Capitalize For Kids Investor Conference – Sahm Adrangi (Kerrisdale Capital) Interview

This post contains a few words on ‘Capitalize for Kids’. At the end, please find a link to an audio interview with Sahm Adrangi of Kerrisdale Capital – a speaker at this year’s ‘Capitalize for Kids Investor Conference’.

The author of this blog is completely independent to both ‘Capitalize for Kids’ and ‘The Hospital for Sick Children’.

 

Introduction

Jeff Gallant (a reader of this blog and Associate Portfolio Manager of Alignvest Capital Management) is the co-founder of ‘Capitalize for Kids’ – a Canadian not-for-profit initiative which is about to host it’s inaugural global investor forum: the ‘Capitalize for Kids Investor Conference’.

The goal of Capitalize for Kids is to bring the investment community together at an annual event (taking place in October this year) centered around great investment ideas and in doing so, provide support for the ‘Hospital for Sick Children’ – one of the largest and most respected pediatric health-science centers in the world. With a staff that includes professionals from all disciplines of health care and research, SickKids provides the best in complex and specialized care by creating scientific and clinical advancements, sharing knowledge and expertise and championing the development of an accessible, comprehensive and sustainable child health system.

For more information on ‘The Hospital for Sick Children’ please visit: http://www.sickkids.ca

 

Details about the Conference

This year’s conference features an all-star line-up: Sahm Adrangi (Kerrisdale Capital), Lee Ainslie (Maverick Capital), Chuck Akre (Akre Capital), Jamie Dinan (York Capital),   Larry Robbins (Glenview Capital Management), Marc Larsy (Avenue Capital) plus so many more. For the full list of names, peruse the brochure below or alternatively click on the tab at the top of this blog:

 

Capitalize for Kids Investors Conference-page-001

Click to view full size.

Please visit the conference website for more information: http://capitalizeforkids.com/

We wish Jeff and his team all the best for the conference and I strongly recommend everyone to check out the wider ‘Capitalize for Kids’ platform. This is a fantastic forum that’s supporting a great cause – plus, you get to brush shoulders with some of the best investors around… what’s not to love?

 

Sahm Adrangi (Kerrisdale Capital) Interview

Sahm Adrangi is the founder of Kerrisdale Capital and will be speaking at this year’s conference. Kerrisdale is famous for a lot of things (such as spotting the great Chinese reverse merger fraud of 2010-2011), however, I personally like to think of them as the fund that returned 200% in a year.

Now that you’ve managed to pop your eyes back in after reading that last sentence, here are some links that may be of interest:

(1) For a video outlining the philosophy behind Kerrisdale, click: here

(2) For a lesser known interview, once again with Australia’s The Intelligent Investor, click on the link below. This audio interview discusses some of Kerrisdale’s most (in)famous investments:

 

 Sahm Adrangi Audio Interview (11 July 2011)

The interview was produced by: The Intelligent Investor    (shhhhh….)

I’d Like The World To Buy A Coke – Reflections On The Most ‘Iconic’ Investment Ever

Whilst I was away, I received numerous emails. 80% of them related to a post that was accidentally deleted titled, “Midas Reveals His Touch”. Below is the full post restored exactly as it was (albeit, with much poorer scans):

Spoiler alert: the post contained a simple, back-of-the-envelope calculation using Coke’s 1988 reported results – the year in which Berkshire Hathaway bought it’s major stake. Berkshire’s investment in Coke is perhaps the most iconic ‘value investment’ ever made. For several months in the late 80′s, Berkshire bought 1/3rd of the volume trading of the most iconic brand on Earth and, a mere decade or so later, a textile-mill-turned-conglomerate from Omaha owned a stake in this global behemoth worth 10x the size of it’s initial investment (unadjusted for dividends or Buffett’s put option shenanigans!).

My early post (above) is a severely bastardised rendition of what really was value-investing’s equivalent of a symphony. To truly appreciate the several layers that went into the greatest lollapalooza of all time, one has to only read a speech by Charlie Munger entitled, ‘Practical Thought About Practical Thought’ (click here for link). Although far from Munger’s actual intent, my favourite investor (who shall go nameless) has called Charlie’s speech “the greatest stock write-up ever!”. In my opinion, this investor understates how good Munger’s speech actually is!

