The Power of Simplification

May 30, 2008

One of the fundamental problems that every value investor faces today is that there are too many financial reports, too many SEC filings and too many models… but we only have 24 hours a day. In the past, I used to work so hard absorbing so much information and so much accounting footnotes and still end up somewhat confused in the end. I would have a cluttered file and a cluttered desk, and still don’t have enough information to make up my mind and place my bet.

On the contrarily, successful investors like Warren Buffett are the masters at the art of simplification. They have a simple framework, a clear focus, and a strict discipline. They focus on what is knowable and what is important. They ignore all the noise and smoke. They don’t get confused at too many unimportant readings and models. And that’s how they become extremely focused, extremely disciplined, and extremely successful.

The amazing power of simplification was discovered hundreds of years ago in Shaolin Temple, China. The Buddhist monks there learned that a simple and focused mind can propel the human body to produce amazing power and strength during Kung Fu fights. This discovery of theirs in the primitive science of human body would later become the foundation of oriental Zen training.

Value investing is the martial art of the mind. In my opinion, there are three basic steps in any discipline of mental art:

(1) Beginner’s Step: The mind starts with a thin and small book of basics.

(2) Advanced Step: The mind accumulates more and more details and becomes a thick and huge encyclopedia.

(3) Enlightenment Step: The mind penetrates and cuts across all the details, and boils down the thick encyclopedia back into a thin booklet pointing direct at the heart of the matter.

This mind process is similar to how we help our kids to solve puzzles: You start with one piece of the puzzle. You then collect more and more pieces. And finally you put together all the pieces to form one big piece from which you see the light.

Only after the third enlightenment step, can the mind start to see the big picture and become a master. The enlightenment or simplification step is what separates true masters from the rest of us. And there is usually no giant leap but a series of small steps and continuous efforts.

In our research meetings at Zenway.com, we always try to focus on the first step to point to the right direction and the third step to get back to the basics. It’s just like the powerful KISS principle in America: “Keep It Simple, Sweetie!”

With that said, we also have to remind ourselves of another Universal principle: the law of yin-yang, that is, there is a flip side to every issue. So in terms of simplification, we have to remember that everything should be made as simple as possible, but not simpler. Einstein said that, if he didn’t, he should.

So the details in the second step is necessary and important. But it is the capacity to simplify and focus that leads to master hood.

What do you think? I appreciate your comment via this web form. (Brian Zen, CFA)

Advertisements

How to Make 50% a Year like Warren Buffett

May 10, 2008

Warren Buffett achieved 50% return on small amount of capital during his early years. When asked about how he would try to do that again today, he shared the following tips:

Focus on things that are knowable and important.
Mr. Buffett wouldn’t care about a possible recession; He wouldn’t spend a minute thinking about it. The next 20 years should be good; He is in the investment game forever. He focus on things that are knowable and important. He doesn’t know how to forecast, it’s meaningless to him.

Win by playing your game or finding weak opponents.
Mr. Buffett looks at himself as a golfer. “We don’t know which holes will come and in what order, but over 18 holes, we will win by playing our game or finding weak opposition,” said Mr. Buffett. Look at See’s Candy, Coca-cola – nothing else is in your mind when it comes to candy or soda. Share of mind equals share of market.

Capitalize on small capitalizations and human emotions.
In 1998, people behaved like frightened cavemen (referring to the Long Term Capital Management meltdown). They will be frozen by fear, excited by greed and it doesn’t matter what are their IQ’s and degrees, etc. Growth of 50% per year is achieved with small capitalization stocks, not large caps. It’s just capitalizing on human behavior. It’s human emotion that creates opportunities when people are frozen by fear or excited by greed. Human behavior allows for success if you are able to detach yourself emotionally. (That’s where Zenway Retreat comes into the picture.)

