Reading Roundup: December 2022

Capital Account, The Snowball, & Pizza Tiger

This month we read:

• Capital Account: A Fund Manager Reports on a Turbulent Decade, 1993-2002 by Edward Chancellor

• The Snowball: Warren Buffett and the Business of Life by Alice Schroeder

• Pizza Tiger by Thomas Monaghan

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Capital Account: A Fund Manager Reports on a Turbulent Decade, 1993-2002 by Edward Chancellor

Capital Account is a compendium of letters from Marathon Asset Management to its clients. The book covers the late 90s dotcom bubble and subsequent bust.

Though clearly written in a different era, Capital Account holds up to the present day. Just swap out telecoms for crypto and fiber for EVs and it will sound modern. Though our circumstances change, human nature never does.

Histories like Capital Returns are particularly valuable because they’re written without the benefit of hindsight. This is not revisionist history. It is easy to criticize the folly of the dotcom bubble in retrospect, another to offer a critique in real time. 

My favorite part of the book is the chapter about Marathon’s Capital Cycle Analysis (CCA). CCA is a mental model for understanding the cyclicality of investment returns that posits a reflexive relationship between stock market valuations (relative to replacement cost) and capital expenditures (“capex”) and investment.

Fiber internet is a common example throughout the book. If it costs X dollars to lay fiber but the stock market values it at some multiple of X (say 4X), then management has an incentive to lay more fiber so that their stock goes up and they get rich. Rich valuations will also incentivize venture capitalists to fund fiber startups and for new entrants to begin laying fiber.

Eventually all of this investment will lead to an oversupply of fiber. It will become obvious that all of these fiber projects are not earning attractive returns and the market valuation of fiber will plummet to X or some fraction of X (i.e. below replacement cost). When valuations are below replacement cost, no one has an incentive to invest. Why spend a dollar when the market will only value it at 50 cents?

Once new investment stops, demand growth can begin chipping away at the oversupply. As this happens multiples will rise, returns will increase, valuations will grow, and investment will resume.

The best time to invest in this cycle is when valuations are below replacement cost and demand growth looks likely to remove the oversupply. The worst time to invest is when valuations are above replacement cost and supply growth exceeds demand growth.

While CCA might sound a lot like Econ 101, there’s nuance to it. Georgia Pacific realized its industry was oversupplied and reduced investment. This strategy was sound but didn’t make Georgia Pacific a good investment because the company’s European competitors kept on increasing supply and depressing prices. Dan and I aim to avoid situations by this by focusing on oligopolistic industries with rational behavior.

Likewise, after WorldCom went bankrupt it restructured and emerged from bankruptcy in a better competitive position than rival AT&T. Bankruptcy not only failed to reduce supply, but actually damaged better managed rivals. When a shipping company or airline goes bankrupt, the ships and planes don’t disappear, they only change ownership. Industries with long-lived assets are especially prone to prolonged stretches of oversupply.

Capital Returns is a classic text I’d recommend every serious investor read. It’s one I’ll certainly re-read. Unfortunately the book is out of print and hard to come by. Copies are going for $900 on Amazon right now. I found a copy at my local library and suggest you start your search there.

Matt

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The Snowball: Warren Buffett and the Business of Life by Alice Schroeder

The Snowball is a tour de force on Buffett’s life and business empire. It’s the most comprehensive biography written about Buffett, and author Alice Schroeder was given unprecedented access to Buffett, his family members, and his associates while writing the book. She spent over 2,000 hours interviewing Buffett and his constituents and reviewing his files and details his life from before he was born through 2009, when the book was published.

There are too many takeaways, both from an investing standpoint and a personal standpoint, to outline in a brief blog post, but here are a few of the lessons that stick out the most.

Inner Scorecard

Investing is an interesting game because every day there is a scorecard. Every stock you own either goes up or down and at any given time an investor can check their outer scorecard. There are major problems with this.

Having access to a constant outer scorecard often makes investors focus on short-term price movements and respond to the price of stocks rather than the fundamentals of the business behind the stock. This can result in buying or selling stocks at the worst time and based on emotions, not logic.

