Articles by Whitney Tilson

Fool.com: Thoughts on Value Investing [Fool on the Hill] November 7, 2000

http://www.fool.com/news/foth/2000/foth001107.htm

With the suspension of the Boring Portfolio, I'll now be writing in this space every Tuesday. Since many Fools may not have spent much time in the backwaters of the Bore Port, I'd like to use this, my first Fool on the Hill, to introduce myself. (I don't have much space here, so I've included links to many of my favorite articles below; links to all 45 Motley Fool columns I've written over the past year are on my website.) Unlike pretty much every other writer for the Fool, I don't work for the Fool. I'm a money manager in New York City, though I'm about as far from the fast trading, Wall Street stereotype as you can get. I've been a consultant and entrepreneur (many times over), and have an MBA, but have never worked for a financial firm. In fact, not too long ago I was an individual investor just like you. I taught myself how to invest by reading voraciously, then began to manage my own money, then some for my family, and eventually started my own firm. What is value investing? I am a value investor, though if you looked at my portfolio, you might scratch your head and wonder. I'd like to use the rest of this column and the next one to share my thoughts on value investing, especially as it applies to the New Economy. Very simply, value investing means attempting to buy a stock (or other financial asset) for less than it's worth. In this case, "worth" is not what you hope someone else might pay for your stock tomorrow or next week or next month -- that's "greater fool investing." Instead, as I wrote in Valuation Matters, "the value of a company (and therefore a fractional ownership stake in that company, which is, of course, a share of its stock) is worth no more and no less than the future cash that can be taken out of the business, discounted back to the present." Buying something for less than it's worth: What a simple and obvious concept. Charlie Munger said it best at this year's Berkshire Hathaway annual

meeting: "All intelligent investing is value investing." Bargain hunting is pretty much what everyone tries to do when buying anything, right? How many people walk into an auto dealership and say, "I want to buy your most popular car, and I don't care about the price. In fact, if the price has doubled recently, I want it even more."? Conversely, why would someone be deterred from buying if the dealer had recently marked down the price by 25%? And how many people would buy a car based on a stranger's recommendation, without doing any of their own research? So why do so many people behave like this when buying stocks? The answer lies in part, I suppose, in the realm of human psychology -- the assumption that the crowd is always right, and the comfort of being part of the herd. Also, there's the thrill of gambling and the hope of a big score. (I intend to return to the topic of behavioral economics -- the subject of my first Motley Fool column, The Perils of Investor Overconfidence -- in future columns.) Another factor is that valuation is tricky -- it's hard to develop scenarios and probabilities to estimate a company's future cash flows. But that's no excuse. As I argued in perhaps my most controversial column, The Arrogance of Stock Picking, if you don't have the three T's -- time, training and temperament -- that are the basic requirements for successful stock picking, then you're very likely to be better off in mutual funds (or, better yet, index funds). As I noted in my follow-up column, More on The Arrogance of Stock Picking, "I think it's a sign of the times that this [point of view] would be considered by some to be controversial or insightful. Heck, I'd give you the same advice were you to undertake any challenging endeavor: piloting a plane, teaching a class, starting a business, building a house, whatever. But when it comes to investing, people are bombarded with messages that they should jump into the market and buy stocks, and of course there is no mention of the risks involved or the skills required to invest properly." I think my arguments largely fell on deaf ears during the madness earlier this year. With the unfortunate pain many unsuspecting investors have experienced since then, maybe now there will be a more receptive audience. What value investing is NOT Many people think that value investing means buying crummy companies at

single-digit P/E ratios. Ha! While some value-oriented investment managers have fallen into this trap (the subject of my column, Should Warren Buffett Call It Quits?, which compared Warren Buffett with the Tiger Funds' Julian Robertson), I'm skeptical that there's much genuine value in companies trading at low multiples but with poor financials and weak future prospects. Buffett agrees. In his latest annual letter, he wrote: "If the choice is between a questionable business at a comfortable price or a comfortable business at a questionable price, we much prefer the latter. What really gets our attention, however, is a comfortable business at a comfortable price." Nor does value investing rule out taking risks. If the potential payoff is high enough, even the risk of total loss is acceptable. For example, every value investor I know of would jump at the chance to invest at least a small portion of their assets in a coin toss, where heads would pay 5x, but tails would yield a total loss. (I make similar calculations when I make venture capital investments.) Unfortunately, however, as I argued last month in Perils and Prospects in Tech, many people take tremendous risks -- often unknowingly - by buying high-flying stocks in the belief that they are making such a bet, when in fact the odds are far worse. This does not mean that value investing excludes all companies with high P/E ratios (though I would argue, as I did in Cisco's Formidable Challenge, that very few businesses of any size are likely to be undervalued if they trade above 50x earnings and certainly 100x). For example, I bought Intel early last year at approximately 25x trailing earnings. That may not sound like a bargain, but I felt that this exceptional company would generate enough cash over time to justify its price. Despite its recent hiccups, my opinion hasn't changed and I'm still holding. As this example shows, I don't believe that value investing precludes buying the stocks of technology companies. While Buffett is famous for his aversion to such stocks (the subject of my column, Why Won't Buffett Invest in Tech Stocks?), he does not deny that there can be wonderful bargains in this arena. He simply says: "I don't want to play in a game where the other guy has an advantage. I could spend all my time thinking about technology for the next year and still not be the 100th, 1,000th, or even the 10,000th smartest guy in the country in

analyzing those businesses. In effect, that's a 7- or 8-foot bar that I can't clear. There are people who can, but I can't. Different people understand different businesses. The important thing is to know which ones you do understand and when you're operating within your circle of competence." (1998 annual meeting) I urge you to think about your circle of competence. Understanding it -- and not straying beyond it -- is one of the most critical elements of successful investing. Another critical element is a firm grasp of Sustainable Competitive Advantage. Conclusion Value investing is very simple in concept, but very difficult in practice. The market, for all its foibles, tends to be quite efficient most of the time, so finding significantly undervalued stocks isn't easy. But this approach, done properly, offers the best chance for substantial long-term gains in varied markets, while protecting against meaningful, permanent losses. Next week I will continue with some thoughts about why, despite being a value investor, I embrace rather than shun the tech sector. -- Whitney Tilson Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for the Motley Fool and other writings, click here.

Traits of Successful Money Managers

http://www.fool.com/news/foth/2001/foth010717.htm By Whitney Tilson 07/17/2001 I have spent an enormous amount of time studying successful money managers, ranging from those still active today -- like Berkshire Hathaway's(NYSE: BRK.A) Warren Buffett and Charlie Munger, and Sequoia Fund masterminds Bill Ruane and Richard Cunniff -- to earlier ones such as Peter Lynch, John Neff, Philip Fisher, John Templeton, and Ben Graham. (This is by no means a comprehensive list.) My goal has been to learn from their successes -- and equally importantly, their failures. Given that investment mistakes are inevitable, I'd at least like mine to be original ones. So what have I learned? That long-term investment success is a function of two things: the right approach and the right person. The right approach There are many ways to make money, but this doesn't mean every way is equally valid. In fact, I believe strongly -- and there is ample evidence to back me up -- that the odds of long-term investment success are greatly enhanced with an approach that embodies most or all of the following characteristics:

Think about investing as the purchasing of companies, rather than the trading of stocks. Ignore the market, other than to take advantage of its occasional mistakes. As Graham wrote in his classic, The Intelligent Investor, "Basically, price fluctuations have only one significant meaning for the true investor. They provide him an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times, he will do better if he forgets about the stock market."

Only buy a stock when it is on sale. Graham's most famous saying is: "To distill the secret of sound investment into three words, we venture

the motto, MARGIN OF SAFETY." (For more on this topic, see my column, "Trembling With Greed.")

Focus first on avoiding losses, and only then think about potential gains. "We look for businesses that in general aren't going to be susceptible to very much change," Buffett said at Berkshire Hathaway's 1999 annual meeting. "It means we miss a lot of very big winners but it also means we have very few big losers.... We're perfectly willing to trade away a big payoff for a certain payoff."

Invest only when the odds are highly favorable -- and then invest heavily. As Fisher argued in Common Stocks and Uncommon Profits, "Investors have been so oversold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others about which they know nothing at all."

Do not focus on predicting macroeconomic factors. "I spend about 15 minutes a year on economic analysis," said Lynch. "The way you lose money in the stock market is to start off with an economic picture. I also spend 15 minutes a year on where the stock market is going."

Be flexible! It makes little sense to limit investments to a particular industry or type of stock (large-cap growth, mid-cap value, etc.). Notes Legg Mason's Bill Miller, the only manager of a diversified mutual fund to beat the S&P 500 index in each of the past 10 years, "We employ no rigid industry, sector, or position limits."

Shun consensus decision-making, as investment committees are generally a route to mediocrity. One of my all-time favorite Buffett quotes is, "My idea of a group decision is looking in a mirror."

The right person The right approach is necessary but not sufficient to long-term investment success. The other key ingredient is the right person. My observation reveals that most successful investors have the following characteristics:

They are businesspeople, and understand how industries work and companies compete. As Buffett said, "I am a better investor because I am a businessman, and a better businessman because I am an investor."

While this may sound elitist, they have a lot of intellectual horsepower. John Templeton, for example, graduated first in his class at Yale and was a Rhodes Scholar. I don't disagree with Buffett -- who noted that "investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ" -- but would point out that he didn't use the numbers 160 and 100.

They are good with numbers -- though advanced math is irrelevant -and are able to seize on the most important nuggets of information in a sea of data.

They are simultaneously confident and humble. Almost all money managers have the former in abundance, while few are blessed with the latter. "Although humility is a trait I much admire," Munger once said, "I don't think I quite got my full share." Of course, Munger also said: "The game of investing is one of making better predictions about the future than other people. How are you going to do that? One way is to limit your tries to areas of competence. If you try to predict the future of everything, you attempt too much." In addition to what Munger is talking about -- understanding and staying within one's circle of competence -- there are many other areas of investing in which humility is critical, which I discussed in "The Perils of Investor Overconfidence."

They are independent, and neither take comfort in standing with the crowd nor derive pride from standing alone. (The latter is more common since, I argued last week, bargains are rarely found among the crowd. John Neff said he typically bought stocks that were "misunderstood and woebegone.")

They are patient. ("Long-term greedy," as Buffett once said.) Templeton noted that, "if you find shares that are low in price, they don't suddenly go up. Our average holding period is five years."

They make decisions based on analysis, not emotion. Miller wrote in his Q4 '98 letter to investors: "Most of the activity that makes active portfolio management active is wasted... [and is] often triggered by ineffective psychological responses such as overweighting recent data, anchoring on irrelevant criteria, and a whole host of other less than optimal decision procedures currently being investigated by cognitive psychologists."

They love what they do. Buffett has said at various times: "I'm the luckiest guy in the world in terms of what I do for a living" and "I wouldn't trade my job for any job" and "I feel like tap dancing all the time."

Obvious? Much of what I've written may seem obvious, but I would argue that the vast majority of money in this country is managed by people who neither have the right approach nor the right personal characterisitics. Consider that the average mutual fund has 86% annual turnover, 132 holdings, and no investment larger than 5% of the fund. Those statistics are disgraceful! Do you think someone flipping a portfolio nearly 100% every year is investing in companies or trading in stocks? And does 132 holdings indicate patience and discipline in buying stocks only when they are on sale and odds are highly favorable? Of course not. It smacks of closet indexing, attempting to predict the herd's next move (but more often mindlessly following it), and ridiculous overconfidence -- in short, rampant speculation rather than prudent and sensible investing. The performance trap I have not discussed historical performance as a metric for evaluating money managers, not because it's unimportant, but rather because it's not as important as most people think. Consider this: If you took 1,000 people and had them throw darts to pick stocks, it is certain that a few of them, due simply to randomness, would have stellar track records, but would these people be likely to outperform in the future? Of course not. The same factors are at work on the lists of top-performing money managers. Some undoubtedly have talent but most are just lucky, which is why countless studies -- I recommend a 1999 article by William Bernstein -have shown that mutual funds with the highest returns in one period do not outperform in future periods. (Look at the Janus family of funds for good recent examples of this phenomenon.) As a result, the key is to find money managers who have both a good track record and the investment approach and personal characteristics I've noted above.

Conclusion The characteristics I've described here are not only useful in evaluating professional money managers. They can also be invaluable in helping you decide whether to pick stocks for yourself. Do you have the right approach and characteristics? -- Whitney Tilson

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The Arrogance of Stock Picking By Whitney Tilson (Tilsonfunds@aol.com)

NEW YORK, NY (Jan. 3, 2000) -- One of the best columns I've ever read on The Motley Fool -- or anywhere else for that matter -- was penned by former Fool Randy Befumo. His Fool on the Hill article, written on November 12, 1997, was entitled "When NOT to Invest." (The article appears in the old Evening News format, so make sure to scroll down past the "Heroes" and "Goats.") I'm afraid I won't be as eloquent as Randy, but I'd like to highlight some of his ideas and add a few of my own. I hate to start the new year by saying something a lot of people aren't going to want to hear, but I think it needs to be said, and given what's going on in the market, it needs to be said sooner rather than later. I believe an awful lot of people who are investing in individual stocks shouldn't be doing so. I realize that as a professional money manager, that sounds self-serving and arrogant, but hear me out. Over the past 25 years, Americans have enjoyed the most remarkable period in the history of the stock market. During that time, the S&P 500 Index has only declined in three years, the worst being a mere 7.4% decline in 1977. The S&P was even up 5.1% in 1987, a year best remembered for the 20-plus percent crash in a single day in October. And the past five years have seen an unprecedented 20% or greater increase each year (the old record was two consecutive years). Little wonder that millions of average Americans are flocking to the stock market. As I wrote in a recent column, I think this is great, as stocks have always provided superior returns vs. bonds and T-bills for long-term investors. And despite the market's high valuation levels today, I expect this will continue to be the case for investors with at least a 20-year time horizon. But the means by which people are investing in stocks concerns me. Rather than investing in diversified funds run by professionals -- or, better yet, in index funds -record numbers of people are picking stocks on their own. Despite the mantra preached on this website, I think this is a mistake for many -perhaps most -- people. Why do I believe this, especially given the success that individual investors have had in recent years? Because I think that beating the market over long periods of time will be difficult and will require a number of things (discussed below) that most people don't have. Based on what I read in the media, on message boards, and in e-mails I get from readers, I fear that many people have been drawn into the market because they felt like they were missing out on a party in which everyone else was partaking. Just buy large-cap, brand-name stocks, especially riskier stocks in the tech/Internet area -- and maybe some IPOs as well -- and you'll get rich quick. You know what? There's been nothing but positive reinforcement for this approach, which of course lures more people to the party and leads everyone to invest even more money (or, heaven forbid, start borrowing money to invest). To some

