East Coast Q3 2014 Letter - Grove of Titans
East Coast Q3 2014 Letter - Grove of Titans
East Coast Q3 2014 Letter - Grove of Titans
The redwoods, once seen, leave a mark or create a vision that stays with you always. No
one has ever successfully painted or photographed a redwood tree. The feeling they
produce is not transferable. From them comes silence and awe. It's not only their
unbelievable stature, nor the color, which seems to shift and vary under your eyes, no,
they are not like any trees we know, they are ambassadors from another time.
John Steinbeck (1902 1968)
Travels with Charlie 1962
To:
Re:
In our third quarter letter you will find our portfolio update and general market observations.
Each quarter we highlight one component of our investment process. This quarter, in the section
titled Grove of Titans, I will discuss the attributes of what we think constitutes an enduring
business. As is our standard practice, client reporting, including performance and positioning,
has been sent under separate cover.
Market Summary1
S&P 500
MSCI AC
World
Index
MSCI
Emerging
Markets
MSCI
EAFE
Index
Barclays
Aggregate
Bond
Index
Gold $/Troy
Oz.
Crude Oil
1,972.29
416.85
1,005.33
1,846.08
1,881.11
1,208.16
91.16
Q3 2014
1.13%
-2.16%
-3.38%
-5.74%
0.17%
-8.98%
-13.49%
YTD
8.34%
4.22%
2.56%
-0.79%
4.10%
0.21%
-7.38%
2013
32.38%
23.53%
-2.34%
23.57%
-2.02%
-28.04%
7.19%
Price
09/30/14
Over the past two months, volatility has returned to the equity markets. A six-year recovery of
equity prices has many investors questioning the viability of an appreciating stock market.
Projecting market expectations through a rearview mirror is a limiting strategy. Instead, we think
harnessing business specific valuation and margin of safety tools are the only forward looking
methods that deserve merit. In these terms, we believe our portfolio of quality businesses at
todays valuations is an attractive and intelligent place to allocate capital.
Loss aversion is a deeply embedded human trait; thus its only normal to feel uncomfortable
when market prices move lower. While volatility can cause uneasiness, we feel that it often
creates the possibility for improved expected returns by increasing per share ownership through
direct purchases and company share buybacks. We think short-term volatility should often be
viewed as an opportunity to the long-term investor who seeks enduring businesses at reasonable
prices.
1
The S&P 500 Index, the MSCI All Country World Daily Total Return Index, the MSCI Emerging Markets Index, the
MSCI Europe Asia Far East Index (EAFE), and the Barclays Aggregate Bond Index are representative broad-based
indices and include the reinvestment of dividends. These indices have been selected for informational purposes only.
East Coasts investment strategy will not seek to replicate the performance of these or any other indices. Past
performance does not guarantee future results. The discussions in this letter are for information purposes only. Please
consult with your investment advisor before making any investment decisions. For complete disclosures about East
Coast Asset Management LLC visit our website or consult our Form ADV and Form ADV Part 2A.
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Price and value are two contrasting sides of the same coin. The value of any investment is simply
the present value of all future cash flows. News and related media spawn noise that create an
environment where price overshoots value and they become disconnected, crisscrossing each
other along a trajectory. The increasingly short-term nature of investors only serves to bolster our
belief that employing a long-term business approach is a winning strategy through time.
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3. Unity of Opposites: Dialectics is the reflection of the motion of reality and how
opposites assert themselves in nature. It is by the continual conflict of opposites and their
final passage into one another or into higher forms that determines the cycle of life
and the nature of how things are. Seeing things from the perspective of form forces
one to compartmentalize and categorize with a label. Dialectics seeks to see things
holistically and, through seeing the whole, one can see that in reality one opposition gives
way to its contrary. The essence of everything can be found in its binary nature where
the principle of opposing forces, or reciprocity, is one of the most powerful fundamental
laws of the universe. This is why inverting vexing questions to arrive at workable
answers can be so effective.
If you are acquainted with the principal, what do you care for a myriad of instances
and applications?
Henry David Thoreau (1817 1862)
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Peter Kaufman shared a quote by Joseph Tussman on the importance of aligning with general
principles What the pupil must learn, if he learns anything at all, is that the world will do most
of the work for you, provided you cooperate with it by identifying how it really works and
aligning with those realities. If we do not let the world teach us, it teaches us a lesson. A
foundational principle that aligns with the world and is applicable across the geological time scale
of human, organic, and inorganic history is compounding. Compounding is one of the most
powerful forces in the universe. In fact it is the
only power law that exists with a variable in its
exponent. The power law of compounding cannot
only be applied to investing but it can even, and
more importantly, be applied to continued learning.
