The Munger Series - Learning from Robert Cialdini

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We all know how important an understanding of psychology is to sound investment practices. And when Charlie Munger espouses the virtues of someone he considers a leader in the Psychology field, its well worth taking note of his opinion. 

Robert Cialdini is the author of an incredibly insightful book, 'Influence'Dr. Cialdini has spent his entire career researching the science of Influence, earning him an international reputation as an expert in the fields of persuasion, compliance, and negotiation. He currently holds the position of Professor Emeritus of Psychology & Marketing at Arizona State University.

Upon reading Cialdini's book, Munger was so appreciative of the collected wisdom in Cialdini's work that he sent him a share of Berkshire Hathaway A-stock to thank him.

“I was in my office and went to the mail box and got a big envelope that came from Berkshire Hathaway. Of course I had heard of Berkshire Hathaway, everyone had by that time about 15 years ago. When I opened it, it was a share of Berkshire stock. The letter from Charlie saying ‘this is by way of thanks, Warren and I have read your books, we’ve made hundreds of millions of dollars. This is our way of saying thanks.’” Robert Cialdini

"Academic psychology has some very important merits alongside its defects. I learnt this eventually, in the course of general reading, from a book, 'Influence', aimed at a popular audience, by a distinguished psychology professor, Robert Cialdini… I immediately sent copies of Cialdini's book to all my children. I also gave a share of Berkshire stock [A share] to thank him for what he had done for me and the public." Charlie Munger

"Fairly late in life I stumbled into this book, Influence, by a psychologist named Bob Cialdini.. Well, it’s an academic book aimed at a popular audience that filled in a lot of holes in my crude system. In those holes it filled in, I thought I had a system that was a good-working tool." Charlie Munger


Charlie Munger has been Buffett's business partner for the best part of 50 years. Together they're the world's undisputed Investment Masters. And while it's Buffett who basks in the spotlight, it's Munger who directed Berkshire away from buying companies cheaply to instead focus on buying high quality businesses at reasonable prices.

Munger's forte is mental models, and over the years he has drawn on these to sculpt investment theses that have generated billions of dollars in profits for shareholders. And when it comes to mental models, some of the most powerful are psychological. It is in psychology that Munger credits Dr. Robert Cialdini with filling in a lot of the gaps in his understanding.

Over the years, reading about the businesses that have attracted Buffett and Munger, I've seen the insights of Cialdini permeate through their thought processes. I've often drawn on the lessons in Cialdani's book myself to help understand a company's competitive advantage, why share prices may be acting in a particular way, why a board has engaged in a certain manner or why shareholders or analysts have taken a certain stand.

I was fortunate enough to meet Robert Cialdini in Omaha at the recent Berkshire meeting.

In his best-selling book 'Influence', Cialdini addresses six psychological principles of influencing - Consistency and Commitment, Reciprocation, Social proof, Authority, Liking, and Scarcity. Each principle tends to have a basis as a useful mental short cut which has evolved with human development and aided society's functioning. The book is an easy and enjoyable read, as Cialdini provides vivid and entertaining anecdotes on each.

When it comes to investing, understanding each of these fundamental principles can provide invaluable insights. In this post I'll cover off on the first two principles, 'consistency commitment' and 'reciprocation', and provide some relevant investment analogies.  The other principles will be covered in a later post. 

Consistency and Commitment

Humans have evolved to value and desire consistency. Cialdini explains "It is, quite simply, our nearly obsessive desire to be (and to appear) consistent with what we have already done." Inconsistency is commonly thought to be an undesirable personality trait, yet a high degree of consistency is normally associated with personal and intellectual strength.

"It allows us a convenient, relatively effortless, and efficient method for dealing with complex daily environments that make severe demands on our mental energies and capacities. It is not hard to understand, then, why automatic consistency is a difficult reaction to curb. It offers us a way to evade the rigors of continuing thought. And as Sir Joshua Reynolds noted, 'There is no expedient to which a man will resort to avoid the real labour of thinking'." Robert Cialdini

The associated bias is commitment. When we make a commitment to something, we like to remain consistent. As humans, we don't like changing our mind.

"Whenever one takes a stand that is visible to others, there arises a drive to maintain that stand in order to look like a consistent person." Robert Cialdini

The dangerous side-effect for investors of commitment and consistency tendencies lies in situations that are changing or when there is contrary information to our initial assumptions. 

"The humankind works a lot like the human egg. When one sperm gets into a human egg, there's an automatic shut-off device that bars any other sperm getting in. The human mind tends strongly toward the same sort of result. And so, people tend to accumulate large mental holdings of fixed conclusions and attitudes that are not often re-examined or changed, even though there is plenty of good evidence that they are wrong." Charlie Munger

Investors often don't change their minds when contradictory evidence makes it obvious they should. As a relevant example, I remember a hedge fund manager who cleaned up in the Financial Crisis. Following this, he made a name for himself as an able short seller and inflows naturally  followed. Unfortunately he'd become committed to shorting stocks; never able to take-off the so-called 'bear suit'. As a result he gave back a good portion of his earlier profits.

"Oscar Wilde said that 'consistency' is the last refuge of the unimaginative" Peter Cundill

Even today, I can think of one reasonably well known manager, a true 'perma-bear' in every sense of the word, whose monthly missives have been a cacophony of doom and gloom since 2009. Here's a very small sample ...  'Strenuously Overbought' (2009), 'Don't Take the Bait' (2010), 'Betting on a Bubble, Bracing for a Fall' (2010), 'Reduce Risk' (2011), 'Hard-Negative' (2011),  'Warning: A New Who's Who of Awful Times to Invest' (2012), 'Dancing at the Edge of a Cliff ' (2012), 'The Endgame is Forced Liquidation' (2013), 'A Textbook Pre-Crash Bubble' (2013), 'Market Peaks are a Process' (2014), 'Ingredients of a Market Crash' (2014), 'Fair Value on the S&P 500 Has Three Digits' (2015), 'Warning with a Capital "W"' (2016). While he's maintained his commitment, his fund has delivered -8%pa return over the last 5 years and -6%pa over 10 years. Like a broken clock, you can expect that his bearish thesis will be right one day, but in the meantime he's lost his investors a lot of money.

The Investment Masters recognize the risk of commitment bias. When facts change, you must change. There are numerous techniques to combat this bias. Being a generalist allows you take a wider view of the investment landscape rather than committing to a certain type of investment. By refraining from publicly disclosing an investment idea there is less risk of becoming committed to it. Consider the following from Buffett's lieutenants:

"I never liked talking to my limited partners about ideas I had, because you become somewhat wedded to it, it's harder to change your mind over time, you become pre-committed to your positions and so forth. That's always been my stance" Todd Combs

"If you speak up and put it [investment idea] on record, you end up getting too wedded to your thesis and that's dangerous because everything your'e invested in is a function of the facts and circumstances on a given day, it changes" Ted Weschler

Getting others to continually test your ideas, or appointing a devil's advocate, can help force you to consider alternative theses and help avoid investment mistakes. Writing an investment thesis prior to investing and then regularly re-checking your reasons can help you maintain an unbiased and rational view should developments evolve contrary to your original expectations. Simply asking yourself if you'd buy the stock today if you didn't own it is another good self-check. 

"You've made an enormous commitment to something. You've poured effort and money in. And the more you put in, the more that the whole consistency principle makes you think, 'Now it has to work. If I put in just a little more, then it will 'all work'. People go broke that way, because they can't stop, rethink, and say, "I can afford to write this one off and live to fight again. I don't have to pursue this thing as an obsession in a way that will break me."  Charlie Munger

Remaining flexible, keeping an open-mind and maintaining a sense of humility is essential. Recognize there are things you can't know. Recognize that you will make mistakes. And when you enter an investment, acknowledge you may be wrong and you'll be far better placed to adjust your thesis if and when required. Remember stocks are just 'three letters' - don't fall in love with ideas.

It's not only investors that get caught in the commitment bias. When a company's management commits to earning guidance or an acquisition policythey may be inclined to take actions which aren't in the interest of shareholders. The Investment Masters tend to be leery of companies with aggressive growth targets and/or acquisition strategies.

"Over the years, Charlie and I have observed many instances in which CEOs engaged in uneconomic operating manoeuvres so that they could meet earnings targets they had announced. Worse still, after exhausting all that operating acrobatics would do, they sometimes played a wide variety of accounting games to 'make the numbers'.” Warren Buffett

“Organisations expected to grow rapidly, usually because of pressure from investors, often turn to acquisitions to meet expectations. This may dilute an organizations strategy, by tempting it to extend its reach beyond its area of expertise. At least one research study has called this practice ‘premature core abandonment,’ citing it as one of the primary reasons that an organization’s growth stalls.” James Heskett, 'The Culture Cycle'

"Number's pressure impairs judgement and robs dignity.. [It] makes good, smart people do ethically dumb things and takes them closer toward ethical collapse." Marianne Jennings, 'The Seven Signs of Ethical Collapse'


As humans we have benefited from placing a high value on reciprocation. Our ancestors learned to share their food and their skills in an honored network of obligations. We feel an obligation to give, an obligation to receive and an obligation to repay. This is particularly relevant for things like gifts and favors. And then there are what are known as 'reciprocal concessions'; someone makes a concession to us and we feel obliged to respond in kind.

In business, the implications can be positive. A good example lies in the intangible qualities of culture. They're hard to replicate. When a company looks after it's staff, when it pays them well, values them, trusts them and empowers them, it can provide a significant competitive advantage. A cultural 'flywheel' develops. The company rewards the staff, the staff go the extra mile for customers, the customers reciprocate. Home Depot is a good example, they support their staff and they also support their communities, particularly in times of need.

"Traditionally, we hire the best people in the industry, so they make more money than their counterparts do at our competition. That breeds initial loyalty when they are hired; receiving company stock further deepens that loyalty; and then they fall in love with the way they are treated .. Every associate at Home Depot has an opportunity to be an owner of the company. Everyone has a stake in the company that goes beyond a day's wages. Associates have a real vested interest in cultivating customers and building lifelong relationships with them." Bernie Marcus, Founder - Home Depot

One of the best predictors of a company's performance is when staff work together, which starts with reciprocation. Adam Grant, a professor at the Wharton School of the University of Pennsylvania explains:

"Evidence from studies led by Indiana University’s Philip Podsakoff demonstrates that the frequency with which employees help one another predicts sales revenues in pharmaceutical units and retail stores; profits, costs, and customer service in banks; creativity in consulting and engineering firms; productivity in paper mills; and revenues, operating efficiency, customer satisfaction, and performance quality in restaurants." 

Across these diverse contexts, organizations benefit when employees freely contribute their knowledge and skills to others. 

While reciprocation tendencies can be positive, they can often lead to sub-optimal investment outcomes.  

"Reciprocation tendency subtly causes many extreme and dangerous consequences, not just on rare occasions but pretty much all the time"  Charlie Munger

An example may be a corporate acquisition. The seller makes a small concession; drops the price a little, waives a condition or two and then the acquirer feels an obligation to respond in kind. Or consider when a company provides assistance for an analyst report or invites the Wall Street analyst on a company tour; is the analyst more or less inclined to write a favourable report? When so-called 'Independent Experts' are appointed to report on the fairness of takeovers, I've noticed they rarely recommend against a transaction. Ditto auditors on company accounts. On the latter, Buffett has opined 'whose bread I eat, his song I sing.'

“It’s a Wall Street truism that good management is important to any company’s success, but the typical analysts report ignores the subject.Chris Davis

"Analysts are competent gatherers of facts and figures, but few can be relied upon for much more. Their assessments of managements are superficial and far too uncritical." Ralph Wanger

“Broker/analysts rarely comment on management in any detail and if so they tend not to criticise." Marathon Asset Management

"Wall Street analysts are unlikely to issue sell recommendations due to an understandable reluctance to say negative things, however truthful they may be, about the  companies they follow. This is especially true when these companies  are corporate-finance clients of the firm."  Seth Klarman

"Enron represents another instance, like the dot-coms, where a) most benignly, we’d have to say brokerage house analysts possess little insight and their opinions are of no value, and (b) cynically, it seems they’re not there to help investors as much as their companies’ investment banking efforts.”  Howard Marks

Directors fees may be considered another form of reciprocation.

"A director getting $150,000 a year from a company, who needs it, is not an independent director." Charlie Munger

"I’ve been on 19 boards. I have never seen a director, where the directors’ fees were important to them, object to an acquisition proposal, object to a compensation arrangement of the CEO. It’s just never happened." Warren Buffett

"The liberal pay [of boards of directors] is counterproductive to good management of the company. There’s a sort of a reciprocation. You know, “You keep raising me, and I keep raising you.” And it gets very club-like. And I think, by and large, the corporations of America would be managed better if the directors weren’t paid at all." Charlie Munger

You can see, even though I have only addressed two of Cialdini's tenets within this post, that the information is more than just valuable, its invaluable to investors. How many people or companies do you know that blindly follow 'consistency' to their detriment? I love Munger's humility in this - being able to acknowledge that he is able to learn from someone else is remarkable for someone with his track record. And not only did he learn, he turned that knowledge to profit and was able to reward Dr Robert Cialdini for the lessons. And when you consider what that single A Class share is worth today, it may seem a high price to pay for the knowledge. For me, the lesson is perhaps beyond invaluable - $300,000 for a book that earnt Munger's shareholders hundreds of millions of dollars is priceless as far as I'm concerned. So read the book - it may well be the best twenty bucks you'll ever spend.



Further Reading:
The Munger Series - Lee Kuan  Yew - Charles Darwin


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Buffett's Filing Cabinet


Having thoroughly enjoyed my time in Omaha a few weeks back, I found a recent illuminating post by John Huber of Saber Capital Management discussing his own key takeaways from this year's Berkshire meeting. Huber referenced an observation made in a speech on Buffett by Alice Schroeder, who wrote Buffett's authorised biography, 'The Snowball.' One of the most interesting points raised by Schroeder was how Buffett didn't use a computer to store information, he kept it all in his head.

“He’s created this immense, vertical filing cabinet in his brain of layers and layers and layers of files with information that he can draw back on from more than 70 years of data. He’s like a human computer. He’s wonderful at math. He can recall phone numbers from his childhood, and populations of cities from his childhood. He can do square roots in his head. He does present values and compound interest in his head… The biggest thing he’s done is to learn and create this cumulative base of knowledge in his head. So one reason he doesn’t use a computer is because, in a sense, he is one.”

It's well recognised that Buffett is a lifelong learner, or as Charlie puts it, 'a learning machine'. And Buffett started early. In that same speech, Schroeder explains... 

"Starting at the age of no later than six, he's read everything that he could find about business; the subject that interests him. He's read newspapers, biographies, trade press. He went over to his grandfather's who was a grocer and read the Progressive Grocer magazine and he read articles on how to stock a meat department. He's gone to visit every company that he could find that was even slightly interesting to him. He went down to visit a barrel maker and spent hours talking about how to make barrels. He went to American Express and he spent hours talking about that business. He went to Geico and talked about the insurance business. He has stacks of reports on his desk from the companies he owns - stalls, jewellery, boat winches - everything you can imagine. He reads hundreds of annual reports every year from companies that he doesn't own yet because he just wants to understand their business and when the opportunity arises then he's ready and he can make a decision."

It's likely that Alice Schroeder knows Buffett as well as anyone. After meeting Buffett as an insurance analyst on Wall Street, he encouraged her to write the book about himself that he would never write. Schroeder was given almost unlimited access to Buffett, his friends and colleagues, in the process spending around 2,000 hours with him.

Here are some great insights on Buffett from a 2010 interview with Schroeder.. 

"His knowledge of business history, politics, and macroeconomics is both encyclopedic and detailed, which informs everything he does. If candy sales are up in a particular zip code in California, he knows what it means because he knows the demographics of that zip code and what’s going on in the California economy. When cotton prices fluctuate, he knows how that affects all sorts of businesses. And so on."

"You’re sitting there talking about something like: “Isn’t it amazing that after Jack Welch left GE, the company started having all these problems because of buried accounting issues?” and he will say, “Yes, that’s like …” and pull a company from 30 years prior and start spouting numbers.  Then he will pick another more recent company, and another."

"He has accumulated a filing cabinet of knowledge about companies, and it's very big."

"Through this vast network of connections that he's built, he's created a sort of database of information about business and the economy that's probably irreplaceable."

"[He is] able to pull elaborate modules out of his memory bank. He has thought about so many things over the years that there are polished nuggets prepared to respond to almost any question."

"If there is new information the old version gets overwritten. It’s gone. He remembers stories and certain facts, and the rest is discarded as if for efficiency or comfort."

"His way of articulating ideas is very original. He is a great synthesizer and especially strong at pattern recognition."

"Pattern recognition is one of his primary skills and perhaps his greatest skill. So in terms of data points, unlike many people who learn by seeking information on an as-needed basis, Warren is always looking for fuel for pattern recognition before he needs it."

"If you look at the dotcom stocks, the meta-message of that era was world-changing innovation. He went back and looked for more patterns of history when there was a similar meta-message, great bursts of technological innovation in canals, airplanes, steamboats, automobiles, television, and radio. Then he looked for sub-patterns and asked what the outcome was in terms of financial results.

With the dotcoms, people were looking to see what was different and unique about them. Warren is always thinking what’s the same between this specific situation and every other situation.

That is the nature of pattern recognition, asking: “What can I infer about this situation based on similarities to what I already know and trust that I understand?” Pattern recognition is his default way of thinking. It creates an impulse always to connect new knowledge to old and to primarily be interested in new knowledge that genuinely builds on the old…"

"I don’t want to dispel any notion of his intuition. But he has internalized so much information over the years and uses so many mental models (to quote a Mungerism) that they have coalesced into an almost visceral reaction to an investing situation. And this is what you strive for. It’s not mystical, even if you can’t verbalize your analysis. Much of his decision-making has sunk to almost the unconscious realm, it is so refined."

"Well, I think there are things you can do to improve recall. But there is something to be said about being born with a prodigious memory. It seems to me that there are 3 qualities of great investors that are rarely discussed:

1. They have a strong memory;

2. They are extremely numerate;

3. They have what Warren calls a “money mind;” an instinctive commercial sense.

Warren is all of these."

John Huber noted as much on his trip to Omaha:"Last week I was in Omaha for the Berkshire annual meeting, and while I sat there in the CenturyLink arena, I was thinking about Schroeder’s description while listening to Buffett rattle off trade deficit data from 1970 off the top of his head in response to a question. His mind is an incredible machine, and it appears to be working as well as ever."

Buffett draws on his extensive experience in both investing and managing businesses to help formulate his investment decisions. In an interview with Buffett post the Berkshire meeting, CNBC's Becky Quick made the point that the combination of Warren and Charlie have 181 years of experience! And in investing, all experience is cumulative - provided you learn from the experiences.

Becky Quick noted how easy Buffett and Charlie made it look up on stage and wondered how much longer they could do it. Buffett responded..

"It is easy, actually, at this point. At some point it won't be. But, no, I would say it's as easy now as ever. I mean, you didn't see me enter the [Berkshire fun run] race that took place or anything of the sort. This job doesn't really require hand-eye coordination or stamina or anything. You know, you just sit at a desk and you apply things that you learned 60 or 70 years ago and they come in a little different form now, maybe-- this way or that way. But-- it's the perfect job for somebody that wants to be working at 80 or 90."

We know that Buffett spends his days learning - reading, observing, and thinking. He talks to businesspeople and he collects facts; the resource from which he draws investment wisdom. It's the same approach adopted by Charles Darwin and Leonardi Da Vinci which we learnt about in recent posts.

"Look, my job is essentially just corralling more and more and more facts and information, and occasionally seeing whether that leads to some action." Warren Buffett

And Buffett remembers. The more he learns and the more he reads, the better he gets.

"Investing is kind of a game of connecting the dots. The nice thing about it is the longer you are in the business, as long as you are intellectually curious, your collection of data points of dots gets bigger and bigger. That is where someone like Warren is just incredible. He has had a passion for investing for well over 70 years. He started by the age of 10 or 12. He keeps building that library of data, the ability to recognize patterns in data." Ted Weschler

Coincidentally, I took up the twenty hours travel time getting to Omaha this year re-reading an old favourite book of mine; 'Moonwalking with Einstein - the Art and Science of Remembering Everything,' by Josh Foerr I was prompted to re-read it by a recent short post by Chris Pavese of Broyhill Capital on the book highlighting the link between memory, information and creativity.

The book tells the true story of how a rookie journalist's coverage of the US memory competition one year spurred his fascination with memory that led to a journey which culminated in entering and winning the US Memory competition the following year. It's an illuminating story showcasing how an average person can empower the mind to do extraordinary things.

Bill Gates described the book as absolutely phenomenal, and noted "Part of the beauty of this book is that it makes clear how memory and understanding are not two different things. Building up the ability to reason and the ability to retain information go hand in hand."

In the book, Foerr takes the opportunity to delve into the history of memory and the relationship between memory, learning and creativity.  It's uncanny, the commonalities with Buffett's skillsets. Take note of some extracts from the book below ...

"The brain is a muscle .. memory training is a form of mental workout. Over time, like any form of exercise, it's make the brain fitter, quicker, and more nimble. Roman orators argued that the art of memory - the proper retention and ordering of knowledge - was a vital instrument for the invention of new ideas."

"The nonlinear associative nature of our brains makes it impossible for us to consciously search our memories in an orderly way. A memory only pops directly into consciousness if it is cued by some other thought or perception - some other node in the nearly limitless interconnected web."

"What makes the brain such an incredible tool is not just the sheer volume of information it contains, but the ease and efficiency with which it can find that information. It uses the greatest random-access indexing system ever invented - one that computer scientists haven't come even close to replicating." 

"Experts see the world differently. They notice things that non-experts don't see. They home in on information that matters most, and have an almost automatic sense of what to do with it. And most important, experts process the enormous amounts of information flowing through their senses in more sophisticated ways."

"What we call expertise is really just 'vast amounts of knowledge, pattern based retrieval, and planning mechanisms acquired over many years of experience in the associated domain.' In other words, a great memory isn't just a by-product of expertise; it is the essence of expertise."

"Memory is primarily an imaginative process. In fact, learning, memory, and creativity are the same fundamental process directed with a different focus. The art and science of memory is about developing the capacity to quickly create images that link disparate ideas. Creativity is the ability to form similar connections between disparate images and to create something new and hurl it into the future so it becomes a poem, or a building, or a dance, or a novel. Creativity is, in a sense, future memory.

"If the essence of creativity is linking disparate facts and ideas, then the more facility you have making associations, and the more facts and ideas you have at your disposal, the better you'll be at coming up with new ideas."

"The notion that memory and creativity are two sides of the same coin sounds counter-intuitive. Remembering and creativity seem like opposite, not complimentary processes. But the idea that they are one and the same is actually quite old, and was once even taken for granted. The Latin root 'inventio' is the basis of two words in our modern English vocabulary: inventory and invention. Where do new ideas come from if not some alchemical blending of old ideas? In order to invent, one first needed a proper inventory, a bank of existing ideas to draw on. Not just an inventory, but an indexed inventory. One needed a way of finding just the right piece of information at just the right moment. This is what the art of memory was ultimately most useful for. It was not merely a tool for recording but also a tool of invention and composition.

"You can't have understanding without facts. And crucially, the more you know, the easier it is to know more. Memory is like a spiderweb that catches new information. The more it catches, the bigger it grows. And the bigger it grows, the more it catches."

"People who have more associations to hang their memories on are more likely to remember new things, which in turn means they will know more, and be able to learn more."

You can see how Buffett has, over the years, accumulated vast sums of information that, because he is always learning and reading and absorbing new data, he can recall fairly easily when he most needs. It's an incredible skill and one that is invariably available to us all. As I understand it, we tend to remember the things that most interest us, and if investing and business are high on that list, our ability to store and then recall relevant information should be relatively easy. Buffett succeeds because he relies on his physical memory rather than an artificial one stored in a computer. We too can utilise our natural gift of memory, but it will only work if information is stored in our own vertical filing cabinet in the first place. So we need to learn. Every day. And we do that by listening, and reading and talking and only then we will have something worth remembering.




