My Notes of BGs Value Investing Seminary.

Value investing is about buying businesses at a fraction of their intrinsic value and holding them for a reasonably long period of time. Having said that, the natural question is: what NON value investing is? There are many short term approaches to investing. The most widespread is what could be called as short term fundamental investing: you forecast either a quarter out or a year out or two years out some appropriate quantity to deal with the company whose securities youre going to be buying (most commonly thats earnings). Then you compare your forecast to the consensus either as its apparent in surveys or as you can infer from the price level of that security. If your forecast is more optimistic than the consensus you should buy. When the opposite is true, you should sell. But in order for this to be successful youve got to have information that nobody else has. Another approach is trading patterns investing, like momentum investing. The other big school of investing for many years was the efficient markets investing, i.e., youre not going to be able to have access to information that everybody else doesnt already have. Therefore, since youre not gonna be able to outguess the market, you should focus on minimizing transaction costs and allocating assets in an appropriate way so that creates an appropriate risk profile. You should know two things about all this. The first is that there is overwhelming statistical evidence that markets are NOT efficient. The second thing is that whenever you think that a stock should be bought because it will go up, somebody else thinks that it should be sold because it will go down. Another way of saying this is that not everybody can outperform the market. So when you start thinking about investing you have to be able to answer the question: why are YOU going to be on the right side of a particular trade? Why are you the one whos right, and the person whos trading with you is wrong? When we talk about value investing theres a lot of evidence that value investors have been on the right side of the trade. The statistical studies that contradict market efficiency all show that low market to book, low PE portfolios outperform the market by significant amounts in all periods of time in all countries. The question is: yes, they historically did outperform the market but did they make money for people? If you look at large institutional investors who have pursued value investing approaches, they outperformed the market significantly. The reason why thats important is that 70% of all professional investors underperformed the market. If you look at individual investors (like Warren Buffett) that created a disproportionate amount of wealth, they are all concentrated on value investing. So statistical evidence suggest that value investing has consistently put people on the right side of the trade. The first assumption of value investing is that the market acts like a partner. Every day he comes to you and offers you a price of your share of the business: if hes good that day the price is remarkably high, if hes depressed that day the price is remarkably low. But mr. Market is a strange guy and prices that he offers you fluctuate a lot. If they fluctuate a lot and you think fundamental value is stable, then prices are going to diverge regularly from fundamental values. The second assumption is more problematic. You can identify which stocks are trading above or below their fundamental values. That means that fundamental values have to be measurable, and that is by no means always the case. When you try and put this into practice, since not all stocks are going to be remarkably undervalued or remarkably overvalued, you have to look intelligently for things that youre going to value. Then when you go about estimating value you have to be rigorous about knowing what you know (not all values are measurable; not everybody is an expert in everything; you have to concentrate on what you believe your circle of competences is). When you look intelligently for opportunities you have to be rigorous about valuing those opportunities and then you have to be patient (as Warren Buffett puts it: investing isnt like baseball where you have to swing at every pitch; you dont have to swing, they can throw as many pitches as you want, but because value is concentration and not

diversification, you wanna wait for your pitch). You have to have some strategy for what youre gonna do when theres no opportunities to invest in. All of this can be described as a process. A sensible investor is going to start with a well formulated search strategy. Some of that is going to be screening on statistical or other bases for particular opportunities to devote research resources to. But some of that is just going to be what you decide to do, what you are going to specialize in, because in this game the specialist is much more likely to be on the right side of the trade than the generalist. Once youve identified opportunities, you need a sound valuation technology. You want an approach to valuation that uses all the information as effectively as possible. The most effective of these technologies is the one that was pioneered by Ben Graham. The valuation technology should identify the critical issues that affect the future value of your investment. And you then wanna concentrate on that information and any collateral indicators that will tell you about that future value, and finally you have to have a strategy for managing risk effectively and systematically. If you look historically retrurns on stocks have been about 10-11% and returns on bonds have been about 3-5%. Short term instruents have returned even less. Buying stocks was a terrific search strategy historically: things no longer seem to be that simple. There are basically two ways to calculate future returns: 1) you can look at dividends returns plus capital gains. Capital gains are presumably driven by growth in earnings. Growth in earinngs is presumably driven in the long run by the growth in GDP, which historically has been about 4.5-5%. Summing up these two numbers (dividends, or about 2%) says that investing in stocks is going to return about 6-6.5%. 2) 1 / PE, add expected inflation, you get more or less the same number. So buying stocks by itself is NOT a successful strategy: so what you wanna do is start looking at things that are obscure. If you decide to buy Microsoft youre competing against 200 other analysts and thousands of other investors who are looking at that company too. No matter how smart you are, that competition is a tough competition. This is generally true for all large cap stocks. Ideally to be on the right side of the trade most often you would like to be the only one seriously studying a particular security, or one of the few people. Therefore, small capitalizations, small companies, small markets, particular cases like spinoffs. Boring is your friend. Restructurings, bankruptcies, industry problems, etc. Ultimately, when youve done your search analysis and all your valuation and this looks to you like a bargain, you have to ask yourself the question: why has God been so kind as to make this opportunity available only to you? And the answer is: theres no good reason. The other question to ask is: as historically value driven strategies have outperformed the market, why do we think that this is going to continue? The answer takes two forms. First is that most trading is done by institutional money managers and theres reason to believe that institutional money managers will for institutional reasons keep concentrating on certain stocks that will lead those stocks to be overbought and overvalued, thereby concentrating themselves away from other stocks that will be underbought and undervalued. Once that process starts theres strong institutional reinforcement: you get in trouble as an institutional money manager by significantly deviating from the performance of other institutional money managers (if you just match the performance of other istitutional money managers or are near it, youre not gonna get into trouble). The way to do that is to buy what everyone else is buying. Furthermore, theres window dressing: in January or before they report their portfolios institutions tend to buy stocks that have done well and that have gotten lots of institutional, supportive research. And this phenomenon goes in the same direction, towards certain overbought and overvalued stocks.

