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Author: ponch73 One star, 50 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 41633  
Subject: Re: Breaking Radio Silence (Part I) Date: 5/17/2006 7:19 PM
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CONFESSIONS OF A LONG-TIME LURKER (PART II)

1. Visual Examinations of the Mouths of Gift Horses.

In the past year, there has been some pointed skepticism relating to BMW's motives, intellectual honesty and scientific rigor. While cautious skepticism is an important hallmark of investing (what Hemingway would have described as his “BS detector”), I ask the skeptics to consider BMW's motives (as you would with any management team of one of your stock investments). What does he have to gain by sharing his method with us? It certainly doesn't help his own investment returns to share a proprietary advantage broadly. What is his upside? Selective adulation? Free trips to Charleston and Cincinnati? And even if you disagree with the merits of his investment “method,” would you agree that there is at least a benefit to having a respectful ongoing discourse with him? Investment opinions are just that, something that we should not forget. I don't want to speak for BMW, but it seems to me that he believes that the mere recognition of the existence of the assumptions underlying his approach will aid your investment results (just like the recognition of the existence of subatomic particles improved scientific discovery). I would most certainly agree.

2. BMW Method and Due Diligence.

You can't have one without the other, and, in my humble opinion, the amount of discussion devoted to the latter on this Board is lacking (with some notable exceptions). I should also point out that I personally believe that BMW is especially gifted in the common sense department (e.g., knowing the cost-side economics of TE's business), and that gives him a leg up on ordinary investors in conducting due diligence. And it is his due diligence (knowing to buy MO and CAT back in 2000) that has significantly contributed to his impressive performance to date, a performance that may be difficult for a lesser being like me to emulate. While I would love to hear more about BMW's due diligence process on a particular stock, it may be difficult for him to fully articulate something that comes so naturally to him. To extend this point further, it is worth noting that just going back and reading all of Buffett's annual reports for the past 20+ years would not confer upon me the ability to equal Berkshire's results in the public markets.

So as to not be hypocritical, I wanted to pepper my long-winded opinions with a little text on what I consider an effective due diligence effort. Comments and criticisms are welcome.

One of the challenges of professional investing is the tyranny of false precision. It is not possible to know everything that is ultimately knowable about a company. Nor is it, in my opinion, necessary. The key is to come to an educated big-picture conclusion with some reasoned due diligence (usually that can be completed within one day). The following is not an exhaustive list, nor must every question on it be answered in extensive detail.

The Business

A. What is the business model? How does the company make money? How high-volume and repeatable are the company's unit sales (or are they low-volume, seasonal and/or lumpy?) What factors, secular or otherwise, drive customer demand?
B. How are revenues logically segmented? Can they be segmented by the different lines of business and/or by price and volume?
C. How large is the industry? What is the company's market share? How has this trended over time?
D. Is the company's business cyclical? If so, where are we in the business cycle?
E. What are the current factors weighing on or propelling the stock? Are these short-lived or more structural in nature?

Competitive Advantage

F. What is the company's durable competitive advantage (which we should expect to see manifest itself in durable cash flows)? Examples would include cost leadership in a scale business, dominant market share and associated network effects, high switching costs, barriers to entry (patents, regulatory benefits, proprietary technology), etc.
G. Does the company have any structural competitive disadvantages? Examples would include an operating cost disadvantage, stagnant or declining market share, inferior core product, etc.
H. Who are the company's competitors? How intense is the competition in this industry? How is competition expected to change over time? What are the relative market shares of competitors?
I. Do the company's customers or suppliers have disproportionate power or influence over the company?

Financial Analysis

J. Are normalized free cash flows (must exclude non-operating and non-recurring items like tax benefit from stock options, deferred income taxes, asset sales and business divestitures and must include cash outflows like capitalized costs) equal to or higher than reported or non-GAAP earnings?
K. What is the ratio of the company's enterprise value (market value plus net debt or minus net cash) to unlevered, normalized free cash flows (excludes net interest income or expense)? How does this ratio compare to the organic revenue and free cash flow growth rate of the company? How does this compare to similar ratios for the S&P 500?
L. What has been the 5-year trend in revenues, gross margins, operating margins (before amortization and non-recurring items) and net margins?
M. What has been the 5-year trend in diluted share count?
N. What does the balance sheet look like? What is the company's net cash position? How are current assets changing? Are receivables and/or inventories growing faster than sales? What is the company's debt load and associated ongoing interest expense?
O. How has the company been spending its cash flow over time? Stock repurchases to offset options dilution (not really a net repurchase)? Acquisitions? Debt paydown?