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extent, this phenomenon creates a self-perpetuating cycle, but I don't believe it can go on forever. Burton Malkiel, author of the brilliant book A Random Walk Down Wall Street, wrote an eloquent article, "Humbling Lessons From Parties Past," about this in yesterday's New York Times that I urge you to read. Let me be clear: I'm not a bitter money manager who has trailed the market (quite the opposite in fact) and who expects a collapse of today's high-flying stocks. I even own some of these stocks -- Microsoft, for example. But, I don't own them because they're popular. I own them because I feel that I have a strong understanding of their businesses, economic characteristics, and competitive positions, and believe that the companies will do well enough over the many years I intend to own them to justify their high current valuations. I don't kid myself about the risks in these stocks, and am careful to diversify by owning some value stocks and small- and mid-cap stocks. Who Should Invest in Individual Stocks I wholeheartedly endorse stock picking, but only for people with realistic expectations, and who have what I refer to as the three T's: time, training, and temperament. Expectations We all know the statistics about the percentage of highly trained mutual fund managers with enormous resources at their disposal who have trailed the S&P 500 Index -- well over 90% over the past five years. On average, individual investors also underperform the market for many of the same reasons, taxes and trading costs in particular (see Odean and Barber's landmark study of 78,000 individual investors). Given these odds, it takes real confidence, bordering on arrogance (or perhaps just naivete), to try to beat the market. And I'm as guilty as the next person. So why do most people try? I explored some of the reasons in my column on "The Perils of Investor Overconfidence." Time Before I started managing money professionally on a full-time basis, I was doing what most of you were doing: investing in stocks part-time while holding down a full-time job. In retrospect, though I was having success, I realize that it was due in part to good fortune, not because I truly understood the companies and industries in which I was investing. Today I have a much deeper understanding -- and I have the time to research more investment ideas -- both of which I believe give me a better chance of beating the market in the long run. I know that Philip Fisher and others who I respect immensely say that once

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you've picked a few good companies, it requires no more than 15 minutes per company every three months to review the quarterly earnings announcements, but I just don't think this is realistic -- especially if you're investing in companies in the fast-moving technology sector. Were I no longer able to invest full-time, I think I would put most of my money in index funds. Training Remember the first time you ever tried rollerblading or skiing? You were probably a little wobbly and started by going slowly and learning how to turn and stop. Of course, nothing prevented you from heading for the biggest hill, but I hope you had the good sense not to. Or maybe you didn't, but ask yourself: even if you didn't crash, was it a good idea? Investing is much more difficult than skiing or rollerblading -- and the consequences of mistakes can be severe -- yet countless people are buying stocks without the foggiest notion of what they're doing. Identifying and exploiting market inefficiencies is the key to successful longterm investing. To do so, you need appropriate skills and training to understand at least a few industries and companies, and think sensibly about valuations. In his column, Randy outlined a number of hurdles: "In my opinion, you should NOT be investing in stocks... if you cannot define any of the following words: gross margin, operating margin, profit margin, earnings per share, costs of goods sold, dilution, share buyback, revenues, receivables, inventories, cash flow, estimates, depreciation, amortization, capital expenditure, GAAP, market capitalization or valuation, shareholder's equity, assets, liabilities, return on equity." To this list, I would add the flow ratio and return on invested capital, among others. How many people have even these tools, much less the many others required to be a successful long-term investor? Learning these things isn't overly difficult and -- I can assure you based on personal experience -- doesn't require an MBA. But it does require quite a bit of time and effort. So where should you start? I, for one, taught myself almost all of what I know about investing by reading (here are my favorite books and quotes on investing). Warren Buffett and Charlie Munger were asked this question at last year's Berkshire Hathaway annual meeting. Munger replied, "I think both Warren and I learn more from the great business magazines than we do anywhere else. I don't think you can be a really good investor over a broad range without doing a massive amount of reading." Buffett replied, "You might think about picking out 5 or 10 companies where you feel quite familiar with their products, but not necessarily so familiar with their financials. Then get lots of annual reports and all of the articles that have been written on those companies for 5 or 10 years. Just sort of immerse yourself.

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"And when you get all through, ask yourself, 'What do I not know that I need to know?' Many years ago, I would go around and talk to competitors, always, and employees.... I just kept asking questions.... It's an investigative process -- a journalistic process. And in the end, you want to write the story.... Some companies are easy to write stories about and other companies are much tougher to write stories about. We try to look for the ones that are easy." Temperament Numerous studies have shown that human beings are extraordinarily irrational about investing. On average, we trade too much, buy and sell at precisely the wrong times, allow emotions to overrule logic, misjudge probabilities, chase performance, etc. The list goes on and on. To invest successfully, you must understand and overcome these natural human tendencies. If you're interested in learning more, see the books and articles I recommended at the end of my column on "The Perils of Investor Overconfidence." What About the Fools? What I am saying here is in many ways in contrast to what The Motley Fool stands for (and it is to their credit that they are publishing this heretical column). For example, in the Rule Breaker Portfolio a few days ago, David Gardner wrote: "In August of 1994, we began with $50,000 of our own money. The aim was to demonstrate to the world what was our own deeply held faith: Namely, that a portfolio of common stocks selected according to simple Foolish principles could beat the Wall Street fat cats at their own game. We're simply private little-guy investors -- not a drop of institutional blood in us -- taught by our parents, by our own reading, and by our experience as consumers and lovers of business. And there's not much more magic to it than that." These average Joes have compounded their money at 69.6% annually since they started in 8/5/94. If they can, why can't you? A number of reasons. I think they would admit that they've been lucky, but it's clearly more than that. I've met the Gardners and read a great deal of what they've written over the past four years. They are most certainly not average Joes. They live, eat, and breathe investing, adhere to a disciplined investment strategy, generate and analyze investment ideas among a number of extremely smart people, and are very analytical and rational. What About the Dow Dogs and Other Backtested Stock-Picking Methods? This topic warrants a separate column, but I'm generally skeptical of backtesting (boy, am I going to get a lot of hate mail for this one!). I've

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looked at the various methods in the Foolish Workshop (Keystone, Spark 5, etc.) and my main concern is that all of these methods have only been backtested to 1986 or 1987. I know that might sound like a long time, but it's not, especially given the steadily rising market during this period. I'm not much interested in methods that will do well should the market continue to soar -- we're all going to do fine if that happens. I'm more concerned about a scenario such as the decade of the 1970s repeating itself. In this case, I don't think the Foolish Workshop methods will work very well. Think about it: What if you had backtested various strategies in 1982. I'll bet the most successful methods would have involved buying many natural resources companies -- which would have been a disaster as an investment approach going forward. But what about the Foolish Four and other Dow Dog strategies, which did very well during the 1970s, and for which there is data going back to the early decades of this century? I think there is more validity to these approaches, but I'm still skeptical of blindly following them -- instead, I use them as a source of investment ideas. The bottom line is that I don't think there's any substitute for doing your homework and truly understanding the companies and industries in which you're investing. Conclusion It's hard for me to discourage anyone from investing in stocks because I enjoy it so much. I find it fascinating to learn about companies and industries and observe the ferocious spectacle of capitalism at work. To me, watching Scott McNealy and Bill Gates and Larry Ellison go head-to-head is the best spectator sport going. But I don't think picking stocks is going to be as easy going forward as it's been for the past few years, and I fear that many people are in over their heads and aren't even aware of it. As Warren Buffett once said, "You can't tell who's swimming naked until the tide goes out." Who knows? Maybe I'm swimming naked too. I understand why people don't invest in index funds -- it's natural to want to do better than average. But the refusal to accept average performance causes most people to suffer below-average results, after all costs are considered. I encourage you to invest in individual stocks, but only if you're willing to take the time and effort to do so properly. -- Whitney Tilson

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FOOL ON THE HILL An Investment Opinion by Randy Befumo When NOT to Invest
Unfortunately, many investors who are seduced by the lure of easy money try to become "active" investors before they have the skills, the resources, or the appropriate intellectual framework to do so. This is not to say that investing in stocks is extraordinarily difficult -- it is not. However, beating the market on a regular basis is far from easy and requires that an investor bring to the investing process a singular discipline, knowledge, or passion that will allow him to rise above the herd. Like any other competition, not everyone can win. In fact, net of new cash in-flows into the market, for every dollar that outperforms a market index, somebody else's dollar is not doing quite so well. How can you tell if you are ready to become an "active" investor? Not an investor who buys and sells stocks on a regular basis, but active in the way the academics mean it -- someone who selects their own stocks. It is not like there is a licensing process or anything. In fact, there is not even a formal course of instruction. Much like parenting, you tend to only find out if you are cut out to be an investor only after you have made a pretty substantial commitment. Today, I wanted to try to give some pointers based on some recent e-mail I have received in an attempt to give some guidance as to when you should start buying your own stocks. In my opinion, you should NOT be investing in stocks... ...if you need the money within two to three years at the least, five years as an intermediate time, and ten years if you are really risk averse. ...if you don't like to do math. ...if you use the word "play," "gamble," "flyer," or any similar speculation-oriented word when you describe your investments. ...if you think indexes matter more than what companies you own. ...if you are unprepared for volatility. A lot of people look at the returns for the stock market only to turn pale at the first loss. If you cannot stand to lose money, you should not own stocks. Period. ...if you think you will only ever buy stocks that go up. News flash --

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you are not perfect. No system is perfect. No provider of advice is perfect. You can -- and will -- lose money at some point during your investment career. You can minimize this loss if you do your homework and are careful about valuation, but money lost is money lost. ...if you believe that the share price alone or share price movements alone tell you anything about the underlying quality of the company or its business. All too often people buy low-priced shares with the idea that they are cheap, only to find out that they are low-priced because the underlying business sucks. ...if you couldn't write down a list of why you bought and what might make you sell. If you don't know why you bought a stock in the first place, how can you know when to sell it? Bad scene. Avoid it. ...if you cannot tell the difference between a balance sheet and an income statement. Especially if you don't even know where to find a copy of either. ...if you don't know how to get the phone number for Investor Relations at the company in case you have question. ...if you cannot make a rudimentary assessment of the underlying quality of a company. ...if you cannot define any of the following words: gross margin, operating margin, profit margin, earnings per share, costs of goods sold, dilution, share buyback, revenues, receivables, inventories, cash flow, estimates, depreciation, amortization, capital expenditure, GAAP, market capitalization or valuation, shareholder's equity, assets, liabilities, return on equity. ...if you only have one source of information about the company. I don't care whether it is your best friend, a message board, or some content provider. If you cannot independently verify the facts, you are bound to get unintentionally bamboozled. No one likes to admit they are wrong. If you depend on one source of information, odds are when it finally coughs up the conclusion that it made a bad call it will be too late. ...if you cannot name the major products a company makes or the company's major competitors.

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...if you only use one technique to value a company. That is like using one tool to build a house. The house will look like crap and be unlivable. Sales, earnings, cash flow, assets, historical returns, management, underlying quality... are just a few of the ways you can value a company. Don't use only one tool. ...if you don't understand that the earnings estimates you get lag. Someone recently wrote to FoolNews commenting that a disk driverelated company looked cheap at five times expected earnings. Unfortunately for that investor, in the past week the estimate had dropped by more than 50%. As estimates are only published once a week for individual investors, if something suddenly changes, the estimates can be very "stale." If that investor had not been following news in the drive industry, he might have made a potentially disastrous investment. ...if you don't follow up on a company at least four times a year. Preferably once a month. These are big investments you are making relative to your savings... put some sweat equity into them. ...if you don't use the Internet. Seriously folks, come on. Almost all of the disadvantage of being an individual investor from the information side was erased by the Internet. If you aren't on it, you are at a major disadvantage to all of the other players. It is like trying to wrestle with no limbs. ...if you buy a stock simply to sell options. Although some might try to convince you this is a conservative, income-oriented approach, the reality is that if you are getting decent premiums for selling the options, you are taking on a lot of risk owning the equity. ...if you refer to management by their first name. This may seem churlish, but nine times out of ten when management is known by their first names the investor has lost all objectivity about the investment.

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Three Steps to Evaluating Stocks

http://www.fool.com/news/foth/2001/foth010925.htm By Whitney Tilson 09/25/2001 I'd like to add one more trait to my list of personal characteristics and professional habits I believe can be found in successful investors, and it's one I believe is more critical now than ever given the market's recent turmoil: a disciplined approach to evaluating stocks. Investors typically encounter many investment ideas each week from reading business publications, using stock screens, talking to other investors, and so forth. Analyzing these ideas quickly and accurately is critical to success in stock picking. My approach, no doubt only one among many that can work, is a three-step process. Circle of competence Berkshire Hathaway's(NYSE: BRK.A) Charlie Munger, who along with Warren Buffett has formed one of the great investing teams of our time, once said: "The game of investing is one of making better predictions about the future than other people. How are you going to do that? One way is to limit your tries to areas of competence. If you try to predict the future of everything, you attempt too much." What simple -- yet widely ignored -advice! Defining your circle of competence, however, is easier said than done. I'm not sure I can succinctly define mine, for example, though I think I have a good understanding of it. I feel to some extent like the late Supreme Court Justice Potter Stewart who admitted he could not formulate a coherent standard for obscenity but wrote, "I know it when I see it." I'm sure most investors believe that they know and stay within their circle of competence, but I really wonder what percentage of investors in such companies as Cisco(Nasdaq: CSCO), Juniper(Nasdaq: JNPR), and JDS Uniphase(Nasdaq: JDSU) really understand these companies' technologies, products and competitors.

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This isn't to say all tech stocks are outside the circle of competence of average investors, however. I don't consider myself a technology expert, but have gotten comfortable enough to own the stocks of certain companies whose businesses I think are reasonably easy to understand, such as Lexmark(NYSE: LXK), Dell(Nasdaq: DELL), and American Power Conversion(Nasdaq: APCC). (I only own the former at this time.) I'll let Warren Buffett have the last word on this topic (from the 1998 Berkshire Hathaway annual meeting): "I don't want to play in a game where the other guy has an advantage. I could spend all my time thinking about technology for the next year and still not be the 100th, 1,000th, or even the 10,000th smartest guy in the country in analyzing those businesses. In effect, that's a seven- or eight-foot bar that I can't clear. There are people who can, but I can't. "The fact that there'll be a lot of money made by somebody doesn't bother me really. There's going to be a lot of money made by somebody in cocoa beans. But I don't know anything about 'em. There are a whole lot of areas I don't know anything about. So more power to 'em. "I think it would be a very valid criticism if it were possible that Charlie [Munger] and I, by spending a year working on it, could become well enough informed so that our judgment would be better than other people's. But that wouldn't happen. And no matter how hard I might train, I still couldn't. Therefore, it's better for us to swing at pitches [that are easy for us]." As I concluded in a March 2000 article, "Different people understand different businesses. The important thing is to know which ones you do understand and when you're operating within your circle of competence...Understanding it -- and not straying beyond it -- is one of the most critical elements of successful investing." Run the numbers Once I determine that a company is within my circle of competence, I go to the financial statements to answer two questions: Is this a good business, and is the stock cheap? Regarding the former, the most important things I'm looking for are high margins and returns on capital, a strong balance sheet,

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modest capital requirements, healthy free cash flow, solid historical growth, and ample room for future growth. As for valuation, I begin -- though certainly don't end -- with the following rule of thumb: Pay no more than 10 times earnings for a decent business, and no more than 20 times earnings for even the greatest business. Given that both the Dow and the S&P 500 are still trading at more than 20x this year's expected earnings, this eliminates an awful lot of stocks. The "soft stuff" By this point, I've discarded at least 95% of investment ideas and can focus my attention on really understanding a company, the hardest -- and most critical -- step. Sustainable competitive advantage The single most important thing I care about is a company's competitive advantage and whether it's sustainable. Buffett agrees. In his November 1999 Fortuneinterview (subscription needed), he said what I believe to be among the wisest words ever said on investing: "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." So how can you determine whether a company has a wide moat around its business, and whether that moat can be sustained or expanded? I've written extensively on this question, so rather than repeating myself, I will refer you to threepastcolumns. In short, however, investors should look for companies with characteristics that will allow them to keep competitors at bay and reap increasing profits as a result. (Among my favorite examples are CocaCola's(NYSE: KO) brand and Microsoft's(Nasdaq: MSFT) control of the operating system.) Management Buffett once said, "A good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of

