Hype is by definition a short-term phenomenon. And Apple’s iPhone has epitomized it.

Of course hype, short-term results, and pumped up demand for product often blind market participants to long-term business ramifications and actual shareholder value creation. But on the other hand, world-changing innovations which started as hypes and were derided as fads have gone on to make fortunes for owners. So what’s the deal on the heels of the iPhone’s much-awaited debut — is AAPL overbought or underestimated?

Well, first a few qualitative thoughts. As much as I may not be able to tell you with certainty where AAPL will be in ten years, I can say this: they are the reigning kings of what I’d call synergistic marketing and demand creation. In other words, whether or not they are actually innovative (that’s up for debate — iPod was not the first MP3 player, for instance), they are better than anyone at convincing customers that there product is the coolest, hippest, and best must-have invention on the face of the planet. And their success has bred only more success and greater cross-selling revenue (Paul Carton has a great discussion of Apple’s halo-effect here).

Think of it this way — that Apple has been so successful and hip with the iPod has made computer buyers more interested in their other, largely unrelated product, the Mac. This should come as no big surprise — simple psychology informs us that, well, people love winners. This is at the heart of what I believe is Apple’s true competitive advantage. Apple has been and should continue for the foreseeable future to be a winner.

From a quantitative perspective, the added revenue if the company meets sales prediction for the next twelve months should be around $5-7 billion (or about 20% of TTM revenue). That’s assuming sales of 10 million iPhones. My quick and dirty estimate might put incremental net income from iPhone sales at around $0.60/share. So it’s not an insubstantial short-term factor. But in the long-term things become more interesting. Who’s to say the iPhone won’t flop in a couple of years and that the shares that have been so heavily bid up will topple?

Certainly not me, which is just part of the reason I won’t take a position in any shares (I generally don’t short, and almost universally avoid stocks with such rich multiples as AAPL unless exponential growth is a no-brainer). But I can at least speculate on what I think the future of the iPhone or iPhone-like products will be. For what it’s worth (and that’s probably not much coming from me), I’ll attempt to prophesy the future. I’ll keep it brief, but bold:

1) 1-4 years. The iPhone sees significant demand, but competing products (likely from shops like Research in Motion) begin to cut into market share and drive down prices as quality and functionality also increases.

2) 5-10 years. Hand-held, all-in-one personal devices will ultimately become nearly as good, affordable and universal as personal computers. They’ll steal share from the desktop and laptop markets, but those devices will never entirely disappear, though they may change forms. We enter new tech era.

3) 11-15 years. Owners of said devices begin to realize that it is too risky to carry their whole life in tablet form, so devices come equipped with a body-encapsulating bubble and a life-insurance policy.

4) 16-17 years. Given the slight inconvenience of personal bubbles, the iPhone as physical device is replaced by implanted brain chip with telepathic email functionality, trance-inducing sedatives that allow you to watch YouTube videos in your mind.

5) 18-20 years. YouTube, Apple, and Google merge to form You-Google-Appletube, with combined market cap (adjusted for inflation) of $17 trillion and a PE of 245.

6) 21-24 years. All human interaction is replaced by electronic communication.

7) 25-26 years. World peace.

Note: I do not have a position in any company mentioned in this article. I also don’t think we’ll ever see world peace. 

So you wanna know the secrets of Buffett’s investing success? Who doesn’t.

Most of the books out there are great for picking up on the important stuff regarding the financial qualities Buffett seeks in a company - profit margins, high return on equity, low debt, hefty cash flow, etc. But there’s a problem with just about all of the information out there: It tries to distill Buffett’s investing prowess into a formula that anyone can use by plugging in numbers. But it’s far from that simple.

When I had the great fortune of meeting Mr. Buffett, he said he does not place nearly as much emphasis on the financial elements of a company as he does the qualitative factors. And for all the stress everyone places on precise DCF analysis, Charlie Munger quipped at a Berkshire Hathaway meeting that he has never seen Buffett run one.

Obviously, the financials matter. They ultimately drive the value of the business. But there are more important considerations that must be taken into account before they mean anything. That is, a company which looks good from a numbers perspective may be of little interest to Buffett. Thus, the logicians might say that strong finances are a necessary, but not sufficient, condition for investment.

