The Scrutability Test

The recent Market Panic finds most of us in a soul searching mode, revisiting investment rules and principles that if better adhered to might have saved us some pain. In this vein, there have been some heated discussions at “the day job” about companies that might be “too big or too complicated” to truly understand. This, in turn, has gotten me thinking about an important principle, or better yet, presupposition, which could be called Scrutability. In this edition, I will attempt to define this concept and illustrate it with some examples from my own recent experience. I will also suggest some criteria by which one might avoid getting on the wrong side of this principle, and conclude by applying this principle to GE, a very prominent recent example of the perils of inscrutability.

We can start with the premise that investors, indeed, thinkers of all stripes, have differing notions as to what it means to “understand” a situation. For some of us, “understanding the business” is a non-negotiable starting point. What do I mean by this? We get a couple of important clues from the likes of Warren Buffett, as seen in his ability to “pass” on most ideas he hears after just a few minutes of discussion, and Peter Lynch with his egg timer rule. It is the ability to honestly say, “Yes, I understand how these guys make their money, why their ability to hold their own against competition should remain intact if not improve, and how they are more likely than not to be able to do more business with more customers over time”. One needs to determine that the company in question is either a great business at a decent price, or a decent business at fire sale price, or a business in an industry that has just changed in a way that it can finally be a decent business but its still priced like its always going to be just a decent business in a terrible industry. If it is not clearly one of these, it is simply something that shouldn’t be bothered with, an opportunity cost versus time well spent. The ability to make these judgments entails at least a bit of knack (business sense) and no small amount of hard work accumulating a body of supporting data that is both “experience” and a good grasp of relevant present and prospective conditions.

We confuse the issue when we talk in terms of “complexity” being the issue. Complexity, which is the opposite of simplicity, is not necessarily a problem. Indeed, it is a source of opportunity, if it is amenable to being reduced by intellectual effort down to something simple, and there is rarely much investment opportunity in that which is both obvious and simple. I would argue that one of the hallmarks of a truly great investor is the ability to recognize a simple understanding of a seemingly complex enterprise. A more accurate term than complexity would be the slightly arcane “scrutability”. To be scrutable is “to be capable of being understood by study and observation”. Another hallmark of an at least mature investor is the ability to recognize when the answers to the central questions about an enterprise are excessively inscrutable. If Warren and Charlie can say that some businesses are “too tough” to understand, why can’t we? It doesn’t mean that there aren’t businesses where just because they wouldn’t try we shouldn’t (they have a much different pallet of opportunities to work with), but we do need to exercise the same sort of humility. If the question of “exactly how do they make their money…?” is at its core inscrutable, just don’t go there!

A couple of points of clarification are in order before I start illustrating with some of my recent misadventures. I think we all understand that no one has 100% clarity about everything there is to know about a situation, especially when entering a new position. It is not an either/or between total ignorance and omniscience. One recognizes what the most important issues are for a company and endeavors to have a really clear understanding of them, but also recognizes that there are other issues that might matter but are “somewhat inscrutable”. That is, one has to have a reasonable expectation that with the passage of time, study and observation will clarify the matter. (I will give examples). The art of investing then includes the ability to recognize where “somewhat inscrutable” issues might be significant enough to do damage the value of the enterprise, which means passing on the idea, as well the ability to recognize the difference between “somewhat” and “completely” inscrutable.

Inscrutability does not refer to that which we wish we knew but can be confident of learning more about at some identifiable event in the future, like an earnings release or court ruling. Questions where there will be a pretty definitive answer “we’ll know when we get there” are about something different than scrutability. Strictly speaking, scrutability is more about whether one has the resources to observe, to ask the right questions of the right people and to otherwise “get one’s arms around it”.


