion of the equity in the community's aggregate capital investment which is owned by persons who do not manage and have no special knowledge of the circumstances, either actual or prospective, of the business in question, the element of real knowledge in the valuation of investments by whose who own them or contemplate purchasing them has seriously declined.

(2) Day-to-day fluctuations in the profits of existing investments, which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even an absurd, influence on the market. It is said, for example, that the shares of American companies which manufacture ice tend to sell at a higher price in summer when their profits are seasonally high than in winter when no one wants ice. The recurrence of a bank-holiday may raise the market valuation of the British railway system by several million pounds.

(3) A conventional valuation which is established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently as the result of a sudden fluctuation of opinion due to factors which do not really make much difference to the prospective yield; since there will be no strong roots of conviction to hold it steady. In abnormal times in particular, when the hypothesis of an indefinite continuance of the existing state of affairs is less plausible than usual even though there are no express grounds to anticipate a definite change, the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no solid basis exists for a reasonable calculation.

(4) But there is one feature in particular which deserves our attention. It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it 'for keeps', but with what the market will value it at, under the influence of mass psychology, three months or a year hence. Moreover, this behaviour is not the outcome of a wrong-headed propensity. It is an inevitable result of an investment market organised along the lines described. For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.

Thus the professional investor is forced to concern himself with the anticipation of impending changes, in the news or in the atmosphere, of the kind by which experience shows that the mass psychology of the market is most influenced. This is the inevitable result of investment markets organised with a view to so-called 'liquidity'. Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of 'liquid' securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day is 'to beat the gun', as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.

This battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years, does not even require gulls amongst the public to feed the maws of the professional;—it can be played by professionals amongst themselves. Nor is it necessary that anyone should keep his simple faith in the conventional basis of valuation having any genuine long-term validity. For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs—a pastime in which he is victor who says Snap neither too soon nor too late, who passed the Old Maid to his neighbour before the game is over, who secures a chair for himself when the music stops. These games can be played with zest and enjoyment, though all the players know that it is the Old Maid which is circulating, or that when the music stops some of the players will find themselves unseated.

Or, to change the metaphor slightly, professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.

If the reader interjects that there must surely be large profits to be gained from the other players in the long run by a skilled individual who, unperturbed by the prevailing pastime, continues to purchase investments on the best genuine long-term expectations he can frame, he must be answered, first of all, that there are, indeed, such serious-minded individuals and that it makes a vast difference to an investment market whether or not they predominate in their influence over the game-players. But we must also add that there are several factors which jeopardise the predominance of such individuals in modern investment markets. Investment based on genuine long-term expectation is so difficult to-day as to be scarcely practicable. He who attempts it must surely lead much more laborious days and run greater risks than he who tries to guess better than the crowd how the crowd will behave; and, given equal intelligence, he may make more disastrous mistakes. There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable. It needs more intelligence to defeat the forces of time and our ignorance of the future than to beat the gun. Moreover, life is not long enough;—human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate. The game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll. Furthermore, an investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money—a further reason for the higher return from the pastime to a given stock of intelligence and resources. Finally it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.

(5) So far we have had chiefly in mind the state of confidence of the speculator or speculative investor himself and may have seemed to be tacitly assuming that, if he himself is satisfied with the prospects, he has unlimited command over money at the market rate of interest. This is, of course, not the case. Thus we must also take account of the other facet of the state of confidence, namely, the confidence of the lending institutions towards those who seek to borrow from them, sometimes described as the state of credit. A collapse in the price of equities, which has had disastrous reactions on the marginal efficiency of capital, may have been due to the weakening either of speculative confidence or of the state of credit. But whereas the weakening of either is enough to cause a collapse, recovery requires the revival of both. For whilst the weakening of credit is sufficient to bring about a collapse, its strengthening, though a necessary condition of recovery, is not a sufficient condition.

These considerations should not lie beyond the purview of the economist. But they must be relegated to their right perspective. If I may be allowed to appropriate the term speculation for the activity of forecasting the psychology of the market, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life, it is by no means always the case that speculation predominates over enterprise. As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase. In one of the greatest investment markets in the world, namely, New York, the influence of speculation (in the above sense) is enormous. Even outside the field of finance, Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the stock market. It is rare, one is told, for an American to invest, as many Englishmen still do, 'for income'; and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that, when he purchases an investment, the American is attaching his hopes, not so much to its prospective yield, as to a favourable change in the conventional basis of valuation, i.e. that he is, in the above sense, a speculator. Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism—which is not surprising, if I am right in thinking that the best brains of Wall Street have been in fact directed towards a different object.

Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits—of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die;—though fears of loss may have a basis no more reasonable than hopes of profit had before.

It is safe to say that enterprise which depends on hopes stretching into the future benefits the community as a whole. But individual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits, so that the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death.

This means, unfortunately, not only that slumps and depressions are exaggerated in degree, but that economic prosperity is excessively dependent on a political and social atmosphere which is congenial to the average business man. If the fear of a Labour Government or a New Deal depresses enterprise, this need not be the result either of a reasonable calculation or of a plot with political intent;—it is the mere consequence of upsetting the delicate balance of spontaneous optimism. In estimating the prospects of investment, we must have regard, therefore, to the nerves and hysteria and even the digestions and reactions to the weather of those upon whose spontaneous activity it largely depends.

We should not conclude from this that everything depends on waves of irrational psychology. On the contrary, the state of long-term expectation is often steady, and, even when it is not, the other factors exert their compensating effects. We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance.”

An Investing Metaphor

I don’t know how productive this will be to anyone’s understanding of investment, but I personally found the following to be a very simple and helpful thought experiment:

Generally speaking, I believe most investors would benefit dramatically from viewing their investments in the belief that their ownership is completely illiquid and that the only source of returns will be dividends. Owners therefore would only generate returns from the receipt of dividends accruing from operating cash flows or from the liquidation of assets. In this thought experiment, the market price with all its fluctuation will be forgotten, and any terminal sale will also be forgotten- they will consider themselves owners until complete liquidation leading to dissolution. You can simplify further and imagine a Coinstar type machine whereby you insert cash and receive coins on an annual basis in an amount which may be stable, rapidly increasing, rapidly declining, or anything in between, with essentially infinite options.

For simplicity, we will assume market cap is always equal to enterprise value and that earnings are indicative of distributable cash flows. This will make things quite a bit easier, as there will be no need to differentiate between net income and the various cash flows you generally need to assess to estimate the equivalent of owner earnings. The discounting of the future to the present will also be ignored. All investments in this scenario cost $100 but deliver differing earnings results.

Returns would therefore be equal to net income / price paid, whether the net income was distributed as a dividend or not, as all net income is potentially distributable.

Clearly we can see that by owning a no-growth company that generates $10 in net income on an investment of $100, one would receive returns of 10% per year in perpetuity. If net income is growing, then returns will be higher- if net income is declining, then returns will be lower than 10%. Very simple- and I believe there is significant value in keeping things simple.

We can see that ignoring the time value of money, it is possible to achieve better returns by purchasing a lower-yielding company that is growing at a higher rate. For example, if one purchases company A for $100 producing $5 a year for a current return of 5%, but which will grow at 20% over the next 10 years, you will do better in total than the investor who owns no-growth company B which also costs $100 but produces $10 forever for a current return of 10%. By year 5, company A will produce $12 a year, and by year 10 it will produce $31 a year. It should be clear that company A should be more attractive to the investor (whether you call yourself a “value” investor or not), as you are receiving much more in future earnings relative to what you are paying.

You can also see that the lower the current yield, the quicker the company must grow, and it must do so for longer and longer periods of time to achieve at minimum average results.

There will be some typical “value” picks which will produce $30 forever on a purchase of $100, and of course the investor would achieve 30% perpetual returns. For every one of those however, there will be many more which currently produce $30 but in 5 or 10 years will produce maybe $10, $5, or $0.

There will be others which have no earnings, but assets valuable enough to eventually deliver high liquidating dividends. So the investor may receive $0 in the first 5 years, then $300 at the end of the sixth year, for a $33 or 33% annual profit, again, excluding the time value of money.

This framework hopefully helps explain both the expectations and potential returns embedded in the prices of investments.

Using the numbers from a current example of a popular stock shed some light on the potential future returns and growth required to achieve favorable returns for a private owner who has no interest in ever selling.

Company G grows at a high rate but also produces a disproportionately low current return. It has a price of $100 and current net income of $0.31. As of right now, a private owner is achieving 1/3 of 1% in annual return. To get a 10% annual return, net income will eventually have to rise to $10. This means that until net income reaches $10, the private owner will obviously achieve returns below 10%. Let’s say that the owner is very patient, and will wait 10 years to achieve a 10% annual return. This means that net income will have to grow at around 41% a year for a decade, and once net income finally hits $10, the owner will then achieve average returns similar to those of the investor who purchased the no-growth firm B producing a perpetual 10% a year. To get total annual returns above 10%, the net income of company G will have to keep growing at a similarly high rate for years after the 10th, given that the investor has received returns far below average in the first 10.

As can easily be seen, the investor in company G needs extraordinary growth for a decade and will at that point be achieving market-average returns. The investor in company G is basically counting on at least 15+ years of constant high-rate growth to best the market. This is a very generous base case given that we are excluding the time value of money, which would discount each year by 10%, as that is the market average and the investor’s cost of capital here.

When prices are embedded with magnificent expectations of future growth, the investor must assess and essentially predict the future, then the company must outperform those expectations to achieve above-average returns. This is why delivering long-run outperformance by purchasing great and popular companies is so difficult. One must: 1. Properly assess the very-long term, in many cases 1-2 decades in the future 2. Purchase these companies at prices at which they will outperform expectations unless if you would like sub-average returns.

Meanwhile, if you purchase the 30% perpetual yielder, you can analyze the present and think about the probability of things remaining as they currently are. If there is no cause for things to rapidly change, and if they do remain constant, the investor will do very well- and they are receiving the cash flows immediately, instead of years from now. Again, in reality the timing of the cash flows will create an enormous difference, because as the high-growing firm needs to compound at 41% a year, a good investor will discount those earnings by 10% a year which will cut an enormous amount from the future yield on those earnings and therefore the present value of the company. Not to mention the fact that in reality many fast-growers are issuing shares and diluting owners, taking on debt, and generating negative cash flows to equity which all need to be accounted for.

With some tinkering with discount rates, you can quickly see that with a 10% annual discount rate, every $1 of earnings in year 10 discounted to the present will be worth only about 38% of earnings in year 1, or about $0.38. This means that it is much, much easier to achieve the equivalent of a 10% return per year in the present if the company is achieving a 10% yield in year 1. This gives the companies generating large earnings relative to price in year 1 a very big advantage, both in potential returns and in ease of choice/estimation for the vast majority of investors.

The Basics of Deep Value Investing

A few years ago I had a blog in which I used to post about the details of deep value investing and some of the methods by which an investor could go about exploiting market inefficiencies. Those posts weren't ever brought over to this site and it dawns on me that despite explaining some theoretical concepts, I've never explained much of anything about how I have been generating our performance over the past few years in basic, practical terms for anyone interested in hearing about it. 

I'm not sure how value investing originally started, but to my knowledge John Keynes is the first professional investor to document his thoughts on how he beat the market. He tried to capitalize on the emotions of the masses to buy companies when you could receive a high earnings yield (buy a company with very high annual earnings compared to the price you pay for the company) and when you could buy companies at prices less than the value of their assets. Benjamin Graham, who is Buffett's mentor, went further with this and used a mechanical, quantitative only method to purchasing cheap companies. Despite being the creator of deep value investing and someone who consistently beat the market, the records show that Graham had little interest or talent in analyzing the quality of companies and thinking about their future potential. He simply analyzed financial statements and bought companies at prices lower than their net worth and relative to the earnings they generated.

Beating the market using a deep value approach is quite difficult in practice, but the ideas behind it are extremely basic. In many cases when people ask about Comus and what I do to achieve our returns, it is difficult to say much more than "I buy cheap companies" and then add some detail on how I analyze them specifically. People within the field of investment in particular expect some complicated story or method where there is none and in many cases I believe are disappointed when that is the thrust of my answer. This is also the reason that quarterly commentary can be an issue for me and frankly useless in many cases. The happenings of the market and our investments on a quarterly basis are completely irrelevant to our long-term performance and methods and I usually don't have much more to add besides saying "this quarter we purchased more cheap companies and sold some others that aren't as cheap as they used to be". Frankly, such a simpleton approach to one's investment focus is how you properly beat the market in the long-run and I believe any other ego inflating topics or economic forecasting are going to distract from what a real investor is supposed to be doing.

Frankly if a portfolio manager is worried about anything other than the analysis of companies and exploiting differences between real value and current market value, it is my opinion they aren't real investors and won't generate any kind of decent long-run returns. This list of completely irrelevant topics include everything that the mainstream financial media and most large money managers speak to, such as interest rates, politics, misleading economic indicators, market sentiment, exchange rates, and recent stock price movements. Wall Street in particular has gained its reputation and profits focusing on such irrelevant topics and is one of the prime movers of corporate 'short-termism'. The current level of stock prices is only relevant in comparing price to value, and any price changes may or may not affect that relationship.

So on to the specifics. I'll use a quick analogy to better explain deep value investing because using financial terms might complicate things.

Imagine you have a rich friend with a net worth of $1 million. Her net worth includes $300,000 in cash and investments, a $700,000 house, and no debt. She also earns $70,000 in cash post-tax. Now let's say that somehow your rich friend is willing to sell both her current net worth and her stream of earnings to you for $500,000. So you would pay $500,000 and receive $1,000,000 in assets (30% of which are immediately liquid) as well as $70,000 in annual cash flows.

Does this seem like a good investment? If you answered yes you are correct. Assuming this person's earnings stay relatively constant and that the assessment value of her assets is fairly accurate, you are receiving a massive annuity for a low price, and are buying her assets at half off their real value.

This is the exact thing that deep value investors are doing, but with companies. They buy assets and earnings at very low prices in the expectation that others will eventually realize how much of a bargain the company currently is, pushing the stock price up (and if nobody else ever realizes, you can buy the entire company yourself). In the example above, even if you excluded earnings completely, you could get this person's assets at half price and immediately liquidate (sell) them for a massive profit- the earnings are simply a bonus and kind of irrelevant to the investment decision. Such decisions make life for deep value investors simple, as they do not have to attempt to predict the future of these bargain companies. This is why Graham never needed to be adept at analyzing competitive dynamics or the future of companies. 

If there were a world in which rich people like your hypothetical friend were out there selling their personal assets and earnings at ludicrous prices far below real value, wouldn't it be a good idea to take advantage of the situation? And if few cared to notice or take advantage of the situation because they believed it to be impossible and against the theoretical laws of market efficiency (which don't correlate with reality)? 

