Expanding Your Sphere of Confidence and Competence
January 16, 2009 | Joe Ponzio | about: USB / WFC
When it comes to buying stocks, there are a million different approaches, a million different ways to value companies, a million different charts to look at… You get the idea – it can be dizzying, especially if you are trying to learn how to invest and find some stable ground on which you can build your strategy and knowledge base.
That said, time and time again, the great value investors – Warren Buffett, Charlie Munger, Seth Klarman, and others – all teach investors one fundamental rule to intelligent investing: Stick with companies you understand really well…in industries you understand really well.
If you don’t know a company or industry really well, you have to choices: learn it or skip it. You should skip it while you’re learning. You should learn more so you have more choices and opportunities at your discretion.
Banks and Financial Services Companies
For years, I chose not to invest in banks and financial services companies because I didn’t understand them. My inability to understand them, it turns out, came from their “toxic assets.” See…understanding how banks and investment firms make money isn’t all that tough. You sell an investment or loan money…you get paid.
The problem was that I couldn’t expand my sphere of confidence and competence to include this sector because there were so many confusing assets and revenue streams that caused me to fail to understand their predictability.
I’m able to clarify my thinking in hindsight, of course. In August of 2007, just before the collapse, I had written this about US Bank and financial services companies:
Many financial services companies are difficult to value because they have so many diverse revenue streams that are tied to the performance of the stock market, the bond market, and/or the housing market. When a business has to rely on sales, it can control its growth (or losses); but, when a business has to rely on sales and uncontrollable forces, it forces me to lose some confidence in my valuation.
At the time, banks and financial services companies left me standing like a deer in the headlights; so, I didn’t invest. I couldn’t wrap my head around their businesses which, in hindsight, was because of their ridiculous investments (aka “toxic assets”). My ignorance caused me to miss a lot of profits in the mid-2000s; my ignorance caused me to miss even more losses in 2008.
Expanding Your Sphere
Of course, when blood runs in the streets, you again have a choice to make: stay on dry ground or get your hands dirty and look for opportunities. The fact that the streets are running red is not a reason to invest; rather, it’s an opportunity to expand your sphere of confidence and competence, and to determine whether or not you can find opportunities you understand really well…in industries you understand really well.
For example, the auto makers are getting crushed. I don’t bother looking because I know that the economics of their businesses are bad. I wouldn’t even look an auto maker as an ongoing entity until it hit critical failure and went into bankruptcy protection.
Over the past year or so, I spent a lot of time mulling it over – reading, studying, and understanding the financial crisis, banks, and the toxic assets. As the banks return to “normal” operations and lending practices and avoid stupid (er…toxic) investments, they become much more predictable and clear.
Buying Wells Fargo
So, on Wednesday, I added a 10% position to Wells Fargo at $23.41. (I guess I should have waited another day to buy it at $19 and change – who knew?) I have traditionally avoided banks; but, in studying them over the past few years, and in really coming to understand them (and their mistakes) in the past year, I feel much more comfortable owning Wells Fargo (though I wouldn’t be comfortable owning a financial services sector mutual fund or many other financial companies).
How did I end up purchasing Wells Fargo? I’ll post a more in-depth analysis in the coming days. For now, I’ll simply state this: Wells Fargo, like most banks, will have a tough few quarters and perhaps a tough few years. Still, when things return to “normal,” Wells Fargo will likely be a $100 to $150 billion company.
It’s far easier to tell what will happen than when it will happen.
Because of their strong position, I don’t expect Wells Fargo to be at the government’s bank window begging for a lifeline (though I wouldn’t be surprised to see them take TARP money – personal feelings about the bailout aside, a bank would probably be nuts not to borrow from the government on such favorable, easy terms).
How Do You Expand Your Sphere?
Read (and google what you don’t understand). Your “too hard” pile doesn’t have to be a black hole from which no company can escape. If you can learn enough about a business and industry to find the predictability and assess the value, you’ll begin to find opportunities where nobody else is looking.
Years later, you just might be amazed at your results.
To The Folks That Have E-mailed Me
I’ll respond this weekend – promise.
Filed under: How to Value a Business
I certainly respect Buffett and his ideals about being comfortable with his circle of competence, but never understood why he seemed reluctant to expand the circle into certain areas (especially with technology). I certainly think that he has the mental capacity to do so.
My question to Joe and anybody else,
1. Do you expand your circle of competence because there are no deals in your current circle (reactive), or
2. Do you expand because your circle is to small at the present time(proactive)?
Thanks!
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I’ve been studying WFC for a while. Noise Free Investing had an article that captured my attention on it in June (http://www.noisefreeinves...). Based on similar logic, i just took the plunge.
