Whitney Tilson: Selected Published Columns

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Whitney Tilson: Selected Published Columns
Whitney Tilson

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Warren Buffett was once asked what is the most important thing he looks for when evaluating a company. Without hesitation, he replied, “Sustainable competitive advantage.”

I agree. While valuation matters, it is the future growth and prosperity of the company underlying a stock, not its current price, that is most important. A company’s prosperity, in turn, is driven by how powerful and enduring its competitive advantages are.

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Powerful competitive advantages (obvious examples are Coke’s brand and Microsoft’s control of the personal computer operating system) create a moat around a business such that it can keep competitors at bay and reap extraordinary growth and profits. Like Buffett, I seek to identify — and then hopefully purchase at an attractive price — the rare companies with wide, deep moats that are getting wider and deeper over time. When a company is able to achieve this, its shareholders can be well rewarded for decades. Take a look at some of the big pharmaceutical companies for great examples of this.

Don’t Confuse Future Growth With Future Profitability
The value of a company is the future cash that can be taken out of the business, discounted back to the present. Thus, the key to valuation — and investing in general — is accurately estimating the magnitude and timing of these future cash flows, which are determined by:

  • How profitable a company is (defined not in terms of margins, but by how much its return on invested capital exceeds its weighted average cost of capital)
  • How much it can grow the amount of capital it can invest at high rates over time
  • How sustainable its excess returns are

It’s easy to calculate a company’s historical growth and costs and returns on capital. And for most companies, it’s not too hard to generate reasonable growth projections. Consequently, I see a large number of high-return-on-capital companies (or those projected to develop high returns on capital) today with enormous valuations based on the assumption of rapid future growth.

While some of these stocks will end up justifying today’s prices, I think that, on average, investors in these companies will be sorely disappointed. I believe this not because the growth projections are terribly wrong, but because the implicit assumptions that the market is making about the sustainability of these companies’ competitive advantages are wildly optimistic. Warren Buffett said it best in his Fortune article last November:

“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”

The Rarity of Sustainable Competitive Advantage

It is extremely difficult for a company to be able to sustain, much less expand, its moat over time. Moats are rarely enduring for many reasons: High profits can lead to complacency and are almost certain to attract competitors, and new technologies, customer preferences, and ways of doing business emerge. Numerous studies confirm that there is a very powerful trend of regression toward the mean for high-return-on-capital companies. In short, the fierce competitiveness of our capitalist system is generally wonderful for consumers and the country as a whole, but bad news for companies that seek to make extraordinary profits over long periods of time.

And the trends are going in the wrong direction, for investors anyway. With the explosion of the Internet, the increasing number of the most talented people leaving corporate America to pursue entrepreneurial dreams, and the easy access to large amounts of capital from the seed stage onward, moats are coming under assault with increased ferocity. As Michael Mauboussin writes in The Triumph of Bits, “Investors in the future should expect higher returns on invested capital (ROIC) than they have ever seen, but for shorter time periods. The shorter time periods, quantified by what we call ‘competitive advantage period,’ reflect the accelerated rate of discontinuous innovation.”

Strategy

In this environment, how can one identify companies with competitive advantages that are likely to endure? It’s not easy and there’s no magic formula, but a good starting point is understanding strategy. In his article “What Is Strategy?” (Harvard Business Review, November-December 1996; you can download it for $6.50 by clicking here), my mentor, Harvard Business School professor Michael Porter, distinguishes between strategic positioning and operational effectiveness, which are often confused: “Operational effectiveness means performing similar activities better than rivals perform them,” whereas “strategic positioning means performing different activities from rivals’ or performing similar activities in different ways.” When attempting to identify companies whose competitive advantages will be enduring, it is critical to understand this distinction, since “few companies have competed successfully on the basis of operational effectiveness over an extended period.”

Professor Porter argues that, in general, sustainable competitive advantage is derived from the following:

  • A unique competitive position
  • Clear tradeoffs and choices vis-à-vis competitors
  • Activities tailored to the company’s strategy
  • A high degree of fit across activities (it is the activity system, not the parts, that ensure sustainability)
  • A high degree of operational effectiveness

He concludes that “when activities complement one another, rivals will get little benefit unless they successfully match the whole system. Such situations tend to promote a winner-take-all competition.” It is my aim to invest in these winner-take-all companies.