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how effectively you row... When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact." No doubt this is true, but evaluating management is still a critical part of any investment analysis. What should you look for? As I wrote in a recent column: "I'm looking for ability and integrity. Both are equally important. The former is pretty straightforward: Is the management team capable and wellrespected, and does it have a track record of success? Integrity is harder to gauge, but here are some of the questions I ask: Do managers underpromise and overdeliver? Are they frank in admitting mistakes? Do they appear to be focused on promoting the stock to satisfy the short-term whims of Wall Street, or on building long-term value for shareholders?" The only thing I would add is that "a track record of success" means both generating strong cash flows and allocating them sensibly. The former is common, while the latter is rarer, as evidenced by the excessive compensation and ill-conceived acquisitions that pervade corporate America. (For more on evaluating management, revisit The Motley Fool's in-depth special feature on the topic.) Finally, I investigate a company's culture. At firms with strong cultures, employees care about the company, each other, and customers. They share information and cooperate. They feel good about their jobs and are willing to go the extra mile. This can provide a meaningful competitive edge. -- Whitney Tilson

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Valuation Matters
How to beat the market
By Whitney Tilson February 7, 2000

"The market, like the Lord, helps those who help themselves. But, unlike the Lord, the market does not forgive those who know not what they do. For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments." -- Warren Buffett, 1982 annual letter to shareholders "We submit to you then, Fool, that valuation isn't half so important as quality and the durability of the business model. At least when you're building a Rule Maker Portfolio. In fact, we'll go so far as to say that the quality of the company is fully 100 times more important than the immediate value of its stock price." -- The Motley Fool (Step 7 of the 11 Steps to Rule Maker Investing) I believe in The Motley Fool's core investment philosophy of buying the stocks of quality companies (or index funds), holding for the long run, and ignoring the hype of Wall Street and the media. But if I were to level one general critique of the Fool, it would be that there is not enough emphasis on valuation. I agree -- and I'm sure Buffett would too -- that the enduring quality of a business is more important than today's price, but 100 times more important? C'mon! The experience of the past few years notwithstanding, that "pay any price for a great business" attitude is a sure route to underperformance. For a number of years now, we have been in a remarkable bull market where valuation hasn't mattered. In fact, I believe that the more investors have focused on valuation in recent times, the worse their returns have been. But this hasn't been true over longer periods historically, and I certainly don't think it's sustainable. While the laws of economic gravity may have been temporarily suspended, I do not believe that they have been fundamentally altered. Don't get me wrong -- I'm a big believer in the ways that the Internet (and other technologies), improved access to capital, better management techniques, etc., have positively and permanently impacted the economy. Nor am I the type of value investor who thinks that anything trading above 20x trailing earnings is overvalued. I simply believe in the universal, fundamental truth that the value of a company (and therefore a fractional ownership stake in that company, which is, of course, a share of its stock) is worth no more and no less than the future cash that can be taken out of the business, discounted back to the present.

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I find it hard to believe that this type of thinking is present in the hottest (mostly emerging, technology-related) sectors of the market today. The enormous valuations imply phenomenal growth and profitability for numerous companies in each sector. That's a mathematical impossibility. Sure, a few of these companies might become the next Ciscos and Microsofts, but very few will. They can't all achieve 80% market share! I believe investors in these sectors are setting themselves up for a fall, not because they're investing in bad businesses, but because the extreme valuations create a highly unfavorable risk-reward equation. I suspect many are not investing at all, but are simply speculating in a greater fool's game. Well, if that doesn't trigger a flood of hate mail, nothing will. But before you flame me, consider this: I own some of today's hottest stocks. But I bought them at much lower (though still high, to be sure) valuations, when I felt confident that their future cash flows would justify their valuations at the time. Now, while I am not as comfortable with their valuations and am certainly not buying more, I am determined to stick to my long-term investment strategy and hang on to these stocks as long as the underlying businesses continue to prosper. Overview of Valuation If the future were predictable with any degree of precision, then valuation would be easy. But the future is inherently unpredictable, so valuation is hard -- and it's ambiguous. Good thinking about valuation is less about plugging numbers into a spreadsheet than weighing many competing factors and determining probabilities. It's neither art nor science -- it's roughly equal amounts of both. The lack of precision around valuation makes a lot of people uncomfortable. To deal with this discomfort, some people wrap themselves in the security blanket of complex discounted cash flow analyses. My view of these things is best summarized by this brief exchange at the 1996 Berkshire Hathaway annual meeting: Charlie Munger (Berkshire Hathaway's vice chairman) said, "Warren talks about these discounted cash flows. I've never seen him do one." "It's true," replied Buffett. "If (the value of a company) doesn't just scream out at you, it's too close." The beauty of valuation -- and investing in general -- is that, to use Buffett's famous analogy, there are no called strikes. You can sit and wait until you're as certain as you can be that you've not only discovered a high-quality business, but also that it is significantly undervalued. Such opportunities are rare these days, so a great deal of patience is required. To discipline myself, I use what I call the "Pinch-Me-I-Must-Be-Dreaming Test." This means that before I'll invest, I have to be saying to myself, "I can't believe my incredible

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good fortune that the market has so misunderstood this company and mispriced its stock that I can buy it at today's low price." Conclusion Since I've been quoting Buffett with reckless abandon, I might as well conclude with another one of my favorites, from his 1978 annual letter to shareholders (keep in mind the context: Buffett wrote these words during a time of stock market and general malaise, only a year before Business Week's infamous cover story, "The Death of Equities"): "We confess considerable optimism regarding our insurance equity investments. Of course, our enthusiasm for stocks is not unconditional. Under some circumstances, common stock investments by insurers make very little sense. "We get excited enough to commit a big percentage of insurance company net worth to equities only when we find (1) businesses we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) priced very attractively. We usually can identify a small number of potential investments meeting requirements (1), (2) and (3), but (4) often prevents action. For example, in 1971 our total common stock position at Berkshire's insurance subsidiaries amounted to only $10.7 million at cost, and $11.7 million at market. There were equities of identifiably excellent companies available -- but very few at interesting prices. (An irresistible footnote: in 1971, pension fund managers invested a record 122% of net funds available in equities -- at full prices they couldn't buy enough of them. In 1974, after the bottom had fallen out, they committed a then record low of 21% to stocks.) "The past few years have been a different story for us. At the end of 1975 our insurance subsidiaries held common equities with a market value exactly equal to cost of $39.3 million. At the end of 1978 this position had been increased to equities (including a convertible preferred) with a cost of $129.1 million and a market value of $216.5 million. During the intervening three years we also had realized pretax gains from common equities of approximately $24.7 million. Therefore, our overall unrealized and realized pretax gains in equities for the three-year period came to approximately $112 million. During this same interval the Dow-Jones Industrial Average declined from 852 to 805. It was a marvelous period for the value-oriented equity buyer." It is clear that Buffett's unparalleled investment track record over many decades is the result of buying high-quality businesses at attractive prices. If he can't find investments that have both characteristics, then he'll patiently wait on the sidelines. That's what's happening today. As in 1971, Buffett has again largely withdrawn from the market, refusing to pay what he considers to be exorbitant prices for stocks. This is a major reason why the stock of

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Berkshire Hathaway (NYSE: BRK.A) has been pummeled. And Buffett himself is ridiculed as being an out-of-touch old fogey (you should read some of the e-mails I get every time I write a favorable word about him). Only time will tell who is right, but I've got my money on Buffett. Next week, I will take this discussion of valuation from the theoretical to the practical by analyzing American Power Conversion's (Nasdaq: APCC) valuation. --Whitney Tilson

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Fool.com: Valuation STILL Matters [Fool on the Hill] February 20, 2001
http://www.fool.com/news/foth/2001/foth010220.htm By Whitney Tilson

Almost exactly a year ago, I wrote a column called Valuation Matters. In it, I said: "I believe in The Motley Fool's core investment philosophy of buying the stocks of quality companies (or index funds), holding for the long run, and ignoring the hype of Wall Street and the media. But if I were to level one general critique of the Fool, it would be that there is not enough emphasis on valuation... The experience of the past few years notwithstanding, [the] 'pay any price for a great business' attitude is a sure route to underperformance." Since I wrote those words on February 7, 2000, here's what has happened: Portfolio/Index S&P 500 Nasdaq Rule Maker Rule Breaker Berkshire Hathaway % change -9% -44% -48% -45% +36%

My goal in showing these figures is not to gloat, but to make a point that I've made over and over again: valuation really does matter. Regular readers might think, "You're beating a dead horse, Whitney. After the events of the past year, everyone already understands and agrees with you." I'm not so sure. As evidence, consider that in a survey TheStreet.com conducted recently to determine which stocks its readers wanted more articles about, 47 of the top 50 were tech stocks. The Fool's own Rule Maker portfolio has dedicated three recent columns to a potential purchase of Siebel Systems (Nasdaq: SEBL) - an exceptional company, but also one whose stock is trading at either 126

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or 264 times trailing earnings per share (depending on whether you use the company's adjusted figures or actual GAAP numbers) and 85x analysts' (very optimistic, in my opinion) estimates for 2001. Siebel is almost certainly overvalued My answer to the question posed by the title of the Rule Maker's most recent column on Siebel, "Is Siebel Overvalued?," is "Almost certainly, yes." In my mind, Siebel falls into the same category of stocks I raised questions about in a column last October. That column named some of the most poplar tech stocks at that time -- Cisco (Nasdaq: CSCO), Oracle (Nasdaq: ORCL), EMC (NYSE: EMC), Sun Microsystems (Nasdaq: SUNW), Nortel Networks (NYSE: NT), and Corning (NYSE: GLW) -- and claimed: "It is a virtual mathematical certainty that these six companies, as a group, cannot possibly grow into the enormous expectations built into their combined $1.2 trillion dollar valuation... Even if the companies perform exceptionally well, their stocks -- in my humble opinion -- are likely at best to compound at a low rate of return, and there's a very real possibility of significant, permanent loss of capital. Investing is at its core a probabilistic exercise, and the probabilities here are very poor." I received more hate emails from that column than any other -- which should have been a clue that I was on to something. Less than five months later, here's how these stocks have performed: Stock Cisco Oracle EMC Sun Nortel Corning Average Nasdaq % change -50% -29% -39% -57% -68% -64% -51% -28%

These numbers certainly highlight the dangers of investing in the most popular stocks that are priced for perfection -- like Siebel.

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Does valuation still matter? One might argue that with so many stocks so far off their highs, perhaps one needn't focus as much on valuation today. I think the opposite is true. A year ago, you could argue that even if you bought an overvalued stock, it didn't matter since someone would come along and buy it from you at a higher price. As silly as that argument might sound, a rapidly rising stock market over the previous few years had lulled many into believing it. But today, with the market psychology broken, I don't think a reasonable argument can be made that the "greater fool theory" of investing is likely to be very rewarding going forward. My kind of Rule Maker: IMS Health So am I rejecting Rule Maker investing? Not at all. I wholeheartedly agree with the strategy of buying and holding for many years the stocks of exceptionally high-quality companies. But I won't pay any price. In fact, I will only buy a stock when I think it is so undervalued that I'm trembling with greed. Let me give you an example: a stock I bought last summer and still own, IMS Health (NYSE: RX). IMS Health is the world's leading provider of information solutions to the pharmaceutical and healthcare industries. Its core business -- in which it has built approximately 90% market share over the past half-century -- is providing prescription data to pharmaceutical companies, which use the data to compensate salespeople, develop and track marketing programs, and more. More than 165 billion records per month flow into IMS databases worldwide. The company has offices in 74 countries, tracks data in 101 countries, and generates 58% of sales overseas. IMS Health has a near-monopoly and there are very high barriers to entry. As a person I interviewed at one of the largest pharmaceutical companies (who is in charge of its relationship with IMS) said, "There will be no more entrants into this market." Due to its powerful competitive position, IMS mints money: It has a healthy balance sheet, very high returns on capital, huge 19% net margins, and solid growth. Revenues in the first three quarters of 2000 (IMS reports Q4 00 earnings after the close today) increased 14%, or 16% in constant currency, and net income rose 16%. With large share buybacks -- in the latest quarter,

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shares outstanding fell 7% year-over-year -- EPS grew 25% in the first three quarters of 2000 and is projected to grow 19% in 2001. (All figures are pro forma, as IMS has spun off a number of entities.) At Friday's close of $25.45, I don't think the stock of IMS Health is cheap enough to buy at this time, but it sure was last July when I bought it for $16, equal to approximately 16x estimated 2001 EPS. It was cheap because management was widely disliked by Wall Street, due in large part to an illconceived merger that was subsequently called off. While I wasn't thrilled with the management team either, I figured this was already reflected in the stock price, and I could not find a single element of weakness in IMS' financials. I couldn't see much downside to owning the stock and, over time, if the business continued to grow strongly, I suspected that management and Wall Street would smooth out their differences. This is exactly what happened. Even better, new management is now in place. This was my kind of Rule Maker: a company with a bulletproof franchise that meets most of the key Rule Maker criteria, but which is priced very attractively due to the market overreacting to a short-term issue. -- Whitney Tilson

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Sustainable Competitive Advantage

By Whitney Tilson (Tilson@Tilsonfunds.com) February 28, 2000 Warren Buffett was once asked what is the most important thing he looks for when evaluating a company. Without hesitation, he replied, "Sustainable competitive advantage." I agree. While valuation matters, it is the future growth and prosperity of the company underlying a stock, not its current price, that is most important. A company's prosperity, in turn, is driven by how powerful and enduring its competitive advantages are. Powerful competitive advantages (obvious examples are Coke's brand and Microsoft's control of the personal computer operating system) create a moat around a business such that it can keep competitors at bay and reap extraordinary growth and profits. Like Buffett, I seek to identify -- and then hopefully purchase at an attractive price -- the rare companies with wide, deep moats that are getting wider and deeper over time. When a company is able to achieve this, its shareholders can be well rewarded for decades. Take a look at some of the big pharmaceutical companies for great examples of this. Don't Confuse Future Growth With Future Profitability The value of a company is the future cash that can be taken out of the business, discounted back to the present. Thus, the key to valuation -- and investing in general -- is accurately estimating the magnitude and timing of these future cash flows, which are determined by: How profitable a company is (defined not in terms of margins, but by how much its return on invested capital exceeds its weighted average cost of capital) How much it can grow the amount of capital it can invest at high rates over time How sustainable its excess returns are It's easy to calculate a company's historical growth and costs and returns on capital. And for most companies, it's not too hard to generate reasonable growth projections. Consequently, I see a large number of high-return-oncapital companies (or those projected to develop high returns on capital) today with enormous valuations based on the assumption of rapid future growth. While some of these stocks will end up justifying today's prices, I think that, on average, investors in these companies will be sorely disappointed. I