Further Reading:
Investment Masters Class Post - 'Connecting the Dots'
Interview with Alice Schroeder [Microsoft Research]
Interview with Alice Schroeder 2010 [SimoleonSense]
Josh Foerr,
'Moonwalking with Einstein: The Art and Science of Remembering Everything'

Follow us on Twitter: @mastersinvest




Learning from Joel Greenblatt

You will have noticed, no doubt, my belief that the information we use to make investment decisions comes from a variety of sources. The data is lurking out there in a wide range of forms for us to discover. Reading is an obvious one, as is meeting and talking with interesting, successful people. Listening is another valuable source of information and I have found podcasts to be both an extremely informative and efficient way of digesting information over time. Given today's excellent variety of formats in which we could hear these sound bites, you can listen in the car on the way to the office, during lunch, or even at work.

One of the best Podcast series I've found is Barry Ritholtz's interviews titled, 'Masters In Business'. Ritholtz runs a great blog. He intuitively understands markets and investing, and he gets a first class line-up of interesting subjects from a diverse array of fields -  from finance to physics professors and even poker champions. Some of my favorites have included Ed Thorp, Brian Greene, Yuval Noah Harari, Marc Andreessen, Jeffrey Sherman and Ray Dalio to name but a few. I enjoyed a recent episode where Ritholtz interviewed Investment Master, Joel Greenblatt. Greenblatt's early success included running Gotham Capital, a hedge fund which compounded capital at an astonishing 50%+pa between 1985 and 1995. I've included some of my favourite comments below ... 

On Diversification...

Greenblatt notes one way to get high returns is to be concentrated. When he ran Gotham Capital, six to eight ideas comprised 80 percent of his fund. He notes that while portfolio management theory doesn’t agree with that strategy, Warren Buffett provides a useful counter:

"[Buffett says] Let’s say you sold out your business and you've got $1 million and you are living in town and you want to figure out something smart to do with it. So you analyze all the businesses in town and let’s say there's hundreds of business. If you find businesses where the management is really good, the prospects for the business are good, it’s run well, and they treat shareholders well, you divide your million dollars between eight businesses that you researched well. No one would think that’s imprudent, they would actually think that was pretty prudent.

"But when you call them stocks and you get stock quotes daily on these pieces of paper that bounce around, people put numbers on it, and volatility, and all these other things where really it’s not that meaningful. You know from one sense if you’re investing in businesses and you did a lot of research and invested in eight different businesses with the proceeds of your sale, people would think you’re a pretty prudent guy.

"All of a sudden if you invested in stocks and did the same type of work, people think you’re insane. It’s just an interesting analogy that I think of when people make fun of me that I was concentrated."

Patience and Hedge Fund Fees - A Conundrum

"I have sat on Penn’s investment board for 10 years, and I saw most of the [hedge fund] managers out there and not many justify one and a half and 20 or two and 20.

And the other part that’s wrong with the hedge fund businesses is that when people pay those kind of prices [ie fees], they are not very patient. So it’s the worst of all worlds. You know, you’re charging too much to your clients and they don’t stay very long because they’re impatient when they're paying so much."

Reading and Mentors

"One of the reasons I read books is because my mentors really came from reading. People who were kind enough to share with me their wisdom over time, people like Andrew Tobias and Benjamin Graham and even Buffet in his letters and David Dreman, who wrote Contrarian Investment Strategy and John Train who wrote the Money Masters. All these people really were helpful in forming and getting me involved in investing and you know I wanted to share some of the things that I learned too, because that’s how I learned.

It really wasn’t so much you know them, some of these people were dead and [yet] they were still sharing [knowledge] with me."

Investors Can't Stick with Winning Funds

"From 2000 to 2010, this was a period where the market was flat but the best-performing mutual fund for that decade was up 18 percent a year. The average investor in that fund managed to lose 11 percent a year on a dollar-weighted basis by moving in and out at all the wrong times. 

Every time the market went up, people piled into that fund, and when the market went down, they piled out. When the fund outperformed, they piled in, when the fund under-performed they piled out. They took that 18 percent annual gain when the market was flat, so that’s great on an annualized basis over 10 year period to beat the market by 18 points, but for outside investors, they went in and out so badly that the average investor on a dollar weighted basis lost 11 percent a year."

Great Managers Underperform & Are Hard to Stick With

"I wrote up a study of institutional managers that showed the top-performing institutional managers for the same decade, 2000 and 2010. Who ended up with the best ten-year record? And, who ended up in the top quartile, what did the results look like?

What the study showed was that 97 percent of those who ended up with the best 10-year record spent at least three of those 10 years in the bottom half of performance. Not shocking. But to beat the market you have to do something different. 

Seventy-nine percent of those who ended up with the best ten-year record spent at least three of those 10 years in the bottom quartile of performance.  And what I love is that 47 percent that ended up with the best 10-year record, spent at least three of those 10 years in the bottom decile, the bottom 10 percent of performers.

So, you know, no one stayed with them."

Remaining Independent & Disciplined

Greenblatt tells the story of how he used an experiment to teach a group of ninth graders from Harlem the concept of independent work and decision making.

"For just one day a week, for an hour a week, we'd come in and teach them [ninth graders] about the stock market ...   I had a fresh opportunity - blue sky with them not know anything about the stock markets - so I really thought long and hard about how I was going to explain the stock market to them.

And so on the first day's class, I brought in a big jar — one of those old-time glass jars filled with jellybeans.  I passed out 3 x 5 cards and I passed the jellybean jar around and I told them to count the rows and do whatever they had to do, and write down how many jellybeans they thought were in the jar. I then went around the classroom and collected the 3 x 5 cards.

Then I said I’m going to go around the room one more time and ask you in front of everybody else how many jellybeans you think are in the jar. I told them you can keep your guess from your 3 x 5 card, or you can change your guess, that’s completely up to you. One by one I went around the room and I asked each student how many jellybeans they thought were in the jar and I wrote that answer down.

So let me tell you the results of the experiment. The average for the 3 x 5 cards, the first guess, was 1771 jellybeans. That’s what it averaged to. There was actually 1776 jellybeans in the jar. So that was pretty good. When I went around the room one by one asking each person publicly how many jellybeans they thought, that average guess was 850 jellybeans.

I explained to the kids that the second guess was actually the stock market.  What I was trying to teach them to do is be the first guess; be cold and calculating, count the rows, be very disciplined in valuing the businesses and not influenced by everyone else around them. When the second guess came in what happened?  What everyone heard was what everyone else was saying and in the stock market, everyone reads the newspapers, they talk to their buddies, they see what everyone else is saying and doing and reading. They're seeing the results in the news every day and they are influenced by everything around them and they’re not being cold and calculating and disciplined.

And so I was going to teach [the students] how to be cold and disciplined and that’s what we try to do. We have a very disciplined process to value businesses and that’s what I was teaching them to do and that is what stocks are, ownership shares of businesses. All the noise, 99.9 percent of the noise you read in the paper every day is really noise, and so that’s — you know, that lesson really resonated"

The Big secret 

"If you can step back and take a longer time horizon, that is the big secret"


A lot of this speaks to my last post on independent thinking and being out of town. Joel's lesson to the ninth graders is a very powerful message on how we can be influenced by the noise from the herd. How, after careful analysis and independent thought, the class on average was able to accurately determine the contents of the jar. And then, when given another opportunity, they were influenced by the 'noise' of those around them, somehow believing the class knew more then they did, and changed their estimate to one that was inherently incorrect. And how true is that? How often is the market affected by uninformed decisions like this? How often are we influenced by others that know less than us? Joel's thoughts and opinions are valuable to us all and I strongly recommend that you listen to the podcast.


Further Reading:
Greenblatt - WealthTrack Interview
Greenblatt - Talks at Google

Greenblatt - Interview with Howard Marks @ Wharton
Greenblatt - Graham & Doddsville Interview




Follow us on Twitter: @mastersinvest


Out of Town

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If there was one thing I learnt from my recent trip to Omaha, Nebraska (and let me tell you: I learnt a lot), it's that you don't have to be hunkered down in a glittering marble office in Wall Street to be a successful investor.

We all recognize Buffett and Munger as the Kings of the Game. Fifty years plus of successful investing has earned them the right to the crown. And they deserve it. Absolutely, without a doubt. And there they were, sitting comfortably and humbly before 20,000 adoring shareholders in one of the smaller towns in America's mid-west - Omaha, Nebraska. Which, if you don't know, is nowhere near Wall Street. In fact, Omaha is the polar opposite in may ways; a small population and very, very quiet. 

So why would the best investors in the world decide to grow roots in a place as divorced from Wall Street as you can get?

The answer is that the world's best investors are Independent Thinkers.

 “The consensus is often wrong, so I have to be an independent thinker. To make any money, you have to be right when they’re wrong.” Ray Dalio

"You can’t be a good value investor without being an independent thinker – you’re seeing valuations that the market is not appreciating." Joel Greenblatt

“Great investing requires an independent spirit, and the courage to acquire assets the crowd disdains.”  Shelby Davis

Locating miles away from the noise of Wall Street allows Buffett to focus on what's important. Rather than obsess over geopolitical developments, economist's forecasts, interest rates, or the Fed's next move, instead Buffett focuses on the businesses as an owner would. He spends most of his day reading and thinking. Buffett only considers businesses he understands, scrutinizing how sustainable their competitive advantages are, the quality of the management and their ability to deploy capital. He reads the raw financial statements, he talks to industry representatives and he collects the facts. Ultimately he's looking for wonderful businesses that can deliver more long-term value than the money than he puts in. It requires patience and discipline.

Like most great investors, Buffett is also somewhat of a contrarian. But not just for the sake of it; only when he has conviction. Basically speaking, if you do what everyone else does, you'll deliver average results. And remember, the average fund fails to beat the market over the long term.

Over the years I've noticed quite a lot of the world's best investors locate themselves away from the noise of Wall Street. I had the good fortune to speak with Chuck Akre while in Omaha and he reiterated his views on working well away from the distractions of Manhattan. Like Warren and Charlie, he prefers to do his thinking in a quieter place.

“The reason we are in a town with one traffic light and away from all the very bright and intellectually interesting people is that their stuff would be intellectually appealing to us and it would distract us from what it is we do well.  And that’s a really important notion.” Chuck Akre

“If I was on Wall Street I’d probably be a lot poorer. You get overstimulated on Wall Street. You hear lots of things. You may shorten your focus and a short focus is not conducive to long profits. Here I can just focus on what businesses are worth. I don’t need to be in Washington to figure out what the Washington Post is worth, or be in New York to figure out what some other company is worth. Here I can just focus on what businesses are worth.” Warren Buffett

“We’ve found for the 22 years we’ve been away from Wall Street our performance has been better than the 22 years we managed from Radio City in New York.  We went to the same meetings as the other analysts and the people who speak are so sensible that we can’t help but be influenced. It’s easier to be odd when your 1,000 miles away.” Sir John Templeton

"The advantage of being located in the foothills of the Blue Ridge Mountains is that we are outside of the fray. Removed from the noise, we are able to climb the mountain and survey the investment landscape with a rational, objective, long-term perspective." Chris Pavese

“Seth Klarman, one of the most successful investors on the planet, works out of a decidedly unflashy office in Boston, far from the intoxications of Wall Street. If he wanted, he could easily rent the top floor of a gleaming skyscraper overlooking the Charles River.. And Buffett is tucked away in Omaha’s Kiewit Plaza – another building that is not exactly known for its razzamatazz. This strikes me as a significantly, yet largely unrecognized factor in the success of these investors. Small wonder, then, that I wanted to create my own version of Omaha.” Guy Spier

In today's day and age, given the access to almost unlimited information on companies online, you don't need to be located on Wall Street to be successful. Many of the world's best sit in offices that are significantly divorced from the glitter and hype of that place and have sustained incredible track records because of it. So where are you? If you look around you and see a little less glitter and noise, dont be discouraged, in fact it might be an edge you didn't know you had!

Overcoming Investment Fears


One of Warren Buffett's most famous sayings is: "To be Successful in the Stock Market, Be Fearful When Others Are Greedy and Greedy When Others Are Fearful. The challenge for investors is that, as humans, we've evolved from hunters and gatherers and are hardwired to feel fear. In fact, fear is our most basic emotion.

One of the best explanations I've found to describe why this is the case can be found in the insightful book 'Sapiens', by Yuval Noah Harari. Mr Harari explains .. 

For millions of years, humans hunted smaller creatures and gathered what they could, all the while being hunted by larger predators. It was only 400,000 years ago that several species of man began to hunt large game on a regular basis, and only in the last 100,000 years with the rise of Homo sapiens that man jumped to the top of the food chain.

That spectacular leap from the middle to the top had enormous consequences. Other animals at the top of the pyramid, such as lions and sharks, evolved into that position very gradually, over millions of years. This enabled the ecosystem to develop checks and balances that prevent lions and sharks from wreaking too much havoc. As lions became deadlier, so gazelles evolved to run faster, hyenas to cooperate better, and rhinoceroses to be more bad-tempered. In contrast, humankind ascended to the top so quickly that the ecosystem was not given time to adjust. Moreover, humans themselves failed to adjust. Most top predators of the planet are majestic creatures.  Millions of years of domination have filled them with self-confidence. Sapiens by contrast is more like a banana republic dictator. Having so recently been one of the underdogs of the savannah, we are full of fears and anxieties over our position.”  

Burdened by fears, it's little wonder the average investor underperforms the stock market. When we are fearful, our decision making is sub-optimal. We do the wrong things at the wrong time.

"Psychologists have persistently shown that pressures, anxieties, tensions and fears seriously degrade our skills as decision makers.” W Morris [1973]

Most investors sell when they are fearful and wait until conditions improve before they re-enter the market. They sell low and buy high.

And it's not easy to make the adjustment required for better investment results. But it's critical if we wish to succeed.

"Fear is overdone concern that prevents investors from taking constructive action when they should." Howard Marks

“Try not to let your emotions affect your judgement. Fear and greed are probably the worst emotions to have in connection with the purchase and sale of stocks.” Walter Schloss

"To remain calm and rational in the face of wild fluctuations in stock prices is, beyond the shadow of a doubt, the most significant quality an investor can have or try to have." Francois Rochon

Emotional mitigation – you’re trying to find some way to mitigate the emotional dimension which is constantly driving people to make incorrect decisions.  Data that’s accumulating from behavioural finance substantiates the fact we are, by and large, horribly wired to be objective.”  William Browne

The good news is that there are strategies an investor can employ to help overcome investment fears and stay the course for better investment returns. These include:

Know What You Own

When you know what you own, you're far less likely to be influenced by the actions of others and take your cues from the stock price. Imagine yourself standing in your office and seeing a lion on the other side of the glass. If you're like most people, you'd run. But imagine, the prior day you'd accidentally driven your car into the glass at high speed and bounced off. Later you found out it was toughened glass that not even a truck could drive through. With that knowledge in hand, you wouldn't run, no matter how large or aggressive the lion was.

And so it is with stocks; when you have confidence in the underlying business through a detailed assessment of the company, you're far more likely to act rationally when others are fleeing. You won't take price action as conveying news.

Fear is overcome by clarity. Bennett Goodspeed

Knowledge is the antidote to fear.Ralph Waldo Emerson

You may remember me writing about walking past someone on the street who is looking up, and without thought, or knowledge as to why, many of us will simply follow suit. Basically, in the absence of information, you'll look to others for guidance. Similarly in investing, most investors don't do the work to understand the businesses they own, so it's easy to see how the crowd can over react. They think someone else knows more and so jump onto that bandwagon, causing a negative feedback loop to emerge. The price becomes the news and stocks trade at levels far from what the fundamentals would suggest appropriate.

"[As humans] we imitate without thinking. Especially when many or similar people do it, when we are uncertain, in an unfamiliar environment, in a crowd, lack knowledge, or we suffer from stress or low self esteem." Peter Bevelin

"Be undeterred by fears or hopes based on conjectures, or conclusions based on surmises" Phil Fisher

Armed with knowledge you can take advantage of fear.

"We like it when others become fearful of the future. Particularly if they sell shares of companies we own (and would want to increase our ownership) at better prices!" Francois Rochon

"[During scary periods such as major market panics] you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy. It will also be unwarranted."  Warren Buffett

Don't Rely On Tips

When you rely on a tip, you've outsourced the thinking to someone else. And there may not be a lot of thinking or analysis behind that tip. Furthermore, you can't possibly know the right thing to do should the share price start falling.

"In a panic it is not easy to avoid being swept along with the mad tide.  [I] emphasize one thing - the importance of getting the facts of a situation free from tips, inside dope, or wishful thinking. In the search for facts I learned that one had to be as unimpassioned as an surgeon. And if one had the facts right, one could stand with confidence against the will or whims of those who were supposed to know best." Bernard Baruch

"A smart man cannot follow another man blindly even though the other man is right, because you cannot have the confidence and act on advice when you do not know what it is based on." William D Gann

Do The Work

"There is an advantage to gathering your own information and making decisions based on facts that you have gathered yourself. Investing is more of an emotional than intellectual exercise, and it becomes very hard to stay on an even keel and to make rational, unbiased judgements if you’re making them based on someone else’s information.

"So if my buddy at hedge fund XYZ tells me that such and such company is a great investment, or if you go to any of these conferences where someone really smart comes up and makes a bold case on whatever company, it may seem compelling at first. So you think, “Maybe I’ll go out and buy it.” Then the stock goes down 40% and you get nervous. How much time did that really smart guy who made the original pitch spend thinking about this issue that is pressuring the stock? You don’t know, because you didn’t do your own work.

When you’re lost in the fog, you tend to make bad decisions because you’re scared. That’s why to me, you don’t necessarily have to know more than the next guy to have an informational advantage. But you are most certainly at an informational disadvantage if you haven’t made the effort to gather enough information to make an informed decision." John Harris

"Doing the analysis yourself gives you the confidence buying securities when a lot of the external factors are negative. It gives you something to hang your hat on." Peter Cundill

Acknowledge Markets will be Volatile

"We are always psychologically ready for recessions or market corrections." Francois Rochon

Buy Value / Seek a Margin of Safety

When you buy stocks based on value criteria and buy with a margin of safety you're more likely to have the confidence to hold on should markets turn down. By having an estimate of the value of the underlying businesses you own you have something to anchor to while others sell in despair.

Furthermore, stocks bought with a large margin of safety are more likely to hold up in difficult investment environments.  

"You might want to give some thought to how you'll fare if the future doesn't oblige. In short, what is it that makes outcomes tolerable even when the future doesn't live up to your expectations?  The answer is margin for error." Howard Marks

Buy Quality Companies

If you buy quality companies, those with good balance sheets, enduring competitive advantages and strong management, you can be more confident that the business will endure.

"People don't believe business quality is a hedge, but if your valuation discipline holds and you get the quality of the business right, you can take a 50 year flood, which is what 2008 was, and live to take advantage of it."  Jeffrey Ubben

Take the Time to Think

It's natural for humans to act on emotion, without thinking. It's hardwired into our DNA. The world's best investors however have developed the ability to detach from their emotions and make good decisions. Before investing, try and consider what could go wrong.

When acting on an investment, take the time to consider whether you may be over-reacting to market noise. When a stock price falls in relation to stock specific news, its important to consider the implications of the news on the company's earnings over the long term. I've seen plenty of examples where a small earnings miss wipes hundreds of millions off a stock's market capitalization, which is many multiples of the implicit value of the miss. Just sitting back and considering whether that makes sense is a worthwhile exercise.

"'If noise behind the bush, then run'. It is a natural tendency to act on impulse - to use emotions before reason. The behavior that was critical for survival and reproduction in our evolutionary history still applies today." Peter Bevelin

Focus on the Facts Not the Story

“We must focus on facts – as Dragnet fans will recall, “Just the facts.” Stories usually have an emotional content, hence they appeal to the X-system – the quick and dirty way of thinking. If you want to use the more logical system of thought (the C-system), then you must focus on the facts. Generally, facts are emotionally cold, and thus will pass from the X-system to the C-system.” James Montier

Recognize the Crowd Might Be Wrong

If you maintain a contrarian mindset, and start with the premise that most investors do the wrong thing at the wrong time, you are less likely to be panicked and act on emotion when others do. That's not to say, you should blindly buy when others are selling or selling when others are buying; the facts must determine that.

"When the price of a stock can be influenced by a 'herd' on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.Warren Buffett

"None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applies with unusual force in the financial world: "Most men would rather die than think. Many do." Warren Buffett

Test Investment Ideas / Understand the Counter Arguments

Testing your investment thesis and seeking out and considering contrarian views can give you confidence to hold positions you may otherwise look to sell.

“I’m not entitled to have an opinion unless I can state the arguments against my position better than the people who are in opposition. I think that I am qualified to speak only when I’ve reached that state.” Charlie Munger

Diversify / Size you Positions

It's inevitable as an investor that some investments won't work out as you expected. That's an unfortunate fact of life. But by ensuring your portfolio holds a collection of securities across a diverse cross section of industries, and maintaining position sizes that are appropriate, will help you maintain a rational viewpoint should a specific event impact those securities. 

"The larger the position, the greater the danger that trading decisions will be driven by fear rather than by judgment and experience" Steve Clark

"You want to limit your size in any position so that fear does not become the prevailing instinct guiding your judgment" Joe Vidich

Plan Ahead

It is at the height of fear when we are most likely to act on emotion. Having a plan ahead of time which has been developed when you are in an unemotional state, will improve your investment results. 

"[Investors should] prepare and pre-commit. We should do our investment research when we are in a cold, rational state - and when nothing much is happening in the markets - and then-pre-commit to following our own analysis and prepared action steps." James Montier

“When we go into a stock, one of the things we ask ourselves once we’ve decide to buy is ‘what will make us wrong.’ We try and decide in advance how strong the investment case is and when will we know that we are wrong. One of the things we have learnt over the years is that you don’t let the stock price tell you if you are wrong. The stock price might tell you something is going to go wrong, but the stock price by itself doesn’t contain any information, especially in this environment when everything is algorithmic and where prices are being marked against each other every day.” Bill Miller

Be Disciplined

“[You must] have the discipline to stay with your strategy when the market tests your confidence, as it inevitably will.” Leon Levy

"At the time of maximum pain, you need to maintain your discipline.Lee Ainslie

"In my view, the best tools for dealing with volatility are preparation, intellectual humility, and the discipline to stick with ideas that are right in your wheelhouse." Allan Mecham

Remember you own a piece of a Business

"I think that whenever you go through a period of poor performance or sharp declines, you have to remind yourself that you own a real business, and over time, business results drive returns. You also need to instill a certain level of humility, which allows to re-assessing assumptions to identify mistakes. I fall back on those two ideas to help me make rational decisions in times of distress." Allan Mecham

Focus on Earnings 

It's important to recognize share prices can be volatile and that from time to time are unlikely to reflect the true underlying value of the business. By recognising shares are the fractional ownership of a business and focusing on the company's earnings as opposed to the share price, you are more likely to hold onto long-term winners. Provided the earnings are improving, there are no structural issues and the stock is reasonably priced, over time the price will reflect the fundamentals of the business as opposed to the emotions of the market.

"I know that stocks represent fractional ownership in businesses and that, over time, the stock market will reflect their true intrinsic values. And crises bring worries and fears that make many investors forget that simple fact." Francois Rochon

“What’s the cure for either the fear of stocks or the poor behaviour in regard to market volatility? My answer is quite simple: just don’t look at the market in the short run. If your obstacle to good results is your emotions about the ups and downs of the market, build a system that shields you from those emotions.” Francois Rochon

Maintain A Long Term View

The majority of the Investment Masters recognize successful investing is a long term game. In the short term prices can swing wildly. While the stock market has delivered 10%pa returns on average over the last century, the range of annual returns have been highly random. It pays to focus on the future; will the companies products continue to be demanded? Is there a long runway to growth? Is management capable? Is the company likely to be earning more in 5 years?