This also often creates a dynamic of FOMO that can be hazardous. During a speculative mania, investors observe other’s outer scorecards and see them getting very rich very quickly by taking outsized risks. Formerly rational investors may get sucked into the mania and end up getting crushed alongside everyone else when the mania ends because of their short term focus on an outer scorecard.

Buffett has an almost inhuman ability to resist any temptations to respond to a short term outer scorecard and maintains relentless focus on his inner scorecard. This manifests itself by Buffett only acting when he finds something sensible to do, not because he feels forced to do something. During the late-1990s Buffett did not participate in the dotcom bubble and pundits began calling him a has-been. For a number of years Berkshire’s returns badly lagged other indexes that were ripping higher. Of course, Buffett was vindicated by vastly outperforming the indexes for years in the early 2000s. We saw an almost perfect replication of this scenario over the past few years, when Berkshire stayed away from high-priced speculative investments, and lagged the market, and after last years’ bust is now far ahead of managers who participated in the recent bubble.

Buffett evaluates himself on an inner scorecard that includes paying sensible prices for great businesses, treating his shareholders as partners, and running his business in a conservative and rational way. As long as those boxes are checked, his inner scorecard is fulfilled and he feels no pressure whatsoever to succumb to the wishes of outsiders.

Ultimately over long time periods the outer scorecard matters greatly. You will be more likely to get the results you’re looking for on the outer scorecard by focusing on your inner scorecard. As Buffett says, “games are won by players who focus on the playing field –- not by those whose eyes are glued to the scoreboard.”

Two Steps Forward, a Fraction of a Step Back

Another theme that sticks out is Buffett’s ability to withstand failures. With the benefit of hindsight, and the best long-term record of virtually any investor, many people assume that Buffett has made hardly any mistakes and that everything came easy to him each step of the way. This is nowhere near reality.

Buffett and Berkshire had many failures along their march to success, including:

• Berkshire Hathaway Textile (the company’s namesake and original operating business) was not a good business and ultimately failed.

• Diversified retailing was another near disaster and Buffett was lucky to get his money back.

• Blue Chip Stamps caused a number of legal headaches, including a lengthy and stressful SEC investigation for Buffett and Munger, and was another business that eventually went to zero.

• Buffett nearly had to oversee the largest financial debacle on record when he was installed as interim Chairman of Solomon Brothers, but was able to reel the business in from the cliff.

• National Indemnity was swindled by a crooked agent and nearly failed under Buffett’s ownership, and General RE (by far Berkshire’s largest acquisition at the time) was a miserable investment for years after Berkshire purchased it.

These are just a few of the many setbacks and failures that Buffett and Berkshire faced over the years. One theme held constant; no single mistake ever came close to sinking Buffett’s ship. Because he had a collection of great businesses and stocks that were purchased with a margin of safety, even the ones that did not work out were still not a disaster for the overall business. Additionally, it was critical that for any operating businesses that failed, Buffett was able to divert the cashflows for years into more attractive opportunities rather than reinvest in subpar businesses, which would have been akin to doubling down on losers.

At least equally important as Buffett’s ability to find winners was the remarkable feat that his losers never knocked him too far backwards.

Two steps forward, a fraction of a step back.

Dan

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Pizza Tiger by Thomas Monaghan

Pizza Tiger is the story of how Tom Monaghan founded Domino’s Pizza. The story is fascinating, filled with funny anecdotes and lots of specific details about how pizza is made and the company grew.

This book covers Domino’s from 1960, when Monaghan started the company, to 1986, when this book was published. I’d love to read a sequel about the subsequent 36 years.

Perhaps the most interesting aspect of this book is what it doesn’t discuss — interest rates, Fed policy, gold, inflation, war, etc. The ‘60s and ‘70s were tumultuous decades roiled in war, recession, inflation, and civil unrest. But none of that mattered to Domino’s. Monaghan kept his head down and made pizza. He made the best pizza he could and focused on making every single customer happy. That’s simple, but not easy.

Instead of macro, Monaghan talks a lot about the micro. I enjoyed reading about how he incrementally improved his pizza by acquiring better ingredients and more efficient machines. Monaghan also talks a lot about incentives.

That should be an instructive lesson for investors — the news and stock market pundits primarily cover macro issues while the most successful businessmen focus on the micro and incentives.