Compounding
knowledge
through
a
multidisciplinary framework is an individuals
greatest enduring advantage.
The illustration to the right outlines how I have
applied this framework of reasoning. Readers of
our quarterly letters will recognize that the first two
hexagons are the two lenses every investment is
taken through the lens of the business (Six Sides
of Great) and the lens of the investment (MTheory). The final three hexagons, or lenses, as
described above, observe a thesiss alignment with
the invariant strategies that we can curate from
human, biological, and physical history. In this
letter I will put this framework into practice as we
apply the question of business endurance to biology
Coastal Redwoods.
The illustration for this framework is based on the
sixth hexagonal number, 66. When a hexagonal
number is plotted, it creates this cornered hexagon
geometry the sixth hexagonal number creates five
hexagons born from a single point. The single
point represents general laws and foundational principles.
66 is the path of a people in flight, refugees from dust and shrinking land, from the
thunder of tractors and shrinking ownership, from the deserts slow northward invasion,
from the twisting winds that howl up out of Texas, from the floods that bring no richness
to the land and steal what little richness is there. From all of these the people are in
flight, and they come into 66 from the tributary side roads [of compartmentalized
knowledge), from the wagon tracks and the rutted country roads [of ingrained thinking].
66 is the mother road, the road of flight.
John Steinbeck (1902 1968)
Grapes of Wrath
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6
tend to look more fractal in the wild.
Fractal Geometry is the ability to measure roughness and complex patterns that repeat in nature.
Benoit Mandelbrot coined this term and this type of physics helped make sense of the rest of the
world, which appeared infinitely complex and immeasurable. Mandelbrot and other Fractalists
came to the conclusion that they could, for example, mathematically measure the roughness and
complexity of the bark of a redwood tree, a cloud, or the irregular geography of a coastline. What
the Fractalists further concluded was that there was self-similarity within some of these patterns
of roughness that could be measured. To multidisciplinary decision-makers trying to make
sense of complex systems, this is an effective way to think about perceiving simplicities when
the questions or problems are optically rough or obscured. When we view certain
complexities, at a proper perspective, what we find is a beautiful pattern of repeating selfsimilarity. A few great value investors are quite skilled at recognizing these patterns and have a
process for sourcing these self-similar fractals. Once someone points them out they seem so
obvious, but for most participants they hide in plain sight, fractally camouflaged.
Examples of where we find self-similar fractal patterns are in companies that are transforming
(systemic, separations, and secular), businesses or industries that have a short-term cloud over
them that obscures truths, and/or situations where there is a large constituency of shareholders
selling for uneconomic reasons. In both Euclidean and Fractal terms we are looking for situations
that are misunderstood and where there is an unrecognized simplicity hiding in plain sight.
In the illustration2 to the right I have demonstrated (using simple successive rules) the evolution
from an equilateral Euclidian triangle toward Fractal geometry. We progressively arrive at the
Koch Snowflake, which is
an interesting fractal shape
because we can continue
our simple successive rule
(of dividing each side of a
triangle in three parts and
bumping out the middle)
into infinity. The shape and
area of the hexagon remain
the same, yet the perimeter
is infinite. This expresses
the universal idea that
within a bounded system
(niche or circle/hexagon of
confidence)
we
can
produce
boundless
outcomes.
Infinite
wonders
leap
from
persistent,
incremental
progress eternally repeated.
You will also note that the interior of our hexagons shows another simple rule repeated. Applied are the iterations of
a plane-filling curve (Peano) to show how knowledge can compound and be plane filling with a domain (hexagon) of
confidence. The plane filling shape begins with the stylized E and its unity of opposites denoting essence,
everlasting, and eternal and fills the plane through simple rules repeated without end.
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Grove of Titans
Coastal Redwoods as a Model of the
Enduring Business:
The Grove of Titans is home to the largest ecosystem of
redwood trees that has been discovered to date. Long
hidden in plain sight off a popular hiking trail in Jedediah
Smith Redwoods State Park, the Grove boasts the Lost
Monarch, the largest coastal redwood on earth. The Lost
Monarch and the nine other Titans that surround her have
stood and observed nearly two thousand years of
geological time: the rise and fall of Rome, the discovery of
America, two World Wars, industrial and technological
revolutions and the growth of the population on Earth
from 200 million to 7 billion. The Grove of Titans was
discovered in 1998 by explorers Dr. Steve Sillett and
Michael Taylor. A handful of others have found the
Grove since then, but none have revealed its location, even
though hikers walk by it every day. The hikers are unable
to see the Grove of Titans for the density of the trees
before them.
