Thinking as a business owner – part II

As I said in my previous post, in theory, we, as long term investors, should all think as business owners. As the teaching of Ben Graham and Warren Buffett, it is right to think we own a piece of a business, instead of own a piece of paper with a price that crawls up and down on the wall street stock chart.

However, I would also argue there are reasons for regular investor who can’t think a business owner. And there are mainly two reasons: lack of information, and lack of control.

First, only a small part of information was disclosed. Sometimes it is to prevent a leak of business secrets and giving advantages to competitors, but more often it is to avoid scaring the investors. However, without complete information, investors are becoming more scared, as we all know the most scary thing is always the “unknown”. Once you get complete knowledge, you can handle it.

Managers often blame wall street analysts (representatives of investors) care quarter-to-quarter results too much. Why do they care so much about quarter-to-quarter fluctuations? Did they know that the business is never meant to have stable straight-line growth every 3 months? It is only because investors are constantly live in fear (generally), and they are prepared to run if things don’t feel right and hopefully they can run faster/earlier than the other longs.

If their knowledge level is comparable to insiders, they wouldn’t be so scared. Sometimes, even after the management told the investors about certain facts, they still get scared, because they don’t fully trust the words of management, since they get cheated from time to time.

Lack of information is one thing, but even if they have all the information, they are not in charge. Can they really stop management from doing stupid or selfish things when the board is on the side of management? (They often have relationships with management, and plus they are getting paid by management.)

So what is the answer to these questions? I think this brings something not many long term investors have carefully thought about. Although these are fundamental issues, we do have ways to mitigate the risks.

1. We have to trust the management before we invest.

If you don’t know the management, or don’t have confidence in management, then you probably shouldn’t invest in that company at all, at least not a big investment. Or we may call it speculation, not investment.

It is hard to really know the management, especially for a small company. But we can always find as much information as we can. Check what the management said and did. If they rewarded investors, cautious on making predictions, not afraid of talking negative things and stay with their words, you can trust them.

With a good management, there will be plenty of pleasant surprises since the managers were cautious to begin with and didn’t set up too much false expectations. On the other hand, with a bad management, it is like sleeping with a bunch of rats, you never know what is going to get left afterwards. (Just think about Bank Of America in 2008)

Buffett said a good business works well even with a bad management, so many people only pay attention to the business, not the management. I think at least half of the bet should be on the management, since good business may survive an incompetent management, but it will not survive a management without integrity, always thinking about stealing from shareholders for their own benefits.

Although I like management to talk about the negative views or their mistakes in public, we shouldn’t take it too far and make it a mandatory requirement before invest in a company. Not everyone wants to directly admit their mistakes, and management’s public statement often has a material impact on the business. For the sake of business reputation, sometimes they are required to stay bullish. This is not intended to fool investors. However, if there are signs of too much hype, or too many failed promises, we should stay away.

One example is Sears’ Lampert. Investors all have to guess what he really wanted to do. Did he really want to turn around this hard-bleeding retailer? Or he wants to slowly liquidate the company? Or he wants to split it to parts, so he can reward the investors in some degree, and yet keep the main company afloat as long as he can, so he don’t have to be irresponsible for 250,000 employees. Maybe he wants to tell investors, but he can’t because that is too much impact to the business, the morale and to the partners/suppliers. In that case, I can understand him not being so straight forward, and I don’t doubt his integrity just because he wasn’t entirely open.

Still, if management is very honest, not shy to admit his/her mistakes, and very conservatives on promises and accounting, that is a huge plus! A P/E of 30 from an honest and conservative management might be equivalent to a P/E of 10 from an all-hype management.

If the management is competent, honest and conservative, you really don’t need to have control and full information on the company. All you need to do is to listen to what management says and act accordingly.

Unfortunately, that is probably asking too much. If we have to invest on a company with mediocre integrity, we have to spend a lot of time to monitor everything, verify what management says against facts, and adjust the expectation accordingly. The whole process is tiring and risk is significantly higher, but may still be worth doing if the value is very appealing. For bad management, you may need to require 4 times more value and still only able to commit a small speculative position.

In a private investment, we wouldn’t entrust a big trunk of money with a friend who is not completely trustable, perhaps we should do the same with stocks too.

2. Make sure the company has a board that represents shareholders’ interest.

If the manager owns a lot of shares, that is a very good sign. If not, at least the board directors should own a lot of shares, or they represent the people who own a big stake. In this way, managers will be monitored and influenced by shareholders.

3. Have enough due-diligent research.

Although a lot of information is not released to public, there is still a lot that is. From 10-K, internet reviews, forums, youtube, investor presentations, and information from competitors, you can find a lot of information that is not easily noticeable by other investors. Without a thorough understanding of the business, certainly there is no way to think like a business owner.

4. Don’t deal with companies that are too hard to understand.

If you feel the company is too hard to understand, or its financial statements are too complex, or its 10-K didn’t disclose a very important piece of information, you may need to stay away from it, or at least mark it as a big risk and give it a big discount. However, if you really trust the management, and strong believe their integrity and their words, you may give complete control to them, and let them take it over from you. In another word, invest solely based on their words and projections.

 

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