Management

P. How long is the tenure of current senior management? What is its track record?
Q. What is the composition of the board?
R. What are the stock holdings of insiders? Have any insiders been recently buying stock?
S. What is the compensation of senior management? Is manager compensation aligned with the interests of shareholders?

Shareholders

T. Who are the largest non-insider shareholders of the company? Is the list of the large holders dominated by a particular investment style – momentum/aggressive growth or long-term value?

3. You Can't Have BMW Without the M and W.

From my unscientific vantage point, it appears that the BMW approach works best with stocks that in addition to trading at or below their low CAGR-implied price have also recently exhibited a double bottom (or a “W”) pattern in their long-term stock charts. My back-of-the-envelope test for identifying the “W” is to pull up a Bigcharts.com stock chart incorporating all historical data. If I can see the W on that chart, it significantly increases my conviction. Conversely, a recent double top pattern in the long-term stock chart at or near the current low CAGR-implied price gives me some pause.

4. Why Applying the BMW Method is Hard

Aside from the obvious risk of investing in a value trap (or falling knife, depending on your vernacular), there are several other factors that make investing this way difficult. Ironically, this is exactly why the approach might be successful.

A. Fear and greed are primordial default elements of the human mind. It's easy to give in to the temptation of either. If a stock is down a lot, you perceive it as more risky because you start viscerally internalizing the risk of capital loss. If a stock is up a lot, you perceive it as less risky because you start viscerally internalizating the satisfaction of capital gain. But investing is not well served by either fear or greed.

B. We like positive reinforcement. I certainly have not enjoyed being recently told that I just “don't get it” or that I “lack heart” or that I am, at best, a mediocre investor. But investing with the BMW approach is contrarian business. By definition, it requires zigging when everyone else is zagging. And that's uncomfortable for our socially-networked minds.

C. We like success stories. Invariably, BMW candidates encapsulate stories of companies or managements that have lost their way, temporarily or otherwise. Or companies that are beset by unusual circumstances. Investing in these types of stories is not nearly as fun or as socially-rewarding as investing in glamorous growth stories. People much prefer to talk about Google at cocktail parties than fill-in-the-blank BMW candidate stock.

5. The Intuitive Appeal of the BMW Method

If you're anything like me, the BMW Method has an innate, intuitive appeal. It embeds the kind of common sense truth that you just sense in your bones to be true. Money is made not by following the crowd, but by taking significant, calculated bets when the odds are tilted in your favor. It isn't all that different from how a group of smart MIT students made a lot of money in the 1990's by taking a coordinated group approach to playing blackjack in the casinos. The BMW Method is also consistent with the sage advice of some of the most successful investors:

A. Investors with a longer investment time horizon are at a relative advantage to shorter-term, trading-oriented investors. They endure lower transaction costs and are less susceptible to counterproductive “market-timing” trades. With time on their side, they are more likely to benefit from short-term market inefficiencies (overreactions based on fear or greed) when they are establishing positions and more likely to benefit from long-term market efficiency (where stock prices converge with intrinsic asset values) when they are exiting positions.

B. Investors have an advantage in having more concentrated portfolios where they invest in fewer, higher-conviction positions than investors who “diworsify” and, by definition, begin to resemble the indexes that they are trying to beat. The real scarcity is in great investable ideas.

C. Investors with more concentrated portfolios have lower research and portfolio maintenance costs. You don't need to outsource the management of your portfolio if you're investing in fewer than 15-20 positions.

D. Value investing has consistently outperformed growth investing over time. Buying fundamentally-sound or stable companies when they go on sale because of short-lived conditions has proven to be a very successful historical strategy.

I hope this has been of some value to the Board.

Best regards,

Ponch73
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