Seek out publishers of stock information and look for various investment guides.
Go through every investment manual page by page. Looking at a copy of the 1951 Moody’s, on page 1433, there’s a stock you could have made some money on. The EPS was $29 and the Price Range was from $3-$21/share. On another page, there is a company that had an EPS of $29.5 and the price range was $27-28, one times earnings. You can get rich finding things like this, things that aren’t written about. Or you can look through investment guides on Korean stocks like Mr. Buffett did.

Look for simple things that can’t go wrong.
“In your investing life, you will have several opportunities and one or two that just can’t go wrong,” said Mr. Buffett. For example, in 1998 the NY Fed offered 30-year treasury bonds yielding less than the 29-½ year treasury bonds by 30 basis points, because Long Term Capital was trying to get out of a highly leveraged trade. In a situation like that, he would jump in with 75% of his networth if he had only a small amount of capital.

It is hard to stick to the basics everyday while finding nothing exciting.
Based on my personal experience with investing and Zen training, the key is to labor through the boring searches with unrelenting attention like a Zen monk day-by-day and suddenly catch the rare moment when other people’s attention is slipping away or they are distracted by the emotions and sensations at the time. It is only during those brief and rare moments when you will catch the Warren Buffett type of simple stuff that can’t go wrong. So sticking to the simple stuff is not easy. But if you try to be a little smarter, you may end up a lot dumber, said Mr. Buffett. At Zenway.com, we try very hard just to stick to what is simple and understandable. This alone is no easy feat since the human mind tends to wander.

Zenway is about doing simple things extraordinarily well.
Our Zen of investing is getting back to the basics, apply ancient tried-and-true mind empowerment techniques, and focus on doing simple things extraordinarily well. (Brian Zen, CFA)


From Wisdom to Wealth

March 10, 2008

ZENWAY.comWHO WE ARE

Zenway.com Inc., a New York-based registered investment advisory firm, specializes in helping successful people to create maximum amount of wealth with the least amount of hassles and taxes. With a team of investment experts, tax strategists, and financial educators, we help our clients to achieve financial success while enjoying longevity and peace of mind. Therefore, our name: A Zenway to Wealth and Wellness.
► We provide wealth management services on a discretionary and non-discretionary basis for both pooled partnerships and separate accounts. We focus on identifying the best investment opportunities that could make a meaningful difference in people’s lives.
► Superior research is our top priority. We do our own research and develop our own Investment Analysts and Strategists internally via a unique coaching and mentoring system, using proprietary and proven training methods to empower the money mind of every associate. Our zeal for research excellence even goes as far as training our partners’ kids and family members. We are fervent believers in maximizing God-given human potentials.
Research FocusWHAT WE DO

Wealth Creation: At Zenway.com, we focus on identifying opportunities that can create meaningful wealth to make a difference in the lives of our clients and partners.

Wealth Preservation
: We employ asset allocation models mainly for those whose priority is to preserve wealth.

Long-term Value Investing
: We take, and urge our clients to take, a long-term value-oriented approach to investing. We believe successful wealth accumulation requires the discipline to save, the courage to invest during the bad times, and the patience to sit through the painful yet inevitable market corrections. Investments in clients’ accounts are generally selected with a minimum three to five year time frame in mind, and all clients are encouraged whenever possible to adopt a minimum of a five year investment horizon for investment funds managed by us.

Downside Risk Management
: Our philosophy is to help our clients to build wealth with peace of mind. We accomplish that by vigorously analyzing the downside rick of each investment. Our first goal is to preserve capital on an individual investment-by-investment basis by focusing on a company’s net asset value and sustainable earnings power while trying to buy its long-term growth prospects for free. We strive to put together a portfolio of individual investments that will (1) preserve capital if we are wrong, and (2) achieve a good return if we are something other than wrong. And we attempt to reduce the risk-factor-correlations between the different investments in the portfolio. We select stocks, bonds, mutual fund managers, etc, all based on this general philosophy of ours. We focus on limiting the downside risk defined as the risk of permanent loss of capital.

