TITLE: Invest in the perfect businesses around you, instead of investing in a house

Transcription

1 Interview Transcript in English (2015) TITLE: Invest in the perfect businesses around you, instead of investing in a house The small family fund that was established 3 years ago by Dr. Erkin Olmez based on the teachings of Warren Buffett and Benjamin Graham surpassed the performance of large funds in Turkey by investing in American stocks and averaging 15% annual returns Could you tell us about your United States adventure? Before I went to US, I had the idea of pursuing entrepreneurial activities in mind, besides the Ph.D. degree I was going for. The Industrial Engineering Department of Middle East Technical University develops generalists. I had tens of ideas in my mind due to the education I had there, and my interest in the business world. I was curious about almost all businesses, from our family business (metallurgy), to the education sector, that I had experience in, and the technology world that I had higher education on. The United States experience furthered my horizons about the possibilities. I had the chance of experiencing the services and products of companies I read about, at first hand in US. I was buying my groceries from Safeway, my clothing from TJ Maxx, my home furnishings from Target. I was drinking my coffee from Starbucks, and using Verizon as my cell phone operator. I truely wanted to replicate the success of such companies (opening up a franchise, or starting up my own company), Despite the fact that I had a certain amount of money for investing, I did not know about the stock market and hence had no vehicle of doing so. How did you get into the stock market? In 2007, I began reading about the stock market. One day when I was researching Apple company I saw that (I am simplifying) the Apple stock that was worth 1 dollar when I went to US back in the start of 2000s, was worth 30 dollars in When I had the first ipod and iphone in hand the first time, I had a sense that one day these products could be in the hands of millions. However I had not acted. I thought "Had I acted back in 2007 when I saw the opportunity, I would multiply my risk money 30 fold. I can't make my mind about starting a new business. Why don't I invest in the already existing businesses such as Apple, Starbucks, Coca Cola and other perfect ones." Following that realization, I began to research the history and financials of hundreds of American businesses. I analyzed the industries, the competition, and categorized the high margin sectors and companies. I also began making passive partnership offers to the owners of small and mid sized companies around me, that I like. What kind of investment strategy did you have in those days?

2 In fact, I did not have any solid strategy. As I am an engineer who knows a little bit of coding, subjects like technical analysis and options trading grabbed my attention first. I got into this aspect of investing, as it gave quicker results. I reverse engineered the trades of successful day traders. However I saw that predicting where the price of a stock would go in one or two weeks ahead was simply speculation. The directions changed quickly with incoming news, and large buys or sells. The indicators gave wrong signals more than they gave the right ones. I concluded that this type of investing "systematically" made people poorer. Rewards such as 100% in a couple of weeks, can only be attained only when unreasonable risks are taken. Soon I was bored with the technical aspect of day trading, and the requirement that it needs you to sit in front of a computer all day long. About Erkin Olmez Erkin Olmez was born in He finished high school at TED Ankara Private College in He obtainded his BSc. in Industrial Engineering in 1997; and his MSc. in Information Systems in 2000 at the Middle East Technical University (METU). He was accepted to the Ph.D. program at the Volgenau School of Engineering at George Mason University in He finished his Ph.D. in Erkin Olmez worked as a faculty member at METU, Atilim University, and George Mason University; and as a management consultant at the US Department of Treasury's IT department. Is this how you were introduced to value investing? Yes. I saw, through day trading, that the ups and downs of stock prices were almost random when observed in short intervals like hours, and days; and the level the price of a stock would go could only be forecasted in a longer time horizon. I began reading about a value investor named Warren Buffett. I analyzed the trades he performed in the past. I read his annual letters. This investment guru, who was graduated from the prestigious Columbia University, said that buying a stock of a company and being a partner to a company essentially meant the same thing. The simple thing one could do to win was to partner with a company in the long term, through purchasing its stock. Wealth creation business was not that algorithmic. It required patience, discipline, and "selection intellect". I started a "value investment fund" under the teachings of Warren Buffett and other notable value investors back in My new daily job was to search for undervalued companies, analyze them, and "marry" their stocks for the long run. And this time I was not losing money. My personal fund has grown consistently with 10+% returns each year in the following years. With the intellectual framework provided to me by people like Buffett, I had become a value investor who knows what he is doing. What is the general strategy of your fund? We are not in the business of stock trading. We invest in and become a passive partner to the good to great companies on a long or very long time horizon. We say that price will follow earnings for a company in the long run. Utilizing the thesis that the price and the (intrinsic) value of a company will differ in certain situations (like big crises), we do not let the market to influence us on crazy booms (for buying), but use its "fears" for good buying opportunities. We do not get into a stock that we

