Picking Unfair Fights
Source: World History Encyclopedia
The Mongolian Empire was the largest contiguous land empire in world history. At its zenith around 1259, it stretched from China to Hungry, through the Balkans and across the Mediterranean into Gaza, north to Siberia, and south to the Himalayas.
The Mongols fought unarmored on horseback with bows and arrows. They defeated every type of soldier imaginable, from Japanese samurai to heavily-armored European knights. There's a lifetime of lessons to learn from the Mongol's triumphs, but one lesson stands above the rest: game selection.
The Mongols won so often because they never picked a fair fight. They scouted enemies up to ten years in advance to learn their strengths and weaknesses. They tried to guess who would come to their aid and made contingencies for every conceivable eventuality. When they fought, they always fought from the high ground. But fighting was the last resort. They often asked for surrender and usually received it. If they didn't, they'd divert rivers and disrupt supply lines to force surrender. Putting men in harm's way was the last resort.
Investor Yen Liow took the idea of picking unfair fights to heart when he started Aravt Global. Aravt is the Mongolian word for ten, the basic unit of their army. Like Eddie Lampert, Yen Liow used case studies to master his craft.
Liow first made a list of the best performing securities over 26 years. He found that 14% of securities above a $1 billion market cap could compound at 20% for five years, and 3% could do it for 10 years. Then, he studied these winners to see what made them tick. He found three types of investments capable of compounding a 20% for 5-10 years.
1. Compounders
Compounders are businesses that can reinvest capital to compound their earnings power. They come in all shapes and sizes: slower and steady growth, hyper-growth, and everything in between. The most elegant and idiot-proof of the bunch are monopolies and oligopolies.
Oligopolies are EPC's bread and butter. AutoZone, Facebook, and McKesson are some examples of oligopolies we own.
2) Secular Within Cyclical
Secular Within Cyclical are commodity companies that benefit from a demand shock plus a delayed supply response.
Lumber is a timely example. The pandemic produced a demand shock that caught sawmills off guard. We have plenty of trees but not enough milling capacity. Building a new sawmill takes almost two years, and no one wants to risk breaking ground at the top of the cycle only to bring a new mill online at the bottom. There’s no immediate way to increase supply to satisfy demand, which is why lumber prices continue to increase.
These are in the "too hard" pile for us. We don't know how to predict commodity prices and are uncomfortable owning businesses that don't control their end prices.
3) Quality Transitions
Quality Transitions occur when a good manager turns around a bad business. Transitions can occur organically or as a result of activism. Liow found that these companies usually use M&A to buy their way into a better business. Quality Transitions can also encompass entire industries, like railroads, where consolidation reduces competition and increases profits for everyone.
NortonLifeLock and Schmitt are Quality Transitions we've owned.
Most investors would have stopped their analysis here, the moment they'd found three viable strategies. Liow kept going. He wondered what the best strategy was among these three. He surveyed his personality and temperament, analyzed his investment track record, and concluded that the best game for him to play was investing in monopolies and oligopolies.
Owning a monopoly or oligopoly is the investing equivalent of picking an unfair fight. It doesn't guarantee success, but it sure stacks the odds in your favor. You don't need to go to business school to figure out that monopolies and oligopolies are the best businesses to own.
What could be simpler? What could be more obvious? If you can invest in anything, why bother owning anything other than monopolies and oligopolies? As Oscar Wilde wrote, "I'm a man of simple tastes. I'm always satisfied with the best."
Of course, limiting your investments to monopolies and oligopolies sounds simple but it is not necessarily easy. That's why virtually no one does it.
Valuation matters, even for monopolies. Since everyone knows monopolies are great businesses, they tend to trade at full prices. For example, Verisign and ASML are monopolies that trade for 40x and 50x earnings. Investors pursuing a "monopolies and oligopolies only" strategy should prepare for long stretches of inactivity while they wait for an opportunity to buy.
Game selection is another way of framing a circle of competence. In investing, it's not necessarily important to know a lot. It's more important to know what you know and what you don't. There's no penalty for avoiding an investment that's in your grey area, but there is a penalty for overstepping your competency.
Every investor needs to decide for themselves what game they're playing. The “right” answer will vary with personality. While Yen Liow chose monopolies and oligopolies, Nick Sleep chose an even narrower game. Towards the end of his career, Sleep decided he only wanted to own companies using the Scaled Economics Shared business model. This model benefits from a positive feedback loop that widens the competitive advantage or "moat" as the business grows. Investing in these businesses was Sleep's version of picking an unfair fight. When Sleep retired, he only owned Amazon, Costco, and Berkshire Hathaway.
Bill Ackman has selected a broader game, but one that is still much narrower than the unbounded game most investors play. He owns almost exclusively retailers, restaurants, and hotels. While these are ostensibly in different industries, they follow a similar value-creation formula: same-store sales growth plus unit growth plus yield. Once you understand one of them, you understand all of them (at a high level). They're among the most simple, predictable, and profitable businesses out there.
When Ackman first disclosed his investment in Starbucks in 2018, an investor tweeted:
lol, you pay 2 and 20 for an idea like Starbucks?
This misguided investor seemed to think that Ackman ought to invest in difficult situations to justify his fees. In reality, there are no points for difficulty. High returns are the only way to justify high fees. Ackman knows that the most idiot-proof way to generate high returns is to pick unfair fights.
Ackman ended up selling Starbucks in February 2020 for a 73% gain in 19 months. A month later, amidst the coronavirus crash in March 2020, he repurchased it for a fraction of what he sold it for weeks earlier. He recently disclosed that he sold it again, this time for a double in 15 months. If that doesn't justify 2 & 20, I don't know what does.
EPC's goal is to produce superior returns while minimizing the chance of permanent loss. Like Ackman, we've found that the best way for us to do this is by buying simple, predictable, and profitable businesses. Like Yen Liow, we prefer companies with dominant market positions and enduring competitive advantages. Like Nick Sleep, we want to own businesses that create value for both shareholders and customers. On top of that, we want Outsider management and a valuation low enough that we don't have to make bold predictions to succeed.
If that sounds like a tall order, that’s because it is! You don't generate above-average returns by buying mediocre investments. You generate above-average returns by picking unfair fights.
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.