A summary of this week’s best articles. Follow us on Twitter (@INTRINSICINV) for similar ongoing posts and shares.

Want to Kill Your Economy? Have MBA Programs Churn out Takers Not Makers. (Rana Foroohar, @RanaForoohar, evonomics)

It’s a problem for stakeholders when “80 percent of CEOs surveyed in one study said they’d pass up making an investment that would fuel a decade’s worth of innovation if it meant they’d miss a quarter of earnings results.” One of the stops on the path for many CEOs is business school. This is could be why many CEOs put short-term results over long-term success. The curriculum of many MBA programs focus on financial theory and appeasing Wall Street than critical and long-term thinking.

Larry Page’s Flying Taxis, Now Exiting Stealth Mode (Andrew Ross Sorkin, @andrewrsorkin, NYT)

While the focus in the news has been about self-driving cars, Alphabet has a team in New Zealand building self-flying planes. Some of the people involved are well suited for the project. Kitty Hawk is run by Sebastian Thrun, “who helped start Google’s autonomous car unit as the director of Google X”.  Zephyr, which was set up by Kitty Hawk, is run by Fred Reid, “who is a former chief executive of Virgin America. Before that he was president of Delta Air Lines and president of Lufthansa Airlines, where he was co-architect of the Star Alliance.”

Walmart to Offer Home Delivery of Groceries in 100 Cities (Sarah Nassauer, @SarahNassauer, WSJ)

In an effort to compete with Amazon Now, Walmart is launching a grocery deliver service. There is no monthly or annual fee. The cost is $9.95 per delivery with a $30 minimum order. The groceries will be sourced and packed in the local Walmart store and delivered by crowdsource deliver companies, like Uber and Deliv Inc.

The Secretive Company That Pours America’s Coffee (Zeke Turner and Julie Jargon, @zekefturner and @juliejargon, WSJ)

JAB may be one of the largest companies you’ve never heard of. Starting out as a chemical manufacturer, they’ve shifted to a coffee powerhouse by acquiring of such household names as Keurig, Peet’s, Panera, and Krispy Kreme. The next step in their coffee conquest is distribution of cold-brew coffee. They recently purchased Dr. Pepper to help with distribution. This is causing the rivalry with Nestle to heat up. (pun intended)

Parts Suppliers Call for Cleaner Cars, Splitting With Their Main Customers: Automakers (Hiroko Tabuchi, @HirokoTabuchi, NYT)

The Obama administration issued mandates that “require automakers to nearly double the average fuel economy of new cars and light trucks by 2025.” Auto part companies were pleased with the mandates because developing and selling newer parts meant they could charge more. With the current administration’s pledge to reduce regulation and undo many Obama-era initiatives, automakers are now pushing to repeal this mandate.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by clients invested in Ensemble Capital’s core equity strategy you will find a disclosure regarding the security held above. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument. Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein. Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances.

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In August of last year we published a piece titled The Death of (Many) Brands in which we argued that there were two main types of brands in the world and that one of these types was collapsing as a source of competitive advantage.

“Brands created value by lowering search costs for consumers. Search costs are the costs incurred by a prospective buyer in trying to determine what to buy… It is important not to underestimate how powerful search cost brands have been in economic value creation in the past. Over the past 50 years, the top performing sector of the stock market has been consumer staples.

Now, however, the era of search cost brands is coming to an end. The moats are being breached. Over the long term, we do not believe that these types of brands will provide a significant competitive advantage to their owners…”

A recent Wall Street Journal article explored some of these same concepts through the lens of the role of Amazon’s Alexa virtual assistant and the risk it poses to consumer brands.

“Unlike in stores or online, where an array of brands get plenty of exposure, voice-search assistants like Amazon.com Inc.’s Alexa often steer shoppers to a single product, usually selected by an algorithm with no input from the sellers… In a test conducted in October, Bain & Co. found that for customers making a first-time purchase without specifying a brand, over half of the time Alexa’s first recommendation was a product from the “Amazon’s Choice” algorithm, which implies a well-rated, well-priced item that ships with Prime. Bain also found that in categories in which Amazon has a private brand, 17% of the time Alexa recommends the private-label product even though such products make up just 2% of volume sold.”

