The Coffee Can EdgeJohn Huber
“In the end, what counts is buying a good business at a decent price, and then forgetting about it for a long, long, long time.” – Warren Buffett
Some will take issue with the quote above. It’s obviously important to stay informed, and I promise that Buffett doesn’t “forget” about any of his investments. But what Buffett is implying is that once you make an investment, you should not get distracted by “noise”.
There is a real tendency among investors to place too much importance on headlines. With big companies, newsworthy events occur regularly. Often, these events are also stock price moving events. But rarely are these newsworthy and market moving events actually “intrinsic value moving” events.
A boycott of Facebook’s platform is certainly newsworthy (and should be covered), and it also was market moving. But it’s unlikely to have much impact on Facebook’s long-term value (Unilever trumpeted its decision to boycott, saying advertising “on these platforms at this time would not add value to people and society”. What the company didn’t mention is that it continues to advertise on Facebook’s platforms outside the US, where around 85% of its ad spending on Facebook occurs).
Facebook is a lightning rod, and it provides a high number of situations where the noise moves the stock price much more than the intrinsic value, but Facebook’s stock price volatility isn’t unusual.
Most investors understand this. Ignore the short-term noise; focus on the long-term. But practice is always harder than theory, and this is where Buffett’s quote is really valuable. The idea is not to literally forget about the company, but to forget about the inevitable noise that will routinely and frequently surround the company.
One way to defend against the noise is to use a famous (but hardly ever used) portfolio management concept called the “coffee can portfolio”. I’ve always loved this concept, and it is one that I like to employ at Saber Capital. After hearing it referenced twice recently (once on a podcast by Geoff Gannon and Andrew Kuhn of Focused Compounding, and once in a blog I like by Ahmad Jivraj), I decided to share some thoughts.
What is the Coffee Can Portfolio?
The coffee can portfolio is one of the simplest and most interesting concepts in all of portfolio management theory. It’s a term coined in 1984 by Robert Kirby, a portfolio manager who noticed that one of his clients did better than his own portfolio by secretly using all of Kirby’s buy recommendations but ignoring his sell recommendations. This particular client would put around $5,000 into each stock that Kirby bought, and then never touched the stock again. He put the stock certificate in the proverbial “coffee can” and didn’t think about it again. The results of each individual decision varied widely. Some stocks lost a majority of their value, some went up by an average amount, but a few performed incredibly well. The biggest winner was worth $800,000 (on a $5,000 initial investment).
One benefit of the coffee can approach is it forces you to think about what companies will be looking like in 5-10 years, as opposed to next year or the year after, which is the time frame that most investors (even those in the value investing community) tend to reside. The coffee can incentivizes you to think about two types of companies: the durable businesses that are likely to maintain their competitive position; or the businesses with the potential for much greater earning power in the future (and thus much greater value).
I wrote a series five years ago discussing the importance of returns on capital inside of a business, with the idea that there are two groups of companies in the world: those that are increasing their underlying value per share, and those that are eroding it. While it’s possible to make money buying stocks of mediocre businesses perhaps by buying something cheap and flipping it a year later, I’ve always thought that the vast majority of losses in the stock market come from picking the wrong business, not picking the wrong valuation on the right business.
The coffee can forces you to focus on the first group of stocks, which I think will lead to better results over time.
Pulling the Flowers and Watering the Weeds
The Coffee Can strategy’s main tenet is to let your winners run. It’s the opposite of how most of the investment world operates, as Kirby says:
“As your most successful investments grow in value, you make partial sales and transfer the capital involved to your less successful investments that have gotten cheaper. The process results in a stream of capital being transferred from the most dynamic companies, which usually appear somewhat overvalued, to the least dynamic companies, which usually appear somewhat undervalued”.
So the coffee can concept helps you focus on looking for great companies to invest in, and great companies are the ones that create the most wealth in the stock market over the long run.
Why Is It So Hard to Use the Coffee Can?