SOME EXAMPLES OF WHAT I MEAN
A couple of years ago I decided to buy shares in Pfizer. I was able to get very comfortable with the broad and diverse product lines that were going to deliver sales, earnings and cash flow over the next several years. We knew the company was committed to getting costs out and that redeployment of cash into dividends and repurchase was a high priority. We also nailed down a “what if they lose the patent challenge?” worst case valuation pretty well. There was a lot there, though, that was relatively inscrutable. However many potential new drugs were in the pipeline, no one, not even the company, knew which project would produce what revenues. We discerned an ongoing attack on intellectual property, as manifested in Ranbaxy’s patent challenge, as one of those issues that could get better, get worse or stay the same. All one can do regarding an issue like that is to make sure that a worst case outcome is not a company killer and then pay attention and look for clues. The same goes for that assault on the fruits of innovation that is being undertaken by the Tort industry. With PFE, we enjoyed an above average dividend supported by a very identifiable stream of free cash flow while we waited for the passage of time to give us opportunities to clarify some of the issues that would bear on long term profit growth potential. There were surprises both positive (additional indications for Lyrica, troubles for competitors to Lipitor) and negative (early loss of Norvasc, Exubera, torceptrapib getting pulled from trials). A new CEO came along promising “increased urgency”. Over the course of a year or so, I was able to surmise that while there was no danger of PFE not being able to post moderate earnings growth near term and fund its generous dividend, the risk/reward of “the core of what they do” (developing and marketing new drugs) was at best barely holding its own. Not only does the bar keep going up on new drug approval (i.e., it has to be more efficacious than the drug it will supplant) but the threats that patent challenges and tort might steal away the rewards of innovation were at least holding their own. Coming to this conclusion, which could only happen by patient study and observation of “peripheral” issues over an extended period of time, lead us to exit the stock at an approximately break even price.

Similarly, when we entered into Seagate Technology, we knew we had a technology leader and the low cost producer of an essential item for meeting the rapid growth in demand for data storage. We had a pretty firm basis, which proved out, for industry consolidation leading to improved profitability. We had the core of “how these guys make their money” figured out. However, there were a couple of issues which could only be regarded as “relatively inscrutable”. One was that while STX is far and away the leader among what was then seven (now six) companies that make disk drives (HDD), most of the competitors are subsidiaries of Asian conglomerates, so an understanding of the competitive dynamic would be less than ideal at the outset and slow in coming. Similarly, there was a lot of buzz about flash memory as a potential substitute for HDD. I was able to determine that neither of these issues were likely to matter near term and proceed with the investment. Since then, the beneficial effects of industry consolidation exceeded expectations, even if in the midst of the Hundred Year Financial Flood it is no longer apparent. I have learned only bits and pieces about Asian drive makers, but enough to know that they are at best holding their own. I have learned considerably more about flash memory, including where it is likely to start selling in any kind of quantity, but also that the point when solid state drives start taking enough share to materially slow the growth in HDD keeps slipping out in time.

As I reflect on how varying degrees of inscrutability have affected other recent investments, a couple of general observations come to mind. One is that when the prevailing bias of the Market turns negative as it did a year ago, inscrutability even with regard to secondary (non core) issues can be deadly. Inscrutable problems are the fodder of “short” ideas. Things that are easily ignored when the bias is positive loom large when the aversion to uncertainty intensifies. It also goes without saying that financial leverage magnifies the damage that can be done when inscrutability turns against us. In thinking more specifically about stocks I have owned recently, I find a common source of “inscrutability that hurt” where there are impediments to understanding the competitive dynamic. This occurs when all or most of the competition is privately held, in a non-reporting JV or buried deep in a big company. In the cases of STX and CYMI, the passage of time has rendered the competitive dynamic reasonably scrutable. The same could be said about HTCH, although the question still lingers as to whether TDK will be successful in fixing the Magnecomp assets it acquired and what it might eventually do with them. KEM would be a good example where an inscrutable competitive dynamic has remained obdurately so, as so many capacitor makers are either buried deep in a Japanese conglomerate or are small niche producers. Finally, the worst example of getting bit by an inscrutable matter would be in Handleman, where I failed to recognize that the music industry’s inability to recover its faltering value proposition could be so detrimental to a distributor’s welfare. Surely, “How well is the music industry going to do in competing for discretionary income?” is an inscrutable matter.