Branded consumer product companies recognize this risk, with the CFO of Unilever telling the Wall Street Journal, “Of all the disruptions that are taking place in all the things technology is bringing into our space, voice [search] is among the most disruptive. When it comes to voice search you go first position or you go home because beyond the first or second place there is no future.”

In other words, voice search means that even for the most powerful consumer product companies in the world, if Alexa doesn’t point consumers to you, there is no future.

Consumers’ need to quickly and easily identify products that offer solid quality for good value has not gone away. In our post we described the ways in which Amazon and Uber are in the process of supplanting the role of lowering search costs by substituting their own brand as a source of trust for consumer to make confident purchase decisions. Amazon has become such a trusted source of information for consumers that it is not just an online retailer but the vertical search engine of choice for products. If Amazon lists an item #1, most consumers will trust that it is of high quality and a good value. That’s why the #1 result for “batteries” on Amazon is not Duracell or Energizer, but a pack of AmazonBasics batteries that sell for less than half the price of the comparable Energizer batteries listed further down the page. For any consumer who might question if Amazon was just pushing their own product rather than the best option, the 18,975 ratings with an average score of 4.5 stars out of 5 will put their mind at ease.

Similarly, as described in our original article, Uber’s brand has become such a trusted symbol to consumers that they will “literally summon strangers from the internet to get in their car.”

Concierge brands are not new. They have existed in multiple forms in the past. Moody’s brand stamped on a bond rating tells investors that a bond on which they have done no due diligence of their own is of a known quality. Consumer Reports has steered consumers to high quality, value priced products for many, many years. When a mutual fund receives a five star Morningstar rating, the fund’s employees are ecstatic because they know this stamp of approval is the key to massive fund inflows.

The trusted reviews at TripAdvisor allows travelers to confidently book travel plans to far flung locations knowing that their experience will be great. Believe me, without TripAdvisor, my family never would have had the confidence to spend the night with a hilltribe in the northern mountains of Thailand. But TripAdvisor’s concierge brand provided a seal of approval to a small, family run tour operation that opened up a travel experience that would have been unavailable to us otherwise. And of course it was the highlight of our trip.

But our view that the end is coming for search cost brands does not mean the power has shifted decisively to the Amazons and Ubers of the world. The trust in a concierge brand is only durable if the recommendations made by the brand are good ones. Headlines about Uber drivers assaulting a customer are poisonous to the Uber brand because what they offer is not just logistics but the seal of approval that the random strangers who offers you a lift will deliver you safely to your destination. It only takes a couple of unhappy trips to TripAdvisor recommended hotels to ruin the site’s reputation and therefore whole reason for being.

So there is an opening for product companies to capture value as the concierge brands muscle their way into their industry’s profit pool: Make differentiated products that are great and sell them at a fair price.

The Death of Brands does not imply the death of great products. It implies the death of top brands that do not in fact represent an outstanding product at a fair price. The very worst thing the concierge brands could do is recommend products that serve the concierge’s financial interests, but are not in fact in the best interest of the customer. If Amazon’s Alexa starts regularly recommending Amazon’s own products despite superior, better priced products on the market, Amazon’s concierge brand will go down in flames.

Concierge brands are valuable because they reduce search costs. This isn’t difficult to understand. When you are in a city you’ve never been to and a friend who has been before recommends a great place to eat, you will choose that location confidently without doing extensive research on your own. This is what search cost brands offered in the past. Now we see the rise of concierge brands inserting themselves into the equation, delivering value to consumers and extracting profits from the legacy brands. But their power is not unlimited. There is a real risk that in the pursuit of profit maximization they will overreach, point consumers to products that serve their interests rather than the consumers, lose trust and lose out on profits.

