Hero to toad

Investing is a brutally competitive business. Unlike being a doctor or plumber, where you fix things in reality, investing is all about how you perform relative to your peers. No one gets an appendectomy, or has their pipes unclogged, and then asks how that fix compares to all other fixes done by all other professionals. If the problem gets fixed, the customer is happy.  

Investing is more like sports in this way. Hardly anyone asks about a football, baseball or basketball players’ career stats. Instead, people want to know how athletes stack up to the competition, and more specifically, how many championships have been won.

I was reminded of this recently with the announcement that Bill Miller is retiring from managing Legg Mason’s Value mutual fund. You may not have heard of Miller, but he became famous in the early 2000’s for beating the S&P 500 year after year. Amazingly, he managed to beat the S&P 500 every calendar year for the 15 years ending in 2005. This made him a deity among many individual and professional investors.  

If Miller had retired in 2005, he would still be touted as the hero he seemed to be. He’d be able to write best-selling books, make a fortune with speaking engagements, and perhaps even milk that hero status for the rest of his life.

Instead, Miller stayed on the job and has gone from hero to toad. Not only did he fail to continue out-performing the S&P 500 every year after 2005, he managed to lose a huge amount of his clients’ money (after making a ton for them prior to that). Investors have abandoned him en masse as his fund went from over $20 billion in assets to around $2 billion, now.  

A good question to ask is whether Miller “lost his touch,” or if he ever had a touch to begin with. I don’t think Miller lost his touch, I think the odds simply caught up with him.  

Looking at Miller’s record, you’d see that he didn’t out-perform every period, he just happened to out-perform calendar years over 15 years. Change the date to October 31st instead of December 31st, and you would have seen that he didn’t out-perform every year. Added to that, he really didn’t out-perform the market by that much over those 15 years. His edge was small and has been completely erased.

Look deeper into his process, and you’ll see an almost blind contrary approach–buy what others hate and wait. Because the market always recovered nicely between 1990 and 2005, Miller looked like a genius (even though he wasn’t). In fact, I believe Miller was one of the most over-rated money managers of the last 20 years.

Does that make Miller the toad he is being treated as now? Not at all. Miller out-performed most (probably 80%) professional and individual investors. He’s neither a hero nor a toad, but clearly an above average money manager.

And yet, people’s perception of him is based on his retirement date, not his career stats. One feels for Bill Miller like one feels for sports greats that never win the championship. They are always seen as “could-have-beens” instead of the out-performers they are. Such is life.

Many seem to forget the role that luck plays in life, and particularly in sports and investing. Many that seem great, are both good and lucky; and many that seem mediocre are actually much better than perceived.  

Think for a second, about Steve Jobs. Looking at his career in 1985, 1990 or 1995, he seemed like a loser to most. Even in 2000, when he was clearly (in hindsight) on the come-back trail, most (including me) had written him off as a has-been. Then he went on to change the computer, mobile phone, music and movie-making industries and become what many consider the greatest CEO ever. It’s sad to say it, but perhaps cancer saved Jobs’ reputation from the fate of Bill Miller.

Look, too, at Robert Rodriguez, one of the best mutual fund managers alive. He under-performed the S&P 500 over 15 of 18 5-year periods from 1973-1991. But, if you invested with him in 1968, you’d have three times the money you would have had investing in the S&P 500. It pays to back the right horse, not the one who just looks pretty. Looking at Rodriguez’s process, I could see he was great. Not so much with Miller.

Investors with the right process win in the long run, even if they don’t rack up amazing, headline-grabbing statistics. Look at how they do what they do, not just the results. Look for the Jobs or Rodriguez that hasn’t broken out instead of the famous show-boat who might be short-term lucky instead of long-term good. Look for single-minded focus, an ability to learn from mistakes, and an inherent love of the game and you’ll likely find a winner. If you over-simplify the process and look for the bandwagon everyone else is jumping on, you’re likely to find the odds will catch up with you, too.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Hero to toad

Profit magnitude AND duration

It’s not enough to focus on a company’s profitability–especially if it’s huge; you must also understand the durability of that profitability.

A single payout of $1 million is not worth as much as a lifetime payout of $150,000 a year forever (unless you can get better than 15% returns forever). The same is true with buying businesses (whether in the form of a whole private business, or shares of stock).

This may seem elementary, but some investors lose this focus when they dwell on short term high or low profits. A couple of examples may help concretize this point.  

Exxon Mobile is a hugely profitable company. But, there are non-trivial questions about whether it can replace its current productive capacity over the next 10 years.  

Or, consider Apple. It’s hugely profitable right now, but can that profitability be sustained and grown in the face of many smart and well-resourced competitors (that are spending 2x to 4x as much on research and development)? The answer to that question is vitally important for Apple’s valuation.

Or, what about Sprint (the telecom company)? It’s clearly not making money now, but the price paid for the company should reflect profits 5 and 10 years from now as well as this year. Does Sprint’s valuation reflect its current profitability or its profitability over time?

Think about Research in Motion, the maker of Blackberry mobile phones. It had rapidly growing sales and profits within the last year, but both have started rolling over. Will that trend accelerate, continue, or reverse?  The value of the business hinges on the outcome.

I don’t mean to imply that answers to these questions are easy–they aren’t. In fact, I’ll be the first admit I don’t have the answers to any of those four questions. But, they must be thought about in order to achieve good investment results.  

I should know, I’ve fumbled that ball several times in the past (business analysis is extremely complex, and no one is omniscient). I bought Reebok and Novell in 1996 after years of outstanding profitability. Over the following 10 years, though, both saw profitability and their stock prices tank–a great lesson that durability of profits is more important than recent magnitude.