You dont have to pretend you can value everything. So you need to have a search strategy. Just to identify what securities are likely to fit into this category, it makes sense to go through the sense in which theres just no way youre going to be able to evaluate Microsoft. This was done in 2000 when MSFT was trading at 110, which was 80x earnings. At that point MSFT was not paying any dividend. But assuming that they started to pay dividends from 2000 to 2010 at a rate of 15% of their profits (which they still have not done although theyve done something closer to that). Second assumption is that growth in sales between 2000 and 2010 is going to be what it was in 2000, which was 40% a year. This means that by 2010 MSFT will be 28 times as big as it was in 2000. And right away that tells you something about the range of possibilities that you have to cope with if youve got to understand the future of MSFT. Then I discount actual payments by 15% (given high interest rates in 2000, thats a fair assumption). What you see between 2000 and 2010 is dividends. Anything else you can get depends on conditions in 2010 and forward. If you discount these 15% dividends that are growing at 40% a year, the NPV of the dividend payments you could expect is about 15% of the price that you pay for the stock today! Which means that 85% of what youre paying for is based on whatever it is thats going to go on beyond 2010. This is a calculation that is worth doing for any stock. Because in an environment thats changing as rapidly as the PC market, to think that in 2000 you have a good idea of whats going to happen in 2010 requires a degree of hubris that suggests you should really be in a different business and not in the business of investment! Theres another common investing mistake that is related to this kind of calculation, which is people say theyre gonna have two good years, I know that; therefore Im gonna pay 40 times earnings. Two good years in a stock thats trading at 20x earnings is 10% of what youre paying for the stock; that means 90% of what youre paying has nothing to do with that short term earnings forecast. It has to do with a judgement thats implicit. And implicit judgements tend not to be good judgements in how that company is going to be valued. So when you think about where is possible to do valuation effectively you want to think first about this distribution of payoffs and what the forecast that you think you can make say about the fraction or overall valuation that youre explaining. The second thing that is useful to show is the actual studies that support the statistical numbers that I gave you in summary form (that cheap stocks and disappointing stocks outperform other types of stocks and so on). The first of these studies has been published in 1984, but has been replicated since then as these studies tend to be done over and over again. This guy, called Richard Thaler, now at University of Chicago, picked a year, say 1933, and looked between January 1 1933 and January 1 1932, and looked at stocks that performed best over the past year, and which ones performed worst over the past year. He then formed a portfolio of the 10% worst performing stocks, and a portfolio of the 10% best performing stocks. He then looked at which of these portfolios performed best over the last year. The measure used is the performance of the worst performing stocks portfolio minus the performance of the best performing stock portfolio. Over the next 12 month period from the portfolio formation he observed that the good performing stocks outperformed the disappointing stocks. But from month 12 to month 24 (longer period) theres no performance difference between the good stocks and the disappointing stocks (first curve from bottom of chart on page 5). Then he re-did the study and looked at stocks over the prior two years. So he formed the portfolios with the best and the worst (both 10%) over the course of the prior 24 months (since Jan 1 1931). Again the measure was the difference in performance between the two portfolios. In this case theres a significant outperformance by the disappointing stocks over the good stocks (second curve from bottom of chart on page 5; always above the zero). Then he went back and did the study again with three past years of performance. The results were even better for the disappointing stocks portfolio (third curve from bottom of chart on page 5; always above zero and above the second curve). Theres a lesson to learn from all these studies, which is slightly disappointing is not enough. When we talk about cheap, disappointing, obscure as the basis for statistical portfolio building, its got to be very disappointing, very obscure; it cant be that the stock is just down 30% in the last month, because then the momentum is going to take over. Its got to be

2-3 years that the stock has been breaking the hearts of investors! The best measure of that is a study done by Fama, who is the father of efficient markets. What he did was something slightly different: at the end of every month he formed portfolios of stocks that were the lowest book-tomarket (or the highest market-to-book) and the highest book-to-market (or the lowest market-tobook). He did this for every decile of stocks. He also did it for small cap and large cap stocks. He changed the portfolios at the end of every month. The first thing to look at is the difference in return between the lowest market-to-book and the highest market-to-book portfolios. The glamour stocks (high M/B) had an average monthly return of 0,64% (which is about 7,5% on a yearly basis); the ugly stocks (low (M/B) had an average monthly return of 1,63% (which is about 1% higher per month that the glamour stocks!). Usually the ugly stocks will be in the low M/B area; not just because the have disappointing in their performance. So the action is coming from buying extremely cheap stocks and staying away from the extremely expensive stocks. You need the extremes: just cheap doesnt get it. Same thing happened to small cap vs. large cap stocks. Same procedure: every month he would rebalance the portfolios. Small cap stocks (which by the way include the companies in or near bankruptcy because they dont tend to have large capitalizations) returned almost 1,5% a month, large cap stocks returned 0,89% a month. Again, the difference appears at the extremes. So the message here is that if youre going to do statistical value, its going to have to be extreme statistical value (its not going to be the bottom half stocks by P/E, which is a definition often used by the newspapers: its going to be the bottom deciles). Finally, these ugly stock, small cap stock portfolios are also the lowest risk portfolios by the conventional measures of risk, i.e., lowest variance. Theres another study that looked