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believe this not because the growth projections are terribly wrong, but because the implicit assumptions that the market is making about the sustainability of these companies' competitive advantages are wildly optimistic. Warren Buffett said it best in his Fortune article last November: "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." The Rarity of Sustainable Competitive Advantage It is extremely difficult for a company to be able to sustain, much less expand, its moat over time. Moats are rarely enduring for many reasons: High profits can lead to complacency and are almost certain to attract competitors, and new technologies, customer preferences, and ways of doing business emerge. Numerous studies confirm that there is a very powerful trend of regression toward the mean for high-return-on-capital companies. In short, the fierce competitiveness of our capitalist system is generally wonderful for consumers and the country as a whole, but bad news for companies that seek to make extraordinary profits over long periods of time. And the trends are going in the wrong direction, for investors anyway. With the explosion of the Internet, the increasing number of the most talented people leaving corporate America to pursue entrepreneurial dreams, and the easy access to large amounts of capital from the seed stage onward, moats are coming under assault with increased ferocity. As Michael Mauboussin writes in The Triumph of Bits, "Investors in the future should expect higher returns on invested capital (ROIC) than they have ever seen, but for shorter time periods. The shorter time periods, quantified by what we call 'competitive advantage period,' reflect the accelerated rate of discontinuous innovation." Strategy In this environment, how can one identify companies with competitive advantages that are likely to endure? It's not easy and there's no magic formula, but a good starting point is understanding strategy. In his article "What Is Strategy?" (Harvard Business Review, November-December 1996; you can download it for $6.50 by clicking here), my mentor, Harvard Business School professor Michael Porter, distinguishes between strategic positioning and operational effectiveness, which are often confused: "Operational effectiveness means performing similar activities better than rivals perform them," whereas "strategic positioning means performing different activities from rivals' or performing similar activities in different ways." When attempting to identify companies whose competitive advantages will be enduring, it is critical to understand this distinction, since

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"few companies have competed successfully on the basis of operational effectiveness over an extended period." Professor Porter argues that, in general, sustainable competitive advantage is derived from the following: A unique competitive position Clear tradeoffs and choices vis--vis competitors Activities tailored to the company's strategy A high degree of fit across activities (it is the activity system, not the parts, that ensure sustainability) A high degree of operational effectiveness He concludes that "when activities complement one another, rivals will get little benefit unless they successfully match the whole system. Such situations tend to promote a winner-take-all competition." It is my aim to invest in these winner-take-all companies. -- Whitney Tilson

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Fool.com: Strategy Creates Sustainable Advantage [Fool on the Hill] March 6, 2001
http://www.fool.com/news/foth/2001/foth010306.htm By Whitney Tilson If you could ask only one question about a company before deciding whether to invest in it, what would it be? How rapidly is it growing? How good is management? How attractive is its industry? What is its return on equity, or return on invested capital? What is its P/E ratio? Are its shares at a 52-week low (or high)? All of those -- except the last one -- are good questions, but I believe they are superceded by the following: "How strong is the company's competitive advantage, and how sustainable is it?" Warren Buffett agrees, noting in a 1999 Fortune article: "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." Powerful competitive advantages -- obvious examples are Coca-Cola's (NYSE: KO) brand, or Microsoft's (Nasdaq: MSFT) control of the personal computer operating system -- create moats around businesses, allowing them to keep competitors at bay and reap extraordinary growth and profits. The best long-term investments, assuming one pays attention to valuation and doesn't overpay for the stock, tend to be the rare companies that not only have wide, deep moats, but moats that widen and deepen over time. Few companies succeed in this endeavor. As I wrote a year ago, "Moats are rarely enduring for many reasons: High profits can lead to complacency and are almost certain to attract competitors, and new technologies, customer preferences, and ways of doing business emerge. Numerous studies confirm that there is a very powerful trend of regression toward the mean for high-return-on-capital companies. In short, the fierce competitiveness of our capitalist system is generally

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wonderful for consumers and the country as a whole, but bad news for companies that seek to make extraordinary profits over long periods of time." So how does one identify companies with powerful, sustainable competitive advantages? Look for companies with sensible, consistent, well-defined strategies, because strategy is the root of competitive advantage for most companies. Michael Porter on strategy For further thoughts on this topic, let's turn to one of the world's leading experts on strategy and competitive advantage, Harvard Business School Professor Michael Porter. (I worked with Porter for six years and consider him a friend and mentor.) To read his work, you normally have to buy one of his books or download one of his Harvard Business Review articles -I recommend "What is Strategy?" ($6.50) and his latest, "Strategy and the Internet" ($5.50) -- but now his latest thinking is available for free online in an interview published in this month's Fast Company. I urge you to read the entire article. Here are some extensive excerpts -- I can't say it better than he can:

"Only strategy can create sustainable advantage. And strategy must start with a different value proposition. A strategy delineates a territory in which a company seeks to be unique. Strategy 101 is about choices: You can't be all things to all people."

"Many [companies] have abandoned strategy almost completely. Executives won't say that, of course... Typically, their 'strategy' is to produce the highest-quality products at the lowest cost or to consolidate their industry. They're just trying to improve on best practices. That's not a strategy."

"There's a fundamental distinction between strategy and operational effectiveness. Strategy is about making choices, trade-offs; it's about deliberately choosing to be different. Operational effectiveness is about things that you really shouldn't have to make choices on; it's about what's good for everybody and about what every business should be doing. Lately, leaders have tended to dwell on operational effectiveness."

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"If all you're trying to do is essentially the same thing as your rivals, then it's unlikely that you'll be very successful. It's incredibly arrogant for a company to believe that it can deliver the same sort of product that its rivals do and actually do better for very long. That's especially true today, when the flow of information and capital is incredibly fast. It's extremely dangerous to bet on the incompetence of your competitors -- and that's what you're doing when you're competing on operational effectiveness."

"The underlying principles of strategy are enduring, regardless of technology or the pace of change. Consider the Internet. Whether you're on the Net or not, your profitability is still determined by the structure of your industry. If there are no barriers to entry, if customers have all the power, and if rivalry is based on price, then the Net doesn't matter -- you won't be very profitable."

"The error that some managers make is that they see all of the change and all of the new technology out there, and they say, "God, I've just got to get out there and implement like hell." They forget that if you don't have a direction, if you don't have something distinctive at the end of the day, it's going to be very hard to win."

"A leader ... has to make sure that everyone understands the strategy. Strategy used to be thought of as some mystical vision that only the people at the top understood. But that violated the most fundamental purpose of a strategy, which is to inform each of the many thousands of things that get done in an organization every day, and to make sure that those things are all aligned in the same basic direction."

"In great companies, strategy becomes a cause. That's because a strategy is about being different. So if you have a really great strategy, people are fired up."

Conclusion When you're analyzing a company as a potential investment, you can apply Porter's thinking by asking a few key questions: What is this company's strategy? Is it sensible and distinct? Does it -- or will it -- lead to superior profitability? And, most importantly: Is it defensible? -- Whitney Tilson

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The Importance of Strategy

http://www.fool.com/news/foth/2001/foth010807.htm By Whitney Tilson 08/07/2001 I have argued in the past that strategy is critical to creating sustainable competitive advantage, which Warren Buffett has said is the most important thing he looks for when evaluating a company. Strategy, however, is an amorphous concept to many people. How can one determine whether a company is pursuing the right strategy? Perhaps case studies of three stocks I own -- Office Depot(NYSE: ODP), AAON(Nasdaq: AAON), and TheStreet.com(Nasdaq: TSCM) -- will be illustrative. In addition, I highly recommend reading a March Fast Companyinterview with the godfather of strategy, Harvard Business School Professor Michael Porter. Office Depot Office Depot was one of the great growth stocks of the early 1990s, rising from a low of under $2 in 1990 to more than $21 at its peak in 1995. After a failed merger with Staples(Nasdaq: SPLS) in 1997, Office Depot launched a massive expansion plan, increasing its North American store base by nearly 50% between the end of 1997 to the end of 2000. The new stores have been duds, by and large, due to an ill-conceived strategy. With Staples and OfficeMax(NYSE: OMX) also expanding rapidly, Office Depot was building in markets that were becoming saturated. Poor execution compounded the strategic error, in part because most of Office Depot's real estate team had departed in anticipation of the merger with Staples. When the new stores' poor results became apparent, the stock tanked, declining more than 75% from above $25 in mid-1999 to a low of $6 last December. So why did I buy the stock in January? In large part because I believe new CEO Bruce Nelson has adopted the right strategy. Rather than investing in growing the low-margin North American retail store base, he wants it to

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generate cash -- the company is closing underperforming stores and improving operations -- to be reinvested into the higher-margin, fastergrowing catalog, contract, Internet, and international businesses, where Office Depot has real competitive advantages. It's a classic strategy -- milk the cash cow and invest in the growth businesses -- and in the company's latest earnings report, there's evidence that it's beginning to work AAON AAON, a company I discuss in the latest issue of The Motley Fool Select, specializes in manufacturing commercial rooftop heating, ventilation, and air conditioning (HVAC) units. Its four primary competitors are all far more diversified, and each has more than 20 times AAON's revenues. In situations like this, a small company can often achieve impressive growth by stealing market share in a niche from slow-moving, bureaucratic conglomerates. The game often ends, however, when the giants wake up and squash the little guy. I'm betting that this won't happen to AAON, in part due to its wise strategy. AAON makes semi-customized HVAC units, which offer a compelling value proposition to customers. The HVAC industry is fragmented into two types of companies at opposite extremes: those that make standard HVAC units, and those that build custom units from scratch -- for three times the price. Many customers want some degree of customization, but are reluctant to pay triple the cost, so AAON has built a highly efficient manufacturing system that permits substantial customization at little incremental cost. This allows AAON to earn the highest margins in the industry while charging an average price premium of only 4% over a standard unit. The competition has found it difficult to match AAON, and I think the company will continue to take market share and maintain its high margins. AAON's growth strategy is also wise. Rather than assaulting the core businesses of its huge competitors, AAON instead focuses on niches that are being poorly served, often because they're too small for large companies to spend much time on. AAON then develops a better product, builds scale, and expands from that base. This is exactly what happened in the commercial

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rooftop HVAC business, and AAON is now applying the same strategy to other niches. TheStreet.com Revealing my position in TheStreet.com may ruin my credibility as a "value investor," but at least hear me out. The core of my investment thesis -which is more in-depth than I have the space to outline in a few paragraphs here -- is that TheStreet.com has had the wrong strategy since inception, but now has one that gives it a reasonable chance to make it to profitability. TheStreet.com aimed, at its genesis, to be a major news organization, and to provide opinion and commentary. But it's expensive to be a news organization, and TheStreet.com has no competitive advantage whatsoever in this area. I, for example, am quite content to get my business news from The Wall Street Journal and The New York Times. If I want late-breaking news on the Web, I can just as easily get it from Yahoo!(Nasdaq: YHOO) Finance, CBS MarketWatch(Nasdaq: MKTW), and elsewhere. Where TheStreet.com does have a franchise -- The Motley Fool does as well - is in the area of opinion and commentary. With Wall Street's sell-side analysts discredited (have you read the shocking revelations from the recent SEC investigation?), there are few places investors can turn to for timely, insightful, unbiased opinion and commentary that can help them make money. Having a valuable franchise has not yet translated into lots of revenues, however. TheStreet.com generates plenty of traffic -- it had 3 million average monthly unique visitors in Q2 -- but advertising revenues are plunging for nearly every Internet company and the number of paid subscribers is stagnant. I'm not expecting a rebound in the advertising market, but I think TheStreet.com has a big opportunity to increase its subscriber base. To date, the great majority of TheStreet.com's opinion and commentary has been available for free a day after it appears on the paid site, RealMoney.com, which helps explain why the company has only 66,000 paid subscribers. If TheStreet.com were to only publish its opinion and commentary on RealMoney.com, something I would not be surprised to see

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by year's end, I believe the number of paid subscribers would rise materially. While this might reduce the overall number of readers, perhaps hurting advertising revenue, such a strategy -- which has no incremental costs associated with it -- plus additional revenue from a number of other new initiatives and further cost-cutting, could propel the company to profitability. All that said, TheStreet.com is a very risky stock and is only a small part of my portfolio. With a mere $3.6 million in revenues last quarter and $9.0 million in expenses, the company has its work cut out for it. (The Motley Fool also counsels investors to avoid "penny stocks," which TheStreet.com -- with a share price and market capitalization of around $1 and $30 million, respectively -- is.) Lessons Office Depot, AAON, and TheStreet.com are vastly different companies, pursuing vastly different strategies, yet I believe each will be successful. Why? Because they are focusing their energies in areas in which they are different -- and in my opinion, better -- than their competitors. As Harvard's Porter noted in Fast Company: Strategy 101 is about choices: You can't be all things to all people... Strategy must start with a different value proposition. A strategy delineates a territory in which a company seeks to be unique... If all you're trying to do is essentially the same thing as your rivals, then it's unlikely that you'll be very successful. Investors would be well served to keep that in mind, and avoid "me-too" companies. -- Whitney Tilson

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Avoiding Investing Traps

http://www.fool.com/news/foth/2002/foth020501.htm By Whitney Tilson 05/01/2002 Over the past 18 months, I have made 63 specific recommendations to avoid particular stocks. As of yesterday's close, 57 of them (90%) have fallen in price, and the average decline is 39% (click here to see the performance of all of my pans and picks). Luck? To some extent, certainly. I don't ever expect to be right 90% of the time when it comes to predicting something as uncertain as future stock prices. But I'd like to think there's some skill and discipline involved as well. I invest with a set of mental guidelines that helps me identify stocks that are likely to rise and, far more importantly, avoid those that might blow up. It's the latter -- avoiding big mistakes -- that is the key to successful long-term investing, not (contrary to popular opinion) picking home run stocks. Yet in the greedy and/or nave pursuit of quick riches, millions of investors swung for the fences and ended up losing a significant fraction of their savings over the past two years. How sad -- and how avoidable! Here are six simple rules that guide me: 1. Shun the crowd. Run far, far away from the hottest stocks in the hottest sectors, which are invariably priced for perfection. While the occasional stock -- like Krispy Kreme(NYSE: KKD) -- can defy gravity (for a while, anyway) almost no company achieves perfection, and the odds of picking one that does are tiny. It's far safer and more profitable to invest in stocks that are either wellknown but hated, or obscure and unknown (for more on this topic, see my article, The Cocktail Party Test). Bashing tech stocks is getting old (though, in general, they're still significantly overvalued) so I'll instead warn investors to stay away from the more mundane sectors that growth-addicted investors piling out of tech are piling into, like restaurants. Yes, restaurants. Companies like Tricon(NYSE:

