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FocusInvestor.com: The Focused Few Presents:

The Focus Investing Series: Part 2

Written by:

Richard M. Rockwood
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Introduction

This second article in the Focus Investing Series will focus on three parts of the investment
equation: selecting great businesses to invest in, determining the proper price to pay for the
business, and the psychology of investing. Since the idea of maintaining a concentrated portfolio
is a key element of the focus investing philosophy, it is critical that focus investing practitioners
be able to identify companies that have sustainable competitive advantages.

Finding companies that possess a durable competitive advantage is often the easiest part of the
investment process. The tough part of investing is finding the combination of a great business at
a great price. Investors should always remember that the price paid will always determine your
future investment returns.

The last section of this article covers the psychology of investing, and it will show the investor
what traits and habits will hinder them in their search for the best investment possibilities. The
securities market can go through prolonged periods of irrational behavior and the investor should
understand how these periods occur, and what behaviors they should avoid practicing.

Please keep in mind that the purpose of the focus investing series of articles is to provide
interested parties with a broad overview of the focus approach towards investing.































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Chapter 1: Competitive Advantages

Lets start the discussion on how to identify great businesses with an examination of Michael
Porters thoughts on the competitive forces that affect industry profitability. Mr. Porter is a
professor at Harvard and in 1980 wrote an excellent book on the subject called Competitive
Strategy: Techniques for Analyzing Industries and Competitors. I will try to sum up his thoughts
on the subject in the following chart.

Chart 1: Five Forces of Competition Models
I. Rivalry Among Existing Firms
- What is the industry growth rate? If an industry is growing rapidly, competing firms
dont need to grab market share from each other. If the industry is not growing, then firms
will tend to attack each other in an attempt to steal market share. This can lead to irrational
behavior as companies struggle to maintain their market share.
- The concentration and balance of industry power needs to be closely examined to
determine the severity of the price competition.
- How does product and service differentiation affect the industrys competitive dynamics?
- Is it easy for an industrys customer base to change companies within the industry and
still receive the same basic product or level of service quality?
- Is there a steep learning curve present, or are there other types of scale economics to
consider in the industry under examination?
- Is their excess capacity in the industry?

II. Threat of New Entrants
- Are economies of scale relevant in the industry? If so it may be difficult for new entrants
to gain a foothold in the industry under examination.
- Does the industry already have an established powerhouse that sets industry standards?
If so, identify the source of this strong position (i.e. cost advantage, network effect, or high
switching costs).
- Do the established firms have a hard-to-replicate distribution system? What would be
the cost of creating a new distribution system? Think of the large competitive advantages
Coca-Cola enjoys due to its worldwide distribution system.
- Do the established companies in the industry possess any legal barriers to entry, such as
patents, licensing, or copyrights?

III. Threat of Substitute Products
- How willing and able are the industry customers to switch products and services? Are
the products sold or the services offered by the company under examination have little to
no differentiation with other companies products and services?

IV. Buying Power of Buyers
- Do any companies in the industry sell an easy-to-replicate product or service? If so,
price sensitivity becomes an issue and investors should look for low cost providers.
- Do any companies within the industry produce a product or provide a service that is
considered vital to other companies operations?

V. Bargaining Power of Suppliers
- Does the industry under examination have many efficient suppliers? Do one or two
suppliers dominate the market?
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Investors should keep these questions in mind when searching for a company in which to invest.
In most cases, when a company is earning an abnormal profit, the intensity of competition will
increase dramatically as additional companies try to enter the field and attempt to capture pieces
of this abnormal profit. That is why finding a company with a sustainable competitive advantage
is so important. For an example of a company with a sustainable competitive advantage, I
suggest focus investors examine Moodys. This company competes in an industry with only two
other competitors, and its brand is so strong that it is practically a requirement that companies
have their debt rated by Moodys.

Competitive advantages often fall into two categories. These categories are cost leadership and
product/service differentiation. Cost leadership enables a company to sell the same product or
service that other firms are offering for a lower price, with comparable quality. These
efficiencies usually result from the company having a lower cost of production (for example
economies of scale or a higher efficiency production process). This competitive advantage is
particularly important when the product being produced or the service being offered is a
commodity.