Avoid Leverage

"There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions." Warren Buffett

Be Optimistic

In times of extreme market stress, it pays to remember human ingenuity and the long term resilience of the developed world. Simply changing the environment such as taking a stroll outside and away from your desk, can help you think clearer. You're likely to find that not a lot has changed. People outside the confines of the financial markets will be doing what they were doing the day before.

"Since 1945, there have been 11 recessions. Four times, the stock market dropped by more than 40%. And crises have one thing in common: they all ended!" Francois Rochion

"An unwavering confidence in human potential in the long term stands as a lighthouse guiding us towards our destination in the investing world—particularly when the storms are raging.” Francois Rochon


None of the above, implies that acting when fearful is the wrong strategy. But the acting must be based on sound, rational and unemotional analysis, and you quite simply can't do that if you're afraid, and you certainly can't do that if the herd is afraid and you're blindly following them. And despite this, you will also not always be right, regardless of how well you plan and think and prepare - and you will still require humility to accept this on occasion.

Fear and emotions are the great undoers - allow them to control you and the outcomes will be less than ideal. 

I think Buffet said it best: "To be Successful in the Stock Market, Be Fearful When Others Are Greedy and Greedy When Others Are Fearful.


Further suggested reading:
Investment Masters Class Tutorial - Weak MarketPessimism, Uncertainty & Panic
Giverny Capital - [Francois Rochon] 2008 Letter 'The Opportunity of a Generation'


Follow us on Twitter: @mastersinvest





Stock Prices Follow Earnings

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More than 50 years ago, Benjamin Graham, the 'Father of Value Investing', observed "In the short run the market is a voting machine, but in the long run, it is a weighing machine". That one quote contains as much wisdom today as it did then and it's implications have been long recognised by those we consider Investment Masters. 

What Graham was referring to were the two forces acting on securities, namely human psychology and business fundamentals. In the short run, human psychology can overwhelm fundamentals. However, over the long term it's a securities earnings that determines returns. 

Stocks are more than just pieces of paper. When you invest in stocks you are investing in the underlying businesses; management prowess, business culture, competitive advantages, re-investment opportunities and the like. The ultimate determinant of the price of the stock will be the underlying business' performance. Buffett once again reiterated this in his 2017 annual letter.

"Charlie and I view the marketable common stocks that Berkshire owns as interests in businesses, not as ticker symbols to be bought or sold based on their “chart” patterns, the “target” prices of analysts or the opinions of media pundits. Instead, we simply believe that if the businesses of the investees are successful (as we believe most will be) our investments will be successful as well."

The key to long term market beating results then is to identify quality businesses whose earnings will grow, buy them at a reasonable price and stick with them. It is the sticking with them where most investors come undone. Adopting the mindset of a business owner as opposed to a stock trader can help.

“Our business owner mentality.. allows us to virtually ignore the constant babble of short term macro noise." Allan Mecham

"People buy a stock and they look at the price next morning and they decide to see if they are doing well or not doing well. It is crazy. They are buying a piece of the business..  You are not buying a stock, you are buying part ownership in a business. You will do well if the business does well, if you didn't pay a totally silly price. That is what it is all about." Warren Buffett

There are some good reasons a focus on earnings works. Firstly, share prices are volatile, and far more so than corporate profits. Share prices are influenced by the emotions of the crowd. And even more relevant today, they can be driven by the flows of indexing, ETF's and momentum strategies. 

"Securities prices rise and fall much more than profit ... Why is that so? Primarily, I think, because of the dramatic ups and downs in investor psychologyHoward Marks

“When an S&P 500 ETF is purchased, its underlying securities are not bought for their individual value, earnings potential, financial health, or any other metric. Those securities are purchased simply because they are on the ETF’s shopping list. This process is without regard to the price/value relationship. As a result, serious distortions in price have accumulated.” Frank Martin

Consequently, short term share prices can do almost anything. The record amount of money in passive funds today, means you can and should, expect irrational prices. There is no price too high for an index fund to BUY and there is no price too low for an index fund to SELL. Prices get set by flow not fundamentals. 

Secondly, a business' value is a function of its future earnings, often estimated using a multiple of earnings approach. 

“Business value is rooted in long-term earnings.Allan Mecham

"Investors own a claim to the current and future profits of a company" Christopher Bloomstran

“Past profits only rewards past investors not today’s buyers. And it is future earnings that make up intrinsic value.” Francois Rochon

If you buy a business whose earnings are higher in the future, it's likely the share price will be as well. Consider a simple example. You buy a $100 stock earning $10, ie an undemanding P/E of 10X. If its earnings grow at 12%pa, in ten years it will be earning almost $28. Providing the P/E's unchanged, it will be trading at $280. If it is still trading at $100, the P/E would be just 3.6X, an unlikely scenario.

“There are only two things that matter in investing.  What are they going to earn, and what multiple are people going to put on that.  Let’s not make our business any more complicated than this” Larry Robbins

The good news for investors with a long term investment horizon is that in the long run, earnings and shares prices do converge.

“If the business does well, the stock eventually followsWarren Buffett

Ultimately the market does reflect value, even if it may seem to lose its marbles for unbearably long periods” Leon Levy

“Stock prices often move in opposite directions from fundamentals but long term, the direction and sustainability of profits will prevail” Peter Lynch

"Over time, earnings determine a stock's value" Joel Tillinghast

“We believe that the market performance of a share of common stock, over an extended period of time, is likely to follow the business performance of the underlying company” Lou Simpson

"Market performance and corporate performance are rarely synchronized over the course of a calendar year. But as more time passes, the synchronization between the two inevitably begins to reveal itself.  Francois Rochon

“We recognize that over long periods of time, the share prices of our holdings should grow at a pace driven by the economics of the underlying businesses.” Chuck Akre

“Over the intermediate to long-term in the stock market, business performance has been inexorably reflected in share price performance.” Bill Ackman

"On any given day, market prices are driven almost 100% by sentiment.  As one's investment horizon lengthens, however sentiment matters less and returns are more dominated by cash flows" Andy Redleaf

“Long-term gains in the intrinsic value of a company are more important than short-term gains in stock prices. The market has a way of fairly pricing stocks over long periods. Provided a company performs well, its stock price will invariably reflect the performance” Christopher Bloomstran

Maintaining your focus on a company's earnings rather than the share price can give you the fortitude to hold-on when share prices maybe telling you to sell.

"Following Ben's teachings, Charlie and I let our marketable equities tell us by their operating results – not by their daily, or even yearly, price quotations – whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it...  The speed at which a business's success is recognized, furthermore, is not that important as long as the company's intrinsic value is increasing at a satisfactory rate." Warren Buffett

“Note that I have no interest in the development of share prices. This is why I don’t waste your time with a discussion of the fund’s or individual company’s price development. If a company regularly increases its earnings power, the share price will track this over time. A robust investment process correctly identifies companies which increase their earnings power. A rising share price is the outcome. My sights are firmly trained on process.”  Robert Vinall

“We do not evaluate the quality of an investment by the short-term fluctuations in its stock price. Our wiring is such that we consider ourselves owners of the companies in which we invest. Consequently, we study the growth in earnings of our companies and their long-term outlook.” Francois Rochon

And by thinking about future earnings you're also less likely to overpay for a stock or get caught in a value trap. 

“Bear in mind--this is a critical fact often ignored--that investors as a whole cannot get anything out of their businesses except what the businesses earn. Sure, you and I can sell each other stocks at higher and higher prices.” Warren Buffett

“Occasionally, people lose track of the fact that in the long run, shares can’t do much better than the companies that issue them”  Howard Marks

“The inescapable fact is that the value of an asset, whatever its character, cannot over the long term grow faster than its earnings do.” Warren Buffett

“Wild swings in market prices far above and below business value, do not change the final gains for owners in aggregate; in the end, investor gains must equal business gains” Warren Buffett

It's time to look for businesses which offer the potential for sustainable earnings growth. Buy them at reasonable share prices and the returns will follow!

“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now ... . Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio's market value. “ Warren Buffett


Beware of Averages, Zeros & Non-Linearity


Over the two decades that I have been advising institutional clients on markets, I've experienced my fair share of extreme stock market volatility. This has included market crashes, stock price death spirals and short squeezes. During this time I've often witnessed whole analyst communities get blindsided by unexpected outcomes, rendering their forecasts and recommendations completely obsolete. I've also seen investors lose significant sums. Some of these outcomes may have been avoided by recognising a few simple mathematical concepts, namely Averages, Zeros and Non-Linearity

Understanding these three concepts, which as you'll see, can often be inter-related, can help you avoid the permanent loss of capital.


Averages are a form of simplification. They can summarize a lot information into one key output. You'll often see market commentators reference an average to support a recommendation ...  "Historically, the market has rallied/fallen x% when xyz happens."

The danger in relying on averages is that the range of historic outcomes may be very wide; the range may contain a zero, or the future outcome may end up being far outside those historic outcomes. It's also quite likely the outcome will be nowhere near the historic average.

The average annual stock market return over the last century is a case in point. While the average return for the S&P500 has been c10% pa, the typical yearly return is far from that. Buffett made that point in his 2004 letter ... 

"In one respect, 2004 was a remarkable year for the stock market, a fact buried in the maze of numbers on page 2. If you examine the 35 years since the 1960s ended, you will find that an investor's return, including dividends, from owning the S&P has averaged 11.2% annually. But if you look for years with returns anywhere close to that 11.2% - say, between 8% and 14% - you will find only one before 2004. In other words, last year's 'normal' return is anything but."

Whenever I hear references to an 'average', I remind myself of the story of the 6-foot man who drowned crossing the river that was, on average, 5-feet deep. 

“Over the  past 100 years, it is generally understood that the stock market’s annualized return is approximately 10%. That 100 year annualized return for the S&P 500 Index masks a great deal of volatility, or variability around the average. It calls to mind the parable of the 6-foot man who drowned in the 5-foot average depth river. The lesson: beware of averages!Chuck Akre

Another limitation of averages is that the future might look a lot different to the past. Billions of dollars were lost in the Global Financial Crisis as people relied on the notion that`On a national basis, US house prices never go down'. Never forget that absence of evidence is not evidence of absence.

“The mother of all harmful investment errors is mistaking the absence of evidence... for the evidence of absence. In other words, assuming that just because historically infrequent and potentially catastrophic events, known as Black Swans, haven’t happened… they won’t.”  Frank Martin

As an investor you must structure your portfolio to cope with the unexpected. This means stress-testing individual ideas and the assumptions that underpin them and taking the time to think about what a worst case scenario might do to each position and the portfolio as a whole.

"We should all be humble enough to realize that once every 20 or 30 or 40 years, values go to real extremes. Any investment program must take into account the impossibility of knowing when and to what extent such extremes might occur."  Paul Singer


Averages also mask historic outcomes that resulted in zeros. Regardless of the potential return, if there is a possibility of a complete loss, investors should steer clear.

“Makes sure that the probability of the unacceptable (i.e: the risk of ruin) is nil.Ray Dalio

Zero means game over.

"Never forget that anything times zero is zero. No matter how many winners you’ve got, if you either leverage too much or do anything that gives you the chance of having a zero in there, it’ll all turn to pumpkins and mice.”  Warren Buffett

"In business and also investment, success is measured through the compounding of a series of returns.  Mathematically, the biggest risk to a compounded series of returns is large negative numbers or even a single negative number, if large enough.  Take however many spectacular annual outcomes and multiply them by just one zero and the answer is of course, zero."   Marathon Asset Management

“There is a difference between opportunities missed and capital lost, with which most investors, anecdotally, do not appear adequately familiar. You can miss a million opportunities in a lifetime and still become very rich. Every asset that has risen in price that one didn’t purchase was an opportunity lost.  Capital losses are not so forgiving. If you lose 100 percent of your capital – just once – you're broke.” Frank Martin

"One single loss can eradicate a century of profits." Nicholas Nassim Taleb

"No matter what price you pay for a stock, when it goes to zero you've lost 100% of your money." Peter Lynch

And, as we saw above, history may not be a good guide to the future. To manage that risk requires creative thinking, consideration of potential alternative outcomes and acknowledging worst case scenarios.

“In my book 'The Most Important Thing', I mentioned something I call “the failure of imagination.” I defined it as, “either being unable to conceive the full range of possible outcomes, or not understanding the consequences of the more extreme occurrences.”  Howard Marks

"In life, both financial and social, sometimes events swing to extremes that seem inconceivable to conventional minds."  Barton Biggs

As Warren Buffett noted above, a common cause of investment ruin is leverage. I've seen plenty of over-leveraged companies turn into zeros.

"The floor for any business is different. If a company is highly levered, the floor could be zero." Mohnish Pabrai

"More than anything else, it's debt that determines which companies will survive and which will go bankrupt in a crisis. Young companies with heavy debts are always at risk."  Peter Lynch

Another danger is complex businesses that are difficult to understand or lack transparency. I recently witnessed a well-capitalized insurance company turn to dust when a fraction of its long-tail reinsurance liabilities blew up the balance sheet.  Earlier this year Buffett said: "You can make big mistakes in insurance.”

It's no wonder the Investment Masters generally steer clear of companies with lots of debt, lack transparency or that are difficult to understand. 


Humans are wired to think in a linear fashion. Most things in life work that way, but we often fail to see the potential for non-linear outcomes.

“The greatest shortcoming of the human race is our inability to understand the exponential function.” Albert Allen Bartlett

“Our intuitions are not cut out for nonlinearities. Consider our life in a primitive environment where process and result are closely connected. You are thirsty; drinking brings you adequate satisfaction. Or even in a not-so-primitive environment, when you engage in building, say, a bridge or a stone house, more work will lead to more apparent results, so your mood is propped up by visible continuous feedback.” Nassim Nicholas Taleb

“Decades of research in cognitive psychology show that the human mind struggles to understand non-linear relationships. Our brain wants to make simple straight lines. In many situations, that kind of thinking serves us well: If you can store 50 books on a shelf, you can store 100 books if you add another shelf, and 150 books if you add yet another. Similarly, if the price of coffee is $2, you can buy five coffees with $10, 10 coffees with $20, and 15 coffees with $30.  But in business there are many highly non-linear relationships, and we need to recognize when they’re in play. This is true for generalists and specialists alike, because even experts who are aware of non-linearity in their fields can fail to take it into account and default instead to relying on their gut. But when people do that, they often end up making poor decisions.” Whitney Tilson

But in markets small changes can have large impacts on outcomes. Sometimes things don't work in a linear fashion.

“With linearities, relationships between variables are clear, crisp, and constant, therefore platonically easy to grasp in a single sentence, such as, "A 10 percent increase in money in the bank corresponds to a 10 percent increase in interest income and a 5 percent increase in obsequiousness on the part of the personal banker." If you have more money in the bank, you get more interest. Non-linear relationships can vary; perhaps the best way to describe them is to say that they cannot be expressed verbally in a way that does justice to them.” Nassim Nicholas Taleb

Jamie Dimon touched on this topic in his recent annual letter ... 

"I am a little perplexed when people are surprised by large market moves. Oftentimes, it takes only an unexpected supply/demand imbalance of a few percent and changing sentiment to dramatically move markets. We have seen that condition occur recently in oil, but I have also seen it multiple times in my career in cotton, corn, aluminium, soybeans, chicken, beef, copper, iron – you get the point.

Each industry or commodity has continually changing supply and demand, different investment horizons to add or subtract supply, varying marginal and fixed costs, and different inventory and supply lines. In all cases, extreme volatility can be created by slightly changing factors.

It is fundamentally the same for stocks, bonds, and interest rates and currencies. Changing expectations, whether around inflation, growth or recession (yes, there will be another recession – we just don’t know when), supply and demand, sentiment and other factors, can cause drastic volatility."

Over the years I've witnessed numerous events cause unexpected negative outcomes due to non-linearity. Here are a few ..

High Fixed Operating Cost Businesses - when businesses have high fixed operating costs and low profit margins, small changes in top line revenue can have a huge impact on a businesses profitability. When sales are booming this is a great benefit, but when things turn down, profit can disappear quickly.

Highly Leveraged Businesses - when businesses carrying a lot of debt turn down, profit can disappear quickly. While the value of the enterprise might decline by 50%, if the business is 50% geared it means the equity is wiped out. These can be very profitable short candidates..

“You have to remember that if you are shorting a leveraged company, with 90% of the capitalization in debt and 10% in equity, a 50% decline in the stock only wipes out 5% of the total capitalization. You have to look at the total capitalization.”  Jim Chanos

Commodity Companies - Analysts often expect supply and demand curves to be linear. Often they are not. A good example was when China entered the iron ore market in the early 2000's. The chart below shows a stable iron ore price from c1985 until 2009 when a supply bottleneck saw prices spike dramatically. Analysts expected the iron ore to be supported by the high Chinese marginal cost of production post c2012. Huge increases in supply and large debt loads that needed to be serviced saw iron ore prices collapse as the supply and demand curve proved non-linear.


Peter Brandt, a CTA since 1976, summed it up nicely in regards to commodities trading below costs ... "But, you might say, this kind of drop is impossible because producers must make money. Who says?? Markets in supply surplus tend to go the production price of the most efficient producers. Plus, who would have ever believed when Crude was at $148 in mid-2008 that prices would retreat to below $40 in just six months. So take your pet macro-economic/fundamental scenario and burn it with the trash!"

Non-linear outcomes can lead to extreme events, also know as 'tail risks'. They too, don't show up in past averages.

Averages mask non-linearity and lead to prediction errors.”  Bart de Langhe

Having an understanding and awareness of the possibility of non-linear outcomes can better prepare you and your portfolio for success in the markets. 

"Don’t project along a straight line." Jim Tisch

"Nonlinear outcomes, those exponentially greater than the apparent precipitating causes, are a great threat to financial and economic stability. Having even a crude understanding of power laws, as they are known,particularly in the area of fat tails, is critically important for effective risk management, for appreciating the potential magnitude of rare market upheavals."  Frank Martin

I particularly like the anecdote about the six foot man to explain most of this. Consider that if the average depth of the river he wanted to cross was 5', and the shallowest depth was 0', the deepest part of the water could be well in excess of his 6' height. Which is why he drowned. The message is don't rely on averages. Or expect that all things will conveniently follow a straight line. Buffett's comment that the market's returns bore a resemblance to the average in only one year across the 35 years he was reviewing, is quite simply, astonishing. And let's face it, who wants to drown? Or suffer a permanent loss of capital? 



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Buffett's Edge


Defining what your game is, where you are going to have an edge is enormously important”  Warren Buffett

Every successful investor has an edge. And when I say 'edge', I'm referring to the difference we have that gives us an advantage in a situation. In investing, this could be a structural edge such as access to better information or low-cost permanent capital, or it may be an intellectual edge derived from creativity or lateral thinking or a psychological edge like emotional rigor or temperament. It could also mean having a longer time horizon than other investors, or even a better reputation. Outperformance as we know it is usually derived from a combination of more than one edge.  

"First answer the question, 'What's your edge?" Seth Klarman

"You have to figure out where you have an edge." Charlie Munger

I've long thought about the edges Warren Buffett has. These are his differences that he has utilized to allow him to deliver returns far in excess of the market indices; you don't compound capital at nearly 20%pa for over 50 years without some sort of serious edge. 

I've outlined the multitude of Buffett's edges below. There are probably others however these tend to define the key differences for me...

Reads & Thinks

“I insist on a lot of time being spent, almost every day, to just sit and think. That is very uncommon in American business. I read and think. So I do more reading and thinking, and make less impulse decisions than most people in business." Warren Buffett


"An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style.  He can earn them only by carefully evaluating facts and continuously exercising discipline." Warren Buffett


“If you’re emotional about investment you’re not going to do well.”  Warren Buffett

Loves Investing

“I get to do what I love to do every day.” Warren Buffett

No Distractions

"The best CEO's love operating their companies and don't prefer going to Business Round Table meetings or playing golf at Augusta National." Warren Buffett

"The wooden shutters on the [office] windows are always closed. You get no sense that a world exists outside, which is what he wants, no distractions. As far as I can tell, he doesn’t need sunlight." Alice Schroeder

No Ulterior Motives

“There’s nothing material I want very much.” Warren Buffett


“You gotta hit a few in the woods.” Warren Buffett

"You have to put mistakes behind you and not look back. Tomorrow is another day. Just go on to the next thing and strive to do your best." Warren Buffett

Learns from Mistakes

“One of the reason Warren’s so successful is that he is brutal in appraising his own past.  He wants to identify mis-thinkings and avoid them in the future” Charlie Munger

"It's good to learn from your mistakes. It's better to learn from other people's mistakes." Warren Buffett

Independent Thinker

“You will not be right simply because a large number of people momentarily agree with you.  You will not be right simply because important people agree with you. You will be right over the course of many transactions, if your hypothesis are correct, your facts are correct, and your reasoning is correct.”  Warren Buffett

Contrarian in Nature

“We have usually made our best purchases when apprehension about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.”  Warren Buffett

"Berkshire buys when the lemmings are heading the other way." Warren Buffett


"It's hard to believe that he's getting better with each passing year. It won't go on forever, but Warren is actually improving. It's remarkable: Most seventy-two-year-old men are not improving, but Warren is."  Charlie Munger

Communication Skills

"We also believe candor benefits us as managers: The CEO who misleads others in public may eventually mislead himself in private." Warren Buffett

"By our policies and communications, we can encourage informed, rational behavior by owners that, in turn, will tend to produce a stock price that is also rational. Our it's-as-bad-to-be- overvalued-as-to-be-undervalued approach may disappoint some shareholders. We believe, however, that it affords Berkshire the best prospect of attracting long-term investors who seek to profit from the progress of the company rather than from the investment mistakes of their partners." Warren Buffett

[Buffett's skill in writing has helped him develop a rapport with Berkshire's shareholders. He's under no pressure to buy or sell assets or keep up with an index. He doesn't have to worry investors will pull their money. Unlike most managers, it has allowed him to maintain a long term focus].

Away from Wall Street

If I was on Wall Street I’d probably be a lot poorer. You get overstimulated on Wall Street. You hear lots of things. You may shorten your focus and a short focus is not conducive to long profits. Here I can just focus on what businesses are worth.  I don’t need to be in Washington to figure out what the Washington Post is worth, or be in New York to figure out what some other company is worth. Here I can just focus on what businesses are worth.” Warren Buffett

Value Approach

"As far as I can observe and speak to with statistics, there has only been one style which has reliably and safely brought investors exceptional long term returns: value investing. Today, Buffett has a 57-year track record." Li Lu

Generalist / Opportunistic

“Our rule is pure opportunism. If there is a masterplan somewhere in Berkshire, they’re hiding it from me. Not only do we not have a master plan, we don’t have a master planner.” Charlie Munger

"We do have a few advantages, perhaps the greatest being that we don't have a strategic plan. Thus we feel no need to proceed in an ordained direction (a course leading almost invariably to silly purchase prices) but can instead simply decide what makes sense for our owners" Warren Buffett

[Buffett doesn't have constraints such as benchmarks, indexes, asset types, time horizon, etc. There is no pressure to keep up with an index. As a private business owner, Buffett doesn't have to invest in any business if the return profile is unattractive. Furthermore, with a fortress balance sheet, Buffett is often sought out for transactions at times when others are constrained.]

Long Term Focus

"One factor that has caused some reluctance on my part to write semi-annual letters is the fear that partners may begin to think in terms of short-term performance which can be most misleading. My own thinking is much more geared to five year performance, preferably with tests of relative results in both strong and weak markets.” Warren Buffett

[Having a long term focus allows Buffett to allocate capital to businesses which may depress short term earnings at the expense of long term gains. When investing, he can focus on what a business will be earning and likely worth many years into the future without the pressure of short term performance.]