Such a deep value investment operation keeps in mind that the future is difficult and in some cases impossible to predict. Very talented and studied investors can in some cases properly analyze and predict the future of a company or industry, but there have been few that have shown to do this on a consistent basis over their careers and they generally stay within a very small circle of companies that they can understand. More than a few famous and previously successful investors (there are some great recent examples) have met their end overestimating their abilities in this regard, and have strayed too far from what they could properly understand and analyze. Like Icarus, their ego ruined their flight.

A deep value approach generally uses only current and past data to analyze firms rather than use predictions about the future. There are many styles within deep-value, but they all take advantage of discounts to real asset and earning value of companies, and generally purchase stable companies, assuming results will remain constant unless there are indications things will change or there has been some deterioration of results. I am personally comfortable holding a very focused portfolio because of the massive discount to real assets of some of the companies we own and the historical stability of their results (and my judgement of the industry) but there are others who like to on average own a 'cheap portfolio' but have fewer judgments about individual companies. All approaches are valid as long as one is comfortable with and capable of their approach and as long as focusing, as I do, doesn't detract from the returns one could have received from a more open and unbiased approach (sounds similar to the generally valid argument for indexing doesn't it?)

The stock market and the prices it gives to companies are only to be exploited, never taken as reality. Those of us who venture into individual company analysis and invest with the goal to beat the market understand we have some capacity to disagree with the market as to its pricing of companies. Stock prices are to be seen as temporary, ephemeral, ever changing, and almost always wrong. The idea is to analyze financials to get a general idea of a fair value of the company and then buy it when the market is giving that company a completely ridiculous price. It is a form of sentiment and time arbitrage- you buy now when people aren't interested and wait until they are.

Despite the general idea that technology, the proliferation of active managers, and indexing has created widespread market efficiency, I believe it has done the exact opposite to an extreme degree. The best managers manage large amounts which limit them to the components of the S&P 500 which they all trade amongst themselves. Indexing has no opinion as to value and indices generally hold the largest group of companies in a given economy which funnels most of the funds of the population into those few investments- mutual funds, index funds, and pension funds all collectively own the exact same companies (good luck getting decent returns when you all own the exact same companies and will pay any price for them). Frankly very few people care about company analysis and even fewer have the funds to look under the obscure rocks as Buffett once did- and this is why value investors such as myself will always exist. There will always be some form of market arbitrage in all types of asset classes which allow for exploitative returns relative to the general performance investors can receive from an index.

The Game of Capitalism


In the game of Monopoly, all players start out with a modest amount of play money from which they can begin to invest and build their property empire. As players move around the board over and over again, they buy properties, collect cash, and increase their wealth. The winner of the game is the player who has collected properties to the point at which they have monopolized the entire board. Players make property purchase decisions based on the amount they have to spend in the present to buy each property along with the amount they expect to receive in the future from the property. They attempt to maximize the amount of future cash they will collect from other players based on each $ of their play money they invest in the present.

In Monopoly, there is both a positive-sum and zero-sum component of the game. Everyone gets $200 when they pass go, which is positive for everyone, as everyone gets richer as a result, and the monopoly "economy" grows. There is also a zero-sum component in that any cash collected from other players from properties keeps the total player wealth neutral but the cash changes possession. In order to monopolize the board, the zero-sum game is taken to the extreme and one player eventually holds all the wealth, at which point the game ends.

There is a reason the game of Monopoly is called Monopoly.

Capitalism is a game very similar to Monopoly. In capitalism however, most people start the game with almost nothing. In the game of capitalism, there are employees, firms (similar to Monopoly properties), and owners of firms and these groups of course aren't mutually exclusive. Employees work for firms, and firms generate cash for owners of firms- in some cases employees also own the firms they work for. Employees are therefore beholden to their firms and exchange their time/labor for cash, while firms are beholden to their owners and as an organization provide a product or service in the attempt to bring profit to their owners. People, generally investors, who understand the game of capitalism attempt to do exactly what players in Monopoly do- increase their wealth and accumulate assets- capitalism is just a much longer game than Monopoly is and most people don't know they are playing it.

Along with being a much longer game than Monopoly, capitalism is also a much tougher game. Some people are given all the means necessary to do well, and some start with nothing. On average, nobody starts with much of anything and so everyone begins the game by working for a business to increase their wealth as all they have to offer at start are their personal skills and labor.

A small percentage of the population in the game of capitalism either start their own businesses or buy existing ones in an attempt to grow their wealth. Similar to the game of Monopoly, those who maximize their future cash received from each dollar invested today are the most skilled capitalists and will accumulate assets faster than other players, growing rapidly and becoming the most wealthy players in the process. Some investors and business people have done this at such a high pace or over such a long time period (preferably both) that they end their lives with an enormous wealth and they generally own a historically large and successful company, or they own many companies in different industries. There are many examples that come to mind but it seems that the best players in this game have publicly acknowledged the game they are playing and planned decades in the future to maximize the assets they own. These players have started just like everyone else and gone from employees at one point, to buying small pieces of companies (or starting one from scratch), to eventually becoming the largest owners in the economy and owning large companies outright. 

Most players will never glimpse or even fathom this point as they either don't understand they are playing the game, do not care to play the game, or aren't very good at playing it (aren't good at maximizing future cash from cash invested now). Most players simply want to accumulate enough wealth to stop working for a company at some point and finally enjoy their lives. It also takes a very long time-frame and a lifetime of focus to become one of the most successful players in the game of capitalism and to become a large owner of companies.

In capitalism, there are also positive-sum and zero-sum components to the game. Everyone gets richer as the economy grows and companies retain earnings- collective wealth and assets rise (although this wealth certainly isn't distributed equally among all players). To attain a return higher than average by investing however, you must access the zero-sum component of the game just like in Monopoly and exploit the mistakes of others in their investing decisions. To receive a return higher than average, another investor must receive a return lower than average. If nobody made mistakes and all businesses were priced rationally, nobody could exploit anybody else and everyone would receive the market average return, accumulating wealth at the same pace. This is not necessarily the case for entrepreneurs, who create businesses and new products instead of capitalizing on existing ones, but in many cases they take from older companies as they disrupt industries and affect existing companies. Entrepreneurs therefore generate new wealth while good investors mainly redistribute wealth from unskilled investors to themselves.

In Monopoly, everyone starts by growing their wealth at a good pace but as players eventually collide certain players must mortgage or sell off their properties and their wealth declines as a result of mistakes they have made or just being unlucky and having to pay other players. When you mortgage or sell off a property in Monopoly, you not only lose your current wealth, but also your ability to generate income which hurts your future wealth even more. In capitalism, any loss of wealth is a huge mistake which can set a player back years and can be the result of just one poor investment. Just like mortgaging or selling a property in Monopoly, your wealth drops and your ability to create wealth drops- since as an investor you need money to make money. The more money you have, the more money you can make as an investor- this is the general principle of compounding and so your income grows as your wealth grows- this is why wealth grows at an exponential/accelerating pace, not a constant/linear pace. This is why the most important thing is to avoid this at all costs- generally with a proper understanding of one's investments and a certain mindset of aggressive conservatism- the desire to compound at the highest rate possible while ensuring the protection of your current wealth and remaining within your boundary of knowledge and understanding.

Once you see capitalism as a game, you can understand why public companies go to no end to please their owners, provide consistent guidance to Wall Street and attempt to meet quarterly objectives (it isn't to provide a better product/service to their customers). You can understand why companies lobby our government in an attempt to change the rules of the game to benefit themselves or why owners collide with employees as they argue over the distribution of wealth they create. You can see why greed and misunderstanding in the financial sector spawn crises on a cyclical basis which leads to opportunity for others willing to take it. You can understand how mispricing of public companies can happen as some unskilled players make mistakes in buying/selling stocks, and why certain investors would dedicate their lives to exploiting these mistakes for a much higher future return than could be obtained from a market average.

Seeing the game of capitalism for what it is is the first step towards understanding how to play it properly and it brings the proper long-term planning and asset accumulation mindset necessary to become one of the most successful players of the game.

Stock Price Fluctuations Are Your Friend

This is by far the most important thing I will ever write about investing and it is essentially mandatory reading for anyone looking to become a client and partner of this firm. If you're not with me on this you likely won't be a good fit for us (or for proper investing in general). What I will explain is extremely simple and in my opinion the most important thing to understand and follow in order to achieve excess returns but for whatever reason, it is difficult for most investors to implement in their practice. 

Let's start with a riddle. If you could choose between equity markets rising to a very high point or dropping to a very low point and staying at that point permanently, which would you choose? This would mean that the price of all stocks worldwide would move to that point and stay there forever. Think about it for a second. 


Unless if you are about to retire and don't care about money beyond that which is necessary to pay for your basic retirement expenses, you should have picked the second choice- let prices drop to a low point and remain there forever. If you are okay with never purchasing a stock again, the first option of high prices might work out well. If you wanted to become wealthy beyond belief however, you would choose the second option of permanently low prices.

With low stock prices, it wouldn't matter how much earnings grow or how high dividend payments are- you would still be able to purchase at that low price permanently. You'd be able to purchase basically any publicly traded company and achieve incredible annual returns. With stock prices flat, your only returns would come from dividends. Of course, in the very long-run, dividends are the only reason investors own companies and is what valuation depends upon.

In the first option of rising prices, you would receive a nice gain but your future returns would be horrendous for a long period of time. It is possible you would have no reason to ever purchase a stock again because the returns would be so low.

Let's say the market cap of Apple Inc dropped from its current level of around $830 billion down to $100 billion. It currently pays out around $10 billion a year in dividends, so you would get a 10% total return with flat prices- not impressive. Apple has $260 billion in cash on its books though, and it generates over $50 billion in free cash flow a year. If it were to pay out $200 billion of its cash and investment reserves, investors could buy up stock at that market cap of $100 billion and receive the $200 billion dividend for a 200% instant return. If Apple wanted, it could pay out $20-$30 billion a year for a 20-30% annual return on that low price. 

Think about 10 years from now, when the prices of all those good companies that are now much larger and have better dividend paying potential are still low. Think about a smaller company growing earnings at 20% a year- in 10 years it would have earnings 600% higher than they were at the beginning of that period and yet have the same stock price. Think about 20 years from now, when the size of these companies dwarfs their stock prices, so that investors could receive returns upwards of 1,000% a year simply from dividend payments. Your capital would multiply itself by 10x a year with a simple dividend payment. Think about 30-50 years from now, when companies have compounded at decent rates over that period- prices would be unimaginably low relative to business values and dividends. Compounding at such rates in this theoretical vacuum would lead you to be richer than the entire world economy rather quickly.

Those who took the first option of getting that initial boost from price increases would be stuck with permanently high prices and would have to wait a while to ever receive a decent return. What if their salary and net worth has grown over that time, so that they have a much larger base of capital that cannot compound at any decent rate because stock prices are too high? If you are a young person who would like to purchase stocks in the future this is your worst nightmare. The retiree would be okay but younger people would have to wait at least a few decades before receiving a return that could affect their net worth. 

As this example illustrates, if you are a long-term investor, you would be perfectly satisfied if stock prices never increased again, or even if they permanently decreased. Low stock prices are always your friend- you can purchase more of a business for each dollar you invest.

This is why stock price decreases make me happy. For whatever reason, people don't like paying high prices for groceries, rent, cars, or anything else- but they seem to want to pay high prices for companies. Most investors seem to like it when the cost of ownership of their companies increases. If you plan on ever buying stock again, you should rather wish the price to drop- frankly your optimum price of ownership would be $0- you could get ownership for free. 

I would say the main problem here is the assumption that swings in stock prices indicate swings in business values. For so many reasons that I have summarized in previous blog posts, this cannot be the case, and every day I come to believe that markets are more and more inefficient. Once you realize this simple fact and notice it on display on a daily basis, it is as if you have left the matrix or gone to Hogwarts to join some small and unusual group of people- it is astounding that the vast majority of investors, mainstream commentators, and academic theorists can be so wrong about this and that stock prices can be so inaccurate so frequently. 

The vast majority of investors are not accurately estimating (or even trying to estimate) the present value of all future free cash flows of the companies they own, and the herd mentality and group think are truly difficult for many to circumvent. Most investors feel as if they are losing money if their stock prices decline- they feel scared, worried and they believe they need to save what they have and sell out.

This is exactly how wise investors make money- by purchasing companies from the fearful and emotionally weak. As Buffett says, "the stock market is a device for transferring money from the impatient to the patient". I believe the processes through which this occurs are fear, group-think and short-term thinking.

Further, as Munger says, "in fact, you can argue that if you're not willing to react with equanimity to a market price decline of 50% two or three times a century you're not fit to be a common shareholder, and you deserve the mediocre result you're going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations".

How would you feel about the price of your rent payments decreasing 50%, or 90%? Awesome, right? How would you feel if the only stock you held dropped in price 50%, or 90%? Most people would become an emotional train-wreck and feel as if their net-worth has been crushed permanently. If the value of that business has not changed, you should be buying hand-over-fist in such an occurrence. The investor who understands the nature of markets would see it as a massive opportunity. Price declines look bad on paper, but they are the best thing you can ask for as a real investor if business values haven't changed and you if you haven't let your irrational fear affect your ability to purchase stock moving forward.

This is exactly why volatility works to your advantage as an investor. Changes in stock prices are simply changes in public sentiment of a business.

Let's say you own a small tool-shop. The shop's earnings are stable, it has a strong balance sheet, and you manage to take it public. Its stock now trades between investors on this secondary equities market and somehow the price of your business changes every day- but the business itself isn't changing much. Would you as an owner really care if the company was de-listed for a decade? Would a wise and formerly private owner really care if the price of ownership dropped 50%? It is all irrelevant- none of that affects the business. It is just part of the game of capitalism and a wise investor uses it to their advantage.

I'm going to summarize Ben Graham's Mr. Market metaphor here as simply as possible:

 Lets say you and a friend own a private business with stable earnings and prospects. Your friend has bi-polar disorder and his mood changes every day- one day he is very happy and optimistic, the next he is depressed and pessimistic about the future. Every day he offers to sell you his half of the business and his condition affects his opinion of the future of the business. Some days when he is optimistic, he thinks the business will do great and will only sell his half to you at high prices when he thinks it is worth more. On his bad days, he is down on the firm and will sell you his 50% at almost any price because he thinks it is worth less. Do his mood changes and ask prices affect your opinion of the business? Would you believe that the value of the business depends on his ask price on a given day? If you were smart (and willing to take advantage of this person) you would buy his 50% when he is depressed and sell to him when he is optimistic. You wouldn't worry when his ask price drops; you would be stupid to believe your 50% is now worth less based on his opinion.

