Article and video about Altria

My article in Seeking Alpha about Altria.

And my video in Spanish about Altria

Article and video about YY Inc

I’ve recently began writing on Seeking Alpha and also posting videos on YouTube about investing.

My article analyzing YY Inc on Seeking Alpha.

And my video about YY Inc. in Spanish.

Por qué estoy vendiendo Gowex / Why I’m shorting Gowex.

Por qué estoy vendiendo Gowex. (English version bellow)

Hasta el día 1 de Julio, solo conocía a Gowex por su lamentable servicio wifi instalado por todo Madrid. Cuando me he quedado sin mi tarifa móvil 3G, he intentado conectarme a Gowex y prefiero enviar las emails por paloma mensajera que aun con tráfico aéreo llegan más rápido. Ni sabía que Gowex estaba listada en la bolsa. El descubrimiento vino gracias a mi amigo Ernesto que me hizo saber de la reciente aparición de Gotham City Research y la caída del 50% del valor de Gowex en bolsa. Mi primera reacción fue de pasotismo, no suelo mirar empresas listadas en el mercado alternativo ya que si los sistemas de control en el Ibex son regulares, en el mercado alternativo son de coña (como en todos los países por cierto, que por eso se llaman mercados alternativos o OTC/Pink Sheets). Sin embargo, si me picó la curiosidad para leerme el informe de Gotham y empezar a ver los comentarios de prensa y distintos usuarios de los foros.

La reacción

La casi inmediata reacción de la prensa y los usuarios en general es que Gotham, una empresa anónima con nombre de ciudad de Batman, debía tener unos motivos ocultos o habría sido contratada para arruinar a Gowex con todo tipo de artimañas. Tenía que ser ataque coordinado de estas ratas de alcantarilla. Estas lindezas no paraban de asomar por las noticias y todo el mundo dudaba de Gotham.

Por mi parte, suelo ponerme del lado de los analistas que escriben un informe negativo sobre cualquier empresa. El motivo es muy sencillo. Es totalmente legal escribir algo positivo o negativo sobre una empresa y tomar posiciones acorde con tu análisis si lo pones en conocimiento público y mientras la información proporcionada no sea falsa. No solamente es legal, es que además es lo más ético que se puede hacer. Si alguien escribe falsedades sobre una empresa para embellecerla y que la acción suba a niveles ridículos, generalmente la gente no se queja y no hay demandas a pesar de que es estrictamente un fraude. Sin embargo, si escribes un análisis negativo y el valor de las acciones caen, más vale que sea cierto porque te van a investigar hasta la ropa interior. Gotham además está registrada en Nueva York (Gotham es Nueva York, para los frikis de Batman), y en Estados Unidos casi te pueden caen denuncias y multas por respirar inapropiadamente, así que mi instinto dice que Gotham no se va a jugar publicar un informe falso rompiendo la ley. Con este historial me pongo a mirar la información disponible.

–          Una empresa con valoración de más de 1500 millones de Euros listada en el mercado alternativo es como intentar colar a un señor de 50 años como menor en el autobús. No tiene ni pies ni cabeza. El mercado alternativo se ha creado para que empresas pequeñas, de baja cotización, puedan tener acceso a financiación sin todos los requisitos de un listado mayor. Léase: la regulación, requisitos y vigilancia de empresas en un mercado alternativo es mínimo. Gowex está listado en el mercado alternativo de Madrid, Paris y un ADR en Nueva York. Seria básico preguntarse el motivo por el que no están listados en ningún mercado con mayor regulación.

 

–          Tampoco me llego a convencer el informe de Gotham por sí solo como para ponerme en posición corta. Aunque el informe esta malamente redactado y con cerca de la mitad de las 90 páginas enfocadas en cosas que no tienen mucho impacto en el negocio de Gowex, sí hacen afirmaciones muy serias que, de ser ciertas, no solo podría hacer quebrar la empresa sino mandar a la cárcel al CEO. Las principales son:

 

1)      Proporcionar información falsa y diferente a distintos inversores por vía pública y privada.

2)      Falsificar las cuentas.

3)      Engañar sobre el nombre, número de clientes e ingresos que los mismos proporcionan a la empresa.

Todo esto sería delito. Aun así, no se sabía nada a ciencia cierta y podría ser todo un invento de Gotham.

 

–          Gowex tenía una valoración de 20 Euros por acción antes del informe. En menos de un año había pasado de 5 Euros a más de 25 Euros en abril.