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Re: Mike,
Personally, I think you should always be trying to expand your circle. That would also mean yes to both of your questions.
As for the technology part of your question, my difficulty for long term buys, is how do you know the company you are interested in will have the “next best thing” in the tech world. I have no comfort in that. It changes too fast to feel comfortable with respect to a sustainable economic moat. Some with niche clothing operators for me, Crox for example.
Note: I look for long term holdings, 10 years to forever kind of holds.
Joe: Did you get an email from me yesterday?
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I admire and follow Buffett, just like countless others. I guess I must be pretty arrogant, because when he bought BAC I thought “bonehead” and it’s pretty much turned out that way. Other things he buys, I can’t get the same deal he gets. I agree that WFC looks pretty good as far as banks go, but I’m not touching it with a ten foot pole. Banks, when run appropriately, should be boring and not nearly as profitable as many other industries. Lately, they’ve been more exciting because of their Vegas gambler managements and because of their parasitic fees and unfair lending practices. Congress is going to put an end to the later and the bubble has burst on the ponzi scheme that was the former. That said, WFC is indeed a well run bank and might benefit from being the “last man standing”, after Citi collapses and a few others become “dead bank walking”. At any rate, good luck with it, but I rather invest in companies that make things.
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I agree with you on the uncertain nature of financial institutions, so I am eagerly awaiting Joe’s further elaboration.
Note BAC may not be a purchase by Buffett himself. There is a possibility that it was done by GEICO’s investing maesto Simpson, like Pier-1 (definitely) and Carmax (possible).
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Hi Joe,
Your blog — especially posts like this one — have helped me reflect on my investing experience.
In terms of defining your circle of competence, do you draw the lines by industry, country, company, or how? I tend to look for companies with operating leverage — rather than financial leverage — and I try to understand how those “levers” work. What do you think of this approach?
Thank you.
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WFC at 14-15$ today JOE, damn u just gotta love when Mr. Market works against you.
If it happened a month later, I wouldnt have considered the opportunity cost.
However, indisputable, if you were investing in WFC for the long-term, today was a great day to do it !
The extra margin of safety is unquestionnable at 14$ vs 23$
Nice pic though Joe, I just cant invest in banks PERIOD.
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From my experience, over-optimism is real danger when expanding a circle of competence. You convince yourself that you know the company/industry better than you do because the do-something syndrome has you wanting to make an investment.
I find that taking Buffett’s advice, when he says to write a short essay “I am buying XYZ Co. at $XXX because…….” before I buy a business. It does wonders for clarification.
Any thoughts?
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Does anyone have any thoughts on the stock exchanges? I have been looking at NYX (New York Stock Exchange Euronext) and they have been hit as hard as any other financial company, yet there revenues, stemming from people trading stocks, should only increase during such volatile times. As far as future revenues are concerned, I don’t think the credit crises means that people are done trading stocks for the long-term…Any ideas why this company is down so much? It also pays a 6% dividend at today’s closing price…
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What do you think of Wells Fargo bonds? Right now, both are really beaten up, and return terrific yields. Of course they have less upside but for that matter, less risk. A bank must pay its creditors otherwise, it risk default and other bad consequences.
Or preferred stock?
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Ziv: In my opinion, and this is not very Buffett-like for today’s Buffett, it’s okay to invest in technology to a certain degree, if I find a scenario as I outline below. I like to go to the Google argument — will Google be the industry leader twenty years from now? It’s easy to say “yes” when you look at Google today; but, we know that tons of people are working on the “next” google. Ten years ago, you’d say “google” and most people would stare at you blankly. Today, it’s very much a part of the English language.
Twenty years ago, the term “video” meant VCR tape and music was on “records.” Because of changes in technology, the VCR and vinyl record industries no longer exist (for the most part) and the meanings of these words changed. Could you, back then, have looked at these revolutionary industries and predicted their future twenty years out?
When it comes to investing in technology, I wouldn’t try to figure out the industry leader twenty years from now. I don’t know that anyone can. Instead, I will do it when I think something is grossly underpriced, when I feel there is a catalyst for growth in the next three to five years (this is a Phil Fisher point), and if I feel that the company will continue to be fiscally strong ten years from now. (The last point speaks mainly to their current financial strength and the quality of management.)
I think that this is what Buffett referred to in his early partnership letters when he looked for Relatively Undervalued Securities. Over the years, I’ve probably made less than a dozen investments in tech.