at glamour stocks vs. ugly stocks in two dimensions (so far weve looked only at one dimension, i.e. M/B or market cap). The first dimension was cash flow-to-price (glamour stock have low CF/P, the value stocks have high CF/P). Here the stocks werent divided into deciles, they were divided into thirds. The second dimension used was the growth rate in sales, on the theory that fast growing stocks are attractive stocks that are apt to be overvalued. Stock in the lowest third were the ones with the lowest CF/P and the highest sales growth rate: these stocks underperformed the market by about 3,3% a year. Stock in the highest third were the ones with the highest CF/P and the lowest sales growth rate: these stocks outperformed the market by about 5,4% a year. If you add those two the difference in returns between the two thirds is about 8,7%. This is a lower difference than in the other study (with just M/B as a dimension about 12%), and it is the reflection of two things: a) these portfolios are formed annually and not monthly (this explains 1-2% of the difference); b) these stocks are divided in thirds, which are much more extensive than deciles (with deciles you could be more extreme). One of the lessons of the statistics is that you need to be fairly careful about it and you need to be prepared to look at extreme alternatives. All this is however history. If youre going to invest from now on you have to believe that that history is sustainable. The institutional and individual psychological forces that look to be driving these statistical results seem likely to continue to be true of the investing industry. When confronted with the choice of $500 profit with certainty and a lottery the expected value of which could be a $500 profit, 95% of the people choose the $500 profit with certainty. When, on the other hand, confronted with $500 of loss with certainty and a lottery with expected value negative $500, people choose the lottery. The two choices are exactly the same, yet how the choice is posed completely changes the answer. To avoid losses, people would take unreasonable risk, they would take irrational actions. People would dump stocks reflectively to avoid the possibility of loss; the prices of those stocks are going to fall below whats justified. That is precisely why those forces are going to continue to be there, thereby leaving value premia intact. Lets go back to valuation. You start with whats tangible, which are the assets. When looking at the assets theres one critical assumption: is this industry viable or not? If the industry is not viable youre going to value those assets at liquidation cost. In the Depression, when Graham started out, he valued all of these assets at liquidation cost. If the industry is viable, then the assets are going to

be replaced, and youre going to value them at reproduction cost. Lets see what that process looks like. The nice thing about assets values is that you can just go down the balance sheet and value each item separately. Were not worried about this as an operation. If they have $200m in cash thats easy: $200m is both the liquidation value and what it would cost to reproduce that cash. As for accounts receivable, Graham was willing to apply them at book value although in liquidation you probably are not going to recover the full amount. If its a viable industry, and your competitors wanted to reproduce those A/R they would sell products to customers. In this process, to reproduce $200m of A/R you typically and inevitably are going to incur bad debt, so that the reproduction cost of those A/R is going to be something greater than the book value: at a minimum, you can add back an allowance for bad debt (reported in the footnotes of any annual report), but this is not going to be a big adjustment anyway. So when Graham just took book value, it was probably a reasonable compromise (in the 30s) between liquidation value and reproduction value. What about inventory? If you were liquidating you would write it down, but if you were continuing and you valued the inventory at LIFO, you probably are going to be undervaluing the inventory, because to reproduce this inventory youve got to do production; to do the production, youve got to produce on a FIFO basis. So if you have a LIFO reserve, you can probably add it back although it could be a little lower than that. Again, this is going to be very close to book value. The hard assets to value are the ones below the current assets (for current assets, no mater how you value them, youre going to get both liquidation and reproduction values very close to book values). But how can you think about valuing PP&E? You do have the original cost in the financials. For buildings, land, and construction in progress, theyre almost never going to be replaceable at less than their original cost. So using just the original cost for those assets is probably conservative. On the other hand, if those assets are a big part of the assets of the firm, youre going to send out an assessor to value those items. For example, if its an ongoing plant like an aluminium plant, youre going to have to be sophisticated about the valuation. For PP&E the difference between original cost and reproduction value depends on the trend in prices for capital goods. Capital goods prices have been falling over the last 10 years at a rate of about 5-7% per year. So the reproduction value of these assets is going to be substantially less even if they havent worn out than their original cost. Then youve got to start to think about the intangibles. Companies have product portfolios. The value of those product portfolios, unless theyve been acquired in takeovers, are not going to appear on the balance sheet. You have to think about what it would cost to reproduce those product portfolios because that cost is part of what protects the earnings of the company, among other things. How many years of R&D it would take to reproduce the product portfolio for an efficient competitor? Look at the companys average R&D spending. If it would take 3 years to reproduce most consumer products portfolios and theyre spending $150m a year, its $450m to reproduce it. If its like the auto companies where it takes 6 years, then youre going to have 6 years of R&D spending. For the reproduction value of brands you just go see the price paid in private market transactions for similar brands, or you can go to an advisor. For the liabilities, you just subtract those at book for the spontaneous liabilities and you get the reproduction value of the assets. If you subtract the market value of debt you get the reproduction value of the equity. But whether you value the assets at cost, at Graham, or at reproduction value, theres a number of things that you have to consider. The nice thing about asset values is that they are a good way to think about management: good management always adds value to the assets, its not already embedded in the earnings; bad management subtracts value from the assets and if youre going to buy assets and have bad management you have to think about getting rid of it. If youre going to use private market values, some of them are unstable: theyre not as stable as the reproduction cost of these assets directly estimated. Multiples are changing very rapidly. But the most important thing is to understand that book value by itself, whatever you think of the accounting profession and the conventions that people use, does extremely well in picking cheap stocks. If the reproduction value and the book value are not going to be very different, then go ahead and just use book. Where theres going to be big differences is where there are big intangibles, big real estate, or technological trends that have either added value for environmental