There is only one path forward for product companies: Ship great products and force the concierges brands to point everyone your way.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by clients invested in Ensemble Capital’s core equity strategy you will find a disclosure regarding the security held above. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument. Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein. Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances.

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Over the last few decades, there’s been much debate about what makes for useful management guidance on conference calls and investor presentations.

Here’s Warren Buffett, for example, in his 2000 letter to Berkshire Hathaway shareholders, providing some reasons why guidance is dangerous:

Charlie and I think it is both deceptive and dangerous for CEOs to predict growth rates for their companies. They are, of course, frequently egged on to do so by both analysts and their own investor relations departments. They should resist, however, because too often these predictions lead to trouble.

It’s fine for a CEO to have his own internal goals and, in our view, it’s even appropriate for the CEO to publicly express some hopes about the future, if these expectations are accompanied by sensible caveats. But for a major corporation to predict that its per-share earnings will grow over the long term at, say, 15% annually is to court trouble. That’s true because a growth rate of that magnitude can only be maintained by a very small percentage of large businesses…

The problem arising from lofty predictions is not just that they spread unwarranted optimism. Even more troublesome is the fact that they corrode CEO behavior. Over the years, Charlie and I have observed many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings targets they had announced.

On the other hand, Professor Baruch Lev at the NYU Stern School of Business, makes the case that the more information investors have to consider, the better.

More broadly, getting more information out helps everyone involved—shareholders, analysts and companies. By sharing information with the market, companies reduce investor uncertainty and prevent stock prices from swinging wildly upon unexpected bad news. My research shows that managers’ quarterly earnings guidance is more accurate than the current analysts’ consensus forecast in 70% of cases. Analysts know this and are quick to revise their forecasts upon the release of guidance.

But warning investors about potential disappointments doesn’t just help protect them from losses—it helps protects companies, too. Guidance released prior to weak earnings is considered a mitigating factor in shareholder lawsuits, and was shown in a study published in 1997 to reduce settlement figures.

Both arguments have merit, but we believe returning to first principles is critical. If you were making a five-plus year investment in a business, what information would you want to know? Which metrics would you use to hold management accountable?

The long and short of it

We understand that CEOs and CFOs may feel compelled by analysts, traders, or corporate inertia (“We’ve always done it.”) to provide quarterly revenue and EPS guidance.

A 2006 survey by McKinsey, for example, found that executives were reluctant to change guidance practices, as they “fear the potential for increased share price volatility upon the release of earnings data, as well as the possibility of a decrease in share prices…The executives also worry that discontinuing guidance will make their companies less visible to investors and analysts.”

Fair enough, but it’s a problem when guidance becomes a “game” and surpassing revenue or EPS guidance comes at the expense of long-term value creation. If this happens frequently enough, share price volatility will occur anyway. It just gets deferred. Abandoned value-creating projects are fertile ground for competition.

Further, companies that consistently create shareholder value will not be invisible to the market for long, whether or not they issue guidance. Importantly, all stakeholders in a business benefit from long-term value creation: employee stock options are more valuable, shareholders gain from a higher stock price, and creditors and suppliers are more eager to work with you. As Jeff Bezos has noted, “If you’re long-term oriented, customer interest and shareholder interests are aligned.”

Yet we recognize that, as Nobel Prize-winning behavioral economist Daniel Kahneman puts it, “exclusive concern with the long term may be prescriptively sterile, because the long term is not where life is lived.” Setting some shorter-term goals is fine, as long as they are designed to measure progress toward widening the company’s economic moat.

Ensemble’s Wish List for Management Teams

Given the complexity of markets and industries, it’s unfair to recommend a one-size-fits-all solution for improved guidance. Instead, we offer three principles that both investors and companies can use when evaluating guidance practices.

Avoid EPS guidance, if possible. There’s no question that EPS is an important metric to the markets. It is the denominator of the popular price/earnings ratio and is the first metric splashed on financial media headlines. That said, a quarter’s-worth of EPS has almost no bearing on a company’s intrinsic value. Of course, optics are at play here. Growth companies, in particular, can impress the market by frequently beating and raising EPS guidance. Mature firms may need to justify their P/E ratios with steady EPS growth.