Given the recent (controversial) attention surrounding Coke’s management and Berkshire’s investment in the company, regular readers (there must be some!) may find the following article from our files interesting:

He Put The Kick Back Into Coke

It’s an lengthy article from Fortune magazine written in 1987, mainly detailing the genius of Robert Goizuieta (the man largely credited for creating the ‘modern day’ Coca-Cola Company). Interestingly: it’s written like a semi-investment-thesis, with a clear ‘BUY’ signal at the end of the report.

Two things that should immediately catch a reader’s eye: (1) the article is dated 1987, implying it was written at a time before Berkshire bought it’s stake (or, at least at a similar time) and (2) Berkshire’s annual letters are edited by Carol Loomis, Fortune Magazine’s Senior Editor…

…. to fill you in on the blanks: I’m guessing Buffett read this!

The Chiefs of Value – Two In-depth Interviews With Greenberg And Shapiro (Part 1)

Glenn Greenberg and John Shapiro of Chieftain Capital are legends in every sense of the word. Although now split into two firms, Chieftain – when Shapiro and Greenberg were together – had perhaps one of the best long-term track records of all time.

Their strategy was simple: unearth good companies at cheap prices, establish concentrated positions in them and sit on your hands whilst they compound in value. Nothing new. What the strategy lacked in complexity, it made up for in outperformance. From 1984 to 2000, according to Bruce Greenwald’s Value Investing: From Graham to Buffett and Beyond, the pair averaged a 25% p.a. gross returns. Not too shabby!

Whilst I’m unaware of Mr. Shapiro’s performance after the (unfortunate) split, I’m told by friends that Glenn is still trouncing the S&P, with returns north of 17% since inception (inception being the 80′s!). Greenberg is apparently close to Lou Simpson of Berkshire/GEICO fame too (another investor we have covered here).

Here is an article about the firms split: ‘Investment Firm Splits in Two Over Internal Rifts’

Below are two profiles of Greenberg and Shapiro during their heyday. It covers the periods of 1987 and 1988 – i.e. before and after some great stock market hysteria. It details their picks and the thought process behind each stock:

Chieftain Capital Profiles (Part 1) – 1987 and 1988

A Long Interview With A Short Seller – John Hempton’s Hunt for Scumbags

Given this blog’s semi-Australian-base, it was about time we injected some National Pride into our posts. As far as we’re concerned, John Hempton is a true National treasure.

After a long stint at Platinum Asset Management, run by Australian investment legend and billionarie ‘Kerr Neilson’, John Hempton set out on his own in 2009 to form ‘Bronte Capital’ – thereby also creating the always insightful (and often controversial) investment blog of the same moniker.

$10,000 invested in Bronte Capital at inception in 2009 would now be worth around $37,000. Who knew finding pests could be so profitable?

Although Hempton’s succinct and illuminating views are circulated widely, the man himself – and his incredibly successful hedge fund – remain somewhat a mystery.

Without giving any more away, below is an hour-long audio interview with John Hempton (from last year) conducted by ‘The Intelligent Investor’; an Australian stock-market publication:

John Hempton’s Hunt For Scumbags – 2013 Interview with the Intelligent Investor (click for link)

Copyright © 2014 Intelligent Investor Share Advisor

For more on Bronte Capital, go to: http://brontecapital.com/ (tell them how you were referred)

For more on The Intelligent Investor Share Advisor: http://shares.intelligentinvestor.com.au/ (don’t tell them how you were referred).

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From Barron’s Roundtable to Berkshire’s Roundtable – A Meryl Witmer Compilation

So far we’ve shared Lou Simpson and Ted Weschler resources, why buck our own trend?

Meryl Witmer shot to (even more) fame recently after being hand-picked by Warren and Charlie to join the prestigious Berkshire Hathaway Board of Directors. Interestingly, Witmer herself is a very seasoned and astute stock-picker. Meryl ran a successful eponymous asset management firm before joining other legendary value-investors at Eagle Capital.