Think about stalwart companies like McDonalds, or Coca-Cola, or Proctor & Gamble. They have extremely high profitability and almost zero chance of seeing that profitability vaporize like we could see happen with Exxon, Apple, Sprint or Research in Motion. That’s why their stock prices are almost never as low relative to fundamentals. Investors as a whole get this concept, even if they forget it at times (1999 and 2000 for technology, 2005 and 2006 for housing).  

As I said last week: it’s not about market share, it’s about profitability. Now, I’d like to add that it’s not just about profitability, but also durability. Your investing future depends on both.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Profit magnitude AND duration

Profits, not market share

As a shareholder of Dell, I must admit to being frustrated by all the focus both Wall Street and the media apply to market share. Listening to them, you’d think all that matters is market share. They’re wrong.

What matters in business is profits.  Not market share, but profits and their sustainability. Market share is a measure of sales relative to other companies. It’s a top-line focus. Profits are bottom-line. It’s the money a company makes, it’s a measure of value-added, and it’s the money a business has to compete in the future.

In Wall Street and the media’s defense, there are some businesses where market share is all important. In Internet search, for example, Google dominates with high market share and very high profits. There’s a network effect in search that hugely rewards number one. Number two and below not only don’t make much money, they lose big-time (just ask Yahoo! and Microsoft (another holding of mine)).

Let me give you a quick theoretical example of how to gain very high market share but lose in the end.  Buy $30,000 Honda’s sell them for $15,000. I guarantee you’ll have #1 market share. But, you’ll be out of business so quickly it won’t matter. Now, buy those Honda’s and sell them for $29,000. Once again, you’ll have very high market share and you’ll last longer, but you’ll still be out of business in the long run, guaranteed.

Now, back to the computer market.  

A couple of years ago, Acer overtook Dell by grabbing the #2 market share spot. Was that #2 in profits? Not at all. In fact, Acer gained #2 market share selling netbooks. Remember those. Perhaps not, because they’ve been almost completely supplanted by tablets–mostly Apple’s iPads. Acer gained market share selling a cheap, low profit margin product. Dell didn’t follow. Since then, Acer has fallen back below #2 and Dell continues making profits and competing successfully. Dell focused on profitability, not market share, and it worked.

Fast forward to today, and Lenovo just overtook Dell for #2 in market share. Instead of selling netbooks, Lenovo is dominating sales in China and doing very well in emerging markets. Their profit margins?  1.85% at last report on an accounting basis. Dell’s profit margins? 5.8% on an accounting basis (7.6% on a cash basis).

Now, think about that. Profits are what is used to buy inventory, innovate new and better products, build supply chains, hire productive employees, etc. Just for the sake of the argument, let’s assume Lenovo is selling a product that’s just as good as Dell’s (which is unlikely with so much lower profit margins). Lenovo is essentially selling $30,000 Honda’s for $30,555 and Dell is selling them for $31,740.  Lenovo is making $555 on each sale and Dell makes $1,740–more than three times as much!

That’s the money each company has to pump back into the business. Lenovo would have to have over three times the market share to have the same amount of profits to plow back into the business in order to be competitive. Does Lenovo have three times Dell’s market share? Not even close. In other words, Lenovo cannot compete by focusing on market share, it must either focus on profitability or risk losing that market share over the long run.

I’m simplifying the argument a bit to make things clear, but my point is still valid. For a company to survive and thrive over time, it’s about profitability, not market share. An over-focus on market share is the wrong way to think.  It’s a focus on effects, not causes.

In the long run, Dell doesn’t need high market share to succeed. It needs profitability. That, it has.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Profits, not market share


I’ve been writing since December 2009 about how sovereign debt will evolve into the next sub-prime credit crisis, and how it will all start to come apart with Greece.

One of the first really ugly steps down this path began this last week as members of the European Union decided to write down Greece’s sovereign debt by 50% (only 21% for government holders–“All animals are equal, but some animals are more equal than others”).

To commemorate this unraveling, I decided the scariest thing I could turn my Halloween pumpkin into this year was the euro–Europe’s supposed common currency.  At right, that’s my Jack-O-Lantern at the top, with my wife’s cat and my daughter’s Blue from Blue’s Clues below.

My mother-in-law was not, I think, amused by my choice (she’s German), but I was.  Not only was Europe’s plan inadequate, but it also set in motion some market dynamics that may reverberate for some time.

One of the games European officials decided to play was to describe the 50% write-down as a voluntary restructuring instead of a default.  This may seem like a minor technicality, unless of course you own Greek debt and bought insurance on its default (which won’t be honored, now).  It sounds like the Europeans are going to violate the sanctity of contracts, and that has left a lot of folks who bought insurance scrambling, and with big questions.

Can you buy insurance on sovereign debt and really be insured?  It doesn’t look like it.  In fact, the market’s rally last week may very well have been due to investors having to cover investing positions rather than a positive evaluation of Europe’s “solution.”

No, Europe has not solved Greece’s debt problem.  They just kicked the can down the road a little farther (a 90% write-down will more likely be necessary, followed by major structural reforms to Greece’s economy).  

No, this solution will not build confidence that Ireland, Portugal, Italy or Spain’s debt problems can be solved, not to mention Belgium and France (French, German and British banks own a ton of Greek, Irish, Portuguese, Italian and Spanish debt–now you know the real reason why they are searching for solutions).

No, this will not be good for the economy in the long run.  No, this is not a model for solving the same huge problems that exist in Japan and the U.S. (due to Medicare, Social Security, Illinois, California, New York, etc.).

This problem will be with us for a while–probably another 5 to 10 years.  But, when we get past it, the global economy and stocks will go on a 15 to 20 year bull market.  

Until then, we’ll have to be satisfied with lower returns, preservation of capital, and a little amusement as Greek Tragedy justly punishes those who haven’t learned from history.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.