The exact same mechanism is at play in the stock market as a whole. For whatever reason, with massive wealth at risk, many people are highly vulnerable to fear, group-think and the typical lemming-like behavior that leads to buying at high points and selling at low points. When you hold a stock and you see it drop from $50 to $40 to $30 then to $15 most people believe they are being left out, are losing money, and are prone to follow the group and sell. I believe it is a simply overwhelming feeling for the typical investor, even if they can rationalize why its a bad idea they do it anyways.

You should not see the stock market as some collective of rational observers making decisions based on logic. You should picture a bunch of potential buyers and sellers constantly waving around bid and ask prices. I usually picture the large boards in the 1800's-1900's whereby trades were made by shouting out offers as the current price is noted on the board in chalk as seen in the picture below. When a buyer and seller yell out and agree on a price, the stock then trades at that price. The changes in price are just a result of the most recent trades and changes in sentiment. The same thing is happening now electronically at a much quicker pace and higher volume. 



Now it should be said that fluctuations only matter in relation to business values. If the company you own is overpriced, holding through a big price drop won't necessarily help you if you purchased at that high price. If the business you own is worth $200 and the price drops from $500 to $300, that's not going to cut it. Depending on the quality of the business, the price would have to drop to anywhere from $100-200 for there to be a buying opportunity. This is why you must be certain you are purchasing companies at fair or cheap prices. In the case above, the price drop of 40% from $500 to $300 hasn't presented a buying opportunity but you have suffered a likely permanent loss of capital. Obviously, a buying opportunity is only present if the price is equal to or lower than the value of the business- the lower the quality of the business, the higher the discount to fair value you must demand.

This is the reason that volatility must be embraced in any proper investment operation. For a stock that isn't cheap to become cheap, a 10-20% drop won't do- it will typically need to be more. Of course, you'd prefer this price drop to occur before purchase but that is not always possible- cheap companies sometimes become cheaper based on short-term sentiment. In any case, it should elate investors as price drops in general are a positive thing for future returns.

If one purchases cheap companies, it reduces the potential for price decreases. If you are purchasing companies at half of their fair value, it is going to be difficult for them to become any cheaper, which is why purchasing companies at a discount to intrinsic value both reduces the risk of permanent loss and maximizes returns- it would be difficult for them to get cheaper and if they reach fair value one will experience dramatic returns. Purchasing at large discounts to fair value is both extremely conservative and will bring high returns to the investor. It is the exact opposite of the typical 'risk/reward' paradigm- the higher the discount to fair value, the lower the risk of permanent loss and the higher the potential returns. Of course, risk is usually seen as volatility which is an improper and superficial definition- risk is the chance permanent loss.

I think one of the main reasons investors succumb to fear in times of volatility is because they don't have a sense of the values of their companies. They may have purchased at a high price during a time of euphoria and if they have not assessed the value of the firm, they will react to price fluctuations as if they are indicative of changes in value. To act on price fluctuations makes you a speculator and a gambler. You must always have in mind the value of the business and see prices relative to values. When you are confident in what the business is worth, price changes don't affect your opinion or emotions, and it is only in this case that you are comfortable buying when the stock price drops and the company becomes cheaper.

"Buy low and sell high" is thrown around a lot and for some reason people think it is difficult to do. It is really quite simple, it just requires a high level of emotional tolerance, a disassociation from price changes, confidence in one's analysis, and a bit of contrarianism. Although it seems to be every investor's goal, it is the rare breed that truly buys low and sells high.

The Assumptions Built into Stock Prices- Netflix & Amazon

This should be a short piece, but I wanted to use a few examples to describe the assumptions inherent in stock prices and why investors need to think through stock valuations. Given that price is a major factor in predicting future returns, investors should of course be unwilling to pay anything greater than the present value of all future free cash flows, discounted at an appropriate rate for any investment. If the investor pays anything more than that, they will likely receive returns lower than their discount rate/required return.

I think at present there are certain instances in which investors are a bit euphoric and may not be critically examining the assumptions built into the prices of the companies they own. I'd like to use Netflix as an example here, because I believe it is the most egregious offender on this front.

Netflix currently has a market capitalization of around $75 billion, and had $360 million of net profits in the past 12 months, for a P/E of 208. For the non-financial types, this would mean at Netflix's current level of earnings, it would take an investor 208 years to re-coup their investment before making any profits. Of course, the assumption is that massive growth will lead to the earnings eventually becoming high enough to justify this valuation.

I've discussed Netflix on certain online forums and would rather not get into explaining my opinion regarding the company's potential for competitive advantage in the future. I won't even discuss the number of subscribers or revenues it will need to attain, as that would require forecasting profit margins and we could all disagree on what Netflix's mature-level profit margins may be. This analysis will be as simple as it gets- we will look at what the market capitalization must be 10 years from now in order for Netflix investors to receive a 10% annual return, and what earnings must be in that case to deliver a reasonable mature P/E.

With no share buybacks, to get an annual return of 10%, Netflix's market cap will also have to grow 10% a year. The table below (all $ in billions) shows this. In the row 'market cap', I took NFLX's current market cap and made it compound at a 10% rate over the next 10 years. I then calculated what the earnings must be to deliver a P/E ratio of either 20 or 30 in the two columns below. With NFLX's market cap growing at 10% a year, to get a P/E of 20 in 2027, earnings would have to be $9 billion and to get a P/E of 30, earnings would have to be $6 billion.


To get to $9 billion in earnings by 2027, Netflix's current earnings would have to grow by about 39% a year. To get to $6 billion in earnings by 2027, Netflix's current earnings would have to grow by about 34% a year. Over the past 10 years, Netflix's revenues have grown by 24% a year, and its earnings have grown by 14% a year. To get to either $9 or $6 billion in earnings by 2027, Netflix would have to somehow grow earnings over the next 10 years about 50% faster than it grew revenues over the past 10 years. It would also have to almost triple its earnings growth rate of the past 10 years. Does this seem plausible?

In the row titled 'net profit', I took Netflix's current earnings and had them grow at a 25% annual rate over the next 10 years- so if Netflix somehow grew earnings over the next 10 years at the rate it grew revenues over the last 10, it would have about $2.7 billion in earnings by 2027. For the market cap to have grown at a 10% rate through 2027, with those earnings, the P/E would be 66, so it would take an investor 66 years of current earnings to pay back the price of the stock. If we go even further and assume it keeps growing earnings at 25% a year after 2027, and the investor wants a 10% return, we would finally reach a P/E of 20 in 2037, with $25 billion of earnings and a market cap of $459 billion. So earnings growth would have to nearly double and remain that high over the next 20 years and only then would investors receive a 10% annual return. Clearly this is not going to work to bring investors a 10% annual return, even in very the long-run.

The numbers required for an annual return of 5% aren't promising either. NFLX would need $4 or $6bn of earnings to have a 2027 P/E of 30 or 20, respectively. Even to get those $4bn of 2027 earnings would require 27% annual growth in earnings. Again, I don't see how the company could grow earnings at a higher rate than its revenue growth rate over the past 10 years.

The same exercise could be done with Amazon. AMZN currently has a market cap of $469bn, with 2016 earnings of $2bn for a P/E of 246. To get a 10% return over the next 10 years, it would have to have a market cap of $1.2 Trillion in 2027. At a P/E of 30, it would need around $40bn of annual earnings. Unlike Netflix, I actually believe Amazon has a chance to justify its valuation in the long run but it cannot have free cash flows permanently higher than operating earnings as it currently does- it will eventually have to generate earnings high enough to justify its valuation. Like every other company, when it matures, its free cash flows will be lower than its operating earnings. I do not believe a 10% return for Amazon shareholders is in the cards for reasons similar to that of Netflix- the current valuation is simply too high.

Investors willing to purchase rapidly growing companies at earnings multiples north of 200 need to seriously consider their future potential returns from such investments. Even with perfect business execution and total global market domination, I believe investors in both Amazon and Netflix in particular will be lucky to generate mid-single digit returns over the next decade. Of course, the future is difficult to predict and industry conditions can change quite rapidly. Amazon seems to be well positioned for the long-run, but there will no doubt be imitators and competitors for both of them, and Netflix's position is not as impenetrable as Amazon's. Again, to generate significant returns the investor much receive value relative to the purchase price, no matter how high the company's growth or returns on capital. I do not see any value here.

Growth, Returns on Capital, and Business Valuation

Before I start this piece on valuation, I just want to say that nothing in business or finance is as complicated as it looks, and nearly all of it is much simpler than you think. I’m going to get a bit wonky in explaining some terms here but what’s important is that the concepts are understood. Equations don’t mean much of anything without an understanding of their importance and relevance.  

The intrinsic value of a company is the present value of all of its future free cash flows. Quite a simple statement, but it’s of course not always easy to estimate those cash flows given that they accrue to the firm in the future. Note that word all in the original sentence. That means from now until the end of time- all the free cash flows that it will ever generate.

What’s free cash flow (FCF)? If we are talking about free cash flows that will accrue to the entire firm- both debt and equity-holders, then it is the following:

FCF = NOPAT – Net Investment

NOPAT is the operating profit of the firm (earnings before interest and taxes) less its income taxes. NOPAT is therefore a measure of earnings excluding the effects of debt on the firm’s net income. By excluding debt it focuses on the value of the firm’s operations and shows how much cash is generated which can be used to either pay debtholders, pay owners, or reinvest in the firm.

NOPAT = EBIT x (1 – Tax Rate)

Net Investment is the amount the firm reinvests into its operations. Unless the firm has cash reserves, is taking on debt, or issues shares, net investment cannot be greater than NOPAT. It can be calculated by taking the firm’s total invested capital in a certain year and comparing it to that of the prior year:

Net Investment = Invested Capital in Year 2 – Invested Capital in Year 1

So, free cash flow is the amount of cash that the firm generated from its operations minus the amount of cash that it reinvested into its operations. These cash flows are “free” because they can be used freely to pay off debt, buy back shares, pay dividends, or just leave in the firm’s bank account. If you are an owner of a private company, this is what you would think of as “real earnings” that you can pay yourself with, given that you don’t have to reinvest those funds back into the operation. This of course differs from GAAP accounting earnings that are displayed on an income statement, as you must likely reinvest some of that back into the business to maintain sales and grow.

So to properly value a company, one must predict all the free cash flows the firm will ever generate, discount them back to the present (since cash earned in the future is worth less than cash in hand now), and then sum it all up. This would be called the intrinsic value of the firm.

If we assume your company’s free cash flows will grow at a constant rate forever (which of course is not reasonable), we can use the perpetuity present value formula to find the intrinsic value of the firm:

Intrinsic Value = FCF / (W –G)

FCF in this equation is the free cash flow your firm will generate in the first year.

W is the required return- aka the return that you require on this investment. Academics use WACC, but since us investors don’t care about the CAPM, beta, or volatility, you will simply use whatever rate of return you need from an investment. You will have to use this same W when valuing all potential investments so you have a level playing field on which to compare stock valuations, otherwise you could simply call a firm undervalued because you decreased the W from 10% to 1%. Also note that this would be the intrinsic value based on the returns you require- those who only need a 5% annual return should be willing to pay more for their investments than somebody who needs a 15% annual return.

G is the annual growth rate of the firm’s free cash flows, and in this equation we assume it remains constant forever.

Both W and G are expressed as decimals, with 1 being equal to 100%.

If the FCF of the firm in year 1 is 10, and we require a 10% annual return, and it will never grow its FCFs, then the intrinsic value is as follows:

$10 / (0.1-0) = $100

So this firm is worth $100. It is useful to know that if a firm will never grow, you can multiply its average annual free cash flows by 10 to get a pretty decent measure of its intrinsic value.

If you ramp up growth, it is of course worth more. Let’s try 5% annual growth forever using the same FCF and RR.

$10 / (0.1-0.05) = $200

The value of the firm doubled. Again, remember this would be 5% annual growth not just for the next 10 years, or the next 50 years, but forever. This is why using such a simple formula is almost never practical.

In a previous post, I noted that a firm grows based on its return on invested capital (ROIC) and its reinvestment rate (RR). Simply, ROIC is the amount of NOPAT that the firm generates compared to its invested capital. It is a good measure of how much profit it generates for each dollar invested into the firm’s operations by both equity and debt-holders.

ROIC = NOPAT / Invested Capital

The reinvestment rate is the percentage of this NOPAT that the firm reinvests back into the firm’s operations.

RR = Net Investment / NOPAT

So the organic growth of any company (excluding debt or equity issuance) will be equal to:


All this is saying is that companies take their earnings and reinvest them to buy more assets and attempt to generate higher profits. The growth rate in earnings and cash flows can be calculated therefore, by asking how much earnings the firm generates for every dollar it has invested in its assets, and what percentage of the firm’s earnings are reinvested into the business. This then shows the percentage growth in earnings, cash flows, and the equity value of the firm. If ROIC decreases over time, as is usually the case, then you would have to compare all additional earnings to newly invested capital. This would be calculated as:

RONIC = (NOPAT Year 2 – NOPAT Year 1) / (Invested Capital Year 2 – Invested Capital Year 1)

We will assume a constant ROIC and so we can ignore this equation for now.

The organic growth equation can be turned around to express RR in terms of ROIC and G:


This is saying that if the ROIC of the firm is 25% and the growth of the firm is also 25%, it must be the case that the firm is reinvesting all of its earnings back into the firm. If the ROIC is 20% and growth is 10%, then it must be reinvesting only half of its earnings back into the firm.

Now, if we take that original formula expressing free cash flows, we can substitute other formulas into it to express FCF based on G and ROIC:

FCF = NOPAT – Net Investment

Net Investment = NOPAT x RR


FCF = NOPAT x (1 - RR)

Instead of finding the net investment by subtracting year 2’s invested capital by year 1’s invested capital, we can just multiply the firm’s operating earnings after taxes by the rate at which the firm reinvested them into its operations. We then swap out Net Investment with NOPAT x RR in the first of the three formulas, and can pull that second NOPAT out from under its parentheses in the third equation.

We can take the formula for RR and plug it into that final FCF equation to get:

FCF = NOPAT x (1 – RR)


FCF = NOPAT x (1 – (G / ROIC))

Finally, we can plug this equation into the intrinsic value equation to get:

Intrinsic Value = FCF / (W –G)

FCF = NOPAT x (1 – (G / ROIC))

Intrinsic Value = (NOPAT x (1 – (G / ROIC))) / (W / G)

This final equation is usually called the key driver value formula, or the Zen of finance. It shows intrinsic value at its most basic roots in terms of G and ROIC (displayed in that theoretical constant growth perpetuity equation). We can see the relationship between G, ROIC, and RR, and how they affect a firm’s cash flows and total value of the firm.