reasons or reduce value substantially for the PP&E. But to do better than book you have to know a lot about the industry. For non viable industries, typically you are going to do a liquidation value. Then youre going to take a second look at values, that is from the earnings perspective. Youre going to focus on the companys earnings power as its reflected in the company that you see there today, without any growth. Why? Because growth is where all the uncertainty in valuation lies and you want to segregate that uncertainty from what you know. Youre going to estimate an earnings power and youre going to multiply it by 1 over the cost of capital. In a sense its less reliable than the asset value because you have to extrapolate. The mechanics is: take accounting earnings and do adjustments to get earnings power; then estimate a cost of capital. Usually when you estimate the earnings you talk about the earnings to the enterprise. You make an assumption that the current profitability is sustainable. What are the adjustments to earnings that you have to make? Usually is best to start with operating earnings. If were talking about a company where operating earnings as reposrted for accounti purposes are suspicious, you have to adjust them. Suspicious means that if they have recurring non recurring charges (so every year they have some non recurring charges that they dont put in ebit) you have to charge ebit for an average of them: you cant pretend that these non recurring charges are actually non recurring. Secondly you have to adjust for the business cycle. In the auto industry you could have losses this year and that does not mean that they have negative earnings power. In the business cycle for the capital goods industry there are good years and bad years, you dont wanna look at those years if its an extreme, you wanna look at average earnings over the cycle. Taxes sometimes vary. People run out of NOLs, they have special events that cut their taxes, and so on. You wanna look at average tax rates. Remember: were looking at sustainable earnings power, i.e., the amount on average that the company as it is today could distribute every year and still be in the same condition at the end of the year as it was in the beginning of the year. Depreciation numbers today tend not to reflect true depreciation. True depreciation is what it would cost to put the company in the same condition at the end of the year as it was at the beginning of the year. Accounting depreciation is based on the historical cost of assets and these days it is usually higher than true depreciation because capital goods prices are going down. In an inflationary environment, where reproduction costs are above historical costs, accounting depreciation would understate true depreciation. But in an environment where replacement costs are below historical costs, the opposite is true. The simplest way to do the cyclical adjustment is just to take historical averages, and the best device for doing that is value line. You start with the reported operating earnings for a period like 7 years, then you add back the one-time charges to get an adjusted earnings number. The next thing to do is convert that to a margin on sales, because absolute numbers typically vary in a business cycle. Then just go ahead and average these margins and apply it to current year sales (that should account both for cyclical fluctuations and accounting fluctuations; it would also alert you to the extent theres a positive or negative trend in operating margins). The next adjustment is usually in depreciation. What you want is maintenance or zero growth capital expense as the true measure of depreciation. Start with actual capex and subtract an estimate of the fraction of this that over the last several years has gone to growth. The simplest way to do that is just look at the capital intensity of the business PP&E / Sales and multiply this by the dollar increase in sales. Once you get that growth capex you can subtract it from the actual capex to get an estimate of maintenance capex. Look at that over 2-3 prior years and youll get a pretty good idea of what maintenance capex is (if it looks ridiculously low or high, you have to talk to someone in the industry). Subtract that zero growth capex from depreciation and add the difference back. Thats a pre tax number. To get an after tax number subtract an average tax rate. Finally you have to estimate a cost of capital. Doing this through an estimate of Beta is in practice a complete waste of time. Average error in the estimate of beta is 0.5. That means that beta could go from 0.5 to 1.5. By multiplying this by the risk premium tat could be all over the place, you could get a very wide range of cost of equity (like 6%-22%). We can do better than that. First of all the cost of equity is going to be always above the cost of debt. Secondly the most expensive kind of equity is what the VC are paying, like a 15% per annum. So without doing any betas you