Mike: I think that investors should always try to expand their sphere, either by looking at new investments, strategies, and industries, or by becoming better at existing ones. It’s easy to look at 21st century Buffett and say that he’s “stodgy” to a certain degree in how he invests. That said, his sphere has certainly expanded from where it was fifty years ago.
With a bigger sphere, you can look for more opportunities. Instead of being stuck looking solely at, say, manufacturing (because that’s your sphere) and finding that your “best” idea is at a 30% discount, you might be able to expand your sphere and find a retailer of similar quality at a 70% discount.
Casey: I did. I apologize — I’ll e-mail you this afternoon.
Rene & Aigle: We don’t know if it was Buffett that bought BAC. We do know that Berkshire has effectively halved its position in BAC over the past year, and I would guess that it’s because of the poor acquisitions by management (Countrywide for sure, perhaps Merrill too) that were done with stock instead of cash. We know that Buffett, at least in Berkshire, would much prefer to buy businesses with cash rather than stock.
MPC: I have one line when it comes to my sphere. On one side, you’ll find airlines, auto manufacturers, oil exploration, precious metals mining, and a few other “nevers” where bad economics or rapid change (or the prospect for rapid change through technology) is likely to occur. (This is when I’m looking for businesses as an ongoing concern. When looking for break-ups, everything is fair game.) Everyone else is on the other side, where I then have my three boxes — yes, no, and too hard.
In my opinion, you should look at the world of companies, not industries. If you can’t figure out what a company does and why it should be making more money ten years from now, skip it. That said, you’d be amazed at what you can understand in a wide array of industries if you look at the companies.
Jason: I agree, except that, when looking at a business as an ongoing concern, the answer will most likely be the same every time: I like XYZ Company because this, this, and that virtually insure that XYZ Company will be making more money ten years from now than they are today, and the price is well below the value.
For me personally, I can do that in my head. (That is, I don’t write a thesis for each company I look at or invest in.) On a blog, I don’t know that I can say, “I bought XYZ Company. Trust me — it makes sense in my head,” and have too many repeat visitors 
gabi: There will always be dumb, active money changing hands. My concern — and the reason I avoid them — is the technology issue. Will we eventually have “virtual” exchanges? If so, will NYX be the company to do it? Will we need to pay them to do it if someone like Google is willing to do it for because they want to load your trading platform up with ads? See my comment to MPC above — Will technology cause rapid, financially devastating change to the companies operating the exchanges?
Ryan: Though the bonds and preferred offer more safety in the event of a liquidation, I think the common stock offers much more appreciation in just about any other scenario.
al: You might be right. The question — which I hope to address in my upcoming post and the answer to which lies only in the future — is: Will Wells Fargo be making more money and worth more five years from now?
B: Wal-Mart’s huge CapEx made it much more difficult to value; so, I separated them to get better insight into the “growth” spending vs. the “maintenance” spending. With AEO, the numbers were attractive even without separating the two; so, I didn’t. Unfortunately, I did a poor job of analyzing AEO’s prospects considering the economic problems on the horizon. Though separating growth vs. maintenance capex on WMT helped me make sense of their operations from a financial standpoint, doing so on AEO was not necessary because I saw a margin of safety in the price even without whipping out the calculator.
The mistake in AEO was in my rationale, not in the calculation of the numbers or in carrying any math out to a precise decimal.
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In my research on bonds, I have been amazed to find how little information is out there. Does anyone know of a good website for corporate bond research?
I found one website where I can look up the bonds of, say, Disney, and I see they have bonds maturing in 2032, 2037, 2039, 2011, 2012, etc…and I also see the related coupon payments, but where would I find information on which bonds are most senior of all their outstanding debt?
If anyone could let me know of a good place for researching bonds, I would really appreciate it. Also, if anyone knows of a good online brokerage to buy/sell bonds, please post that as well. I use fidelity, and they are very limited in the bonds section.
thanks
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g-
Unfortunately, I don’t have a good website for corporate bond research beyond the SEC’s EDGAR. I work on the institutional side in bonds, so I have access to research from brokers, private analysts services, the ratings agencies (Moody’s and S&P), and most importantly I have a Bloomberg terminal.
I say EDGAR because public bond deals have to be registered with SEC, so you can at least pull up the offering prospectus for the specific bond deal. However, not all company bond deals have the same prospectus and thus not the same legal mumbo jumbo describing what the borrow can and cannot do as well as penalties like step-up language, change of control, seniority, and what not. Private placements do not have to be registered and are only open to certain types of investors. These also have prospectuses, but they’re not available from the SEC and EDGAR.