Gowex desde Julio del 2013. Source: Yahoo Finance

 

Al fin y al cabo, esto es típico de mercados alternativos. Sin embargo, haciendo un análisis rápido de lo que debería valer la empresa, a duras penas puedo justificar que valga más de 3 euros por acción y haciendo auténticas florituras y en una orgia de optimismo lo podría poner a 5 euros por acción. Estamos hablando de una empresa que su negocio principal es proporcionar Wifi gratis y valorada en 1500 millones de euros. ¡Además proporcionando un servicio lamentable! Si esto lo comparamos con cualquier otro servicio de Wifi gratis, que funcionan bastante bien pero generan una décima parte de los beneficios que Gowex, cuanto menos es sospecho. El informe de Gotham hace referencia a esto y con mucha razón.

 

The Catalyst (La Chispa)

Llegados a este punto, claramente dirías que debería tomar una posición corta cuanto antes. Es cierto, pero creo que es un buen ejemplo para explicar por qué ahora sí y antes del día 1 de Julio hubiera podido ser un gran error.

Para empezar, de todos los puntos explicados en anterioridad lo único importante es la valoración de la empresa. Asumo que Gowex es una empresa totalmente legal y que no ha cometido fraude, y aun así, no puedo justificar más de 5 euros por acción lo pinte como lo pinte. Me da igual si Gotham es la resurrección del mal como algunos lo quieren pintar. El informe podría ser totalmente falso. Pero es que ni en los mundos de yupi Gowex debería valer 1500 millones de euros. El mercado tarde o temprano detectara esta anomalía y ajustará el precio. Ahora, el problema con toda inversión y que se suele omitir en todo análisis porque es imposible saberlo, es ¿Cuánto tardara el mercado en ajustar el precio?

Supongamos que hicimos nuestro análisis en Septiembre del 2013 cuando la acción estaba por encima de los 5.5 euros. Si hubiéramos tomado posiciones cortas en ese momento, en Abril del 2014 estaríamos perdiendo más de 5 veces nuestra inversión. El mercado puede ser irracional y dar valoraciones ridículas durante meses, años o incluso décadas (Léase Terra o Amazon). Podremos tener toda la razón del mundo pero nos arruinaríamos antes de probarlo.

Es por ello que es mala idea tomar una posición corta o larga, sino estamos convencidos de que habrá una chispa que provoque la explosión para colocar todo en su sitio. Esta chispa fue Gotham.

Si lo que indica Gotham es falso, daría igual porque gracias a ellos Gowex es ahora el centro de atención del país. Se van a analizar las cuentas con lupa y ver que efectivamente no puede valer 20 euros por acción.

Si además lo que indica Gotham es cierto, Gowex estaría en un serio problema. Lamentablemente a día de hoy (5 de Julio), Gowex ha sido incapaz de esclarecer la situación y sin embargo cada noticia que sale corrobora uno por uno lo indicado por Gotham:

–          Que Gowex iba a ser investigado y sus acciones paralizadas.

–          Que la ciudad de Nueva York no ha pagado 7,5 millones a Gowex.

–          Que la ciudad de San Francisco no ha pagado ni un dolar a Gowex.

–          Que no disponen de los 100.000 hotspots de los que presumían.

–          Que el auditor de Gowex no tiene capacidad para auditar las cuentas y tendrían que buscar otro auditor.

–          Que se ha proporcionado información falsa en inglés y otra distinta en español.

–          Que ninguno de los operadores de telecomunicaciones que aparecen en sus presentaciones tienen trato comercial con Gowex como clientes.

 

Gowex no solo no ha respondido a las acusaciones después de 5 días, sino que se ha limitado a decir que:

“Que la información publicada en el día de hoy por Gotham City Research LLC es rotundamente falsa.”

Rotundamente falsa no es. Ya se ha probado los puntos mencionados arriba. Pero quizás lo más increíble es que después de no decir nada, Gowex añade al final de la nota oficial como defensa:

“La mayoría de los informes de analistas publicados siguen manteniendo recomendaciones de compra de las acciones de GOWEX, incluyendo precios objetivos que oscilan entre los 17 euros y 31 euros por acción. El consenso de mercado se sitúa en un valor de 23,97 euros por acción.”

