Mental Model: The Profitability Factor

In 2012 Robert Novy-Marx wrote the paper The Other Side of Value:The Gross Profitability Premium. You could say that it is an attempt to test the hypothesis of Charles Munger and Warren Buffett that it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Novy-Marx measures profitability by using a ratio of gross profit to assets. Efficiency ratios such as the Du Pont analysis (asset turnover x profit) have been used for a long time in finance and accounting, but the unconventionality of his approach is by only using the cost of goods sold and disregarding other costs.

Looking at NYSE firms between 1963 and 2010 and international firms between 1990 and 2009 (ex-financials), Novy-Marx discovered that a company’s gross profitability did as good a job at predicting its future returns as conventional value metrics like book-to-market. More profitable companies today tend to be more profitable companies tomorrow.  Although it gets reflected in their future stock prices, the market systematically underestimates this today, making their shares a relative bargain – diamonds in the rough.

– The Mysterious Factor ‘P’: Charlie Munger, Robert Novy-Marx And The Profitability Factor from Forbes (June, 2013)


Mental Model: Spin-offs

A spin-off study – Chris Mayer (2005)

Spinoff Companies: Four Reasons Companies Spin Of

But before I tackle the reasons why this apparent inefficiency exists, let us consider the various reasons why companies engage in spinoffs at all:

1. To spinoff an unrelated business. Big unwieldy conglomerates that are involved in everything from insurance to restaurants may decide to separate an unrelated business to unlock the value in that business.

2. To separate a “bad business” from a “good business.” Sometimes a company with a profitable core of operations will spin off a laggard that is draining resources and management attention from the main group. Once separated, each of the businesses can stand on their own merits, often to the benefit of both.

3. To unload debt and/or other liabilities. Sometimes a spinoff will be loaded up with debt, freeing the parent company but leaving an overleveraged business in its wake. The spinoffs that have failed have often been of this kind. However, this maneuver can be lucrative for the parent company, as you might imagine.

4. To take advantage of tax benefits. A spinoff can qualify as a tax-free event and may be the most efficient way to pass value on to shareholders. If the company were sold outright, for example, the cash distributed to shareholders would be taxable. There are sound economic reasons for spinoffs, and this may explain their initial outperformance.

Think about it: You have a new company with a new, dedicated management team that is likely to be highly motivated. As Greenblatt writes, “Pent-up entrepreneurial forces are unleashed. The combination of accountability, responsibility and more direct incentives take their natural course.”

Curiously enough, as Greenblatt points out, the biggest gains from spinoffs often came in the second year, not the first. This indicates that perhaps it takes some time for the changes to kick in and deliver tangible results.


In Spinoffs, a Chance to Jettison Liabilities – Davidoff (2012)

“A spinoff is a product of Wall Street math that says one plus one can equal three. Yet as shareholders ofTime Warner may be about to find out, it can also be all about subtraction, as a company ditches an unwanted business, in this case, magazines.

The business argument for a spinoff is typically that a separation of the assets allows both the former parent and the newly independent company to be better run, freeing management to take bolder steps with the new company. And because Wall Street is a place where magic works, the market will recognize this, giving each of the separated companies a higher price.

There is evidence of this effect. Studies of spinoffs have found that they produce short-term gains, although these gains evaporate over the long term.”


Mental Model: Defined benefit pension plans

This is a dossier with resources and material regarding the valuation of defined benefit pension plans.

This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research

Pension Plan Calculator (spreadsheet provided by

Actuarial Methods and Assumptions used in the Valuation of Retirement Benefits in the EU and other European countries

Defined benefit audit techniques –

Robert Meegan (Northeast) a


Dave Harstein (Northeast), and Donna Prestia (CE&O), Reviewers

Stress Tests for Defined Benefit Pension Plans – A Primer – Gregorio Impavido


An Economist article on US public pension plans – Buttonwood

“Final salary pensions are a debt-like obligation, particularly in the public sector where the rights of pensioners are established in law (and even the constitution) in some states; there is an interesting case going on in Stockton, California, which may set the rights of creditors against those of pensioners. On corporate balance sheets, pension liabilities are discounted with a corporate bond yield. Falling bond yields have pushed up liabilities and widened deficits; hence many corporates have switched to defined contribution schemes. (Of course, the problem of low returns and falling rates dogs those schemes too, and are made worse by the low level of contributions that are made.)

