Green Lumber Fallacy

I sometimes think of the Green Lumber Fallacy and how the trader thought that the lumber was painted green instead of being freshly cut, yet he traded it as a profession.

So let us call the green lumber fallacy the situation in which one mistakes a source of visible knowledge — the greenness of lumber — for another, less visible from the outside, less tractable, less narratable.

Argus Sour Crude Index was launched in 2009 as it served better than the Cushing's WTI which had deviated from fundamentals of the oil market due to bottlenecks in shipping. Refiners in the Midwest that no doubt Tesoro probably owned a few operated with a spread between the indexes and what they could refine to sell. I remembered that in 2010 era looking at the Brent or WTI prices to drop to allieviate margins as I was invested in Tesoro. I was not looking at the right thing possibly. My knowledge was not as encompassing as it should have been, but maybe the value was the replacement cost and the moat of an irreplaceable asset due to NIMBY. As Kirkegard said, "Life can only be understood backwards, but must be lived forward."

Streaks

I am not sure when do you know doubling down on a decreasing stock price is akin to "Gambler's Fallacy" and I will go broke doing that. I do know that in one study of 6,500 stocks from 1985-2024, the median drawdown was 85% and peak to trough took 2.5 years. Then again half of the stocks never recovered. In order to finish first, you must first survive.

Stories

Everyone likes a good stockstory. Go to any small town in the US and there will be plenty of DG stores. AZO and ORLY also seem prevalent. There are always those TSCO and plenty of ogliogopoly/monopoly lying in their wake. The real question is what is the next story.

Financials

The financial sector is the 2nd biggest sector in the SPX. I am not sure if I am fighting the last war though when trying to avoid it as the circle of competence does not include any of it. I lived through the 2008 and it seems everything can dissappear even if it's not your fault. The leverage is always necessary making the quality of earnings low. Then again, CM's two biggest positions at Daily Journal was BAC and WFC. The sub-categories I would brand financials into are Big banks: BAC, WFC, C, ALLY, Credit Cards/Payment Processsors/Fintech: V, MA, SYF, AXP, COP, DFS, PYPL, FISV, GPN, FOUR, Insurance divided into PC, reinsurance, specialty insurance, diversified into life/annuity, It is too hard to understand all the risks it has with its mismatching of assets/liabilities of borrowing long and lending short, counterparty risks, and unknown unknowns.

Original Sin

One of investing's original sins is summed up perfectly by the phrase: “past performance is not indicative of future results." That remains true in every facet outside of the value vs. growth one too. I lean too much towards "value" even if they are attached to the hip and fail to understand how important ROIC/ROC is vs. FCF. I know the Munger quote:

"Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result."

But knowing is not understanding. I am finally understanding with a thought bringing the numbers to an understandable limit. If a company has a fcf of 10% and just pays it all out in dividends, the return is 10%. If the company has a fcf yield of 10% and is rebuying stock with the free cashflow, you can compound at 1.1^n. If a company only has a fcf yield of 5%, but it manages to retain 50% while deploying at a ROIC of 30%, the return is 20%. Its fcf will grow .75% a year (30% of 2.5%). Its return is theoretically 5% fcf + .75*20 (.75 growth and 20 is the valuation of the growth) 15% for a total of 20%. Eventually the growth will be exhausted and its fcf yield will have to equal all the return as nothing can grow infinitely. The bond rate is a good rate to discount a company's fcf yield to. Until I actually used numbers to fill in the quote that I knew, I did not understand ROIC is not just a proxy for a durable competitive advantage, but can provide details about the future if its retained earnings can be deployed at the ROIC rate. It is easy to hunt for fcf yield, but combining it with ROIC will be measurably more powerful. I am starting to look at the distributors in the "real asset" space in FERG(plumbing/HVAC), MAS(plubmbing/paint), amd POOL(pool supplies). Their ROIC seem to be good even if their fcf are in the low single digits. I am not sure MAS can deploy their capital in the future as much as FERG or POOL even if its higher fcf yield makes it attractive. UNH might be getting interesting as healthcare is robust and a space that is not going away. NVO always stares at a patent cliff, but its ROIC is high as well. Again, ROIC might not be important though because if there is nowhere to deploy retained earnings, then the future dictates that only fcf matters as ROIC would be a measure of past employed capital.

Habits

"The chains of habit are too light to be felt until they are too heavy to be broken."

"We are what we repeatedly do. Excellence, then, is not an act, but a habit."