So what are the important considerations, and how does Buffett evaluate them? If we can answer this question, I contend, we get “the secret.”

Well, it’s no surprise that Buffett is seeking companies with “durable competitive advantages” and which are run by honest and capable management. He’s gone on record countless times saying this. And to this end, Berkshire’s acquisitions and stock purchases seem to verify the truthiness of Mr. Buffett’s not-so-secret claims. He ain’t hiding anything here.

But how does one find and evaluate these competitive advantages? And how does one evaluate management?

As for the latter, I’ve already written on evaluating management here. So no need to reinvent the wheel. On to competitive advantages…

Many companies that are household names have competitive advantages that are obvious and which we’re all aware of. Coca-Cola has an indestructible brand name and high customer loyalty. Microsoft has a huge market share with its Windows operating system. Google is the king of internet search and its Google Adwords a virtual necessity for online advertisers. Wal-Mart can undercut any competitor with absurdly low costs. The Altria Group sells an addictive product, sporting the ultimate form of customer retention, with a strong brand in Marlboro and Parliament to boot.

But not all competitive advantages are as obvious. What kinds of advantages does Buffett look for, and how does he spot them? There are several prospects we can consider:

1) Brand name – a company with a recognizable and trusted brand can count on important benefits. Products with brand names can be placed right next to generic competitors, command higher prices, and STILL sell in higher volumes. Just ask Advil. Normally priced at a premium to the generic Ibuprofen bottles that flank it, it sells a lot more at nearly any drug store.
2) High switching costs – This is sometimes, but not always, closely related to a strong brand name. When a company or its product has some unique quality that leads to intense consumer loyalty or makes it difficult for consumers to switch to another company’s product, they benefit from “switching costs.” Trying to get Windows users to switch to a new operating system when they are so intimately familiar and used to Windows is no easy task.
3) Superior Product – Some companies just know how to provide a better product or service than others. Google’s search is simply superior to others’. Internet users have quickly come to realize that.
4) Intellectual property – Patents can bestow temporary, legal monopolies upon a company. Pharmaceutical companies can rely heavily on this advantage, which enables them exclusive rights to sell a product for a period when no others can.
5) Economies of Scale – This refers to the advantage a company can get when it leverages size to obtain lower costs for itself. Wal-Mart is a classic example. By buying in HUGE amounts from suppliers, it can obtain tremendous volume discounts, passing these on to customers in the form of low prices.
6) Unmatched human capital – The people behind a business are absolutely crucial to the business’ success. In some cases, the people running and/or staffing a business are so incredibly good at what they do that they bestow a competitive advantage upon their companies. Berkshire Hathaway, with legendary investor Warren Buffett at the helm, is one such example. Goldman Sachs, with its ability to attract the top minds in the world, is another.
7) Government granted monopolies – Sometimes, the government regulates an industry and one or two companies obtain monopolies that prevent others from entering the business. Utilities are a common example. And Buffett has invested in them before (think MidAmerican).
8) Huge fixed costs – A company may get itself a “natural” monopoly if it has very large startup costs, which would prove prohibitive for any competitor to try to duplicate. For instance, network television used to have such an advantage. After a huge initial investment in the infrastructure, the company would profit as it had little ongoing (marginal) costs.

Now, anyone who knows anything about Buffett knows that he would not invest in Google or a pharmaceutical company. This is partly because he does not understand them and partly because he wouldn’t rely on something like patents as a durable competitive advantage (after all, they’re not durable). Our next questions, then, are 1) what does it mean for him to “understand” something (after all, Buffett’s not a dumb man) and 2) what makes the competitive advantage durable and, hence, appealing to him?

Well the first question is often misconstrued but has an easy answer. When Buffett claims to understand something, he means he understands it almost 100% and can say with virtual certainty what the company will look like in ten or twenty years. It’s not that Buffett is out of touch and doesn’t know what a computer or a prescription drug is. He may have you think that in jest, but, as Bill Gates has said, he knows their businesses, opportunities, and challenges quite well. Yet, and here’s the key, he does not have any advantage or insight into how the will perform in ten years due to the fickleness of their industries.

The second question is a bit tougher to answer. What makes a competitive advantage durable? How does Buffett know? Again, some of these are obvious. For instance, Wal-Mart won’t have many competitors able to duplicate its success anytime soon.