This is NOT just a theoretical issue. If a company wants to offload its pension promise, or an individual wants to secure his pension by buying a fixed annuity, they find the cost has risen substantially.

But this doesn’t show up in the public sector. It uses the expected rate of return to discount its liabilities; since the expected rate of return is higher (7.5-8% is standard) than bond yields, it makes the liabilities look smaller, and reduces the apparent cost to taxpayers. The rationale for this approach is that pension funds can afford to take a long-term view and benefit from the returns on risky assets; contributions can be smoothed over the long term, avoiding any sudden jumps in employer (taxpayer) payments.”

Ryan Morris and the Value of the Activist Option

Ryan Morris of Meson Capital has been showing up on my radar frequently over the last six months (often through SumZero). From what I have read, he seems very capable and his write-ups have struck a chord with me. There is something about his approach that makes me think of the old Buffett partnership letters. I can´t really pinpoint what it is that makes me make the connection, but I think it is really his general approach. Morris is focused and and he looks for opportunities in obscure situations, often derived from misconception. But most importantly, if he needs to, he will get active.  It is my opinion that the ability to take on an activist role, can be highly valuable for an investor and I base this opinion on Warren Buffett´s Partnership letters.

In the Partnership letters, you can find two detailed accounts of Buffett´s approach to activism in the cases of Sanborn Map and Dumpster Mill. I really love those two accounts and I find myself reading those sections every now and then.  The way I see it, one of Buffett´s competitive advantages was a  “decision-tree” -approach. The process would be something like this:

(1)    He recognizes mis-pricing in a security.

(2)    He takes on a position, putting it in the “Generals”-category.

(3)    If there is a correction, he can sell and monetize his profits.

(4)    If the divergence increases or the price lingers, he can add to his position until he gets into a control position and can exercise his influence to extract the value out of the its assets.

The brilliance with this approach is that once you enter a position, the price movement does not really matter. Up or down, either way will give you options to work with. Buffett explains in his first half letter in 1964:

What we really like to see in situations like the three mentioned above is a condition where the company is making substantial progress in terms of improving earnings, increasing asset values, etc., but where the market price of the stock is doing very little while we continue to acquire it. This doesn’t do much for our short-term performance, particularly relative to a rising market, but it is a comfortable and logical producer of longer-term profits. Such activity should usually result in either appreciation of market prices from external factors or the acquisition by us of a controlling position in a business at a bargain price. Either alternative suits me.

In order to do this the companies he invests in (1) must be small enough for him to be able to get to a control position and (2) the incentives and possible actions of other blocks of shareholders and the executive management must be clear.

Now consider this quote from Mr. Morris:

InfuSystem Holdings Inc (Nasdaq: INFU) is an interesting example of what I mean by no competition because of “structural factors” above. When I made it a large position in November, it was only about a $25M market cap and the shareholders were mostly hedge funds managing $100M+ and it was a sub 1% position for them.

The assets are great, but the performance has lagged due to the CEO and board of directors (who have granted themselves roughly 18% of the shares over the last 4 years while the stock has declined 75%). It made no economic sense for any of these holders to try to do something about this, as being an activist takes a significant dedication of time and effort so it wouldn’t make sense to triple a 1% position. Because I could make it a much larger position to my fund, it was proportionally worth it to “bang the brick wall down with my head” and do something about the situation. I’ve been so lucky to work with some great and supportive partners for this investment.

Pinnacle Airlines (Nasdaq: PNCL) has a similar structural issue where the board owns basically no stock and the other holders are large. In general, there is a nearly total competitive void in microcap companies that need a change of direction at the board level, which is another reason why I have been increasing my involvement in that and why I think there is a significant source of excess return there.

