The ScuttleBug Approach

How does one get a more accurate picture of the strength and weakness of a company?

Both Mary Buffett and P. Fisher talks about the scuttlebutt approach.

• Fisher : 'It is amazing what an accurate picture of the relative points of strength and weakness of each company in an industry can be obtained from a representative cross-section of the opinions of those who in one way or another are concerned with any particular company'.
  
  This is an investigative technique in which the prospective investor calls the competition and customers of a business and asks them about the company in question.
  
  Accordingly Buffett actually gets on the phone and calls the competition and asks them what they think of a particular company. All one would need to do is to spend some time in the library reading and make a few phone calls. Don't be shy. After all, it is your money, and if you are not willing to do at least a little work on your investment decisions, then it probably wouldn't be your money for very long. (M.Buffett, chapter 18, Buffettology)
  
  According to Fisher, the business 'grapevine' is a remarkable thing. And most people, particularly if they feel sure there is no danger of their being quoted, like to talk about the field of work in which they are engaged in and will talk rather freely about their competitors. Go to five companies in a industry, ask each of them intelligent questions about the points of strength and weakness of the other four, and nine of ten a surprisingly detailed and accurate picture of all five will emerge.

Here are some of my views.

The scuttlebutt approach ultimately gives us only the impression of a company's business. It's a perception which is not backed by any financial facts.

For example, a visit to any market would tell us that eggs sells like hot cakes in any market. But is eggs a good business to be in?

Now if we don't take a look at the financial data of the company itself, we would never know the true profitability of the business. For example, a look at any of the poultry financial data would only show that they are managed in a poor manner. Capex is spend way beyond what the earnings can actually bring in.

These stuff can't be known via scuttle butting alone.

However, on the other hand, if a company reports great set of earnings and let's assume that for example, company ABC claims that their products is generating million in sales. However if an investigative scuttlebutt approach gives one a totally different impression because the visits to ABC stores paints a totally different picture, a business that's rather quiet and worse still the stores salesperson compounds the issue more by issuing conflicting views by stating that business has been rather poor. So in this instance, the scuttlebutt contradicts ABC financial data. And if this is the case, shouldn't one have doubts over the company's financial data?

Speaking to employees is a good scuttlebutt approach but it has its limitations because the integrity of the employee is in doubt too! This is because all kind of folks exist and if we are not lucky, we could run into a big talker who gives us nothing but distorted information! Or what the possibility that the employee we talked to has a personal vendetta against the company? And what about the position of the employee? Is it safe to assume the higher the position in the management level, the more accurate the information we will get?

So for me, the danger of scuttle butting is the accuracy of our scuttlebutt itself. Just how accurate is our info? And not forgetting our own ability to decipher the info accurately ourselves.

In conclusion, I do agree that the scuttlebutt is a good exercise to do but it should not be abused, for it has its limitations. Meaning to say, I reckon that one should not base their investment decisions solely on scuttle butting.

Buying Opportunities

How does Warren Buffett define buying opportunities?

In her first book Buffettology , Mary Buffett wrote..

Warren believes that the technical mechanics of the stock market can create situations that will whipsaw security prices regardless of the underlying economics of the business. Buffett believes this irrational economic behavior can create situations that present excellent buying opportunities for the practitioner of business perspective investing, ie investing in excellent business selling at the Less Price.

This is slightly different than individual business aberrations or general business cycles created buying opportunities. This technical mechanics phenomenon is a quirk in the stock market infrastructure that occurs because of the ways and methods that securities are bought and sold. And combined with certain investment strategies such as portfolio insurance and index arbitrage, the stock market is always exploited in which the stock of an individual business becomes nothing but a commodity. Demand for the stock is then not driven by business values or economics but its demand is determined by the direction and rate of speed at which the price level of the whole market changes.

In which, this infrastructure problem can be the depature point of mass hysteria, in which people experience a great loss of wealth for no apparent rational reason, for they often panic and this selling their securities and staying on the sidelines until the market stabilizes. The panic exacerbates the severity of the situation, a situation that offers an opportunity for one to practise business perspective investing.

In a perfect world all the information about a particular company is interpreted and defined by two different stock market philosophies, in which one is short term oriented whilst the other long term. They, in turn, determine the market price for the stock of that company. Since the short term strategy is the dominant force in the marketplace and so will dominate the force that determine's the stock's price. And this is where the long term business perspective gets his or her buying opportunity.

In short, there are large forces at work that buy and sell huge amount of securities. And they couldn't care less about the economics of the businesses that they are buying or selling, for they treat as a commodity itself. And when to go bonkers, that is doing the total irrational things, like the stock market crash of 1901 and then the famous Black Monday of 1987, this always create wonderful opportunities in the stock market. And so it will happen again and again and again. Fools and greed go hand in hand which creates a field of opportunity for the rational.

In her other book, The New Buffettology , Mary Buffett spoke of the buying opportunity again, telling the tale of Benjamin Graham's Mr.Market again.

Benjamin Graham introduced Mr.Market to Warren. (see page 34)

Mr.Market had an interesting personality trait that some days allowed him to see only the wonderful things about the business. This, of course, made him wildly enthusiastic about the world and the business's prospects. On other days, he couldn't see past the negative aspects of the business, which, of course, made him overly pessimistic about the world and the immediate future of the businesses.

