Minneapolis Portfolio Management Group | info@mpmgllc.com | 612.334.2000
quarterly newsletter featured image

If you want to play the game, you had better know the rules

Market Summary – 1st Quarter, 2014

Michael Lewis may be the only man in the world capable of drawing the nation’s attention away from Russian President Vladimir Putin.

Mr. Lewis, the financial journalist and best-selling non-fiction author of Moneyball, The Blind Side, The Big Short, and Liar’s Poker has garnered national attention with his controversial statement that “the stock market is rigged” in his March 30th interview on “60 Minutes” when describing the subject of his latest book, Flash Boys. In Flash Boys Mr. Lewis exposes exchanges and intermediaries for permitting high-frequency traders (“HFTs”) – traders with faster internet connections – for front-running¹ customer orders. According to Mr. Lewis, this leads to the market being rigged in favor of HFTs at the expense of customers. By skimming a penny or a fraction of a penny off of each share in each trade, the cost appears to be insignificant. However, over thousands of trades a day HFTs are, in aggregate, skimming billions of dollars from investors. At the time of this publication (and likely spurred by the attention generated by Flash Boys), high frequency trading was being probed by the U.S. Justice Department, the Federal Bureau of Investigation, and the Securities and Exchange Commission.

q113 cartoonWe applaud Mr. Lewis for bringing this critical issue to the forefront. HFTs are a serious risk to the integrity of the market and one that we discussed back in 2011 in two separate newsletters². Given the gravity of the issue and timeliness of its nature, we are pleased to announce that Michael Lewis will be the featured speaker at our annual Speaker Series event to be held this summer. At that time Mr. Lewis will elaborate on his findings in Flash Boys, and address questions on this issue.

While Mr. Lewis may claim that the markets are rigged, we maintain that the ability to create wealth by investing through the stock market remains unchanged. The “little guy” has been at a disadvantage since securities first started trading in the 18th century. The combination of speed and technology has always been an advantage for professional traders. Consider the advantages to the professional trader brought about by the telegraph and later the telephone and the ticker tape. However, these advantages have never prevented the “little guy” from profiting considerably in the market, provided that they were long-term investors and not short-term speculators.

In essence, if you want to play the game, you had better know the rules.

The Rules of Value Investing, according to MPMG

If one hopes to make money by investing, one must know the rules by which to play so as not to put oneself at a disadvantage against the latest incarnations of Wall Street. Investing is a serious endeavor and the stakes are high. Success is critical in order to meet one’s lifetime financial goals. Regardless of the environment, the basic rules of MPMG’s unique value-based investment philosophy have remained constant and served our clients well. There is no super-computer or magic formula that one can use to find great investments. It takes a lot of hard work, research, and judgment – there are no shortcuts.

MPMG’s founding 20 years ago was based on a simple principle – successful investing should focus on company-specific analysis. Concentrating on what is happening in the broader market on a minute-by-minute basis is nothing but an expensive distraction. Since our inception we have experienced multiple bull and bear markets, economic expansions and deep recessions, and, recently, the near collapse of the global financial system. During each of these market phases we saw countless newfangled investment strategies and fads claim that they could outsmart the market, but ultimately failed to deliver. Shortcuts in life rarely, if ever, produce exceptional results. There is no substitute for buying a great business at an inexpensive price.

Over our team’s collective 75 years of investing experience, we have identified the following rules as a guide for successful investing.

Rule #1 – Price is everything!
Regular readers of our letters won’t be surprised that this rule, above all else, is considered the key to success. We’re convinced that it creates the best opportunity to build wealth. But it also protects investors from losses. Investing in a business after its stock has already plunged significantly reduces both the likelihood and severity of further precipitous price declines. If the business is sound and inexpensive, much of the market risk has been removed from the investment. Throughout our history there have been times when we’ve been content to hold a relatively larger cash position, not because we were safeguarding against a market correction, but because we could not identify enough attractively priced stocks that justified an investment. We do not invest our clients’ money without good reason.

Rule #2 – Invest in businesses that are unique and have a “moat”
Barriers to entry, similar to a moat protecting a castle, are an essential defense mechanism. They keep competitors at bay, and drive long-term and high-profit business. These barriers to entry may be in the form of a licensed or proprietary technology that customers need but few can provide. Alternatively, they may be found within businesses in old-line industries that may not have cutting-edge technology, but have insurmountable cost or distribution capabilities that make their business lucrative for them but uneconomical to others. A company with a moat enables them to produce difficult to duplicate products and/or services that distance them from the competition and protect earnings and growth for years to come.

Rule #3 – Capitalize on a changing world
To some people, change is hard to handle. But in our world, change represents investment potential. We’re interested in the big picture themes that are going to change the landscape of broad economies and of individual industries. Trends like the growth of a global middle class, the need for updated infrastructure across the planet, and the worldwide thirst for fresh water are all big picture developments that create investment opportunity. Each represents a potential breeding ground for outstanding, long-term investment returns. Investors should embrace change and be a beneficiary of it.