Now here is Buffett´s discussion on his investment in Sanborn Map:

The bulk of Sanborn’s business was done with about thirty insurance companies although maps were also sold to customers outside the insurance industry such as public utilities, mortgage companies, and taxing authorities.

For seventy-five years the business operated in a more or less monopolistic manner, with profits realized in every year accompanied by almost complete immunity to recession and lack of need for any sales effort. In the earlier years of the business, the insurance industry became fearful that Sanborn’s profits would become too great and placed a number of prominent insurance men on Sanborn’s board of directors to act in a watch-dog capacity.

Prior to my entry on the Board, of the fourteen directors, nine were prominent men from the insurance industry who combined held 46 shares of stock out of 105,000 shares outstanding. Despite their top positions with very large companies which would suggest the financial wherewithal to make at least a modest commitment, the largest holding in this group was ten shares. In several cases, the insurance companies these men ran owned small blocks of stock but these were token investments in relation to the portfolios in which they were held.

The tenth director was the company attorney, who held ten shares. The eleventh was a banker with ten shares who recognized the problems of the company, actively pointed them out, and later added to his holdings. The next two directors were the top officers of Sanborn who owned about 300 shares combined. The officers were capable, aware of the problems of the business, but kept in a subservient role by the Board of Directors. The final member of our cast was a son of a deceased president of Sanborn. The widow owned about 15,000 shares of stock.

The Sanborn story plays out with Buffett buying the widow´s shares and additional shares on the open market, he teams up with other disgruntled investors and they set up a plan to split the business (the mapping business and the securities portfolio). The board opposes, but a proxy fight scenario is unlikely as Buffett and co. are almost certain to win it, would that situation occur. In the end the SEC approves a plan to sort of spin-off the securities portfolio.  

Now, consider Morris´ situation with Pinnacle. As with Sanborn situation, the incentives of the Board of Directors at Pinnacle aren´t necessarily in line with the common shareholder.  The biggest client (Delta) is  also the biggest claimant. In a chapter 11, whose interest is management and BoD going to look after? Here´s Mr. Morris on the subject:

To reduce risk, I have formed a 13D group with another large shareholder to get a voice for shareholders.  Hopefully that voice is on the board that currently owns a mere 1% of the company, or if necessary through an equity committee should they decide to file chapter 11.  As was the case with HearUSA, chapter 11 is not the same as equity being wiped out.  Pinnacle is definitely more messy and less certain than the aircraft lessor situation in 2009 but I am also more sophisticated an investor and don’t make the position size as big.  It definitely fits the criteria that I like where most everyone else is panic selling for reasons that look valid at first glance, but metaphorically once you do some real research you find yourself alone in the library and that the covers of the books are very different than the contents.

For the sake of argument, here are two other quotes from the SumZero interview:

I have evolved in a more activist direction over the last year and a half because the big risk factor that you can’t control just with research is that of the stewards between you and the assets of the company you own. If you have a great asset but a board of directors and CEO who don’t know how or don’t want the value of those assets to accrue to shareholders, then you have a problem as an investor. So I have been increasing my ability to use this tool when necessary to change the risk/reward profile of an investment. For smaller companies, which I really exclusively look at for competitive reasons, it is particularly important because the range of management quality is so wide. I got into this tack first by having some bad experiences with my positions and reacting and now people I know tend to contact me and ask for help. So if any readers out there have a cheap company that will stay cheap because the directors aren’t acting in the shareholder’s best interests, let me know and maybe I can help!

Another aspect of this passive-with-an –option-to-control approach is that the control situations are behaviorally different from the ‘Generals’. Here´s Buffett discussing control situations in a Partnership letter:

Of course, this section of our portfolio is not going to be worth more money merely because General Motors, U.S. Steel, etc., sell higher. In a raging bull market, operations in control situations will seem like a very difficult way to make money, compared to just buying the general market. However, I am more conscious of the dangers presented at current market levels than the opportunities. Control situations, along with work-outs, provide a means of insulating a portion of our portfolio from these dangers.