Witmer is most visible as a regular member of the ‘Barron’s Roundtable’ – a yearly event/column run by the magazine that features stock ideas from value-investing’s “hall of fame”  (the column has featured the likes of Peter Lynch, Mario Gabelli and Bill Gross in the past… often alongside Witmer).

The file below contains a compilation of Meryl Witmer’s stock picks from the 2002-2014 period. Reading through this, two things become very apparent: (1) Meryl Witmer’s stock picks on average trounce the market and (2) Meryl Witmer is smart…. scarily smart.

Meryl Witmer – A Barron’s Roundtable Compilation (2002-2014)

Ted’s Brief Moment of Grace – An Early Interview with Ted Weschler

Ted Weschler is an investor I really admire (for obvious reasons). However, admiring an extremely publicity-shy, yet shrewd investor is incredibly frustrating.

In case you’ve been under an investment rock, Ted Weschler was handpicked by Warren Buffett to manage part of Berkshire’s investments. Weschler’s story and involvement with Buffett/Berkshire is insightfully covered here by our old friends at BusinessWeek (although, I hope the title of this article isn’t too auspicious).

Much has been written about his big winners: DaVita, DirecTV, Valassis and W.R. Grace.  Each one multi-bagged… and then some.

No bigger winner existed in Weschler’s fund than W.R. Grace. Weschler piled into the stock for less than $3 per-share. Today, 12 years later, it’s touching $100 per-share. A $30m investment was transformed into a cool half-billion dollar holding. W.R. Grace has a special connection with Weschler – it was where he landed one of his first jobs. He was also instrumental in it’s bankruptcy (did I forget to mention that W.R Grace was technically bankrupt for most of Weschler’s investment?).

Here is a brief, early interview focusing exclusively on Weschler’s Grace investment. Weschler talks about bankruptcies in general and his simplified valuation of the company:

Ted Weschler – an Interview on W.R. Grace (2002)

Pavlov’s Margins – Thinking, Fast and Slow in Business and Investing

I went to a broker-hosted management meeting this morning with a retailer* (for the usual reasons, I wont disclose the company).

I’m sure non-Australian investors engage in a similar thing too: a broker will wheel out the management team from a particular company in front of a few of their institutional clients. The management team’s hand is held by an Investor Relations person who has gone to the trouble of preparing a glossy ‘Highlights of the Year Presentation’ ahead of time, a document that’s usually long on ‘presentation’ and short of true ‘highlights’. Then, the institutional investors ask some basic questions, the answers to which could have been easily gleaned from reading the annual report. The whole affair is rounded off with an exchange of business cards and hot beverages are provided by our friendly broker (unfortunately, the only person from the company’s side willing to hand over their business card to us investors is usually the aforementioned Investor Relations person).

Sometimes, if a broker really wants commissions, a nice complementary meal is provided afterwards (these meetings are the ones I unashamedly and regularly attend). Sometimes the company will, in an amazing spate of coincidence, use this same broker down the line for a capital-raising or rights issue.

In the relatively few I’ve been to, I’ve never seen a management team forecast prospects downwards (why would they tour the country, informing every investor of the terrible job they are doing?). So, my tactic is always the same: take notes sparingly, listen for comments from management about competitors or the industry or emerging companies/products and observe what other investors are hastily writing notes about.

Occasionally – very occasionally, you get an unintentional insight into a business that you can only understand upon reflection after the meeting. That happened today…

Kahneman’s System I and System II

Daniel Kahneman is the father of behavioural finance. Surely, by now you’ve read his book, Thinking, Fast and Slow – if you haven’t, drop everything, go to Amazon right now and slap yourself after purchasing it for being so slow to obtain this masterpiece in the first place.

In summary, Kahneman states that most of our follies occur because the human brain has two ways of thinking: System I and II. System I is fast, automatic, emotional, frequent, subconscious and stereotypical. It’s the type of thinking we needed to survive as caveman in our prehistoric past. System I is purely instinctive. System II – as you will know, since you’ve now read the book – involves more effort, uses more logic and is, importantly, slower. System II is purely analytical.