The ratings agencies do some things right including breaking out the legal mumbo jumbo on individual bond deals, so that you can get some idea of senority or lender protections. Bloomberg…well, Bloomberg is a data aggregator that when it was developed was specifically started to deal with bonds. Thus, I can pull up a company and see the outstanding bond issues. I can also see outstanding bank loans and so forth. I can also see the prospectuses fairly easy. As an institutional invsestor I also see pricing runs from the brokers throughout the day sent via Bloomberg’s email system. You must remember that the vast majority of bonds do not trade on public exchages and instead trade over-the-counter which makes price transperency difficult.
However, all is not lost for the retail buyer. Besides EDGAR, you can badger the investor relations people for info on their bonds and such. I do this sometimes when I can’t find an answer from other resources. Usually, they have to call me back because most IR folks are used to dealing with equity investors. Sometimes you get passed on to somebody in the company’s treasurer’s office or whoever deals with capital funding. This is better than an IR person because you’ll get answers that are more substantial than the IR folks will give. I’ll bet that if you call an individual company’s IR department enough asking bond questions that you would eventually get a direct number for the person who can actually answer your questions.
Another source for documentation would probaby be a full-service broker who might even have Bloomberg access. Unfortunately, that’s going to cost something in higher transaction fees. Depending on your cash pile, you might also be able to find a boutique or regional broker who’s
If you are really interested in getting some insight into credit analysis and in particular what kinds of documents exist for your senority and lender protection analyis a good place to start would be the book, “Fundamental of Corporate Credit Analysis.” This is written by some folks at S&P. Learning about bonds investing by the way would also be a way of expanding your circle of competence without have to learn a new idustry or new companies. Instead you’re learning about a new investable asset.
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Here are a couple of links to articles that might be of value to value investors re: the state of our financial system. The first is a link to Catherine Austin Fitts’ article on Fannie, Freddie and value investor Dodge & Cox. http://solari.com/blog/?p...
Here’s another link to an article on the downfall of Bill Miller that she posted at her website: http://finance.yahoo.com/...%27Broken-Strategy%27:-The-Fall-of-Legendary-Investor-Bill-Miller
Catherine Austin Fitts is a financial whiz, graduate of Wharton, former financial adviser to FHA, and a former Assistant Secretary of HUD
And here’s part of a note from Catherine to here e-mail list that prefaced these links:
“It is difficult for me to express how upset I am with investors being
misled by traditional portfolio strategy. Let me state for the record:
there is no such thing as a diversified portfolio when most stocks and
bonds represent companies or municipalities that are dependent on
federal government funds. In addition, there is a difference between a
traditional business cycle and a financial coup d’etat.
“Finally, if the rule of law is not available to ensure functioning
markets, all bets are off. There are some things that even zero
percent interest rates and an infinite amount of loans from the Fed
and the Treasury can’t solve.”
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I just finished reading Susie Gharib’s (from the Nightly Business Report on PBS) interview with Warren Buffett. It is hilarious how befuddled she is throughout the whole thing. It’s like watching a Martian interview a Venusian on first contact. It is obvious (and also unbelievable) that she has never read The Intelligent Investor and perhaps never even heard of it. This is why value investing will always be around, people just refuse to “get it”. Sure, look at it as a buying a business, check, ignore the stock ticker, check, understand the business or don’t buy it, check, but Mr. Buffett, what’s the stock market going to do next week? Anybody want to start a real business show? We could call it The Real Nightly Business Report. Oh wait, investing, just like poker is BORING when done properly. Never mind.
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I have been watching GE for sometime now and wondering what the folks think about this behemoth trying to sort out the financial mess in its capital arm and yet maintaining its dividend. I ran some numbers and just based on what I am seeing (without the 2008 year end numbers) it seems to be discounted 69% at the closing price of $12.03 even at 7% growth rate (avg growth rate has been 13.4% for GE). Based on the dividend of $1.24/yr (assuming that GE is able to maintain it) the return seems to be attractive at more than 10.3% just from dividend. The question is at what point is GE a good buy with the understanding that there is a downside risk of more losses from its financial arm.
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Joe-
I think that you’re right about Wells Fargo from an eventual valuation standpoint. I think they’ve firmly entrenched themselves as one of the big money center banks in this country. They’ve always been operationally well run and focused more on the banking business and none to very little on the securities trading business. Because of this focus in this time of turmoil they are less exposed then the other more fleshed out (proprietary traders) financial supermarket banks like JPMorgan, Citi, and B of A. Ultimately, I believe that recent events may have even strengthened Wells Fargo’s competitive advantage thus ultimately resulting in a higher potential valuation then previously existed.