know that the cost of equity is between these two extremes. Usually for a low-risk firm with a lot of debt the cost of capital is going to be 7-8%. For a medium-risk firm with reasonable debt is going to be 9-10%. For high-risk firms is going to be 11-13%. The nice thing about not including the growth is that the errors in the wacc estimate are not producing large shifts in value. By multiplying the earnings by 1 over the cost of capital I get an earnings power value. Now Im ready to really think about what the critical issues are. Is management the problem with an asset value higher than the EPV (Earnings Power Value)? In this case growth is going to have negative value. Do Asset Value and EPV match? In this case there are no barriers to entry and I have a good measure of value. Or is it a case like Coca Cola, where the EPV is way above the asset value? In this case Im going to be buying EPV because these earnings are protected by barriers to entry. A good valuation technology should help you identify what are the critical issues in any particular investment decision. And if the EPV is higher than the asset value the critical issue is whether this EPV is sustainable and therefore whether the growth is going to have some value. How do you assess the sustainability of those excess earnings? If you apply the Warren Buffet rule and you buy only good companies, how do you know what a good company looks like and whether it continues to be a good company? The classic way of doing that was to do a forecast of future companys earnings (section 2, pag. 34-35). And what you did as estimate a market size, a target market share, your revenues, your operating margins, tax effect those, subtract your investments, that would give you cash flows, you applied an estimate of cost of capital to get a NPV. That was your idea of looking at the future of the business. The problems with doing that is that youre making a huge number of assumptions, most of which are buried in the parametric numbers that youre putting into your model. In the end you may have assumed you way into investing. You have to step back and look at whether this makes sense in broad business terms. The way to do that is attributable to Michael Porter: if you wanna look at a business you wanna look at the 5 basic forces that affect the operations of the business; you make a list of all sorts of pros and cons and then you try and arrive at a qualitative conclusion to suppor your quantitative analysis. The real problem with these 5 forces is basically that its 4 forces too many! You wanna focus on what is the dominant force determining whether this is a good business or not. The dominant force is entrance and expansion, which is equivalent to entrance by existing firms in the industry. If I talk about a commodity business nobody worries about the competitive dynamics within the industry, or suppliers power, or customers power; nobody worries about substitutes. If this is the steel market, theres a price for steel. You have a current cost curve which includes some reasonable return on capital. If you are in a situation where theres an output at which the price exceeds the total average cost of producing that output. Youre going to see above normal profits (or economic profits). Thats going to be reflected in returns on equity well above the cost of capital. But in this situation, whats going to happen in that industry? People are going to expand, theyre going to build new steel plants to take advantage of those returns, and thats going to be both new entrance and existing entrance. As they expand, whats going to happen to that price? Its going to fall. As the price falls, profitability falls, and entry and expansion is not going to stop until the economic incentive to do it disappears. In commodity markets, the idea that anybody for any long period of time is going to make excess returns with the above described dynamics of entrance and disappearance of extra profit, does not make this a good business. In business school the answer to this problem is product differentiation: you have to differentiate your product. Its a lie! Its not going to help. The costs of product differentiation just offsets the benefits of product differentiation: people pile into the market as long as theres a profit opportunity, and theyre just going to eliminate the profit opportunity in a different way. So the distinction between commodity and differentiated products is not the critical distinction. The critical distinction of a good business is not that there are differentiated products but that theres something to interfere with the process of entry. And what that something has to be is a competitive advantage that incumbent firms enjoy. Suppose we are in the cellular business, the guy with the latest technology in its network gets all the customers. Once hes entered and gets this technology embedded into the network he just gets destroyed by next new technology. So entrant

competitive advantage dont make any difference. You have to have incumbent competitive advantage and fortunately they are very small in number. An obvious one is that the incumbent has a lower cost structure than the entrants, so that when the entrants, even if they face the same demand, are just barely profitable and do not have any economic profit (the incumbent still makes money). What are the underlying circumstances that correspond to that picture? One obvious case is when the incumbent has a proprietary technology, either protected by patents or process research, or because its moved down the learning curve and has learnt to have a lower cost structure than the later entrants. The second possibility is that the incumbent has cheaper resources, like cheaper labor, than the entrants. Access to capital is almost never a competitive advantage. Another possibility is access to demand, i.e., having access to customers that my competitors dont have (a higher demand curve). Is that brand image? No its not, because in the case of Mercedes other car companies can reproduce the same brand image. What it means to say that I have access to demand that my customers dont, is that I have captive customers. The competitive advantage is not differentiation but its customer captivity. And that is the aspect of its brand that makes coca cola such a powerfully profitable company. Because theres habit, and drinking cola drinks thats reinforced by very high purchase frequency. Why habits are so powerful is something people dont understand: they are extremely powerful in sigarettes, theyre extremely powerful in toothpaste, theyre extremely powerful in cola, theyre not so powerful in beer. Habits in drinking cola are much more stable than habits in drinking beer, and this makes customers captive to coca cola. Trying to displace coca cola means changing those habits, which is expensive and difficult to do. The second thing that makes customer captivity is search costs. If you have a good relationship with a doctor or a professional services firm, going to a bad alternative is very costly: searching for a cheaper alternative is going to be very costly. So high value added, high complexity services are going to be subject to substantial customer captivity. And finally, for things like Microsoft there are just large switching costs, bacause if you switch and nobody else does you difficulties communicating, you have to learn a whole new system of operating instructions, and you have substantial switching costs. So the second source of competitive advantages is just customer captivity and is due to either habits, search costs or switching costs, and you can ask if thats characteristic of the company