No Gowex, el consenso de mercado sitúa ahora mismo la acción a 7.92. Pero realmente importa poco el consenso de mercado si lo que se está diciendo es que los números que has entregado a los analistas son falsos. Algo que cualquier empresa podría haber solucionado en un par de horas publicando los números e información solicitada, Gowex lleva 5 días poniendo excusas o lo que puede ser peor, fabricando números. Tal vez debería enfocarse más en publicar esos números y menos en intentar subir el valor de sus acciones.

Por último, si eres CEO de una empresa “atacada por posiciones cortas”, podrías ser uno de los hombres más felices del mundo. Si realmente las acciones de tu empresa valen 23,97 y están a 7,92, lo que deberías hacer INMEDIATAMENTE como CEO es dar orden de compra de todas las acciones que te sea posible ya que estarías ahorrando una millonada (más de 800 millones de euros) a los accionistas en cuestión de meses según se esclarezca la situación actual. Si lo que quieres como CEO es que suban el precio de tus acciones antes de esclarecer nada, o eres un desastre de gestor o algo huele mal en Gowex. Ambas cosas son malignas para el futuro de la empresa.

 

== ENGLISH ==

 

Why I’m shorting Gowex.

Until July 1, I knew Gowex for its horrible WIFI service installed throughout Madrid. When I found myself running out of my 3G data limit, I had tried to connect to Gowex. In my experience, emails sent by pigeon would arrive faster than using Gowex’s network. It was surprised that Gowex was listed on the stock exchange. My friend Ernesto brought to my attention the existence of Gotham City Research and the fall of 50% in Gowex’s stock price. My first reaction was of “whatever”. I don’t usually look at companies listed on the alternative market because of the lack of regulation. However, it got me curious enough to begin reading the report from Gotham and take a look at the press and users at different forums.

The reaction

The immediate reaction for much of the press and people in general was that Gotham, a company baring the name of Batman’s hometown, should have some hidden motives or would have been contracted to ruin Gowex with all kinds of dirty tricks. It had to be coordinated attack of these sewer rats. These niceties were written all over the news and everybody doubted Gotham.

For my part, I tend side with analysts who write a negative report on any company. The reason is very simple. It is completely legal to write something positive or negative about a company and take positions according to your analysis as long as you disclosure it and as long as the information provided is not false. It is not only legal, it is also the ethical thing to do. If someone write falsehoods about a company to beautify it and those actions rise the stock price to ridiculous levels, people won’t complain and few times there are lawsuits even when it is strictly a fraud. However, if you write a negative analysis and the value of the shares drops, you better be certain because people will come to hunt you. Also, Gotham is registered in New York (Gotham IS New York, for you Batman geeks), and in the United States you can almost get sued and fined by breathing improperly. Therefore, my instincts say that Gotham is not risk a lawsuit by publishing a false report. With this in mind, I begin to look at the available information.

–          A company with more than 1500 million Euros valuation listed in the alternative market (OTC or Pink Sheets) is like trying to sneak a 50 years old man as a minor in the bus. It makes no sense. The OTC has been created for very small companies that want to gain access to financing without lot of requirements. Read: regulation, paperwork and monitoring of enterprises in an OTC is minimal. Gowex is listed on the alternative market of Madrid, Paris and as an ADR in New York. People would wonder why such a big company is listed in any market with greater regulation.

 

–          Gotham’s report didn’t fully convince me to short the position. The report is badly presented (as bad as my English) and with about half of the 90 pages focused on things that do not have much impact on the business of Gowex. Yet, Gotham makes very serious claims which, if true, could not only bankrupt Gowex but also send its CEO to jail. The main claims are:

 

 

1)      Gowex provided false and conflicting information among different public and private investors.

2)      Its financial reports are inaccurate. It is fraud and they’ve been cooking the books.

3)      Gowex misled about names, amount and revenue provided by its customers.

All this would be a crime. But at that moment in time, we didn’t know whether this is true or just Gotham’s great evil’s masterpiece.

 

–          Gowex was trading at 20 Euros before the report. In less than a year, Gowex went from 5 Euros to more than 25 Euros in April.

Gowex from July 2013. Source: Yahoo Finance

 

This is common in OTC markets. However, doing a quick valuation of the company, I can barely justify a stock price of 3 euros and making favorable assumptions to a point of becoming an orgy of optimism, I could put it at 5 euros per share. We are talking about a company that its core business is to provide free WIFI and valued at 1500 million euros. Meanwhile it does a horrible job at providing its service! Gowex’s competitors provide a better service, not for free and with 10 times less profit than Gowex. Gotham’s report makes reference to this, and quite rightly so.

