Tuesday, June 9, 2009

Sisyphus Meets Seinfeld

In a previous post I said the culture of Wall Street seems to have Sisyphus as its inspiration.

In Greek mythology Sisyphus was a king of Ephyra (now known as Corinth) punished for chronic deceitfulness by being compelled to roll an immense boulder up a hill, only to watch it roll back down, and to repeat this action forever. - Wikipedia

So Sisyphus was forced to roll a huge boulder up a hill, watch it roll back down, and repeat the pattern throughout eternity. As an adjective, Sisyphean can mean an activity that is unending, repetitive, pointless, and unrewarding.

Technical, quantitative, long/short, and options trading strategies, among others, all sound complex and difficult to execute. I'm certain that it takes great skill to implement these approaches effectively. While more than a bit skeptical of the risk/reward of these methods, I'm guessing some actually make it work. Still, this hardly seems a recipe for most investors to build sustainable wealth. It feels Sisyphean to me.

At a minimum, lets just say it's in the witch doctor's interest to convince us that it requires special expertise to make money investing.

"...most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising 'Take two aspirins'." - Warren Buffett in the 1987 Berkshire Hathaway Shareholder Letter

Back to Greek mythology...

Munger quotes 19th century mathematician Carl Jacobi when he says "Invert, always invert" if you want to solve a difficult problem.

"...it is not enough to think problems through forward. You must also think in reverse, much like the rustic who wanted to know where he was going to die so that he'd never go there. Indeed, many problems can't be solved forward. and that is why the great algebraist, Carl Jacobi so often said: 'invert, always invert'. And why Pythagoras thought in reverse to prove that the square root of 2 was an irrational number." - Charlie Munger

Personally, I've never regretted following that advice. It works wonders in problem solving.

So here goes. As an investor, clearly you want to avoid being like the George character from Seinfeld. However, that serial failure George Costanza pulled off one of the great all-time transformations in sit-com history when he decided to do the opposite of every instinct that he had. 

It worked.

"A job with the New York Yankees! This has been the dream of my life ever since I was a child, and it's all happening because I'm completely ignoring every urge towards common sense and good judgement I've ever had." - George Costanza in the Seinfeld episode: "The Opposite"

Sisyphus is basically Costanza (pre-transformation). And through a similar inversion I think you end up with something close to the right inspiration for investing:

The new bizarre Sisyphus does not push that huge boulder up a hill in perpetuity. Following George's lead he trades that high effort/no return activity for a low effort/high return activity. As soon as the opportunity presents itself, he purchases a toll bridge franchise (at a fair price). This new investment essentially allows him to sit comfortably on his ass collecting all the tolls. Net of operating expenses including maintenance, lane expansion etc this activity is very lucrative... something like a 25% profit (the "net pre-tax toll"). Not only are the margins high, but the business requires minimal new capital. What makes the economics so favorable? That bridge (including capacity for lane expansions to accommodate population growth), is built predominantly in today's dollars or yesterday's dollars (even better), while the growing stream of tolls collected will be inflation adjusted future dollars. As a result the long-term return on capital is excellent.

With all the extra dough he pays someone else to push that stupid rock.

Coca-Cola, Philip Morris, Diageo are, in effect, "toll bridge franchises" for daily global beverage, cigarette and alcohol consumption. In this case, the "bridge franchise" is replaced with a global "brands and distribution franchise". And yes...most of these brands and distribution franchise assets are, in fact, built mostly with yesterday's dollars while the growing future profits will always be at least inflation adjusted.

The reason? Great brands with broad distribution become "price setters" through the reputation established with its customers.

"Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price. Consumer franchises are a prime source of economic Goodwill." - Warren Buffett in the 1983 Berkshire Hathaway Shareholder Letter

Price setting franchises generally produce excess returns. The capitalized value of these excess returns is economic Goodwill. Commodities, in contrast, are "price takers" that ride the waves of booms and busts in supply/demand. (i.e. Your favorite Vodka probably didn't drop at all in price during the most recent recession. Most commodities collapsed 50-75%. Of course, they will jump in price again no doubt based upon supply/demand.)

In the long run, when you take into account population growth, expanding brands and distribution of these franchises you are buying a growing stream of cash flows...and the ability to compound at excess rates of return.

As an example, of the many servings of Diageo products (Captain Morgan, Guinness, Smirnoff, Johnnie Walker, Baileys etc) consumed each day, shareholders collect a net pre-tax "toll" of roughly 25 cents on the dollar after deducting all expenses. Since those excess funds are generally not needed to run the existing business, they can be reinvested (after tax) with high returns back into the business to expand distribution and brands or the excess cash can be distributed to shareholders. In contrast, the occasional profits you earn with an airline (even a fast growing one) are illusory; those profits will sooner or later be needed to buy new planes, fight off a competitor and on and on.

The question comes down to whether you want to have to perpetually hunt for the next great trade. Even if you are capable of pulling off trade after trade successfully, you always have to find the next one. There's no self-sustaining autopilot. This approach may work, but seems likely to result in major mistakes and unnecessary frictional costs over the long run. In contrast, the intrinsic value of the Berkshire Hathaway portfolio will likely increase meaningfully over the next decade on autopilot (i.e. if Buffett did not make even a single move within the portfolio).

From a previous post:

...there are many professional money managers and traders (some of them frequently appearing on various business news media outlets) recommending various, sometimes rather complex, investing and trading strategies.

It's easy to imagine and expect with all the expertise on display that quite a few of them must seriously outperform. In particular, some might reasonably expect them to outperform a participant who just buys -- at a reasonable price -- and holds long-term the stocks of companies that make the stuff found in a typical cupboard, refrigerator, and medicine cabinet.
(Well, at least those participants who understand business economics, are able to identify sustainable competitive advantages, have a price vs value discipline, while controlling their emotions during inevitable market fluctuations. Not complicated but, based upon investor behavioral patterns revealed in studies, apparently not easy for many to accomplish either.)

Yet, the verifiable evidence at least suggests that many pros do not, over a long time horizon, beat high quality stocks (or the market as a whole) bought when prices are reasonable or better. Also, for those experts that do outperform, there's just no easy way to separate the future fund "winners" from the mediocre (or worse).

Knowing how to buy shares of great business franchises at the right price and allowing them to compound long-term may not be easy. Yet, by comparison and with some hard work, it seems a more straightforward and doable exercise than some of the other popular methods employed by market participants.

Adam

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
 
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