whose exceptional earnings youre paying for. The problem, though, with both of these sources of competitive advantage that is lower cost structure and customer captivity is of course that they apply to existing technologies and to existing customers. If those customers die, in the struggle for virgin customers or virgin technologies there are no competitive advantages almost by definition. So the sustainability of those two sources of competitive advantages is necessarily final. There is however one more source of competitive advantage: economies of scale (a cost curve that declines throughout its whole range, so the more gets produced the lower the cost per unit produced). Economies of scale have two characteristics: 1) by themselves theyre not enough to create a competitive advantage. If you dont have some small degree of customer captivity or a minimim customer inertia,when two people enter the market theyre going to divide the demand essentially evenly and the scale of the incumbent is going to be easily replicable by the entrant. So when we talk about economies of scale, we cant just talk about economies of scale, it has to be associated with something that prevents the entrant from matching the scale of the incumbent, and thats some sort of temporary or permanent customer captivity; 2) the market cant be too big relative to the necessary fixed costs: if effective scale is 40% of the market, so that to compete with the incumbent you have to capture 40% of the relevant market, that is a high barrier to entry. If the market is so big that you can essentially amortize all the fixed costs with only 2% of the market, then economies of scale advantages are going to disappear. Thats a sense in which globalization and large and fast growth is the enemy of competitive advantages and therefore profitability. But if you have significant fixed costs relative to the size of the market and you have costomer captivity, then you have economies of scale advantages. And they are wonderful to have, because they apply not just to the old technology or to existing customers, but also to the acquisition of new technologies and the acquisition of new customers. The best example to think

about here is Intel. Intel is 10x as big as AMD or Motorola; it has substantial customer captivity (if amd or motorola come out with a better chip, customers for Intel, who are the big PC manufacturers, will typically not all disert Intel for amd or motorola, because of the working relationships, because of the Intel Inside, because of their belief in the ability of Intel to supply large quantities reliably, they will wait for Intel. So Intel has customer captivity. That means that when Intel invests in the generation of chips it can expect, if it succeeds, to capture 90% of the market: Motorola, when it invests in the next generation of chips, if successful it can expect to capture only 10-15% of the market. This means that motorola can afford ony to spend 1/10 to 1/6 of what Intel does in pursuing the next generation of chips, and in that race who is inevitably going to win when Intel is spending 6 to 10 times as much as amd or motorola? So generation after generation of chips (on average every 18 months) Intel is always there producing either the best chip or a chip thats at least as good as its rivals, and that situation is not going to change. So a series of short, light competitive advantages, combined with economies of scale, translate into long term, sustainable competitive advantages. The same applies to coca cola for the acquisition of new customers. Coke has big economies of scale in distribution and bottling; plus it has big economies of scale in advertising (ads in tv and so on are fixed costs). They can expect to get a disproportionate share of the market of new cola drinkers. Just like Intel in the market for new technology, coke can afford to outspend its rivals (except for pepsi) by a factor of 6 to 10 to one for acquiring new customers. And if thats the case who is going to win the struggle for new customers? The answer is coca cola. So again, a demand advantage that otherwise would die as customers die, supported by economies of scale, translates into a demand advantage with succeding generations of customers. The striking thing is: what makes coca cola a powerful brand? Its not a quality image. It turns out that it is economies of scale, and these peculiar characteristics that cola drinks have of significant habit formation and customer captivity. But when you think of economies of scale, the critical thing is to ask: what is that constitutes scale? Is it just big size? An example. In the US the way insurance is provided is companies contract with a local HMO (Health Management Organization). The HMO signs up doctors, who are part of its network, and all the employees of that company have to go to one of those doctors. It turns out that HMOs have local presence, so if you live in the NYC metro area, 60% of the employees are signed up with a company called Oxford. Because of this, 90% of the doctors are signed up for Oxford. That means that Oxford has a lot more bargaining power and gets lower prices from those doctors. If youre a new company signing up, youre going to sign up with Oxford. On the other hand if you look at the USA as a whole, Oxford is a tiny company because its only in NYC. Aetna has a more widespread presence as it has 10% in NYC, 20% in LA, 10% in Chicago, and so on. Who has the economies of scale? Its Oxford. Not Aetna. Because each health market is local in nature: having a lot of doctors signed up in LA doesnt help if you live in NYC. The fixed costs of running tat system are determined by your regional footprint. And the same applies to retail where there are economies of scale in distribution, in advertising and in local hiring, but they have to do with local not national market share. Thats why when Wal Mart has come up against German retailers or Japanese retailers with large shares in particular markets, Wal Mart has done very badly. Wal Mart does well in markets where its dominant. Local markets where its dominant. So you have to understand what is the market size that determines fixed costs. In some cases (retail and medical care and most services) it is geographic: your infrastructure and advertising costs are fixed on a geographic basis, and economies of scale are tied to geographic scale. In some cases its product lines. If you think of the history of the PC industry, Apple tried to do everything and were in fact the dominant competitors. MSFT did only one thing, they concentrated only in one area which was operating systems, they dominated that, and then they extended at the edges of that adding application software. Intel concentrated solely in CPU chips. So its the particular product market that most often determines fixed costs. The bottom line of what constitutes good businesses is: good businesses are those where either captive customers or proprietary technology (these tend to shrink if they are all that there is) are combined with economies of scale (in the relevan market) so that they enjoy sustainable

