Write a note

Whilst we can debate whether thought precedes language or language precedes thought, we cannot deny that language and thought are intertwined; the way you think influences what you say and how you say it, which again influences the way you think. Clearly, language is powerful, and we must be mindful of the way we use it.

Often, we unknowingly misuse language. We use words such as "like", "problematic", and "good", which add ambiguity to our statements. We also establish non-links between sentences to make arguments seem more bullet-proof. I have unconsciously included an example of the latter in the first paragraph, when I suggest that my preceding statements make it "clear" that language is powerful. This is unclear communication. This unclarity in language may lead to unclarity of thought. This could in turn be a self-reinforcing loop. This is dangerous.

For an investor, clarity of thought is of utmost importance: it is necessary to have a specific thesis, which you can constantly test and evaluate. This is because if one is unclear about the investment case, one is more likely to make decisions influenced by emotion. For example, one might hold on to an investment even as the company's thesis story fails to play out. Alternatively, one might sell when a risk we were previously aware of - and comfortable with - actually materialises. In both scenarios, the action may actually be right; the long term story may be intact in the former case, or the risk may be bigger than one perceived it to be in the latter. However, if an investor's decision is driven by emotion, it is a bad decision - regardless of the outcome.

In order to have clarity in thought, an investor must have clarity of language. This clarity of language can be achieved by writing. When we are forced to put concrete thoughts down on paper, we are forced to clarify what it is we mean, and be more precise in our thesis. This results in greater clarity of thought.

So, I urge you to "write a note".

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This post was inspired by my attendance of a seminar titled "Am I Helping Tyrants When I Say 'Like'? George Orwell and Alexis de Tocqueville on How Political Language Manipulates and Liberates" at Yale Young Global Scholars, PLE II, 2019. The following was the provided description of the Seminar:

Terry Smith's Investment Philosophy

Terry Smith is the founder and chief executive Fundsmith. This post will summarise his investment philosophy as presented in the above video.

Invest in good quality businesses

1. High Return on Capital Employed: Charlie Munger says that "Over the long term, its hard for a stock to earn a higher return than the business which underlies it earns."  This is because companies with a high ROCE (above their cost of capital) are increasing in value over time; meanwhile, businesses with a low ROCE are like melting ice cubes, whose value is being eroded. Thus, instead of investing in companies which seek EPS growth at the expense of ROCE, it is far better to invest in businesses that target high ROCE. The idea is that in the long-term, the company's capital allocation decisions are the only thing that will really matter. Franchisee businesses are great in this respect, as they rely on someone else's capital.

2. Sustainable Growth Resulting from Secular Trends: Companies which are growing can retain earnings and reinvest them at high ROIC. This allows investments to compound in value over time. Smith says that one must invest in businesses with compounding value instead of investing for dividend income. This is why he seeks to invest in businesses which are in sectors experiencing secular growth that results from consumerisation of people in the developing world, or premiumisation of consumers in developed markets. Alternatively, seeking to invest in businesses which can expand into white space, or which will benefit from demographic shifts is also likely to result in compounding value creation.

3. Moat: The high ROCE of a business should revert - eventually - to the mean. A moat (entry barriers), in the form of brand loyalty/trust, distribution and supply chains, and software helps protect the high ROCE of a good quality business. Businesses that make differentiated goods, whose consumption is a legal requirement, are also likely to survive. That being said, some moats are more easily crossed than others: patents expire, tangible moats comprising land or factories, for example, can be overcome easily with debt or cash, and businesses in rapidly changing sectors, are unlikely to have any moat at all. Companies that have operated in a sector for very long periods of time, and have never had to raise money often have sizeable moats.

4. Mr. Smith never invests in a company that needs his money. He looks for big private companies operating in the sector, which have never had to list; this gives him comfort about the profitability of the business.

Try not to overpay.

For Mr. Smith, this is a secondary consideration. He subscribes to the belief that “If a business earns a very high ROCE, even if you pay an expensive looking price, you'll end up with one hell of a result.” This is because a good company, which is growing in value will dig you out with time; meanwhile, a bad company with low ROCE, and negative growth will shrinks in value, burying you over time, even if you pay a seemingly low price. That being said, you still don't want to pay too much as you want a high rate of return. In addition, it is worth remembering that if you overpay for a great business you could lose money, and if you buy a declining business very cheap, you could make a lot of money.

Do Nothing.