“Defensive Management” is the cornerstone of Monaghan’s style and one that is near and dear to my heart. Defensive Management means focusing on the day-to-day fundamental blocking and tackling. The idea is to play defense so well that the offense only needs to score once to win. If you avoid making unforced errors, all of the alternatives are good. I wrote more about winning by not losing back in October 2021.

The best example of Defensive Management is Monaghan’s obsession with Domino’s 30-minute delivery promise. If just 5% of a store’s orders are delivered late, that might come to 50 orders per week. 10% of late orders result in lost customers, which means the store is losing at least five customers per week. If you extrapolate that over 52 weeks in a year and multiply it by 26, the average orders per customer per year, it comes to 6,760 orders per year. That’s before considering lost orders due to bad word of mouth from disgruntled customers. It would take a lot of time and money spent on advertising to bring in 6,760 orders per year per store, which is why an ounce of prevention is worth a pound of cure.

Monaghan writes:

Defensive management means taking care of the business you have. I’ve always said that if you just take care of every single customer, your business will grow 50% a year. Make sure every pizza gets there in thirty minutes, make sure everyone is good — no burned pizzas and no raw pizzas — and don’t skimp on the ingredients. That’s it. You don’t need any sophisticated marketing programs. The solution is simple, and it’s right before your nose.

Monaghan came to his philosophy of simplicity by studying Ray Kroc and McDonald’s. He wrote, “McDonald’s is my model, and Mr.Kroc is my idol.” Domino’s focused relentlessly on simplicity in order to maximize product quality and efficiency. Domino’s went so far as to only offer a single size of pizza in some early stores and only Coke to drink. It didn’t have anything else on the menu. I’d love to know when and why Domino’s scrapped this policy. It worked well at the fledgling companies outset when the company had limited resources but probably wasn’t ideal for a mature company capable of handing greater complexity.

Monaghan struggled to convince outsiders — people who hadn’t worked in a Domino’s kitchen — that simple operations made the pizzas better, delivery faster, and profit margins higher. Eventually Monaghan quit recruiting outside franchisees. Domino’s required franchisees to have managed a Domino’s store for at least a year.

Though this book is 36 years old, it holds up well. It is easy to see the roots of Domino’s current competitive advantages in the company’s early years. For instance, Domino’s decided early on not to offer dine-in seating. That allowed stores to be smaller and cheaper, producing higher returns for franchisees and therefore producing higher unit growth than Pizza Hut.

You can also see the root of Domino’s current fortressing strategy all the way back in 1986. Monaghan writes:

“When we reach the point where all store service areas have been filled in nationwide, we’ll strengthen stores by moving them — a strategy that follows from the natural tendency for business areas to change over time. What was a hot area five years ago is likely to be on the fringe tomorrow.

We can use this phenomenon to our advantage by staying alert to trends everywhere we have stores and, when the time is ripe, splitting an area, moving the existing store into the center of one half, and building a new store in the center of the other half.

That strategy works even when there isn’t much change in an area, because a new Domino’s store always makes sales in an existing store stronger… divide and conquer — move your service closer to the customer.”

Monaghan even (briefly) mentions EVs and how they may someday make good delivery cars because they have fewer moving parts. That day has been a long time coming considering folks are still saying the same thing today.

I’d highly recommend Pizza Tiger to anyone interested in Domino’s, franchising, or who just enjoys business books. If you liked Shoe Dog, you’ll like this.

I stumbled upon Pizza Tiger while I was in the library checking out Capital Returns. Libraries are great for introducing a randomness into your reading. If you are reading the same things as everyone else, how do you expect to think differently? The internet rewards recency so it is hard to discover older but still relevant books. 

For more on Domino’s check out our posts on Domino’s and Domino’s UK.

Matt

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The Best Of The Rest

• Howard Marks: Sea Change

  • “The bottom line for me is that, in many ways, conditions at this moment are overwhelmingly different from - and mostly less favorable than - those of the post-GFC climate…the environment is and may continue to be very different from what it was over the last 13 years - and most of the last 40 years - it should follow that the investment strategies that worked best over those periods may not be the ones that outperform in the years ahead.”