Sticks with What he Knows / Defined Filters

I don’t need to make money in every game. I don’t know what coca beans are going to do. There are all kinds of things I don’t know about. That maybe too bad but why should I know all about them, I haven’t worked that hard on them.” Warren Buffett

"We do have filters. And sometimes those filters are very irritating to people who check in with us about businesses - because we really can say "no" in 10 seconds or so to 90%+ of all of the things that come along simply because we have these filters." Warren Buffett

"Typically, and this is not well understood, his [Buffett's] way of thinking is that there are disqualifying features to an investment. So he rifles through and as soon as you hit one of those it’s done. Doesn’t like the CEO, forget it. Too much tail risk, forget it. Low-margin business, forget it. Many people would try to see whether a balance of other factors made up for these things. He doesn’t analyze from A to Z; it’s a time-waster." Alice Schroeder

Thinks as a Businessman

“When we buy a stock, we always think in terms of buying the whole enterprise because it enables us to think as businessmen rather than stock speculators.” Warren Buffett

“I did a lot of work in the earlier years just getting familiar with businesses and the way I would do that is use what Phil Fisher would call, the ―Scuttlebutt Approach - I would go out and talk to customers, suppliers, and maybe ex-employees in some cases. Everybody."

Buys Simple Businesses He Understands

“We try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character” Warren Buffett

Insists on Good Management

"In making both control purchases and stock purchases, we try to buy not only good businesses, but ones run by high-grade, talented and likable managers." Warren Buffett

Conservative assumptions

“.. take all of the variables and calculate ‘em reasonably conservatively .. don’t focus too much on extreme conservatism on each variable in terms of the discount rate and the growth rate and so on; but try to be as realistic as you can on these numbers, with any errors being on the conservative side. And then when you get all through, you apply the margin of safety.” Warren Buffett

Access to Information

"We have dozens and dozens and dozens of businesses. I've always said I'm a better investor because I've had experience in business and better businessman because I've had experience in investments. Berkshire is about as good a place as you can find to really understand competitive dynamics and all that." Warren Buffett

"There is almost no industry Berkshire doesn't touch in one form or another. I can't count the number of times when I'm looking at something and pick up the phone and talk to [one of our CEOs] and if it's in any one of their adjacent industries, they know more about it in 15 minutes than an investor can learn in a lifetime." Todd Combs

Looks at Price Last

“I always like to look at investments without knowing the price – because if you see the price, it automatically has some influence on you.” Warren Buffett

Doesn't Disclose Positions

“We cannot talk about our current investment operations. Such an “open mouth” policy could never improve our results and in some situations could seriously hurt us. For this reason, should anyone, including partners, ask us whether we are interested in any security, we must plead the “5th Amendment”. Warren Buffett

Buys Established, Predictable, Quality Businesses

"Experience indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago."

“At Berkshire we will stick with businesses whose profit picture for decades to come seems reasonably predictable.” Warren Buffett

"It must be noted that your Chairman, always a quick study, required only 20 years to recognize how important it was to buy good businesses. In the interim, I searched for "bargains" - and had the misfortune to find some.  My punishment was an education in the economics of short-line farm implement manufacturers, third-place department stores, and New England textile manufacturers." Warren Buffett

No Committees / Groupthink

"As your company gets larger and larger and you have larger groups making decisions, the decisions get more homogenised.  I don't think you will ever get brilliant investment decisions out of a large committee." Warren Buffett

Aligned Shareholders

Boredom is a problem with most professional money managers. If they sit out an inning or two, not only do they get somewhat antsy, but their clients start yelling ‘swing you bum’ from the stands.” Warren Buffett

"We do not view Berkshire shareholders as faceless members of an ever-shifting crowd, but rather as co-venturers who have entrusted their funds to us for what may well turn out to be the remainder of their lives." Warren Buffett

Avoids Leverage

"Borrowed money has no place in the investor’s tool kit: Anything can happen anytime in markets." Warren Buffett

Maintains Significant Cash

"There will be some incident, it could be tomorrow. At that time, you need cash. Cash at that time is like oxygen. When you don't need it, you don't notice it. When you do need it, it's the only thing you need. We operate from a level of liquidity that no one else does." Warren Buffett

No Guidance to Hit

"We do not follow the usual practice of giving earnings 'guidance.'" Warren Buffett

Zero Cost Permanent Capital

"Berkshire has access to two low-cost, non-perilous sources of leverage that allow us to safely own far more assets than our equity capital alone would permit: deferred taxes and "float," the funds of others that our insurance business holds because it receives premiums before needing to pay out losses"

Better yet, this funding to date has been cost-free. Deferred tax liabilities bear no interest.  And as long as we can break even in our insurance underwriting - which we have done, on the average, during our 32 years in the business - the cost of the float developed from that operation is zero. Neither item, of course, is equity; these are real liabilities. But they are liabilities without covenants or due dates attached to them. In effect, they give us the benefit of debt - an ability to have more assets working for us - but saddle us with none of its drawbacks."

[Berkshire's insurance operations have their own significant edges versus competitors, including the absence of pressure to grow premiums if/when pricing is unattractive, the ability to write premiums no other insurer has the balance sheet to write, speed of response time, lack of bureaucracy, lowest costs (Geico) etc]

No Mark to Market on Wholly Owned Businesses

"Our equity holdings have fallen considerably as a percentage of our net worth, from an average of 114% in the 1980's, for example, to less than 50% in recent years. Therefore, yearly movements in the stock market now affect a much smaller percentage of our net worth than was once the case, a fact that will normally cause us to underperform in years when stocks rise substantially and over perform in years when they fall." Warren Buffett 2004

[While Berkshire owns marketable securities that fluctuate with markets, wholly owned subsidiaries are not marked to market. On a short term basis this limits exposure to large stock market declines. Over the long term, it's the business performance that drives returns. Buffett focuses on the earnings of the businesses he owns not the share prices]

Avoids Potential Blow-Ups / Focuses on Downside

“If we can’t tolerate a possible consequence, remote though it may be, we steer clear of plantings its seeds.” Warren Buffett

Avoids Turnarounds, Start-Ups and IPO's

"Start-ups are not our game." Warren Buffett

“After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems.  What we have learned is to avoid them.” Warren Buffett

“It’s almost a mathematical impossibility to imagine that, out of the thousands of things for sale on a given day, the most attractively priced is the one being sold by a knowledgeable seller (company insiders) to a less-knowledgeable buyer (investors).”  Warren Buffett


“Both of us [Warren] know that we’ve done better by having ethics”  Charlie Munger

Seeks Win-Win Outcomes

“He [Buffett] wanted win/win results everywhere - in gaining loyalty by giving it, for instance." Charlie Munger

Good Home for Businesses

"I won’t close down businesses of sub-normal profitability merely to add a fraction of a point to our corporate rate of return. However, I also feel it inappropriate for even an exceptionally profitable company to fund an operation once it appears to have unending losses in prospect. Adam Smith would disagree with my first proposition, and Karl Marx would disagree with my second; the middle ground is the only position that leaves me comfortable." Warren Buffett

"We are also very reluctant to sell sub-par businesses as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations. We hope not to repeat the capital-allocation mistakes that led us into such sub- par businesses." Warren Buffett

“You can sell it to Berkshire, and we’ll put it in the Metropolitan Museum; it’ll have a wing all by itself; it’ll be there forever. Or you can sell it to some porn shop operator, and he’ll take the painting and he’ll make the boobs a little bigger and he’ll stick it up in the window, and some other guy will come along in a raincoat, and he’ll buy it.” Warren Buffett

"We can promise that we won’t sell their business, for example, if it turns out to be disappointing, as long as it doesn’t run into the prospect of continuing losses or having significant labor problems. But we keep — we are keeping — certain businesses that you would not get a passing grade at business school on if you wrote down our reasons for keeping them. We promise the managers, you know, that they are going to continue to run their businesses. And believe me, if we didn’t do it, the word would get around on that very quickly. But we’ve been doing it now for 49 years. And we’ve put ourselves in a class that is hard for other people to compete with, if that’s important to the seller of a business." Warren Buffett

"Financial profit was not the key to ISCAR's sale. We wanted to ensure that ISCAR could continue to grow, and we saw Warren Buffett as the person who would help achieve that.. In truth, the money - $4b for 80% of ISCAR - was not the most important consideration for us in this deal .. I liked the fact that Buffett does not operate in the stock market as a speculator but as an investor. He does not look for a rapid profit but instead for stability and growth potential in the companies he acquires. He has said that he buys businesses, not stocks, they are businesses he wants to own forever. For us, the deal was more than a tribute to the unique value of the company I had founded fifty-four years earlier with an old lathe in our two-room apartment in Nahariya" Stef Werthheimer

[Over time Buffett has attracted more and more quality businesses to join Berkshire. Business founders often prioritize legacy, staff morale, business continuity and management independence above financial gain. Buffett has developed an enviable track record and a reputation as an ethical, discreet, and timely buyer who will maintain a business for the long term. Buffett doesn't participate in auctions (another edge!) and is often the only party to be offered the businesses he buys. The counter to this is that negotiated private asset sales are rarely done at knock-down prices as they occasionally are in the stock market .. Buffett notes .. "You will never make the kind of buy in a negotiated purchase that you can in a bad market— that you can make via stocks in a stock — in a weak stock market. It just isn’t going to happen." ]


While the list of Buffett's edges is long and I'm sure you can think of others, he does have some headwinds. One of those is size. Another is the fact he doesn't close under-performing businesses - that's the likely cost of seeing more private opportunities. He's also conservative. Carrying more debt would have generated even more returns, but it could also have led to the permanent loss of capital. And that would have broken Buffett's first rule: Don't lose money.

Many of Buffett's edges are available to all investors. He certainly doesn't hide them; he's been writing about them for the last 50 years. But there's one other edge I haven't mentioned, and it could be the most important of all - Charlie Munger. And what an edge that is. Buffet has given us much in the way of learning over those 50 years, and Charlie has as much and more to teach. And if you're looking for more, you could certainly start with him. 



Further Reading: Charlie Munger 50th Anniversary Letter

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Learning From Jamie Dimon


There are a number of letters that I look forward to reading each year. Some of them are well known and Buffett's are, of course, a classic example. There are also others that have added enormous value to my thinking over the years, and that have opened my eyes to many new and varied investment opportunities. They have also helped me spot emerging themes, new ideas, thought processes and mental models. I mentioned Buffett because his 2011 letter is a case in point. In that Buffett recommended reading Jamie Dimon's annual letters. And it's little wonder; Buffett has said this about Dimon in the past...

"I think he knows more about markets than probably anybody you could find in the world." 

Jamie Dimon, the son of a stockbroker, has been at the helm of JP Morgan [and it's predecessor firm 'Bank One'] since March 2000. In that time the tangible book value has compounded at 11.8%pa vs 5.2%pa for the S&P500. Not surprisingly, the stock price has followed, delivering a 12.4%pa return vs the S&P500's 5.2%pa over that period. A cumulative gain of 691% versus 147% for the S&P500. Not bad considering the multitude of challenges that have faced global banks over that period, including the worst financial crisis since the Great Depression.

  Source: Jamie Dimon Annual Letter [JP Morgan]

Source: Jamie Dimon Annual Letter [JP Morgan]

What's evident from Dimon's letters is his grasp of both investing and business; two essential characteristics according to Buffett which are required for success. 

"Being an investor you're buying pieces of a business. And being a businessman, you better understand alternatives for money, in terms of allocating capital - and therefore you are partially an investor. So I've benefited in both roles by the fact I was in the other one." Warren Buffett

Dimon's 2017 letter covers off on many of the themes we have highlighted in other posts that define successful businesses and CEOs. Dimon's information is likely as good as it gets, he has a bird's eye view of the global economy and his letter provides insights into markets, the economy and possibilities for the future.  At 47 pages, it's comprehensive. But it's an easy read and for that you can thank Warren Buffett...

"I read his [Buffett's] partnership letters when I was in high school or college and he would say 'I'll speak to you as if you're my smart sister who doesn't know everything I know so I have to go out of my way to explain it to you and business isn't complicated'. I always felt exactly the same way." Jamie Dimon

I've included some of my favourite extracts below..

How to Consider Banks

" .. we believe tangible book value per share is a good measure of the value we have created for our shareholders. If our asset and liability values are appropriate — and we believe they are — and if we can continue to deploy this capital profitably, we now think that it can earn approximately 17% return on tangible equity for the foreseeable future. Then, in our view, our company should ultimately be worth considerably more than tangible book value."

"... tangible book value “anchors” the stock price."

  Source: Jamie Dimon Annual Letter [JP Morgan]

Source: Jamie Dimon Annual Letter [JP Morgan]


"In prior years, I explained why buying back our stock at tangible book value per share was a no-brainer..  While we prefer buying back our stock at tangible book value, we think it makes sense to do so even at or above two times tangible book value."

" ... we much prefer to use our capital to grow than to buy back stock. Buying back stock should only be considered when we either cannot invest (sometimes that’s a function of regulatory policies) or when we are generating excess, unusable capital."

Quarterly Earnings & Stock Price

"Our stock price is a measure of the progress we have made over the years. This progress is a function of continually making important investments, in good times and not-so-good times, to build our capabilities — people, systems and products. These investments drive the future prospects of our company and position it to grow and prosper for decades."

"We do not worry about the stock price in the short run, and we do not worry about quarterly earnings. Our mindset is that we consistently build the company — if you do the right things, the stock price will take care of itself."

  Source: Jamie Dimon Annual Letter [JP Morgan]

Source: Jamie Dimon Annual Letter [JP Morgan]

"Do not confuse financial success with profits in a quarter or even in a year. All businesses have a different customer and investment life-cycle, which can be anywhere from one year to 30 years – think of building new restaurants to developing new airplanes or building electrical grids. Generally, anything our business does to grow will cost money in the short term (whether it’s opening branches or conducting research and development (R&D) or launching products), but it does not mean that it is not the right financial decision.

A company could be losing money on its way to bankruptcy or on its way to a very high return on invested capital. Diligent management teams understand the difference between the two scenarios and invest in a way that will make the company financially successful over time.

You need to invest continually for better products and services so you can serve your customers in the future. A bank cannot simply stop serving its clients or halt investing because of quarterly or annual earnings pressures.

It does not work when long-term investing is changed because of short-term pressures – you cannot stop/start training programs and the development of new products, among other investments. You need to serve your clients and make investments while explaining to shareholders why certain decisions are appropriate at that time. Earnings results for any one quarter or even the next few years are fundamentally the result of decisions that were made years and even decades earlier."

Satisfy Your Customers

"It is a given that you will not grow your share – unless you are satisfying your customers – and we know they can always walk across the street to be served by another bank."


"If you build the right culture, where management teams are intensely analytical and critical of their own business’ strengths, weaknesses and opportunities, you can create great clarity about what those opportunities are."


"Building shareholder value is the primary goal of a business, but it is simply not possible to do well if a company is not properly treating and serving its customers, training and motivating its employees, and being a good citizen in the community. If they are all done well, it enhances shareholder value."

Importance of Employees

"Talented, diverse employees deliver lifelong – and satisfied – customers. They also deliver innovative products, excellent training and outstanding ideas. Basically, everything we do emanates from our employees. And all of this creates shareholder value."

"We want to have the best people, period. We know happy customers start with happy employees, and we want to be the best place to work everywhere we do business."

Long Term

"We would rather earn a fair return and grow our businesses long term than try to maximize our profit over any one time period."

"Diligent management invest in a way that will make the company financially successful over time."

"[Public companies] can continue to resist pressures to focus on the short term at the expense of long-term strategy, growth and sustainable performance. And in my mind, quarterly and annual earnings per share guidance is a major contributor to that short-term focus.

It can cause companies to hold back on technology spending, marketing expenditures and other investments in their future in order to meet a prognostication affected by factors outside the company’s control, such as fluctuations in commodity prices, stock market volatility and even the weather.

That’s why during my time as JPMorgan Chase’s CEO we’ve never provided quarterly or annual net earnings guidance and why we would support any company that considers dropping such guidance in the future. We totally support being open and transparent about our financial and operational numbers with our shareholders – this includes providing guidance or expectations around number of branches, likely expense levels, “what ifs” and other specific items."

"With their own sizable investment portfolios, most public companies could use their power as shareholders to urge public companies and asset managers to take a relentlessly long-term focus...  That may mean using performance benchmarks over three-, five- and even 10-year periods, in addition to shorter period benchmarks."

Fortress Balance Sheet

"Our bank operates in a complex and sometimes volatile world. We must maintain a fortress balance sheet if we want to continually invest and support our clients through thick and thin."

"We have always believed that maintaining a strong balance sheet (including liquidity and conservative accounting) is an absolute necessity."

"JPMorgan Chase has to be prepared to handle multiple, complex, global and interrelated types of risk."

Stress Testing

"To explain how serious we are about stress testing, you should know that we run several hundred tests a week – including a number of complicated, potentially disastrous scenarios – to prepare our company for almost every type of event. While we never know exactly how and when the next major crisis will unfold, these rigorous exercises keep us constantly prepared."

Consider Alternative Scenarios

"In the financial markets, we must be prepared for the full range of possibilities and probabilities."

"We strive to try to understand the possibilities and probabilities of potential outcomes so as to be prepared for any outcome. We analyze multiple scenarios (in addition to the stress testing I wrote about earlier in this section). So regardless of what you think about the probabilities, we need to be prepared for the possibilities, including the worst case."

"In essence, we try to manage the company such that all possibilities, including the “fat tails” (the worst-case scenarios), cannot hurt the company."

Mitigate Risk

"When I hear people talk about banks taking risks, it often sounds as if we are taking big bets like you would at a casino or a racetrack. This is the complete opposite of reality.

Every loan we extend is a proprietary risk. Every new facility we build is a risk. Whether we are adding branches or bankers – or making markets or expanding operations – we perform extensive analytics and stress testing to challenge our assumptions. In short, we look at the best- and worst-case scenarios before we “take risk.” Much of what we do as a bank is to mitigate or manage the risk being taken."

Don't Overly Rely on Models

"We try to intelligently, thoughtfully and analytically make decisions and manage risk (and not overly rely on models)."

"We rely heavily on detailed and constantly improving models as a foundational element of that analysis. But we are cognizant of the fact that models by their nature are backward looking and have a difficult time adjusting to material items, including the following:

• The character and integrity of those with whom you are doing business
• Changing technology as it impacts industries (including the banking industry)
• Future changes in the law or even how the law might be interpreted differently 10 years from now
• Deteriorating international competiveness (as what happened to our tax code)
• Emerging competitive threats
• Changes in industrial structure; e.g., new sources of competition
• Political influence and unexpected litigation
• Public sector fiscal challenges, demographic changes and challenges managing the nation’s healthcare resources

There are other items – but you get the point. Judgment (which will never be perfect all of the time) cannot be removed from the process."

"There has been an excessive reliance on models [in markets]"

"Banks and regulators need to be more forward looking and less backward looking — particularly when examining risks across the system."


"Since we know we will be wrong sometimes, we almost always look at the worst possible case – to ensure JPMorgan Chase can survive any situation."

Understand Volatility and Non-Linearity

"We are always prepared for volatility and rapidly moving markets – they should surprise no one.

I am a little perplexed when people are surprised by large market moves. Oftentimes, it takes only an unexpected supply/demand imbalance of a few percent and changing sentiment to dramatically move markets. We have seen that condition occur recently in oil, but I have also seen it multiple times in my career in cotton, corn, aluminium, soybeans, chicken, beef, copper, iron – you get the point.

Each industry or commodity has continually changing supply and demand, different investment horizons to add or subtract supply, varying marginal and fixed costs, and different inventory and supply lines. In all cases, extreme volatility can be created by slightly changing factors.

It is fundamentally the same for stocks, bonds, and interest rates and currencies. Changing expectations, whether around inflation, growth or recession (yes, there will be another recession – we just don’t know when), supply and demand, sentiment and other factors, can cause drastic volatility."

"The biggest negative effect of volatile markets is that it can create market panic, which could start to slow the growth of the real economy."

Avoid Bureaucracy

"Bureaucracy is a disease. Bureaucracy drives out good people, slows down decision making, kills innovation and is often the petri dish of bad politics"

"Leaders must continually drive for speed and accuracy to eliminate waste and kill bureaucracy. When you get in great shape, you don’t stop exercising."


"We need to simplify our processes while accelerating the pace of change and driving new innovations."

"You can take any part of your business and re-imagine it. You can get all the right people in the room to think about a certain process and re-imagine how it could be done from the ground up."


"Complacency is another disease. It is usually borne out of arrogance or success, but it is a guarantee of future failure. Our competitors are not resting on their laurels – nor can we. The only way to fight complacency is to always analyze our own actions and point out your own weaknesses. It’s great to openly celebrate our successes, but when the door is closed, management should emphasize the negatives."

Continue Learning

"In less mutable times, a degree meant that formal learning was complete. You had acquired what you needed for a successful career in your field. A degree in today’s world cannot mean the end of your studies. New discoveries, new advancements, new technologies and new terminology all mean that a degree will not carry you as far into the future as it once did. We must place a higher premium on lifelong learning. Corporations can do a lot to encourage and foster such a shift."


"I will not spend time dwelling on geopolitics here, which can – but rarely does – upset the global economy."

US Economy

"Unemployment may very well drop to 3.5% this year, and there are more and more signals that business will improve capital expenditures and raise payrolls. Credit is readily available (though still not enough in some mortgage markets). Wages, jobs and household formation are increasing. Housing is in short supply. Underlying consumer and corporate credit have been relatively strong. All these signs lead to a positive outlook for the economy for the next year or so."

US Tax Changes

"The good news is that the recent changes in the U.S. tax system have many of the key ingredients to fuel economic expansion: a business tax rate that will make the U.S. competitive around the world; provisions to free U.S. companies to bring back profits earned overseas; and, importantly, tax relief for the middle class."

"I believe tax reform will have both short and long-term benefits. In the short term, we already are seeing some companies increasing capital expenditures, hiring and raising wages."

"Some argue that the added cash flow going to dividends and buybacks is a negative – it is not. It simply represents capital finding a higher and better use than the current owner has with it. And that higher and better use will be reinvestment in companies, innovation, R&D or consumption. Thinking this is a bad thing is just wrong. Tax reform’s real benefit will be the long-term cumulative effect of retained and reinvested capital in the United States, which means more companies, innovation and employment will stay in this country."


"Importantly, as long as rates are rising because the economy is strengthening and inflation is contained, it is reasonable to expect that the reversal of QE will not be painful. The benefits of a strong economy are more important than the negative impact from modest increases in interest rates."

"I believe that many people underestimate the possibility of higher inflation and wages, which means they might be underestimating the chance that the Federal Reserve may have to raise rates faster than we all think. While in the past, interest rates have been lower and for longer than people expected, they may go higher and faster than people expect. If this happens, it is useful to look at how the table is set – what are all the things that are different or better or worse than during prior crises, particularly the last one – and try to think through the possible effects."

Uncertainty of QE

"One scenario that we must be prepared for is the possibility that the reversal of quantitative easing (QE) by the world’s central banks — in a new regulatory environment — will be different from what people expect."

"Since QE has never been done on this scale and we don’t completely know the myriad effects it has had on asset prices, confidence, capital expenditures and other factors, we cannot possibly know all of the effects of its reversal. We have to deal with the possibility that at one point, the Federal Reserve and other central banks may have to take more drastic action than they currently anticipate – reacting to the markets, not guiding the markets"

Passive Investing and ETF's

"Far more money than before (about $9 trillion of assets, which represents about 30% of total mutual fund long-term assets) is managed passively in index funds or ETFs (both of which are very easy to get out of). Some of these funds provide far more liquidity to the customer than the underlying assets in the fund, and it is reasonable to worry about what would happen if these funds went into large liquidation.


"It would be a reasonable expectation that with normal growth and inflation approaching 2%, the 10-year bond could or should be trading at around 4%. And the short end should be trading at around 2½% (these would be fairly normal historical experiences). And this is still a little lower than the Fed is forecasting under these conditions. It is also a reasonable explanation (and one that many economists believe) that today’s rates of the 10-year bond trading below 3% are due to the large purchases of U.S. debt by the Federal Reserve (and others)."