We think companies, however, have too many levers to pull to meet or beat EPS guidance. Some levers are more innocuous than others. The market is aware of this flexibility, which makes missing earnings guidance even worse.

Naturally, there are clear incentives for management to hit EPS guidance. Indeed, a 2005 study that surveyed 400 CFOs found that “78% of surveyed executives would give up economic value in exchange for smooth earnings.” When management sacrifices value-creating projects or research & development spending to hit a 90-day target, it comes at the expense of long-term shareholders.

Finally, as long as management is sharing other useful data points (see below), analysts should be able to formulate their own EPS figures.

Instead, companies should share internal operating assumptions. If you invested in a private business, you’d want to know what internal metrics management uses to measure progress. For example, if you were researching a local dry-cleaning business, you’d want to know production output trends, the number of new and repeat customers, customer acquisition costs, and transactions per customer. All of these factors help you understand whether or not the company’s moat is widening or narrowing.

These figures don’t need to be to the basis point or penny, either. Providing a reasonable range for each internal operating metric would be fair and useful.

Some publicly-traded companies do a good job of delivering useful business-level guidance in quarterly reports.

For instance:

  • Schwab’s guidance includes assumptions on market returns, interest rates, and net interest margin. Business updates include metrics on client engagement, competitive dynamics, and expense management.
  • Landstar System’s guidance describes incremental margins on a net revenue basis. It provides revenue per load and number of loads hauled each quarter as well as their color commentary on how trends played out during each month of the quarter and how they are playing out so far this quarter.
  • International Paper’s quarterly presentations include an outlook on demand trends, margins, catalysts, and free cash flow, as well as commentary on input costs, and its capital investment plans.

Even if management feels it must give revenue or EPS guidance, providing additional operating metrics offers investors more insight into underlying business performance.

Intermediate-term (3-5 year) “targets” should be conservative. Newly-installed CEOs are particularly prone to making ambitious 3-5 year forecasts at analyst days. Perhaps there are qualitative reasons for this – inspiring the team, marking a new era, or building investor confidence – but there’s no better way to erode credibility than to overpromise and underdeliver.

Published intermediate-term targets should be conservatively arrived at, supported with detail, and tempered with a risk discussion. We’re not aware of a company doing a “pre-mortem” (explaining the reasons why they would fall short) on an intermediate-term target, but would consider that a healthy practice.

While management teams often focus medium-term targets on revenue and earnings goals, we think these are less useful than providing targets on working capital needs, line item expenses, capital structure, and capital expenditure plans.

Medium of communication

Some companies, like Expeditors International of Washington and Morningstar, don’t host conference calls. Instead, they welcome questions from all investors (not just sell-side analysts) and respond thoughtfully to the questions in writing. We appreciate the egalitarian nature of this approach. Questions from the broader shareholder base can often be more useful than typical sell-side analyst questions.

We also like that the medium of communication allows management to think about the question and respond with greater detail. A cynic might say this only enables management to artfully dodge questions. Perhaps this is true. However, conference call responses are also usually well-rehearsed.

Of course, we recognize that doing away with conference calls may not be realistic for most companies. And, to be fair, we do find value in hearing management’s tone on conference calls. That said, we would like to see more management teams spend less time on prepared remarks and more time on Q&A with analysts. An excellent example of this practice is Constellation Software.

Bottom line

Management shouldn’t abandon guidance altogether. Rather, we hope more management teams will share information they’d like to receive if they were outside shareholders in the company. Spending less time on the earnings game and more on value creation is in the interest of all stakeholders.

Clients, employees, and/or principals of Ensemble Capital own shares of Charles Schwab Corp (SCHW) and Landstar System (LSTR). The author owns shares of Morningstar (MORN) and Berkshire Hathaway (BRK.B).

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by clients invested in Ensemble Capital’s core equity strategy you will find a disclosure regarding the security held above. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument. Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein. Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances.

