“One of the best ways to get confidence in an idea is to find the best argument out there and see if there is a case that you haven’t considered or if there is something you don’t know. If what I’ve heard are the best arguments that can be made against being short Herbalife, then I want to be short more.”
I was reading the latest issue of Graham & Doddsville (link) and came across the above quote from Bill Ackman (Trades, Portfolio). This reminds of me another great saying from another great investor – Seth Klarman (Trades, Portfolio):
“You need to balance arrogance and humility…when you buy anything, it’s an arrogant act. You are saying the markets are gyrating and somebody wants to sell this to me and I know more than everybody else so I am going to stand here and buy it. I am going to pay an 1/8th more than the next guy wants to pay and buy it. That’s arrogant. And you need the humility to say ‘but I might be wrong.’ And you have to do that on everything.”
As a fanatic Munger apostle, I can’t help but to tie them to a mental model which I call reasoning and argument. In my mind, every investment decision is a result of an imaginary argument. Unless you can have a better argument supported by better reasoning, you should not act arrogantly. But even if you think you are right and your reasoning is better, you should always remember that you might be wrong. The way you go about this process is to find out the best argument for or against the companies you plan to invest in, maybe from some very smart investors, and try to counter-argue their thesis. When Bill Ackman (Trades, Portfolio) found out that Jim Chanos (Trades, Portfolio) was short Valeant, he actually called him up and inquired about Mr. Chanos’ reasoning. I think this is a very intelligent way to gain conviction and check the validity of your investment thesis.
Personally I use the following steps to practice this mental model:
- What is the conclusion?
- What are the reasons?
- How good is the evidence?
- Is there anything missing or ambiguous?
As always, let me use an example. I noted that many gurus were buying General Motor (GM, Financial)’s common stock or warrants. So I googled some of the common arguments for GM. For instance, this is what Kyle Bass (Trades, Portfolio) said on TV during October 2014:
“GM is worth $28 billion in enterprise value. They will do $16 billion in EBITDA value next year. They will do $6 billion in free cash flow. It is much leaner, with capacity utilization is in the 90s. At the current stock price, the FCF yield is 20%.”
- The conclusion is obvious – GM is cheap.
- The reason is that at the current price FCF yield is 20%.
- The evidence is that GM “will” generate $16 billion in EBITDA and $6 billion in FCF.
You can see that the evidence part is where you really want to dig into. In this case, I was highly skeptical of this $6 billion FCF figure Mr. Bass cited. So I pulled out GM’s filings and did my own calculation. For fiscal year ended 2014, GM generated $10.1 billion GAAP operating cash flow, which included $1.6 billion recall-related cash payments. Excluding this recall-related cash payments, GM generated $11.7 billion operating cash flow. Although there was ~$1 billion related to restructuring charges, considering that this so-called “restructuring” is almost recurring, I would not exclude it from FCF calculation. For 2014, GM contributed $1.3 billion cash to the pension plan but management said there should be no need for contribution in the next few years. I don’t think this is practical but for the sake of it, let us exclude this pension contribution from normal cash flow, GM’s adjusted operating cash flow comes up to $13 billion, from which we then deduct an arbitrary $500 million to account for cash outflows that I haven’t considered. This gives me $12.5 billion normalized expected operating cash flow in 2015. Management has guided $9 billion capex in 2015. Simple subtraction shows that GM’s FCF is $12.5 billion minus $9 billion, or $3.5 billion, instead of $6 billion Mr. Bass claimed. At the current EV of $73.7 billion, the free cash flow yield is less than 5%, far from Mr. Bass’ 20% yield.
Then we move on to the next step - Is there anything missing or ambiguous? In my mind, the most important thing – where we are in the cycle, is missing from the argument. The U.S auto market, which accounted for the majority of GM’s profit and operating cash flow, has been improving year over year since 2009, which is the cycle trough. As the pendulum swings from one side to the other, which has been the case for the past six years, every player in the auto industry benefits. However, when we are only a few percentage points away from historical auto sale record in the U.S, shouldn’t we consider the likelihood that the cycle may be about to change? Shouldn’t we heed Howard Marks (Trades, Portfolio)’ words that “most forecasting is done incrementally, and few predictors contemplate order-of-magnitude changes.” Especially for an industry dominated by such terrible dynamics?
Therefore, I am not convinced by Mr. Bass’ argument. He may be right on the price action of GM’s common stock, but his reasoning is not convincing.
I did this exercise a few times because there are many smart investors in GM. I was able to find arguments from Third Avenue, Bill Nygren (Trades, Portfolio) and tried to see whether their reasoning made sense to me. It would take another two articles to write out my findings but I encourage the readers to go through this exercise.
One bonus point from doing this is that I found out that I may be wrong on GM’s pension plan when examining Third Avenue’s GM thesis. In 2014, I wrote the following about GM’s pension obligation:
A little further digging reveals that this $25 billion is a result of a deal between GM and Prudential to shift GM’s pension obligations to Prudential through an annuity deal.
Essentially, GM transferred pension obligations to Prudential by buying a group annuity for its employees at a price that includes a premium. Prudential then agrees to use the funds it gets from GM’s pension plan to make regular payments to GM retirees for as long as they live. GM paid a hefty 10% premium or $2.5 billion to Prudential.
I don’t think this deal makes too much sense because GM basically paid out 110% of what GM owned just to get rid of the liabilities on the balance sheet. In a sense, it’s an expensive hedging because management lacked the confidence in its pension manager’s ability to deliver returns that will meet future obligations. If you are a GM shareholder, you probably want to take a $2.5 billion haircut off GM’s intrinsic value.
After some conversation and discussions with a few friends who are more familiar with the insurance business, I actually found out that the 10% premium was actually a good bargain as historically the premium has been more like 20%. This deal may actually be value-adding to GM’s shareholders. I could be dead wrong.
I wouldn’t have thought about this had I not gone through this mental model practice. It took a lot of time, but boy, isn’t that worth it.
For further readings, I recommend the following books:
The Art of Reasoning by David Kelley.
Asking the Right Questions by Neil Browne and Stuart Keeley.