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YUM), Wendy's(NYSE: WEN), and Jack in the Box(NYSE: JBX) are at or near 52-week highs -- probably deservedly so, as they were undervalued previously. The stocks to avoid in this sector are the high-growth darlings like Krispy Kreme, Panera Bread Company(Nasdaq: PNRA), and P.F. Chang's China Bistro(Nasdaq: PFCB). These are all decent companies that are growing rapidly, but their valuations are ridiculous, at 62x, 51x, and 46x this year's estimated earnings, respectively. I wouldn't touch any of them at half their current price. 2. Look for consistently positive cash flow and beware of debt. Companies that generate consistently positive cash flow can control their destinies and reward shareholders in so many more ways than companies that must rely on often-fickle capital markets. Consider two of the three best-performing stocks in the S&P 500 in 2001, Office Depot(NYSE: ODP) (which I owned) and AutoZone(NYSE: AZO). Both hit multi-year lows in late 2000 and Wall Street sentiment couldn't have been worse, but they were buying back mountains of stock and investing in their businesses. They were able to maintain moderate debt levels because, even at the low point, they had significant positive free cash flow. A similarly beaten-down stock today, WorldCom(Nasdaq: WCOM), is in a more difficult situation because of its barely positive free cash flow and high debt level. Last year, WorldCom (including subsidiary MCI Group(Nasdaq: MCIT)) generated $8.0 billion of operating cash flow, but $7.9 billion of capital expenditures consumed nearly all of it. Weak free cash flow, combined with a perilously high net debt level of $27.9 billion as of the end of Q1, has fueled concerns that WorldCom might go bankrupt, so not surprisingly the stock has been obliterated. Could it be a buy at today's levels? Perhaps, but I know with certainty that there are easier, less-risky investments I can make. (For further thoughts, see Don't Forget Debt.) 3. Avoid serial acquirers and big acquisitions. I could also use WorldCom as an example of an acquisition strategy gone bad, but let's instead look at Tyco(NYSE: TYC), a serial acquirer, and AOL Time Warner(NYSE: AOL), the result of a mega-merger. I took a lot of flak when I warned investors last November about these two stocks, but they've fallen 62% and 42%, respectively, since then. Making many small acquisitions or one big one are both fraught with peril, yet some CEOs insist

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on engaging in such behavior. There's not much the average shareholder can do about it -- other than sell the stock, of course. Today, my least-favorite acquisition/merger is Hewlett-Packard(NYSE: HWP) and Compaq(NYSE: CPQ). Two stones tied together still sink, so avoid this one like the plague. 4. Don't speculate. Among the stocks I've panned, Sunrise Technologies (OTC BB: SNRSE), Active Power(Nasdaq: ACPW), and Loudcloud(Nasdaq: LDCL) were -- and are -- pure speculations. None of these companies has ever earned a penny of operating cash flow, much less free cash flow, and I question whether they ever will. Not surprisingly, these stocks are down 96%, 82%, and 65%, respectively, since I first warned about them. Keep in mind Peter Lynch's admonition in Beating the Street: "Long shots almost always miss the mark." The speculative stock I suggest avoiding at this time is chip design software maker Magma Design Automation(Nasdaq: LAVA), which trades at a big valuation premium to its larger, stronger, highly profitable competitors. 5. Don't bet against the shorts. Speaking of Magma, according to the company profile on Yahoo! Finance, 35% of its tradable shares (i.e., the float) are sold short -- meaning many investors are betting the stock will decline. A high short interest should always be a huge warning flag, as the short sellers I am aware of are extremely smart and analytically rigorous, in marked contrast to the majority of Wall Street analysts (read: cheerleaders). Shorts aren't always right, but if you're going to bet against them, you'd better be awfully sure of yourself. Other stocks that have crossed my radar screen with a high short interest include PolyMedica(Nasdaq: PLMD) (66% of the float is sold short), Black Box(Nasdaq: BBOX) (34%), AstroPower(Nasdaq: APWR) (34%), and Take-Two Interactive(Nasdaq: TTWO) (32%). Sure, the shorts might be wrong about one or more of these companies, but I don't really care. I simply avoid controversial, messy situations like these.

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6. Keep it simple. I can't say it any better than Warren Buffett, who wrote in his 1989 annual letter: "Easy does it. After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers. The finding may seem unfair, but in both business and investments it is usually far more profitable to simply stick with the easy and obvious than it is to resolve the difficult." Conclusion If you stick to these guidelines, you have a good chance of compounding your money at a reasonable rate. If you violate them, I can assure you from painful personal experience that you are inviting trouble.

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Focus Investing
http://www.fool.com/news/commentary/2004/commentary04102203.htm By Whitney Tilson 10/22/2004 Most investors focus their efforts on stock picking, but I believe that portfolio management is an equally important component of long-term investment success. By this, I mean four things: 1. How many stocks to hold and how large to make each position (concentration) 2. How diversified the portfolio should be (by industry, market cap, etc.) 3. Knowing when to buy more 4. Knowing when to sell These are all big topics, so today I'm going to focus on only the first one. Focus investing While there are a handful of exceptions such as Peter Lynch, the overwhelming majority of great investors that I'm aware of practice focus investing. They invest infrequently, only when they're highly confident that the odds are heavily in their favor, and then they bet big. (Not surprisingly, research shows that the same approach works in other endeavors such as poker or betting on horse races. For more on focus investing, see Bob Hagstrom's excellent book, The WarrenBuffett Way.) Berkshire Hathaway's(NYSE: BRK.A) Warren Buffett and Charlie Munger have commented on this topic in recent annual meetings (click here for links to my transcripts from the past five Berkshire and Wesco(NYSE: WSC) meetings). Munger commented, "If you took out our 15 best ideas, most of you wouldn't be here.We have this investment discipline of waiting for a fat pitch." Buffett added:

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I keep xeroxes from annual reports 50 years ago. [Some ideas were] just so obvious. I knew when I sat with the CEO of GEICO 50 years ago that it was a big idea. If we start buying a stock, we want to go in heavy. I can't think of a stock where we wanted to quit. We've made some big mistakes starting to buy something that was cheap and within our circle of competence, but trickled off because price went up a bit. Good ideas are too scarce to be parsimonious with. You don't have to be right on everything or 20%, 10%, or 5% of businesses. You only have to be right one or two times a year. You can come up with a very profitable decision on a single company. If someone asked me to handicap the 500 companies in the S&P 500, I wouldn't do a very good job. You only have to be right a few times in your lifetime, as long as you don't make any big mistakes. It seems so obvious that it makes more sense to buy more of your best idea than add a 100th position to a 99-stock portfolio, yet the average mutual fund holds more than 100 stocks. In almost all cases, this is foolish "deworsification" and reflects closet indexing rather than prudent money management. Munger agrees, noting that "What's funny is that most big investment organizations don't [look for the fat pitch]. They hire lots of people, evaluate Merck vs. Pfizer and every stock in the S&P 500, and think they can beat the market. You can't do it. Very few people have adopted our approach." Buffett added: "Ted Williams, in his book The Science of Hitting, talked about how he carved up the strike zone into different zones and only swung at pitches that were in his sweet spot. Investing is the same way." Position sizing OK, let's say you're convinced that focus investing is the way to go, and you've found a stock about which you're trembling with greed. What percent of your assets should you invest in it? 2%? 20%? (Or, given the cheap, easy leverage these days, 200%?) The answer depends on a number of factors such as your tolerance for volatility, the expected upside, and the potential downside. Generally speaking, my ideal portfolio would have 12-20 welldiversified 50-cent dollars (e.g., stocks trading at half of my conservative

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estimate of their intrinsic value), of which roughly five were 10% positions and rest were 5-9% positions. I did not pick this range of 12-20 stocks arbitrarily. In Joel Greenblatt's brilliant book, You Can Be a Stock Market Genius, he provides the following statistics (see pages 20-21):

Owning two stocks eliminates 46% of nonmarket risk of just owning one stock Four stocks eliminates 72% of the risk Eight stocks eliminates 81% of the risk 16 stocks eliminates 93% of the risk 32 stocks eliminates 96% of the risk 500 stocks eliminates 99% of the risk

Once one has a well-diversified, balanced portfolio of a dozen or so stocks, adding additional stocks does little to reduce risk, yet there's obviously a big penalty in terms of performance if one's best ideas are 3-5% positions instead of 7-10% positions. Keep in mind, however, that there is no right answer. I know many fantastic money managers who own a few dozen stocks and some who own only a half dozen, but 12-20 is the level at which I'm comfortable. You need to find your own comfort zone. At one point in my investing career, I invested in a more concentrated fashion -- for example, I doubled my Berkshire Hathaway holdings to an 18% position on March 10, 2000, a day I remember well because it was the last spasm of forced selling of the stock, driven by investors piling into tech stocks (it was the very day that the Nasdaq peaked at 5,032 -- a level that, mark my words, we will not see for at least another 10 years). While that investment worked out well (I still own some of the Berkshire stock), I'd be surprised if I ever again invested so much of my portfolio in one stock. Why? Let me show you the scars on my back and tell you some stories. Just in the past two years -- two very good years, incidentally -- I've had a 10% position decline by 30%, two 7% positions lose two-thirds of their value (all three subsequently recovered), and a 2% position go bankrupt (I

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bought at $6 and sold at a penny -- ouch!). As a result, I've learned that no matter how much confidence I have in an investment, the future is inherently unpredictable and all sorts of unexpected calamities can occur. I still practice focus investing, but thanks to Mr. Market teaching me some humility, I'm not quite as focused as I used to be. Sizing common stocks I typically will not add a common stock position to my portfolio unless I'm willing to make it a 5% position. If I don't feel confident enough to invest at least this much, that's a good signal I shouldn't own it at all. Once this initial position is established, I cross my fingers and hope that the stock goes down. Yup, you read that right, down! Why? Because I want to buy more and make it a 10% position but need a bigger margin of safety to do so. Let me give you an example of a dream scenario. At the end of 2002, the worst year in the fast food industry in 20 years thanks to a weak economy and a burger war between McDonald's(NYSE: MCD) and Burger King, McDonald's stock hit a multiyear low in the $16 range. I believed that, despite horrible mismanagement, McDonald's remained one of the world's great businesses and that the new CEO had a sound turnaround plan (see "CEO of the Year: McDonald'sCantalupo"). My estimate of intrinsic value was in the mid-$20 range, so at $16, I felt that I was buying with a 40% margin of safety -- enough to make the stock a 5% position. Then I got lucky: McDonald's continued to report weak results and investors became very bearish on consumer spending as the Iraq war loomed, so the stock fell to a 10-year low of just above $12 in March 2003. At the same time, I interviewed a longtime McDonald's franchisee who gave me insights into the dramatic positive changes that were occurring within the company but whose impact was not yet visible in the numbers. Thus, while the stock I had purchased initially was down 25% in only a few months, I had even more confidence in my investment thesis and was thrilled to be able to buy the stock at an even lower price, so I backed up the truck and doubled the position (which I still own). Sizing shorts Though I do some shorting, it's an awful business for many reasons, one of which is that one shouldn't do it in size, as losses are potentially unlimited. If

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a stock is a 7% long position at $15 and drops to $5, it will cost you nearly five points of return, but it won't put you out of business, you aren't forced to sell at the bottom, and -- if you have real guts and conviction -- you can buy more. But what about a 7% short position at $5 that jumps to $15? That costs you 14 percentage points of return and you may be forced to cover to prevent further losses, even if you have more confidence in the position. Thus, you can see why I rarely make a short position larger than 2-3% and prefer a basket of even smaller positions. Sizing options Given the implicit leverage of options, I tend to make them small positions -generally 0.5%-2.5%, though it's hard to share any rules of thumb since some long-dated, deep-in-the-money options are very similar to the underlying stock, while short-dated, out-of-the-money options are highly speculative. Speculations One might ask why a conservative value investor like myself would ever invest in something highly speculative, but I'm willing to make such investments with a small portion of my portfolio as long as I'm confident that the expected value is much higher than the price I'm paying. Consider an investment with the following expected one-year payoffs:

Loss of entire investment: 60% chance No gain or loss: 10% chance 2x gain: 10% chance 5x gain: 10% chance 10x gain: 10% chance

The expected value of a $1 investment given these probabilities is $1.80, a fabulous return, but let's assume you could only make this investment once. Would you do so, knowing that there's a 60% chance that you'd lose it all? Try explaining that to your investors (or worse yet, your spouse)!

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If you did make the investment, how much of your portfolio would you risk? This is not a hypothetical question; in the past few weeks, I faced a very similar choice and chose to invest 2% of my portfolio. Conclusion While there's little doubt that focus investing is likely to yield the highest long-term returns, there are no hard and fast rules about how concentrated one's portfolio should be -- it depends on tolerance for volatility, availability of other investment options, the confidence in one's analysis, and many other factors.

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Gaining an Investment Edge

http://www.fool.com/news/commentary/2004/commentary04120304.htm By Whitney Tilson 12/03/2004 Successful stock picking has always been a challenge, but as more and more money and talent pour into the investment field -- it's a deluge right now -the task is especially difficult. Companies with issues such as Merck(NYSE: MRK), Marsh & McLennan(NYSE: MMC), and Coca-Cola(NYSE: KO) should all be trading at least $10 lower than they are right now, but everyone's a value guy these days, piling into stocks that have gotten crushed, so they don't fall nearly far enough. Yes, I'm frustrated! (Though not for an instant do I think that the market's regular swings from fear to greed and back again have come to a halt. It's just a matter of time -- and I would bet not very much time -- before something causes fear to return.) How to beat the market There are only three ways to beat the market: better stock picking, better market timing, or more portfolio leverage. It seems obvious, to me at least, that the former is the best option. Market timing is a fool's errand -- I challenge you to show me anyone among the wealthiest Americans who made their fortune doing so -- and if you use much leverage, the market will eventually carry you out on a stretcher. But with so many smart people with so much money looking for bargains, even the traditional pockets of inefficiency such as distressed securities, spinoffs and micro caps are increasingly picked over. So how can one pick stocks that will outperform? Only by having an edge. If you don't -- if you're the proverbial sucker at the poker table -- you're going to get creamed. There are many different kinds of edges: Size edge If you're an individual investor, your biggest advantage by far is that you're managing a lot less money than almost all professionals, which allows you to invest in the nooks and crannies of the markets, where the greatest

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inefficiencies lie. At the 1999 Berkshire Hathaway (NYSE: BRK.A) annual meeting, Warren Buffett agreed, noting: "If I had $10,000 to invest, I would probably focus on smaller companies because there would be a greater chance that something was overlooked in that arena. There are little tiny areas where if you look at everything -- and look for small securities in your area of competence where you can understand the business and occasionally find little arbitrage situations or little wrinkles here and there in the market -- I think working with a very small sum, there's an opportunity to earn very high returns. I could name half a dozen people that I think could compound $1 million at 50% per year. But they couldn't compound $100 million or $1 billion at anything remotely like that rate." The argument for focusing on obscure companies makes a great deal of sense intuitively. Do you think a stock is more likely to be mispriced if only a few people have ever heard of the company and not a single analyst follows the stock, or if it's a household name, with dozens of analysts covering it? Time horizon edge Money managers are generally evaluated and compensated based on their performance over a relatively short time period: at most, one year, and increasingly quarterly or even monthly. This means that if they find a stock they think is really cheap, but there's no obvious short-term catalyst that will cause it to rise, they often won't buy it. So, it's a huge advantage to be able to invest with a 3-5 year (or longer) time horizon. Concentration edge Investment success is not measured by the number of stocks one buys that go up vs. those that go down. Rather, total profits are the amount of profit you make on your winners, minus the losses on your losers, which is not the same thing. For example, if you buy 10 stocks and two double in value and eight go down by 50%, you can still make money -- even with an 80% failure rate -- if the two winners are huge positions (if you started with $100 and the two winners were each, say, 20% positions, then you've made $40 on them and lost $30 on the eight losers, leaving you with a $10 profit).