 

The Catalyst

At this point, you would wonder why not take a short position as soon as possible. True, but I think it is a good example to explain why now and why before July 1 could have been a big mistake.

To begin with, from all of the points explained previously the most important one is the valuation of the company. I assume that Gowex is a completely legal and that it has not committed fraud, and even so, I cannot justify more than 5 euros per share. No matter whether Gotham is the resurrection of evil neither if the report is completely false. No way on earth I can justify a 1500 million valuation. The market sooner or later would detect this anomaly and adjust the price. Now, the problem with all investment is, how long will it take for the market to correct the mispricing?

Suppose we did our analysis in September of 2013 when the share price was about 5.5 euros. If we had taken short positions at that time, in April of 2014 we would be losing more than 5 times our investment. The market can be irrational and give ridiculous valuations for months, years or even decades (read Terra or Amazon). As the saying goes: The market can remain irrational longer than we can remain solvent.

It is for this reason that it is bad idea to take a long or short position unless we are convinced that there will be a catalyst to realize its proper value. This catalyst was Gotham.

If Gotham’s claims are false, it doesn’t matter anymore. Gowex is now the center of attention of the country. Regulators will analyze its accounts with magnifying glass and investors will see that it can’t be worth 20 euros per share.

On the other hand, if Gotham is right, Gowex would be in serious trouble. Unfortunately until today (July 5), Gowex has been unable to throw any light into the matter. Yet, each piece of news coming out validates one by one Gotham’s claims:

-That Gowex was going to be investigated and its stock halted.

-That the city of New York has not paid 7.5 million to Gowex.

-That the city of San Francisco has not even paid a single dollar to Gowex.

-That Gowex do not have the 100,000 hotspots it boasted.

-That the auditor of Gowex has no capacity to audit the accounts and Gowex will need to find another auditor.

-That has provided false information in English and different one in Spanish.

-That none of the telecom operators that appear in their presentations have commercial dealings with Gowex as customers.

 

Gowex has not only replied to the accusations after 5 days, but it has limited itself to saying:

“That information published today by Gotham City Research LLC is categorically false.”

Well, it doesn’t look categorically or flatly false. The above mentioned points have been already checked and investigated by different newspapers. But perhaps the most amazing thing is that after not saying anything, Gowex adds to the end of the official note as a defense:

“The majority of published analyst reports recommend to buy shares of GOWEX, including prices ranging between 17 and 31 euros per share. The market consensus value it at 23,97 EUR per share.”

No Gowex, the consensus right now is 7.92 EUR. But really, who cares about market consensus when you are been accused of delivering false financial reports to the analyst? This situation would have been solved by any company in a couple of hours just by posting numbers and the information requested but Gowex takes 5 days making excuses or worse, we begin to assume that they are fabricating the numbers. Perhaps Gowex should focus more on publishing those numbers and less on trying to raise the value of its shares.

Finally, if you were a CEO of a company “under attack by shorts”, you could be one of the happiest men in the world. If your company’s shares are really worth 23.97 and not 7.92, what you should do immediately as CEO is to give the order to purchase as many shares as possible since you’d be saving tons of money (more than 800 million euros) to shareholders in a matter of months once the dust settle. If what you want as CEO is to raise the share price prior to clarifying anything, you are either a bad manager or something stinks in Gowex. Neither option is good for the future of the company.

A bit over a year after the stock panic.

I almost didn’t write here for a year so I came back today and was checking what I wrote last time I was around. So I want to verify how anyone that read my last stocks recommendations during the stock panic would have fared with my picks.
This was my post from last year: https://principleinvesting.wordpress.com/2011/06/15/stock-panic-yet-again/

Here the results.
Stock price on the date of the post, June 15, 2011. Stock price today. And % change.
USB 23.99 34.93 45.60%
WFC 26.55 36.13 36.08%
STI 25.41 29.91 17.71%
BAC 10.5 9.55 -9.05%
C 38 34.79 -8.45%
NVDA 16.77 13.84 -17.47%
AAPL 326.75 691.28 111.56%
GOOG 502.95 709.68 41.10%
ARMH 27.82 28.37 1.98%
AKAM 28.99 39.03 34.63%
INTC 21.42 23.37 9.10%
MSFT 23.74 31.21 31.47%
BRK-A 110700 133000 20.14%

So if you bought 1 single share of each …

You would be sitting on a 20.50% profit today if the market didn’t scare you back then. Not bad.