A company can also attempt to maintain a competitive advantage by differentiating its products
from others in its industry. The customer perceives that the differentiated product is of higher
quality or has a high brand appeal. Tiffany is an excellent example of a company with this type of
competitive advantage.

Mr. Warren E. Buffett, CEO of Berkshire Hathaway, has made several pertinent comments
regarding competitive advantage over the years. Since he is one of the most successful investors
of all time (and a very skilled writer), I have included several of his quotes below:

The key to investing is not assessing how much an industry is going to affect society, or how
much it will grow, but rather determining the competitive advantage of any given company and,
above all, the durability of that advantage. The products or services that have wide, sustainable
moats around them are the ones that deliver rewards to investors.
1


We like a business with enduring competitive advantages that is run by able and owner-oriented
people. When these attributes exist, and when we can make purchases at sensible prices, it is
hard to go wrong (a challenge we periodically manage to overcome.)
2


sustainable competitive advantages are the core of any business, and thats exactly the way we
think. That is the key to investing. The best way to understand this is to study businesses that
have achieved it. Ask yourself why there are no new entrants in the razor blade business. Or
study Mrs. B [the founder of the Nebraska Furniture Mart, a Berkshire Hathaway-owned
company].

Mr. Buffett has spoken extensively on the subject of competitive advantage for a very good
reason. Investors in the process of examining businesses should be concentrating their efforts on
two things: firstly, whether the business in question possesses a competitive advantage; and
secondly, how sustainable it is.




1
Fortune Magazine dated 11/22/1999
2
1984 Berkshire Hathaway Annual Report
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Chapter 2: Assessing Companies

When examining a company as a potential investment, what should the investor look for? The
first thing the investor should do is to try to find and examine companies that have competitive
advantages. Investors should refer back to Chapter 1 for more information on assessing
companies and their competitive advantages. Other areas to examine would be the economics of
the business and its management team.

Economics of the Business

Focus investors are looking for businesses that are experiencing strong tailwinds. They desire
companies that ideally require small capital expenditures to grow sales, have minimal debt on
their balance sheets, and earn high rates of return on their equity. They are willing to invest in
quality businesses for fair prices.

The focus investor should be aware that great businesses can operate under several different
business models. For instance, several great businesses, such as Costco, Nebraska Furniture Mart
and Wal-Mart, use a high turnover/low margin business model. Other great businesses, Tiffany &
Co., for example, make use of a low turnover/high margin business model. Focus investors
should examine these great businesses individually to determine what elements of their business
models made them so successful.

Focus investors should look closely at competitors in the industry to assess how great a threat
they are to the company under examination. Competition that doesnt behave rationally can
really harm the economics of even the best-run businesses. Avoid investing in industries that are
involved in price wars on a regular basis, as this behavior tends to be self-destructive and will
hurt everyones financial performance in the industry in question.

The focus investor should also examine several financial ratios that will help them understand the
economics of the business they are examining. One of the first ratios that a focus investor should
look at is the firms return on equity (ROE).

ROE can be broken down into three separate aspects. The first aspect to calculate is the
companys return on sales (Net Income/Sales). This calculation will help the investor assess the
profitability of the company. The second aspect to be calculated is the companys asset turnover
(Sales/Asses). This calculation will help the investor assess the operational performance of the
company. The last aspect to be calculated is the companys financial leverage (Assets/Equity).
This last calculation will allow the investor to examine the companys financial flexibility.

Return on equity can be used as a tool to determine what type of return the company in question
is able to achieve on assets employed. For instance, if a company is able to achieve a 15% return
on its equity, then, in effect, it has been able to create 15 cents in new assets per dollar invested.

Focus investors should also examine the firms profit margins and ask themselves if they are in
line with their competitors. If they are noticeably higher or lower than the industry average, the
investors should investigate and determine the reasons for the difference. If margins are
noticeably higher than the industry average, the investor may also want to investigate whether the
margins have historically been at the current level. Focus investors should also keep in mind that
a high-margin business tends to attract competition, unless the company in question has some
type of competitive advantage.

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It is also important to examine the companys financial history and try to determine how
recessions and industry downturns affect the firms results. Value Line is a tool that helps
investors in examining the historical financial records of approximately 1,700 companies. Focus
investors should seek out companies that have consistently produced solid results over a long
time period. Stable businesses with repeat-use products (for example Gillette) should always be
examined closely. Cash flows from these types of business models are typically more accurate to
model and usually the market leaders have solid moats around their businesses.