The Value Investor’s System I

Investors often use this analogous System I way of thinking too. For value investors, the bias that effects us most arises from Pavlovian conditioning (click for the Wiki page if this term is foreign). Such conditioning has been ingrained into us through years and years of scanning for the ugly, cheap or overlooked. Low P/B, high dividend yield or low EV/EBITDA are all stimulant metrics that ring a value-investor’s Pavlovian bell, causing us to salivate at the opportunity.

This way of thinking isn’t incredibly dangerous to us. Often, our Pavlovian instincts prove to be right. Statistically cheap stocks have been shown to outperform the broader market. However, sometimes it’s flawed. It doesn’t pick up loss-making divisions for example. If one division is earning $12m in EBITDA and another division is losing -$10m in EBITDA, then an Enterprise Value of $30m (15x EV/EBITDA) isnt necessarily expensive. If management  shut down that loss-making division, you’d be left with a business generating $12m in EBITDA (for a price of 2.5x EBITDA).

Business logic has a Pavlovian element to it as well. For example, consider the words ’70% margins’. Anyone, including myself, would be drawn to this if they saw such a proclamation in an annual report. However, purely focusing on high margins misses out on a bigger picture too. For example, high margins are meaningless without considering the degree of operating leverage within a company or the cyclical nature of some industries.

The Gore and Glory of Our System II

Thankfully, both investing and business share a common System II way of thinking: accounting. Accounting is the intricate, logical language of business. Even the most grandiose business strategy must eventually unravel itself in a company’s financial statements. If a company’s is waxing lyrical about it’s “brand”, then it must turn up in the accounts somewhere. Perhaps the company’s yearly advertising expense is higher than competitors, or maybe it can acquire customers for less than competitors, or maybe it’s revenues per-unit (i.e. the average sale price) is consistently higher than competitors – whatever the reason, merely stating you have an ‘excellent brand’ without accounting proof simply isn’t good enough.

Accounting, as much it pains me to say this fellow non-accountants, is also insightful into human behaviour. Every transaction recorded and every assumption used is a gateway into a manager’s mind. If a manager aggressively capitalises an asset today, for example, this assumption must unravel itself through write-downs in the future. Whatever entry a manager tries to dress up today must undress itself tomorrow.

However, this System II way of thinking is hard to adopt for investors too. As an accounting autodidact, this lesson has certainly not been lost on me. Often, converting the nuances of business into what should be seen on the accounting statements over time is a slow, arduous and counterintuitive process.

Translation Issues in the Language of Business

This gets me back to today’s meeting with the retailers (finally… sorry about the convolution). The retailer’s management team boasted that their goal was to stay “the lowest priced retailer” within the particular market they serve. “So far, I think we’ve succeeded”, gloated the CEO glancing up from his deck of powerpoint slides. “As a company”, he continued, “our position is getting stronger as the dominant player within this market… we have managed to implement gross margin increases for three consecutive years. If we continue like this, rapid increases in profitability will hopefully follow”.

The institutional investor’s cheered, congratulating him on his valiant effort. I too was initially impressed – retailing is a tough business and improving margins in the post-bricks-and-mortar world is no small achievement. But it was only on the way back to the office that I realised a discrepancy (ok, I’m sure you’ve picked this up ahead of me).

Basically speaking, gross margins are your selling prices minus what it cost you to acquire the goods from your suppliers (mathematically; Revenue – Cost of Goods Sold). If your margins are constantly improving, then you are selling goods for more and more each year than what it costs for you to purchase them. If your sole aim is to offer customers the lowest prices in the industry, then you have to pass on whatever savings you negotiate straight to your customers. So, ideally, your gross margins should remain the same or decrease every year if you wanted to build a true sustainable competitive advantage.

Low cost retailers drive their gross margins down to the lowest level possible in an attempt to boost turnover. It’s ok not to earn much money per customer, but if you can get the most customers, then you can still be extremely profitable. This is why they often operate from massive, dystopian warehouse-like stores: they can stock more inventory per-square foot and spread their operating costs over a larger floorspace. The customer wins because such a store has the best prices. The shareholders win because the company uses its humungous floorspace, combined with its low-overhead per-square-foot, to drive massive amounts of volume through the store and, ultimately, this rockets it’s returns on capital through the roof.