"This situation is completely reversing. Sometime in the next year or so, many of the major buyers of U.S. debt, including the Federal Reserve, will either stop their buying or reverse their purchases (think foreign exchange managers or central banks in Japan or China and Europe). So far, only one central bank, the Federal Reserve, has started to reverse QE – and even that in a minor way. However, by the end of this year, the Fed has indicated it might reduce its holding of Treasuries by up to $150 billion a quarter. And finally, the U.S. government will need to sell more than $250 billion a quarter to fund its deficit."

"... we could be going into a situation where the Fed will have to raise rates faster and/ or sell more securities, which certainly could lead to more uncertainty and market volatility. Whether this would lead to a recession or not, we don’t know – but even that is not the worst case. If growth in America is accelerating, which it seems to be, and any remaining slack in the labor markets is disappearing – and wages start going up, as do commodity prices – then it is not an unreasonable possibility that inflation could go higher than people might expect. As a result, the Federal Reserve will also need to raise rates faster and higher than people might expect. In this case, markets will get more volatile as all asset prices adjust to a new and maybe not-so-positive environment."


"Overall, technology is the greatest thing that has ever happened to mankind. It is the reason why we enjoy our high living standard. It is staggering how our lives have changed when compared with 100 years ago. We live longer and work less; we are healthier and safer; and during that time period, billions of people have been pulled out of poverty."

".. our vibrant economy has always found a way to adjust to job loss by creating new jobs and sometimes changing the way we work by reducing work days and work hours.

"We know technology has been a great force, and for the benefit of mankind, that force should be left unleashed. In the event that it creates change faster in the future than it has in the past – and the economy is unable to adjust jobs fast enough – the best protection is continual workforce training, education and re-education, supplemented by income assistance and relocation."

Trade & Global Engagement

"Global engagement, trade and immigration — America’s role in the world is critical."

"As a nation, we cannot isolate ourselves any more than we can stem the ocean’s tide."

"Any system created by humans, however, is ultimately fallible. Sustaining the current order and ensuring its longevity mean acknowledging its flaws."

"Retreating from the world is not the solution, nor is burning down the current system and starting anew. At the same time, we cannot and should not turn a blind eye to the real pressures millions of families face at the hands of globalization, technological advances and other factors."

"We should acknowledge many of the legitimate complaints around trade. Tariffs and non-tariff barriers to trade are often not fair; intellectual property is frequently stolen; and the rights to invest in and own companies in some countries, in many cases, are not equal. Countries commonly subsidize state-owned enterprises. When the U.S. administration talks about “free” and “fair,” it essentially means the same on all counts. This is not what has existed. It is not unreasonable for the United States to press ahead for more equivalency."

"China has realized significant economic and employment gains since joining the WTO in 2001. China was expected to continue on an aggressive path of opening up its economy, but this has happened at a much slower pace than most nations expected. Now, more than 16 years later, it has the second-largest economy in the world and is home to 20% of the Fortune 500 companies, yet it still considers itself a “developing” nation that should not be subject to the same WTO standards as the United States and other “developed” countries."

"Anything that starts to resemble a trade war creates risk and uncertainty to the global economic system."

I don't think that it needs to be said how remarkably similar Jamie Dimon's thinking is to other great Business and Investment Masters. We have written about their collective emphasis on innovative thinking and learning from mistakes, understanding non-linearity and volatility, whilst avoiding things like bureaucracy and an over reliance on models many times before. And this is not a coincidence; these are important fundamentals that each of these Masters value as the reason for their success. And the good news is that you can access this learning without having to have gained the many years of experience each has had to undergo to obtain it in the first place. Lucky you! I strongly recommend reading the entirety of Jamie's letter - it is both insightful and educational and should add as much value to you as it has to me.


Sources: Jamie Dimon, Annual Letter 2017, JP Morgan






Learning from Ron Shaich

The restaurant industry is a hyper competitive industry - this has long been the case. It's mature, fragmented and has negligible barriers to entry. New entrants are attacking all the time. And it's an industry which is as “tough as hell” to succeed - did you know that more than one third of restaurant chains are out of business within a decade or two? If that's the case, how on earth can a bread company significantly outperform Warren Buffett's Berkshire Hathaway over two decades?

The answer to that question lies at the feet of Ron Shaich, the founder and Chairman of Panera Bread. Panera was the best-performing restaurant stock of the past 20 years, delivering a total shareholder return up 86-fold from 1997 to July 2017 [before being taken private], compared to a less than two-fold increase for the S&P 500 during the same period. The stock annualised returns at an astonishing 25 per cent per annum.  

 Source: Bloomberg

Source: Bloomberg

It's no secret that I'm always interested in learning from great CEO's and investors - those people with outstanding track records of success regardless of the industries they work within. I recently enjoyed listening to a Forbes interview by Steven Bertoni with Ron Shaich. This prompted me to learn more about how this 26-year veteran CEO successfully navigated the changing dynamics of the restaurant business, empowered his staff and adjusted to change to maintain a competitive advantage over the long term. And once again, you'll find many of the characteristics that define Mr Shaich define other world class CEO's. 

Here are some of my favourite snippets from both the Forbes Podcast and Ron Shaich's excellent website ...


"This is what we do as business leaders; we discover today what is going to matter tomorrow and make sure our companies are prepared and ready for that as the world unfolds."

"The role of leadership is to separate the wheat from the chaff and know what the deeper trends are. We don't follow fads. What we do it try to figure out is what is going to really matter in a deep and profound way three to five years from now."

"Leadership always requires developing a hypothesis, understanding where the world is going and making a smart bet into that."

"I believe one of our roles as leaders is to tell the truth, and tell the truth most importantly to ourselves."


"I go to work to learn .. I love the sense of making a difference and figuring things out."

“We as leaders don’t take enough time to learn. The one thing that I don’t think we learn and value enough is empathy. We don’t feel what the customer feels.”

"I view my work as a lifelong learning journey. I go to work to learn about how the world works. How humanity works. And what will work in the world."

"The British author John le Carré once quipped, "The desk is a dangerous place from which to view the world." I couldn't agree more. I visit anywhere from 25 to 100 Panera cafes every month. And what I always find is a kind of real-time performance art—dynamic interactions between our frontline crews and constantly shifting casts of customers, with the overriding goal of ensuring that when customers exit our "stage," they are nourished in soul as well as body. The performances always differ. And I inevitably learn something new. When I learn, the results are actionable ideas and a broadened vision. Opportunities for change are revealed."

Three-Step Process

"It's not complicated. It starts first by telling ourselves the truth. In a really ruthless way. Second, to understand what few things really matter to get the jobs done that consumers are hiring us to do.  What do we really have to do and how do we prepare ourselves to be able to do that as the world plays out over the next two to five years. Thirdly, we get it done. You take those three things and you can have success."

"I tell my team all the time that Panera’s success comes down to three things we’ve always been able to do: 1. Tell the truth. 2. Know what matters. 3. Get the job done. Most people do not have the insight, foresight, or wherewithal to do all three. But I firmly believe that doing all three is the key to success in business and in life."

What Job Clients Hire For

"[With Panera] it was very clear to me we were serving real consumer needs. We had a dominant position, a better competitive alternative in a range of different jobs that consumers were willing to hire us for. That manifested itself in very high unit volumes, consistent from Detroit, Portland to Miami. You could see its reproducability."

Long Term

"I think long term."

"I've won because I had enough credibility, I voted enough stock, that I was able to make these long term bets. That's what gave us competitive advantage."

"What drove our outperformance was our ability to make long-term transformations multiple times over 36 years. As a long term CEO; 26 years, I've had the opportunity to really look back and really reflect on the public markets. And here is what I see - I see investors no longer owning companies but renting stock. Forty years ago the average holding time for a public company was 8 years, today it is 8 months. People are renting their stock. You have a very different world.

 Source: Ron Shaich IGNITE 2010 Presentation

Source: Ron Shaich IGNITE 2010 Presentation

You have activists, you have a lot of money managed passively and you have the index funds deferring often to ISS to make judgments, and nobody feels capable of separating the wheat from the chaff. So we go to the path of least resistance and say it can't hurt to help the activists. We see it across multiple industries - a company has a flat year after years of success, and activists get voted in to control the board. Someone can walk in and say I own 2% of the company and another 6% in derivatives, I'm your owner, cut costs in half and R&D, lever up the balance sheet, sell the stock and let someone worry about the carcass.

That has an effect on CEO's. At the same time we see the FANG companies. The hottest companies in the public markets.  They are the ones who are winning. What is their competitive advantage? They have capital structures that let them make long term decisions.

I was on the board of Wholefoods which was sold to Amazon. And what is Amazon doing? The same things we would have done at Wholefoods; investing in digital and cutting prices because the competitive environment changed. But in Wholefoods we couldn't do it because of the short term pressures coming at us from people who wanted us to produce the results right now. What has Amazon got? The room and time to make these kinds of investments.

Here's my point. These put CEO's in a very weak position. CEO's want to please. They don't want the vulnerability of someone walking in and taking control. So they tighten up. They get short term. That's the reality. They go for cost cutting, and ignore innovation and building community and taking care of team members. The ultimate result is that it dramatically affects the ability to do long term transformation, dramatically effects GDP growth and economic competitiveness for society."

"I began to recognise for our ability to continue to do great work, I could think of no place better than with an ultra-long term investor, that allowed our people to do it."

"Studies such as this one from the Harvard Business Review conclude that founder-led businesses often outperform professionally managed firms. I would suggest that
they do so because the founder's commitment runs far deeper and is often longer-term in nature than that of the professional manager. And commitment and focus is what drives performance."

Importance of Competitive Advantage

"I've learned that competitive advantage is everything. Simply put, competitive advantage is what prompts customers to choose you over your competitors. Without it, your business just fades away."

"You must develop true competitive advantage. You must be the best alternative for certain guests, so much so that they walk past the establishment next door to visit your concept. Sounds easy, right? Well, in a world where a new restaurant pops up every day, true competitive advantage is one of the most difficult things to attain. But it is the critical piece that separates those who succeed from those who fail."

"You will accomplish little if you don’t maintain long term competitive advantage. It will take courage. Whatever your situation, you will ultimately fail if you don’t deliver a superior experience for your target customer by doing what competitors don’t."

"What sustains a company over the long term is how it thinks, not what it does. Because what is does is a by-product of how it thinks. Panera in its core comes from a view that competitive advantage is everything. If we don't have a reason for people to walk past competitors and come to Panera, then we don't exist. Losing competitive advantage is the greatest risk in business, and that's where our focus is." 

"When [EPS] growth does occur, it’s only because the management team is intently focused on continually sharpening the concept’s competitive position through food, experience, people, communication and operational excellence."

"Focus intensely on making the right decisions today to build your same-store profitability in the future. Recognize that same-store profitability is, in the long term, most directly impacted by your competitive position. Bet on the things that will improve your competitive position. I call these “smart bets.” Making these bets requires an understanding of what the competitive landscape will look like two, three or more years in advance."

"I view my role as CEO as protecting those that discover ways to build competitive advantage."

How to Develop Competitive Advantage

“We may serve 10 million people a week, but if we’re going to be competitive, it’s all about one guest’s experience.”

"So how do you create competitive advantage?

First, make sure the niche you focus on is big enough to sustain you, but not so easily duplicated that you simply become a test lab for larger competitors.

Second, recognize that you can’t please all the people all the time. Instead, develop a concept that’s the singular best choice for some customers on some days rather than the second-best choice for everyone, every day.

Third, accept that maintaining competitive advantage in this industry — with its low barriers to entry — is really difficult. One day you’re the most attractive alternative on the block. The next day your target customer is walking past your door to a “new and better place” down the street.

Fourth, recognize and avoid the reactionary nature of our industry, which often leads to diminished competitive advantage. As concepts begin to look more and more alike, companies move further away from being the best competitive alternative for a certain group of customers. And before you know it, yesterday’s favourite is suddenly an industry has-been.

To avoid this you must stand for something over the long term. You have to mean something to your target customer. You can’t be changing every day."

Long Term Transformation

"The key to me has been to try to find means and mechanisms for competitive advantage and opportunities for long term growth. If you look at it, Panera has continued to transform itself - six different transformations over the 36 years I have run this company. You can go all the way back to its formation. I formed it initially as a 400 square foot cookie store in downtown Boston."


"Driving innovation is the most important role of the CEO."

"Innovation begins with understanding what job you're trying to complete for whom, and then determining what matters to that audience, looking for patterns, and trying to understand it."

"Most companies' systems and functions are designed to efficiently deliver a business model that was successful yesterday. But what you accomplished yesterday won't help you succeed tomorrow. For that, you must continually turn to discovery."

"We must avoid the trap that befalls many big companies. That is, they bulk up their delivery muscle while letting their discovery muscle wither. Instead of innovating and doing the things that will help them discover the next growth opportunity, they devote an inordinate amount of resources and focus to getting the work done, on time and on budget. Of course, delivery matters. A company that busts its budgets and misses its sales targets won't endure for very long. But in terms of the competitive advantage it can generate, discovery matters more. Much more. When it reverses its priorities and puts discovery at the forefront, a company stands a far better chance of getting to the future first."

"I often think of myself as the discoverer-in-chief. The most powerful role I have is protecting the people that are dreaming about where this company can be in two to three to five to 10 years."

"I have long believed that every innovation process starts with learning. And learning depends on observing and questioning, which in fact led to the creation of Panera itself. In 1993, when I was the CEO of Au Bon Pain, we acquired a 19-store chain called the Saint Louis Bread Company, which we believed would help us build a gateway to the nation's suburbs. But instead of immediately trying to scale Saint Louis Bread, we spent the next two years studying it."

"We ran down more than a few dead ends on the road to creating Panera. Nor did we seamlessly move from question to solution. There were many interim steps along the way: observing, brainstorming, testing, prototyping, iterating, retesting, and more. But our innovation process started by asking questions."

People and Incentives

"If an organization is to build same-store profitability, it is essential that it have the right people to actually get the job done. And it must incentivize them to do so. I’m always amazed at the number of restaurant companies that incentivize their operators on the wrong things when it comes to building value. They incentivize on actual versus budgeted results, instead of base store profit growth year over year over year. Frankly, this misguided focus on short-term metrics degrades shareholder value."


 Source: Ron Shaich IGNITE 2010 Presentation

Source: Ron Shaich IGNITE 2010 Presentation

"We Made a Smart Bet on a Clear Set of Shared Behaviours: Cultural Values."

"Ask any of Panera’s 100,000 employees what they like most about our corporate
and they will undoubtedly reply, “No jerks.” Those two words — No. 1 on our
list of cultural values — set Panera apart as an enterprise. They ensure that our
relationships with each other and with our guests are based on respect and honesty,
and they establish a standard for our conduct."


"In my opinion, growth is not a pedal to be pushed. It is not an end in itself. Rather, growth is simply a means of building shareholder value by capitalizing on a successful business model.

Growth is a double-edged sword; it is either additive or subtractive of economic value. The bottom line is that growth can only build value if the underlying business model is worthy of being reproduced. Because let’s face it, the world does not need another restaurant — not unless that restaurant actually offers its customers something better.

Growth only makes sense once you have already built a business model that offers a better competitive alternative, and if management is highly confident they can deliver strong and consistent returns on investment. You must have these two elements in place or else you really have no right growing. Indeed, without these two elements in place, growth simply becomes a form of gambling with your stakeholders’ money — foolishly placing bets when the odds are strongly stacked against you."

"We can all recall numerous concepts that said they “needed to grow” to keep their P/E high and their shareholders happy. Unfortunately, a misguided focus on growth as an end often leads to more bad outcomes than good. Like lemmings, those management teams that encourage reckless growth march their companies right off the side of the cliff."

Contrarian Approach

"I'm contrarian by nature. I am looking for where the world is going to be in three to five years and where am I going to be."

"Your management team must be prepared to go against the herd. I call this being contrarian."

'Contrarianism' is not unique to Panera. In fact, I would argue that the most successful companies in our industry — the McDonald’s, Dardens, Starbucks, Chipotles and Yum! Brands of the world — have all utilized contrarian thinking, applied consistently over the long term, to build competitive advantage. Each of these companies is obsessively focused on their target niches, steadfast in their long-term strategy and contrarian in their thinking — all to build further competitive advantage."

Stock Prices

"I have never focused on the stock price or the financial performance. It's a by-product. I don't make the financial performance . What I can make is a better guest experience. And when you deliver on the guest's experience in an absolutely committed fashion, the by-product is performance. One of the things we often confuse in business and life is the difference between means, ends and byproducts.

 Source: Ron Shaich - IGNITE 2010 Presentation

Source: Ron Shaich - IGNITE 2010 Presentation

I focus on the guest experience. When we deliver a superior guest experience, when we deliver large runways for growth, we then have a future. That is what drive's the financial performance.

The folks that focus on the stock price, in the end, always hit the rocks. They are giving me a great competitive alternative because they're short terming. When you're focused on the next quarter and squeezing the company, you're giving me a great big opportunity to do a better job than you are. Because things of value take time."

Quarterly Earnings

"Wall Street judges Panera and every other public company by what we've achieved over the previous thirteen weeks and what it appears we'll achieve over the next thirteen. Such shortsightedness is one reason why I pay very little attention to quarterly earnings. Today's performance is the byproduct of discoveries and decisions that we made many months and often even years ago. Our time horizon must always extend far beyond the next quarter. As always, that means doing the hard work of imagining what the world will look like in five years and aligning ourselves with those long-term consumer trends."

"Every 13 weeks brings the beginning of yet another cycle of reporting to our investors, analysts, board, banks, franchisees, and team members. After hearing our reports, many of these stakeholders focus on a metric that means a lot to them but comparatively little in and of itself to me, earnings-per-share growth. In the aftermath of every call, we get either applause or boos based solely on how our EPS growth has fared against analysts’ estimates, which always amuses me. If we exceed Wall Street’s consensus estimates for the quarter, we are deemed a brilliant, forward-thinking management team. If we miss the Street’s estimate, we land on the list of downwardly spiralling companies that are plagued with questionable leadership. That’s an awfully wrongheaded approach to gauging a company’s long-term prospects."

"Despite the constant pressure to submit to quick fixes, you stand a far better chance of delivering strong quarterly results year after year when you focus on strengthening your competitive advantage and growing only when your business model offers a proven competitive alternative."

Win-Win Approach

 Source: Ron Shaich 2010 IGNITE presentation

Source: Ron Shaich 2010 IGNITE presentation

"When I go to the ATM, I'm usually required to make a deposit before I make a withdrawal. I'd argue it's the same in business. We have to spend less time figuring out how to extract economic value from our stakeholders and more time creating what is valuable to them. Doing so is what ultimately creates long-term value."

"From its inception, Panera has utilized the principles that some call conscious capitalism, and which we at Panera like to call “enlightened self-interest.” This notion of a conscious approach to value creation is built on the fundamental premise that every business has a deeper purpose than short-term profit maximization. Indeed, we regard profit and the creation of shareholder value as the byproduct of making a difference for our key stakeholders and society. When we deliver for our customers, employees, vendors, and the wider community, shareholder value follows."


"Turnarounds are long-shots, and almost impossible to pull off. Business books abound with stories of heroic CEOs who come to the rescue of once proud companies that failed to adapt to a changing world.

There's Lou Gerstner's turnaround at IBM. Steve Jobs' improbable resurrection of Apple. And Lee Iacocca's stirring rescue of Chrysler. We can celebrate those stories, even as we recognize that turnaround attempts seldom turn out very well. Equally problematic, a turnaround is an expensive substitute—in terms of squandered resources and the toll its takes on associates—for serial innovation. As the strategist Gary Hamel puts it in The Future of Management, a turnaround "is transformation tragically delayed." For any executive team, the real challenge is "to build organizations that are capable of continuous self-renewal in the absence of a crisis [my emphasis]."

"My message: Don’t avoid the inevitable. Be a realist now and innovate while you have the breathing room, the resources, and the credibility with your stakeholders. Do that, and your company will avoid the need for a “radical turnaroundexpert in the future."


"Many executives have a love affair with spreadsheets. I am not one of them. In fact, I encourage my team to approach spreadsheets with a healthy dose of skepticism, and I caution everyone else to do the same.

The future is filled with uncertainty and no one likes uncertainty. Uncertainty implies risk, and we all seek ways to minimize risk. The hard numbers of the spreadsheet make the future seem more certain. However, a spreadsheet is only one possibility of the answer, not the answer itself. A spreadsheet is merely a way to organize data. Its numbers generally capture trends of the past, but it is in no way predictive of what’s to come.

The best strategic decisions reflect a healthy balance of historic data and well-considered knowledge. We need to look to other companies and industries as models for what will happen in the future.

Here’s a metaphor: 16-year-olds. If you are familiar with any 16-year-olds, you know
they can be terrors to live with. Given raging hormones and the developmental need to
question and reject authority, 16-year-olds can truly test the parent-child bond. I know
of what I speak. If I looked at the accumulating data related to my 16-year-old son’s
recent behavior and projected that into the future, I would consider putting him up for
adoption. I’m not going to do that, however, because I know the past is not likely to
be predictive of what’s to come. By the time most 16-year-olds reach the age of 25,
they lose much of their edge and morph into wonderful adults — at least that’s what I
see when I look at my friends’ older children. The spreadsheet I would build based
solely on the behavior of 16-year-olds may reflect what is going on in the recent past and today, but not the changes that looking to other models tell us will occur in future months and years.

"French writer and philosopher Voltaire noted long ago that, “Doubt is not a pleasant condition, but certainty is absurd.” Today’s executives would be wise to apply that thinking to spreadsheets. Their data reveals yesterday’s truths; their spreadsheets of tomorrow are merely one possibility, but not a likely outcome. What they need is perspective and guardrails."


"I wrote a memo for the guy who took over from me, and I basically defined how I would compete with Panera if I wasn't part of Panera. How I would take out Panera. Our CEO asked me to work on it. I ended up painting a vision for how Panera could re-transform itself. That transformation was rooted in using digital to fix guest experience. Redefining how we innovate. Build a loyalty program. Finding large adjacent billion dollar businesses we could enter. I was asked to step back in as CEO [as the CEO was sick] and I did and I used this transformation model."

"I think we've approached technology very different from anybody else. Back in 2011 we didn't start out to create a digital program or a mobile app. We started out to solve a guest experience. And so much of what we do as business people is rooted in empathy. Empathy for our guests. That's one of the most powerful skills we as business leaders can have. On my way to work I would call Panera ahead and speak to a manager to make an order and my son would run in and pick up in 30 seconds. He'd do that and I thought wow this is phenomenal. What about the other 8.5m people we serve every week, they don't have that experience. It was great to have your food made simultaneously with your trip to the store. I began to imagine how we would do that. I began to say digital offered a powerful alternative to meet a guest need."

What I find particularly enlightening about Mr Shaich's approach, beyond the obvious similarities between his own and other Investment and Business Masters' approaches, is that he dares to think differently. It obviously has made a  profound difference to his company's performance. You can't argue against an 86-fold increase in shareholder returns over 20 years! Even Warren Buffet's Berkshire Hathaway hasn't done that well, and Berkshire is a shining light for most investors. By simply thinking differently, Shaich has been able to transform his business multiple times and after some trial and error, and learning along the way, develop a brand and customer experience that offers tremendous value to all stakeholders - customers, staff and shareholders alike. Its truly remarkable to see.

His approach also makes me question my own portfolio - am I a business owner or a mere renter of stocks? I know what I would prefer to be. How about you?



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Further Reading on CEO Masters:

The Investment Masters on bonds...

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If we were asked to come up with 5 or 10 names of the world's greatest stock market investors, most of us could do it easily and many of us would probably include one or more of the following - Buffett, Munger, Graham, Templeton, Lynch, Fisher, Steinhardt et, al. But picking bond market gurus is a much more difficult task, however. Bill Gross and Jeff Gundlach are two names that come to mind for me, and to be honest, I can't think of many others.

Gross and Gundlach's ability to unravel the economic landscape has allowed their portfolios to beat their bond market benchmarks time and time again, and fund inflows have followed. But relative to the great stock market investors, their returns have been rather pedestrian. That's in no way to say they're inferior investors, they're just fishing in a different pond. 