— Whitney Tilson

Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at [email protected] To read his previous guest columns in the Boring Port and other writings, click here.

Related Links:

Michael Mauboussin, 9/29/98: Why Strategy Matters
Michael Mauboussin, 1/14/97: Competitive Advantage Period “CAP,” The Neglected Value Driver

P.S. At the end of my column three weeks ago on Valuation Matters, I neglected to add links to two fantastic articles, both on the [email protected] web site (which is chock-full of brilliant articles — and they’re free!):

Michael Mauboussin, 10/21/97: Thoughts on Valuation
Paul Johnson, 6/16/97: Does Valuation Matter?

Mauboussin is a Managing Director and Chief U.S. Investment Strategist at Credit Suisse First Boston, and teaches the Securities Analysis course at Columbia Business School that Ben Graham used to teach. Johnson is a Managing Director in the Equity Research Department of Robertson Stephens, and is co-author of The Gorilla Game, a book I highly recommend.

Traits of Successful Money Managers

Successful long-term money managers, Whitney Tilson says, share 16 traits, divided equally between personal characteristics and professional habits. Understanding these traits not only helps you identify exemplary professional money managers, but may also help you understand how you stack up as an individual investor.

By Whitney Tilson
Published on the Motley Fool web site, 7/17/01

(http://www.fool.com/news/foth/2001/foth010717.htm)

I have spent an enormous amount of time studying successful money managers, ranging from those still active today — like Berkshire Hathaway’s (NYSE: BRK.A) Warren Buffett and Charlie Munger, and Sequoia Fund masterminds Bill Ruane and Richard Cunniff — to earlier ones such as Peter Lynch, John Neff, Philip Fisher, John Templeton, and Ben Graham. (This is by no means a comprehensive list.)

My goal has been to learn from their successes — and equally importantly, their failures. Given that investment mistakes are inevitable, I’d at least like mine to be original ones.

So what have I learned? That long-term investment success is a function of two things: the right approach and the right person.

The right approach

There are many ways to make money, but this doesn’t mean every way is equally valid. In fact, I believe strongly — and there is ample evidence to back me up — that the odds of long-term investment success are greatly enhanced with an approach that embodies most or all of the following characteristics:

  • Think about investing as the purchasing of companies, rather than the trading of stocks.
  • Ignore the market, other than to take advantage of its occasional mistakes. As Graham wrote in his classic, The Intelligent Investor, “Basically, price fluctuations have only one significant meaning for the true investor. They provide him an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times, he will do better if he forgets about the stock market.”
  • Only buy a stock when it is on sale. Graham’s most famous saying is: “To distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.” (For more on this topic, see my column, “Trembling With Greed.”)
  • Focus first on avoiding losses, and only then think about potential gains. “We look for businesses that in general aren’t going to be susceptible to very much change,” Buffett said at Berkshire Hathaway’s 1999 annual meeting. “It means we miss a lot of very big winners but it also means we have very few big losers…. We’re perfectly willing to trade away a big payoff for a certain payoff.”
  • Invest only when the odds are highly favorable — and then invest heavily. As Fisher argued in Common Stocks and Uncommon Profits, “Investors have been so oversold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others about which they know nothing at all.”
  • Do not focus on predicting macroeconomic factors. “I spend about 15 minutes a year on economic analysis,” said Lynch. “The way you lose money in the stock market is to start off with an economic picture. I also spend 15 minutes a year on where the stock market is going.”
  • Be flexible! It makes little sense to limit investments to a particular industry or type of stock (large-cap growth, mid-cap value, etc.). Notes Legg Mason’s Bill Miller, the only manager of a diversified mutual fund to beat the S&P 500 index in each of the past 10 years, “We employ no rigid industry, sector, or position limits.”
  • Shun consensus decision-making, as investment committees are generally a route to mediocrity. One of my all-time favorite Buffett quotes is, “My idea of a group decision is looking in a mirror.”