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One of the best things about raising kids is watching them learn.

Our three-year-old, for instance, recently entered the “Why?” phase, leaving Mom and Dad scrambling to answer heavy questions like, “Why is there a universe?” and “Why are there earthquakes?”

Thankfully, our five-month-old still has a few years before she peppers Mom and Dad with existential questions. Among the first skills that she’ll learn is sorting objects by colors and shapes. Learning to group objects is an essential skill to develop. In a primal sense, classifying allowed our distant ancestors on the plains to promptly assess threats (a big animal) from non-threats (a tree).

A recent paper by Blue Mountain Capital Management’s Michael Mauboussin explored how the investment world makes comparisons. More specifically, Mauboussin shows how our field frequently does a poor job comparing companies. He concludes that:

“Comparing, essential to effective decision making, comes naturally to humans. But our basic approach of relying on analogy can limit our ability to compare effectively. In particular, we fail to incorporate sufficient breadth and depth into our comparisons, and we can be easily swayed by the presentation of information or the allocation of our attention.”

We believe there are opportunities to capitalize on these bad habits by seeking idiosyncratic companies. These are companies that we think are difficult to classify because they have a differentiated business model.

Tangerines among oranges

Most sell-side research shops use the Global Industry Classification System (GICS) to organize their analyst staff. For example, analysts are typically placed into sector-based teams (e.g., energy, consumer staples, healthcare, etc.). Each team is divided further into industries (e.g., energy equipment, beverages, healthcare technology, etc.) for which an analyst or a group of analysts is responsible.

Let’s say you’re the beverages analyst. Your job is to provide clients with deep research and actionable ideas among a specific group of brewers, soft drinks, and distillery companies.

Not only are you incentivized to be laser-focused in this niche, but a sell-side analyst with only “hold” recommendations is of little value to clients. As a consequence relative valuation techniques – i.e., comparing multiples – reign supreme in determining price targets. It makes sense. You’re intimately familiar with the companies you’re comparing and, regardless of market trends, you’ll always have names that are relatively under- or over-valued.

Relative valuation works fine for the analyst and his or her clients when the compared stocks have similar fundamental characteristics. There are circumstances, however, where a stock on an analyst’s coverage list has unique fundamental characteristics and may thus be misunderstood.

Square peg, round hole

We’ve found that First Republic Bank to be a case in point. The regional banking industry is broadly commoditized, making relative valuation a fair way to assess value among regional banks.

However, we believe that First Republic’s fundamental characteristics are different from its GICS-assigned peer group. To illustrate, First Republic’s Net Promoter Score is miles ahead of the U.S. banking industry and more in line with retail businesses with highly-regarded customer service.

Source: First Republic investor presentation

Put simply, we think First Republic is playing a different game than its banking peers. As a result, judging it against banks alone is a mistake.

Going back to late January 2011, for instance, the average percentage of “buy” ratings on First Republic is just 44.9%, according to Bloomberg, despite the fact the stock price has more than tripled over that period. Instead, “hold” ratings dominated analyst opinion for most of the last seven years. This suggests that the covering analysts likely struggled to assess First Republic’s value on a regular basis.

Consider these November 2011 statements from a well-regarded sell-side research shop: “We are impressed by the uniqueness and simplicity of the First Republic business model. Its focus on customer service goes above and beyond that offered by any other bank…What holds us back from taking a more constructive view is relative valuation.”

In other words, the analyst recognized First Republic’s unique franchise, but still valued First Republic solely against other banks. When the report was released, First Republic traded at $26.52 (dividend adjusted). It recently traded near $91.

Granted, the banking regulations by which First Republic must abide will never make it entirely comparable with customer-friendly retail or hotel franchises, either. As such, it’s reasonable to compare First Republic against other high-quality banks, but it shouldn’t be the only approach used.

Bottom line

At Ensemble, we are drawn to businesses that aren’t easily categorized. Differentiated business models can not only be a source of competitive advantage, but can also present value opportunities. Because analysts and investors have a natural tendency to classify – and subsequently cling to that classification – there’s a good chance that firms with idiosyncratic business models will be misunderstood and therefore mispriced.