It is important for investors to remember that you don’t need activity, you need results. This is because, inactivity often gets the best results, and “it’s awfully hard work doing nothing”.

Don’t try to time the market.

Mr. Smith says that there are two types of people: those who can’t time the market, and those who don’t know they can’t time it. Market timing is a futile exercise. It is better to identify good companies and then make long-term investments at attractive valuations.

Seek long-term returns.

The Tour de France has never been won by someone who won every stage. In fact, it is often won by people who never won a single stage. Investing is like the Tour de France. You are not trying to have the highest return in a given year, but the best return over a lifetime.

Good Corporations Benefit ALL Stakeholders

I have just completed a summer program at Yale University. At the Yale Young Global Scholars' Politics, Law, and Economics session, I had several discussions about the role of corporations in society. A number of individuals expressed strong views against corporations, and the profit motive. A common sentiment was that in order to seek profits for shareholders, corporations must abuse their workers' rights, and the environment they operate in.

Unfortunately, it is true that some corporations do mistreat their workers and their environment. However, I believe it is wrong to think that this benefits shareholders. Mistreating workers leads to dissatisfaction, poor customer service, and high worker turnover. Similarly, a company which destroys the local environment may face backlash from workers and customers in the community.  Over time, dissatisfaction and backlash kill a company.

Thus, seeking sustainable, long-term profits for shareholders and caring for other stakeholders aren't mutually exclusive - to me, the two are synonymous.

What is ESG investing? Does it work?

ESG refers to the Environmental, Social and Corporate Governance. ESG investors often evaluate companies solely on a range of ESG metrics, and allocate capital to companies with "high ESG scores". Over the last few years, "ESG funds" have outperformed "non-ESG" ones. Consequently, they have gained popularity, with ESG-focussed asset managers receiving record inflows of capital in 2018, and Q1 2019.

I have attended two lectures - one at Columbia University, and another at Yale - about ESG investing in order to understand the reasons for its rise. I frequently hear people saying that being ESG-investing generates better returns. I partly disagree with this statement.

Just because you invest based on ESG scores does not mean you will necessarily generate better returns; ultimately, all that counts is that you buy businesses for less than they are worth. That being said, I do not believe that an evaluation of a company's ESG standards is futile. Indeed, I advocate considering how a company thinks of Corporate Social and Environmental Responsibility; a company which is fulfilling its responsibility to its employees, and attempting to reduce the negative effects of its operation is likely to be better managed. And, a better management is likely to create more long-term value for shareholders.

Thus, I wish to suggest that ESG should be one of many factors that drives a capital allocation decision. Having tweaked the layman's definition of "ESG investing", I can say that there is no such thing as ESG vs. non-ESG investing: all investors must consider ESG standards when evaluating a company. 

Insider ownership is great, insider control is less so.

As an investor, one feels comfortable when founders/executives have a significant portion of their net-worth in their company’s stock. This is because it indicates that they believe in the company’s future success. This also ensures that their interests are aligned with those of minority stakeholders. Indeed, the fact that Mr. Howard Marks’ income was entirely from his stock holding in Oaktree Capital Management was a source of comfort for me when I invested in the company.

However, in some companies (generally tech companies, and nowadays in other newly listed companies) founders are not only personally invested, but they control the company through controlling stakes, or shares with supervoting rights. This has its positives. Firms with such ownership can take a longer-term view and not succumb to the short-term performance pressures exerted by the capital markets, which tend to have shorter investment horizons than those required by businesses investing for the long term. However, total control is a double edged sword and can also be dangerous. This is because when one/few individual(s) has complete control over a company they cannot be held accountable. Thus, their decisions receive less scrutiny and less challenge. Furthermore, the controlling shareholders could act to serve their personal interest at the expense of minority shareholders. For example, they could engage in related party transactions that may destroy value, or even sell the company at low valuations, whilst securing a better deal for themselves. The latter may well have occurred in Oaktree’s sale to Brookfield, in which I feel that minority investors received less than intrinsic value, while the management team will be bought out over a longer time period, and appears to have a potentially more favourable deal. It was frustrating to have trusted the alignment of my interests with Mr. Marks’, only to realise that super voting shares meant interests were not completely aligned after all.

My conclusion is that controlling founder ownership by visionary entrepreneurs is often a positive attribute of an investment. However, we must be keenly aware of the risks as interests are not completely aligned.