And Ryan Morris:

I am not actively short them, but I don’t understand why people are valuing so many cyclical stocks like Caterpillar (NYSE: CAT) as if they are not cyclical.  I think the market has become more superficially focused than ever as evidenced by, for example, dividend stocks being the highest performing category last year.  The current dividend on a stock is nearly meaningless but if the market just prices things that are immediately apparent then it explains this kind of behavior.  It creates a good buying environment for my “bad perception/good reality” style of investing but it also means that things that appear ugly will get cheaper for a while.

Now, on to Dempster Mill. Here´s Buffett´s own recap of the investment:

This situation started as a general in 1956. At that time the stock was selling at $18 with about $72 in book value of which $50 per share was in current assets (Cash, receivables and inventory) less all liabilities. Dempster had earned good money in the past but was only breaking even currently.

The qualitative situation was on the negative side (a fairly tough industry and unimpressive management), but the figures were extremely attractive. Experience shows you can buy 100 situations like this and have perhaps 70 or 80 work out to reasonable profits in one to three years. Just why any particular one should do so is hard to say at the time of purchase, but the group expectancy is favorable, whether the impetus is from an improved industry situation, a takeover offer, a change in investor psychology, etc.

We continued to buy the stock in small quantities for five years. During most or this period I was a director and was becoming consistently less impressed with the earnings prospects under existing management. However, I also became more familiar with the assets and operations and my evaluation of the quantitative factors remained very favorable.

By mid-1961 we owned about 30% or Dempster (we had made several tender offers with poor results), but in August and September 1961 made, several large purchases at $30.25 per share, which coupled with a subsequent tender offer at the same price, brought our holding to over 70%. Our purchases over the previous five years had been in the $16-$25 range.

On assuming control, we elevated the executive vice president to president to see what he would do unfettered by the previous policies. The results were unsatisfactory and on April 23, 1962 we hired Harry Bottle as president.

As Buffett explains in his letters, once in control it’s not a mispricing problem anymore, but more of an asset conversion problem. Accordingly, now it all comes down to execution. In an earlier letter, Buffett had talked about the new CEO Harry Bottle (allegedly recommended by Charles Munger) :

There is one final point of real significance for Buffett Partnership, Ltd. We now have a relationship with an operating man which could be of great benefit in future control situations. Harry had never thought of running an implement company six days before he took over. He is mobile, hardworking and carries out policies once they are set. He likes to get paid well for doing well, and I like dealing with someone who is not trying to figure how to get the fixtures in the executive washroom gold-plated.

Morris became active at Infusys Holdings after holding the position for four years. Here´s the first paragraph from the cover letter:

As stockholders of InfuSystem for as long as the past 4 years, we have been disappointed with the performance of the Company as the stock has lost almost half its value. This culminated with the write down of the entire goodwill balance in 2011. At the same time as the Company’s value has eroded, we believe the board of directors and current executive management have enriched themselves with excessive stock and cash grants. In summary, we believe that the current direction of the Company and the current board of directors are not in the best interests of stockholders.

And here are quotes from Morris, after he became the executive chairman of Infusystem Holdings:

“Our prime mandate is to create value for all shareholders,” says new Executive Chairman Morris.  “Further, we believe that our personal economic fates should continue to be entirely tied to performance.  Accordingly, new board members will be compensated solely in stock options. “

“We are pleased to have someone of Dilip Singh’s stature to serve as Interim CEO,” Mr. Dreyer said. “Dilip has nearly 40 years of operational, executive management and board experience with global Fortune 500 companies and a proven record of overseeing profitable growth in rapidly emerging sectors.”

Perhaps I am struck by a severe case of confirmation bias and undoubtedly, as these comparisons also demonstrate, these situations are not identical. But in both cases these two investors are focusing on investments in which they see themselves having a competitive advantage against their counter-parties.