Clients, employees, and/or principals of Ensemble Capital own shares of First Republic Bank (FRC).

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by clients invested in Ensemble Capital’s core equity strategy you will find a disclosure regarding the security held above. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument. Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein. Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances.

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“Rule #1: Never lose money. Rule #2: Never forget rule #1.” -Warren Buffett

Warren Buffett’s “Rule #1 and #2” hold special appeal to many investors. They seem to sum up so much good advice in just 11 words. And from a philosophical standpoint they do. But from a practical sense they can cause investors to set such a high bar for making investments that they are unable to fully invest their savings and end up not reaching their financial goals.

What Buffett’s rules help with is avoiding “sins of commission”. These are the mistakes we make when we take an action that goes wrong. Buying a stock that loses money is a sin of commission. Outside of investing, asking someone on a date who says no and leads you to be embarrassed is a sin of commission.

But “sins of omission” can be just as painful. Not investing in a great stock because it wasn’t perfect or because you were too busy learning every last detail of the stocks you already owned to find time to work on new ideas are sins of omission. So is not getting up the nerve to ask that attractive someone out on a date.

There is a sort of wicked tension between avoiding sins of commission and sins of omission when it comes to investing. Every smart and successful investor wishes they knew just a little bit more about the companies in their portfolio. On the other hand every smart and successful investor works hard to allocate more time to researching new ideas.

The problem with Buffett’s advice is that it ignores this tension and focuses investors exclusively on avoiding sins of commission.

In a recent post, Ben Carlson looked at how investors who stayed out of the market in the wake of the financial crisis now must achieve massive gains just to get back to zero. For all the times that you’ve heard about how you need to double your money to get back to even if you take a 50% losses, no one ever talks about the reverse. Similarly, in this 2014 presentation Robert Vinall looks at the dangers of Sins of Omission.

But Warren Buffett is a funny guy. While he’s a fountain of wisdom, many of his quotes are contradictory. While his “Rule #1 and #2” quote is one of his most famous, here is Buffett talking about his biggest mistakes at the 2004 Berkshire Hathaway shareholder meeting (according to notes taken by Whitney Tilson):

“The main mistakes we’ve made – some of them big time – are: 1) Ones when we didn’t invest at all, even when we understood it was cheap; and 2) Starting in on an investment and not maximizing it… We’re more likely to make mistakes of omission, not commission.”

So Rule #1 is “don’t make sins of commission” and yet Buffett admits it is sins of omission that have been his biggest mistakes. How do we reconcile this contradiction?

Warren Buffett is way to complex and sophisticated of a thinker to be summed up in a sound bite. But that’s what people have done with the Rule #1 and #2 quote. Life would be so easy if we could act on the basis of simplistic soundbites. But life, and investing, is far more complex. Yes, when investing we should always seek to protect our capital and be sure to focus on downside risks as much as upside potential. But also, we should recognize that not investing can be just as big of a mistake as making a bad investment. The issue for investors is not to try to avoid any and all mistakes. The goal is to compound your capital as much as possible over the long-term. Doing this well requires taking risks that might cause you to lose money, in direct violation of Buffett’s Rules. But it also requires protecting your capital and paying attention to the risk of loss as much as you pay attention to the opportunity for gains.

It is where Never Lose Money meets Mistakes of Omission that we find the interesting frictions and incongruities that lay at the center of successful investing.

The soundbite of the Rule #1 quote is, quite literally, a danger to reaching your long term investment goals. But in practice, Buffett has figured out how to reconcile the two opposing concepts of not losing money while also not being too afraid to act even in the face of uncertainty. It is this ability to reconcile opposing ideas that stands at the center of Buffett’s brilliance.

“The test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function.” -F. Scott Fitzgerald

 

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by clients invested in Ensemble Capital’s core equity strategy you will find a disclosure regarding the security held above. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument. Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein. Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances.

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