My investment philosophy, as outlined here, is guided by the principle of survivorship and long-term sustainable capital appreciation. I want to stay profitable and in the business of investing for a very long time so as to maximally benefit from the magic of compounding.

Two key ideas that I have internalized so as to maximize my odds of success are (a) leverage and (b) moat.

Leverage

Leverage works great on the upside, especially if taken for the right reasons, and is supported with strong collateral. An excellent example of good leverage is the purchase of one’s primary house. Ability to borrow on favorable terms– at a fixed interest rate– with skin in the game through a down payment of say 20 % of property value–  and having the ability to sustain monthly mortgage payments for the duration of the loan, can serve to bootstrap sustainable wealth creation as the owner of the residence benefits from appreciation of the property over time.

Leverage on the downside, on the other hand, can be disastrous to one’s financial well-being and no matter the smartness, if one is not wise in backing the loan with solid collateral, and does not have a thoroughly vetted risk management strategy, the outcome will be disastrous in due course.

The most famous example of leverage gone south is the fall of the venerable hedge-fund, Long-Term Capital Management L.P (LTCM). As noted here, “Virtually every analysis of the LTCM case concludes that the excessive leverage of LTCM through its balance sheet and off-balance-sheet exposures was a crucial factor in causing its near failure”.

LTCM was started in 1993 by renowned Saloman Brothers investor John Meriwether and Nobel-prize-winning economist Myron Scholes of the Black-Scholes Model. Here’s a brief excerpt by Warren Buffett, when asked about the collapse at the Q&A session with the University of Florida Business school in Oct. 1998

“…the whole story is really fascinating because if you take John Meriwether, Eric Rosenfeld, Larry Hillenbrand, Greg Hawkins, Victor Haghani, the two Nobel prize winners Merton Scholes… If you take the 16 of them, they probably have as high an average IQ as any 16 people working together in one business in the country, including Microsoft or where ever you want to name…”

“…they had in aggregate, the 16, probably had 350 or 400 years of experience doing exactly what they were doing. And then you throw in the third factor that most of them had virtually all their very substantial net worths in the business. So they had their own money up. Hundreds and hundreds of millions of dollars of their own money up, super high intellect, working in a field they knew, and essentially they went broke…”

Buffetts conclusion— “…but to make money they didn’t have and didn’t need, they risked what they did have and did need. That is foolish. That is just plain foolish…”

And here’s what Buffett had to say about LCTM business model and the leverage

“…If you got $100 million at the start of the year and you’re going to make 10% if you are unleveraged and 20% if you are leveraged 99 times out of a 100  [sic], what difference does it make at the end of the year whether you got $110 million or $120 million? It makes no difference at all. I mean, if you die at the end of the year, the guy who writes the story might make a typo and he may say 110 even if you have 120. You have gained nothing at all. It makes absolutely no difference. It makes no difference to your family. It makes no difference to anything. Yet, the downside, particularly managing other people’s money, is not only losing all your money, but it’s disgrace, humiliation, and facing friends whose money you have lost. I just can’t imagine an equation that makes sense for. [sic]…”

I have personally internalized this advice in my approach to the game of money management. In my approach to analyzing businesses that I want to own, therefore, an analysis of the balance sheet, in particular, the short- and long-term debt on the books and how it ties to the business growth and business sustainability in hard times is going to be paramount.

Moat

At the Berkshire Hathaway annual meeting circa 1995, Buffett was asked the following question: “What are the fundamental rules of the economics you used to make money for Berkshire?“.  Buffett responded, “The most important thing… trying to find a business with a wide and long-lasting moat around it… protecting a terrific economic castle with an honest to lord [sic] in charge of the castle”

Here’s another quote from Warren Buffett espousing the benefits of economic moat– “If you have a big enough moat, you don’t need as much management. You know, it gets back to Peter Lynch’s remark that he likes to buy a business that’s so good that an idiot can run it because sooner or later one will. He was saying that what he really likes is a business with a terrific moat where nothing can happen to the moat. And there aren’t very many businesses like that.”

What is a moat in the context of investing and why is it important?

Moat can be thought of as the secret sauce (think the vaunted Coca-Cola recipe) or a durable competitive advantage that a business has to ward off competitors. Again quoting Buffett,

“If you have an economic castle, people are going to come and want to take that castle away from you. You better have a strong moat, and a knight in that castle that knows what he’s doing.”

Essentially, the economic moat is what protects successful businesses remain successful in a cut-throat competitive capitalistic environment. Here are some examples of economic moats–

1. low cost or pricing moat— think Costco or Walmart

2. switching cost moat– think banking or your ISP provider

3. trade secret moat– think Coco-Cola or 3M (the creator of products around adhesives)

4. toll bridge moat– think Utility companies or again your ISP provider.. if you live in northern California, PG&E is about the only source of electricity–

5. brand moat– think LVHM, the French conglomerate specializing in luxury goods or Apple

6. network moat– think Facebook or Google

Long-term survival in the game of investing essentially requires identifying and investing in firms with a sustainable competitive advantage that is either intrinsic to the business or is built over time by prudent decision-making and capital allocation by management.

My success as a money manager and my ability to sustain myself in the business of investing for a long time will essentially require me to identify such businesses and be prepared to take a huge stake (relative to the assets under management) when these firms are on sale at discount to their intrinsic value.

So how do I go about searching for businesses with management that make sound capital allocation decisions, avoid bad leverage, and are operating businesses with a sustainable economic moat? My next post will delve in-depth into this topic!