Management

Although the economics of a business will often be the determining factor in whether or not a
company should be considered for possible investment, the management team of the company is
also an important consideration.

An ideal management team should be strong advocates for the companys shareholders. They
should be oriented towards the long-term, as well as rational capital allocaters. The focus
investor should be able to get a good feel for a management team simply by closely observing
their actions and behavior. For example, in the letters to shareholders section of the annual
report, do they write letters which portray both the positive and negative aspects of the business?
Have they paid rational prices for acquisitions they have made? Do they have rational
compensation structures? Are they continually reinforcing and expanding the moat around their
businesses? These are just a few ways an investor can form an opinion of a management team
without being able to meet with them.

Another item to watch for is if the management (and/or founders) of the firm under examination
tend to eat their own cooking. Has management acquired a stake in the company via open
market purchases? If they have, this could be a very positive sign that they will tend to think like
a long-term business owner, as well as a sign of how passionate and focused they are on the
company and its long-term success.

Focus investors should ideally be searching for a business that has healthy enough economics for
it to be able to withstand a period of neglect, because over the years a bad manager is bound to
operate the company at some time or another.

This quote from Mr. Buffett serves as a fitting conclusion to this section on the importance of
management, and is well worth remembering: With few exceptions, when a management with a
reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation
of the business that remains intact.
3













3
1989 Berkshire Hathaway Annual Report
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Chapter 3: Intrinsic Value

Once the focus investor has selected a business to invest in that they believe possesses good
business economics and has an excellent, shareholder-friendly management team, the next item to
focus on is the current price being quoted for that business.

A business that is publicly traded rarely trades at its intrinsic value. One reason for this is that all
investors calculate intrinsic value in a slightly different manner. For instance, one investor might
have a slightly different viewpoint with regard to the direction of interest rates; another investor
might be more optimistic about the companys future generation of cash flows. These
differences, at times, can present the investor with attractive entry points when the general market
is overly pessimistic about a certain company or industry.

How do I define intrinsic value? I agree with Mr. Buffetts definition in the 1996 Berkshire
Hathaway Owners Manual: Intrinsic value can be defined simply: it is the discounted value of
the cash that can be taken out of a business during its remaining life. I also believe that the
definition provided by Graham and Dodd in Security Analysis is correct. They defined intrinsic
value as the value which is justified by assets, earnings, dividends, definite prospects and the
management factor.

Basically, intrinsic value is a measure of all the cash a company will generate in future years,
discounted to the value of that cash generation in todays dollar. The further in the future the cash
flows are, the less they are worth today (the time value of money concept). The discounted cash
flow method is the primary method I use to calculate a companys intrinsic value. I would refer
the reader back to Chart 4 in Part 1 of the Focus Investing Series to see an example of how this is
calculated.

Investors can also value a firm by trying to determine what the company would sell for if it were
placed on the auction block, or finding out what comparable companies have sold for in recent
transactions. The latter method of company valuationshould be treated with some degree of
skepticism, however, since CEOs can fall prey to excessive optimism just as easily as individual
investors can.

Benjamin Grahams margin of safety concept fits well with the intrinsic value concept, stating
that the investor should only pay a given price for a business that allows for a margin of error. In
this way the investor can still expect to earn a reasonable return even if the business doesnt
perform as initially expected.














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Chapter 4: Psychology of Investing

The efficient market theory states that since the stock market is so quick to adjust to new
information, security prices very quickly represent all the public and private information
available. This is not a realistic tenet, however: investors tend to fall prey to their emotions and
as a group may decrease a stock price below intrinsic value when bad news initially arrives at the
marketplace. By the same token, they tend to increase stock prices to levels above intrinsic value
when unanticipated good news arrives at the marketplace. Letting emotions control the
investment decision-making process can lead to sub-standard investment returns. In an effort to
understand how these emotions affect the investment decision-making process, several common
emotional errors will be covered here in the hopes that, once the investor is aware of them, they
can be avoided.