Buffett was able to compound his habits to generate 19.9% over 60 years at the helm of BRK for 5,502,284% vs. 39,054% under SPX. $1 would have returned 55,022 with Buffett vs $390 for SPX the last 60 years. The SPX return was 10.46% a year. It's so important to build the foundation/habits to insure a house will stand stable for many years. I am currently reading another book about Amazon in addition to the 3 I have read the last few years and have it ingrained in me that Jeff wanted to start with reading because it could develop the "habit" with the consumer. It's now the goliath that is a force like Berkshire has been. Maybe more so as it's the times with data, scale, and technology applied. The three books over the last three years are: The Everything Store by Brad Stone Working Backwards by Colin Bryar and Bill Carr Bezonomics by Brian Dumaine Currently, I am reading "The Everything War" by Dana Mattioli and have Amazon Unbound by Brad Stone on my list.

I Hate Bonds

Warren once said that bonds that were once "priced as risk-free return were now return-free risks." Yes, he might have changed his mind with the recent increase in yields to combat inflation by the Fed, but that statement has always poignant in my mind. I have always abhored bonds as "safe." I try not to be risk-averse or risk-loving, but risk-neutral. I think one day when I need to transtion to have some stability to anchor the portfolio, it will not be in bonds. It will be in stalwarts, but the downfall of UNH and PEP leads me to ask are they just like the bonds in the past. Risk is not knowing what you are doing. Maybe there will be a stalwart, but every portion of the portfolio should be a well-priced risk.

Scaled Economics Shared

Just finished a Greenwald piece on local strategy in HBR and he details how the two best advantages a business can have are customer captivity and scaled economics shared. Another way of saying it would be scaled economics shared. A bit nicer way to put the network effect/switching cost with scale. Strategy is how to respond to competition and what separates one from its competition with barriers to entry. I prefer to think of it as choices of what not to do as a way of inverting. https://archive.is/53ru5#selection-1585.577-1585.970

Just a Little Bit

Margins are very thin and not just with it being the Bezo's opportunity. In the 8 years from the start of 2017 to the end of 2024, the SPX compounded at 14.85% leading to 1 dollar becoming 3.03 dollars. The SPX is now down 13.54% after Liberation day and if you take away that performance from the previous 8 years, you will be left with 2.62 for a CAGR of 12.79% return. Nearly 2 percent of performance a year for 8 years wiped away. You still have to build that lead for the inevitable downswings at times. SPX had 5 days of >5% loss in 2008 and 2020. We have one this year, but Thursday was a 4.8%. All arbitrary, but inside the human minds, there are certain hurdles that mark milestones. Larry Fink claims in his annual letter that in a 30 year, the average pension outperforms a 401k by 0.5%. Compounded over 30 years, you will get returns of 17.45x instead of 19.99x assumming a 10% vs. 10.50% rate leading to 14.5% less in the retirement fund or 9 years of retirement. Charlie Munger always illustrated with 15% compounding for 30 years and paying 35% tax once or 15% each year and taxed 35% before investing again. It's the difference of 13.3% vs 9.75% return and over 30 years, what 3.5% does is a lot. Little things. On the Margin. A little late or a little slow.

Bounded Rationality

Sometimes it is better to just make a decision with just as much information as you have. From Bezo's 2016 shareholder letter:

Second, most decisions should probably be made with somewhere around 70% of the information you wish you had. If you wait for 90%, in most cases, you’re probably being slow. Plus, either way, you need to be good at quickly recognizing and correcting bad decisions. If you’re good at course correcting, being wrong may be less costly than you think, whereas being slow is going to be expensive for sure.

It is prudent to be patient, but a small starter position to learn more about a company is not the end of the world. Break problems down into managemable chunks and move fast and break things like Tech likes to live by.

Compounding and Consistency

It is amazing how much can be gained from preserverance and consistency as it compounds with time. Never unnecessarily interrupt compounding and just one step at a time and it will pile up.

Patterns

Munger's 3 ideas for fishing: spinoffs, 13fs, andshare cannibals Huber's three sources of returns 1. Revenue Increase Consolidation in industry leading to rational supply. This happened to semi-conductors as I once viewed it as simply too cyclical and a commodity. Pricing Power 2. Capital Allocation Asset-light Share buybacks leading to cannibalization 3. Rerating of Multiples Story stock Sentiment 3 Types of Investments: Stable, recurring cash-flowing companies that have high ROIC; turnarounds that may seldom turn around, and cyclicals. Invariant perception is what is the market missing and what I think about the value. It has to be bridged. I can be good at identifying it, but luck will be the arbiter in the short-term until the thesis plays out.