The higher the ROIC, the higher the firm’s organic annual growth rate can be. The more the firm reinvests in its operations, the higher the growth rate, but the lower the FCF. The higher the growth rate, the higher the continuing value of the firm’s operations. The lower the amount the firm has to reinvest in order to grow, the higher the FCF.

The value of a company depends on both its returns on capital and growth. This is why the “value versus growth” debate is so meaningless. Growth influences value- they are one in the same. This is also why earnings multiples can be misleading at times. Some companies with high P/E’s may be cheap, and some with low P/E’s may be expensive. It all depends on future free cash flows.

In practice you wouldn’t use a formula like this to value a company, but it is useful to go through that derivation to show the relationships between the variables relevant to a firm’s intrinsic value. To actually value a company you would have to think about future cash flows and how they will grow over time. Using a formula like this is in my opinion, of little practical use. In reality you would have to estimate each year’s cash flows over a certain period of time when the firm is growing at an above-average pace and then thereafter assume a constant growth rate like the example at this link.

You may have noticed that if the reinvestment rate is 100%, the value of the firm according to this equation is 0. This is because it assumes constant growth of an initial positive FCF, and if that FCF is 0, then the firm cannot be valued in the formula- so it is only relevant to mature firms.

So how do we go about valuing a company if it is reinvesting all its earnings back into the business to grow and therefore generates no free cash flows? I’ll show a simple example of a lemonade stand and why this can be initially confusing. Let’s assume we started a lemonade stand with $5,000. The business generates a 20% ROIC every year on total invested capital and it reinvests all earnings back into inventory and upgrading the lemonade stand. We assume the business has no debt. At the end of 5 years, this business has grown earnings at 20% annually, has a book value of equity of $10,368, and has generated $7,442 of total earnings, but hasn’t generated any free cash flows. Obviously, the firm is worth a significant amount, but we cannot value it on FCF yet because it is growing and reinvesting at a high rate.


lemonade stand.png

Buffett helped us with that by creating a concept called owner earnings. It is basically a measure of the firm’s potential free cash flows if it weren’t reinvesting them:

Owner Earnings = Earnings + Depreciation & Amortization + Other Non-Cash Charges - Maintenance Capital Expenditures

Maintenance Capital Expenditures are the level of investment the firm needs to keep its buildings, plant, and equipment in working order to maintain current sales volumes. In this case, it would just be the level of investment we need to make sure our lemonade stand looks nice. It is simplest (and generally accurate) to assume that the depreciation and amortization figures are what is necessary to maintain current property and equipment, so we can cancel out Maintenance Capex and D&A in that equation to get:

Owner Earnings = Earnings + Other Non-Cash Charges

This equation does not include changes in working capital because it assumes the firm can maintain sales at its current working capital levels. So if we assume that for our lemonade stand there are no other non-cash charges besides D&A to deal with, and that D&A are a good representation of the amount we need to keep our lemonade stand in working order, then owner earnings would be equal to our NOPAT figures. Generally speaking, operating earnings are a decent benchmark for a firm’s owner earnings.

ROIC and Growth are the two main determinants of the value of a firm’s operations, and clearly the best firms deliver extraordinary returns on capital and grow quickly due to their potential expansion opportunities. Most mature firms have stable ROICs but lower growth. Mediocre companies usually grow slowly and have lower ROICs. The WORST possible outcome however, is to have a low ROIC business growing rapidly- I will show why that is the case. Below you can see four different scenarios of company based on ROIC and Growth. Slow/Fast represents the speed of growth, and Low/High represents the ROIC.



First up is the slow growing, high ROIC firm. It’s likely a very mature firm and is paying out 80% of operating earnings as dividends. Earnings growth is very slow, but the firm doesn’t have to reinvest much to get that earnings growth. Earnings are reinvested at high rates of return, so this would be similar to a high dividend yielding oligopolist with limited growth opportunities.



Next is the fast growing, high ROIC firm. Growing at 20% a year, and reinvesting all earnings back into the business. This one has the most potential to increase intrinsic value at high rates going forward. Paying fair value for such a firm would allow the owner to achieve excellent returns over time.



The slow growing, low ROIC firm has poor returns on capital, but is only investing a modest amount of its earnings annually to get that tiny growth while paying out the rest. This firm doesn’t have much potential, but if purchased at a very low price it could be a good investment. With equity so much higher than earnings, it is possible that even at a reasonable multiple of earnings the stock would be undervalued based on the value of its net assets- for example, at a P/E of 8 you would be paying $256, or 24% of its Year 3 book value. Of course, we would have to ensure that book value is representative of underlying asset values since paying a low price is paramount to such a business delivering high returns as an investment.

Since the value of this firm’s operations is quite low relative to asset values, the equity value comes into play and we may be able to purchase those assets at a massive discount (along with the low earnings the firm generates). It isn’t the prettiest way to invest, but it has been done by many successful investors and can be highly rewarding. Additionally, if the equity value is highly liquid- say it’s nearly all cash for example, we could purchase the firm for $800 at a high P/E of 25 and still do quite well. In that case, the value of operations would be more of an additional benefit than anything. For good businesses such as the high ROIC ones above however, equity value is largely irrelevant as nearly all of the firm’s value comes from its operations. If a firm’s assets are worth more than the value of its operations, long-time owners have been harmed. As an example, for a restaurant it clearly isn’t good for the long-term owners if the building they once purchased is worth more than the value of the business as a going-concern. If the stock is cheap enough however, bargain hunters can benefit from this situation.



This last one is the fast growing, low ROIC firm. This one is an absolute disaster and basically requires poor management to enable its growth. If you noticed, equity and earnings are growing at 20% annually with an ROIC of only 3%, how could that be? It is because the owners are increasing their invested capital in the firm- essentially paying out of their own pockets to buy assets in order to increase growth. Privately held small businesses do this all the time, and some large public companies do it as well by issuing shares to unwitting investors. This firm is a capital-waster and is sucking in more and more cash to deploy it at low returns.

The main problem with this business is that every year it is deploying more money at 3% returns, while that could have been deployed at average returns somewhere else. This means that every year, investors are losing money as the firm reinvests to grow. Equity investors might not know it, and they can’t feel this loss, but if they were to calculate their future earnings if they invested that money in something delivering say 10% a year versus this 3%, they would realize how much money they are throwing away.

To summarize, the intrinsic value of a firm’s operations are a result of its growth and returns on capital. To achieve decent returns, you can pay fair amounts for companies with high growth and ROIC, or very low amounts for firms with low growth and ROIC. If the firm is deploying high amounts of capital at a low ROIC, management is enabling poor business results and will be more interested in the ‘institutional imperative’ of keeping the business alive and growing rather than being focused on the interests of owners.

There is no growth versus value debate, there is only value and it depends on growth and ROIC. If you are capable of properly valuing companies that you can understand, it is certainly possible to do extremely well in public equity markets given the irrational and frequent changes in stock prices. The key is to accurately value companies and purchase them when cheap relative to that value.

I personally do not use excel sheets much for valuation- I understand that may seem ironic after taking you through the above exercise. Excel can be helpful in certain situations (such as understanding general concepts and theory), but in terms of valuing a business you are looking at, it is as Buffett says:

“If the value of a company doesn’t scream out at you, it’s too close”.

If you understand the basics of valuation and invest in what you know, playing with numbers on a spreadsheet isn’t going to be of much use. You will know rather quickly whether it is relatively cheap or not based on the reasonable range of potential fair values- if it is far below this range, buy as much as you can. If you have to squint at an excel sheet and engineer your assumptions to determine whether it’s a good buy or not, then either you do not understand the business well enough or the margin of safety is far too small.

U.S. Stock Market Valuations and Future Returns of the S&P 500

In 2013, Eugene Fama, Lars Hansen, and Robert Shiller won the Nobel Prize in Economics. It was an odd trio, given that Fama is one of the fathers of the efficient markets theory and Shiller wrote a book titled 'Irrational Exuberance' in which he discussed the irrationally high stock prices  shortly before the crash of 1999. The three were given the prize based on their careers' work of asset price prediction. Fama's work has focused on the difficulty of predicting stock prices in the short-run. Shiller, on the other hand, has focused on long-run predictions based on current valuations- as an investor would.

Shiller's work is particularly relevant to us, as it provides an empirical basis on which long-term predictions regarding asset prices can be made- for the general market in particular. A stock's fair value is the present value of all future free cash flows which will accrue to it. In the very long-run, those free cash flows must be eventually paid as dividends for them to be of value to the owner of the business. On this basis, Shiller developed a chart of the fair value of the S&P 500 by taking the future dividends of the index and determining the present value of them at each year since 1860.

Since Shiller created this chart in 2013, the present value of dividends after that were estimated based on the previous year's growth rate. For all years before 2013 we have future historical dividends on which to make this fair value claim. The dotted blue line indicates the fair value of these dividends for the S&P 500 over time. As we can see, the fair value of the index increases quite smoothly as the companies within the index compound earnings and pay higher dividends. The red line is the S&P 500 index price- much more volatile and ever changing. It is nearly always inaccurate by a decent margin. As we know, these stock price changes, even in the entire market index, are irrational, misguided, and not based on business values. 


The question relevant to us as investors is how to determine whether the market as a whole is fairly priced or not. This of course, doesn't affect our individual investment decision- if a company is cheap we still buy it. It does however, give us an indication of future returns accruing to the general market and what we can expect going forward. Instead of valuing the index (as this depends on one's personal required rate of return), we can simply look at another chart Shiller made which presents his modified version of a P/E ratio along with the next 10 year returns of the index if purchased at that price to earnings ratio since 1883. This will help us determine our potential range of returns over the next 10 years based on historical data.

The modified P/E is called the Shiller CAPE ratio, which stands for the Cyclically Adjusted Price-Earnings ratio. This basically means that it leaves the asset price in the numerator, but instead of presenting the prior year's earnings in the denominator, it uses an average of the past 10 year's earnings. As I have said numerous times on this blog, P/E ratios can be extremely misleading and inaccurate in terms of valuing individual companies, but P/E's work well on average. Of course, the S&P 500 index is a weighted average of the largest 500 companies in America and its earnings grow at a very low rate, so in this case, P/Es are quite accurate for valuation purposes.


As of 8/23/2017, the S&P 500 index is trading at $2,444 per share and has earned approximately $100 per share over the past 12 months (based on data from S&P Dow Jones). Its P/E using earnings from the past 12 months would be about 24, and its CAPE P/E is approximately 30. As the chart above shows, since 1883, the highest next 10 year annual returns from purchasing the S&P 500 (or its 1800's equivalent) at a CAPE P/E of 30 was about 6%. 

If you are currently holding the S&P 500 index and expect an annual return higher than 6% over the next 10 years, you are betting on beating the highest returns ever achieved from purchasing the index at this price. If this is the case, I would advise you to reduce your expectations. From a cursory look at the chart, you will likely achieve anywhere from -4 to 6%.

The chart is quite muddled at a CAPE P/E between 15 and 25, for reasons based on differing time periods, wars, economic growth rates, political outcomes, and other. At the extremes however, the model becomes much clearer. If you were to buy the index at anything lower than a CAPE P/E of 10 you would likely have done very well, and if you were to purchase it at a CAPE P/E over 30 you would likely have done extremely poorly over the next 10 years.

Something else we can look at is the CAPE P/E over time. Below is the chart of this. As you can see, we now have the same CAPE P/E valuation as we did in 1929, and only in the late 1990's was it ever higher. 


If you're asking why I use the CAPE P/E instead of the normal trailing year P/E, it's because it smooths out earnings of prior years and it has more predictive power. The normal P/E chart shown below looks a tad better, but again, only in the late 1990's were valuations higher (and 2009 which doesn't exactly count because this is simply the result of prices dropping but total market earnings dropping at a faster rate to nearly 0). The long-run historical P/E looks to be around 15 or so, which would indicate a current price of around $1500. 


The S&P 500 is comprised of the largest and most successful companies traded on U.S. public equity markets. As a result, it would be unwise to expect their earnings to grow at a high rate- more likely that they would grow slower than that of the total economy right? It would seem irrational to expect the largest 500 companies in the economy to grow faster than the entire economy, and history shows they have grown a bit slower- around 2-3% annually. With the entire economy growing at around 2% annually, we couldn't expect the earnings of the S&P 500 to grow any faster than that 2% or so. So, by purchasing the S&P 500, you are paying around $24 for every $1 of 2016 earnings it generated ($30 for every $1 it generated on average in the past 10 years) and as a whole it grows earnings at 2% or so per annum. There is no feasible way for such an asset, purchased at such a price, to produce anything near 10% annual returns.

Further, interest rates tend to act as a lever to lift or weigh down asset prices. As interest rates drop, the yields of assets (earnings / price) look more attractive in comparison and so the prices of those assets rise and vice versa if interest rates rise. Historically, this relationship is not so clear, but in theory it holds. Over the past 8 years, interest rates have been rock-bottom and historically low as shown below. This near-zero interest rate increases the value of all assets, including stocks, bonds, and real estate. (Not to mention the fact that debt is cheaper so people are more willing to take it on in order to purchase such assets at more expensive prices). 


In any case, interest rates could not be lowered to induce asset price inflation as we historically have done in times of recession. This situation is called a liquidity trap- when interest rates are already so low that the Fed is unable to effectively conduct its monetary goals. The Fed will not be of much help if these asset prices were to significantly decline.

If you look closely at the forward ten year returns versus CAPE P/E chart again, you can see that at a CAPE P/E of 30, the highest annual 10 year forward returns of around 6% were achieved in the 1980's, 1910s-1920s, and the late 1800's. In the late 1800's through the 1920's, the GDP of the U.S. was growing at a higher rate than it is now. In the 1980's interest rates dropped from mid-to-high teens to mid single digits, and that helped boost stock prices dramatically over that period. Right now, investors of the S&P 500 do not have either of those benefits, which is why I would suggest that the returns of the next 10 years will be on the lower end of the range of historical values- my optimistic guess would be 2-3% per year.

Nobody can predict the movement of stock prices in the short-term (less than a few years), but Shiller was one of the three Nobel laureates in 2013 because he helped explain why stock prices over the long-run are quite predictable. It all depends on the future performance of the stock versus its current price- on this basis we can tell whether the general market is cheap, fairly priced, or expensive. It should be clear from this quick analysis that it is historically expensive. The higher the price you pay for a financial asset, the lower the future returns and vice versa. The earnings of the S&P 500 are quite slowly growing, so determining potential future returns from this index is not complex.