3 would not be comfortable with holding for at least 10 years. We are also in search for good small and midsized private companies around us that we can buy as a whole. How are you different from your competition? Most of the larger funds in the industry return less than what a lot of people think they do. They also have quite high fees which most people are not aware of. When you analyze the history of companies such as Goldman Sachs, Merrill Lynch, and J.P. Morgan, you would see that, in the long run, the investment rooms of such companies return a consistent 10% annual return (which is the long term return of an index fund like S&P). In shorter terms, most funds in the industry aim for maximizing returns in periods of a year or so, and get into highly risky trades. Aiming for 50% returns a year, also brings in a lot of risk. No fund can sustain such performances over a long period of time, and their performance sinks eventually. If a fund could grow 50% for years, it would seize the whole economy you know. The investment rooms of the well-known investment companies announce record losses as often they announce record gains. What is your performance target? When you look at the last 100 years of the stock market in US, you will see that the compounded annual return of a basket of successful companies (like the S&P 500) is around 10% (including dividends). This number, despite seemingly low, is better than what investing in a house (about 7% including rent income), and much better than keeping your money as cash in a bank account (which only allows preservation for inflation). By investing in good companies at crisis times (when they are undervalued), we hope to achieve around a 15% return consistently for a long time. In fact we focus on not losing money, and making limited yet reasonable capital gains. Compounding your wealth 15% is serious business. This means doubling your money every 4 to 5 years. This type of growth is close to the growth of revenues and incomes that many successful companies dream to achieve. You say that you never lost money doing value investing. Is this really possible? If you look at the past 100 years of the American stock market you will see that the stocks survived all the crises. Take Coca Cola as an example. Coca Cola is a 130 years old firm which outlived two world wars. It stopped production during the wars, but after they are over it restarted doing what it does. The number of people who drink Coke in the world increased almost every year, and this trend still continues. As our investment philosophy we concentrate on durable companies like Coca Cola. On those companies whose revenues we think would most likely be higher in 10 years. On those companies which we are fine with holding for 10 or more years, and which could come back to work even a crisis such as a war occurs. And we do this when such companies are cheap. As we do not get in and out of positions in the short run, the transactions leasing to any monetary losses is almost never existent. We make mistakes, but these mistakes are mostly errors of omission, rather than commission (as Buffett says); the lost opportunities that we do not invest in due to our conservative strategy.

4 How do people lose money in the stock market then? Most people buy stocks without knowing the fundamentals of the companies they invest in (such as revenue, net income changes; competitive landscape and so on). This is comparable to making bad marriages. To cite an example, about half of the 4000 or so companies in the American stock market were not able to increase their net income last year. And on certain occasions, people get into the right stocks, in the wrong time, when the stocks are overvalued. They merely look at the movements of price, and get in on anything that increases. This is a huge mistake even if the company you purchase is a high quality business. If you had invested in Coca Cola back in the beginning of 2000s, when there was a huge bubble in valuations, and when the stock was sold for 80 times of its earnings, you were doomed. Because after the bubble market of , the price of the Coca Cola stock fell tremendously and did not attain the same level for about 15 years. The last I checked Coca Cola was trading at about 20 times of its earnings which is a much reasonable level. Patience is a must, and you have to think in terms of years, not in days. And, of course, you must play the probabilities well. There will always be certain unpredictable things that will happen. Therefore you need to understand from risk management (not putting all eggs in one basket). If you had to use only one criterion, what would it be to select a high quality business? I would say "pricing flexibility". I think pricing flexibility is the most important criterion. If, when your sales go down, you can increase the price of your product, say by 1 dollar, and your consumers are still coming to your door, to buy your product, then you are in a successful business, and you do not have much competition to be afraid of. But only a handful of companies have this luxury. Especially, those companies, in sectors where there is fierce competition and products can not be differentiated (such as a commoditized product), work utilizing very thin operating margins. Take the steel maker that does the exterior of your vehicle as an example. Do you know its name? Probably not. Such companies are not the best businesses to invest in. How long are you holding onto the stocks you invest in? There is a saying like "Eternity is a good investment horizon" in value investing. When you jump onto the right train, time will only grow your profits. Time is the friend of good businesses, and the enemy of the mediocre as Buffett puts it. Those companies with simple business models, and that work as a machine, without much change (boringly stable) are the best companies to invest in generally. How many trades do you perform each year?

