Geoff Gannon On Warren Buffett's Concentrated Investments

This is the second part of Geoff Gannon's e-mail (refer here for the first part) and it largely discusses Gannon's thoughts on concentrated investing for a Buffett-like investor. Note that Buffett uses multiple strategies and when I say Buffett-like in this post, I'm referring to the 'buy & hold forever' strategy (generally this applies to concentrated holdings of wide-moat companies.)

I am going to quote a portion of my e-mail and then most of his response. Phrases in brackets are my comments; emphasis (bold) are by me. Nothing Geoff Gannon nor I say should be construed as investment advice suitable for you. There is some talk about Lexmark but the specific stock is irrelevant (pretend it was your favourite stock or something.)

Sivaram Velauthapillai: ...I'm looking at this more like a Buffett-type investment than a Graham-type investment. That is, I'm willing to pay way more than book value if it can sustain an ROE above, say, 15%...

Geoff Gannon's response:

Geoff Gannon: Very few businesses are so clearly good enough - predictable enough - that you can invest with confidence in the idea that ROE will exceed 15%. There are several problems with Lexmark in this regard that make it an unlikely investment for a concentrated investor. Most are not the fault of management or even that specific to the company.

One: it is in some respects a technology company. That is, technology is a competitive aspect of its business. As a rule, this means it will be less likely to have long-term earnings, cash flow, return on capital numbers that are easy to predict. Two: price is a factor in its products. Three: it faces tough, direct competition and in that sense does not entirely control its own destiny.

In general, the companies you want to buy if you're a highly concentrated investor are clearly wonderful businesses facing temporary setbacks. That is not the case with LXK. Lexmark performed well in a business that was not necessarily a great one. Think of my post on Energizer Holdings. That's the kind of business (batteries, razors, and now some other consumer products) where the #2 player can have very good returns on capital and where entry is very difficult. Lexmark is not in that kind of business.

If you look at the kinds of businesses Buffett usually buys, the truth is that multiple players in the same industry also have good returns. He owns Fruit of the Loom. It's basically a duopoly with Hanes (HBI). He owns Shaw carpets. It's basically a duopoly with Mohawk. He owns Coke and yet Pepsi does fine. He owned Gillette and yet that didn't mean Schick/Energizer couldn't do well.

There are some exceptions. But many of those were bought at Graham like prices. For instance, Posco (PKX). It was very cheap. Even with a company like Moody's (which he's been selling lately) or Burlington Northern Buffett saw that the competition wasn't really that scary. He tends to focus on industries in which everyone will do okay over time.

Look at some of his past purchases (like from the 1970s). Some are media names that no longer apply. He would never buy a newspaper today. Others still work. For instance, advertising agencies. If you look at their history very long-term they tend to be the kind of business you earn high returns on capital in as long as you are well managed, execute well, and don't make any dumb mistakes. The advertising business is hard to screw up in the long-run. Printers are not hard to screw up. PCs are not hard to screw up. And so on.

A good example of a temporarily challenged but essentially still a very Buffett like purchase is IMS Health (RX). That's truly a wide moat company. And it's certainly not very Graham like - it has a negative book value!

Yet that's the kind of business Buffett would own. These sorts of businesses are few and far between. I mention RX because it's still cheap, whereas most businesses of this quality were only cheap enough to offer large margins of safety before the market turned up in March.

Although it's true Berkshire bought LXK at one time, if that's the kind of business you're looking for (and especially if you're a concentrated investor) you shouldn't buy it. It definitely isn't the kind of stock you're looking for. What you're looking for is very rare and requires a lot of patience.

Don't look for stocks with as much uncertainty as LXK. These aren't the kind of stocks you can buy and hold for 5-10 years based on a Buffett like rationale.

If you'd like some ideas in that direction, I'd be happy to discuss those kinds of stocks. But from what I'm hearing from you I definitely think LXK is NOT what you're looking for.

I was thinking of injecting my own opinion into this but I don't have time to write anything detailed. All I will say is that I actually disagree with some of Gannon's thinking. For instance, I don't believe that one should rule out technology because it "appears" competitive. I'm influenced by Bill Miller's thinking—yes, I realize he is public enemy #1 in some circles ;)—that one should look at technology companies' market share rather than the products. That is, in technology, products constantly change but you will find that some companies, the ones with an actual moat, seem to retain their market share. Examples include Intel, Oracle, and Microsoft. If you looked at their products, most of whom will probably be obsolete within 5 years, you might assume that these companies have no moat. Yet, you would be mistaken, at least in my opinion.

On another note, do note that Gannon's response does not put much weight on qualitative factors specific to Lexmark (he mentions it casually though.) I think one really has to get the qualitative elements—particularly barriers to entry and strength of competitors—to be successful with a Buffett-style portfolio. For instance, Washington Post in the 1970's probably would not have seemed so great. Newspapers were a mature industry (if I'm not mistaken) and were under threat from television. However, as is quite obvious now, they had huge barriers to entry and various other characteristics not obvious from the financial statements. The market completely missed this. Washington Post actually became a safe Graham-type investment (price less than liquidation value) but even if it didn't fall so much, it would have been a pretty good investment.

Finally, one should keep in mind that they don't have to use Buffett-type strategies if you are looking at distressed or contrarian investments. The discussion above was mainly about Buffett-type strategies because those are the kind I'm trying to master. You can also use Graham-type strategies, which rely more on asset values, or macro strategies, which value investors consider as speculative (an example of a macro strategy, in my eyes, is someone who blindly bet on natural gas a few months ago because the price had fallen a lot and may have been below marginal cost of production.) In addition, although small investors can't invest like them, you can also look at private equity, hedge funds, and such, to get some ideas on investment strategies that may work. A good example of a contrarian fund in Canada is Onex (TSX: OCX), the private equity megafund run by Gerry Schwartz. However, these latter strategies depend on taking control position and essentially controlling the business.