As market indices continue to rise, studies of investor expectations have shown that investors increasingly expect higher performance as a result of new-found record market index prices and feel that the chance of a recession is ever lower. When others become complacent and/or greedy, the prudent investor should become more aware and fearful. If you find yourself expecting substantial future performance from the S&P 500 or any other U.S. market index based on the results of recent history, be aware that you are betting against both history and logic. 

The Irrationality of the Efficient Market Hypothesis

“I’d be a bum on the street with a tin cup if the markets were always efficient. - Warren Buffett

“It is hard for me to see how anyone can consider the stock market efficient.” - Phil Fisher

“Value investors know – although efficient market believers fail to comprehend – that the underlying value of a security is distinguishable from its daily market price, which is set by the whim of buyers and sellers, as are the prices of rare art and other collectibles.” - Seth Klarman

"One of the worst examples of what physics envy did to economics was cause adaptation and hard-form efficient market theory. And then when you logically derived consequences from this wrong theory, you would get conclusions such as: it can never be correct for any corporation to buy its own stock. Because the price by definition is totally efficient, there could never be any advantage. And they taught this theory to some partner at McKinsey when he was at some school of business that had adopted this crazy line of reasoning from economics, and the partner became a paid consultant for the Washington Post. And Washington Post stock was selling at a fifth of what an orangutan could figure was the plain value per share by just counting up the values and dividing. But he so believed what he’d been taught in graduate school that he told the Washington Post they shouldn’t buy their own stock. Well, fortunately, they put Warren Buffett on the Board, and he convinced them to buy back more than half of the outstanding stock, which enriched the remaining shareholders by much more than a billion dollars. So, there was at least one instance of a place that quickly killed a wrong academic theory." - Charlie Munger

Unlike many fields of study, finance isn't a hard science. Most theories cannot be tested in a laboratory and quickly falsified. Finance has done a great job of explaining the inner-workings of corporations through mathematically verifiable equations, but I believe finance has led many students astray with its attempt to explain financial markets in the same manner. Financial markets involve significant estimates of the future in determining the valuation of assets, and for many reasons that I have previously discussed, such valuations may not reflect economic reality.

In summary, investors are highly emotional, have differing goals, have differing opinions, have differing time horizons, are significantly loss-averse, can become greedy, and of course- the future is difficult to predict. For these reasons, I believe that at nearly all times, valuations of financial assets will be inaccurate- the only question is how inaccurate. If they are within the range of reasonable values, we can say the security trades 'at fair value'- of course every now and then securities can be unreasonably priced. As Benjamin Graham noted, in most cases we cannot say with certainty the age or weight of a person. We can however, notice if they are young/old or underweight/overweight. Similarly, the value investor looks for situations where the security is significantly mispriced, even if the exact value cannot be determined with specificity. As long as the range of potential fair values isn't too wide, profitable investments can be made if we are certain the security trades far outside of that range.

To discuss the theory of market efficiency, I would rather not nit-pick every detail, but rather focus on the few big concepts which I believe to be rather absurd and which, as Charlie Munger would say, "violate mental decency". The theory of market efficiency dominates financial theory and is taught to business students worldwide as common knowledge, so it is both highly distressing and highly beneficial to value-investors that it has been so easily adopted as mainstream thought.

The main issue is the concept of risk. Simply, risk is the probability of a permanent loss. In its attempt to create a mathematically sound theory however, theorists have accepted the idea that risk is volatility. Risk, according to this framework, is how much one's financial assets change in price. A formula (CAPM) has been developed to help predict future returns based on this idea of risk being volatility, but what's important to note is that beta (β) represents the volatility of a stock relative to the general market. This equation of course, based on the idea that risk and returns are positively correlated- the higher the risk, the higher the returns. So, if a stock price moves more than that of the general market does, it is deemed to be riskier than the market and would be expected to deliver higher returns. Now that is a very smooth mathematical theory, as it allows one a nice equation on which to base returns and risk. The problem is that it defies logic. Along with the definition of risk being inaccurately defined, the idea that risk and returns are correlated is false, for reasons I will explain below.

A stock is a share of the ownership of a business. The stock price is the price one would have to pay for that share of ownership. If the stock price changes, it simply means that investors have changed their minds on the price of that ownership based on their trading action. Price changes can be completely coincidental- if an owner sells a large piece of that company, the price of the stock would drop. Do we believe that the value of the business has changed because that owner sold shares? Do we believe the company and its stock is riskier now after that trade occurred? What if people sell their shares out of fear and the stock price drops significantly, or if they become greedy and the stock price rises significantly in a short period- is the stock/business any riskier than it was a short while ago? 

The risk of any stock or business is the chance that one pays too much to become an owner. Only then can one experience a loss. All other price changes are temporary and simply a result of flippant changes in demand versus supply of the stock. 

Further, we can create a simple thought experiment to expound on this. Let's say that I purchase stock of company A which is certain to experience permanently but very slowly declining earnings and as a result the stock decreases by $1 a year, starting at a price of $100. In year 1, the stock trades at $100, in year two it trades at $99, and so on. Investors will experience permanent loss as the stock price and the company's earnings slowly deteriorate and never recover. 

Another stock of company B has rapidly growing earnings. It is tough to determine the exact future growth of earnings, so the stock price experiences swings over time, but as the company does well so does the stock. The stock starts at $100, increases to $140 in year 2, decreases to $120 in year 3, increases to $180 in year 4, and so on- ever upward.

Could any reasonable person say that the stock of company B is riskier than that of company A? Financial theory would say that since volatility is higher in company B, company A's stock is less risky. Such a statement defies reasonable borders of logic and small children could explain why that idea is flawed. Investors in company A will permanently lose wealth, and those in company B will do well over time. Volatility is of no help in determining the risk of these investments. There is an 100% chance of loss by investing in company A, but since its volatility is lower, it would have been deemed to be safer.

Another quick example. In 1999, stocks crashed. The stock prices of many large tech companies dropped 70%+. Now because of that price change and volatility, those stocks would have been deemed riskier after the drop than they were before it at higher prices. Would you rather purchase a company at $1 million or $300,000, all else being equal? Clearly the cheaper the company, the better the investor will do. Somehow, financial theory would indicate that paying a higher price is safer.

You could take this logic to its extremes. Say Apple Inc.'s market cap (the price of the entire firm) is $800 billion. If it were to drop to $100 tomorrow, would you say that it is riskier now? Somehow, financial theory would say that purchasing Apple at a grand total of $100 after that price drop would be riskier than purchasing it for $800 billion. I'll take Apple for $100. The CAPM formula posits that returns of a stock can be determined by its beta and volatility. I cannot be clearer that this idea fails basic tests of logic.

What's the risk of purchasing Apple at $100 after that massive price drop? I would say it is limited, because it has current annual earnings of $45 billion +. Purchasing a company which earns over $45 billion a year for only $100 doesn't sound risky whatsoever to me. As for the returns of this hypothetical investment? They are astounding. I would pay $100 and own a company earning over $45 billion a year. Thus, as the price to purchase Apple decreases, the risk to an investor decreases, and the returns increase. This is the case for any investment- the lower the price you pay for a company, the higher your returns. Risk and returns are negatively correlated for investors- aka as one increases, the other decreases.

If we define risk as the chance of loss, by purchasing a company at a low price we have minimized potential risk and maximized our potential returns. All the good investors of the past have understood this idea. As the stock price drops, the margin of safety between the purchase price and fair value of the business widen, and as that safety increases, so do returns as the investor buys earnings at a lower price. In our example here, as Apple drops from a market cap of $800 billion down to $500 billion, then $300 billion, then $500 million, then $1 million, then $100, the risk decreases and returns to the investor increase. Not complicated, but for whatever reason this is never explained in mainstream financial discussions.

If you are currently contending that changes in stock prices wouldn't happen without changes in real business value- I would firstly ask you to read my prior posts, and secondly I couldn't disagree more. There was a good piece put up by John Huber at BaseHitInvesting about fluctuations over the past year in the 10 largest companies in the U.S. based on market cap. These have the most analyst coverage, with very stable businesses and solid results. The swings in just a year range up to 72%. If you look at the stock charts, they fluctuate wildly up and down over time but have stable and promising results. Do we really believe that the value of Johnson & Johnson, an 131 year old company with incredibly stable and slowly growing earnings that sells basic consumer products such as diapers and baby powder has swung by over 40% in just a year? Clearly not. The swings in price are even more drastic for lesser-known firms and in my experience usually have nothing to do with changes in business value.

Apple has been a great investment over time because it has produced highly popular and profitable products that other firms are unable to replicate and as a result, has grown earnings at high rates over the past decade. The changes in its stock price based on temporary swings in supply and demand are of no matter to its returns to investors in the long-run.

All firms which compound earnings and net worth have stock charts which look like the one below of Starbucks- exponentially upwards. Note the Dow Jones Index below in red, which has been handily defeated over the entire public history of the company. Do we believe that Starbucks has done so well compared to the Dow because the stock is somehow riskier and more volatile? Or do we think it is because of its ability to compound earnings as the firm grew over time? It shouldn't be a difficult question to answer. Also note that the beta of Starbucks is 0.81- a beta under 1 indicates that the stock is less volatile than the market, above 1 indicates it is more volatile. Somehow its beta is lower than that of the market and therefore less volatile and yet it has handily beat the market over basically any period of time you can think of (1 year, 5 years, 10 years, 10+ years, etc). Once again, it seems clear what the answer is.



Fama and French, two theorists who have been at the forefront of this market efficiency movement, have identified 'anomalies' to their theory. These anomalies include the fact that smaller firms on average deliver higher returns and that firms purchased at low price-to-book values on average deliver higher returns. This has caused much debate as to why this is the case in academic circles, but it should be clear to us as investors and business-people why this is the case. Small companies tend to grow earnings faster, and therefore grow their market capitalizations/ intrinsic values quicker. Similarly, if you purchase a company for less than its net-worth (book value), you are also more likely to do well. Other studies have shown that low P/E stocks on average beat the S&P 500 index- it should be clear why this is the case. On average, if you pay less for a company's earnings, you will have a higher rate of return. On a case-by-case basis P/E is merely a crude tool and not always indicative of true value, but regardless the reasoning should be simple to understand.

Buffett once said that you either understand that perfect market efficiency is irrational quite quickly, or not at all. If after reading all this I haven't convinced you, or at least shaken your faith in the theory of perfect market efficiency, then as Obi-Wan Kenobi once said- "You are truly lost".

Economic Cycles and Debt- The Cause of Recessions

I'm going to take a step back here and talk a bit about macro-economics. Macro-economics shouldn't be relevant to a value-investor's decision making process, but it is fascinating and interesting to study and speculate on. One of the most interesting questions facing economists is what causes economic cycles? As far as I know, mainstream theorists don't have a clear explanation for this. Keynesians would say that recessions are caused by a decline in spending and investment and monetarists would say the cause is a reduction in the supply of money.

Neither of those are explanations. Yes, spending and investment declines in recessions and so does the supply of money, but what causes the reduced spending and supply of money? They don't happen in and of themselves. In my opinion, the best answer is debt. Simply put, increased debt allows us to spend more in the short-run, leading to increased incomes and 'booms'. Of course, debts must be repaid (or defaulted on) which will lead to reduced spending and incomes - 'recessions'. Recessions naturally come with decreases in the supply of money as credit is repaid and 'destroyed'.

Ray Dalio is the manager of the largest hedge fund in the world which has done extremely well by making large macro-economic bets since its inception in 1975. He created a simple but highly explanatory video to explain all of this. It is about 30 minutes long, but it will certainly be worth your time. 

Major points to take away from this:

1. Both private and government debt increase short-term demand and spending, but cycles are primarily caused by swings in private-debt as consumers and businesses take on and repay debt. These changes in the level of debt cause changes in total demand and spending. As private debt decreases, spending drops, leading to reductions in GDP and the prices of financial assets, aka recessions. In the long-run, government debt likely plays a role as well if it leads to reduced government spending. A mainstream economist would say that debt repayment cannot reduce demand because one's debts are another's income. The problem is that debt is destroyed as it is repaid since banks essentially create credit out of thin air. The Bank of England described this process in a 2014 study.  Contrary to mainstream economic beliefs, banks are not intermediaries which lend the funds of others; they create debt and directly influence total demand and economic growth. As a result, debt directly influences total demand, and so reductions in debt reduce total demand. This isn't a difficult concept- if I cannot afford a house without a mortgage, but a bank lends the money so that I can purchase the house, total economic spending has increased as a result of that debt. If banks suddenly stop lending to potential home-buyers, much fewer homes would be purchased.

2. In an economy without debt, cycles wouldn't exist. Increases in GDP and wealth would be based on productivity growth and entrepreneurialism. In the long-run, our cycles follow our productivity growth path but with major short-run differences in spending and wealth. 

3. The U.S., as well as many other developed nations, are currently at the end of a century-long leveraging cycle. The Global Financial Crisis did not fully deleverage the global economy. The developed world very briefly deleveraged from 2008-2009 with disastrous results, but private debt has once again been rising and it is higher now than it was at that time. If the world were allowed to fully deleverage to the long-run average private debt to GDP ratio, the impact would have been at least as severe as the Great Depression of the 1930's. The chart below shows private debt to GDP levels for a few nations since 1740. It isn't the prettiest chart, but it should be clear that depressions coincide with massive reductions in private debt. 


pd2gdp (1).png

The numbers may not mean much to you, but just know that countries usually get into trouble when private debt to GDP rises above 150%. The deleveraging process can happen rapidly such as the U.S. in the 1930's, or over a longer period of time such as Japan's 'lost decade' from the 1990's until the present. In 1989, Japan's Nikkei Index traded at around ¥39,000. As of right now, it trades at around ¥20,000. Over this period of 28 years, investors holding the Japanese index would have experienced horrific returns of approximately -50% in total. Clearly, Japan has experienced productivity growth over this period of time, but the drop in private debt wiped away significant demand and reduced asset prices.


japannikkei225 (1).png

This is something that has worried me for a while now, as our economic growth over the past 100 years has been fueled by an increase in private debt relative to GDP (both for the U.S. and globally). After 2008, we have maintained a slow but steady GDP growth rate and as usual, it has required an increase in private debt to do so. Although the chart above excludes government debt, when you include it the situation seems even worse. Total debt to GDP is over 300% for nearly all developed nations- going as high as 1000% for some countries. The point of this is that growth in spending and GDP cannot continue at this rate, since growth in debt cannot permanently increase at this rate.

I don't mean to be pessimistic or incite fear mongering, but the data looks bleak for GDP growth and the returns which will accrue to financial assets over the next 30+ years. Our countries will of course, make massive productivity gains over this time, but whenever a full deleveraging occurs, GDP worldwide will drop in spite of those real productivity gains. When this will happen and how long the process will take to complete is anyone's guess. Hopefully this analysis will be incorrect, but it will be an interesting few decades, economically speaking.