The most common thought-processing errors occur when individuals use shortcuts to make
investment decisions. The field of Behavioral Finance refers to these shortcuts as heuristics.
These shortcuts are vital in other aspects of an investors life. Imagine making normal day-to-day
decisions with the same intensity as when making the decision on what college to attend after
graduating high school. So the shortcuts are vital to anyone leading a normal life, but successful
investors must learn to avoid these mental shortcuts when investing.

These shortcuts are influenced by several psychological factors:

Availability Bias - Individuals tend to have a stronger recollection of information recently
obtained or information that has left a strong impression on them. These memories can influence
the decision-making process when making investment choices. An example of this behaviour
would be an investor buying a stock solely because a favorite money manager talks it up on a
CNBC interview.

Representativeness - Most people make decisions based on stereotypes they have developed over
time. Reversion to the mean is an example of this psychological factor. For instance, many
investors may believe that the market will decline in value in a given year, just because it has
gone up every year for the last five years and is now due for a fall. This is not a rational way of
looking at the situation. The market is not likely to experience a decline simply because it has
risen for the last five years. There will always be many factors involved in any move in the
direction of the market, but the investor will never to be able to forecast future movements based
on past performance.

Another related example of representativeness is a concept called gamblers fallacy. Gamblers
tend to believe the notion that if a fair coin has landed on heads six times in a row, it is more
likely to land tails up on the seventh toss. In fact, the coin has the same chance of landing heads
up or tails up on any given toss, so any heads up or tails up streak means nothing when
considering the probability of which side will land face up on the next toss.

This can be seen in the investment field, when investors watch for trends in the movement of a
stocks price or a companys earnings. These so-called investors have concluded that since a
business stock price or earnings have steadily increased over the last four quarters, it will
certainly continue this trend into the next quarter. I fail to understand the rationality of this
process of investment selection.



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Hersh Shefrin says it best in this quote from his book, Beyond Fear and Greed:

The point is markets behave a lot like coin tosses. Coin tosses produce interesting patterns, but
past patterns provide little if no guidance about how to predict patterns of the future.

Over-confidence Most active investors believe they possess superior capabilities when it comes
to stock selection, or else they would invest in actively managed mutual funds or funds that track
the performance of various stock market indexes. In fact, most investors would probably be
better off selecting a passive investment process, such as investing in a low cost index fund.

Anchoring Investors have a tendency to stay on a course of action once it has been decided
upon. For example, if investors watch a businesses stock price trade within a certain price range,
they may come to believe it should continue to trade within that range and make future purchase
or selling decisions based on these ranges. I say let the business economics decide when to buy or
sell, not the price range in which the stock is trading.

Excessive Optimism As has been shown in a report by Barber and Owen, the majority of
investors fall prey to over-stimulation and over-confidence in their ability to predict short-term
trends and, as a result, they trade in and out of their holdings much too frequently. This frenzied
trading increases the amount of choices that must be made correctly; it increases trading costs;
and it increases the amount of taxes that will have to be paid. The combination of all of these
factors greatly increases the probability that any investor practicing this behavior will under-
perform in the market.

Investors should realize they will not always make the correct decisions in investment selection
but, when an error is made, the important thing is to examine how it occurred and vow not to
repeat the same mistake. They should also realize that it is not rational to expect the market to
always increase by 24%, year in and year out. For a fascinating look into what Mr. Buffet thinks
the direction of future stock market returns will be and how he arrives at his conclusions, I
strongly recommend that investors read his 1999 and 2001 articles which appeared in Fortune
magazine. The link section of FocusInvestor.com contains hyperlinks to both of these articles.

Illusion of Validity In the course of their research, investors will often ignore evidence that goes
against the conclusions they have already formed. They may similarly place too high a value on
evidence that agrees with their conclusions, while disregarding information that refutes their
theories. This behavior is called confirmation bias and may lead investors to act confidently on
views that may, in fact, be incorrect.

Hindsight Bias The examination of past market behavior and/or results can lead investors to
falsely extrapolate past trends into future predicted behavior. This is dangerous reasoning, as past
behavior is certainly not a good indicator of the future behavior of the market. It is always easier
to see how markets reacted to stimuli when you already understand the outcome which came to
pass.