Areas of Operation
: We generally select investments within, but not limited to, three areas:
(1) Good growth business at bargain prices.
(2) Special situations and risk arbitrage investments that are event-driven.
(3) Asset plays, a diversified baskets of poor businesses at dirt cheap prices, often below liquidation value.

Good and Cheap: Our main strategy is to search for Growth-at-a-Bargain-Price. Buying good businesses at cheap prices is also known as “Magic Formula Investing” as described by Joel Greenblatt with an impressive back-tested record. We developed our proprietary Zenway Version of Magic Formula Investing. We try to find the stars or leaders of profitable industries or sectors. Study their operations and finances in exhaustive details. When those stocks are selling at a price below its worth because of problems of temporary nature, buy them in a large scale. In time, the market will re-recognize their quality and the price will rise.

This philosophy raises two important questions.
1. How do we identify a real star?
2. Why do star companies sell at prices well below their value?

How Do We Identify a Good Business?
At Zenway.com, we stick to the proven methods developed and tested by proven superinvestors. And in terms of proven investment methods, nothing is more so than the analytical methods introduced in the 1934 classic, Security Analysis, widely recognized as the Bible of Wall Street. Benjamin Graham, the father of security analysis, introduced the idea that stocks should be viewed as small parts of a business that’s for sale. He developed a system for identifying the value of a business based on measurable data. This system was later modified and further developed by Warren Buffett, the greatest investor in the world. Our Zenway investment system is based on the Old Testament written by Benjamin Graham and the New Testament written by Warren Buffett, supplemented by what we learned from our own experience and from superinvestors like Peter Lynch, Joel Greenblatt, and John Templeton, etc.

Why Do Wonderful Businesses Sell Below Their Intrinsic Value?
The markets are not efficient or rational. In fact, they’re emotional or manic-depressive. People (including professional investors) buy on the basis of fad, hope and fear. When great companies lose emotional appeal, their price fall–often well below that they’re really worth. We seek out these “undervalued” stars. The gap between price and value gives us a margin of safety, which protects our capital and limits our downside risk. We focus on fallen stars of the stock market. We dissect a company’s accounting data in great detail to make sure that those fallen stars are “real” stars with great economics and future profitability.


The Little Essay That Beats the Market

January 1, 2006

By Joel Greenblatt

I love movies. I hate reading movie reviews. That’s because I don’t like people telling me what to think, plus most reviews merely summarize the plot and give away the ending. That kind of ruins things for me.

Nevertheless, my plan is to ruin things for you. Luckily, we’re not talking about a movie. We’re talking about stock market investing. I’m going to tell you what to think, summarize the basic idea and end with a “magic formula” that can make you a better stock market investor.

So, what should you think? If you want to be a successful stock market investor, you should think about buying pieces of “good” businesses at “bargain” prices. Yes, that sounds simple, but if you actually could find a good business at a bargain price, wouldn’t it make sense to buy it? Doesn’t that sound like an investment strategy that should work!

The only problem is figuring out what’s a “good” business? Well, a “good” business is a business that can earn a high return on capital. What’s that? It’s a pretty simple concept really.

Say you own a store. In my recent book, The Little Book That Beats the Market, we used the example of a gum store (yes, a store that sells only gum–don’t ask!). Anyway, say that store costs $400,000 to build (including inventory, store displays, etc) and last year that store earned $200,000. This works out to a 50% yearly return ($200,000 divided by $400,000) on the initial cost of opening a gum store. This result is often referred to as a 50 percent return on capital. Without knowing much else, earning $200,000 each year from a store that costs $400,000 to build, sounds like a pretty good business.

But what if we compared that to another kind of store, say a store that sells only Broccoli (we called that store, Just Broccoli, for obvious reasons). What if it also costs $400,000 to open a Just Broccoli store? But what if that store only earned $10,000 last year? Earning $10,000 a year from a store that costs $400,000 to build works out to a one-year return of only 2.5 percent, or a 2.5 percent return on capital.