The Proper Analysis of an Investment

In this post I would like to summarize my thoughts on how one goes about analyzing an investment. I will focus on the situation where one is analyzing a potential 'good business' which is expected to compound value over time and which you can hold for the long run.

In my experience, one understands a business, its competitive advantage, and potential for future growth rather quickly or not at all. It is seldom the case when I begin with little understanding of a company's products/industry and end my research feeling that I have a solid understanding of the future of the company or its industry. This is mainly because the companies that I cannot initially understand would require too much time for me to feel comfortable with- I could use many examples such as industrial companies with highly technical products that are sold to other companies, pharmaceutical companies which sell drugs I cannot pronounce and fix ailments I have never heard of, certain software developers, and companies which manufacture certain highly technological products.

To become comfortable investing in such industries would take years of study at a minimum. Although there are a number of companies in these industries who sell products I can fully understand, they exist in rapidly changing industries and it is quite difficult to predict the future 5 or 10 years out. This of course, makes it nearly impossible to value a company and determine how much I should be willing to pay for it. 

The prudent investor who understands the limits of her/his own knowledge will rule out a significant number of public firms (likely the vast majority) as a result. This does not mean they are any worse off. To determine the suitability of a company for investment, one must understand its products, its industry, its position within the industry, and the future of both the industry and the company's position within the industry into the future. Of course, after those considerations the firm must be selling at a reasonable price or the stock will produce mediocre returns to its owners even if it is a truly extraordinary business. Thinking about an industry 5, 10 or 20 years from now is no simple task and requires one to focus on certain industries in which they are truly competent and can understand in their entirety. 

So as stated, at the start of one's research it should become clear quite quickly whether the firm in question can be understood within a reasonable period of time and whether it has potential to compound value into the future. As the research continues, the investor forms an understanding of the industry structure, and then develops the basis for the firm's current advantage and how the firm will retain that advantage in the future. 

Something I personally do once I reach this stage and believe the firm is in a very enviable position for the long-term is think about all my potential biases and whether my perception of the firm could be in any way skewed, if I could be acting on emotion in any way or if this is the result of truly logical reasoning.

After considering all potential biases, I invert my thinking and consider all of the things that could possibly harm this business and its position in the future. Which factors could reduce demand for this firm's product/service? There are a nearly countless number of potential factors to consider for any business, including current competition, potential new entrants, a new technology which revolutionizes or destroys the industry in any manner, any substitute product in a separate industry which could affect demand for this firm's products, and many more. Further, which factors would make it so that the firm doesn't do as well as I believe it will? For any industry there will be a large list of potential risks and influences to consider. It is important for the investor to determine which are benign and which could seriously harm the firm's performance.

It is my opinion that in many cases, the harm will come from that which you don't know you don't know. This is particularly the case in highly volatile and rapidly changing industries. Attempt to consider all material things and you will be better prepared to value the business and its future prospects accurately.

After this analysis has been done, and the investor has a rational basis on which to believe the firm will continue to do well in the future, the company must be purchased at a fair price. There are many books on valuation and I don't want to bore my readers to death, but it is always important to note that the price you pay (even for a compounder) can have a big impact on your returns- see here for more on that

It is both an investment and mathematical certainty that if you purchase a company for less than what it is worth you will do well, no matter the quality of the business (one caveat- the business has to be worth something). Of course, you must be able to accurately determine what the company is worth. Business values however, are never certain, and even if one has a great understanding of a business only a range of fair value can be produced at best- it is impossible to say with certainty that a company is worth some exact value. 

My point here is that the investor's entire analysis of the firm was done in an effort to properly value the company. The value of a company includes all future cash flows until the year infinity, so the better that understanding, the more accurate the valuation will be. If the investor is wrong on any material point, the value of the business could be much less than what she/he originally thought, and therefore the price paid could then be too high. It is always a matter of price paid versus intrinsic value.

To summarize:

1. Understand the business and its competitive advantage

2. Ensure the business will retain that advantage in the future

3. Understand how quickly the business will grow over time

4. Make sure you buy the company at a fair price

When an investor has finished this process, she/he will be able to concisely describe the firm and its potential in a logical manner. It should be simple to understand and explain to others in a few sentences.

I will use two quick examples- firstly one which illustrates how one shouldn't think about a business, and secondly how to do this process well.

I must say that firstly, I have never seen an analysis or valuation from a Wall Street analyst that had any substance. I don't mean this as an insult, just as constructive criticism. I believe this is because they have different goals at heart, but it usually is the case in such analyses that a year in the future is considered the long-term and a price target as well as quarterly estimates over the next few months will be given without any regard to long-term business value. This is why I believe that investors can profitably exploit mispriced securities even if they are covered by many analysts- the wise investor considers long-term values and whether the business will compound over time; temporary issues and poor quarters are of little concern. Frankly, if you believe stock market volatility is a result of real changes in business values you are mistaken (more on this in future posts).

Last year, I was looking at a business that I believed was severely mispriced. I believed, and still do for good reason, that it would compound value over the long-run. Its stock had experienced a significant decline over a few months due to temporary concerns which I believed weren't material to the long-run. The company was covered by many analysts and I was able to read the research that one of them had published. The analysis focused mainly on the next 6 months, presented the current weakness of the company, and put a 'price target' on the firm, which is basically an estimate of where the stock will be priced within the next few months. That was essentially the entire analysis. No mention of potential future growth of the company, the firm's competitive position or the value it provides to consumers. If people were making investment decisions based on this information it became clear to me why analyst coverage and widespread knowledge of all current events of the firm weren't harming my ability to purchase the firm at a low price- they were all focused on the next 3-6 months while I was thinking about the next 10+ years.

Here on the other hand, is a great and concise analysis of Geico by Warren Buffett in 1951. The link will take you to another website and it may take you a few minutes to read, but I assure you it will be worth the time and you will quickly understand why I used it as an example.

1. He discusses that the firm has a major cost advantage due to the fact that it has no branch offices or agents, and as a result can charge much lower prices than its competitors. Since insurance is a near commodity and difficult to differentiate, those who can sell it at the lowest price will do extremely well. As a result of its low-cost structure, its underwriting results are far more profitable in comparison to premiums generated than other insurance firms.

2. He doesn't discuss whether any other firm could replicate Geico's low cost model, but it is clear that it would be difficult as all its competitors had higher cost structures and Geico has the advantage of loss-experience and brand over any new firms.

3. He discusses Geico's past results and why it will do well in the future. Note that it is not simply, "Geico has grown at such and such rate, so I assume it will continue to grow at this rate". It is a reasonable analysis of how many consumers would benefit from switching to Geico and notes that Geico was only doing business in 15 states until the current year. If the firm operates in a commodity industry, is by far the lowest-cost player, is only doing business in 15 of 50 states, and is rapidly growing, it is likely that it will continue to grow at high rates. 

4. The company was selling at only 8x current earnings. Price to Earnings (P/E) ratios are only a crude valuation tool but for those new to P/E ratios, a P/E of 10 would indicate approximately flat earnings forever. If a company is selling at 8x earnings, the market is pricing the firm as if it would have flat or reduced earnings indefinitely. That clearly was not an accurate assessment of Geico in 1951. Geico's earnings and future prospects were being discounted because it had experienced a drop in earnings compared to the prior year- this is very common in commodity-like industries and good insurers will usually decrease the number of policies they write in times where prices are abnormally low. A long-term investor would have understood that while earnings decreased, it was not an issue inherent to Geico but rather an industry-wide condition and there will be a time when premium prices rise once more.

Of course, we know what happens. Looking back 66 years later we can be truly amused at how inaccurate the market was. In 2016, 65 years after the market priced Geico as a permanently declining firm, Geico's premium volumes rose 12.5%. This was not the only time Geico was priced incorrectly either- at any period of premium price softening Buffett was able to load up on shares at cheap prices. Given that there are many such cycles on a regular basis in the insurance industry, you can be sure many investors suffered by selling their shares to Buffett at ridiculous prices. The difference between the parties on each side of the trade? Understanding competitive advantage and thinking about long-term business value.

Cigar Butts and the Advantage of Investing Small Sums

In any lecture or interview about investing, Warren Buffett often says that you should buy great businesses at fair prices. The idea being that as long as you purchase a great business at a reasonable price, the firm will generate higher earnings in the future than it does now, increasing potential future dividends while using retained earnings to increase the asset base and further improve earnings. If you buy into a business with a durable competitive advantage, or a wide moat as Buffett likes to say, then you can be sure of the quality of your investment for years to come without having to worry about stock prices. Such is the life of a successful entrepreneur or owner of a great business. This can be compared to private ownership of a business- one would never care how others valued their company, they only care about the cash flows of the firm and potential for future dividends. If you own a great company, it frankly wouldn't matter if the stock was removed from the stock exchange for a few years- or ever for that matter.

This leads many novice and aspiring investors to go out seeking the best companies at reasonable prices and attempt to generate the 20% returns that Berkshire Hathaway has attained since it was formed. While these are the ideal qualities of proper investment and some can be successful following them, in my opinion the vast majority of investors will not. There are many reasons, but a few important ones are listed here:

1.       The best firms are covered by all the best Wall Street investment firms and institutional investment companies.

2.      This coverage of the top 500 or so firms makes it harder to buy in at reasonable prices. From what I have noticed, surprisingly the fluctuations of these top firms can be frequent and dramatic, so I have come to believe that analyst coverage may not be the most important factor (due to Wall Street's obsession with short-term performance and inability to see themselves as owners for the long-run), but regardless a stock is more likely to be properly priced the more coverage it has.

3.      When valuing good companies, the investor must not only examine current performance, but also forecast the future of the business and the growth rate of future earnings and cash flows.

4.      Many of the top businesses are in highly volatile industries subject to rapid technological change and disruption, making it very difficult to predict future growth rates and earnings. Since competitive advantage can be fleeting in highly technological firms, sometimes one's estimate of the leading companies in the future may be completely false due to these changes in the nature of business in the industry.

5.      Even if you purchase a great business at fair prices, many of the top businesses experience lower growth than smaller firms, leading to lower returns for investors than what otherwise could be made.

6. It can be difficult to understand competitive advantage, and even more difficult to predict how long that competitive advantage will grant the firm in question excess returns on capital. Competitive advantage is a form of market failure in my opinion- ideally all industries would be perfectly competitive for the benefit of the consumer. Competitive advantage is therefore the postponement of perfectly competitive conditions for as long as the firm can manage in order to achieve abnormal profits. As Joseph Schumpeter once explained, creative destruction is the norm in capitalism and the companies that can postpone competition for significant periods of time are few and far between.

These factors lead academics and others to conclude that the market is highly efficient and that it is near impossible or essentially luck to be a successful investor. The best way to summarize this effect in the top firms is how Aswath Damodaran, a professor of finance and valuation obsessive at NYU did:

"The market is certainly not efficient, if you define efficiency as an all-knowing, rational market, but it certainly seems efficient, if you define efficiency as investors being unable to take advantage of market mistakes."

Now of course, I would disagree as there have been many, many investors who have beat the market over long periods of time- but for the largest asset managers who mainly invest in the components of the S&P 500 it is generally true.

Further, by investing in the largest and most successful businesses, the small investor is wasting their sole advantage- their size. There are over 9,000 stocks on public U.S. exchanges alone, and the vast majority of them are lacking in coverage due to their size. Many of them are too small for Wall Street firms and other investment companies to invest in, as they have hundreds of millions or billions in Assets Under Management (AUM). Good news is that you don't. The small and nimble investor can gain enormously by finding the ignored and depressed stocks.

Despite what is frequently said in news articles and what Warren Buffett himself says about proper investing, his best returns were made by investing in small, poorly managed, undervalued, and ignored companies. From 1957-1969, Buffett ran his own investment partnership and invested a significant percentage of his assets in mediocre but cheap companies (cheap relative to assets, earnings or cash flows). Below are his returns from using this strategy.


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Over the 12 year period, he averaged 30% a year (before removing his take of the management fees) while the Dow generated a measly 7.4% annually. Even better, Buffett has discussed his investment results through the 1950's in the Berkshire Hathaway 2014 Annual Report:


"My cigar-butt strategy worked very well while I was managing small sums. Indeed, the many dozens of free puffs I obtained in the 1950s made that decade by far the best of my life for both relative and absolute investment performance."

"The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts. It would perhaps even be easier to make that much money in today's environment because information is easier to access."

“If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”

For those who have not heard the term 'cigar butt' used in the context of investing before, it is essentially when you purchase a mediocre company at a very cheap price relative to fair value. As explained in my last post, you can ride the stock up to fair value, and thereafter you will receive returns equal to that of the growth of the company's earnings, and so you must sell. This jump to fair value is the last puff of the cigar butt.

In a lecture-type event to university students, someone asked him how he would invest if he were a small investor again and answered:

"Yeah, if I were working with small sums, I certainly would be much more inclined to look among what you might call classic Graham stocks, very low PEs and maybe below working capital and all that. Although -- and incidentally I would do far better percentage wise if I were working with small sums -- there are just way more opportunities. If you're working with a small sum you have thousands and thousands of potential opportunities and when we work with large sums, we just -- we have relatively few possibilities in the investment world which can make a real difference in our net worth. So, you have a huge advantage over me if you're working with very little money."

Maybe it's just me, but his advice to the mainstream and what he would actually do if he were in our position seem quite contradictory. Of course, he can't tell the masses to go looking for undervalued businesses as they would surely hurt themselves doing so- which is why he advises to invest in low cost S&P 500 index funds or go for the best companies. At Berkshire Hathaway's size it is impossible for him to invest in these types of companies, leaving them all for us.

Investing in larger and better companies from 1965 to 2014 led to returns of 19.4% annually for Berkshire Hathaway which is market dominating performance, yet still it pales in comparison to the returns he achieved when he was young and going for deep-value stocks.

The Difference Between a Good Business and a Good Investment

In my last post, I discussed the basics of what gives companies competitive advantage and what makes good businesses. In this post, I want to move from the analysis of a business towards the analysis of an investment. The difference between the two? The price one pays to become an owner of the business.

To explain the difference, it must be said that a business is an organization which provides a product or service. Common stock, which grants one ownership of a company, is a financial instrument wholly separate and different from the company. Stocks are traded on a stock exchange between parties of investors, and can be traded at any price. The price paid for a stock depends on the intersection of supply and demand. So if demand for a stock is high, it will trade at a high price and vice versa. Technically speaking, there is no anchor that ensures that stock must trade at a reasonable price. It certainly is the case that stocks can trade at unreasonable prices for long periods of time, but the magic of investing is that in the long run stock prices and intrinsic business values usually align.