In addition to heuristic-driven errors, frame dependence is another area in which the investors
thought-processing abilities might break down. Frame dependence occurs when errors are made
in an investors perceptions of risk and return as a result of how decision problems are presented
to them. Three examples will be covered: loss aversion & loss realization; mental accounting and
risk tolerance; and regret complex.


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Loss Aversion and Loss Realization

Investors have a distinct aversion to loss and will avoid the perceived possibility of sustaining a
loss if at all possible. In their 1982 book, Judgement under Uncertainty: Heuristics & Biases,
Daniel Kahneman and Amos Tverksky found that a loss resulted in two and a half times the
emotional impact of an equivalent gain. This may explain why some people are unable to invest
in the stock market; they just cant face the fact that they may experience a short-term loss,
irrespective of the amount of long-term gains that could possibly be attained. This fact may also
explain why lotteries are so popular; the amount of money being risked is so small on an
individual ticket level that the impact of its loss is minimal.

Loss realization is another example of frame dependence. If an investment has been made, and
the price has since declined, some investors find it difficult to sell and realize the loss (this applies
only if the business economics have declined along with the stock price). The investor finds it
difficult to admit a mistake may have been made when purchasing the investment in the first
place, and believes the stock price (or business performance) will rebound. Focus investors
shouldnt make the mistake of holding onto losing investments because it is too hard to admit an
error has occurred.

Meir Statman and Hersh Shefrin, in a 1985 article in the Journal of Finance, confirm the idea that
investors sell the winners in their portfolio too early and hold their losers too long. Focus
investors should admit the error, take the loss, investigate how the error occurred and apply the
lessons learned in future investing decisions.

Mental Accounting and Risk Tolerance

Mental accounting occurs when people treat money decisions differently based on how the
money was earned, or what source it originated from. Here are two examples of this behavior:

John has just received $50,000 in a surprise inheritance. He subconsciously considers this "free"
money; after all, he didn't plan to have it and didn't work hard to accumulate it. John decides that,
rather than investing all of it, he will buy a new car and take a much-deserved vacation. Even
though there is nothing wrong with this activity, it is interesting since John would probably never
consider buying a new car or taking a vacation with the $50,000 he has saved in his retirement
plan. Hence, he has placed this new money in a different mental account.

Sue has just won $500 in a poker game. She has been lucky and has grown her stake to $600
from the $100 with which she began gambling. Sue's mental accounting classifies this additional
$500 as free money. Sue decides to risk the $500 in profit, and keeps betting. By the end of the
night she leaves, happy that she still has $150 in her pocket, $50 more than she started with.

Sue and John have both made mental accounting errors. John made decisions he would normally
not have contemplated with the money he received, and Sue was happy to leave with $50 more
than she had when she entered the casino. Sue doesn't realize that she actually lost $450 during
her visit, because she classified the other $450 in her mind as free money.

To avoid these frame dependence errors, try not to focus on short-term losses in your investment
portfolio. Overly conservative portfolios can result in an under-performing portfolio (avoid
having a portfolio in 80% US Treasury notes and 20% in stocks unless good opportunities to
invest the cash are scarce). Focus investors should always keep in mind the time frame they have
when investing: why worry over a short-term dip in a stock price that has no correlation with its
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intrinsic value in a company you have investigated thoroughly? Remember, you only have to
follow the crowd if you believe they are correct in a given instance. If your reasoning is correct,
don't be upset that the crowd is not thinking the same thoughts. Take advantage of the opportunity
being presented to you.

Regret Complex

Some investors choose investment options they believe will cause them the least amount of regret
at the end of the day. This can cause irrational behavior, such as a potential investor deciding not
to invest in equities and instead purchasing certificates of deposits at a local bank, because he or
she simply cant face the possibility of short-term losses. This choice will minimize the
possibility of regret if equities decline, but also cause a major loss of wealth over time due to
inflation and the better returns stocks have historically provided over certificates of deposit.
Some potential investors just can't deal with the possibility that they might be responsible for
making a bad decision, and this results in irrational behavior.

The negative impact of experiencing the regret complex can cause irrational behavior when
investors experience their first bear market. If they don't have the right temperament, they will
regret ever having invested in equities in the first place, and may decide to pull all of their money
out of the market (probably at the worst possible time), which is an extremely bad decision to
make. Investors shouldnt summarily dismiss this concept if they havent experienced a
significant downturn in their portfolio or the market, as they never know how they will react to
this situation.