Here the discourse gets a bit fuzzier, Buffett’s analysis (at least my claim of what it is) becomes a bit less concrete, and, heroically, Charlie Munger enters the scene.

I personally believe Munger’s influence at Berkshire and on Buffett’s thinking goes, regrettably, unsung. Very unsung. If Munger hadn’t been around, Buffett arguably would not have gained an appreciation of buying great businesses rather than cigar butts. Munger helped make Berkshire’s returns phenomenal, while allowing for scalability that could not have otherwise been achieved. In other words, Berkshire could never have been scaled to its huge size by purchasing cigar butts — there aren’t enough of them, and the returns are not “continuing” (i.e. when they reach fair value, there’s no further upside. You must sell it and move on). Berkshire, therefore, needed to invest in great businesses that it could hold on to.

But I digress. Back to Munger and durable competitive advantages.

Charlie Munger is a staunch proponent of a type of interdisciplinary model of thinking in which one draws on the accumulated wisdom of many different disciplines (including, but certainly not limited to, psychology, physics, biology, economics, etc.) and understands how they interact. This “latticework” of mental models ultimately becomes worldly wisdom. And it is a structure for thinking, solving problems, and, yes, finding investments.

Why is this important for Buffett? Because he runs Berkshire this way. He manages people this way. He finds investments this way. And it is a tool for determining what is a durable competitive advantage. An example would probably help.

In Poor Charlie’s Almanack, a great read that I highly recommend to anyone, Munger gives a talk in which he poses the hypothetical problem of how to turn $2 million into $2 trillion in less than 150 years. Thus he begins the “fictional” proposition that he and his partner, Glotz, create a non-alcoholic beverage. But to make this worth $2 trillion, generic won’t do. So they create a trademark and brand: Coca-Cola.

The story continues as Munger and Glotz figure out how to make this work. Key, they know, is human psychology. For instance, they must get customers “classically” and “operantly” conditioned to drink this beverage. That is, customers must associate the brand with positive things so as to create positive Pavlovian mental associations. They must also be “trained” so to speak, to reach for the beverage when they see the brand and the beverage must maximize rewards while minimizing the possibility that reflexes are extinguished. And, since they need a huge market share, the brand must be ubiquitous and lots of people must be conditioned in this way. But for this to work, of course, and so as not to risk competition with others, the drink must be available anywhere and at anytime. This all starts to create what Munger calls a “lollapalooza effect” — an outsized result coming from a combination of factors working together.

So they create an exotic-sounding, good-tasting, stimulating drink and advertise it heavily. But that’s not enough. They think in reverse (an important skill, says Munger) and avoid the things they shouldn’t do. They know every drink must taste the same and that they must avoid changing the flavor, because they cannot afford to lose or extinguish the conditioning they have achieved. So they guard their secret recipe, protecting their creation and adding to the allure of the product. Of course, if all goes according to plan, they will create a durable competitive advantage. Even if, say, some crazy competitor (Pepsi, anyone?) comes along and takes some market share, Coke will still be so ingrained in culture and human psyches that it can remain dominant and valuable as ever. And even if the flavor can be duplicated to perfection by someone else and priced lower, no one would overcome the powerful psychological effects and the indestructible brand of Coca-Cola. So the advantage is durable.

This is all how the plan played out in real life and Coke, no doubt, has done pretty well and should continue to do so. Naturally, it doesn’t take a genius to realize that Coke has competitive advantages. And clearly, not every opportunity can be analyzed exactly like Coke. Each durable competitive advantage is different. So understanding why something (like Coke) has advantages can shed light on how to think about less obvious opportunities. Learning how Buffett and Munger think is far more important than learning what they think.

To truly understand a durable competitive advantage like Buffett and Munger, I believe, requires a thought process uncommon amongst investors, or, for that matter, anyone. And most importantly, Buffettologists, if you will, should stop trying to turn Berkshire’s investment strategy into a quantitative formula, because that misses the whole point. So what does one need to do to start thinking like Buffett and Munger? Here’s my top five list. Be forewarned, it requires work and it cannot be turned into a formula (sorry!)…

1) Read. Alot. Draw from different disciplines. See and appreciate how they interact and what they can learn from one another. One who pigeonholes disciplines goes through life, as Munger has said, as a one-legged man in an ass-kicking contest.