• Ben Thompson: Consoles and Competition (Microsoft’s Antitrust Case)

• Graham and Doddsville Fall 2022 (interviews with Colin Haley and Chris Bloomstran)

• CNET: Could ChatGPT actually challenge Google someday?

  • The tool, from a power player in artificial intelligence, lets you type questions using natural language that the chatbot answers in conversational, if somewhat stilted, language. The bot remembers the thread of your dialog, using previous questions and answers to inform its next responses.

    It's a big deal. The tool seems pretty knowledgeable if not omniscient -- it can be creative and its answers can sound downright authoritative. A few days after its launch, more than a million people are trying out ChatGPT.

• Barron’s Jack Hough Likes T. Rowe Price

  • “Overall, [T. Rowe’s] funds beat their benchmarks in 73% of rolling 10-year time periods, versus 47% for other firms.”

• Chris Mayer: 100 Bagger

  • “All the commentary on individual quarters, the dithering around with pennies and nickels on earnings estimates, the chitchat on the recent stock performance, the macro talk on the economy… All of it looks pointless with the benefit of time. With every business there are a few key things to know. Call it the essence of the business, call it the beating heart, call it the core engine… something! Find out what those key things are and focus on them.”

• Neckar: Between Rest and Overdrive: Are Great Investors Lazy?

  • “An active investor aspiring to a long career of compounding needs to think carefully about managing their energy and attention, their stress levels, and the structures that support or undermine each.”

  • We wrote more about this concept in October 2022.

• Michael Lewis: Jonathan Lebed's Extracurricular Activities (Published 2001)

  • Lewis profiles a 15-year-old high school student from New Jersey that the SEC accused of market manipulation and fraud. Lebed was pumping his stocks on Yahoo message board in the late 90s and got caught. Lewis uses his signature wit and charm to craft a sympathetic narrative around the situation.

• NYTimes: Military Spending Surges, Creating New Boom for Arms Makers

  • “We went through six years of Stingers in 10 months… So it will take us multiple years to restock and replenish.”

  • “Congress this year has moved to allow the Defense Department to more broadly make multiyear spending commitments for certain weapons systems and shipbuilding operations. That is a provision that industry lobbyists have long pushed for, arguing it gives companies certainty that investments they make to start production will see continued returns in future years.”

  • “You cannot throw much more money at the seven shipbuilders that build U.S. warships in the United States of America right now,” Adm. Michael M. Gilday, the chief of naval operations, said this month during the Reagan National Defense Forum in California, referring to a $32.6 billion shipbuilding budget in the military authorization bill that is $4.7 billion more than the Pentagon requested. “Their capacity is about at max. And Congress is helping us max them out.”

• WSJ: Boring Was King of Healthcare in 2022

  • “The business of drug distribution isn’t the kind of thing that will get standing ovations at fancy healthcare conferences, but someone needs to move drugs from point A to point B. And it can get pretty complex, especially when dealing with biologic drugs such as cancer therapies, which must be handled with care (and where margins for distributors are highest).”

  • We wrote about McKesson in January 2020 and February 2021.

• Motley Fool: Interview With Value Investor Bill Nygren of Oakmark Funds

  • “I view the goal of the analyst as developing conviction that the consensus is wrong about something important.”

• Matt Levine: How Not To Play The Game (postscript to The Crypto Story)

  • “One imperfect but useful way to think about crypto is that it allowed for the creation of a toy financial system.”

• The Seattle Times: ‘Office Space’ inspired WA software engineer’s theft scheme, prosecutors say

  • A Tacoma man was fired from his software engineering job at Zulily after stealing hundreds of thousands of dollars from the Seattle-based e-commerce company using a scheme inspired by the 1999 cult classic film, “Office Space,” according to prosecutors.

• Nick Sleep: Thinking About How To Think

  • “If a firm’s relationships with its customers is profitable and enduring, then that will provide the cash flow to pay a decent salary to its employees, a fair price to suppliers, a dividend to shareholders, the tax people can have their take and, crucially, still leave something to reinvest in new and better products. A self-reinforcing virtuous spiral can be established.”

  • “Mistakes often result from overweighing an apparent short-term win, without fully recognizing the consequent, long-term cost.”

  • “Patience is a product of confidence and trust.”

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