However, my biggest concern would be who’s going to own the equity of the bank and benefit from the resulting value appreciation. I think the very large banks like Wells Fargo are too big to fail. Because of this, the result will be that the U.S. government will put up any money needed to prevent one of the big 5 or 6 (if you include Goldman and Morgan Stanley) from going down.
There is a 200 basis point difference in borrowing cost (outside of the TLGP issues) between the big banks and the GSEs like Fannie and Freddie. Because of this my feeling is that if one big bank must be saved (nationalized) then they all will be required to take on some form of nationalization just to remain competitive. If a large bank were nationalized my assumption is that its borrowing costs would be equal to the GSEs. In a nationalization, my feeling is that the equity holders would be wiped out while the bond holders would be left whole though probably subordinated to a government senior secured loan. If every very large bank was required to at least partially nationalize to eliminate the competitive imbalance between nationalized and un-nationalized banks this would substantially dilute the current shareholders. This dilution would be the payment for the government guarantee. Yes, Wells is strong, but some of it’s compatriots are weak. It’s similar to being the strongest auto parts manufacturer.
My analysis, or lack of, leads me to some questions for you: a) what’s your estimate of expected dilution (that’s probability weighted) and how does it affect your per share valuation? b) if the bondholders stay whole I would expect a very nice return with very limited downside risk, why not buy the bonds? c) I think there’s value in banks, why buy one of the big ones instead of hunting for a smaller very-well capitalized bank like a sub-regional where it’s likely the risk/reward is much better due to narrower business lines, stickier deposits, personal relationships, and strong loan underwriting? Both Wilbur Ross and Christopher Flowers have or are looking to acquire bank charters in order to start rolling up distressed banks. If these two astute investors think there is value in small banks, I’d say that there are probably industry players already in control of banks who feel the same way. I’d love to be the industry players partners.
As an aside, I assume the bondholders will remain whole because the government can’t afford to scare anybody off who’s willing to help them keep the big banks afloat. They’ve seen what can happen when they’ve handled it incorrectly three times now (Lehman, Wachovia, WaMu). The toll for keeping the bondholders whole will be subordination, but for the very big banks that’s not likely important for valation purposes. In smaller banks, it would be more important I think.
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Girish, I am sure someone can point you in the right direction… I can only give you my limited knowledge.
You’d have to consider the dilution if any is needed in the future. In fact, I think Warren Buffet has also taken a stake in GE with favorable terms (for him of course! lol)
here’s a quote, (just ignore the “noise”)
“”Berkshire will invest $3B in exchange for perpetual preferred stock that pays a 10% annual dividend
Berkshire will receive rights to purchase an additional $3B in common stock at $22.25 per share, exercisable for the next 5 years
GE will raise an additional $12B in common stock through a spot secondary [pricing tonight]
GE can call in the preferred stock at any time over the next three years for a 10% premium”"
“”10% perpetual preferred plus warrants = hardly the same as going out and buying common shares in the open market. Buffett is no altruist, he and his investors expect him to act aggressively when opportunity arises. He’s getting extremely attractive terms because GE and Goldman Sachs feel those terms are warranted; and there’s the rub. GE is an American institution and carries a AAA credit rating. The fact a AAA-rated firm of GE’s caliber would feel compelled to offer a senior perpetual preferred to any investor, even Warren Buffett, is a testament to just how tight liquidity remains throughout the system. To take a page out of my friend Roger’s book…companies are paying a premium for option liquidity. “”
“”So is Buffett signaling a market bottom? Impossible to say. Buffett doesn’t need the equity markets to rally for his investments to pay off. He just needs GE and Goldman Sachs to stay solvent and pay him 10% dividends year in, year out. “
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Well, today’s announcement by Wells Fargo somewhat summed up what I was going to write about it. The F Wall Street portfolio averaged down last week. Our two purchases were:
- 1/14/2009: 404 shares (~10% of the portfolio) @ $23.41
- 1/20/2009: 225 shares (bring investment back up to ~10%) @ 16.63
Position: 629 shares @ an average cost of $20.98 including $9.99 trading commissions on each purchase.
I’ll post my rationale on buying later today or tomorrow.
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great post Joe, Made me think quite a bit.
Every now and then I have the same argument with myself. I did grow up in an tech-internet environment, and sometimes I think that I know what defines the industry, and certain well known companies that are part of it. But then comes the Buffet side, which tells me that it’s quite hard to see where the industry is going and which factors can change and how fast – and I end up not investing and feeling half disappointed half pleased with my decision.
It all ends up in the same place – I can see how there will be television and coke in 50 years, but I can’t find the certainty that there will be internet or graphic cards.
Thoughts?
Ziv.
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