2) Know about human psychology. Understand what motivates people, why and how they misjudge things, and start to change your own biases (and yes, you do have them).

3) Think in reverse. Working through a problem forwards is usually not enough. One must think backwards (not to be confused with backward thinking). For instance, always ask “what should I not do here?”

4) Question everything. Know the “why” and “why not.”

5) Know what you know. That’s not a tautology. It means to define clearly your circle of competence. Humans typically have trouble knowing when they do and do not truly understand something. Be sure you truly understand something before investing in it. Don’t be afraid to say “I don’t know.”

Hopefully, I’ve given you some insight into my own thoughts on the methods of Mr. Buffett and Mr. Munger. Unfortunately, talking the Warren Buffett talk is easier than walking the Warren Buffett walk. And it simply cannot be turned into some quantitative screen or simple checklist. After all, why should it be that easy?

Here’s a great piece from a friend and #1 Businessweek Entrepreneur Under 25, Brad Galiette. I believe it’s an important read looking forward, and I encourage you to take to heart the facts. Brad has first-hand industry experience and knowledge, and below he shares a number of insights with far-reaching implications for entrepreneurs and investors.

“Some of you may have doubted the financial viability of Web 2.0-oriented websites; indeed, this is something that, to an extent, even I don’t like to believe. But that fact of the matter is that the YouTube’s, Facebook’s, and even MySpace’s out there suffer from low-quality Internet traffic (i.e., non-US and under 18) that results in even lower quality monetization. Still doubting? For the first time in the history of the Web 2.0 paradigm, we now have publicly-released numbers from one of these properties (YouTube) thanks to the fact that its parent, Google (GOOG), released its 10K report within the past few days.

Although there is no explicit indication of YouTube’s revenues or income, Google has provisioned a helpful table of what these figures would have been for the company at large had they factored in the performance of YouTube assuming that it started including YouTube’s financials on January 1, 2005 (in one column) and on January 1, 2006 (in another column). Therefore, we can derive exactly what YouTube grossed and netted via subtraction.

According to the 10K, Google actually grossed $10,604,917,000 for FY 2006 and $6,138,560,000 for FY 2005; it recorded net income in the two periods of $3,077,446,000 ($9.94 diluted EPS) and $1,465,397,000 ($5.02 diluted EPS), respectively (page 36). Had YouTube’s financials been included since 2005, however, Google’s revenue would have been $6,138,575,000; therefore, in 2005, YouTube had revenues of:

$6,138,575,000

- $6,138,560,000

==============
$15,000 (yes, that’s dollars … not thousands of dollars)

The picture isn’t much better in 2006, where Google’s revenues, including YouTube financials, were $10,617,810,000, meaning YouTube had 2006 revenues of:

$10,617,810,000

- $10,604,917,000

==============
$12,893,000

Looking at net income, the picture is worse still. Had YouTube’s financials been included in Google’s FY 2005 and 2006 numbers, its income would have been $1,194,814,000 and $2,801,942,000, both noticably less than what they would have been without YouTube. Therefore, YouTube recorded 2005 and 2006 losses as follows:

$1,194,814,000

- $1,465,397,000

==============
($270,583,000) [2005]

$2,801,942,000

- $3,077,446,000

==============
($275,504,000) [2006]

(The YouTube-inclusive figures from which I’m deriving these calculations are all on page 84 of the 10K)

So, how exactly does Google’s board rationalize a price tag of $1.7 billion for YouTube? It’s clearly not the capital asset pricing model (because YouTube didn’t [and still doesn’t] own anything, has no earnings and little prospect thereof, and aside from VC inflows to keep it alive, had no cash to speak of). If you want to see some creative accounting, take a look at the top of page 84 where the purchase price is broken down as follows:

Goodwill: $1,134,687,000

Patents: $24,000,000

Tradename & Other $153,000,000 (this is nearly twice the $82.8 million value Google places on its own trademark, if you consider their 2005 intangible assets)

Liabilities & Deferred

Taxes: ($117,267,000)

That’s an enormous chunk of goodwill, mostly because YouTube owns virtually nothing (before their acquisition, in fact, they rented office space atop a pizza parlor):

http://en.wikipedia.org/wiki/Image:Youtubeheadquarters.jpg

And even today, YouTube is facing mounting lawsuits and lawsuit threats over the fact that they don’t own much of the most popular content that appears on YouTube. And the greatest irony, they still record a loss for doing this (bandwidth expenses for streaming video are exorbitant and cannot easily be absored by even high-quality advertising).