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The ability to bet big when one has maximum conviction about an investment is invaluable, especially given that even the most brilliant investors only have a few good ideas a year. Yet most professional money managers have strict limits -- either formally or informally -- on position sizes. Take a look at most mutual funds: The largest holding is often less than 5% -- a starting position for me -- and managers aren't allowed to hold much cash, so they have to dilute their best ideas with dozens of inferior ones, with the result that the average mutual fund holds more than 100 stocks. If you asked me to manage money this way, I'd give it back to you because I don't think I could beat the market. Analytical edge Some investors are -- or at least think they are -- smarter than almost everyone else. They have the same information, yet process and analyze it better -- filtering out the noise and focusing like a laser on the handful of critical issues -- and thus reach more accurate conclusions and make better investment decisions. If you think you're in this category, well, join the rest of us! Seriously, there are so many brilliant people in this business that even having analytical skills in the top few percent isn't going to provide much differentiation. Experience edge There's a very wise saying that every investor spends his first five years making mistakes and then spends the rest of his career trying not to repeat the same mistakes. In my early days of investing, I didn't really believe this (OK, I didn't want to believe it!), but with many more years under my belt -and plenty of scars on my back -- I now know how true it is. Investing is like history: It never repeats itself exactly, but a lot of pretty similar things happen over and over again, so experience is invaluable. My advice in this area is: Try to learn from others' painful experiences rather than going through it yourself, so read about and talk to as many smart, experienced investors as you can (my recommended reading list is posted here). Start your investing career by working for someone else, so you can learn from her experience and make mistakes on her nickel, not yours! (For tips on how to break into the money management business, see this column.)

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If you're going to pick stocks on your own, do it with a small amount of money until you have some experience under your belt -- and don't confuse brains with a bull market! Emotional edge It is well-documented that human beings are hardwired to be massively irrational when it comes to financial matters. So many investors blindly follow their emotions, run with the herd, pile into the hottest sectors at their peaks, suffer huge losses, and finally panic and sell at the bottom. Thus, investors who can control their emotions can have a substantial edge. As Buffett once noted, "Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ.... Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing." (The study of this topic is called behavioral finance, an area about which I have studied and written extensively -- click here to access my presentation and eight published columns.) Information edge I find that the best investors often have an information edge. They simply do more work, are more creative in collecting information -- often tapping into valuable "scuttlebutt" -- and/or throw more resources into the research process such that they can occasionally gain some proprietary insights that can lead to big profits. Remember, you need only to have a few big ideas each year to be an extremely successful investor. In my next column, I'll focus on how to gain an information edge and share some case studies.

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How to Beat the Market

Portfolio Management
By Whitney Tilson (Tilsonfunds@aol.com)

NEW YORK, NY (Jan. 18, 2000) -- So you want to beat the market? Then pick stocks that go up. But what if they don't go up? Then don't buy 'em! I forget who offered this whimsical piece of advice, but it made me laugh. However, I don't think that picking stocks that go up is the most important determinant of long-term investment success -- a sound portfolio management strategy is. Unfortunately, few professional money managers -and, studies show, too few individual investors -- manage their portfolios in what I believe to be a rational way, making it nearly impossible for them to beat the market over time even if they are good stock pickers. As I've noted in earlier columns, it's hard to beat the market -- especially after all costs and taxes are considered -- as evidenced by the paucity of people (both professionals and individuals) who have been able to do so over an extended period. Those that have been successful have followed a wide range of portfolio management strategies, but I firmly believe that history shows -- and the future will continue to show -- that investors with the best odds for beating the market by a reasonable margin (say, 5-10% annually after all costs and taxes) manage their portfolios in a certain way. Here are the key elements of successful portfolio management. Make Long-term Investments My horizon is at least five years -- and ideally a lifetime -- on pretty much all of my investments. The average mutual fund, in contrast, churns its portfolio 86% annually, while the figure was 80% for individual investors, according to Barber and Odean's powerful study from 1991 to 1996. And it's getting worse. According to an article in Saturday's New York Times, "Among Nasdaq stocks, the hottest shares last year, the average holding period was five months, down from roughly two years [a decade ago]." With so many people churning stocks like mad -- and doing so well (or at least boasting of it) -- why am I recommending the opposite approach? First, holding portfolio turnover to a minimum has the obvious benefit of keeping taxes and trading costs low (yes, trading costs have fallen dramatically, but don't forget about the bid-ask spread). With the S&P 500 rising 20% or more each year for the past five years, worrying about these costs might seem pass, but they matter a great deal in the long run. Taxes especially can crush your long-term returns. As I wrote in an earlier column on "Deferring Capital Gains Taxes": "Consider three scenarios whereby you earn 10% returns per year for the next 20 years on an initial $1,000 investment. If your profits were taxed

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annually as short-term capital gains (39.6%), in 20 years your investment would be worth $3,231. If it were taxed annually as long-term capital gains (20% rate), it would be worth $4,661, 44% more. And if you were to instead buy one stock that compounded at 10% annually, and then after 20 years sold it and paid the 20% capital gains tax, you would have $5,582, 73% more." Many people trade because they think the stock they're buying will outperform the one they're selling. But another study by Odean shows that precisely the opposite is the case: The stocks investors bought underperformed those they sold by an average of 3.2% in the following year, and this doesn't even factor in substantial taxes and trading costs. Ouch! Odean's studies showed a strong correlation between the amount of trading investors did and their returns. Hyperactive traders, with an average of 1,000% annual turnover, had just a 11.4% annualized return after expenses. The least-active investors barely traded, changing just 2.3% of their holdings annually, yet they managed a market-beating 18.5% annualized return (the S&P 500 Index was up 16.9% annually during the period). Note that these figures do not include the tax penalty paid by heavy traders. But what if hyperactive traders tended to pick worse stocks, such that their lower performance was due to this, rather than their trading? Not so, according to the study. Had the least-active traders done no trading, their returns would have only been 0.25% better annually, whereas the heavy traders would have done more than seven percentage points better annually. Not surprisingly, Barber and Odean concluded, "Our central message is that trading is hazardous to your wealth." Only Invest When You Believe the Odds Are Heavily in Your Favor The future is very difficult to predict. Even when I'm highly confident about an investment, I consider myself lucky to be right a bit more than half the time. Therefore, I only invest when I'm as confident as I can possibly be about a favorable outcome. That doesn't mean I don't take risks -- I have invested in some fairly speculative situations -- but I have to believe strongly that there is a highly favorable risk-reward equation before I will invest. This means that I make relatively few investments. Why dilute my best ideas with inferior ones? In contrast, I read a few weeks ago that the average mutual fund holds 132 stocks. That's crazy! I hope not to make that many investment decisions in my lifetime. How can an investment manager -- even supported by a team of analysts -- possibly keep track of that many companies and industries? And I'll never be persuaded that the manager is highly confident of so many investments. Hold a Concentrated Portfolio

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An obvious consequence of making few investments is making big ones. To invest successfully, I believe you have to find stocks that the market is mispricing, which doesn't happen very often. These days, it's hard to find good companies trading at a bargain price, or great companies trading at anything close to a reasonable price. Thus, when I find an attractive situation where I'm highly confident of a favorable outcome, I invest a meaningful amount -- usually at least 5% of my fund. In general, my top five holdings account for 50% of my fund, and the top 10 holdings, 80%. So that they are not labeled "undiversified," most mutual funds cannot invest more than 5% in a single stock, and I rarely find a fund where the top 10 holdings account for more than 25-30% of the fund. Conclusion and a Word of Caution I'd like to think that I'm a good stock picker, but if you told me that I had to manage my fund as the average mutual fund manager does -- 86% annual turnover, 132 holdings, and no investment larger than 5% of the fund -then I would give my investors their money back and find a different career because I don't think I could beat the market over a long period of time, after all taxes and costs are considered, no matter how good a stock picker I was. Be careful, though. Investing in the way I have recommended increases the chances for beating the market, but holding a concentrated portfolio is almost certain to lead to more short-term volatility and can result in large losses. If you aren't certain that you know what you're doing, then I believe you are better off with a highly diversified portfolio -- and perhaps an index fund. -- Whitney Tilson

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How to Beat the Market

Be Flexible!
By Whitney Tilson (Tilson@Tilsonfunds.com)

NEW YORK, NY (Jan. 24, 2000) -- In last week's column, I concluded with the following words: "I'd like to think that I'm a good stock picker, but if you told me that I had to manage my fund as the average mutual fund manager does -- 86% annual turnover, 132 holdings, and no investment larger than 5% of the fund -then I would give my investors their money back and find a different career because I don't think I could beat the market over a long period of time, after all taxes and costs are considered, no matter how good a stock picker I was." There's another big disadvantage that most mutual funds suffer from: They generally have investment restrictions that limit them to a particular industry, investment style (typically value or growth), or market capitalization of stock they can own. These limitations have pernicious effects that work to the detriment of the funds and their investors. Buying a small-cap value stock and then watching it grow into a large-cap growth stock pretty much defines investing nirvana. But how many mutual funds could ever do this? For example, consider a small-cap value fund that might have owned Dell in 1990 when its market capitalization was less than $1 billion and the stock was trading at less than 10x earnings. That fund would have been forced to sell the stock as its market cap and P/E grew, thereby triggering significant capital gains taxes and, even worse, missing out on a subsequent 100-bagger or so. That's a painful double whammy! One of the reasons that Legg Mason Value Trust mutual fund has been able to beat the S&P 500 Index for a remarkable nine consecutive years is that its manager, Bill Miller, bought America Online and Dell when they were mid-cap value stocks, and then had the courage and good sense to hold onto them as they grew into large-cap growth stocks. (You see! I can write something nice about a mutual fund.) It doesn't take very many grand slam investments like these to build a fabulous track record. Or consider a large-cap growth fund today. This type of stock has done extremely well over the past few years, as have the funds in this sector. I've made a great deal of money in this space, too. But with the enormous valuation gap that has developed between today's Nifty Fifty and the rest of the market, I'm investing new cash almost exclusively in value stocks or smaller capitalization companies -- something large-cap growth funds can't do. Speaking of growth and value investing, I completely reject this distinction as

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commonly defined. All investing should be value investing, which I think of as buying something for less than it is worth. The common definition of a value stock -- one that has a low price-to-book or price-to-earnings ratio -- means little to me. I believe that some stocks trading at 50x earnings or more -- or which have no earnings whatsoever today -- are value stocks. And many stocks trading at single-digit earnings multiples do not represent value at all. Having industry-specific funds makes a bit more sense because it allows fund managers to develop deep knowledge in a particular sector. However, these funds are vulnerable to the market's tremendous sector-based herding tendencies. For example, I bought several of my favorite technology stocks last June, when many were out of favor, but as this sector has become enormously popular and prices have soared, I am now making new investments elsewhere. In contrast, managers of technology-focused mutual funds have no choice but to continue to invest in this sector, even if they share my view that there are few attractively priced stocks to buy. (By the way, I'm not advocating that anyone invest outside their areas of expertise, but I think every investor should understand at least a few industries well enough to invest in them should an attractive opportunity present itself.) The investment restrictions of most mutual funds helps explain why their past performance has proven to be no predictor of future results. Numerous studies have shown that the performance of top funds tends to be driven by the sector they're in rather than any unique stock-picking talent of the fund manager. Given that hot sectors rarely remain hot for very long, so too does the performance of top funds tend to wane. Finally, almost no mutual funds invest in privately held businesses due to the risk and lack of liquidity (not to mention SEC regulations). But in a sector like the Internet, where it's entirely possible that there is a "greater fool" game going on, buying the extraordinarily richly valued public stocks is far less appealing than investing in companies before their IPOs. To summarize, I seek to invest in high-quality businesses that I understand well at attractive prices. Companies like these don't consistently fall neatly into certain categories. Depending on the market's moods at any given time, the best investments can be anywhere, so I pursue these opportunities wherever they may lie. You have this flexibility as well. I urge you to use it. -- Whitney Tilson

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Fool.com: Calculating Lucent's Cash Flow [Fool on the Hill] November 28, 2000
http://www.fool.com/news/foth/2000/foth001128.htm

When analyzing a company, it's critical to understand how much free cash flow it is earning from its operations. This is the excess cash the company is generating that can be taken out of the business for the benefit of shareholders via dividends, share repurchases, new investments, acquisitions and the like. Free cash flow is what you should care about most as an owner -- and as a shareholder, that's what you are: a fractional owner of a business. After last week's column on the importance of the cash flow statement, many readers asked me to take an actual cash flow statement and walk them through it. You know what they say about being careful what you wish for. Fasten your seatbelt and prepare to be barraged with numbers. But don't worry if you're not a CPA -- all I'm doing is copying figures from SEC filings and doing some simple addition and subtraction. I'm going to use Lucent (NYSE: LU) as my example because it's a well-known company and its stock is widely held. (At least it used to be. Since its peak less than a year ago, Lucent's stock has fallen 80% from $84.18 to $16.75, as of yesterday's close. That's more than $200 billion of shareholder wealth wiped out!) I also picked Lucent because it provides a good case study of a company where cash flow has significantly trailed net income. Background The cash flow statement has three components: operating activities, investing activities, and financing activities. With a few exceptions, discussed below, there aren't many mysteries about where different items go on the cash flow statement. Things related to a company's operations -- net income, changes in working capital and the like -- fall under operating activities. Capital expenditures, as well as buying and selling stocks, bonds and other companies, fall under investing activities. Paying dividends, as well as issuing or buying back the company's own debt and stock, fall under financing activities. In general -- again, with a few exceptions -- the figures under operating activities tell you how much cash the business is generating. Financing and investing activities simply tell you how the company is allocating its operating cash flow (or financing its operating cash deficit). While a company can sometimes generate meaningful cash flow from its investing activities -- the extremely profitable venture capital investments by many high-tech companies like Intel are a good example -- the free cash flow generated by a company's operations are of paramount importance. Lucent's cash-flow data Here is Lucent's cash flow from operating activities from its 10-Q for Q2 00. I'm using this

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quarter as an example since Lucent's subsequent financial statements have been restated to account for the recent spinoff of Avaya (NYSE: AV), and cannot be compared precisely to those from earlier periods. (All figures in millions of dollars.)

Operating Activities Q1-Q2 00 Net income $2,004 Depreciation and amortization 1,046 Provision for uncollectibles 83 Tax benefit from stock options 909 Deferred income taxes 30 Purchased in-process research and development 11 Adjustment to conform pooled companies' fiscal years 11 Increase in accounts receivable (784) Increase in inventories and contracts in process (614) (Decrease) increase in accounts payable (386) Changes in other operating assets and liabilities (882) (960) Other adjustments for noncash items -- net Net cash provided by (used in) operating activities 468
Cash flow by quarter The figures in cash flow statements are cumulative, so the numbers from Lucent presented above cover six months, not just the second quarter. What I really want to know is what happened in each of the first two quarters, so I can see what the trends are. To do this, one must have the cash flow statement from Lucent's 10-Q for Q1. Here's the data for each of the first two quarters for FY 00. The second column contains the figures presented above.