The Coastal Redwood tree is not only the tallest living organism on the planet but, as a forest, it is
the oldest living ecosystem on Earth. Some of the Coastal Redwood trees have been around since
Lucretius wrote On the Nature of Things in 99 BC. What is it about the nature of things that
endow the Coastal Redwood with near immortality that we can apply to recognizable traits that
would sustain greatness in businesses? And for business operators, what traits can we borrow to
cultivate our businesses from a garden of greatness to a Grove of Titans?
A tree can be thought of as in the business of selling oxygen. For a tree to produce oxygen there
is a simple formula that a tree engages in with natures counterparties, called photosynthesis. A
tree needs six molecules of carbon dioxide (CO2 = cost of goods sold) and six molecules of water
(H2O = salaries and operating expenses). It, then engages in a transaction with the light energy
of the sun (photosynthesis = a customer order), which then produces six molecules of oxygen (O2
= the final product for delivery) and sugar (C6H12O6 = profits). The sugar, or profits, is stored
as cellulose, which is what allows the tree to grow (mass = intrinsic value).
While all trees have the capability to produce oxygen, only one tree has unlocked the capability to
grow to rarified heights, grow more mass than any living organism on the planet and sustain life
for thousands of years. Using the Coastal Redwood as a model, I have compiled six lessons from
this monarch of biology that align with what allows a great business to be truly everlasting.
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8
and fell to this fate. The only moat that is not fleeting, and conversely the only moat that is
truly enduring, is culture.
And they asked me how I did it; and I gave 'em the Scripture text,
"You keep your light so shining a little in front o' the next!"
They copied all they could follow, but they couldn't copy my mind,
And I left 'em sweating and stealing a year and a half behind.
Rudyard Kipling (1865 1936)
Excerpt from The Mary Gloster
Evolutionary biologists attribute the DNA3 (hexaploidal sets of six totaling 66) of the Coastal
Redwood as the phylogenetic competitive advantage that drives its ability to endure through time,
as it has an exponential amount of genetic coding to adapt to an ever-changing ecosystem to
evolve and survive.
The culture, or DNA, of any organization is defined by the unique manner in which it adapts to
change, which can be measured by how effectively the business works with its constituent
counterparties. When viewing the business from an external perspective, I believe there are six
key counterparties that every business is responsible for: suppliers, customers, employees,
owners, stewards and society. Collectively these six counterparties makes up the organizations
ecosystem. An enduring business must be hexaploidal with its counterparties, meaning it must
create a win-win relationship with each counterparty over time. Business
endurance is sum multiplicative if a business scores a zero with any one of
its counterparties over time, it introduces a disease that will eventually limit its
growth and its likelihood of survival.
1. Employees The Leaves: Enduring businesses honor their employees
in exceptional, authentic ways. The leaves of the tree perform the
most important function. They accomplish interacting with all of the
trees counterparties and this is vital. Nature honors this function by
giving them the greatest glory of beauty, height, color and stature.
Enduring businesses turn the organizational chart upside down
invert always invert.
Everlasting businesses know that the
environment of trust and loyalty they engender with employees is of
supreme importance.
2. Suppliers The Roots: Enduring businesses think about their suppliers
as partners. The Coastal Redwoods ability to grow to heights higher
than the Statue of Liberty is directly related to its strong, collaborative
foundation in its roots. A Coastal Redwoods roots provide the
important function of foundational strength and feeding the tree with
its critical needs of nutrients to survive and prosper. A winning
relationship with suppliers is one of the most overlooked areas for
business sustainability.
Most businesses nickel and dime their
suppliers to extract short-term profits. Enduring businesses know that their supplier base
3
The current working hypothesis of evolutionary biologists is that the Coastal Redwood genus (Sequoia Sempervirens
Everlasting Redwood) emerged in the Jurassic period when two existing species, the Sequoia and Dawn Redwood,
hybridized and created a new species. This branch off in the tree of life is even more unique as both of these ancestor
species, like humans and most conifers, have sets of two chromosomes in their DNA (46 in humans). The leaping
emergent effect when the Coastal Redwood hybridized is that the species became polyploidal more than sets of two.
In fact the Coastal Redwood became hexaploidal sets of six chromosomes that total 66.
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is truly the base of the organizations strength. In some Titans I have studied, a few
suppliers feel so well respected and valued by the enduring business that they are content
to have them as their only customer. Mutual collaboration and trust create a leaping
emergent effect.