Now, you will notice that this is not a fair calculation since some stocks are worth more in $ than others. For instance, BRK-A is huge so the percentage change of it compared with others would affect the portfolio a lot if only 1 share was picked.

So I proceeded to calculate it in dollar amount. I created a portfolio of $1000 on each stock (obviously with brk-a you can’t but you could use brk-b instead). The result is even better, if you had purchased $1000 on each of the stocks you would be having a profit of 24.19% today.

On top of this add dividends, which I didn’t consider on this calculation. The good news is that some of them are still very undervalued!

It pays off to keep calm on stock market panics.

Gold fundamentals

This past friday, gold spot prices fell. Then I watched this lady on TV saying that she believed gold would bounce back because fundamentals remained strong.

I don’t do commodity trading although I know a bit about “fundamentals”. I really don’t understand what she meant by fundamentals though.

Commodities such as copper, iron, and in particular gold, increase in value under certain situations:
– Currency depreciation.
– Inflation (because it’s really, currency depreciation).
– Demand.
– Expectation of any of the above three.

None are because of a fly to safety.

If you open up a gold chart, you’ll see that it has more than double in the recent years. Mainly because people thought that inflation was going to shoot up, depreciating the currency and therefore increasing the demand for the metal. Anywhere you go here in Spain, you’ll now see “we buy gold” signs.

I’ve watched lot of interviews saying that gold would keep going up because on times of uncertainty, they buy the metal. I never agreed with this and it’s about to be tested. There is a huge worry about Greece defaulting and Europe collapsing with it. Gold should be shooting to the sky today but… this is today’s Yahoo Finance headline: “Gold eyes biggest 3-day fall in 28 years, investors flee”. Where are they fleeing for safety you wonder? cash.

The problem I see is that the only reason demand on gold has increased is because of expectations that it would keep going up. But no expectation about inflation or currency depreciation has happened yet.
Does this mean that gold will crash? I don’t know. But what i’m sure is that “fundamentals remain strong” is marketing bs. While inflation is low, interest rates are low and gold is not really demanded for any purpose but to speculate, there are no fundamentals in there to justify its current price. The only way you could justify it is if the expectations are in fact correct, in which case, they are already baked in and gold should not go much higher. But markets are not rational, so it can go anywhere until reality sets in.

Stock panic. Yet again.

I’ve been losing money these past weeks… but I’m buying more the more they fall. I think financials for instance, are greatly undervalued at this point. I’m not a trader and I’m horrible at timing the market, but I seem to be good at picking undervalued companies that move on my direction after a few months. USB, WFC, STI, BAC, C… they are all cheap. Even if basel 3 is applied to them, they are oversold.

Tech sector seems to be in a similar situation, NVDA, APPL, GOOG, ARMH, AKAM, INTC, MSFT… it’s just wonderful time to pick them up. Apple might surprise to the down side which would push all of them down but the truth is that mobile devices are selling like ice cream on summer and people don’t realize that not only Apple manufactures those devices. If and when iphone5 is announced, wait for an Apple bounce. Also any mobile device selling means ARMH should get income. Any new tegra2 or tegra3 chip selling means NVDA. Increase on mobile is always good for GOOG, and any news on Intel and its new mobile chip will push its stock up. Akamai should move higher, last time I’ve checked we are not reducing our internet usage. And Microsoft is the king of undervalued, even with no growth, they just need to release anything that produces a bit of income to move that stock up. Windows for ARM chips could be a catalyst.

And then don´t get me started on BRK. It has never been this undervalued as long as I can remember.

So sleep tight and buy cheap while you can. Just don’t put money you are going to need in the short term into this. I leave the market timing to brighter minds.

Why I don’t give a WACC about Beta

One comment I always get when I worry about my financial management exams is: come on, you are an expert on this.

It seems to be a missunderstanding that since I invest and read tons about investing, I must be some kind of guru in all financial matters. Well, this is not true, I don’t get many As on finance, I don’t have a CFA and most likely would do horribly at it since I have a memory span of a fish. This, nevertheless, never stopped me from investing. From my point of view, if for investing I need to do something so complex that I don’t understand it… I don’t invest on it. I go for what I consider easy stuff, why bother if my IQ can’t hit that line? As David Allen very wisely told me: “To be rich, you don’t even need to be smart, just in case that worried you.”