PRACTICAL STEPS TO AVOID PAIN OF LOSS

I think every investor needs to develop their own short list of rules of how to manage inscrutability. Mine starts with the recognition that it matters a lot more in Bear markets (or Bull Markets that are “long in the tooth”). It also should include a daily, if not more frequent, reminder, that the ill consequences of inscrutability going against you will be greatly magnified by financial leverage, including the presence of covenants on credit agreements that seem benign until the floodwaters have been rising for a while. The meat of it, though, is to have a list of “Just Don’t Go There” industries, to work up the same facet of intellectual humility that has served the team of Buffett and Munger so well. For me, such a list includes most financial companies. I say “most” to acknowledge the sort of exception I would make for the likes of Wells Fargo. My approval of WFC is not because Buffett owns it but because Buffett had the wisdom and the opportunity for interaction to be able to “sign off” on the executives who set the tone as to how WFC lends and otherwise manages risk. (Banking reminds me of what they used to say about communism: if it wasn’t for human nature, it would be a great system.) I doubt WFC is unique in this respect, but don’t know how I would recognize the exceptional leader. I also screen out defense companies whose sole business is highly classified contracts. (The classified nature of what USEC does has added to the inscrutability of the issues that surround their position as a fuel supplier to the utility industry.). The issues I mentioned in regard to Pfizer are such that I am unlikely to look at another drug company. I find the competitive dynamic of specialty retailing to be unacceptably inscrutable, although a more “diversified” retailer with a solid value proposition might be attractive at the right price. Even in industries as “safe” as electric utilities are thought to be, some work I did on Public Service of New Mexico indicated that a highly politicized utilities commission can be an unacceptably inscrutable problem.

SO WHAT ABOUT GE?

GE is a great example of a company that has defined inscrutability for about as long as any of us can remember. I actually owned it in 1990, but I was much younger then and even then, the finance part of the giving investors pause (at least during the recession). Based on my ad hoc scrutability screen as it has since evolved, I never would own GE. My belief is that no reasonable amount of study and observation could produce an intellectually honest answer to the core “just how do they make their money” question. It is influenced by past exposure to a few of their operations (How they marketed Power By the Hour and their CAT scan systems comes to mind.) All of the leverage only adds to my aversion. We can debate just how leveraged they are, but to paraphrase a colleague who go unnamed, its “whether she is closer to 300 than to 400 pounds is debatable, whether or not she is blimp is not.” In a Bear Market, it just doesn’t matter.

That said, I am not so alarmed as to think that the stock needs to be sold here in what are probably the last days of a Great Bear Market. Buffett’s deal reminds me of when he bought the assets of Fruit of the Loom. It was a low cost, vertically integrated producer of a consumer staple but badly run. He did not buy the company, he bought assets out of bankruptcy and eventually cobbled it together with Russell (which was a stock buy) and who knows what else. It will never be a great business, but the price was right for the okay business that it can be in a somewhat consolidated market. I believe even though Buffett has many more insights into GE (through personal contacts and in the dealings of BH entities) than mere mortals like us will ever have he comes to the same “it’s too tough” conclusion against owning it on the same terms we would. However, based on what he can know, he has obviously determined that whatever GE’s problems are, they are not terminal. It might take them many years to re-tool the management and compensation systems that were very much geared to what some have called “a golden age for financial services” (usually in the context of said age being over), but he will be well paid to wait.

Buffett probably also recognizes that GE is perhaps singularly well situated with respect to all that energy and transportation infrastructure re-tooling that is going to be the big economic driver of the next decade or so. I also believe that he recognized that the reason GE was willing to pay up to his terms was in part because no one at the company has ever been as uncertain about GE’s future as the last few months events have rendered them. It is also likely that he was able to determine that the capital infusion has a reasonably good chance of being enough to allow them to effect an orderly deleveraging as opposed to joining in on the “fire sale”, resulting not only in better realizations but the preservation of at least a semblance of what used be known at “the GE mystique”.