Further, having the lowest costs drives more volume – since more customers are attracted to the store’s prices – more volume implies more haggling power over suppliers (ok, a lot more haggling power: click for link**). More haggling power, you guessed it, means lower prices still. This business model is an incredibly virtuous cycle.

The somewhat theoretical “lowest-cost retailer” statement from the CEO seemed cognisant of a System I way of thinking and the “increasing margins consistently” seemed completely devoid of any System II logic.

A (Small) Hypothesis Test

I didn’t believe myself (after all, maybe it was me using System I thinking). Could it really be that this retailer’s margin strategy was actually doing the opposite of what they desired? Then I found this graph plotting the margins of ‘the father of all low-cost retailers’, Wal-Mart (taken from www.studentofvalue.com):

WMT-GM

Click picture to enlarge

The top blue line is Wal-Mart’s (WMT) gross margin since it’s IPO. In WMT’s early years of rapidly growing dominance, gross-margins clearly remained stable or fell. If I told you ahead of time that by owning a company which dropped it’s gross margin every other year, Sam Walton would become one of the richest men in history, would you believe me? I wonder how many value-investors, forever swayed by their System I/Pavlovian bells, steered clear of this stock early on?

Interestingly, WMT’s margins started increasing rapidly from, say, 2002 onwards. This margin expansion occurred up until around 2010. Now, I’ve (unfortunately) taken enough statistics subjects in my time to know the difference between ‘correlation’ and ‘causation’. I also know that there are a billion influences on a company over time, but: eerily, between 2002 and 2010 (inclusive of the great market rally of ’03 to ’07) WMT’s stock went nowhere (unadjusted for dividends) as it’s margins increased over the same period.

Ok, enough conspiracy, my basic realisation is this: ‘improving’ margins don’t always mean ‘increasing’ margins… and ‘cheap’ stocks don’t always mean ‘statically cheap‘ stocks. Investing in a world of low-cost brokerage accounts, complex stock screening software, dizzying-Excel-spreadsheets, CNBC’s, Bloomberg phone apps and, dare I say it, investment blogs can often tempt us into relying on System I thinking much more than we realise. Maybe, more often than is actually done nowadays by us new and snobby value-investors, our portfolios would be far better off if we sat down, took deeper breaths, turned off our screens and used our System II tools before rushing out to buy the next low-cost retailer. “All man’s miseries”, explained Blaise Pascal, “derive from not being able to sit in a quite room alone”.

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*after numerous comments, I realise I may have been too vague/inaccurate in my description. This retailer was pursuing a low-price strategy in an “everyday low prices” sense of the word. The retailing industry commonly refers to this as a low-marup, high volume model. Sorry for any confusion

** this link in no way implies that the company I met with today is either Coles or Woolworths.

A Tiger Shows His Stripes – Two Historic Interviews with Julian Robertson

I like interviews with astute and legendary investors. I also love stock-market history. It should be no surprise, therefore, that historic interviews with legendary investors are of particular interest to me.

Julian Robertson is quite literally the ‘Grand-Daddy’ of the funds management world. Moreover, 1987 and 1989 were two monumental years in market and economic history. In this interview, Robertson introduces the ‘Tiger’ investment philosophy and frames some historic trades (including a lucrative, yet long-lasting Japanese Stock Market short):

Barron’s Interviews Julian Robertson – 1987 and 1989

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Whilst ’87 has often been focused on, personally: I’m just as interested in ’89 – the year in which the Japanese stock-market peaked. There have been many things said about the Japanese asset-wide bubble (and subsequent economic black-hole that followed), but there is one word in particular that I find the most interesting:

A (Few) Word(s) on 1989

Nihonjinron: perhaps more than any other, this word sums up the sentiment of the Japanese during their (now distant) economic expansion (which, arguably, begun in the late 1940′s). Nihonjinron, which essentially means “the theory of the Japanese”, refers to the academic body of investigations that took place at the time. These studies attempted to unearth the many reasons as to why Japan was so ‘unique’ and why its people/culture were so ‘superior’. Yes, it’s true: the Japanese literally institutionalised the proverbial ‘this-time-is-different’ mentality.