I have no knowledge on Morris’ performance but I do like his style. It will be interesting to follow him in the future.


Meson Capital Partners

A thread on Ryan Morris on the Corner of Berkshire and Fairfax forum




Mental Model: Continuous Compounding

A mental model is an explanation of a thought process about how something works in the real world. Mental models help shape our behaviour and define our approach to solving problems (akin to a personal algorithm) and carrying out tasks. Mental models have been studied by cognitive scientists as part of efforts to understand how humans know, perceive, make decisions, and construct behavior in a variety of environments. Charles Munger provides a concept of “Elementary, Worldly Wisdom” which consists of a set of mental models framed as a solving problems of business, finance and investing. According to Munger, only 80 or 90 important models will carry about 90% of the freight in making you a worldly-wise person.

Articles on Continuous Compounding as a Mental Model for Investing

In Three consecutive Letters to Partners, Warren Buffett wrote of the “Joys of Compounding”. You can find the excerpts below, but also recommended is the coverage of the letters in an East Coast Asset Management Letter to Investors from 3Q2010.

Buffett on the Joys of Compounding

1963 LtS

“I have it from unreliable sources that the cost of the voyage Isabella originally underwrote for Columbus was approximately $30,000. This has been considered at least a moderately successful utilization of venture capital. Without attempting to evaluate the psychic income derived from finding a new hemisphere, it must be pointed out that even had squatter’s rights prevailed, the whole deal was not exactly another IBM. Figured very roughly, the $30,000 invested at 4% compounded annually would have amounted to something like $2,000,000,000,000 (that’s $2 trillion for those of you who are not government statisticians) by 1962. Historical apologists for the Indians of Manhattan may find refuge in similar calculations. Such fanciful geometric progressions illustrate the value of either living a long time, or compounding your money at a decent rate. I have nothing particularly helpful to say on the former point.

The above table8 indicates the compounded value of $1,000,000 at 4%, 8% 12, and 16% for 10, 20 and 30 years. It is always startling to see how relatively small differences in rates add up to very significant sums over a period of years. That is why, even though we are shooting for more, we feel that a few percentage points advantage over the Dow is a very worthwhile achievement. It can mean a lot of dollars over a decade or two.”

1964 LtS

“Now to the pulse-quickening portion of our essay. Last year, in order to drive home the point on compounding, I took a pot shot at Queen Isabella and her financial advisors. You will remember they were euchred into such an obviously low-compound situation as the discovery of a new hemisphere.

Since the whole subject of compounding has such a crass ring to it, I will attempt to introduce a little class into this discussion by turning to the art world. Francis I of France paid 4,000 ecus in 1540 for Leonardo da Vinci’s Mona Lisa. On the off chance that a few of you have not kept track of the fluctuations of the ecu 4,000 converted out to about $20,000. If Francis had kept his feet on the ground and he (and his trustees) had been able to find a 6% after-tax investment, the estate now would be worth something over $1,000,000,000,000,000. That’s $1 quadrillion or over 3,000 times the present national debt, all from 6%. I trust this will end all discussion in our household about any purchase of paintings qualifying as an investment. However, as I pointed out last year, there are other morals to be drawn here. One is the wisdom of living a long time. The other impressive factor is the swing produced by relatively small changes in the rate of compound. Above are shown the gains from $1,000,000 compounded at various rates.

It is obvious that a variation of merely a few percentage points has an enormous effect on the success of a compounding (investment) program. It is also obvious that this effect mushrooms as the period lengthens. If, over a meaningful period of time, Buffett Partnership can achieve an edge of even a modest number of percentage points over the major investment media, its function will be fulfilled.”