Delayed Gratification

What is the easiest way to become wealthy? Be frugal and under-spend your income (live below
your means) and follow an appropriate investing strategy for the long-term. Here is what Thomas
Stanley and William Danko observed in their book, The Millionaire Next Door:

"What have we discovered in our research? Mainly, that building wealth takes discipline,
sacrifice, and hard work. Do you really want to become financially independent? Are you and
your family willing to reorient your lifestyle to achieve this goal? If you are willing to make the
necessary trade-offs of your time, energy, and consumption habits, however, you can begin
building wealth and achieving financial independence."

I agree completely and would only add that I believe the focused investing strategy has the
potential to aid certain investors in the struggle to become financially independent. Here is
another interesting quote from a book written by Merryle Rukeyser, The Common Sense of
Money and Investments:

"It takes a human being of some imagination and economic intelligence to forego immediate
gratifications for the expectation of future realizations of happiness. And yet the economically
astute will feel to a large extent repaid for avoiding the temptation to spend by the consciousness
that tomorrow has to some extent been provided for. Instead of the fun of spending all surplus
funds on the theater, on expensive furs, and on other vehicles of self-indulgence, the saver will
have bought immunity from the worries and vague fears of poverty. It has been wisely observed
that thrift involves a transfer of part of income to capital. Thrift also entails tying the future to the
present."

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Chapter 5: Conclusion

The successful focus investor must be able to select companies that have enduring competitive
advantages which are selling for a great price. Additionally they must have a keen understanding
of the psychology of investing. If they dont, they are truly operating at a severe disadvantage.

In conclusion the investor should always remember that some types of risk are not worth taking.
Pick the risk best suited for you to achieve financial independence in the long run. I can think of
no better way to conclude this series than with a quote from Benjamin Graham, from a 1974
lecture:

"Let me close with a few words of counsel from an 80-year-old veteran of many a bull and many
a bear market. Do those things as an analyst that you know you can do well, and only those
things. If you can really beat the market by charts, by astrology, or by some rare and valuable gift
of your own, then that's the row you should hoe. If you're really good at picking the stocks most
likely to succeed in the next 12 months, base your work on that endeavor. If you can foretell the
next important development in the economy, or in technology, or in consumers' preferences, and
gauge its consequences for various equity values, then concentrate on that particular activity. But
in each case you must prove to yourself by honest, no-bluffing self-examination and by
continuous testing of performance, that you have what it takes to produce worthwhile results.

"If you believe - as I have always believed - that the value [focus] approach is inherently sound,
workable, and profitable. Stick to it, and don't be led astray by Wall Street's fashions, illusions,
and its constant chase after the fast dollar. It is worth emphasizing that it does not take a genius
or a superior talent to be successful as a value analyst. What it needs is, first, reasonably good
intelligence; second, sound principles of operation; third, and most important, firmness of
character."

Please feel free to visit the FocusInvestor.com message board at
http://www.focusinvestor.com/cgi-bin/ib3/ikonboard.cgi to discuss any topics in this article in
more detail or email me at [email protected].















______________________________________________________________________________
Copyright 2000-2003, FocusInvestor.com. All rights reserved. This material is for personal use only.
Republication and redissemination, including posting to news groups, is expressly prohibited without the
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Bibliography:

Security Analysis (1934, 1940, 1951) by Benjamin Graham and David Dodd

The Intelligent Investor (1973) by Benjamin Graham

The Interpretation of Financial Statements (1955, 1964) by Benjamin Graham

Berkshire Hathaway Letters to Shareholders (1977 to Present) by Warren Buffett

Why Smart People Make Big Money Mistakes (1999) by Gary Blesky and Thomas Gilovich

Beyond Greed and Fear (2000) by Hersh Shefrin

How Inflation Swindles the Equity Investor, (May 1977) Fortune Magazine article by Warren
Buffett

The Warren Buffett Way (1994) by Robert Hagstrom

The Warren Buffett Portfolio (1999) by Robert Hagstron

Common Stocks and Uncommon Profits (1958) by Philip Fisher

Influence: The Psychology of Persuasion (1993) by Robert Cialdini

The Common Sense of Money and Investments (1924) by Merryle S. Rukeyser