So I knew what WACC was, but I’ve never had to use it. It includes Beta, and I’m mostly allergic to it. I had a conversation with one of my financial profs where I explained why I didn’t believe in Beta. He/she argueed that it was the best thing without any doubt to measure investment risk. When I asked how much he/she had made investing using this method, the reply was: “I believe the stock market is a lottery so I don’t invest.”

Good that he/she teaches it as an investment tool then.

So why I don’t believe in Beta or diversification for that matter? Because long ago I read this and I fully agree. It makes sense and it comes from a very trusted source.
==

The strategy we’ve adopted precludes our following standard
diversification dogma. Many pundits would therefore say the
strategy must be riskier than that employed by more conventional
investors. We disagree. We believe that a policy of portfolio
concentration may well decrease risk if it raises, as it should,
both the intensity with which an investor thinks about a business
and the comfort-level he must feel with its economic characteristics
before buying into it. In stating this opinion, we define risk,
using dictionary terms, as “the possibility of loss or injury.”

Academics, however, like to define investment “risk”
differently, averring that it is the relative volatility of a stock
or portfolio of stocks – that is, their volatility as compared to
that of a large universe of stocks. Employing data bases and
statistical skills, these academics compute with precision the
“beta” of a stock – its relative volatility in the past – and then
build arcane investment and capital-allocation theories around this
calculation. In their hunger for a single statistic to measure
risk, however, they forget a fundamental principle: It is better
to be approximately right than precisely wrong.

For owners of a business – and that’s the way we think of
shareholders – the academics’ definition of risk is far off the
mark, so much so that it produces absurdities. For example, under
beta-based theory, a stock that has dropped very sharply compared
to the market – as had Washington Post when we bought it in 1973 –
becomes “riskier” at the lower price than it was at the higher
price. Would that description have then made any sense to someone
who was offered the entire company at a vastly-reduced price?

In fact, the true investor welcomes volatility. Ben Graham
explained why in Chapter 8 of The Intelligent Investor. There he
introduced “Mr. Market,” an obliging fellow who shows up every day
to either buy from you or sell to you, whichever you wish. The
more manic-depressive this chap is, the greater the opportunities
available to the investor. That’s true because a wildly
fluctuating market means that irrationally low prices will
periodically be attached to solid businesses. It is impossible to
see how the availability of such prices can be thought of as
increasing the hazards for an investor who is totally free to
either ignore the market or exploit its folly.

In assessing risk, a beta purist will disdain examining what a
company produces, what its competitors are doing, or how much
borrowed money the business employs. He may even prefer not to
know the company’s name. What he treasures is the price history of
its stock. In contrast, we’ll happily forgo knowing the price
history and instead will seek whatever information will further our
understanding of the company’s business. After we buy a stock,
consequently, we would not be disturbed if markets closed for a
year or two. We don’t need a daily quote on our 100% position in
See’s or H. H. Brown to validate our well-being. Why, then, should
we need a quote on our 7% interest in Coke?

In our opinion, the real risk that an investor must assess is
whether his aggregate after-tax receipts from an investment
(including those he receives on sale) will, over his prospective
holding period, give him at least as much purchasing power as he
had to begin with, plus a modest rate of interest on that initial
stake. Though this risk cannot be calculated with engineering
precision, it can in some cases be judged with a degree of accuracy
that is useful. The primary factors bearing upon this evaluation
are:

1) The certainty with which the long-term economic
characteristics of the business can be evaluated;

2) The certainty with which management can be evaluated,
both as to its ability to realize the full potential of
the business and to wisely employ its cash flows;

3) The certainty with which management can be counted on
to channel the rewards from the business to the
shareholders rather than to itself;

4) The purchase price of the business;

5) The levels of taxation and inflation that will be
experienced and that will determine the degree by which
an investor’s purchasing-power return is reduced from his
gross return.

These factors will probably strike many analysts as unbearably
fuzzy, since they cannot be extracted from a data base of any kind.
But the difficulty of precisely quantifying these matters does not
negate their importance nor is it insuperable. Just as Justice
Stewart found it impossible to formulate a test for obscenity but
nevertheless asserted, “I know it when I see it,” so also can
investors – in an inexact but useful way – “see” the risks inherent
in certain investments without reference to complex equations or
price histories.