The right person

The right approach is necessary but not sufficient to long-term investment success. The other key ingredient is the right person. My observation reveals that most successful investors have the following characteristics:

  • They are businesspeople, and understand how industries work and companies compete. As Buffett said, “I am a better investor because I am a businessman, and a better businessman because I am an investor.”
  • While this may sound elitist, they have a lot of intellectual horsepower. John Templeton, for example, graduated first in his class at Yale and was a Rhodes Scholar. I don’t disagree with Buffett — who noted that “investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ” — but would point out that he didn’t use the numbers 160 and 100.
  • They are good with numbers — though advanced math is irrelevant — and are able to seize on the most important nuggets of information in a sea of data.
  • They are simultaneously confident and humble. Almost all money managers have the former in abundance, while few are blessed with the latter. “Although humility is a trait I much admire,” Munger once said, “I don’t think I quite got my full share.” Of course, Munger also said: “The game of investing is one of making better predictions about the future than other people. How are you going to do that? One way is to limit your tries to areas of competence. If you try to predict the future of everything, you attempt too much.” In addition to what Munger is talking about — understanding and staying within one’s circle of competence — there are many other areas of investing in which humility is critical, which I discussed in “The Perils of Investor Overconfidence.”
  • They are independent, and neither take comfort in standing with the crowd nor derive pride from standing alone. (The latter is more common since, I argued last week, bargains are rarely found among the crowd. John Neff said he typically bought stocks that were “misunderstood and woebegone.”)
  • They are patient. (“Long-term greedy,” as Buffett once said.) Templeton noted that, “if you find shares that are low in price, they don’t suddenly go up. Our average holding period is five years.”
  • They make decisions based on analysis, not emotion. Miller wrote in his Q4 ‘98 letter to investors: “Most of the activity that makes active portfolio management active is wasted… [and is] often triggered by ineffective psychological responses such as overweighting recent data, anchoring on irrelevant criteria, and a whole host of other less than optimal decision procedures currently being investigated by cognitive psychologists.”
  • They love what they do. Buffett has said at various times: “I’m the luckiest guy in the world in terms of what I do for a living” and “I wouldn’t trade my job for any job” and “I feel like tap dancing all the time.”

Obvious?

Much of what I’ve written may seem obvious, but I would argue that the vast majority of money in this country is managed by people who neither have the right approach nor the right personal characteristics. Consider that the average mutual fund has 86% annual turnover, 132 holdings, and no investment larger than 5% of the fund.

Those statistics are disgraceful! Do you think someone flipping a portfolio nearly 100% every year is investing in companies or trading in stocks? And does 132 holdings indicate patience and discipline in buying stocks only when they are on sale and odds are highly favorable? Of course not. It smacks of closet indexing, attempting to predict the herd’s next move (but more often mindlessly following it), and ridiculous overconfidence — in short, rampant speculation rather than prudent and sensible investing.

The performance trap

I have not discussed historical performance as a metric for evaluating money managers, not because it’s unimportant, but rather because it’s not as important as most people think. Consider this: If you took 1,000 people and had them throw darts to pick stocks, it is certain that a few of them, due simply to randomness, would have stellar track records, but would these people be likely to outperform in the future? Of course not.

The same factors are at work on the lists of top-performing money managers. Some undoubtedly have talent but most are just lucky, which is why countless studies — I recommend a 1999 article by William Bernstein — have shown that mutual funds with the highest returns in one period do not outperform in future periods. (Look at the Janus family of funds for good recent examples of this phenomenon.)

As a result, the key is to find money managers who have both a good track record and the investment approach and personal characteristics I’ve noted above.

Conclusion

The characteristics I’ve described here are not only useful in evaluating professional money managers. They can also be invaluable in helping you decide whether to pick stocks for yourself. Do you have the right approach and characteristics?

— Whitney Tilson

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at [email protected] To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com.

The Perils of Investor Overconfidence

By Whitney Tilson ([email protected])

Published on the Motley Fool web site, 9/20/99

(http://www.fool.com/BoringPort/1999/BoringPort990920.htm)

NEW YORK, NY (September 20, 1999) — Hello, fellow Fools. Dale is away this week and he invited me to be a guest columnist today, Wednesday, and Friday in his absence.

First, by way of introduction, when I began investing a few years ago, I tried to educate myself by reading everything I could find on the topic (click here for a list of my all-time favorite books on investing). Being an early user of the Internet, I soon discovered The Motley Fool, which I have enjoyed and learned from immensely.

The topic I’d like to discuss today is behavioral finance, which examines how people’s emotions affect their investment decisions and performance. This area has critical implications for investing; in fact, I believe it is far more important in determining investment success (or lack thereof) than an investor’s intellect. Warren Buffett agrees: “Success in investing doesn’t correlate with I.Q. once you’re above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other

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