Most of those people we consider the investment greats have made their money, not in bonds or 60:40 stock/bond allocations, but through owning stocks. If anything, they've shunned bonds.

"On the whole we are allergic to bonds.Walter Schloss

"Gentlemen who prefer bonds don't know what they're missing." Peter Lynch

In recent years, I can't recall one Investment Master recommending government bonds as an investment. It's fair to say that most have been outright dismissive....

"If I had a choice between holding a US Treasury bond or a hot burning coal in my hand, I would choose the coal. At least that way I would only lose my hand." Paul Tudor Jones

“With interest rates being historically low right now I would not want to invest in bonds. Also a bond is a contract and you can’t do anything with that.” Ted Weschler

“I believe the risk lies in the risk-free rate.” Sir Michael Hintze

“It absolutely baffles me who buys a 30 year bond. I just don't understand it. And, they sell a lot of them so clearly, there's somebody out there buying them." Warren Buffett

"It is very strange situation to have the Fed say our goal is 2% inflation and people buy Treasury bills at 1.5% and have to pay tax on it. The government has announced to you it doesn’t pay to save. You will have nothing in the way of purchasing power.  To me it has just been absurd to see pension funds [in 2013 and future years] saying we ought to have 30% in bonds.” Charlie Munger

“Almost anybody who trades risk assets has felt the impact of low rate policies. If there is a bubble, it is probably in the price of sovereign debt globally.” Jon Pollock

"Long-term government bonds are ridiculous at current yields. They are not safe havens. Investors who have experienced the price run-up in the bond market but who have not marked down their forward expected portfolio rate of return are making, in our view, a possibly fatal mistake.” Paul Singer

There are a few good reasons that the Investment Masters haven't been advocating bonds; they're expensive, the return profile is asymmetric, there's no upside participation, prices have been manipulated, and a bout of unexpected inflation would mean some seriously permanent capital losses. Furthermore, over the long term bond returns have significantly lagged equities, and that's not likely to change in the future. 

Let's consider some of those..

Bonds are Expensive

Buffett advocates a common sense approach to buying bonds; that is, viewing bond investments with a businessman’s perspectiveWhat does the return profile look like? What is an equivalent PE ratio? How long would it take to double your money? On this basis, and relative to equities, bonds have looked horribly expensive.

“The ten-year bond is selling at 40 times earnings. And it's not going to grow. And if you can buy some business that earns high returns on equity and has even got mild growth prospects, you know, at much lower multiple earnings, you are going to do better than buying ten-year bonds at 2.30 or 30-year bonds at three, or something of the sort." Warren Buffett

“A bond that pays you 2% is selling at 50X earnings and the earnings can’t go up. And the Government has told you we would like to take that 2% away from you by decreasing the value of money. That is to absurd to own something like that. To make that a voluntary choice in the last ten years against owning assets has struck me as absolutely foolish." Warren Buffett

No Upside Participation

When you hold a bond you get paid a coupon and hopefully receive your face value at maturity. You don't get more coupons if the government or the company issuing the bond does well. Unlike owning a stock, there is no upside optionality. That's why it's called 'fixed' income. The coupon, maturity date and repayment of par are all fixed.

Bonds offer no growth in intrinsic-worth opportunities comparable to equity securities. A bond indenture makes two primary promises: to make generally fixed semi-annual interest payments and to redeem the bond at par value on maturity date. If there is no upside, it makes no sense to us whatsoever to expose our clients to risk on the downside.” Frank Martin

"Whereas companies routinely reward their shareholders with higher dividends, no company in the history of finance, going back as far as the Medicis, has rewarded its bondholders by raising the interest rate on a bond." Peter Lynch

“In fixed income.. returns are limited and the manager's greatest contribution comes through the avoidance of loss. Because the upside is truly "fixed," the only variability is on the downside, and avoiding it holds the key. Thus, distinguishing yourself as a bond investor isn’t a matter of which paying bonds you hold, but largely of whether you're able to exclude bonds that don't pay. According to Graham and Dodd, this emphasis on exclusion makes fixed income investing a 'negative art.'" Howard Marks

"In stocks you've got the company's growth on your side. You're a partner in a prosperous and expanding business. In bonds, your nothing more than the nearest source of spare change. When you lend money to someone, the best you can hope for is to get it back, plus interest." Peter Lynch

Asymmetry of Bond Yields

When interest rates on bonds are plumbing record lows, close to zero or in some cases negative, it's difficult to imagine them falling much further. However, should yields rise to a level more consistent with history and economic theory [eg Taylor rule], bond prices could fall a lot. The lower the coupon the more downside there is from interest rates rises. If you have to sell before maturity, you could be wearing a large loss. This is the exact opposite type of asymmetry the Investment Masters seek; limited upside, big downside.

“When the [Treasury] yield is below 2.50%, it doesn't take much of either an inflation scare or something else—but it would most likely be an inflation scare—to make rates rise. And as they rise from such low levels, the mathematics are just brutal, and you can get your clock cleaned by going long Treasuries or high-grade bonds.” Michael Lewitt

“How in the world could we be talking about rates never going up when in fact rates have bottomed?…In the investment world when you hear ‘never,’ as in rates are ‘never’ going up, it’s probably about to happen.” Jeff Gundlach

"It would only take a 100 basis point rise in Treasury bond yields to trigger the worst price decline in bonds since the 1981 bond market crash." Ray Dalio

"An investor in fixed income today is beginning a compounding stream with the curve at the mid-1% level on cash to under 3% at 30 years. A rising interest environment will penalise the owner of long-dated debt with price declines, the longer the maturity the more severe the decline. A sustained increase in rates will help by allowing for re-investment at higher yields, but an expectation of returns much above initial yields would be asking for a lot." Christopher Bloomstran

"The Federal Reserve was founded in 1913. This is the first time in 102 years that the central bank bought bonds, and that we've had zero interest rates, and we've had them for five or six years. So do you think this is the worst economic period looking at these numbers we've been in in the last 102 years? To me it's incredible." Stanley Druckenmiller

  US10yr Bond Yield Vs S&P500 Earnings Yield  [Source Bloomberg]

US10yr Bond Yield Vs S&P500 Earnings Yield  [Source Bloomberg]

Permanent Capital Loss

Successful investing requires avoiding the permanent loss of capital. This means not only avoiding absolute capital losses but also the loss of purchasing power inflicted by inflation.

“I define risk as the chance of permanent capital loss adjusted for inflation." Bruce Berkowitz

"What we care about is avoiding the permanent loss of capital and, increasingly relevant today, the permanent loss of purchasing power.David Iben

“The goal of investing is to protect and increase your portfolio in inflation-adjusted dollars over time.” David Dreman

"There is no real safety without preserving purchasing power.”  Sir John Templeton

"The riskiness of an investment is .. measured by the probability — the reasoned probability — of that investment causing its owner a loss of purchasing power over his contemplated holding period." Warren Buffett

Ordinarily, one hundred dollars today will buy you more than $100 in ten years as inflation raises the cost of goods over time. Historically bonds have compensated investors for inflation, providing a real return of a few percent [see chart below]. In recent years, real returns have shrunk and in some instances turned negative.

“In our opinion, the only thing that is guaranteed with a bond that has a lower interest rate than the rate of inflation is impoverishment. Generating negative real returns goes against the very concept of investment. With each passing year, the holders of this asset class have their capital slowly crumble. From our perspective, the certainty of capital loss in purchasing power is the very definition of risk.” Francois Rochon

For the first time in history, some government and corporate bond yields have ventured below zero. Holding these bonds to maturity guarantees a permanent loss of capital even before inflation. Little wonder, the Investment Masters have steered well clear of buying bonds. 

  US10Year Yield less Inflation [Source Bloomberg]

US10Year Yield less Inflation [Source Bloomberg]

Inflation Risks

As we know, investors are prone to focus on the rear-view mirror. Prominent in most investor's rear view mirror has been the financial crisis, where the collapse in aggregate demand raised the prospects of deflation. The subsequent recovery has been characterised by low inflation which has conditioned investors to expect more of the same; extrapolating the last 10 years. But the future could be very different.

In a post last year titled 'The Buffett Series - Thinking About Bonds' I recommended reading the chapter 'The Last Hurrah for Bonds' in the excellent book, 'The Davis Dynasty'. Investment Master, Shelby Davis was an outspoken critic of bond investments in the 1940's. Here's an extract ... 

"[Shelby Davis] became an anti-bond maverick. The recent past had told people bonds were attractive and safe, but the present was telling Davis they were ugly and dangerous. Interest rates were fast approaching what economist John Maynard Keynes called the "balm and sweet simplicity of no percent." Keynes was exaggerating, but not by much - the yield on long-term Treasuries hit bottom-2.03 percent in April 1946. Buyers would have to wait 25 years to double their money, and, to Davis, this was pathetic compounding. He saw the threat in the "sea of money on which the U.S. Treasury has floated this costliest of wars." With the government deep in hock and forced to borrow another $70 billion to cover its latest shortfall, he was certain lenders soon would demand higher rates, not lower.  The most reliable inflation gauge, the consumer price index, rose sharply in 1946."

What followed was a 34-year bear market in bonds that lasted from the Truman era to the Reagan years. The 2 to 3 percent bond yields in the late 1940's expanded to 15 percent in the early 1980's and, as yields rose, bond prices fell and bond investors lost money. The same government bond that sold for $101 in 1946 was worth only $17 in 1981! After three decades, loyal bondholders who had held their bonds lost 83 cents on every dollar they'd invested. Ignoring the scene in the rear-view mirror, Davis focused his attention on navigating the future. 

The biggest dupes in the triple swindle were fat cats and institutions (pension funds, insurance companies, and their ilk). These sophisticated types who could afford bonds might have seen the folly in owning government paper in the late 1940's, but most didn't. Fanciful arguments tranquilized the bond bulls. They believed that because bonds were profitable in the past decade, they’d be profitable in the next. They convinced themselves that the Fed could keep interest rates from rising, indefinitely.  A government that controlled the price of pork chops, it was widely assumed, could also control the price of money."

And Davis was right ...

“An individual in a 50% bracket who put money into T-bills or government bonds after World War 2 and kept re-investing in these instruments to 1996, lost the major part of his or her capital.”  David Dreman

Sound familiar? Since the Financial Crisis, investors have allocated significantly more funds into bonds than stocks. Only now are investors awakening to the risks of rising inflation

"What is the worst investment against inflation? Bonds. The objective of governments who are overly indebted will be to devalue bonds so that their burden can be reduced. Yet, what are investors doing these days? They are aggressively buying bonds and moving away from equities. They rant against debt but continue to buy government notes or leave cash in the bank at 1% interest." 

What is the best hedge against inflation? Owning companies with unique products that have high pricing power. If I were a German investor in 1945, I would have wanted to own Porsche, Beck’s, Hugo Boss, Bayer, Braun, and Nivea. The value of the German currency could have gone to zero, but if the brands were solid, you still could have realized a profit in any currency. Our job is to select solid companies that can withstand inflation and other economic risks." Francois Rochon, 2010

Prices are being Manipulated

The global central banks have become the price setter in the bond market. Having taken short rates to zero, for the first time in history, the global central banks sought to lower the long end of the curve by buying bonds. The endgame was to force investors into riskier assets, [e.g. junk bonds, equities, real estate], create a wealth effect, and stimulate the economy. This may very well be the biggest 'peg' in financial history. 

"While we are aware that debt markets can persist at zero or even modestly negative rates for a period of time, we believe it is best to make capital allocation decisions on the basis that fixed income securities will eventually trade where a fixed income investor would own them rather than where governments and fixed income traders will push them." Larry Robbins

Historic Underperformance

Earlier this century, only bonds were deemed a safe investment; equities were considered too speculative. As a result, bond yields were lower than the yields on common stocks.

"After the great market decline of 1929 to 1932, all common stocks were widely regarded as speculative by nature. A leading authority stated flatly that only bonds could be bought for investment." Benjamin Graham

This changed after the 1930's when it dawned on investors that stocks offered more upside than bonds, as the retained earnings after dividend payments could compound within the company... 

"To report what Edgar Lawrence Smith discovered, I will quote a legendary thinker - John Maynard Keynes, who in 1925 reviewed the book, thereby putting it on the map. In his review, Keynes described 'perhaps Mr. Smith's most important point ... and certainly his most novel point. Well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back in the business. Thus there is an element of compound interest (Keynes' italics) operating in favor of a sound industrial investment.

"It was that simple. It wasn't even news. People certainly knew that companies were not paying out 100% of their earnings. But investors hadn't thought through the implications of the point. Here, though, was this guy Smith saying, "Why do stocks typically outperform bonds? A major reason is that businesses retain earnings, with these going on to generate still more earnings--and dividends, too." Warren Buffett

“In the 1920s, a brilliant and important book by Edgar Smith, Common Stocks for Long-Term Investment, became a prime market influence. It was still popular in the fall of 1929, but most people read it too late. Mr. Smith advocated the benefit to corporate growth of the application of retained earnings and depreciation. Thus capital appreciates. The book may have been influential in changing accepted multiples of 10 x earnings to higher multiples of 20 to 30 x earnings."  Roy Neuberger

And outperform they did. Analysis by Professor Siegel of the Wharton School of Business highlights returns on several major classes of financial assets, including stocks and bonds, in the US during the past two hundred years. The figures are staggering. Long term bonds significantly under-performed stocks.

  Source: Li Lu's Lecture 'The Prospect of Value Investing in China'

Source: Li Lu's Lecture 'The Prospect of Value Investing in China'

"Here is the result: 1 US dollar in stocks, after discounting for inflation, experienced an appreciation of 1 million times the original value over the past 200 years! Its value today would be 1.03MN US dollars. Even the remainder of this number is bigger than the return on every other class of assets. What are the reasons behind such an astonishing performance? The answer lies in the power of compounding. The average annualized rate of return for stocks, discounting inflation, is only 6.7%. No wonder Einstein called compound interest the eighth wonder of the world." Li Lu

David Dreman's excellent book 'Contrarian Investment Strategies' contains a chapter titled 'An Investment for All Seasons' which states; "I will make clear, the crucial but little known fact that stocks are not a risky investment, if you hold them for a number of years... stocks also keep their value better than almost any other investment through hyperinflation and most other crises."



Dreman noted .. "Stocks outperformed T-bills 73% of the time for all five year periods between 1802 and 1996, 81% for ten year periods, 95% and 97% respectively for 20- and 30- year periods. The results after the war are better yet. For any five year period stocks outdistanced T-bills 82% of the time, and for any 20-year or 30-year period 100% of the time. The comparison with long bonds are nearly identical." David Dreman

  Source: Masterinvestor

Source: Masterinvestor

Mr Dreman concludes.. "the probability that the investor holding stocks will double her capital every 10 years after inflation, quadruple every 20, combined with 100% odd that she will outperform T-bills or government bonds in 20 years, can hardly be called risky. Conversely, the supposedly 'risk-free' assets actually display a large and increasing element of risk over time."

Mr Dreman is not alone. The Investment Masters recognise this ... 

"The S&P outperformed inflation, Treasury bills, and corporate bonds in every decade except the ‘70’s, and it outperformed Treasury bonds – supposedly the safest of all investments – in all four decades.  Sir John Templeton

"Stocks outperformed bonds, as Edgar Lawrence Smith, Irving Fisher, and John Maynard Keynes noted as far back as the twenties." David Dreman

"Practical experience demonstrates that stocks provide superior returns over reasonably long holding periods." David Swenson

"In spite of crashes, depressions, wars, recessions, ten different presidential administrations, and numerous changes in skirt lengths [for 60 years until 1987], stocks in general have paid off fifteen times as well as corporate bonds, and well over thirty times better than Treasury bills" Peter Lynch

"In the very long term, equities represent the best investment class." Francois Rochon

"Stocks have historically outperformed over moderate to longer periods by a significant amount." Ed Thorp

And that's likely to continue in the future.. 

"In the long run, a portfolio of well-chosen stocks and/or equity mutual funds will always outperform a portfolio of bonds or a money-market account. In the long run, a portfolio of poorly chosen stocks won't outperform the money left under the mattress." Peter Lynch

"The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities – Treasuries, for example – whose values have been tied to American currency. That was also true in the preceding half-century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century." Warren Buffett

Notwithstanding, there may be occasions where it makes sense to invest in bonds.  

"... though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable:  When bonds are calculated to be the more attractive investment, they should be bought."  Warren Buffett

The last time was back in the 1980's when bond yields peaked at 15% plus.

“We remember vividly 35 years ago staring at long-term impeccable bonds trading at 15% to 17% yields, thinking; “Why bother trading, hedging and knocking ourselves out? Why not just liquidate the whole portfolio and own these things and go on vacation for 10 years?” Paul Singer

“Anyone with a sense of contrarian mentality had to look at interest rates in the early 1980’s as presenting a potentially great opportunity. You knew the Fed would have to ease as soon as business started to run into trouble. In addition, we had already seen an important topping in the rate of inflation.”  Michael Steinhardt

"In 1981 the public should have seen Volcker's jacking up of short-term rates to 21 percent as a very positive move, which would bring down long-term inflation and push up bond and stock prices." Stanley Druckenmiller

"When I purchased long-term zero-coupon bonds in the early 1980's at market yields in excess of 13%, I welcomed the prospect of outsized volatility because I felt it would eventually work in my favour." Frank Martin

That's not the case today..

“It is possible that there could be a time where a wise investor could be all in treasuries. It is virtually impossible for me to see when. I guess I could imagine it, but I haven’t seen it. Long-term treasuries are a losing battle over the long pull.Charlie Munger, 2018

Warren Buffett once again espoused his thoughts in his most recent letter ...

"I want to quickly acknowledge that in any upcoming day, week or even year, stocks will be riskier – far riskier – than short-term U.S. bonds. As an investor’s investment horizon lengthens, however, a diversified portfolio of U.S. equities becomes progressively less risky than bonds, assuming that the stocks are purchased at a sensible multiple of earnings relative to then-prevailing interest rates.

It is a terrible mistake for investors with long-term horizons – among them, pension funds, college endowments and savings-minded individuals – to measure their investment “risk” by their portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk."

So let's wrap it up.. over the very long term, stocks have outperformed bonds by a significant margin. As an investor's holding period lengthens, the chances of a portfolio of quality businesses [low debt, good management, pricing power, etc.] purchased at reasonable prices outperforming a bond portfolio rises. Notwithstanding, if you require funds in the short term, or you can't stomach a large decline in the quoted prices of your portfolio of stocks, you probably shouldn't be investing in the stock market. With rates as close to zero as they've been in decades, today's bond market looks like a bubble to me. It's little wonder the world's greatest investors continue to favour quality businesses over bonds. Wouldn't you?





Further Reading:

David Dreman, 'Contrarian Investment Strategies' - Chapter 13/14 'An Investment for All Seasons'/'What is Risk?'

Peter Lynch, 'One up on Wall Street' - Chapter 3 'Is this Gambling or What'


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Chris Bloomstran - Annual Letter [Part II]

As I mentioned in my last post, Chris Bloomstran's latest letter is a very worthwhile read. Not only does it cover his views of the market's new breed of Super Investors, it also offers insights into the current market environment. And this is valuable to all of us. Hearing the views of someone with skin in the game and a long term track record of success is going to always offer more value than an analyst's perceptions.

Once again I hope you'll note the similarities between his insights and the Investment Masters Class tutorials. Below are his key points concerning recent market activity and his investment considerations ...

Time for caution?

"When smooth sailing is the forecast, it’s usually a good time for caution."

"When the herd stampedes, danger rises."

"Recent returns over the last several years have outpaced underlying fundamentals across nearly all asset classes"

Reversing the Fed's Balance Sheet

"We have no idea how this reversal in the Fed’s balance sheet plays out. The increase was unprecedented and so will be the reversal."

"Think about interest rate increases as the Fed reloading its pistol. You need ammo if you are going to a gun fight, and when rates were taken to zero, the Fed was out of bullets. It needs to reload to fight the next slowdown, and if rates are zero it has no bullets (that’s how we got QE)."

Bond Buyers?

"With the Fed, for now, no longer in the bond buying business, but rather net selling its debt holdings, who will lend needed capital to the US Treasury, especially if the deficit is growing? The answer can only be private investors, those same investors who were able to allocate capital to assets other than Treasuries when the Fed was scarfing up issuance."

"An investor in fixed income today is beginning a compounding stream with the curve at the mid-1% level on cash to under 3% at 30 years. A rising interest environment will penalise the owner of long-dated debt with price declines, the longer the maturity the more severe the decline. A sustained increase in rates will help by allowing for re-investment at higher yields, but an expectation of returns much above initial yields would be asking for a lot"

Rate Hikes and Recessions

"Every major stock market decline and every recession in the last 100 years was preceded by the Federal Reserve raising short term interest rates by enough to provide the pin to prick the balloon. Note the emphasis on every. Yes, there have been periods where the Fed raised rates and a recession didn’t ensue. Everyone knows the famous saw about the stock market having predicted nine of the past five recessions! That may be true, that rising rates don’t necessarily cause a recession. But as an investor you must be aware that every major stock market decline occurred on the heels of a tightening phase by the Fed. More importantly, there have been no substantive Fed tightening phases that did not end with a stock market decline."

The Importance of Price

"The price paid for an investment is a key determinant of outcome."

"The price paid is the initial bracketing endpoint in a compounding series. The same business at twice or thrice the price can’t be as nice."

Time Arb and Patience

"Time is generally required for investment decisions to bear fruit. We think it is a huge advantage to have the patience, and patient clients, to allow prices to ultimately reflect underlying fundamentals."

Dual Margin of Safety: Price and High Quality

"Our dual margin of safety approach combines high business quality with attractive price. One important aspect of business quality is a modest to reasonable use of debt in the capital structure."

Low Corporate Debt and Outperformance

"We believe the far more modest use of leverage [on balance sheets] is important in many ways and strongly has contributed to our outperformance during all bear markets and times of financial crisis over our two-decade existence. Included are the 2000-2002 and the 2008-2009 episodes, which shaved 50% and 65%, respectively, from the index."

"Low debt levels allow managements versatility on the capital front in times of crisis or distress. An unencumbered balance sheet can tolerate the addition of debt when opportunity presents itself."

Earnings Yield

"The inverse of the P/E is the earnings yield, and it’s one of the most important numbers in investing."

"Our core assumption over time, [is that] if we've assessed profitability properly, we should earn the earnings yield of the portfolio, not even allowing for future growth. In addition, we also expect to earn the closing of any discount to our appraisals of intrinsic value"

  Source: Semper Augustus 2017 Letter

Source: Semper Augustus 2017 Letter

Portfolio Analysis

"The stock portfolio is now priced at 13.7 times normalised earnings [versus 23.4X for the S&P500], giving us a 7.3% earnings yield, which becomes our new base case return expectation for a ten to fifteen year horizon."

"Our businesses possess a higher margin structure than the amalgamation of the businesses comprising the S&P500"

"As we survey the managements of the companies we own, we have never had a better roster of management teams"

"Our companies earn far more on their invested capital, which we think is a huge advantage. We also possess far higher EBIT on total capital invested."

"We have $73,000 in earnings power per $1 million working for us against $43,000 for the market. Our relative advantage is as great as it was at the last peak in 2000"

Buy-Backs and Incentives

"Captains of industry, who spend scant few years at the helm, on average, have little incentive to think long-term about return on capital when their horizon to get crazy rich spans the short-term. Stock buybacks, regardless how expensive, are a buy ticket. They reduce shares outstanding and are accretive to earnings per share, period. That they are made at absolute levels which drive profits properly measured downward is largely irrelevant."

Capital Allocation

"The reinvestment of retained earnings is one of the most important jobs of the managers of public companies that retain shareholder profit. Assessing how well they invest those retained profits is one of our most important jobs as investors."