Q1 00 Q1-Q2 00 Net income $1,250 2,004 Depreciation and amortization 505 1,046 Provision for uncollectibles 38 83 Tax benefit from stock options 456 909 Deferred income taxes 102 30 Purchased in-process research and development 0 11 Adjustment to conform pooled companies' fiscal years 11 11 Increase in accounts receivable 14 (784) Increase in inventories and contracts in process (309) (614) (Decrease) increase in accounts payable (719) (386) Changes in other operating assets and liabilities (654) (882) (570) (960) Other adjustments for noncash items -- net Net cash provided by (used in) operating activities 124 468
So now we can see what happened in each quarter, right? Wrong! There's one more step. Since these are cumulative numbers, to see the cash flows in Q2, we need to subtract the Q1

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figures (column 1) from the cumulative numbers from Q1-Q2 (column 2). Doing this simple subtraction yields the following:

Q1 00 Q1-Q2 00 Net income $1,250 754 Depreciation and amortization 505 541 Provision for uncollectibles 38 45 Tax benefit from stock options 456 453 Deferred income taxes 102 (72) Purchased in-process research and development 0 11 Adjustment to conform pooled companies' fiscal years 11 0 Increase in accounts receivable 14 (798) Increase in inventories and contracts in process (309) (305) (Decrease) increase in accounts payable (719) 333 Changes in other operating assets and liabilities (654) (228) (570) (390) Other adjustments for noncash items -- net Net cash provided by (used in) operating activities 124 344
(Note: doing the same calculations for Q3 00 yields a significantly negative operating cash flow. I did not include a column for Q3, however, due to Lucent's financial restatements noted above. Lucent will report restated data for Q2 00 next year, so until then we cannot accurately determine Q3's cash flows. I think it is likely, however, that the general direction of the operating cash flow -- a significant turn for the worse in the quarter -- is correct. As a current or potential investor, not being able to see exactly what happened to cash flow in Q3 would concern me. I'll share some thoughts on how to handle a not-uncommon situation like this in a future column.) Conclusion So, now that we've calculated operating cash flow for each of the first two quarters, we're done, right? Unfortunately not. Free cash flow is not the same as net cash provided by operating activities. A few adjustments must be made, and I'll address those in next week's column. -- Whitney Tilson

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Fool.com: Lucent's Free Cash Flow [Fool on the Hill] December 12, 2000
http://www.fool.com/news/foth/2000/foth001212.htm

Revenues (to some extent) and net income (to an increasingly large extent in this market) are opinions, but cash is a fact. That's why I spend so much time focusing on companies' cash flow statements. The key number I look for is free cash flow, which is the excess cash the company is generating from its operations that can be taken out of the business for the benefit of shareholders via dividends, share repurchases, new investments, acquisitions, and the like. To calculate this figure, a few adjustments must be made to the cash flow from operating activities shown on the cash flow statement. In my column two weeks ago, I showed how to calculate Lucent's (NYSE: LU) cash flow from operating activities for each of the first two quarters of FY '00. Now let's make the necessary adjustments to arrive at free cash flow. (Note that if you put 10 analysts in a room, gave them identical financial statements, and told them to calculate free cash flow, you might get 10 different answers. There's a lot of judgment involved, so you shouldn't necessarily take my approach as gospel.) Adjusting for taxes There are often items in the cash flow statement under operating activities that have nothing to do with a company's actual operations. Do you think the tax deduction a company gets when its employees exercise stock options should be counted as cash from operating activities? I don't, so while new SEC regulations require companies to report this under Operating Activities, I always move "Tax benefits from stock options" to Financing Activities whenever I see it under Operating Activities. (Unfortunately, many companies do not break out this line item separately, so you can't make the adjustment. In addition, some companies continue to report this figure under Financing Activities.) Similarly, I don't believe that changes in "Deferred income taxes" have anything to do with operations either, so I move this line item as well. Adjusting for cap ex The most difficult adjustment is for capital expenditures, which reflect spending to maintain and build property, plant and equipment. (For some companies, other items such as "Software development costs" or "Purchase of software licenses" would also be included in cap ex). These expenses are depreciated over many years, but since depreciation reflects cap ex in the past, it's not a cash cost today. Thus, it is added back on the cash flow statement under "Depreciation and amortization." (Depreciation is for tangible assets; amortization is for intangible assets such as goodwill.) But to balance adding back the non-cash cost of

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depreciation, you must subtract the real cash cost of cap ex, which appears under Investing Activities in the cash flow statement. This is easier said than done, however. The goal is to subtract what a company must spend to maintain its existing operations and market position. But what if a company decides to invest in a new line of business and makes big capital expenditures -- funded from its free cash flow -- to do so? This growth cap ex is not a requirement of the business, as the cash could have been returned to shareholders, but management determines that it can generate a high rate of return from this additional cap ex. In this case, one must estimate how much of a company's cap ex is for maintenance -- and subtract this amount to arrive at free cash flow -and how much is for growth, which should not be subtracted when calculating free cash flow. I don't have the space in this column to give this subject the treatment it deserves, so I have posted further thoughts on the Fool on the Hill discussion board. For simplicity's sake -- and to be conservative -- I generally deduct all cap ex to arrive at free cash flow unless I have a concrete reason to do otherwise. Other thoughts on cash flow Depending on the company, other adjustments to free cash flow may be warranted. For example, there may be line items beyond those I've mentioned that appear under Operating Activities in some companies' cash flow statements that you feel don't truly relate to operations. You may also want to adjust for unusual or one-time gains or charges. For example, American Power Conversion (Nasdaq: APCC) in Q2 '00 had a one-time litigation payment of $47.2 million, which I excluded from my calculations of operating cash flow. I'm afraid there are few hard rules -- you just have to use your judgment. Lucent's adjusted free cash flow We can see how important these adjustments are in the case of Lucent, as modestly positive operating cash flow was in reality significantly negative free cash flow, due mainly to cap ex and huge tax benefits from employees exercising stock options ($909 million in the first half of FY '00 vs. only $394 million for the entire previous year). Incidentally, I always worry when I see a big jump in this number, as it can -- though it doesn't always -- mean employees see storm clouds on the horizon (or simply believe the stock is overvalued) and are consequently exercising their stock options and selling. I have posted further thoughts on this topic and how it relates to Lucent on the Fool on the Hill discussion board.

(continued on next page)

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Here are Lucent's figures for each of the first two quarters of FY '00 (all of these figures are taken from my column two weeks ago except net cap ex):

Net cash provided by operating activities Adjustment for tax benefit from stock options Adjustment for deferred income taxes Adjustment for net cap ex Free cash flow

Q1 '00 124 (456) (102) (585) (1,019)

Q2 '00 344 (453) 72 (634) (671)

(Note: doing the same calculations for Q3 00 yields even greater negative operating cash flow. I did not include a column for Q3, however, because of Lucent's financial restatements due to its spin off of Avaya. In next week's column, I'll share some data on what happened to Lucent's cash flow in Q3 and how to handle not-uncommon situations in which there is imperfect data.) Lucent provides an excellent case study of how important it is to adjust operating cash flow to determine free cash flow. The former was $468 million in the first half of this fiscal year, while the latter was more than $2 billion lower at negative $1.69 billion. Now that we have the numbers we need to begin our analysis of Lucent's cash flows -- I haven't done any analyses yet -- I'll stop and let you think about what these numbers mean. Ask yourself: Why have Lucent's cash flows been so weak? What items on the cash flow statement are driving this? (See my column two weeks ago for a detailed look at Lucent's entire cash flow statement.) How has Lucent been funding its negative free cash flows? At what point might analysts and investors have realized that something was seriously amiss? I'll share some of my thoughts regarding these questions next week. Conclusion Keep in mind that free cash flow is not the only way -- and often not even the best way -- to evaluate and value a business. A company might choose a strategy that results in declining or negative cash flows in the short run, but creates immense shareholder value in the long run. However, understanding and being able to calculate free cash flow is a critical tool that every investor should possess. Finally, don't let all these numbers intimidate you. This isn't calculus -- it's copying data and then doing some basic addition and subtraction, nothing more. Just take your time, since it's easy to make a careless mistake. -- Whitney Tilson

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Fool.com: Lessons From Lucent's Cash Flow [Fool on the Hill] December 19, 2000
http://www.fool.com/news/foth/2000/foth001219.htm

In my columns last week and three weeks ago, I showed -- using telecommunications equipment maker Lucent (NYSE: LU) as an example -how to break down a cash flow statement by quarter and then make the necessary adjustments to arrive at free cash flow. The main reason I picked Lucent is that it is a good example of how a company can report strong and increasing earnings, yet -- due primarily to a deteriorating balance sheet -generate large free cash flow deficits. To get yourself started, take a look at this table. The first line shows Lucent's reported pro forma net income for each quarter from Q1 '98 through Q3 '00, while the second shows free cash flow over the same period:
Lucent Net income (pro forma) Free cash flow Q1 98 1124 173 Q1 99 1523 -1619 Q2 98 186 -499 Q2 99 533 -841 Q3 98 518 794 Q3 99 819 -571 Q3 00 1040 -1348 Q4 98 647 -650 Q4 99 897 -783

Net income (pro forma) Free cash flow

Q1 00 Q2 00 Net income (pro forma) 1250 818 Free cash flow -1019 -671 *All numbers in millions of dollars.

(See last week's column for details on how free cash flow was calculated. Data from Q4 '00 is excluded because net income is being restated and the cash flow statement has not yet been released. In Q3 '00, Lucent restated its financials due to the spin-off of its Enterprise Networks Group into a separate company, Avaya (NYSE: AV). Consequently, I had to estimate net income and cash flows for Q3 '99, Q4 '99, and Q3 '00. The pro forma net income figures are based on the latest data prior to the spin-off of Avaya.)

Here is what the numbers tell us: Over these 11 quarters, Lucent boasted of "pro forma" profits totaling $9.4 billion, which led the market to award the

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company a market capitalization of more than $275 billion, among the top 10 in the country (it was also the most widely held stock in America). But over the same period, Lucent was in fact generating a free cash flow deficit of $7.0 billion. That's a staggering $16.4 billion difference! As I wrote last week, "Revenues (to some extent) and net income (to an increasingly large extent in this market) are opinions, but cash is a fact." Causes of Lucent's negative cash flow How could pro forma net income and free cash flow have been so vastly different? In part, it's because Lucent had so many one-time charges due to acquisitions and the like. In 10 of the 11 quarters noted above, Lucent's pro forma net income differed from actual GAAP net income such that actual net income was $6.4 billion versus $9.4 billion of pro forma net income. In addition, Lucent's capital expenditures rose over this period. The figure varied by quarter, but it was only $234 million in Q1 '98 and was an estimated $713 million in Q3 '00. I subtracted all capital expenditures when I calculated free cash flow, but one could reasonably argue that this penalized Lucent for investing in growth, so if you instead deducted the lower figure for depreciation and amortization, free cash flow would have been $950 million higher. Had you deducted $234 every quarter, free cash flow would have been $3.3 billion higher. The primary driver of Lucent's dismal free cash flow, however, was a deteriorating balance sheet. From Q4 '97 (as reported at that time) to Q3 '00 (I added Avaya's balance sheet to Lucent's), Lucent's Foolish Flow Ratio soared from a solid 1.36 to a terrible 2.67. Over this period, accounts receivable rose from $5.4 billion to $11.7 billion, consuming $6.3 billion of cash, while inventories rose from $2.9 billion to $5.7 billion, consuming an additional $2.8 billion of cash. Increases in other current assets (other than cash) consumed another $2.2 billion of cash, for a total of $11.3 billion. Normally, in a growing company, increases in non-cash current assets are offset at least partially by increases in non-debt-related current liabilities. In the case of Lucent, this was true -- just barely -- as non-debt-related current liabilities rose by $0.2 billion. Thus, we can see that an increase in working capital consumed $11.1 billion in cash over this period.

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Finally, I have posted some thoughts on the 725% rise in Lucent's shareholders' equity from Q4 '97 to Q3 '00 on the Fool on the Hill discussion board. Conclusion My goal here is not to make those who lost money on Lucent feel or appear stupid. I'm aware that hindsight is always 20/20. Rather, it's to help you identify warning flags so you can avoid debacles like this one in the future. To its credit, the story was well covered by the Fool long before the stock began its precipitous decline. Particularly noteworthy was Lessons From Lucent, which was written on January 13, when Lucent's stock closed at $56.25. How ironic that this column -- one of the best ever on the Fool, in my opinion -- purported to be a "postmortem of Lucent's fall from glory." Lucent's fall was just getting underway. Given Lucent's obvious weaknesses, I find it shocking that the warnings on this site were not echoed more broadly. Perhaps it's because the deterioration of Lucent's balance sheet and free cash flows -- while alarming in total -- took place gradually over approximately three years. But I think the primary reason was noted in "Lessons From Lucent": We find it particularly amusing that of the 38 Wise analysts covering Lucent Technologies (as of January 8, there were 15 "strong buy" ratings, 17 "moderate buy" ratings, 6 "hold" ratings, and 0 "sell" ratings on the company), not one pointed out that either the inventory or the receivables for Lucent were skyrocketing. They did not see it or they did not want to see it -- since Lucent represents a very attractive customer of financing business for the investment firms.... It makes one wonder if the analysts are even remotely acquainted with the company's financials. Finally, as for my opinion on the stock today, I'm sure that a strong argument can be made that the stock is now cheap, but I won't be buying. This quote from "Lessons From Lucent" sums up my feelings: From our vantage point... there are precious few attractive buying opportunities among the businesses enduring a significant decline in the strength of their balance sheets. Receivables up, inventories up, borrowings

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up -- this isn't the stuff of quick turnarounds. If Lucent wants to attract our investment dollars, it will have to get down to the business of cleaning up its balance sheet over the next three quarters. If, instead, the quality of its balance sheet remains at the same level or deteriorates, you can expect the stock price to languish, management to get the boot, and Lucent to find itself losing ground swiftly to the competition. This recent fall from grace was rapid and harsh -- but only in terms of stock price. The quality of the company's business has been weakening for two years running. Lucent's comeback from here is likely to be slow and is not inevitable. We won't be investing until there are clear signs of a turnaround in the economics, in the fundamentals, of this business. What amazingly prescient words! -- Whitney Tilson

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Munger Goes Mental

http://www.fool.com/news/commentary/2004/commentary040604wt.htm By Whitney Tilson 06/04/2004 Berkshire Hathaway's(NYSE: BRK.A)(NYSE: BRK.B) Warren Buffett and Charlie Munger are undoubtedly the greatest investment duo ever, so I think any sensible investor should try to learn as much as possible about these two men and how they achieved their success. In the case of Buffett, it's not hard -- there are many books about him, he's published lengthy annual letters for decades (you can read the last 27 of them for free on Berkshire's website), and he gives speeches and makes public appearances regularly. But Munger is more private; there are only two books about him, he is a far less prolific writer, and rarely gives speeches. Thus, my heart skipped a beat when a friend gave me a recording of a speech Munger gave to the economics department at the University of California, Santa Barbara last Oct. 3. It's 85 minutes long and entitled, "Academic Economics: Strengths and Faults After Considering Interdisciplinary Needs." With that kind of title, it sounds like a real snoozer, eh? But it's not. In this speech, Munger applies his famous mental models approach to critiquing how economics is taught and practiced, and I think the lessons he teaches are profound -- both for investors as well as anyone who seeks to be a better, clearer thinker. I transcribed the speech for my own benefit, but after making such an effort (it took forever, as it's 21 single-spaced pages), I thought that others might be interested in Munger's wisdom, so I sent him a copy and asked if I could publish it. He asked me not to until he'd had a chance to review it and make some edits. He has now done so, so I'm delighted to share it with you: Click here to read it. In this column, I will share some of the highlights of the speech.