3. Stewards The Trunk of the Tree: The leaders of enduring businesses are not just
effective operators and intelligent capital allocators, but they think of themselves as
stewards of the enduring enterprise. They want to leave the business in better shape
for the leadership that follows. The trunk of the tree has an important job as it sets the
tone of the whole tree controlling the speed at which water and nutrients must be
transported, employing resources to fight disease, and allocating resources into cellulose
to foster growth. The trunk of the Coastal Redwood operates the essential long pipes, the
xylem, between our aforementioned counterparties of suppliers and employees.
Stewards of enduring businesses operate the businesses to last through time. They do this
by persistent incremental progress repeated without end, continual improvement of
processes and systems and by persistent innovation through research and development,
sowing seeds for the future. These investments may be at the expense of short-term
profits for a longer-term reward. If they starve the future of these nutrients the
organizations will not endure. Wall Street celebrates when companies eke out small
incremental profits at the expense of investments in marketing and research and
development. Thus many business leaders are easily persuaded and motivated to ignore
this critical counterparty.4
4. Customers The Light: The Coastal Redwoods DNA, or culture of excellence, figured
out something quite important in its evolution. Trees need to synthesize sugar from
sunlight to survive and thrive, so they genetically modified themselves to assure
unequaled access to this source by growing higher than any other species on Earth. In
our model of what makes an enduring business, this is quite fitting as the businesses that
can altruistically grow closest to the customers needs and desires are the ones that will
deserve unequaled access to their demand. All of us can look back as consumers where
we felt completely served by a business because they listened to our needs and wants
humanely and delivered a product or service that surpassed our expectations.
The light [customer] is a messenger, carrying a story about the form [essence] of the
object [objective].
William L. Bragg
1915 Nobel Prize for invention of X-ray Crystallography5
5. Owners The Mass of the Tree: The Coastal Redwood astutely takes its excess profits or
sugars and reinvests, creating cellulose that gives these Titans their extraordinary mass
height and width. Enduring businesses take great care in how they allocate the resources
4
An enduring business culture with stewards in place asks the question: What is the one thing our competitors do not
want us to do? And answer consistently with Lets do that! Berkshire Hathaways Geico Insurance is a prime
example. If you are in a region where they operate, look at how they blanket every billboard and advertisement
opportunity for the benefit of long-term gain. How many public insurance companies would spend nearly all of their
earnings to gain a very large reward for the future leaders and owners of their business? That is why Titans are a rare
breed, breathing rarified air.
5
X-ray crystallography has been associated with twenty-nine Nobel Prizes including the discovery of the double helix
structure of DNA. Many of these discoveries were harnessed by the culture of the Cavendish Laboratory a model of
what it takes to build an enduring enterprise.
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of the business to grow the per share value proportionally to all owners. Great businesses
often grow intrinsic value at exceptional rates as they gain a larger percentage of the
revenues of their market by organic growth. Last quarter, I wrote about the importance
of an owner mindset in the letter Horse in Motion.
6. Society The External Ecosystem: If you were to ascend the canopy of a Coastal
Redwood, you would find a unique ecosystem where the Marbled Murrelet, the Northern
Spotted Owl, and countless other species who make their homes only in these old growth
forests. Coastal Redwoods are also one of the greatest consumers of the excessive
carbon we create on our planet. Any business is only allowed to endure because it is sum
additive to both the community and the environment collectively its external
ecosystem. Lose-win, win-lose, and lose-lose systems with the community and the
environment are models destined for failure. Great enduring businesses celebrate and
share their success with society and society will then honor and celebrate what fruits they
enjoy from their success. The general law of reciprocity in practice.
III. Seams and Edges Fog Where there is mystery there is margin:
The Coastal Redwood does not thrive in every environment and location. The Coastal Redwoods
occupy a narrow strip of land approximately 470 miles in length and between 5 - 47 miles in
width along the Pacific coast of North America. They usually grow in the mountains where there
is significant precipitation in the form of fog from the nearby ocean. Coalescence of coastal fog
accounts for a considerable part of the trees' water needs.
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11
Great businesses become great because they occupy a niche that they can serve over a long period
of time, operating with care and doing such an exceptional job that they gain a larger and larger
share of that niche. Competitors will exit or fail because
the towering, altruistic Titan above starves them of the
light of the customer. This niche is often in an area at the
seams and edges of big competitive markets for goods
and services. The Titans dominate this niche where they
can earn extraordinary profits because the customer is
willing to pay a fair price for an exceptional product.