Over time, conclusions from such studies began to get more and more obscure. Some researchers even claimed that Japanese snow was far superior to American snow and, hence, suggested skis imported from the US (or elsewhere) would be of little use on Japan’s slopes. With this kind of asininity peculating from academia, it’s little wonder why the whole Japanese Stock Exchange was inoculated with similar beliefs (as we know too well, similar ‘academia-translated-to-stock-market’ follies are still widely prevalent in most parts of our financial world).

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‘Radioactive’ Investments – A Mental Model To Explain Many Business Models

This post is about how a single mathematical function can explain many businesses. Those that have done their math homework can skip straight to the “What the Hell Are You Talking About?” Section.

“Invert, always invert”

- Carl Jacobi, Berkshire’s favourite mathematician

Introduction

The quote above is from a legendary mathematician and holds the key to how many famous mathematicians think. It also happens to be Berkshire Hathaway’s favorite way of thinking.

Numerical fluency can help investors beyond just teaching us new ways to think. Patterns already deciphered by mathematicians several centuries ago are common place in business.

Enough jibber-jabber, let’s use an example.

One Mighty Useful Function

Anyone who took mathematics at university would have come across logarithmic functions (perhaps you learnt this in high school). To avoid evoking adverse reactions from insomnia sufferers, let’s skip the gory details (for those who simply can’t resist: here is a refresher). All you need to know is that logarithmic (/exponential) functions are special equations that explain how stuff grows and, just as interestingly, how stuff decays (believe it or not, I’m not a professional mathematician).

Given a rate of growth/decay, a time period and a starting point – these functions can tell you what values growing or decaying variables will take in the future.

Maybe an example will clarify? The most common exponential function should be familiar to all investors: compound interest. Think about a bank account: it has a starting point (the principal that you put into your account), a growth/decay rate (the rate of interest you earn and reinvest) and a time period (how long you leave your money in the bank).

Although today’s real interest rates may seem to suggest otherwise, bank accounts are a growing phenomenon. Logarithmic functions can also be used to model things that decay – i.e. things that are declining from their initial value at a constant rate. For example, this is the mathematical equation that dictates how objects cool (for those boffins that still can’t resist: Newton’s Law of Cooling).

Boiling water doesn’t go from 100°C to 25°C (apologies to our American readers) instantly. It decays in temperature over tiny intervals like this: 100°C  ->  75°C  ->  56.25°C -> 42.19°C and so on until it reaches 25°C – each time declining by 25% of its previous temperature.

Decaying functions also explain how radioactive materials work. Every ten years, for example, a radioactive substance may be half as strong as it was previously (hence, the term ‘half-life’) and then ten years later, it will be half as radioactive again. This is how scientists use ‘carbon dating’ to estimate the age of really old stuff (believe it or not, I’m not a professional carbon-dater).

What the Hell Are You Talking About?

“Ok”, your thinking, “all very interesting, but what do logarithmic functions have to do with my stock portfolio?”

Decaying functions are more common in business than many analysts notice. Think of a hypothetical newspaper operating in a small regional town in the 1970’s. Once this newspaper reaches a critical mass in their circulation, say 70% of this fictitious small town reads this dominant newspaper, their subscription rates (if left unattended by management) follow a somewhat decaying equation. Why? Each year, some small portion of that newspaper’s customers will stop subscribing to it: some customers will move towns, some will perish, some will have a change of preferences etc. Whatever the reason, each year there will be some slippage in their customer base.