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Berkshire's success Munger started his speech by highlighting his credentials to talk about economics -- namely the extraordinary success of Berkshire Hathaway over the years he and Buffett have been running it (Buffett ran it for a few years before Munger joined him): When Warren took over Berkshire, the market capitalization was about ten million dollars. And forty something years later, there are not many more shares outstanding now than there were then, and the market capitalization is about a hundred billion dollars, ten thousand for one. And since that has happened, year after year, in kind of a grind-ahead fashion, with very few failures, it eventually drew some attention, indicating that maybe Warren and I knew something useful in microeconomics. Efficient market theory Buffett and Munger have always heaped scorn upon the academics who cling to the efficient market theory, unable to distinguish between an obvious truth -- that the market is mostly efficient most of the time -- and obvious nonsense -- that the market is always perfectly efficient all of the time: Berkshire's whole record has been achieved without paying one ounce of attention to the efficient market theory in its hard form. And not one ounce of attention to the descendants of that idea, which came out of academic economics and went into corporate finance and morphed into such obscenities as the capital asset pricing model, which we also paid no attention to. I think you'd have to believe in the tooth fairy to believe that you could easily outperform the market by seven-percentage points per annum just by investing in high volatility stocks. Yetmany people still believe it. But Berkshire never paid any attention to it. Multidisciplinary education and "man with a hammer syndrome" Over the years, Munger has always preached the importance of learning -and then using -- all of the big disciplines, such as math, science, psychology, etc. To him, this just came naturally: For some odd reason, I had an early and extreme multidisciplinary cast of mind. I couldn't stand reaching for a small idea in my own discipline when there was a big idea right over the fence in somebody else's discipline. So I

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just grabbed in all directions for the big ideas that would really work. Nobody taught me to do that; I was just born with that yen. If one doesn't embrace all multidisciplinary thinking, Munger argues, then one is likely to fall into the trap of: "man with a hammer syndrome." And that's taken from the folk saying: To the man with only a hammer, every problem looks pretty much like a nail. And that works marvelously to gum up all professions, and all departments of academia, and indeed most practical life. The only antidote for being an absolute klutz due to the presence of a man with a hammer syndrome is to have a full kit of tools. You don't have just a hammer. You've got all the tools. And you've got to have one more trick. You've got to use those tools checklist-style, because you'll miss a lot if you just hope that the right tool is going to pop up unaided whenever you need it. Problems to solve During his speech, to illustrate the types of questions his ways of thinking will help answer, Munger posed a number of problems to solve: 1. There's an activity in America, with one-on-one contests, and a national championship. The same person won the championship on two occasions about 65 years apart. Name the activity. 2. You have studied supply and demand curves. You have learned that when you raise the price, ordinarily the volume you can sell goes down, and when you reduce the price, the volume you can sell goes up. Now tell me several instances when, if you want the physical volume to go up, the correct answer is to increase the price? 3. You own a small casino in Las Vegas. It has 50 standard slot machines. Identical in appearance, they're identical in the function. They have exactly the same payout ratios. The things that cause the payouts are exactly the same. They occur in the same percentages. But there's one machine in this group of slot machines that, no matter where you put it among the 50, in fairly short order, when you go to the machines at the end of the day, there will be 25% more winnings from this one machine than from any other machine. What is different about that heavy-winning machine?

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For the answers to these questions, you'll have to read the transcript. Second- and third-order consequences and free trade Munger gave a number of examples of how often people only look at immediate consequences of certain actions and fail to consider second- and third-order consequences. For example: Everybody in economics understands that comparative advantage is a big deal, when one considers first-order advantages in trade from the Ricardo effect. But suppose you've got a very talented ethnic group, like the Chinese, and they're very poor and backward, and you're an advanced nation, and you create free trade with China, and it goes on for a long time. Now let's follow and second- and third-order consequences: You are more prosperous than you would have been if you hadn't traded with China in terms of average well-being in the U.S., right? Ricardo proved it. But which nation is going to be growing faster in economic terms? It's obviously China. They're absorbing all the modern technology of the world through this great facilitator in free trade and, like the Asian Tigers have proved, they will get ahead fast. Look at Hong Kong. Look at Taiwan. Look at early Japan. So, you start in a place where you've got a weak nation of backward peasants, a billion and a quarter of them, and in the end they're going to be a much bigger, stronger nation than you are, maybe even having more and better atomic bombs. Well, Ricardo did not prove that that's a wonderful outcome for the former leading nation. He didn't try to determine second-order and higher-order effects. If you try and talk like this to an economics professor, and I've done this three times, they shrink in horror and offense because they don't like this kind of talk. It really gums up this nice discipline of theirs, which is so much simpler when you ignore second- and third-order consequences. Open-mindedness How many people do you know who actively seek out opinions contrary to their own? Munger certainly does. For example, he said: take Paul Krugman and read his essays, you will be impressed by his fluency. I can't stand his politics; I'm on the other side. [Krugman constantly

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bashes Republicans and the Bush administration on the Op Ed page of The New York Times.] But I love this man's essays. I think Paul Krugman is one of the best essayists alive. Destroying your own best-loved ideas Munger believes that it's absolutely critical not to "cling to failed ideas." You must become good, he argues, "at destroying your own best-loved and hardest-won ideas. If you can get really good at destroying your own wrong ideas, that is a great gift." How important this is when it comes to investing! Not long ago, I publicly recommended a stock, yet a few weeks later, based on new information, I came to the conclusion that it was no longer a good idea. A natural tendency would have been to hold on to the stock and refuse to admit to my readers that I might have been mistaken. Making it even harder to sell was the fact that the stock had declined - why not wait until it rebounded to the price at which I had bought it, right? (This is a deadly error, as I've discussed in previous columns.) Fortunately, I did sell, refusing to "cling to failed ideas." Chutzpah I'll conclude this column with a bit of classic Munger humor: While Buffett bends over backward to appear humble, Munger's the opposite -- he jokes about his big ego. In his opening remarks, he said: As I talk about strengths and weaknesses in academic economics, one interesting fact you are entitled to know is that I never took a course in economics. And with this striking lack of credentials, you may wonder why I have the chutzpah to be up here giving this talk. The answer is I have a black belt in chutzpah. I was born with it.

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The Perils of Investor Overconfidence

By Whitney Tilson

NEW YORK, NY (September 20, 1999) -- Hello, fellow Fools. Dale is away this week and he invited me to be a guest columnist today, Wednesday, and Friday in his absence. First, by way of introduction, when I began investing a few years ago, I tried to educate myself by reading everything I could find on the topic (click here for a list of my all-time favorite books on investing). Being an early user of the Internet, I soon discovered The Motley Fool, which I have enjoyed and learned from immensely. The topic I'd like to discuss today is behavioral finance, which examines how people's emotions affect their investment decisions and performance. This area has critical implications for investing; in fact, I believe it is far more important in determining investment success (or lack thereof) than an investor's intellect. Warren Buffett agrees: "Success in investing doesn't correlate with I.Q. once you're above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing." Numerous studies have shown that human beings are extraordinarily irrational about money. There are many explanations why, but the one I tend to give the most weight to is that humans just aren't "wired" properly. After all, homo sapiens have existed for approximately two million years, and those that survived tended to be the ones that evidenced herding behavior and fled at the first signs of danger -- characteristics that do not lend themselves well to successful investing. In contrast, modern finance theory and capital markets have existed for only 40 years or so. Placing human history on a 24-hour scale, that's less than two seconds. What have you learned in the past two seconds? People make dozens of common mistakes, including: 1) Herding behavior, driven by a desire to be part of the crowd or an assumption that the crowd is omniscient; 2) Using mental accounting to treat some money (such as gambling winnings or an unexpected bonus) differently than other money; 3) Excessive aversion to loss; 4) Fear of change, resulting in an excessive bias for the status quo; 5) Fear of making an incorrect decision and feeling stupid; 6) Failing to act due to an abundance of attractive options; 7) Ignoring important data points and focusing excessively on less important ones; 8) "Anchoring" on irrelevant data; 9) Overestimating the likelihood of certain events based on very memorable data or experiences;

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10) After finding out whether or not an event occurred, overestimating the degree to which they would have predicted the correct outcome; 11) Allowing an overabundance of short-term information to cloud long-term judgments; 12) Drawing conclusions from a limited sample size; 13) Reluctance to admit mistakes; 14) Believing that their investment success is due to their wisdom rather than a rising market; 15) Failing to accurately assess their investment time horizon; 16) A tendency to seek only information that confirms their opinions or decisions; 17) Failing to recognize the large cumulative impact of small amounts over time; 18) Forgetting the powerful tendency of regression to the mean; 19) Confusing familiarity with knowledge; 20) Overconfidence Have you ever been guilty of any of these? I doubt anyone hasn't. This is a vast topic, so for now I will focus on overconfidence. In general, an abundance of confidence is a wonderful thing. It gives us higher motivation, persistence, energy and optimism, and can allow us to accomplish things that we otherwise might not have even undertaken. Confidence also contributes a great deal to happiness. As one author writes (in an example that resonated with me, given the age of my daughters), "Who wants to read their children a bedtime story whose main character is a train that says, 'I doubt I can, I doubt I can'?" But humans are not just robustly confident-they are wildly overconfident. Consider the following: - 82% of people say they are in the top 30% of safe drivers; - 86% of my Harvard Business School classmates say they are better looking than their classmates (would you expect anything less from Harvard graduates?); - 68% of lawyers in civil cases believe that their side will prevail; - Doctors consistently overestimate their ability to detect certain diseases (think about this one the next time you're wondering whether to get a second opinion); - 81% of new business owners think their business has at least a 70% chance of success, but only 39% think any business like theirs would be likely to succeed; - Graduate students were asked to estimate the time it would take them to finish their thesis under three scenarios: best case, expected, and worst case. The average guesses were 27.4 days, 33.9 days, and 48.6 days, respectively. The actual average turned out to be 55.5 days. - Mutual fund managers, analysts, and business executives at a conference were asked to write down how much money they would have at retirement

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and how much the average person in the room would have. The average figures were $5 million and $2.6 million, respectively. The professor who asked the question said that, regardless of the audience, the ratio is always approximately 2:1. Importantly, it turns out that the more difficult the question/task (such as predicting the future of a company or the price of a stock), the greater the degree of overconfidence. And professional investors -- so-called "experts" -are generally even more prone to overconfidence than novices because they have theories and models that they tend to overweight. Perhaps more surprising than the degree of overconfidence itself is that overconfidence doesn't seem to decline over time. After all, one would think that experience would lead people to become more realistic about their capabilities, especially in an area such as investing, where results can be calculated precisely. Part of the explanation is that people often forget failures and, even if they don't, tend to focus primarily on the future, not the past. But the main reason is that people generally remember failures very differently from successes. Successes were due to one's own wisdom and ability, while failures were due to forces beyond one's control. Thus, people believe that with a little better luck or fine-tuning, the outcome will be much better next time. You might be saying to yourself, "Ah, those silly, overconfident people. Good thing I'm not that way." Let's see. Quick! How do you pronounce the capital of Kentucky: "Loo-ee-ville" or "Loo-iss-ville"? Now, how much would you bet that you know the correct answer to the question: $5, $50, or $500? Here's another test: Give high and low estimates for the average weight of an empty Boeing 747 aircraft. Choose numbers far enough apart to be 90% certain that the true answer lies somewhere in between. Similarly, give a 90% confidence interval for the diameter of the moon. No cheating! Write down your answers and I'll come back to this in a moment. So people are overconfident. So what? If healthy confidence is good, why isn't overconfidence better? In some areas -- say, being a world-class athlete -- overconfidence in fact might be beneficial. But when it comes to financial matters, it most certainly is not. Overconfidence often leads people to: 1) Be badly prepared for the future. For example, 83% of parents with children under 18 said that they have a financial plan and 75% expressed confidence about their long-term financial well being. Yet fewer than half of these people were saving for their children's education and fewer than 10% had financial plans that addressed basic issues such as investments, budgeting, insurance, savings, wills, etc. 2) Trade stocks excessively. In Odean and Barber's landmark study of 78,000 individual investors' accounts at a large discount brokerage from 1991-1996, the average annual turnover was 80% (slightly less than the

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84% average for mutual funds). The least active quintile, with average annual turnover of 1%, had 17.5% annual returns, beating the S&P, which was up 16.9% annually during this period. But the most active 20% of investors, with average turnover of more than 9% monthly, had pre-tax returns of 10% annually. The authors of the study rightly conclude that "trading is hazardous to your wealth." Incidentally, I suspect that the number of hyperactive traders has increased dramatically, given the number of investors flocking to online brokerages. Odean and Barber have done another fascinating study showing that investors who switch to online trading suffer significantly lower returns. They conclude this study with another provocative quote: "Trigger-happy investors are prone to shooting themselves in the foot." 3) Believe they can be above-average stock pickers, when there is little evidence to support this belief. The study cited above showed that, after trading costs (but before taxes), the average investor underperformed the market by approximately two percentage points per year. 4) Believe they can pick mutual funds that will deliver superior future performance. The market-trailing performance of the average mutual fund is proof that most people fail in this endeavor. Worse yet, investors tend to trade in and out of mutual funds at the worst possible time as they chase performance. Consider that from 1984 through 1995, the average stock mutual fund posted a yearly return of 12.3% (versus 15.4% for the S&P), yet the average investor in a stock mutual fund earned 6.3%. That means that over these 12 years, the average mutual fund investor would have made nearly twice as much money by simply buying and holding the average mutual fund, and nearly three times as much by buying and holding an S&P 500 index fund. Factoring in taxes would make the differences even more dramatic. Ouch! 5) Have insufficiently diversified investment portfolios. Okay, I won't keep you in suspense any longer. The capital of Kentucky is Frankfort, not "Loo-ee-ville," an empty 747 weighs approximately 390,000 lbs., and the diameter of the moon is 2,160 miles. Most people would have lost $500 on the first question, and at least one of their two guesses would have fallen outside the 90% confidence interval they established. In large studies when people are asked 10 such questions, 4-6 answers are consistently outside their 90% confidence intervals, instead of the expected one of 10. Why? Because people tend to go through the mental process of, for example, guessing the weight of a 747 and moving up and down from this figure to arrive at high and low estimates. But unless they work for Boeing, their initial guess is likely to be wildly off the mark, so the adjustments need to be much bolder. Sticking close to an initial, uninformed estimate reeks of overconfidence. In tests like this, securities analysts and money managers are among the

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most overconfident. I'm not surprised, given my observation that people who go into this business tend to have a very high degree of confidence. Yet ironically, it is precisely the opposite -- a great deal of humility -- that is the key to investment success. --Whitney Tilson P.S. If you wish to read further on the topic of behavioral economics, I recommend the following (I have drawn on heavily on the first two in this column): - Why Smart People Make Big Money Mistakes, by Gary Belsky and Thomas Gilovich. - "What Have You Learned in the Past 2 Seconds?," paper by Michael Mauboussin, CS First Boston. - In May and June this year, David Gardner wrote four excellent columns in The Motley Fool's Rule Breaker Portfolio: The Psychology of Investing, What's My Anchor?, Tails-Tails-Tails-Tails, and The Rear-View Mirror. - There's a great article about one of the leading scholars in the field of behavioral finance, Terrance Odean (whose studies I linked to above), in a recent issue of U.S. News & World Report: "Accidental Economist" - The Winner's Curse, by Richard Thaller. - The Undiscovered Managers website has links to the writings of Odean and many other scholars in this area

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