A stock is in theory supposed to trade at the present value of all future cash flows of the company- so a reasonable investor would attempt to predict the amount of cash the company will generate in the future, and then 'discount' that cash at a reasonable rate due to the fact that cash owned in the future is worth less than cash owned now. The sum of these cash flows would represent an estimate as to the intrinsic value of the company, or a share of the company.

The problem is that stocks of course, do not always trade at reasonable valuations in the short-run. There are a few main reasons for this.

Firstly, humans are incredibly emotional. The stock market is a market with highly volatile asset prices, and it makes one believe that they are losing or making money in very short periods of time depending on changes in stock prices. If you don't understand that these stock price fluctuations are simply changes in demand for stocks, you may mistake them for actual changes in the values of those stocks, and you can do unreasonable things. People work hard for their money, and understandably would be worried if they believed they just lost a significant amount of their net worth in the period of only a few days. Conversely, if people believe they can make significant sums of money in short periods of time then they usually become greedy and can also act irrationally. The wise investor exploits such market emotion to purchase companies at low prices.

Secondly, the future is always hazy and uncertain. For some industries and companies in particular, it is extremely difficult or impossible to predict what will happen 5, 10 or 20 years out. This can lead to massive differences between investor expectations and reality. This effect can be particularly dramatic in high-growth companies which provide exceptional and innovative products. Investors have the tendency to forecast current performance indefinitely and postpone reasonable skepticism. 

Thirdly, I don't know if the average investor understands the relationship between the price paid for a stock and its future returns. It usually is the case that if a company is exceptional, the average investor would be willing to pay nearly any price to become an owner. Of course, being separate entities, stocks and the companies they represent can have vastly differing performance in the short-run.

By the end of 2000, the stock price of Amazon dropped more than 80%- from around $90 to $15. At the time, Amazon was an unprofitable but rapidly growing company. Sales that year increased almost 70%, and gross profit increased over 100%. Despite a larger operating loss, it was clear that the company if anything, was worth more in 2000 than it was in 1999. The problem was not the business, it was the price the stock was trading at in 1999. The stock was significantly overpriced relative to the intrinsic value of the business, and despite having a bright future, Amazon investors suffered a major loss. The stock price of Amazon didn't reach $90 again until 2007. I think nowadays, investors in good companies such as Amazon and Facebook are faced with the same issue- they own a great business, but the price at which the business is selling is extremely high relative to the performance and intrinsic value of the business. If these grand expectations implied by the stock price aren't met, investors will be hurt.

On the other hand, stock prices can be too low in comparison to the value and performance of the business. When this happens, a shrewd investor can do well by purchasing shares and waiting for public demand of ownership of the company to increase.

All companies increase their value at the rate at which they increase earnings. The increase in earnings is determined by two things- the company's return on invested capital (ROIC), and the reinvestment rate (RR). Like all concepts in finance and business, it sounds complicated but it's quite simple.

Earnings Growth Rate = ROIC x RR

A company's return on invested capital is a measure of the earnings it generates for each dollar reinvested in the company. If for every dollar invested back into the company (to buy inventory, factories, etc) the company makes $0.20, then the ROIC is 20%. ROIC is a great measure to help determine the profitability of the firm's operations and how quickly it can increase earnings over time. The reinvestment rate is simply how much of the company's earnings are reinvested in the firm- if all is reinvested, then the RR is 100%, if none of it is, then 0%.

Technically speaking, ROIC measures profits generated by all of the company's assets, while the return on incremental invested capital (ROIIC) measures the profitability of all future investments. So as an example, it is possible that in the past, a company has benefited from a high ROIC of 30%, but as it grew large and its new investments generated lower profits, the ROIIC declined to 15%, and so the total ROIC would also decline. The total ROIC would be = annual profits / total invested capital, while the ROIIC would be = profits generated by new investments / $ amount of new investments. 

To illustrate these phenomena, below are presented the intrinsic values and stock prices for two different companies. Both companies are reinvesting all profits back into the business at all times. The first business - 'Good Business' has a ROIC of 20%, and so is growing earnings as well as its value at 20% a year. The second business - 'Poor Business' has a ROIC of 3%, and as a result is only growing earnings and value at 3% a year. The orange lines represent the intrinsic value  of each business, and the blue lines are the stock prices.

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As we can see, the performance of the good business is much better than that of the poor business- it compounded its earnings and intrinsic value from $50 to around $125 per share over 5 years. The value per share of the poor business only increased from $20 to $23 over those 5 years. Clearly you would have done better by purchasing the good business at $50 in year 1, which would have been at fair value rather than the poor business at $20. If you purchase a business at fair value, your annual return will be the rate at which the firm grows earnings. This is why Buffett tells us to purchase great businesses at fair prices. 

The thing is, depending on when you purchased shares, investors in the good business could have had poor returns, and those in the poor business could have had great returns- it all depends on price paid versus intrinsic value.

For example, if you purchased the good business in year 2 at $125, over the next four years you would have had a 0% total return. If you purchased the poor business in year 4 at $10, your return would have been 100% over two years.

The lesson here is that you can achieve fantastic returns in either great or poor companies, depending on the price paid to own the company. If you overpay for a great business, you may have to wait a long time for the value of the business to catch up to the price you paid. If you are so unfortunate to overpay for a poor business, you will certainly do poorly as the value of the company may never catch up to the price you paid. So either pay fair or low prices for a great company, and pay very low prices for poor companies if you would like to do well.

In Buffett's early years he did extremely well purchasing mediocre companies at low prices. Since mediocre companies don't compound earnings over time, generating high returns depends on buying them for far lower than fair value and selling once they reach fair value. If you purchase a great business at a fair price however, you can do well by holding forever as it compounds value and earnings over time.

Why Some Companies Do Well, and Why Others Don't

Why do some companies do well, while others struggle? It's a simple question with a large number of potential answers, all depending on the situation. To broadly answer this question, I'd like to briefly discuss the nature of competitive advantage and why it matters so much. Competitive advantage is by far the most important topic in business and is what allows companies to become profitable and thrive over time. When investing in companies for the long-term, it is crucial that one understands what it is that separates their firms from others in the industry and why their firm will continue to produce exceptional results down the road.

Firstly, it should be said that business is about providing consumers with a product/service they do not already have. Many think business is about competition, or being 'better' than rival firms- that's a simple-minded and dangerous approach. As it turns out, the most competitive industries and companies are those which experience the lowest profitability because they have to fight tooth-and-nail for customers and revenues. Exceptional business results rely much more on being different than being better- it is in your benefit to avoid competition. The companies that do well in the long-run are those which provide their customers something different/unique that they care about having, and ensuring that competitors cannot imitate what they produce. Think quickly about some of the best companies in the world- Google, Coca-Cola, Microsoft, Apple- they have hardly any competition and are near monopolies (one firm in the market) or in the case of Coke operate in a duopoly (two firms in the market). If you want to search for information online, you basically have to use Google, you don't have much of a choice. On the other hand, the worst companies are those offering products that all their competitors offer- restaurants, commodity companies such as steel manufacturers and farmers, retailers- all extremely competitive and fighting for survival. Customers can walk into any restaurant they please, or purchase corn from any farmer in the world- it's mostly the same product and brand names aren't very important in those industries. It should be clear that a company offers consumers nothing of value by providing the exact same products that are already available to them.

Being better isn't always relevant in business- it's usually about providing something different. As a quick example of this, consider Southwest Airlines. Is it better than Delta or Emirate Airlines? Both Delta and Emirates offer much more comfortable seats than Southwest and on-board service/amenities which Southwest doesn't offer. Southwest is a pretty no-frills airline with no assigned seating, no special on-board amenities, and relatively short flights to secondary airports- but at a much lower cost. What is better in this case depends on what you care about- if it's flight comfortability you would choose Delta or Emirates, if price then you'd choose Southwest. There's no right answer here, and companies have the ability to offer consumers a different offering based on a wide variety of features and options. A differentiated offering is the basis of competitive advantage. 

Another idea many novice investors and business-people have is that by investing in the most innovative companies, or the new companies with products that will change the world, they will do well. This may or may not be the case, and paradoxically it usually doesn't matter what impact the product has on society. Once again, it all depends on whether other companies can offer the same thing. The industries that Warren Buffett uses as examples to explain this concept are automobiles and aviation in the early 1900's. Both cars and airplanes had profound effects on the world, but most investors did poorly as competition and bankruptcies ravaged many of the early competitors in both industries. Feel free to look through the list of defunct automobile manufacturers that went out of business in the early 1900's- there are thousands of them. They all helped change the transportation landscape and form the industry, but most of them exited the industry, to put it politely. Even nowadays, both automobiles and airlines are extremely competitive and difficult industries to compete in. Predicting which ones would prevail would have been a matter of extreme luck, and frankly the few that survived required near flawless execution and timing to survive. I doubt they themselves knew they would be the ones to survive. The same could be said for more recent examples such as social networks, video streaming websites, online retailers, or companies within the solar industry.

As Jeff Bezos has said, innovators must accept the fact that they will almost certainly fail. This makes it extremely difficult for the prudent investor to earn decent returns in new industries in which the major players have not yet been determined. Even after the initial shake-out of a new industry, profitability of the "winners" won't depend on how much the product changes the world, but rather on how competitive the industry is and how easily new firms can enter and compete. Some revolutionary industries will have a small number of tremendously profitable "winners", such as has been the case with search engines, social networks, software developers, and soft-drink manufacturers. Some revolutionary industries, such as automobiles, aviation, and most solar companies will be plagued by competitive conditions and low profitability among many players.

On the other hand, think of some boring and stagnant industries such as hand soap, shampoo, bubble gum, soft-drinks, and beer. The firms in those industries have been around for a very long time and they have for the most part been quite profitable. It is because innovation and the pace of change is very low in these industries and the barriers to entry are very high. It is unlikely that a new competitor could make a bubble gum comparable to Wrigley's at a reasonable price, or a bottle of shampoo comparable to Old Spice at a reasonable price. Thus, companies in these boring industries sell the same products year in and year out at very high profit margins for decades without much competition. Of course, all types of volatile and highly technological industries can be highly profitable, but the point is that innovation and profitability are not necessarily correlated.

For small local companies it is possible to simply out-compete one's rivals. If you are a small retailer, maybe you have access to cheaper products by having a good relationship with a wholesaler, are in a better location, have better selection, have a cleaner store, and have better customer service. All of these things could result in you 'beating' your competitors and doing quite well. Outcompeting your rivals however, relies on your rivals being inefficient- something that is much more common in small owner-operated companies than large corporations. If however, a better owner decided to open up a shop near yours and was just as good at customer service, marketing, and providing a good store environment with a wide selection of products, it is possible that they could infringe upon your business and steal your customers. Excluding customer habit, there wouldn't be much to stop them.

Having a competitive advantage however, essentially means that no matter how capable your competitors or potential entrants, your product would be difficult or impossible to replicate. Having a differentiated offering doesn't necessarily give you a competitive advantage or ensure that competitors cannot copy what you make. For example, if I were the first company to ever make balloons with smiley faces on them, and I did well because the balloons were unique and my customers loved them, it probably wouldn't be too difficult for another manufacturer to copy that design and slap a smiley face on theirs as well. There must be barriers to entry and imitation so that your product would be near impossible to replicate at a similar price.

There are a variety of potential reasons this may be the case, and I would like to summarize a few of them below. This list is in no way all encompassing, and the main idea here is that anything which makes it so that your product is uniquely valuable to consumers and ensures competitors can't copy you will bring high profits and great returns to owners.

1. Your product/service must be unique and provide something different than that of your competitors 

This is a prerequisite for competitive advantage and good performance. A company is merely a group of people using a group of assets to provide a product or service to the public. I personally like to think of firms with a competitive advantage as tailoring these people and assets to maximize a certain outcome. I think of well-run companies as systems that are designed to produce a certain product in a certain way.

I'll use Southwest Airlines as an example of a well-designed system. Southwest understands that most airline travelers care most about price. Most consumers would much rather have a cheap flight than a comfortable flight- so they get rid of everything that customers don't require and that increase costs. They exclude reserved seats, they don't serve meals, they don't fly internationally, they use the same type of planes throughout its network so that pilots have to be trained to fly only one model of plane and so that their mechanics have to know how to repair only one model of plane, and they use the same repair parts for each plane as a result, and finally they have a highly productive workforce which is focused on minimizing turn-around times to ensure their planes are in the air. Southwest understands that to minimize cost, they must make sacrifices in quality and other features. Most of their competitors can't and won't do this, as they serve business travelers and others who desire to fly in class and style.

To sell tickets at the same price as Southwest, competitors would have to do all of the same things- they couldn't just copy a few parts of the system, they'd have to replicate it in its entirety. This requires massive trade-offs in quality versus price. Similarly, a high quality airline such as Emirates and others would rather focus on offering comfy and spacious seats and beds, meals, tvs, games, wi-fi, and other on its planes to cater to those willing to pay more for an excellent flight experience.

The idea, as originally developed by the strategy theorist Michael Porter, is that many trade-offs must be made in order to develop a system that maximizes a particular feature of a product. In Southwest's system, it caters all of its elements and decisions to minimizing price. Even if a competitor tried to imitate the system, it is not certain that they would be able to copy every particular trade-off- so the more trade-offs that must be made, the better.

A simple math equation explains this idea. If there is a 90% chance that a competitor will be able to replicate any trade-off you have made, then if only 3 trade-offs have been made in your system, the chance of imitation is = 90% x 90% x 90% = 0.9x0.9x0.9 = 0.9^3 = 0.729 or 72.9%. 

Now let's say the system requires 10 trade-offs to be made, in which case the chance of imitating the entire system becomes 0.9^10 = 35%. The more trade-offs that must be made, the harder it is to copy the system. In reality, it is likely that the chance of imitating any particular trade-off is lower than 90% for most systems, ensuring that the chance of imitation of a well-designed system will be remote.

To summarize, if different customer segments within an industry have differing needs, companies can develop differing systems to optimize their product offering to that group of customers, at the expense of other customer groups. It requires making trade-offs, understanding the sacrifices, and knowing that developing the 'optimal' product to your desired customers requires giving up other customers with different needs. Tough choices will be made, but the benefits if executed well can be massive.

2. Supply-Side Economies of Scale

Supply side economies of scale (usually just called economies of scale) are both immensely powerful and magical. It is a very simple mechanism which allows large companies to offer products at a much lower cost than smaller companies. It is even possible (and in fact likely) that the large company will have both a better product at a lower price- clearly a high barrier to get over for any new entrant. It involves spreading a large fixed cost over the number of units sold, and if all firms require the same fixed costs then the firm which sells the most units will have the lowest fixed costs per unit sold. This is explained in plain terms below. 