Rule #4 –Don’t walk the fence – construct a concentrated portfolio
Finding a good business that the market doesn’t appreciate and therefore is undervalued is extremely difficult. When you identify a great investment opportunity with limited downside, you should buy enough shares of the company so that you may benefit from your insight. Great investing requires one to be proactive and invest in a business before the rest of the market understands the opportunity. It’s nearly impossible to intimately know much more than 25 companies well (including their industry and competitors). Contrary to conventional wisdom, a more concentrated portfolio doesn’t increase your risk – it reduces it. Buying a good business that you fully understand at a low price is safer than owning 100 businesses where you possess only a tertiary understanding of the risks and rewards.

Rule #5 – Avoid the mob mentality
Humans are wired to find comfort in conformity. The seminal book by Charles Mackay about irrational exuberance and the grave dangers of the mob mentality, Extraordinary Popular Delusions and the Madness of Crowds, was published nearly two centuries ago. It documented among other things, financial manias in history, such as the Dutch tulip bubble of the 1600s. Yet mob mentality persists in investing (more recently in dot-com stocks, real estate, and bonds). Mob mentality leads to the cessation of independent judgment and discipline, which leads to fads that ultimately become bubbles. Many investors will seek to ride the wave of this momentum, but history has repeatedly demonstrated that excessive prices aren’t sustainable. Those that follow the crowd into overpriced investments cannot ride the momentum wave for long, and the losses that ensue are typically much greater than the temporary gains.

Rule #6 – Don’t erect artificial barriers to success
Too often money managers establish or hew to arbitrary rules to guide their investment policy. They may put a limit on the percentage that a single position can represent in the portfolio. Once that level is reached, they are compelled to sell some of the position, even if they firmly believe in the stock and its future growth potential. In other instances, they may pigeonhole themselves into a “style box” that precludes a large segment of the investment universe from consideration in their portfolios. Outstanding investment opportunities are few and far between. There’s no need to create barriers to owning them. We believe in seeking opportunities from every corner of the global marketplace.

Rule #7 – Exhibit Patience
Great investments are priced well below their true value because they are misunderstood or ignored by the market. It takes time for the crowd to catch up. Investors must learn to exhibit patience and be forever mindful that buying stock means buying a share of ownership in a specific business. No rational person would buy 100% of a private business and then expect to sell it the next week for a significant gain. Great opportunities often take time to develop. Value investing doesn’t work every second of every day; markets are not efficient. But over time the markets will recognize undervalued businesses and reward them with a fair (and oftentimes excessive) price. Valuation is to markets as gravity is to physics.

Rule #8 – Treat the market as a place to transact business
The market is a place to conduct the business of investing. It is where investments are acquired, not how wealth is created. Trying to outguess “the market” by using options, derivatives, and frequently trading your account in the pursuit of speculative and short-term profits is a fool’s game. These investors rarely last and, after paying for commission and taxes, they are often lucky to break even.

Rule #9 – Tune out the noise
It is easy to become distracted by the interestingly unimportant stories of the day. What is more difficult is to collect the relevant data points and connect these independent points in order to build a unique investment hypothesis. The news has its uses, but when it comes to successful investing the public consensus is typically wrong.

Rule #10 – Stay humble
As Phil Grodnick tells clients, “I have been doing this [investing] for over 50 years and I am going to keep working at it until I get it right!” Sometimes our investment theses don’t play out the way we expect. Sometimes we are wrong. The crime isn’t in being wrong, but in failing to remain open-minded and absorb new information objectively. Recognize when your investment thesis needs to be modified and act accordingly.

q113 book20th Anniversary Celebration – MPMG Welcomes Michael Lewis
If any writer can be considered the definitive chronicler of our investment age, it is Michael Lewis. While he started his career on Wall Street, he quickly found his calling as an author, beginning with Liar’s Poker, his exposé of the inner workings on life inside Wall Street’s powerhouse Salomon Brothers at the onset of the late 20th century go-go days. The book gave us our first taste of a writer with a unique ability to relate spellbinding true tales of extraordinary individuals as a way to help us better understand complex aspects of our world. Mr. Lewis did it again with his blockbuster that laid bare the mania that created the 2008 financial crisis in The Big Short. He documented further stories about that period in a compendium of his Vanity Fair articles titled, “Boomerang: Travels in the New Third World,” about the global debt crisis.

Mr. Lewis’ rare ability to weave powerful stories of rare characters in the context of the bigger world around them has extended beyond the financial markets. His other bestsellers include The Blind Side: Evolution of a Game and Moneyball: The Art of Winning an Unfair Game. Both were made into popular motion pictures (of course, the subject of Moneyball, Billy Beane, was our guest speaker last year).

And now, it’s Flash Boys: A Wall Street Revolt, as Mr. Lewis helps decipher what the sometimes-mysterious world of high frequency trading really means to the rest of us. He’ll talk about that and share his unique perspectives gathered from decades of journeying through America and the financial world. Mr. Lewis is one of the most visible and respected writers and commentators in America today, and we are honored to have him help us celebrate 20 years of MPMG at our Speaker Series event on July 31st. We are excited to bring Michael Lewis to Minneapolis and continue the MPMG Speaker Series tradition of fostering insight to the Twin Cities investment community. We expect this to be our most popular event ever.

~MPMG

Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.

The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.