Is it really so difficult to conclude that Coca-Cola and
Gillette possess far less business risk over the long term than,
say, any computer company or retailer? Worldwide, Coke sells about
44% of all soft drinks, and Gillette has more than a 60% share (in
value) of the blade market. Leaving aside chewing gum, in which
Wrigley is dominant, I know of no other significant businesses in
which the leading company has long enjoyed such global power.

Moreover, both Coke and Gillette have actually increased their
worldwide shares of market in recent years. The might of their
brand names, the attributes of their products, and the strength of
their distribution systems give them an enormous competitive
advantage, setting up a protective moat around their economic
castles. The average company, in contrast, does battle daily
without any such means of protection. As Peter Lynch says, stocks
of companies selling commodity-like products should come with a
warning label: “Competition may prove hazardous to human wealth.”

The competitive strengths of a Coke or Gillette are obvious to
even the casual observer of business. Yet the beta of their stocks
is similar to that of a great many run-of-the-mill companies who
possess little or no competitive advantage. Should we conclude
from this similarity that the competitive strength of Coke and
Gillette gains them nothing when business risk is being measured?
Or should we conclude that the risk in owning a piece of a company
– its stock – is somehow divorced from the long-term risk inherent
in its business operations? We believe neither conclusion makes
sense and that equating beta with investment risk also makes no
sense.

The theoretician bred on beta has no mechanism for
differentiating the risk inherent in, say, a single-product toy
company selling pet rocks or hula hoops from that of another toy
company whose sole product is Monopoly or Barbie. But it’s quite
possible for ordinary investors to make such distinctions if they
have a reasonable understanding of consumer behavior and the
factors that create long-term competitive strength or weakness.
Obviously, every investor will make mistakes. But by confining
himself to a relatively few, easy-to-understand cases, a reasonably
intelligent, informed and diligent person can judge investment
risks with a useful degree of accuracy.

In many industries, of course, Charlie and I can’t determine
whether we are dealing with a “pet rock” or a “Barbie.” We
couldn’t solve this problem, moreover, even if we were to spend
years intensely studying those industries. Sometimes our own
intellectual shortcomings would stand in the way of understanding,
and in other cases the nature of the industry would be the
roadblock. For example, a business that must deal with fast-moving
technology is not going to lend itself to reliable evaluations of
its long-term economics. Did we foresee thirty years ago what
would transpire in the television-manufacturing or computer
industries? Of course not. (Nor did most of the investors and
corporate managers who enthusiastically entered those industries.)
Why, then, should Charlie and I now think we can predict the
future of other rapidly-evolving businesses? We’ll stick instead
with the easy cases. Why search for a needle buried in a haystack
when one is sitting in plain sight?

Of course, some investment strategies – for instance, our
efforts in arbitrage over the years – require wide diversification.
If significant risk exists in a single transaction, overall risk
should be reduced by making that purchase one of many mutually-
independent commitments. Thus, you may consciously purchase a
risky investment – one that indeed has a significant possibility of
causing loss or injury – if you believe that your gain, weighted
for probabilities, considerably exceeds your loss, comparably
weighted, and if you can commit to a number of similar, but
unrelated opportunities. Most venture capitalists employ this
strategy. Should you choose to pursue this course, you should
adopt the outlook of the casino that owns a roulette wheel, which
will want to see lots of action because it is favored by
probabilities, but will refuse to accept a single, huge bet.

Another situation requiring wide diversification occurs when
an investor who does not understand the economics of specific
businesses nevertheless believes it in his interest to be a long-
term owner of American industry. That investor should both own a
large number of equities and space out his purchases. By
periodically investing in an index fund, for example, the know-
nothing investor can actually out-perform most investment
professionals. Paradoxically, when “dumb” money acknowledges its
limitations, it ceases to be dumb.

On the other hand, if you are a know-something investor, able
to understand business economics and to find five to ten sensibly-
priced companies that possess important long-term competitive
advantages, conventional diversification makes no sense for you.
It is apt simply to hurt your results and increase your risk. I
cannot understand why an investor of that sort elects to put money
into a business that is his 20th favorite rather than simply adding
that money to his top choices – the businesses he understands best
and that present the least risk, along with the greatest profit
potential. In the words of the prophet Mae West: “Too much of a
good thing can be wonderful.”

From Warren Buffett in 1992 annual report. Full text in:
http://www.berkshirehathaway.com/letters/1993.html