Great Investors don't always Outperform

"The great track records are not produced in linear fashion, and are far from consistent. Outperforming over many market cycles is not done each year, or every three years, or five years, or ten years. There are long periods of underperformance that go with every outstanding track record. All the great investors have had clients leave them after periods of underperforming. Walter Schloss, who compiled one of the all-time brilliant track records, shrugged as he was losing clients in the late 1990’s because he was underperforming and wouldn’t give them the tech and internet exposure they felt they needed. He had seemingly “lost his touch” and was out of touch with modern thinking. Many that fired him had been clients for decades, having invested with him since the 1950’s and 1960’s. It must be expected that long term outperformance will come with durations of underperformance, perhaps as much as half of the time over short-term intervals. As the intervals lengthen, periods of underperforming recede. At the end of the day, we all know what happened with the tech bubble. It ended badly."

Acknowledging Fear

"How many investors do you know that sold everything in 1974, or 1987, or 2002, or 2009? We’ve met plenty. And of those, most have rushed back in, but only after sustained recoveries, when the appearance of risk has receded."

Recommended Books

"Ben Graham’s, The Intelligent Investor - the best investment book ever written for the lay person"

"Ben Graham and David Dodd’s Security Analysis is the bible for value investors."

Passing Investing

"A takeaway for those passively invested or index-hugging: It is very difficult making money when the price paid is high."

"The proportion of the stock market passively owned and flowing into passive investment strategies are at records. The concept of passive investing is simple, efficient and grounded in logic. However, a good idea taken to excess can produce a terrible outcome."

"An index holder owns the whole index – every component at the prevailing price, regardless of quality or price. No exclusions. We saw this picture show in the 1990’s and it ended badly. Money is funnelling into the largest of index components, pushing valuations and index weights to extremes. Risk is mounting in passive portfolios, and it’s largely of the passive investor’s own making."

"Large flows [from indexing] can impart a momentum effect, driving narrowing prices in certain assets higher. Often, those allocating capital don’t even realize they are contributing to momentum-induced returns. Many are simply reacting to a fear or envy of not having an allocation in microcaps in countries beginning with Z, especially if all the other kids are already there and making money. The mindset breeds mediocrity at best, and ultimately can be a dangerous thing."

"If we owned the S&P 500 we’d probably be ill from watching companies squander capital. We’d own companies with aggressive accounting that write down assets to boost returns on equity and capital. We’d have shares being bought at prices that we would never pay. We’d own businesses with huge unfunded pension funds that have little chance to earn enough on their plan assets to fund plan liabilities. We’d own companies that exclude one legitimate expense after another from their “pro-forma” or “adjusted” earning presentations. No thanks."

"Mr. Buffett has made clarifying remarks about his advice regarding indexing and passive investing. He duly notes that outperformance can’t be accomplished without certain elements. It requires devoted work and proper wiring, which involves a willingness to deviate from the herd or the crowd. Outside of a value-based approach, there aren’t approaches that have the right orientation."

"As money moves from ETF to ETF, somebody is making an active decision with passive investments. You could make the case that flows to the ETF world are done with less, or little, concern for valuation, with no attempt to capture a disparity that may exist between price and underlying value."

"At what point does the growing proportion of indexed assets become dangerous? The S&P 500 as a proportion of the stock market is far more concentrated now than at any time. Some of the increase is surely the result of mergers and acquisitions. But the degree is concerning. Also, as the index marches higher, it attracts more capital and the momentum drives prices up far faster than underlying value, at a point making it impossible for future results to come close to anything reasonable or expected."

"Recall the logic, or lack of, that for every $100 invested, $3.80 must now go to Apple shares. $2.90 must be allocated to Microsoft. Amazon gets two bucks, Facebook a buck eighty, and so on. It does not matter the price to value. It does not matter if the business will go bankrupt. If it’s in the index you must own it, in the proportion at which it exists. The more money gravitates to the index, away from other pools or strategies, the higher the largest components will rise. Somewhere between then and now, the amount of momentum-induced concentrated risk rises. At a point, prices are no longer reflective of fundamentals. To a passive investor, it matters not. It matters quite a bit to us, however, and it presents opportunity."

"Large cap active investors have been replaced en masse with a passive approach."

"Words can't do justice to the degree to which passive investing is now in an epic bubble, with money funnelling into a narrow group of names. Behold the insanity... Wow, I would never have guessed that passive index flows could create this kind of unnatural disparity across every major equity index! [see table below]"

  Source: Semper Augustus 2017 Letter

Source: Semper Augustus 2017 Letter

"Capital allocators keep feeding the fat kid"

"Money is pushing the largest even higher and it likely doesn't correlate to underlying fundamentals. It's flow, baby"

  Source: Semper Augustus 2017 Letter

Source: Semper Augustus 2017 Letter

"We don’t know when the situation will reverse itself. If you believed flows to passive funds and strategies would continue to run, why not just own the five biggest components of each index? Had you done that in 2017, you would have looked like a genius. When the flows finally reverse course, the money invested in passive portfolios is going to get hurt."

"Capitalizing on opportunity requires thought, which can’t be done with software allocating $3.80 of every dollar invested to Apple because that happens to be its weight in an index."

"Passive investing is done with computers allocating capital based on component size in an index. Attention is not paid to business quality, and a rising price attracts more capital. It can be a self-fulfilling phenomenon, until flows reverse. Investing as we know it requires thought, experience, patience and reason. Too much active investing is done poorly.

Chris has identified many important aspects in his commentary that should provide valuable insight to us all.  Whether its the history of Fed hikes, the evolving status of central bank balance sheets, the comparisons of the similarities between the tech bubble and today, or any of his other perceptions, all should go a long way to assisting you to look at your own investment activity with a little more knowledge. And that can't hurt, right? 


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Learning from Einstein

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In my post on Leonardo DaVinci, I spoke about the man's defining success characteristic - curiousity. Despite his multi-disciplinary genius and innovative mindset, his natural curiousity set him apart in his time and allowed him to develop skills and ideas that still shape the world 500 years later.

But he was not alone.

We know that successful investing requires a curious mind, a multi-disciplinary approach and an ability to see what others can't. The same characteristics that defined DaVinci also are encompassed in Albert Einstein, who was eloquently described by Walter Isaacson as 'the most thoughtful wonderer who appeared among us in three centuries.' It's little wonder many of the Investment Masters admire Albert Einstein, and that they have spent time studying his characteristics and processes as an aid to better thinking and more successful investing.

"To me, heroes were people like Albert Schweitzer, Albert Einstein, and David Ben-Gurion, none of whom was rich but each of whom had enriched the world." Michael Steinhardt

"For Einstein simplicity was simply then the highest level of intellect. Everything about Warren Buffett's investment style is simple. It is the thinkers like Einstein and Buffett, who fixate on simplicity, who triumph." Mohnish Pabrai

"One of my favourite books is 'Einstein's Mistakes' ... Provide people with as much exposure as possible to what’s going on around them. Allowing people direct access lets them form their own views and greatly enhances accuracy and the pursuit of truth." Ray Dalio

"There are many historical figures that I admire greatly. Newton, Einstein, and Darwin among them." Ed Thorp

"I read scientific biography as a permanent, lifelong habit. That has given me insight into how the scientific achievements have occurred. The most interesting man to me is Einstein. Einstein came very close to dying in total obscurity. If it had not been for his friends, his pals with whom he discussed physics he never would have gotten the job in the patent office that enabled him to survive in life at a time when he was failing. If he had not had people to talk to about physics he would not have been able to make his discoveries. He got a reputation for being alone, but he wasn’t totally alone. Even Einstein needed to talk to other people who knew a lot about physics." Charlie Munger

"Visionaries are not people who see things that are not there, but who see things that others do not see. As Einstein quipped, "Why do some people see the unseen?" (It should be noted that Einstein's 'thought experiences' were frequently visual)." Bennett Goodspeed

“I admit that I have always harbored an exaggerated view of my self-importance—to put it bluntly, I  fancied myself as some kind of god or an economic reformer like Keynes (each with his General Theory) or, even better, a scientist like Einstein" George Soros

I always enjoy reading those books recommended by the Investment Masters and Walter Isaacson's biographies are regular fare. Ray Dalio, in his recently released book 'Principles' shares his endeavors to learn more about the people he considered 'shapers.' These are people whom he defines as, 'a person who comes up with unique and valuable visions and builds them out beautifully, typically over the doubts and opposition of others.' Examples Dalio cites include Jeff Bezos, Elon Musk, Steve Jobs, Lee Kuan Yew, Andrew Carnegie, Einstein, Darwin et al.

After reading Isaacson's book on Steve Jobs, Dalio sought out Isaacson to help understand Steve Job's qualities and principles in an attempt to form an archetype of a typical 'shaper.' Dalio explains, "I started by exploring the qualities of Jobs and other shapers with Isaacson, at first in a private conversation in his office, and later at a public forum at Bridgewater. Since Isaacson had also written biographies of Albert Einstein and Ben Franklin - two other great shapers - I read them and probed him about them to try to glean what characteristics they had in common."

I've included some of my favourite excerpts from Isaacson's 'Einstein - His Life and Universe' below...

"In 1915, he [Einstein] wrestled from nature his crowning glory, one of the most beautiful theories in all of science, the general theory of relativity. As with the special theory, his thinking had evolved through thought experiments." 

"[Einstein] was comfortable not conforming. Independent in his thinking, he was driven by an imagination that broke from the confines of conventional wisdom."

[Einstein] made imaginative leaps and discerned great principles through thought experiments rather than by methodical inductions based on experimental data"

"As a young student he never did well with rote learning. And later as a theorist, his success came not from the brute strength of his mental processing power but from his imagination and creativity."

"He was very uncomfortable in school. He found the style of teaching - rote drills, impatience with questioning - to be repugnant."


"[Einstein said] 'The value of a college education is not the learning of many facts but the training of the mind to think.'"

"Skepticism and a resistance to received wisdom became a hallmark of his life."

'Einstein once explained, 'The ordinary adult never bothers his head about the problems of space and time. These are things he had thought of as a child. But I developed so slowly that I began to wonder about space and time only when I was already grown up. Consequently, I have probed more deeply into the problem that an ordinary child would have.'"

"[Einstein] wrote a friend in later life: 'We never cease to stand like curious children before the great mystery into which we were born."

"[Einstein] generally preferred to think in pictures, most notably in famous thought experiments, such as watching lightning strikes from a moving train or experiencing gravity while inside an elevator. 'I rarely think in words at all', he later told a psychologist."

"The visual understanding of concepts .. became a significant aspect of Einstein's genius"

"[Einstein's] visual imagination allowed him to make the conceptional leaps that eluded more traditional thinkers"

"His success came from questioning conventional wisdom, challenging authority, and marveling at mysteries that struck others as mundane."

"[Einstein's] view of maths and physics as well as of Mozart, 'like all great beauty, his music was pure simplicity'."

"Throughout his life, Albert Einstein would retain the intuition and the awe of a child. He never lost his sense of wonder at the magic of nature's phenomena - magnetic fields, gravity, inertia, acceleration, light beams - which grown-ups find so commonplace."

"'A new idea comes suddenly and in a rather intuitive way,' Einstein once said."

"Einsteins's discovery of special relativity involved an intuition based on a decade of intellectual as well as personal experiences."

"He postulates grand theories while minimising the role played by data ... he described his approach .. 'The truly great advances in our understanding of nature originated in a way almost diametrically opposed to induction. The intuitive grasp of the essentials of a large complex of facts leads the scientist to the postulation of a hypothetical basic law or laws. From these laws, he derives his conclusions.'"

"Einstein invited Saint-John Perse to Princeton to find out how the poet worked. 'How does the idea of a poem come?' Einstein asked. The poet spoke of the role played by intuition and imagination. 'It's the same for a man of science,' Einstein responded with delight. 'It is a sudden illumination, almost a rapture. Later, to be sure, intelligence analyses and experiments confirm or validate the intuition. But initially there is a great forward leap of the imagination.'"

"There was a link between his [Einstein's] creativity and his willingness to defy authority. He had no sentimental attachment to the old order, thus was energised by upending it."

"Among many surprising things about the life of Albert Einstein was the trouble he had in getting an academic job."

"Einstein believed there was 'a definite connection between the knowledge acquired at the patent office and the theoretical results.'"

"[Poincare spoke of Einstein, noting he] 'adapts himself to new concepts. He does not remain attached to classical principles, and, when presented with a problem in physics, is prompt to envision all the possibilities.'"

"Although he was tenacious, he was not mindlessly stubborn. When he finally decided his 'Entswurf' approach was untenable, he was willing to abandon it abruptly."

"Like a good scientist, Einstein could change his attitudes when confronted with new evidence."

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"For a scientist, altering your doctrines when the facts change is not a sign of weakness."

"For a scientist to change his philosophical beliefs so fundamentally is rare."

"When shown his office [at Princeton], he was asked what equipment he might need. 'A desk or table, a chair, paper and pencils," he replied. "Oh yes, and a large wastebasket, so I can throw away all my mistakes."

"His life was a constant quest for unifying theories."


"When excited discussion failed to break the deadlock, Einstein would quietly say in his quaint English, 'I will a little tink.'"

"Einstein proclaimed 'Blind respect for authority is the greatest enemy of truth.'" 

"[Einstein] had an urge - indeed, a compulsion, to unify concepts from different branches of physics. 'It is a glorious feeling to discover the unity of a set of phenomena that seem at first to be completely separate' he wrote."

"The wariness of authority reflected the most fundamental of all Einstein's moral principles: Freedom and individualism are necessary for creativity and imagination to flourish."

"Creativity requires a willingness not to conform. That required nurturing free minds and free spirits, which in turn required a 'spirit of tolerance', And the underpinning of tolerance was humility - the belief that no one had the right to impose ideas and beliefs on others."

"[Einstein's] mind and soul were tempered by this humility. He could be serenely self-confident in his lonely course yet also humbly awed by the beauty of nature's handiwork."

"How did he get his ideas? 'I'm enough of an artist to draw freely on my imagination. Imagination is more important than knowledge. Knowledge is limited. Imaginations encircles the world.'"

"Simplicity and unity, he believed, were hallmarks of the Old One's handiwork. 'A theory is more impressive the greater the simplicity of its premises, the more different things it relates, and the more expanded its area of applicability' he wrote."

'[Einstein said] 'I simply enjoy giving more than receiving in every respect, do not take myself nor the doings of the masses seriously, am not ashamed of my weaknesses and vices, and naturally take things as they come with equanimity and humour."

"As he put it near the end of his life, "I have no special talents: I am only passionately curious." 

And a few of my favorite quotes ... 

"The intuitive mind is a sacred gift and the rational mind is a faithful servant. We have created a society that honors the servant and has forgotten the gift." Albert Einstein

“Don’t think about why you question, simply don’t stop questioning. Don’t worry about what you can’t answer, and don’t try to explain what you can’t know. Curiosity is its own reason. Aren’t you in awe when you contemplate the mysteries of eternity, of life, of the marvelous structure behind reality? And this is the miracle of the human mind—to use its constructions, concepts, and formulas as tools to explain what man sees, feels and touches. Try to comprehend a little more each day. Have holy curiosity.” Albert Einstein

"Life is like riding a bicycle. To keep your balance you must keep moving." Albert Einstein

Like many of the individual Investment Masters, Einstein's genius stems from those same traits that define so many of the Investment and Business success stories of both our time and history. Challenging conventional wisdom and rational thought, non conformism, humility, independent thinking, intuition above induction, adopting a multi-disciplinary mindset, learning from mistakes and indeed, happily abandoning the ideas he knew were wrong; creativity and imagination and of course, curiosity. These traits allowed Einstein, like so few others, to see what others couldn't and to develop insights that have helped shape our world. Despite knowing all this, you don't need to be 'Einstein' to be successful in the world of Investing. These traits can be found in many ordinary people and the smartest people out there aren't necessarily good at investing. Remember: Imagination is more important than knowledge... 


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Christopher Bloomstran: The New Super Investors

I always enjoy reading the letters of investment managers with long term records of success; whether it's a new investment idea or perhaps a new ways of thinking about the economy, markets, psychology, risk or market history, there is always something to learn. Give me a letter from a practitioner with skin-in-the-game over a Wall Street analyst any day of the week.

And Christopher Bloomstran's are no exception.

Christopher Bloomstran founded his firm Semper Augustus Investments in late 1998, toward the peak of the internet bubble. He named the firm Semper Augustus after the most rare and valuable of the high-end tulips during the Tulip mania.

Bloomstran's 2017 Annual Letter, is a fascinating 44 page journey through the current market environment. There are two key areas of learning within its pages. Firstly, as it wades through Bloomstran's perceptions of the market, it compares the similarities between the tech bubble and today, provides insights into the history of Fed hikes, delves into the evolving status of central bank balance sheets, ponders the implications of the transition away from quantitative easing, and provides metrics delineating the Semper Augustus portfolio with the S&P500. It also highlights the trends and risks in passive investing. Secondly, and for me the most enjoyable section of the letter, it identifies the common threads that run through what Bloomstran refers to as, the New Super Investors.

Given its size and the amount of territory it covers, I've decided to split his letter into those two areas and therefore two separate posts - the current market environment, and the topic for this post; the New Super Investors.

The New Super Investors

One of the things that should strike you almost immediately is the striking parallels between the characteristics and traits Chris identifies of these Super Investors, and the topics contained in the Investment Masters Class tutorials.

"It’s not the nuts and bolts that go into a track record that matter. It’s the people behind the record. The light finally went on once real thought went into identifying the commonality between these investors and friends."

It’s not why they own a certain company or even how high is too high a price to pay for an outstanding business. The single common thread shared by the very best investors in our circle is a love of and passion for business analysis. Ours is not a business but a profession, and the best live, breathe and eat it. Understanding a business is like a solving a puzzle. They are curious. They are also deeply devoted to their families and live moral and ethical lives. Knowing them is a privilege. In thinking about them collectively, those who would be perfectly suited at managing our families’ capital if we couldn’t do it, what they earned over the last one, three or five years is irrelevant. Each should outperform markets over the very long haul, but that’s not what’s relevant either. It’s the threads regarding character and philosophy that count, with character being by far the most important.

On Character: Every outstanding investor we know is humble. The investment business teaches it, as does life. At the same time, each is happy and successful.

An ability to admit and know when they are wrong. Investing provides plenty of mistakes to be made and to learn from. Mistakes learned from lead to confidence. Confidence can only be earned through failure. The best freely discuss mistakes and use them as lessons.

All have an insatiable desire to learn, and a high work ethic. Intellectual curiosity is hard wired.

It’s never a job and there is no time clock. Some snuck in annual reports on honeymoons (not advice for you young guys who haven’t yet been initiated to the bliss of marriage). Some friends would lay on the floor reading company filings by the tub as their toddlers bathed.

Many had a chip on their shoulder. Each wanted a better life and independence from worries about money.

Perhaps it’s the nature of our small corner of the value world but everyone is extremely collegial and nice.

Willingness to teach and give back for the gifts of wisdom learned from others is a common thread.

Contrarianism. When it matters, not for the sake of it.

Extreme patience.

Independence of thought. This goes hand in hand with contrarianism. None are hindered by large group think or decision by committee. Even in larger groups, the individual is allowed autonomy of process and thought. In fact, some of the very best investors work together in partnership with like-minded peers and as a group are collectively outstanding.

On Philosophy: All possess a core belief that a disparity can exist between price and value. It’s the key concept of value investing. Price matters greatly. The best are disciplined on both business quality and price. Growth is a part of the value equation and the price paid for it matters. The investment process to each is consistent, repeatable, easily understood and explained, and is a competitive advantage.

Risk is a permanent loss of capital. It’s not the volatility of price. Price volatility simply creates opportunity at times when price and value are disparate. The best I know spend far more time worrying and thinking about what can go wrong than modeling what will go right. Without a deep understanding of the downside, even of the unfathomable, conviction and concentration can be dangerous to disastrous.

Each own concentrated stock portfolios in deeply understood businesses, with high conviction about the business and its value. Without the appreciation of risk, however, these unique aspects of great investing can become the Achilles heel of value investing. We see too many young bucks wanting to build a track record in three years, swinging for the fences in only a few extremely concentrated ideas. Stewardship isn’t on the radar. When the unanticipated comes along, and we’ve seen it with the young and inexperienced as well as with the seasoned, big bets that weren’t well thought out or that misunderstood risk that was there all along, can produce disaster. The best investors understand diversification but know when it’s too much, and when it’s not enough. None are index huggers, it would be anathema to their belief system. None are concerned about having investments across multiple or all sectors. But they all appreciate risk.

Unconstrained. You don’t know where the next opportunity will come from, you have the capability to research and understand it, and you have the mandate to invest in it. Those that are boxed into certain segments invariably must invest in those segments, even if the entire segment is uninvestable from a business quality or price standpoint. We know very good industry analysts that wouldn’t make for good investors.

Not managing too much money. Many have stopped taking new assets or clients on. An ability to buy smaller cap and mid-sized businesses in meaningful enough size when value exists in smaller names is important to the best we know. One of the silliest things seen is the investor who must sell an outstanding business that has grown too large for his “mandate.” Size is an anchor, but so is too little time. Knowing if you are being pulled in too many directions is a common issue and the best understand and deal accordingly with it. Time for reading and thinking is a necessity and the best guard it well.

Every outstanding investor we know lives in the footnotes. Deep research on individual companies is in their DNA, and it’s a never-ending process. Business changes, risks that didn’t exist appear, sometimes slowly and sometimes suddenly. At the same time, however, living in the footnotes isn’t done so deeply that you get so bogged down in an irrelevant data point that you miss the Mack truck barreling full speed right at you.

Patient temperament that results in low portfolio turnover. Active management shouldn’t require activity. Until you own businesses whose share prices grow to three, five, ten times your original investment, you don’t really have an appreciation for compounding. Time is the arbiter of value, and when you have businesses that grow, and those that don’t, only then, over the passage of time, can you truly understand the drivers of compounding. It’s all right there in a discounted cash flow formula, but until you live and breathe it, I don’t think you can understand or appreciate it. Investors that buy and sell all the time, thinking high levels of activity add value, don’t allow themselves to learn the nature of compounding. All great investors we know have companies in their portfolios that have compounded for years.

Expanding on the last point, by owning businesses that have compounded for years, an appreciation for growth and what growth is worth is a common characteristic. Mr. Munger talks about Mr. Buffett’s evolution as an investor. We see it in the businesses our contemporaries have owned for years and decades. Cash is another anchor, and held too long drags returns downward. Holding cash for long periods of time doesn’t help. We’ve never seen it help others. It certainly hasn’t helped us. Allowing cash to accumulate briefly as part of the investment process can be necessary to the process. When it happens, it should be during the rare times of very high market overvaluation. The opportunity cost of waiting around for years for prices to fall is an expensive one, particularly when cash yields are far below available earnings yields.

Aware of one’s circle of competence. This comes with the humility listed first that we see every day in the best investors, and it also comes with having made mistakes by treading too far outside the circle. Universally, mistakes aren’t brushed under the rug but they are studied and used as teaching tools or reminders. The passion for the business and the amount of ongoing learning that goes on works to expand the circle over time.

Act like business owners. No one thinks about stocks without thinking about owning the business first.

Investing is a profession, not so much a business. They don’t invest using different “strategies”. Investing is not a strategy but a philosophy. Some do have multiple “products” and make it work, but the core research process is the same. The very best don’t have teams covering myriad sectors or caps or regions. The best groups are made up of generalists, and the investment philosophy is universally shared. There is a sacrifice involved in investing well, and it often results in fewer assets managed. You can’t be all things to all people and you can’t serve multiple masters, and they don’t.

Expectation of underperformance, even for many years. Intelligent allocation of capital takes time to work. Good investors understand this, and don’t think in the same time intervals as many who allocate capital to them for management. It’s an enigma of the investment world. Too often, when periods of underperformance create doubt, both from within and from the outside, the temptation exists to change from what is seemingly not working, not producing relative results, for what apparently is. Those who understand why what they do works over time don’t change philosophy and do develop the ability to deal with and address the doubts. It often requires the ability to communicate well.

Whether working individually or as a group, a culture of excellence and stewardship exists. Compensation and ownership is structured logically and avoids any motivation to behave badly.