Heuristics

Is P/E a good short-cut? It measures the price of a stock as compared to its earnings, but it the metric could be very flawed. It measures the past year's earnings and there could be a lot of cyclicality in the industry so a low P/E is buying at the peak of the cycle. What has been true in the past will not necessarily be true in the future. And GAAP earnings is not cash flow. Is cashflow a better measure? It's better, but not perfect. What is the duration of the cashflow. What is the quality of the cash flow. How is the cashflow allocated. Is Return on Capital or its subsets of Return on Invested Capital or Return on Incremental Invested Captial a better measure? The returns should all trend towards that in the long-run, but it's more important to understand the why. Why are all these measures a good heuristic. They also don't exist in a vacuum and it has to be compared against opportunity cost and its risks taken. Rules are the guidance for the wise and the obediecne of the fool.

Profitable Companies and Where to Look

I am not sure what industries I want to concentrate on fishing as I am a generalist and still learning. The top profitable companies shown above are energy, technology, finance, healthcare, auto, retail, telecoms, and household products. The map is not the territory. That is just one year and gives no thought to the capital employed to achieve those profits and like Malone says:

“It’s not about earnings, it’s about wealth creation and levered cash-flow growth. Tell them you don’t care about earnings..” “The first thing you do is make sure you have enough juice to survive and you don’t have any credit issues that are going to bite you in the near term, and that you’ve thought about how you manage your way through those issues.” “I used to go to shareholder meetings and someone would ask about earnings, and I’d say, ‘I think you’re in the wrong meeting.’ That’s the wrong metric. In fact, in the cable industry, if you start generating earnings that means you’ve stopped growing and the government is now participating in what otherwise should be your growth metric.”

Like Malone, the masters that have influenced me most are Buffett and Munger, Lynch, Greenblatt, Pabrai, Berkowitz, Schloss, Bill Miller, Einhorn, Ackman, Klarman, Burry, Prem Watsa, Francis Chou, Li Liu, Zell, Howard Marks, Rochon, Chuck Akre, Tom Gayner, Nick Sleep and Qais Zakaria, Spier, Terry Smith. I will do well to reread and contemplate their ideas. And always there are many more beyond what I know and want to know. The things I don't know that I don't know.

Where to Fish

“The first rule of fishing is fish where the fish are.”- Charlie Munger

I think before thinking of a geographic region, a sector might be more fundamental. Terry Smith's ideas of fishing in the 3 sectors of consumer products, healthcare and technology is due to the enduring ROIC of those three. The enduring ROIC of those three is from its moat(s) that provide it with a competitive advantage and pricing power. My fondness for tangible wealth is silly at times and leads me to energy, material and cable companies. Those three sectors require a tremendous amount of capital expenditure and its pricing power is almost non-existent due to commodity cycles. Even cable as it works against the wheels of technology when access gets cheaper over time. This is compared to sectors I should look at with light-asset companies that have pricing power due to its structure. I need to get the structure right from the foundation of the building. It is hard to change habits though as evidenced by my infatuation in my portfolio with energy and increasingly material. It is difficult to know something about technology and medicine, but I can start learning from consumer products as I am a consumer. Medicine will need to be worked on and maybe I can see patterns from the two in technology one day.

Change

It seems like living in the past is dangerous even if they say history rhymes. It's fascinating how things change, but it seems that change itself is changing. The dominant companies are now even more dominant and have gotten there in only since the 2010's.

Three Types of Value Creating Companies vs. Value Destructing Companies

1. Can redeploy capital and grow it in early stages of building out such as Wal-mart or Amazon in the past. 2. Can redeploy some of the capital, but return the rest of it such as Lowe's. 3. Capital light and returns all of the capital such as tobacco companies or See's Candy. 1. Cannot reploy capital efficiently and needs more of it such as Berkshire's early mills. 2. A slowly melting ice cube such as cable stations in face of NFLX. 3. Does not have a satisfactory return on capital and has little or no prosect of future growth such as newspapers or B&N.

All One Long Game

It is all one long game. Calendar year performances are silly and I always think about the legendary Bill Miller streak and the arbitrary divisions of a calendar year. Miller quickly dismisses the significance of the streak: "Our so-called 'streak' is a fortunate accident of the calendar ... If your expectation is that we will outperform the market each year, you can expect to be disappointed."