So here’s the tough question. Which sounds better–a business that earns a 50% return on capital or one that earns a 2.5% return on capital? Of course, the answer is obvious. You would rather own a business that earns a high return on capital than one that earns a low return on capital.

So, now we know what “good” is–a business that earns a high return on capital . But what’s cheap? In the book, we defined cheap as a business with a high earnings yield. What’s that? Take two businesses, one earned $300,000 last year, one earned $100,000. Both are for sale for $1 million. If we buy the first, we get an earnings yield of 30% ($300,000 in earnings divided by the $1 million purchase price). The second has an earnings yield of 10% ($100,000 in earnings divided by the $1 million purchase price).

Which is cheaper? All other things being equal, the company that earns more relative to the price we’re paying is cheaper than the one that earns less. In other words, getting a 30% earnings yield is better than a 10% earnings yield–a high earnings yield is better than a low one.

And that’s it. Now you know the “magic formula”! What do I mean? Well, in the book we show that if you just stick to buying “good” companies (those with a high return on capital) but you buy them only when they are available at bargain prices (when they have a high earnings yield), you can more than double the market’s average annual return. And you can do it with very low risk.

Having trouble believing that it’s that easy? Well, how about this? A study we conducted over the last 17 years shows that holding a portfolio of stocks with the best combination of a high earnings yield and a high return on capital produced over 30% annual returns vs. just 12% for the overall market during the same period (see Table 1).

Table 1. The Magic Formula in Action
  Magic Formula Market Average S&P 500
1988 27.1% 24.8% 16.6%
1989 44.6 18.0 31.7
1990 1.7 (16.1) (3.1)
1991 70.6 45.6 30.5
1992 32.4 11.4 7.6
1993 17.2 15.9 10.1
1994 22.0 (4.5) 1.3
1995 34.0 29.1 37.6
1996 17.3 14.9 23.0
1997 40.4 16.8 33.4
1998 25.5 (2.0) 28.6
1999 53.0 36.1 21.0
2000 7.9 (16.80) (9.1)
2001 69.6 11.5 (11.9)
2002 (4.0) (24.2) (22.1)
2003 79.9 68.8 28.7
2004 19.3 17.8 10.9
  30.8% 12.3% 12.4%
Note: The “market average” return is an equally weighted index of our 3500 stock universe. Each stock in the index contributes equally to the return. The S&P 500 index is a market weighted index of 500 large stocks. Larger stocks (those with the highest market capitalizations) are counted more heavily than smaller stocks.

Over 17 years, earning 30% a year means $11,000 would have turned into over $1 million! Not bad.

But what if we made it even easier for people to follow the magic formula? What if we created a free website–magicformulainvesting.com–that made finding “magic formula” stocks completely automatic? Would that convince you to try it yourself?

Actually, maybe not. With me being such a blabbermouth, if everyone “knows” the “magic formula” maybe it will stop working? After all, how can any strategy keep working if everyone follows it?

Well, here’s the answer. The great thing about the “magic formula” is that it isn’t that great! It doesn’t work all the time. That’s right. Over long periods of time, it’s true, the results are amazing. But…there are still 1, 2 and even 3 years periods when the formula doesn’t work at all! Most people just don’t have the patience or the discipline to stick it out during those tough periods. After a year or two of following a strategy that underperforms the market, most people simply give up!

That means for the “magic formula” to work for you, you must “believe” that the formula makes sense and that it will continue to work over the long term–even if it hasn’t worked for months or even years. For that, you’ll have to understand why the magic formula makes sense. You’ll have to continue to believe that it still makes sense even when friends, experts, the news media, and Mr. Market indicate otherwise. That’s tough to do! Unfortunately, to really “believe”, I mean really, truly “believe”, you’ll have to be convinced that buying above average companies at below average prices actually makes sense. I believe it does. I hope you “believe” too.

If you do, I know you’ll become a more successful investor. But darn if I didn’t just give away the ending.