What’s historic about this 10K is that it is the first time that a Web 2.0 property has gone public with its financials. Even prior to the acquisition, Google didn’t make any details about the deal pricing public, nor did it reveal YouTube’s financials. The same was true in their November 2006 10-Q where the company said little more than that acquisitions (such as YouTube) may result in “writeoffs of goodwill” down the road. At least in the recently published 10K, the problems YouTube face are stated more clearly:

“…the anticipated benefit of many of our acquisitions may not materialize. For example, we have yet to realize significant revenue benefits from our acquisitions of dMarc Broadcasting (Audio Ads) and YouTube. “

Within the past week at a Morgan Stanley industry conference, CEO Eric Schmidt even went as far as to say that while he saw potential in YouTube, he noted that “it will take some time for the industry to figure out the right business model [for monetizing video].” (see it here)

But YouTube’s problems aren’t just limited to its exorbitant bandwidth costs — its traffic is unproductive (because it doesn’t represent an ideal demographic). A few months ago, I did a test run by buying some space on YouTube and seeing how it performed with some of the campaigns I manage in conjunction with my own business. In retrospect, that decision ranks among the worst decisions I ever made as an entrepreneur; I nearly lost a client because the quality was that bad.

Until YouTube figures out a way to get somewhat older, US-only visitors (said differently, until it figures out how to stop being YouTube), it will tax Google’s statements heavily until it’s spun off. Fortunately, the rest of the company does so well in its search unit that these problems won’t weigh too heavily on its long-term performance. The question, though, is how long shareholders will tolerate YouTube’s financial underperformance.

In fact, stuff is already hitting the proverbial fan:

“Google CEO hits back on YouTube purchase” (posted today at 2:12 PM)

See it here

Note: Neither Brad nor Joe own shares in Google.

Two words on minimalism.

First, I’ve changed the design of the header of the page to simplify it a bit. I’ve added an extra search feature to the top of the site for convenience.

Second, this simplicity got me thinking: if you haven’t noticed, I tend to be minimalist when it comes to my portfolio. I own around 3-4 stocks at any given time, and most are highly simple ideas that don’t take rocket science to figure out. For my purposes (and I argue for most individual investors purposes), this is the way to go. It enables you to keep track of fewer variables (that is, “things”) and, while it may increase short term volatility, for the long term investor, it enhances profit potential by not “diluting” your best ideas and allowing you to focus on important, knowable “things.”

Just some late-night investing ramblings to ponder.

There’s a branch of psychology dedicated to the study of emotions and how we perceive, understand, and use them in our daily lives. The concept, which originated almost jokingly by Yale professor and current dean, Peter Salovey, along with two colleagues, has garnered international media attention since the 1990s. For us as investors, “EI” as it’s known, holds important lessons.

The standard view of emotions, both as the ancients felt and as many investors feel today, is that they are maladaptive and serve little purpose. The standard advice in investing is that one should never get too “emotional” about a stock — that doing so will lead to irrational decisions, like holding when you should sell, for instance.

In many cases this may be sound advice. But I would argue that investors, rather than attempting to rid themselves of emotion entirely as some have contended, should focus on learning from the theory of emotional intelligence, which maintains that emotions serve a purpose and can be understood and used to facilitate decision making. Rather than trying to ignore emotions, investors should try to understand them in order to gain greater insight into not only their own investing psyche, but also the company’s and the market’s.

It is better for an investor to know why he or she feels some way about a stock than simply to know that he or she feels this way and that this is patently “bad”. In some cases, the emotion may be maladaptive, but in others it may be telling you something important about a company in which you’ve invested. Yet, the only way to know is not to ignore the emotions.

For instance, an investor may feel his stomach drop at a sudden price plummet or his spirits rise when an unexpected surprise leads to a spike in price. These emotions may well serve little purpose — for in most cases it will be better for the investor to remain detached from random price changes.

