Wednesday, February 15, 2006

Winning Wars And Losing Fortunes!

Selling Early Can Win Wars and Lose Fortunes!


According to a story passed down through many generations, more than 800 years ago in China, in the State of Song, there lived a man by the name of Zhang. He bleached fabrics for a living, which was tough work, especially during the brutal cold winters in Northern China when the gone-dry air rapidly cracked the skin on Zhang’s wet hands. An enterprising man, Zhang formulated a special hand cream to prevent his skin from cracking as he worked. His secret formula became well known in his land.

One day, as Zhang was working on his fabrics, a merchant by the name of Lu appeared at his door and offered hum 100 ounces of gold for his secret hand cream formula. Zhang had been bleaching fabrics his entire life. He had learned his trade from his father, who had learned from his father before him. They had always been poor, and the three generations of fabric bleachers combined had never amassed a fortune equivalent to this sudden offer of 100 ounces of pure gold. With this amount of money Zhang could feed his parents, his wife and his children for their entire lives, and there may still be some left over to will to his children when he died. So Zhang accepted the offer and sold away the rights to his secret hand cream formula.

It was winter, and Merchant Lu had a plan. He took Zhang’s recipe to the State of Wu, which was in the midst of a bitter war with the State of Yue. Merchant Lu made a huge supply of Zhang’s hand cream and presented it to the King of Wu. The King of Wu was on the verge of a grand naval offensive against the King of Yue, and immediately saw the advantage of Merchant Wu’s offer. Before the battle began, the King of Wu ordered his soldiers to apply a generous coating of Zhang’s secret cream to their hands.

Soon a fierce battle erupted. It was bitter cold and a strong dry wind blew from the north. The water was freezing cold and the soldiers fought spiritedly. They fought for three days and three nights before the battle eventually ended. The war was over because the Yue solders could no longer fight. Their hands were so cold and the skin was severely cracked and their flesh was so sore they could no longer wield their swords. They could no longer throw their spears. They could not even raise their shields. They had no choice but to surrender to Wu’s army.

King Wu had won a great victory. To show his gratitude to Merchant Lu, the King awarded him with 10,000 gold coins and a large estate worth more than 10,000 times the price he had paid Zhang for the secret hand cream formula only a month earlier.

What is the moral of this ancient story of Zhang? When Sun Tzu-style investors hone their skills to the point they can confidently identify a great business and bravely purchase the shares when they are safely priced below half the intrinsic value, they should be very reluctant to sell, even for what appears to be a sudden windfall profit. As your business gains momentum with improving sales and profit, there will be many a Merchant Wu offering you a seemingly tidy sum for your shares. Like poor Zhang, you may find that a short time later your hand cream company shares had escalated in value 10,000-fold.

Wait for the next release of financial results, investigate further to uncover new developments, and recycle each business back through your screening and valuation process with all new data before you make a hasty decision. Had Zhang waited just a few days to consider Wu’s offer, the anxious Wu would have likely made a much larger follow-up offer for Zhang’s secret formula in pursuit of a profitable deal with the King of Wu. Think carefully why the market is suddenly offering you a much higher price for your shares. Remember Master Sun’s discussion of the nine grounds, as an exhaustive re-assessment of your investment business, industry environment, and psychological conditions of the market can prevent you from costly early sales of fine long-term investments just beginning to blossom.

Learn to buy assertively when opportunity presents itself, but sell reluctantly and consider selling your losers first.


This great story is again taken from Curtis Montgomery's Sun Tzu On Investing.

This story reminds me of Warren Buffett's investment success in Washington Post ( see Using Our Advantage ) . Warren's success story in Washington Post was also mentioned by Montgomery in his book.

Here is Montgomery's version of Warren's Washongton Post success story:

The Washington Post

In 1971, Katherine Graham decided to take her family newspaper and publishing business public. Katherine Graham was respected as an independent leader, and just two days after issuing public shares, she gave the go ahead to publish the Pentagon Papers despite governmental threats. In 1972, the share price of the Post climbed steadily, from $24.75 in January to $38 in December. Although business at the paper was improving, the mood on Wall Street was turning gloomy.

In 1973, the Dow Jones Industrial Average began to slide. By spring, it was down more than one hundred points to 921. The Washington Post share price was down 14 points to $23. Gold broke through $100 per ounce, the Federal Reserve boosted the discount rate to 6%, and again to 6.5% by June, and the Dow Jones Index fell below the 900 point level. Meanwhile, Warren Buffett was quietly buying shares in the Washington Post, eventually accumulating 467,150 shares at an average cost of $22.75, a purchase worth US$10,628,000.

How did Buffett view the gloom and doom market that was driving the Post price to new lows? In 1973, the total market value of The Washington Post was $80 million, yet Buffett independently calculated the intrinsic value of the business at $400 million to $500 million. Cash flow produced by the Post in 1973 was:
net earnings ($13.3 million) + depreciation ($3.7 million) - capital expenditures ($6.6 million)= $10.4 million.

If the annual cash production of $10.4 million is divided by long-term Treasury bond yields at the time (6.8%), the value of The Washington Post Company reaches $150 million. Buffett believed capital expenditures would eventually equal depreciation, increasing the value to $200 million. Furthermore, he believed the unusual pricing power of a newspaper, a natural consumer monopoly, allowed earnings to grow faster than inflation, increasing the value to $350 million, and if profit margins improved as much as 15%, the value would rise to $485 million.

According to Berkshire Hathaway’s 2001 Annual Report, Buffett’s initial investment of less than $11 million in Washing Post stock had grown in value to $916 million, an astonishing return of more than 83-times the initial outlay, an annual compounded return from 1973 to 2001 of 17% before considering significant dividend income.


Warren identified the great business in Washingto Post and realised that it was selling at a large discount from its underlying business values. He purchased the stock some 33 years and he has held on to his investment ever since. An investment which grew from 11 million to about 1.3 billion! An annual compounded return of 15.58% for 33 years.

See how Warren won his fortune?

Btw.. for those that is interested... here is Washington Post's pretty pix..