1965 LtS

“Our last two excursions into the mythology of financial expertise have revealed that purportedly shrewd investments by Isabella (backing the voyage of Columbus) and Francis I (original purchase of Mona Lisa) bordered on fiscal lunacy. Apologists for these parties have presented an array of sentimental trivia. Through it all, our compounding tables have not been dented by attack. Nevertheless, one criticism has stung a bit. The charge has been made that this column has acquired a negative tone with only the financial incompetents of history receiving comment. We have been challenged to record on these pages a story of financial perspicacity which will be a bench mark of brilliance down through the ages.

One story stands out. This, of course, is the saga of trading acumen etched into history by the Manhattan Indians when they unloaded their island to that notorious spendthrift, Peter Minuit in 1626. My understanding is that they received $24 net. For this, Minuit received 22.3 square miles which works out to about 621,688,320 square feet. While on the basis of comparable sales, it is difficult to arrive at a precise appraisal, a $20 per square foot estimate seems reasonable giving a current land value for the island of $12,433,766,400 ($12 1/2 billion). To the novice, perhaps this sounds like a decent deal. However, the Indians have only had to achieve a 6 1/2% return (The tribal mutual fund representative would have promised them this.) to obtain the last laugh on Minuit. At 6 1/2%, $24 becomes $42,105,772,800 ($42 billion) in 338 years, and if they just managed to squeeze out an extra half point to get to 7%, the present value becomes $205 billion. So much for that. Some of you may view your investment policies on a shorter term basis. For your convenience, we include our usual table indicating the gains from compounding $1,000,000 at various rates.

This table indicates the financial advantages of:
(1) A long life (in the erudite vocabulary of the financial sophisticate this is referred to as the Methusalah Technique)
(2) A high compound rate
(3) A combination of both (especially recommended by this author)
To be observed are the enormous benefits produced by relatively small gains in the annual earnings rate. This explains our attitude which while hopeful of achieving a striking margin of superiority over average investment results, nevertheless, regards every percentage point of investment return above average as having real meaning.”


How many times do you need to fold a piece of paper to make it reach the moon? on
(The answer is 42…)

Mental Model: Booms, Busts & Fragile Systems

What I hope to collect here is a collection of resources that handle the historical representation of the booms and busts of fragile financial systems.

Articles & presentations

Who´s Holding the Bag” by Pershing Square Capital Management (May 2007)

The Age of Balance Sheet Recessions: What Post-2008 U.S., Europe and China Can Learn from Japan 1990-2005” by Richard Koo (2010)

Chapter 2. The Souk and the Office Building, an Introduction to the Intervention Bias” by Nassim Taleb (a draft from 2011)

Tipping Points: Annual Report 2010-2011” by the Institute of Hazard, Risk and Resilence (features a historical data on banking system failures)

The Fat Pitch” by (August, 2001)

A Template for Understanding What’s Going On” by Ray Dalio


Has Financial Development made the World Riskier?” by Raghuram G. Rajan (2005)

This time is different: An example of a giant, wildly speculative, and successful investment mania” by Andrew Odlyzko (2010)

The collapse of the Railway Mania, the development of capital markets, and Robert Lucas Nash, a forgotten pioneer of accounting and financial analysis” by Andrew Odlyzko (2011)

Mental Model: Ecological Systems

A mental model is an explanation of a thought process about how something works in the real world. Mental models help shape our behaviour and define our approach to solving problems (akin to a personal algorithm) and carrying out tasks. Mental models have been studied by cognitive scientists as part of efforts to understand how humans know, perceive, make decisions, and construct behavior in a variety of environments. Charles Munger provides a concept of “Elementary, Worldly Wisdom” which consists of a set of mental models framed as a solving problems of business, finance and investing. According to Munger, only 80 or 90 important models will carry about 90% of the freight in making you a worldly-wise person.

Articles on Ecological Systems as a Mental Model for Investing

Matching Social and Ecological Systems in Complex Ocean Fisheries” by James A. Wilson. Ecology and Society 11(1): 9.

Where Busy Bees and Business Converge: The striking similarities between ecological and organizational networks” based on the Research of Serguei Saavedra, Brian Uzzi And Felix Reed-Tsochas. 2011. Kellogg School of Management