A simple example will explain the basics of economies of scale:

Consider two shoe companies. The first is Sadidas Inc., a company which has been selling and designing athletic footwear for decades. The second is Lab brands, a new entrant which would like to offer shoes to the same type of customer. Let's say that to make shoes, you have to open a shoe factory and that a shoe factory costs $1 million to open. So both companies have to pay $1 million to open their shoe factories- it's the cost of entry in the shoe business. Sadidas, being a large and established company, sells 1 million pairs of shoes a year. Lab brands, being an upstart company, only sells 100 pairs of shoes a year. 

We are going to exclude all other costs of business besides the factories for now. So for each shoe sold, the factory costs Sadidas only $1.00 ($1 million factory cost / 1 million shoes sold). This means that Sadidas can sell its shoes at any price over $1.00 and be profitable. Lab brands on the other hand, has a factory cost per pair of shoes of $10,000 ($1 million / 100 shoes sold) - so because Lab only sells 100 pairs of shoes a year but has the same factory costs as Sadidas, they have a much, much higher total cost per unit sold. For Lab brands to make any profit from its shoes, it would have to sell each pair at a minimum of $10,000, which is exactly 10,000 times the price of a pair of Sadidas.

Now couple this higher price of Lab's shoes with the fact that Sadidas has been designing and perfecting its footwear for decades for elite athletes, while Lab is inexperienced and just starting to figure out how to design comfortable and safe shoes that perform well. The result is that Lab's shoes are likely not as flashy or attractive, not as safe, will not perform as well, and are priced 10,000 times higher than Sadidas' shoes.

All of the above combine for a near impossible barrier for Lab brands to overcome. For Lab to survive, their customers will have to be willing to pay a much higher price for each pair, meaning Lab's shoes will have to be attractive in some way that Sadidas' aren't. Maybe they can achieve profitability by marketing to a different (likely smaller) customer base with unique shoe needs, and design their shoes in a much different way than Sadidas to best meet those unique needs. In any case, they are at an extreme disadvantage and would have to think deeply about how they would ever be able to compete with the existing shoe companies. If they provide a similar product to what Sadidas offers, they will not survive.

Economies of scale apply to any fixed costs required in business, and even any costs that may be semi-fixed, such as advertising. Advertising is usually seen as a variable cost, but can act to provide economies of scale. Consider television advertising- it is expensive on a national scale and the same concept applies. If a national television ad costs $1 million, and if firm A sells 1 million units from running that ad, and firm B only sells 100, then the advertising costs per unit sold are far higher for firm B. This is the reason large consumer product industries had incredible barriers to entry in the mid to late 1900's- they had massive economies of scale from both factory and advertising costs. There were only a few national television channels, and so an ad ran on television would reach a huge percentage of the American population. If you were a large consumer products company, you could reach most Americans on a daily basis with TV ads, and have a tiny ad cost per unit sold- helping to keep the industry highly concentrated with only a few major, large players. This is still true today, but not to the same effect, as there are many methods of advertising and as TV is far more decentralized.

Now the advantage of economies of scale of course depends on the assumption that new firms will have the same fixed costs as the existing firms. If instead, a revolutionary manufacturing process was developed that reduced the cost of a factory to only $1,000, then the entrants would be in a much better place.

The higher the cost of investment required to enter the industry, the more powerful the economies of scale are and the more difficult it will be to compete with larger firms. In summary, economies of scale are powerful barriers to entry for existing firms in industries where high fixed costs are required to compete. If no fixed costs are required, economies of scale will not exist. 

3. Economies of Scope

Economies of scope are very similar to economies of scale, but instead of operating in a single product-line, it implies the sharing of a fixed-asset for a variety of products. This allows for both high quality and low costs across these products which share the fixed asset. An example will clear this cloudy sentence up for us:

Although Honda is known for making cars, its advantage comes primarily from its superior engines. Honda puts these powerful engines in not only cars, but also aircraft, motorcycles, and power equipment such as lawnmowers and generators. So this does two things for Honda. Firstly, if Honda makes awesome engines (which it apparently does), it can put these great engines in a variety of products which require engines, allowing it to produce a wide range of products at high quality. Secondly, if these engines are the same, or very similar, they could be made from a small number of factories which would give Honda the same lower fixed cost per unit effect as described in the economies of scale section with shoes above. This gives Honda both lower prices and higher quality products because all of its products use a similar engine.

Starbucks does something similar with its coffee products. It basically uses the same high-quality beans in all of its drinks (drip coffee, cappuccino, macchiato, frappuccino, iced coffees, and more). By using the same beans in all its products, Starbucks can make a wide variety of coffee-type drinks at high quality.

4. Brands

Brands matter. For the most part, I don't believe that they in and of themselves provide a competitive advantage to a firm, but if a differentiated and/or high quality product/service is combined with a strong brand and unique marketing, it could produce a powerful effect. This seems to work best in industries where consumers develop strong habits- Coca-Cola being the best example. Despite the public conception, there are many more reasons for Coke's great performance over the decades than simply its branding, but no doubt the addictive nature of its product combined with a powerful brand helped it dominate the soft-drink industry. Consumers will almost always purchase the products they are comfortable with, and won't try a new product and accept that 'risk' unless they truly feel they need to. Many of these products have economies of scale, so firstly a new product wouldn't be capable of matching the existing brand's price, but even if it could offer a similar product at a lower price, consumers probably wouldn't be willing to switch. The new product would have to be demonstrably different and/or better in some way. Nearly all blind-taste tests show that Pepsi is far more popular in terms of taste than Coca-Cola because it is much sweeter, but nobody seems to care. Most people feel better when drinking Coke- the brand has a measurable effect on their willingness to pay for Coke and they come to believe that Coke is better while their unbiased tongues would say otherwise.

5. Patents

Developing a complex product, or one which requires significant research and development costs usually allows one to file for a patent. As we all know, patents are given to those products which display some form of technological, biological, or other advance and grant the owner a monopoly over a certain period of time in exchange for information on how the product is created. Having a government-enforced monopoly on your product is clearly a great way to achieve competitive advantage, but you must be sure that the product cannot be manufactured in a similar but slightly different manner or that anyone will be able to infringe upon your patent until it expires. If you are a start-up, expect large companies to attempt to infringe upon your patent and take you to court as you may not be able to afford the legal fees to impose your legally granted monopoly. Whenever the patent expires, massive imitation will ensue if the product is at all in demand. 

6. Demand-Side Economies of Scale (Network Effects)

Demand-side economies of scale, or more often known as network effects, are extremely powerful- so much so that they usually create industries in which the winner takes all. The basic explanation of network effects is that as the number of customers or users of a product increases, the value of that product to each user also increases. Unlike in industrial firms, the companies that benefit from network effects usually provide a free service and so differentiation based on features of quality versus price isn't as relevant- the firm that provides the "best" option usually will take an enormous chunk of market share (70%+). The winner in this case would be the firm that is able to best fulfill the average user's needs. Generally this requires user needs to be relatively homogeneous.

A few well-known examples follow:

The example closest to our hearts- Facebook. Of course, the value of a social network to its users depends on the total number of users. If a social network has only 50 members, it probably isn't very valuable. If it has over 1 billion members, it will become extremely valuable to most users and users wouldn't have much of a reason to leave for another social networking site- unless of course the alternative is by far superior in some major way.

Myspace at one point benefited from network effects, just as Facebook now does. The problem? Myspace was primarily focused, as the company name suggests, on the users' personal profile. Facebook understood that to do well in social networking, it had to create a far more immersive and inter-connective experience. I could be wrong in my analysis below, but in my opinion there are a few main factors which allowed Facebook to thrive and dominate in this industry. 

Firstly, Facebook required all users to upload photos of themselves and to use their real names. This made it so that users were not simply anonymous users, but real people. Secondly, the Facebook timeline where you can see your friends activity massively increased user connectivity. Facebook members almost certainly interacted at a much higher level than Myspace users because of it. Of course, if users on your network are more active with each other, then the network effects are more powerful. If you create a social network where massive interactivity isn't crucial, then the number of total users doesn't matter as much to the average user. Thirdly, Facebook allowed users a wide range of benefits which would increase activity with one another, including the upload all types of content, the creation of pages and groups, games, and the ability to search for one another much easier than one could on Myspace. Since Facebook provides much of what the average internet user requires of a social network, and since most internet users have a Facebook profile, there is with few exception no need to move to another social network.

Next example- Google. When looking for a search engine, all of us consumers and seekers of information really care about is the relevancy of that information to our needs and the speed at which we can find it. By optimizing its search algorithm, Google has managed to create what is by far the best search engine in terms of providing relevant information to users.

Google is a multi-sided platform. This means that it has two groups of users- consumers looking for information, and companies willing to advertise to those consumers of information. It is a similar system to that of newspapers in the mid 1900's which dominated their local cities- except Google operates on a global scale. It is basically the gatekeeper of all information searched for on the internet, and as a result it has become one of the best companies in history. Consumers need no second search engine, and so Google is the only search engine on which most advertisers are willing to buy ads. The more users that use Google, the more advertisers are willing to pay Google for ads. These network effects are tremendous. Google controls over 80% of the search industry, and that is with Bing currently paying users to search through its engine. If you are paying people to use your product, and they still choose your competitor's offering instead, it should be clear that you are in a bad position.

The last example I'd like to mention to illustrate network effects is a physical network. A physical network doesn't always increase in value to its users as the number of users increases, but it might. The advantage of a large physical network is a mixture of supply-side economies of scale and network effects. Let me explain:

Consider the two largest private logistics firms in the U.S. - UPS and Fedex. They have facilities worldwide which sort and distribute packages. Now, imagine you are a new delivery company and you'd like to send packages to and from customers across the U.S. just like Fedex and UPS. How would you go about doing this? You couldn't just build a facility in one location, because you'd have nowhere to send packages to. You couldn't really just place buildings in a handful of locations either, because then you'd only be able to send packages between a few select locations and your customers need to send packages to all sorts of locations around the country. The answer is that you'd basically have to replicate the entire network at once, which is obviously a daunting and immensely expensive task. Now let's just say you somehow came up with the funds to construct buildings so you could send packages all over the world, just like UPS and Fedex. The problem here is that you still have no customers, and so your cost per package sent will be much, much higher than that of UPS or Fedex, causing your prices to be much higher as well. Why would anyone want to use your delivery services at a higher price? It's an incredible catch 22 in which you need the physical network to get customers, but to build the network you need a lot of customers. All in all, this semi-network effect combined with economies of scale create a near impossible barrier to entry.

Amazon seems to be attempting to bypass this catch 22 by slowly building its delivery facilities to service its large base of customers. I will discuss this in a future blog post, but just know that the capital expenditures required to replicate such a physical network would be overwhelming for even the largest of firms.

7. Complicated Processes- the Learning Curve

If a complicated process is required to provide a product/service to customers, it may be hard to imitate by competitors. As a quick example, I'll use UPS and Fedex again. In order to send packages all around the world, a new competitors in the delivery business would have to figure out how to take those packages, sort them, and send them to their end destinations in a timely manner. Some packages require different pickup times, some require different delivery times, some are urgent, some are fragile and need extra care, and some are very heavy, but they're all going to different locations around the world. Providing all of the above services require meticulous and complicated procedures and planning on a constant basis. You also have to ensure that this is done in an efficient and cost-effective manner. It requires years of experience, learning and planning to perform at a reasonable level.

With any task, we get better as we repeat it and do it over and over again. We pick up on how to save time without affecting the outcome, how to improve the outcome, and more. The same goes for large companies- it's called the learning curve. 

8. Vertical Integration

This is one that business novices feel will always help a firm dominate an industry. It is thought that if you buy your suppliers, and your customers if they are companies, you can run the entire supply chain from beginning to end-customer. While vastly overvalued in most cases, vertical integration can sometimes be very powerful. Usually the benefits don't come from cutting out middle-men and saving costs, because in most cases these middle-men provide something of value that must be done to the product. If you cut them out, you'll have to perform that same activity, so you won't save much and it may even cost you more. Vertical integration usually benefits firms by providing them with a much higher quality source of supply than they otherwise could have. It may also allow them to keep their entire production process secret. 

Starbucks is a good example of a company that is vertically integrated. It buys beans from farmers in certain areas of South America which produce the best quality beans. It then has its own proprietary process for roasting its beans which allow for a much bolder and unique flavor than its competitors. It then uses these beans for all of its coffee drinks worldwide. These drinks are of course sold in the company-owned stores which provide for great atmosphere and customer service. Starbucks integrated backwards into bean roasting, because their process allowed for much bolder and better tasting beans. They also decided to control the retailing of coffee, so they could use the beans in all their drinks and control the setting in which their coffee was sold. Integrating back even further into farming likely wouldn't help them and would only add complexity. The lesson from successfully vertical integrated firms? Only integrate forwards or backwards if you can provide something unique and different to the activity that will benefit your product offering. 

9. Regulation

The last major topic I can think of that provides for competitive advantage is regulation. A few quick examples to explain this are below:

After the initial airline shake-down in the very early 1900's when it was a new industry, the government implemented regulations on entry into the industry. This allowed the established players some comfort in pricing because entry and competition was limited. In 1978, the industry was de-regulated, and firms began entering the industry en-masse which ruined industry profitability for the next few decades. 

Another more recent example is that of marijuana retailers in U.S. states where it is currently legalized for recreational use. Since marijuana is a basic commodity, nearly anyone can grow and sell it, so growers are largely unprofitable and sell their produce to wholesalers and retailers for whatever they can (which as expected, is increasingly at a lower price as more people grow the plant).

Retail stores which are licensed to sell marijuana to consumers are for now quite profitable, and for one big reason- in these states the number of retail licenses is limited. In Washington state for example, only a certain number of licensed retailers can exist at any time (and the number is quite small), so after that number, entry is impossible. This means that the established retailers have what may be the best barrier to entry imaginable- the government disallows all new firms from entering the industry and competing. Of course, this makes retail prices of marijuana higher than they would be in a free-market scenario and as a result these retailers are highly profitable. If and when the industry is de-regulated to the point where anyone could open a marijuana retail shop, the industry would change dramatically. As with most other local retail stores, there would be almost no barriers to entry. The entrants would compete profits away, and marijuana shops would be about as profitable as coffee shops (maybe slightly more because it requires higher product selection and more product knowledge, but either way- not a great business when fully deregulated). 

If your firm is doing well, it is likely that it benefits from one or a few of the above effects. The above summary is not all-inclusive and I may certainly be forgetting a few things, but hopefully it provides a basic mental framework for those looking to understand how companies do well, both for their customers and themselves.