Mr.Market also had another quirk. Every morning he tried to sell you his interest in the business. On days he was wildly enthusiastic about the immediate future of the business, he asked for a high selling price. On doom-and-gloom days, when he was overly pessimistic about the immediate future of the business, he quoted you a low selling price hoping that you will be foolish enough to take the troubled business of his hands.

One other thing, Mr.Market doesn't mind if you don't pay any attention to him. He shows up to work every day - rain, sheet, or snow - ready and willing to sell you his half of the business, the price depending entirely on his mood. You are free to ignore him or take up on his offer. Regardless of what you do, he will be back tomorrow with a new quote.

If you think that the long-term prospects for the business are good and would like to own the entire business, when do you take Mr.Market on his offer?

When he is wildly enthusiastic and quoting you a really high price?

Or when he feels pessimistic and quotes you a very low price?

Obviously you buy when Mr.Market is feeling pessimistic about the immediate future of the business, because that's when you get the best price.

Graham added one more twist. He thought Warren that Mr.Market was there to benefit him, not to guide him.

You should be interested only in the price that Mr.Market is quoting you, not his thoughts on what the business is worth.

In fact, listening to his erratic thinking could be financially disastrous to you. Either you will become overly enthusiastic about the business and pay too much for it, or you become overly pessimistic and miss taking advantage of Mr.Market's insanely low selling price.

Warren says that, to this day, he still likes to imagine himself being in business with Mr.Market. To his delight he has found that Mr.Market still has his eye on the short term and is still manic-depressive about what businesses are worth.

Warren has discovered that to take advantage of the market's pessimistic shortsightedness, he must invest in companies whose economics will allow them to survive and prosper beyond the negative news that creates a great buying opportunity.

To do this Warren has to make sure that the company in which he is investing is not only intrinsically sound enterprise, but also has the economic ability to excel and earn fantastic profits. Warren isn't interested in the traditional contrarian investor approach of bottom picking.Only by selectively picking the cream of the crop is he able to recover, but continue upward.

Mary Buffett continues by telling the story of the two racehorses. Healthy and Sickly.

Think of it this way.

You have two racehorses. One, called Healthy, has a great track record with lots of wins. The other, called Sickly, has a less-than-average track record.
Both catch the flu and are out of action for a year.
The value of both shrinks because neither is going to win any money this season.
Their owners, intending to cut their losses, offer them up for sale.
Which would you want to invest your money in? Healthy or Sickly?

Healthy is clearly the best bet. First of all, you know that Healthy is usually a strong horse. Not only does Healthy have a better chance of recovering from the flu than Sickly does, he has a better shot at winning races (and making you tons of money) once he does!

Even if Sickly recovers, the horse will more than likely remain true to its name and get sick again and again. The return on your investment will be Sickly's health - poor.

And when put into business perspective, Mary introduces the reader the two categories of business. The healthy, durable-competitive-advantage business and the sick, price-competitive businesses.

Warren separates the world of businesses into two categories: healthy, durable-competitive-advantage businesses and sick, price-competitive-commodity businesses.

A company with a durable competitive advantage usually produces a brand-name product or occupies a unique position in the marketplace that allows it to act like a monopoly. If you want this particular product or service, you have to purchase it from the company and no one else. This gives the company the freedom to raise prices and produce higher earnings. These companies also have the greatest potential for long term economic growth. They have fewer ups and downs they possess the wherewithal to weather the storms that a shortsighted stock market will overreact to.
A price-competitive-commodity business manufactures a generic product or service that many other companies produce or sell and they competes for customers solely on the basis of price.

And some of the most common characteristics of a commodity business mentioned by Mary Buffett in her earlier book, Buffettology, are these companies operates on low profit margins, they have a low return of equity, lack of any brand-name loyatly, the existence of many similiar producers of the same product, excess production capacity of the same product in the same industry, eratic historical profits, and in some cases the profitability depends on the management utlization of its assets such as plant and equipment and not on such intangible assets as patents, copyrights, and brand names.

Healthy and Sickly

Taken from Mary Buffett's The New Buffettology

Warren has discovered that to take advantage of the market's pessimistic shortsightedness, he must invest in companies whose economics will allow them to survive and prosper beyond the negative news that creates a great buying opportunity.

To do this Warren has to make sure that the company in which he is investing is not only intrinsically sound enterprise, but also has the economic ability to excel and earn fantastic profits. Warren isn't interested in the traditional contrarian investor approach of bottom picking.

Only by selectively picking the cream of the crop is he able to recover, but continue upward.

Think of it this way.

You have two racehorses. One, called Healthy, has a great track record with lots of wins. The other, called Sickly, has a less-than-average track record.

Both catch the flu and are out of action for a year.

The value of both shrinks because neither is going to win any money this season.

Their owners, intending to cut their losses, offer them up for sale.

Which would you want to invest your money in? Healthy or Sickly?

Healthy is clearly the best bet. First of all, you know that Healthy is usually a strong horse. Not only does Healthy have a better chance of recovering from the flu than Sickly does, he has a better shot at winning races (and making you tons of money) once he does!

Even if Sickly recovers, the horse will more than likely remain true to its name and get sick again and again. The return on your investment will be Sickly's health - poor.

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Make sense?

So when a stock get bashed down.. do make sure that the stock's underlying business economics is still healthy. If one chooses a stock whose business is showing poor health, like clear deterioration in business fundamentals, then it is very likely the return of investment will be but poor!