competitive advantages. So if youre going to pay for above average returns on capital and earnings what youre going to look for is basically sustainable competitive advantages that look like one of these three but most importantly involve economies of scale. There are a small number of other competitive advantages. Sometimes the Government is your friend: there are not going to be a lot of new entrants into the sigarette business, that means that there are barriers to entry that have been erected by lawyers and governments and they can do whatever they want with prices. In financial services informational advantages are critically important, and are very often intrinsically related to scale. So there are other competitive advantages but they tend to be very specialized by industry. The basic competitive advanteges are proprietary technology, customer captivity and, behind them, economies of scale. And if you cant find them in your company thats making the excess earnings or you doubt their existence, you probably are not going to pay for those earnings as if they were sustainable. Thats the basic theory. What Id like to do with the rest of my time is going through a cookbook about how for a particular industry you go about performing the kind of analysis that this theory of competitive advantages suggests. Youre going to start with a clear picture of what the industry looks like. Youre going to start with an industry map. If you dont have a clear picture of the structure of the industry youre going to get in trouble. Once you have identified segments in the industry, youre going to look at the industry history for those segments to see if barriers to entry existed historically up to the present time. Youre going to see if the evidence is consistent with the existence of barriers to entry. A classic case where it wasnt was Enron. Enron told a story of how they were going to dominate the markets in trading energy and bandwidth, but if you looked at their historical return on capital with all the lies they were between 4% and 6%. Such returns on capital are not consistent with enjoying sustained competitive advantages. So youre going to look at the history of the industry to see whether competitive advantages exist. Then youre going to try and identify the nature of the competitive advantages and youre going to see what that says about the appropriateness of managements strategy and likely sustainability of those advantages and future profitability. Im going to do this analysis for the specific case of Apple. Were going to start to think about Apple and whether this is a good business or not (this was 1999). If you look at that industry, start with just a list of potential segments. Chips, can be broken down into CPU chips and memory chips (for now lets keep the number of segments manageable, we can always expand the number later). Hardware, which is putting the machines together and selling them. Software, broken down into application and system software. Network providers. Components suppliers. So start with a manageable list of segments (5 is a good number). Once you have the list of segments, all you have to do is write down the firms in each segment, starting with the dominant player. For chips: Intel, AMD, Motorola, Apple (they made their own chips). For HW: Dell, HP, Gateway, IBM, Apple. For SW: Microsoft, Apple, Oracle. For Networks: AOL, Yahoo. So just writing down the names of the players is extraordinarily revealing. Looking at these sets of names youll notice that they have almost nothing in common, theyre totally different names. Therefore, youre going to treat each of these as independent segments. Youre going to analyze each segment separately, not worrying about synergies (if the names were the same, then you could think about combining them). If in doubt, when you have a manageable number of segments like these, treat them as separate industries. For the purposes of Apple, were going to analyze 3 segments: chips, HW and SW. Then youre going to ask the question: are there competitive advantages, or have they been historically competitive advantages in these markets? There are two simptoms of competitive advantages: 1) stable, above average returns on capital, especially for the dominant competitor (if you look at Intel they returned about 25% on capital since the seventies: enormous even after stripping out excess cash; MSFT are about 20%; HW companies ROIC were historically lower and less stable: so it looks like that on the grounds of ROIC you have competitive advantages enjoyed by the dominant players in chips and SW; less so in HW); 2) if there are competitive advantages and sustained and high profitability, there also ought to be barriers to entry to sustain that profitability. Barriers to

entry are the same as barriers to firms within the market stealing share from each other, so you can look at share stability. The simplest way to da that is to ask: has the identity of the dominant competitor in this industry changed? Since 1985 the dominant competitor in CPU chips has been Intel. It hasnt changed at all. Since 1982 the dominant competitor in SW has been MSFT; it hasnt changed at all. However, if you look at the HW market, who was the dominant competitor in the early 80s? It was Apple. In 1984 it was IBM. By 1990 it was Compaq. By 2000 it was Dell. There is much less stability in those markets in the identity of the dominant competitor. The second simple thing to look at is just the history of entry. Has anybody successfully entered the CPU business since 1985? No. The same for SW since 1982. What about entrance in the last 10 yrs in HW? Dell barely existed at the beginning of that period. Same thing for Gateway. There has been lots of entry by Chinese players since then. But you can also actually do a direct calculation of share stability: you take 2 years, say 1990 and 1998, and see whats changed in the market shares of the top players. The average change in share for HW players within these two years has been 10.5%. This is a very high number. For cola players that same number is about 1%. For beer is about 4-5%. So the HW number confirms that there has been very little share stability over the years, high rate of entry and change of the identity of the dominant player. So if you look at chips and SW, theres high share stability and theres high profitability, and that certainly suggests that you have high barriers to entry. If you look at HW theres relatively low share stability and