In our example, let’s say 3% of the paper’s subscribers don’t renew their subscription the following year. This means that the newspaper in the following year owns 67% of the small town’s readership (70% – 3% = 67%). To maintain their monopoly in percentage terms¸ all things being equal, the newspaper now has to make up for this 3% deficit (by extolling the virtues of their ‘news hole’ to the rest of the unsubscribed population or by capturing new subscribers from those emigrating to the small town). To grow its subscriber base in percentage terms, it has to not only make up for this slippage, but the newspaper has to recruit even more, new customers on top of it. In our example, if the paper wanted a 75% market share, it would first have to make up the 3% natural decay in subscriber numbers and then win 5% more market share (ok, media analysts, this is a very simplified analogy).

This is more or less how all subscription-based businesses work: be it newsletters, Satellite TV companies, database owners (Morningstar, Bloomberg et. al.) or some other service providers.

Banking (Very, Very Simplified)

This principle also applies to mortgages. A bank’s loan book is also a decaying asset in a way. Loans are getting paid-off every day, thereby shrinking the size of the bank’s asset constantly. Banks, therefore, have to make up for this repayment rate through originating new loans or even through refinancing old ones.

The mortgage industry has a term for this; they call it the Conditional Prepayment Rate or CPR for short. The ‘CPR’ is the annualized percentage of the existing mortgage pool that is expected to be prepaid in a year – For example, if each year, 8% of a bank’s loan book prepays their loans earlier than scheduled, then the CPR is said to be 8%. The monthly equivalent to the CPR is the morbid sounding ‘Single Monthly Mortality’ rate.

Personally, I like the irony of the abbreviation ‘CPR’, as it can be thought of percentage of mortgages that the bank has to ‘resuscitate’ back in to their balance sheet to keep their assets more or less unchanged.

Predicting Profitability and Growth

Those of you who have managed to battle through yawns and keep their eyes open thus far might have realised that this has implications for the profitability and growth of such businesses. Newspapers during their Golden Era were not really impacted by this slippage at all. Whatever they lost in market share percentage, they made up for in price hikes. Given their customer captivity and large fixed-cost base, a 5% increase newspaper prices (the impact of which was felt mostly by advertisers within the paper) dropped straight to the bottom line.

Even today’s modern subscription-based businesses barely blink at the thought of customer-attrition. By definition, their customers are somewhat held captive in most cases. The services provided by some of these businesses (niche databases, mission-critical software etc.) are often essential to the customer’s livelihood. So ‘sticky’ are these customers, they often offer to pay in advance for such services.

For banks*, however, the mathematics works differently. To achieve profit growth (all other variables, like interest rates, being equal), a bank pretty much needs credit growth – i.e. has to make more loans next year than this year. Credit growth, by extrapolation, requires more borrowers or larger loans. Thereby, banking growth can be seen as a ‘give out more to get back more’ type of situation.

Now, fellow investors, you’re getting the picture: the worst time to buy a bank has often been when they look the most profitable – often coinciding with an analysts mindless extrapolation of previous profits in their DCF models.

This too explains why, as pointed out by economists like Hyman Minsky, today’s credit growth can lead to tomorrow’s credit decay. Add to banking’s ‘lose-some-then-win-even-more’ business model the aggressive leverage and poor reserving that occurs periodically in the industry. Now you can see why accelerated, industry-wide decay becomes a mathematical inevitability.   Some businesses literally are ‘radioactive’.

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Postscript: A reader of our blog (‘R Ray’) very astutely pointed out the connection between  the CPR rate in banking industry and the ‘Reserve Replacement Ratio’ (RRR) in the oil industry. Oil fields are a decaying asset too. Hence, the RRR measures the percentage of decaying reserves that are replenished by a given oil company. It’s a useful metric to gauge the industry as a whole, as well as evaluating projects/management teams on their ability to find prospects.

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Post-Postscript: Berkshire Hathaway was all too aware of the impact this slippage/churn could have on the profitability of their newspaper, Buffalo Evening News. In fact, one of the primary reasons for Buffalo News’ extreme level of profitability (as stated by Warren in 1983) was:

         "Both emigration and immigration are relatively 
         low in Buffalo.  A stable population is more interested 
         and involved in the activities of its community than is 
         a shifting population - and, as a result, is more 
         interested in the content of the local daily paper.  
         Increase the movement in and out of a city and 
         penetration ratios will fall."