5 The good side of value investing is that it does not require you to swing at every ball thrown at you. You need to time your swing. Majority of people practicing value investing had scored big gains through one or two big and right decisions they made in their lifetime. As an example Warren Buffett still holds onto the Coca Cola stocks he bought in the 1987 stock market crash of U.S. He had invested close to 1/4th of his total equity, for this opportunity. He still holds on to these stocks, because, when the dividends are also included, the investment still gives him double digit returns. How closely do you monitor the market movements? We do not look at the markets' ups and downs as frequently as one would assume. There are times, that I do not check the prices for 2 or more months. What we closely follow are annual company reports. We analyze to what extent the companies that we hold increased their revenues and incomes, and whether this trend is likely to continue. When the right moment comes, and these moments are generally crisis moments, take it macroeconomically, or crisis moments specific to certain companies, you can buy valuable things at a low price. Just like in real estate. When that moment comes we jump onto the train, and watch the revenues, earnings and of course the price of the company we invested in grow year by year. The American stock market consists of above 4000 public companies. It is such a large pool of opportunities. We are fine with finding one or two big ideas that this pool throws at us every year. What are your plans for the future? We want to grow our private fund larger, much like a family, and hope that others around us also make use of the experience and knowledge base we developed. The stock market is an ocean. Managing 100 thousand dollars, is not much different than managing 100 million dollars. Therefore we wish to make what we did until today, simply, on a larger scale. What would you recommend to those people who wish to get started with value investing? For the American stock market per se, there is a pool of close to 4000 public companies. These companies can be grouped under 200 sectors. If you want to start this business, you have to read the history of the majority of these companies and sectors. Starting from the letter "A" I mean. You should also read the defunct companies. Did you know there were close to 2000 auto manufacturers back in the beginning of 1900s. Only a handful remains today. If you find the time and the effort to read these stories, you will develop a formidable wisdom on business in general. In fact I recommend this to anyone who wants to start his or her own business. What would you recommend to people who do not understand from stock markets? What should they do with their money?

6 Even if you don't understand much from the stock market, you could invest in the future of commerce, or in the future of a country, through index funds that aggregate the top companies of a given stock market. Productive assets, like companies and stocks, will always generate higher earnings than other passive investments that just sit there and produce nothing (like commodities, houses, or cash sitting in a bank account). Do you have to be supersmart to invest? No, not at all. Warren Buffett says if you are investing in the stock market and have 160 IQ, give away the 30 as you would not need it. This game is not a game in which someone with a 160 IQ, beats some other with a 120 IQ. It requires work, common sense, and most importantly emotional discipline. How does it feel like to manage a fund? Is it stressful? It definitely is not if you know what you are doing. A wrong philosophy will bring you sleepless nights in the long run, although it might make you win once or twice. If you are taking crazy risks in this business, know that you are in the wrong track. Investing in a bunch of companies, whose earnings in 10 years would (with a high probability) be higher than today, and investing in this basket when the prices are right has nothing in it that shall make you lose a night s sleep. You are working and having fun I suppose. I would not even get close to the investing business had I not any fun. Reading annual company letters is like reading magazines to me. I look forward to the date they will come out. I read about 3-4 newspapers everyday. I wake up every morning, thinking about the new opportunities and ideas that the market will throw at me that day. How large is your team? The business of selecting companies for investment and allocating capital to these is a business that is best done alone. It requires reading 4-5 hours a day, and centralized decision making. You need to learn the companies, and follow the annual company letters. Warren Buffett, whose company was worth around 350 billion dollars the last time I checked, did not even pay for an office during the beginnings of his career. Today he manages billions through a small office consisting of around 15 people. Most of which are secretarial by the way.