theres relatively low profitability, and therefor low or much lower barriers to entry. So it looks like in these 3 segments in which Apples operates historically theres been competitive advantages in chips and SW, very weak competitive advantages in HW, if they exist at all. Thats the history. If you want to project into the future you have to ask: can I identify the source of those competitive advantages? Are they understood by the firms and are they sustainable? If you think about chips: is there customer captivity? They are the PC manufacturers. Do they tend to stick with existing suppliers? Yes they do. Changing the CPU supplier is a very risky and expensive thing to do. There are substantial switching costs. So it looks like in chips theres customer captivity. Is there proprietary technology? Almost certainly not. Because if you look at amd and the other suppliers they seem to be able to come up with better chips, they just cant do it for very long and they cant break into the market. The technology is developed in research universities and institutes and its widely available. What about economies of scale? Theyre enormous in chip production: in the scale of the plants, in R&D, but especially in the development that goes into rising yields (process development). So you have strong customer captivity and huge economies of scale. Is Intel likely to continue to dominate the market for CPU chips? Very much so. In particular, in this market is Apple operating at a competitive advantage or disadvantage? The answer is: at a competitive disadvantage. They dont use Intel chips. In this particular market Apples has been operating at a competitive disadvantage historically and is likely to continue. Lets look at SW: there is very powerful customer captivity and not very strong proprietary technology in writing SW. What about economies of scale? Enormous: operating SW are a fixed cost business and on top of that there are network effects in that the more people use MSFT the more you have to use MSFT. Is this competitive advantage from MSFT likely to be sustainable? Yes, at least until somebody makes a computer that can seamlessly operate with SW that mimics windows thats not windows sw. Apple are on the wrong side of that competitive advantage: they have a small number of customers for their operating system but they cant put down the investment to catch up with MSFT. On the HW side: are you captive to any particulare HW supplier? Typically not. Every time you buy a new computer you shop around. Is there proprietary technology? No, these are simple assembly operations. Therere maybe some economies of scale in the Dell ordering system but typically the infrastructure cost it looks like its replicable by all the other big companies. If thats the case (history says that these competitive advantages are weak), our bet is that this is a level playing field. So in the 3 segments in which Apples operates (or operated historically), its operating at a competitive disadvantage in 2 segments, and essentially on a level playing field on the other segment. They recently started to utilize Intel chips and offer a windows environment on a Mac. Is that going to save them? Probably

not because now theyre just a commodity, like everybody else. So whats the history of Apple as a good business? Its a terrible business: its operating historically at big competitive disadvantages. If we went back to look at the segments in more detail, you would see that if we broke up SW into application and system SW, and in particular we looked at desktop publishing, where would Apple stand in desktop publishing? They would have been dominant. They were also dominant in education. Are they likely to save their position in education? No because if people are going to have to use windows systems when they have to go out into the world, ultimately they are going to have to be educated on windows systems. So that part of the market is gone. But what about in desktop publishing? Did they have captive customers there? Yes they did. Did they have economies of scale there? Yes they did. Did they have proprietary technology? Some. What should have been their future in desktop publishing? They should have dominated that market forever. But what happened, what did they do? They tied their desktop publishing software to their personal computers, where theye were operating at a competitive disadvantage. When we started this analysis they had about 90% of the market in desktop publishing. Today that same share is well below 50%. So if you have a competitive advantage and a management that understands it, you wanna protect that competitive advantage and not tie it to powerful competitive disadvantages or negative synergies in other segments the way Apple did. What about the i-pod? Is the i-pod going to save Apple? How should you think about that? Its a new market, so you dont have history. If youre interested in investing in new markets what do you wanna think about if you wanna think about potential competitive advantages? You have to think about the sources of competitive advantages. Are there captive customers for download equipment? No, theres an mp3 standard that everybody has. Are there captive customers for the distribution systems? No, anybody can work off any of them. So is there customer captivity to the i-pod? Probably not. Are there big economies of scale? There are fixed costs in the song distribution, but are they big relative to the size of the potential market? Theyre tiny: the sotware cost of the distribution system is small; lots of people can afford to crowd into that market. So there are probably not economies of scale. Are there proprietary technologies? Do they have any technology that anybody else doesnt have? The answer again is no. If thats the case, what is the i-pod ultimately going to look like? Like any other product in consumer technology. Unless they can generate customer captivity and significant economies of scale relative to the size of the market (and the same btw goes for google. In google you have a history of search engines displacing other search engines), i-pod is not going to create competitive advantages for Apple. Ultimately, therefore, if youre paying a lot for Apples current earnings, and in addition youre paying a multiple because you think theyre going to grow, my advice to you is: lots of luck! So if you do all this I think you can have a good understanding of the competitive advantages that make a business a good business. When you invest on an earnings basis, that is if you buy franchise value, which is the situation where growth has value, or you hire investors to do that for you, it seems to me the most important characteristics that you want in growth oriented investors is a good understanding of competitive advantages.