These niches are often obscured in a fog of mystery
because a few businesses dominate the domain, or to
compete against entrenched players would be near
impossible. One of the most important business sayings I
have ever heard is fitting to describe these niche
opportunities for operator and investor where there is
mystery [fog], there is margin.
All services, professional as truly as other services, obey the law of supply and demand.
There is always a large supply of poor work in all walks of life and for that sort of service a
limited demand. There is always a small, a very limited supply of good workmanship and a
correspondingly great demand for it. And it always commands high compensation and that,
too, of various desirable kinds. Every step a man takes in capacity to work, and to do better
work will bring him into a higher plane of action a plane in which there will be fewer
competitors, greater demand, and higher rewards. The life of such a man will be a pyramid,
which rises higher step by step, with ever narrowing competition, until it reaches the summit
of excellence, influence, and success, where a man stands at the head of his profession.
Dr. Martin B. Anderson
Teacher/Mentor to Frederick Taylor Gates University of Rochester
Chapters of My Life (1928) - Memoir of Frederick Taylor Gates
Trusted Advisor to John D. Rockefeller, Sr.
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and in how management teams follow inferior mergers and acquisitions strategies. How often do
we see mergers and acquisitions work well in biology? It is a biologically flawed objective, so
why should it work seamlessly in business? It is a short-cut strategy to produce growth that often
creates that same embolism that will eventually rot the decent business as they try to merge
contrasting DNAs.
There are evolved business systems that can integrate mergers and
acquisitions well, but they are outliers.
V. Limits and Enduring Societal Value Cathedral Rings and Fairy Rings:
While Coastal Redwoods are nearly excluded from the saying
that trees do not grow to the sky, they are not immune from the
laws of physics. Size and age eventually can prove limiting,
even for redwoods. If you walk in the Grove of Titans, and in
other redwood forests, you will notice that many of the large
redwoods grow in circular rings. The rings are referred to as
cathedral rings or fairy rings and are formed after a large Coastal
Redwood has been felled and eventually dies. The immortal
nature of the Coastal Redwood genus is that new growth will
asexually spring from the old monarchs root system around the
trunk of the decaying tree.
Enduring businesses often find it necessary, at times, to divide in order to thrive. John D.
Rockefellers Standard Oil Company is a living example of a cathedral ring in business. When
the government found it necessary to break up Standard Oil in 1911, it created 33 Baby
Standards that would evolve over time. Exxon Mobil, Chevron, and other sprouts born from
Standard Oil represent the largest immortal case study on business that exists in human history.
Chernows biography, aptly titled Titan, is in my opinion the best biography ever written that
documents the history of how Rockefeller conducted his affairs. Charlie Munger recently
commented on John D. Rockefeller Sr. and Titan at the Daily Journal meeting.
Question: You mentioned recently that you enjoyed Ron Chernows book on John D.
Rockefeller, Sr.
Munger: Oh, hugely. If any of you havent read that book, you should read it. Thats a
wonderful biography. [Titan, by Ron Chernow] It shows how high grade that man was as a
business partner. He may have been tough on competitors, but as a partner, he was one of
the most admirable people who have ever lived. And as a philanthropist you can actually
chart what his philanthropy has accomplished some of the most remarkable things in the
whole history of philanthropy.
What Titans of enduring businesses do with the wealth they create is of meaningful importance to
society. Just as Standard Oils cathedral ring thrives today, as Charlie references above, John Sr.
created another ring of philanthropy that has not been equaled yet in human history. With the
intelligent insight of his most trusted advisor Frederick T. Gates and his son John D. Rockefeller
Jr., created a Fairy Ring6 of philanthropies that have done unprecedented compounded good for
6
A fitting memorial to the good works of John D. Rockefeller and the Rockefeller Family can be found artistically in
the Union Church of Pocantico Hills. Just as the Grove of Titans has nine Coastal Redwoods surrounding the Lost
Monarch, the Union Church has the last work of the master Henri Matisse, a stained-glass rose window surrounded by
nine Marc Chagall stained-glass windows, which includes his masterpiece The Good Samaritan in memory of John
D. Rockefeller Jr.
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society. Today we are witness to an equally unprecedented philanthropic force in the form and
essence of The Gates Foundation, endowed by Bill and Melinda Gates and Warren Buffett.
Firm Updates:
We look forward to meeting and talking with you soon. We greatly value your support and trust.
When we try to pick out anything by itself, we find it hitched to everything else in the
Universe.
John Muir (1838 1914)
On behalf of the firm,
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