When I started out investing I summarized Warren Buffettâs letters to shareholders into a document I jokingly called the âTractatus Logico-Valere.â The title, Latin errors aside, was intended to be an homage to Ludwig Wittgensteinâs Tractatus Logico-Philosophicus (which, according to Wikipedia, may in turn have been an homage to the Tractatus Theologico-Politicus by Baruch Spinoza). The idea was to create a comprehensive summary of Buffettâs investment process set out in a succinct, logical fashion. I kept Wittgensteinâs seventh and final proposition â âWhereof one cannot speak, thereof one must be silentâ â as my own and interpreted it to mean âwhere you canât value something, donât investâ or âstay in your circle of competence.â My Tractatus wasnât very good, and Iâm not Warren Buffettâs shoelace. Consequently, I didnât do very well with it. (Wittgenstein was not similarly burdened with self-doubt. Wikipedia says that he concluded that with his Tractatus he had resolved all philosophical problems, and upon its publication retired to become a schoolteacher in Austria.) My abortive experience attempting to create a comprehensive guide to earnings and growth-based investing has given me a great appreciation for those who are able to successfully create such a document and live by it. One investor who has done so is setting out his process for the world to see at The Fallible Investor.
The author of The Fallible Investor is a private investor who has âpreviously worked for a private hedge fund in Bermuda and Bankers Trust in Sydney, Australia.â He calls himself The Fallible Investor because he âoften makes errors when he invests, and says, âRecognising such a weakness is also useful. As Taleb says:
Greenbackd
http://greenbackd.com/
The author of The Fallible Investor is a private investor who has âpreviously worked for a private hedge fund in Bermuda and Bankers Trust in Sydney, Australia.â He calls himself The Fallible Investor because he âoften makes errors when he invests, and says, âRecognising such a weakness is also useful. As Taleb says:
Soros⌠knew how to handle randomness, by keeping a critical open mind and changing his opinions with minimal shame⌠he walked around calling himself fallible, but was so potent because he knew it while others had loftier ideas about themselves. He understood Popper. He lived the Popperian life.I have found particularly useful his elucidation of the linkage between return-on-invested-capital, market value, replacement value, and sustainable competitive advantage:
I define the replacement value of a business as what the businessâs assets would be worth if itâs ROIC was equal to its cost of capital.The Fallible Investor has provided me with a full copy of his notes. I highly recommend following his posts as he sets out his investment process on the site.
The market value of a business with a high ROIC and no sustainable competitive advantage should (assuming the market eventually prices a business at its intrinsic value[1]) fall to its replacement value. This should happen because if an incumbent business has a high ROIC, and no sustainable competitive advantage, other businesses will enter this industry, or expand within the industry, to seek these higher returns. These competitors will drive down the incumbent businessâs profits until its ROIC declines to the average return of a commodity business. Once this occurs, the incumbent business can only be worth the cost of replacing the businessâs assets.
Professor Greenwald has another way of describing this process. He points out that if an incumbent business, with no competitive advantage, has a replacement value of $100 million and its market value is $200 million[2], competitors will drive its market value down to $100 million. Competitors will calculate that by spending $100 million to reproduce the assets of that business they can also create an enterprise with a market value higher than $100 million. These competitors will think, correctly, there is no reason for why they should have a different economic experience from the incumbent because there is nothing it can do that they cannot. Remember the incumbent business has no sustainable competitive advantage. Competitors, by reproducing the assets of the incumbent business, will increase the supply of products or services in the industry. There will now be more competition for the same business. Either prices will fall or, for differentiated products, each producer will sell fewer units. In both cases, the incumbentâs profits will decline and the market value of its business will decline with them. This process, capacity continuing to expand, and the profits and the market value of the incumbentâs business falling, will continue until the incumbentâs market value falls to the replacement value of its assets ($100 million). Its competitors will suffer the same fate.
Greenwald points out that while this process does not happen smoothly or automatically it will eventually turn out this way. It happens because the incentives for businesspeople to take advantage of the marketâs excessive valuation of the incumbentâs business are too powerful.[3]
The market value of a business with a sustainable competitive advantage can, by contrast, stay much higher than its replacement value simply because it can sustain a high ROIC.
[1] The intrinsic value of a business is what I think the business is worth to a rational businessperson.
[2] Assuming the business has a high market value because it has a high ROIC.
[3] P38, âValue Investing: From Graham To Buffett And Beyondâ, Bruce Greenwald et al, 2001.
Greenbackd
http://greenbackd.com/