Yet, now imagine an investor has followed a company for some time, and the company releases a highly disappointing 10-K. It seems the business has begun faltering in earnest, and the investor is quite upset with this difficult fact. While it sounds like great advice to remain detached, the simple fact of the matter is that it may be highly difficult if not impossible to do so. On the one hand, the company is one the investor has admired for some time and feel a certain liking toward. On the other hand, the 10-K and loss of value are things that upsets the investor. Instead of ignoring the emotions, the investor would be best served by taking time to understand these conflicting emotions to help in the decision making process.

Furthermore, understanding EI can help investors in understanding customers, management, and brand image. Knowing what motivates people — what drives emotion –  can assist investors in getting a better hold on how a company is building its brand image, how management is rallying and incentivizing its human capital, and even how other investors feel about a company and why. There is no doubt that many great companies create long-lasting success by evoking strong emotions and loyalty in their customers and employees.

Anyway, this was just some food for thought as I take a break in studying for my exam in a class called — you guessed it — Emotional Intelligence. Wish me luck.

As a wise man once said: “The bold print giveth, but the fine print taketh away.”

Some investors may well be enticed by the common stocks of post-reorganization companies. Here’s why:

In a typical Chapter 11 Bankruptcy proceeding, most creditors are not made whole in cash. So instead of liquidating and giving creditors whatever proceeds are available from the sale of assets, companies offer equity stakes in the newly reorganized company. This both keeps the company alive and provides a better deal for creditors since they extract more on the dollar by owning stock rather than getting a smaller value of cash in liquidation.

But because many creditors either a) prefer to just have the cash (at least after the new equity starts trading) or b) cannot own the equity (due to regulatory issues, the creditors’ covenants to their own constituency, etc.), the stock of the reorganized company suffers a sell-off unrelated to the nature of its business.

Because the companies (usually) come out with a lightened debt load and can be okay businesses post-Chapter 11, this selloff can lead to bargains for investors willing to purchase what everyone else is dumping. That’s all well and good.

But obviously these “special situations” are not universally good investments simply by virtue of being post-reorganization stocks (after all, they WERE struggling businesses, otherwise they would not have needed to file Chapter 11 in the first place). Luckily, the reorganization plan and disclosure statements filed with the SEC often contain quite thorough and useful information on the company post-Chapter 11, often including projections for earnings many years out.

Which brings me to an example from very recent history (i.e. about 2 months ago). Winn-Dixie Stores (WINN) emerged from bankruptcy in November, and the stock rose sharply before — you guessed it — the selloff. Looking at the situation superficially, WINN appears to trade for just 11-12 times earnings and has little debt. This may jump out to some as a bargain.

But even ignoring the lengthy minutiae of the disclosure statement (which you can find here) and just skipping down to the juicy part at the bottom of the document entitled “Projected Statement of Operations” (go ahead and do it. I’ll wait…) reveals that management expects net income of $137 million by year 2011. Given Winn-Dixie’s market cap of $1.9 Billion right now, I ask you the following [Editor’s Note: At the time of writing, Winn-Dixie’s market cap was actually closer to $760MM. Joe made a big blunder here, and the example, not necessarily the point, is not a great one]:

Would you really want to own a run-of-the-mill grocery operation trading for 14 times earnings more than four years away? [Another Editor’s Note: No, you wouldn’t. However, since Joe botched this one and needs to take his own advice to read the small print, the actual price to earnings four years out is more like 5.5. Big difference]

I know I don’t. Even assuming that management’s projections are right (they usually never are, and often err on the generous side), and further assuming that this mediocre company will trade at 20 times earnings in four years from now, investors stand to make just about 9% on an investment. That’s not spectacular, and becomes even less enticing considering the inherent risks of the situation, including a Chapter 22 filing (Ch. 11 times 2), widely erroneous projections, and many others. [Yet Another Editor’s Note: Just to rub it in and show how wrong Joe was, this scenario would actually lead to around a 40% annualized result. Obviously, it’s still unlikely that the projections are accurate and that a grocer would trade at 20 times earnings, but you get the point].

Bottom line? Investors just have to read the fine print. Avoid falling prey to the value trap. Just because companies sell off a bit or seem to be bargains superficially does not make them wise investments. [A Final Editor’s Note: Bottom line? Joe needs to take his own advice )