This concept is also one that is hardly ever used. It requires patience; an attribute that forms the foundations of one of the most enduring edges in all of markets; an edge whose moat is only widening as time horizons continue to shorten and the speed of information continues to quicken. In fact, as I’ve said before, the advantage of patience is inversely correlated to the advantage of information; the weaker that info edge becomes, the stronger the edge that relies on time horizon becomes.
Kirby’s comment from 1984 is even more relevant today:
“As a money manager, I have frequently looked at an investment decision that I felt had a high probability of success on a three-year time horizon, but about which I had many doubts on a six-month time horizon. Institutional investing… simply makes it more difficult to make a high-conviction, long-term decision than to make a low-conviction, short-term decision. The rewards of short-term results substantially superior to the market, and the penalties of short-term results well below the market, are awesome.”
There is just too much career risk in underperforming in the short-term. Managers are highly incentivized to produce good short-term results, and so naturally this is where most focus.
Go to the Islands
I wrote a note to Saber Capital investors in March citing a passage from Roger Lowenstein’s book on Buffett where he cites an investor who knew stocks were cheap in 1974 but also knew it was risky to be an aggressive buyer “unless you could put me on an island and we were taking a three-year view.”
It’s actually a great metaphor. Go to the island. How many stocks are undervalued right now because they operate in industries that could get impacted in a Covid second-wave? Find the strong businesses with durable balance sheets and predictable revenue streams whose earning power will be stronger in five years and put those in the coffee can. It’s almost always the case that the reason why stocks of well-known companies get mispriced is because the marginal investor (the one who sets the price) is too concerned over what the next 6 months looks like.
I often illustrate this point by looking at the gap between the yearly high and low prices of even the largest stocks in the market.
The long-term coffee can strategy could be used by individual investors could to gain a sizable edge over their professional counterparts. Most large funds have too many institutional imperatives that prevent truly long-term thinking, but those who operate entrepreneurial funds with their own capital invested alongside clients should play where competition is lower, and that occurs on the outskirts of the time spectrum, not in the densely populated arena that is the current quarter.
Of course, a long-term mindset doesn’t guarantee results, as stock picking itself is the most critically important factor in investment success, but it’s hard to overstate the value in the behavioral edge that can be garnered by even an average individual stock picker who simply ignores the noise, avoids complexity, and focuses on great companies with a long-term owner’s mindset.
A Better Way
Kirby ends his post with a comment that really motivated me to recap his article:
“Our business needs to encourage “investing”, both for our benefit and for the benefit of our clients. Though a bit gimmicky, the Coffee Can portfolio would serve this end.”
A few years ago, I wrote a post responding to a post I liked by John Hempton regarding the Punch Card portfolio. The punch card and the coffee can metaphors go hand in hand. Hempton’s point was that everyone talks about the “punch card” approach, but no one actually does it.
An exception is Berkshire Hathaway, which itself acts like the coffee can. Assets go in but rarely come out, and the biggest winners (Apple, Coke, Geico, Washington Post) become more meaningful while the losers (Dexter, World Book, the airlines, the textile mill itself) become unimportant. (An interesting side note: the total loss incurred on Buffett’s aggregate airline investment is less than just the year-to-date gain on his stake in Apple, and Berkshire’s total unrealized gain on Apple is close to $50 billion; I’m not sure there is any single stock investment in the history of the public markets that has ever earned more than this one).
There are other exceptions (I covered a few in that post), but generally I think Hempton is right. It’s very unlikely that any substantive portion of the investment world ever adopts the coffee can/punch card approach. Despite the potential benefits, it’s hard for most people to maintain such a long-term view when there is so much noise occurring every day, and this in turn puts pressure on fund managers to respond to the noise. Managers are worried about next quarter because they think their clients are worried, which creates a negative feedback loop that’s tough to break.
The edge in today’s stock market comes not from trying to compete within that noisy arena for better information, but rather from going “over the top” of all of that noise and truly evaluating stocks as long-term ownership stakes in real businesses. The coffee can mindset can aid such an effort.
John Huber is the founder of Saber Capital Management, LLC. Saber is the general partner and manager of an investment fund modeled after the original Buffett partnerships. Saber’s strategy is to make very carefully selected investments in undervalued stocks of great businesses.
John can be reached at [email protected]