Much more could be added to these common threads of character and philosophy, only because we are blessed to know some outstanding human beings. Life is easy when the people around you are extraordinary. Whether in the investing arena or at home with family, life is a joy thanks to people that make it that way. The motivation for discussing the commonalities among the great investors and friends we have the privilege of sharing the arena with wasn’t to let you know we have the succession planning box checked. We do, but that’s not it. We wanted to highlight the characteristics of active investors that do it right and who understand risk deeply. With the capital allocation world pouring money into passive strategies, there is going to be a reminder that risk is a four-letter world. The logic behind indexing makes perfect sense, but its overuse today is likely going to harm a lot of people.

It really is no surprise to me that Chris also recognises these success traits among both the Investment Masters and the new Super Investors. Time and time again we see the similarities that exist in all of these people, even as we notice their tremendous track records.

Chris' letter also contains a significant amount of insight into the current market environment and his portfolio characteristics that we will cover in our next post.


Further Reading:
'100 Common Threads of the Investment Masters' Investment Masters Class

Follow us on Twitter: @mastersinvest


Learning from Benoit Mandelbrot

If you've been reading some of my recent posts, you will have noted my, and the Investment Masters belief, that many of the investment theories taught in most business schools are flawed. And they can be dangerous too, the recent Financial Crisis is evidence of as much. One man who, prior to the Financial Crisis, issued a challenge to regulators including the Federal Reserve Chairman Alan Greenspan, to recognise these flaws and develop more realistic risk models was Benoit Mandelbrot.

Over the years I've read a lot of investment books, and the name Benoit Mandelbrot comes up from time to time. I recently finished his book 'The (Mis)Behaviour of Markets - A Fractal View of Risk, Ruin and Reward'

So who was Benoit Mandelbrot, why is he famous, and what can we learn from him?

Benoit Mandelbrot was a Polish-born mathematician and polymath, a Sterling Professor of Mathematical Sciences at Yale University and IBM Fellow Emeritus (Physics) who developed a new branch of mathematics known as 'Fractal' geometry.  This geometry recognises the hidden order in the seemingly disordered, the plan in the unplanned, the regular pattern in the irregularity and roughness of nature. It has been successfully applied to the natural sciences helping model weather, study river flows, analyse brainwaves and seismic tremors. 

A 'fractal' is defined as a rough or fragmented shape that can be split into parts, each of which is at least a close approximation of its original-self. In nature, think of clouds, mountains, trees, ferns, river networks, broccoli, or cauliflower. Nassim Nicholas Taleb, who dedicated his best-selling book, 'Black Swan' to Mandelbrot, explains "This character of self-affinity implies that one deceptively short and simple rule of iteration can be used, whether by a computer or, more randomly, by Mother Nature, to build shapes of seemingly great complexity.

When it comes to the stock market and fractals, think of hourly, daily, weekly, monthly or yearly stock price moves. Remove the x-axis labelled 'time', and they all looks pretty much alike. 

 Source: J SHEI

Source: J SHEI

Mandelbrot found that the underlying power law that was evident in random patterns in nature also applies to the positive and negative price movements of many financial instruments. The movement of stock prices followed a power law rather than a 'Bell', 'Gaussian' curve or 'Normal Distribution'.

"In the 1960's a maverick mathematician named Benoit Mandelbrot argued the tails of the distribution might be fatter than the normal bell curve assumed; and Eugene Fama, the father of efficient-market theory who got to know Mandelbrot at the time, conducted tests on stock prices changes that confirmed Mandelbrot's assertion. If price changes had been normally distributed, jumps greater than five standard deviations should have shown up in a daily price data about once every seven thousand years. Instead, they cropped up about once every three to four years." Sebastian Mallaby, 'More Money than God.'

While Mandelbrot's theory won't help us predict where a stock or commodity price is going or help us value a company, it can help us extract an element of order from the randomness of markets. It can also help us better understand and recognise risk - a prerequisite for successful investing. 

"The value of the great Benoit Mandelbrot's work lies more in telling us that there is a 'wild' type of randomness of which we will never know much (owing to their unstable properties.)" Nassim Nicholas Taleb

The essence of investment management is the management of risks, not the management of returns. Well-managed portfolios start with this precept.”  Benjamin Graham

"A thoughtful investment approach focuses at least as much on risk as on return. But in the moment-by-moment frenzy of the markets, all the pressure is on generating returns, risk be damned." Seth Klarman

"Above all, we think vigilance towards risk is central to solid investment returns" Allan Mecham

Today, the Investment Masters recognise the traditional model, a core component of business school curricula, is flawed.  It has the propensity to significantly underestimate the probability of extreme volatility, known as tail events, that can lead to the permanent loss of capital.

"Things like Gaussian curves and Value at Risk (VAR) were some of the dumbest ideas ever put forward." Charlie Munger

"The idea that you have a bell-shaped curve is false. You have outlying phenomena that you can't anticipate on the basis of previous experience." George Soros

"I think we pay more respect to the tails of the bell curve than most funds do: we tend to be at the tighter end of the spectrum." Israel Englander

 "The devil is in the residuals, as all of us have discovered to our sorrow." Howard Marks

"Extreme events are where ruin is found. It's also true that these extreme changes in securities prices may be much greater than you would expect from the Gaussian or normal statistics commonly used." Ed Thorp

"I discovered along the way that the economists and social scientists were almost always applying the wrong maths to the problems, what became later the theme of the Black Swan. Their statistical tools were not just wrong, they were outrageously wrong - they still are. Their methods underestimated "tail events," those rare but consequential jumps. They were too arrogant to accept it.  This discovery allowed me to achieve financial independence in my twenties, after the crash of 1987."  Nassim Nicholas Taleb

 Source: Paul D Kaplan, 'Beyond the Bell Curve'

Source: Paul D Kaplan, 'Beyond the Bell Curve'

While I've long recognised the flaws in the 'bell curve' and witnessed them on an almost daily basis, I found the book a useful construct to help think about volatility and market risk. Benoit's book decimates the notion of a normal distribution of stock price changes and all of the models that rely on it: the efficient-market hypothesis, CAPM, Value at Risk [VAR] etc. 

Below I've included some of my favourite quotes from the book ..

"I am not a Luther fomenting schism in the Church. I am an Erasmus who, through study, reason, and good humour, tries to talk some sense. My aim; to change the way people think, so that reform may go forward." 

"My life's work has been to develop a new mathematical tool to add to man's small survival kit."

"Since my youth I have been shamelessly disrespectful of received wisdom."

"My understanding of economics comes not from abstract theory, but from observation."

"Keep it simple is the catchphrase of good models."

"Contrary to orthodoxy, price changes are very far from following the bell curve."

"Examine price records more closely, and you typically find a different kind of distribution than the bell curve. The tails do not become imperceptible but follow a 'power law.'"

"If price changes scale, the overhang can be catastrophic. Once you are riding out on the far ends of a scaling probability curve, the journey gets very rough."

"Periods of big price changes groups together, interspersed by intervals of more sedate variation - the tell tale marks of long memory and persistence. It shows scaling."

"The very heart of finance is fractal."

"The market is very risky - far more risky than if you blithely assume that prices meander around a polite Gaussian average."

"Market turbulence tends to cluster. This is no surprise to an experienced trader. They also know that is in those wildest moments - the rare but recurring crisis of the financial world - where the biggest fortunes of Wall Street are made and lost. They need no economists to tell them this. But their intuition is entirely validated by the multi-fractal model."

"Large price changes tend to be followed by more large price changes, positive or negative. Small changes tend to be followed by more small changes. Volatility clusters."

"That cotton prices should vary the way income does [ie. to a power law]; that income variations should look like Swedish fire insurance claims, that these, in turn, are in the same mathematical family as formulae describing the way we speak, or how earthquakes happen - this is, truly, the greatest mystery of all."

"Greater knowledge of danger permits greater safety. For centuries, shipbuilders have put care into the design of their hulls and sails. They know that, in most cases, the sea is moderate. But they also know that typhoons arise and hurricanes happen. They design not just for the 95% of sailing days when the weather is clement, but also for the other 5%, when storms blow and their skill is tested. The financiers and investors of the world are, at the moment, like mariners who heed no weather warnings. This book is such a warning."

"Why does the old order continue? Habit and convenience. The math is, at bottom is easy and can be made to look impressive, inscrutable to all but the rocket scientist Business schools around the world who keep teaching it."

"Real markets are wild. Their price fluctuations can be hair-raising - far greater and more damaging than the mild variations of orthodox finance. That means that individual stocks and currencies are riskier than normally assumed. It means that stock portfolios are being put together incorrectly; far from managing risk, they may be magnifying it. It means that some trading strategies are misguided, and options mis-priced. Anywhere the bell curve assumption enters the financial calculations, an error can come out."

"Markets are turbulent, deceptive, prone to bubbles, infested by false trends. It may well be that you cannot forecast prices. But evaluating risk is another matter entirely."

"Most financial models say little with much. They input endless data, require many parameters, take long calculation. When they fail, by losing money, they are seldom thrown away as a bad start. Rather, they are 'fixed'. They are amended, qualified, particularised, expanded and complicated. Bit by bit, from a bad seed a big but sickly tree is built, with glue, nails, screws and scaffolding. That people still lose money on these models should come as no great surprise."

"Whether guide or master, modern portfolio theory bases everything on the conventional market assumptions that prices vary mildly, independently, and smoothly from one moment to the next. If those assumptions are wrong, everything falls apart; rather than a carefully tuned profit engine, your portfolio may actually be a dangerous, careening rattletrap."

"The same false assumptions that underestimates stock-market risk, mis-price options, build bad portfolios, and generally misconstrue the financial world are also built into the standard risk software used by many of the world's banks. The method is called Value at Risk."

"Finance today is in the primitive state of natural history three centuries ago. Its concepts and tools are limited, and so it frequently confounds species."

"I am not yet finished; nor do I believe we are ever to have a perfect understanding of so complex a system as the global money machine. In economics, there can never be a "theory of everything." But I believe each attempt comes closer to a proper understanding of how markets behave."

Within Mandelbrot's book lies many truisms of the market, with one of the most recurring themes being that traditional business school financial models are quite simply, wrong. Mr Market does not play ball the way we would all like, nor does it conventionally follow the gentle line of a Gaussian Curve. Mandelbrot's genius lies in the fact that he has observed the markets over a long time, and using similar thought patterns to other Investment Masters, has been able to see what others haven't or wouldn't. What he teaches is to look beyond the obvious and the common; from chaos one can find order and from order one can find chaos. How visual complexity can be created from simple rules and that it is dangerous to blindly follow false assumptions. Mandelbrot is a genius and his learning is another gift to us all.

Further Reading:
Investment Masters Class Tutorial 'Efficient Market Hypothesis'
Investment Masters Class Tutorial 'Value at Risk'

Buffett's Annual Letter - 2017

Screen Shot 2018-02-25 at 6.10.48 PM.png

Warren Buffett's annual Berkshire Hathaway letter was released after the market closed on Friday. Like a lot of things Buffett, this is unconventional. Buffett wants to ensure analysts and his investors, or 'partners' as he considers them, have ample time to study the letter before trading re-commences Monday. 

Buffett's genius is not only his stock picking ability, business acumen and all-round investing prowess, but his communication skills. In his annual letters, Buffett talks to the average layperson, often conveying complex issues with both clarity and humour.

"Do not try to impress by big words. Impress by the clarity of your ideas." Lee Kuan Yew
"The definition of genius is taking the complex and making it simple." Albert Einstein

A year or so ago I took the time to read all of the Berkshire Letters, beginning to end. I found so many nuggets of wisdom - which formed part of a series of posts I wrote titled 'The Buffett Series' . 

It continues to amaze me that so few business schools spend the time to study the lessons of arguably the world's greatest investor. These lessons are a gift to investors.

"I think almost anybody can draw [on the] lessons from Warren’s achievement at Berkshire. The interesting thing is you could go to the top business schools and none are studying and teaching what Warren has done." Charlie Munger
"The fact that everyone who cares about business and finance can benefit from his wisdom - just by reading his annual letters - is pretty amazing" Bill Gates

Once again Buffett this year lays out in simple terms how Berkshire performed over the past year, provides some insights into the environment, and enlightens us with some investment guidance.

So let's take a quick look at this year's letter ....

Buffett's 2017 Gain in Book Value was 23%, Berkshire Market Value gain 21.9%, S&P500 21.8%.

"Berkshire’s gain in net worth during 2017 was $65.3 billion, which increased the per-share book value of both our Class A and Class B stock by 23%. Over the last 53 years (that is, since present management took over), per share book value has grown from $19 to $211,750, a rate of 19.1% compounded annually"

Buffett notes prices of Stand-Alone Business are at an all-time high ....

"In our search for new stand-alone businesses, the key qualities we seek are durable competitive strengths; able and high-grade management; good returns on the net tangible assets required to operate the business; opportunities for internal growth at attractive returns; and, finally, a sensible purchase price

That last requirement proved a barrier to virtually all deals we reviewed in 2017, as prices for decent, but far from spectacular, businesses hit an all-time high. Indeed, price seemed almost irrelevant to an army of optimistic purchasers."

"The ample availability of extraordinarily cheap debt in 2017 further fuelled purchase activity [by competitors]. After all, even a high-priced deal will usually boost per-share earnings if it is debt-financed."

"If the historical performance of the target falls short of validating its acquisition, large “synergies” will be forecast. Spreadsheets never disappoint."

"We also never factor in, nor do we often find, synergies." 

On Insurance Float ..

"Unlike bank deposits or life insurance policies containing surrender options, p/c float can’t be withdrawn. This means that p/c companies can’t experience massive “runs” in times of widespread financial stress, a characteristic of prime importance to Berkshire that we factor into our investment decisions."

"The downside of float is that it comes with risk, sometimes oceans of risk. What looks predictable in insurance can be anything but. Take the famous Lloyds insurance market, which produced decent results for three centuries. In the 1980’s, though, huge latent problems from a few long-tail lines of insurance surfaced at Lloyds and, for a time, threatened to destroy its storied operation. (It has, I should add, fully recovered.)"

Thoughts on Hurricane Losses ..

"My guess at this time is that the insured losses arising from the hurricanes are $100 billion or so. That figure, however, could be far off the mark. The pattern with most mega-catastrophes has been that initial loss estimates ran low. As well-known analyst V.J. Dowling has pointed out, the loss reserves of an insurer are similar to a self-graded exam. Ignorance, wishful thinking or, occasionally, downright fraud can deliver inaccurate figures about an insurer’s financial condition for a very long time."

Buffett is holding a lot of Cash ... 

"At year end Berkshire held $116.0 billion in cash and U.S. Treasury Bills (whose average maturity was 88 days), up from $86.4 billion at yearend 2016. This extraordinary liquidity earns only a pittance and is far beyond the level Charlie and I wish Berkshire to have. Our smiles will broaden when we have redeployed Berkshire’s excess funds into more productive assets."

Buffett sees stocks as interests in businesses... 

"Charlie and I view the marketable common stocks that Berkshire owns as interests in businesses, not as ticker symbols to be bought or sold based on their “chart” patterns, the “target” prices of analysts or the opinions of media pundits. Instead, we simply believe that if the businesses of the investees are successful (as we believe most will be) our investments will be successful as well. Sometimes the payoffs to us will be modest; occasionally the cash register will ring loudly. And sometimes I will make expensive mistakes. Overall – and over time – we should get decent results. In America, equity investors have the wind at their back."

Eventually Valuation Matters ... 

"Stocks surge and swoon, seemingly untethered to any year-to-year buildup in their underlying value. Over time, however, Ben Graham’s oft-quoted maxim proves true: “In the short run, the market is a voting machine; in the long run, however, it becomes a weighing machine.”

Stocks can be Volatile, so avoid Debt ...

"Berkshire, itself, provides some vivid examples of how price randomness in the short term can obscure long- term growth in value. For the last 53 years, the company has built value by reinvesting its earnings and letting compound interest work its magic. Year by year, we have moved forward. Yet Berkshire shares have suffered four truly major dips. Here are the gory details:

Screen Shot 2018-02-25 at 6.41.16 PM.png


This table offers the strongest argument I can muster against ever using borrowed money to own stocks. There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions."

In the next 53 years our shares (and others) will experience declines resembling those in the table. No one can tell you when these will happen. The light can at any time go from green to red without pausing at yellow.

When major declines occur, however, they offer extraordinary opportunities to those who are not handicapped by debt. That’s the time to heed these lines from Kipling’s If:

“If you can keep your head when all about you are losing theirs . . . If you can wait and not be tired by waiting . . .
If you can think – and not make thoughts your aim . . .
If you can trust yourself when all men doubt you . . .
Yours is the Earth and everything that’s in it.”

Buffett tallies his bet against Hedge Funds versus the S&P500 with Protégé Partners..

"Performance comes, performance goes. Fees never falter."

"The bet illuminated another important investment lesson: Though markets are generally rational, they occasionally do crazy things. Seizing the opportunities then offered does not require great intelligence, a degree in economics or a familiarity with Wall Street jargon such as alpha and beta. What investors then need instead is an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals. A willingness to look unimaginative for a sustained period – or even to look foolish – is also essential."

Buffett and the counter-party to his bet, Protege, funded their portion of the prize by purchasing zero-coupon bonds.. 

"Protégé and I originally intended to do no more than tally the annual returns and distribute $1 million to the winning charity when the bonds matured late in 2017.

After our purchase, however, some very strange things took place in the bond market. By November 2012, our bonds – now with about five years to go before they matured – were selling for 95.7% of their face value. At that price, their annual yield to maturity was less than 1%. Or, to be precise, .88%.

Given that pathetic return, our bonds had become a dumb – a really dumb – investment compared to American equities. Over time, the S&P 500 – which mirrors a huge cross-section of American business, appropriately weighted by market value – has earned far more than 10% annually on shareholders’ equity (net worth)."

Buffett sold the zero's in 2012 and put the money into Berkshire .. he also won the bet ... 

"The result: Girls Inc. of Omaha found itself receiving $2,222,279 last month rather than the $1 million it had originally hoped for."

Buffett expands on Bonds as an investment .. 

"I want to quickly acknowledge that in any upcoming day, week or even year, stocks will be riskier – far riskier – than short-term U.S. bonds. As an investor’s investment horizon lengthens, however, a diversified portfolio of U.S. equities becomes progressively less risky than bonds, assuming that the stocks are purchased at a sensible multiple of earnings relative to then-prevailing interest rates.

It is a terrible mistake for investors with long-term horizons – among them, pension funds, college endowments and savings-minded individuals – to measure their investment “risk” by their portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk."

And finally keep it simple ... 

"A final lesson from our bet: Stick with big, “easy” decisions and eschew activity. During the ten-year bet, the 200-plus hedge-fund managers that were involved almost certainly made tens of thousands of buy and sell decisions. Most of those managers undoubtedly thought hard about their decisions, each of which they believed would prove advantageous. In the process of investing, they studied 10-Ks, interviewed managements, read trade journals and conferred with Wall Street analysts."

Buffett concludes ... "Come to Omaha – the cradle of capitalism – on May 5th and meet the Berkshire Bunch. All of us look forward to your visit."..  I also hope to see you there!


Source: Berkshire Hathaway 2017 - Warren Buffett Letter


Investment Models - Need to Know


Over the last 20 years or so I've studied the world's greatest investors and I've tried to unpick the characteristics that have made them successful. While business schools all over the world focus an inordinate amount of time on teaching students how to model, I'm yet to find an Investment Master whose made his name by having the most detailed financial models. Consider a few of these gems ...

"If you need to use a computer or calculator to make the calculation, you shouldn't buy it...It should scream at you...we do not sit down with spreadsheets and do all that sort of thing. We just see something that obviously is better than anything else around that we understand — and then we act." Warren Buffett

"We never sit down, run the numbers out and discount them back to net present value ... The decision should be obvious."  Charlie Munger

"In general, I haven't run spreadsheets and I find that, if there is a need to run a spreadsheet, that is a red flag to take a pass." Mohnish Pabrai

Sure it's important to be able to navigate around a balance sheet, cash flow statement and income statement, but the really great investors spend their time reading, thinking, focusing on the qualitative data and testing ideas. I've not once heard an Investment Master say "All I do is sit and model all day."

So why don't the Investment Masters spend their time building 5,000 line spreadsheet models like most Wall Street analysts do? In part it's because models have their limitations including:

Stuck in the Rear-View Mirror

Typically an analyst will build a spreadsheet model by plugging in the last five years financials for a company and then building out the future years from there. The problem is historic data is just that, historic. A company is worth the discounted value of its earnings in the future, not the past. The historic data may provide a useful insight into a company's revenue trends, the quality of the balance sheet and how attractive margins are, as well as provide a basis to compare the company with competitors. But problems can arise because the future may look a lot different to the past. Models are good for extrapolating, but dangerous when it comes to changing circumstances. This is as relevant today as ever given the rapid technological changes taking place.

"The qualitative analysis is even more important than the quantitative analysis because quantitative is always a lagging indicator. By the time you see it in the numbers, it's often too late." C.T Fitzpatrick

"One cannot analyse events until they have already happened. Numbers, the 'oxygen' of analysis, lag behind reality. Analytic methodology is ineffective in identifying change in the early stages and thus contributes to what Marshall McLuhan refers to as man's tendency to walk into the future looking in the rear-view mirror." Bennett Goodspeed

"Data is backward looking and it is the future that will determine our returns." Jake Rosser

"Avoid over-relying on numbers and models. Investors often feel comfortable with numbers and models because they appear definitive. However, they can be misleading because they often are based on historical data that may not be repeatable or are based on assumptions that may not prove valid." Ed Wachenheim

"Typically, analysts evaluating the future prospects of a company look at its past. Where else can they look, after all? And yet, even if they had a perfect snapshot of the past, they would be mistaken to assume that the conditions that held in the past will hold in the present or future" Leon Levy

Over-Confidence and Anchoring

Studies show that the more information someone has the more likely they are to become over-confident. And more information doesn't necessarily mean more profits. Remember, humility is a key ingredient to investment success. An analyst or investor with a detailed model risks becoming over committed to an idea,"I've built a 5,000 line spreadsheet, I must be right!";or becoming anchored to the outcome of a spreadsheet, "The model says it's worth $x, it must be true"

“Having more information doesn’t necessarily improve decision-making. We know from studies of horse racing than when handicappers receive more information about horses and riders, they become proportionately more confident even though they are no more likely to pick the winner. When analysts have too much data, there’s a danger they won’t see the wood for the trees.” Marathon Asset Management

"I’m reminded of a study which showed that as the number of variables requiring analysis increase, the odds of success decline, yet the confidence of participants soar due to extensive time and energy invested." Allan Mecham

"The harder you work, the more confidence you get. But you may be working on something that is false" Charlie Munger

"[Computer] models can lull decision makers into a false sense of security and thereby increase their chances of making a really huge mistake" Warren Buffett

"Far too many people treat numbers like sacred totems offering divine insight. The truly numerate know that numbers are tools, nothing more, and their quality can range from wretched to superb" Philip Tetlock

Difficult To Model

Einstein famously said "Not everything that counts can be counted, and not everything that can be counted counts." It's an apt quote for investing. The brain and financial models tend to operate in a linear fashion. But it's often the case that the best and worst investment outcomes are derived from non-linear situations. Charlie Munger often talks about 'Lollapalooza' effects where a number of forces combine to greatly amplify a positive outcome - more than simple addition. Alternatively, a credit crunch is an example of a non-linear event that can decimate a business but won't show up in a model.

There are plenty of other qualitative factors that are critical drivers of investment success but are hard to model. Corporate culture and innovation, management qualitycapital allocation prowess and incentives would be some examples. Networks effects, product obsolescence, scalability,  first-mover-advantages, industry developments, winner-takes-all, etc are also challenging to model.

"When we analyze a business, we pay close attention to the qualitative and intangible variables –such factors are often difficult to ‘model’. We are uneasy with fancy numerical models .. which have almost ubiquitous acceptance by the high priests of modern finance. We believe one is susceptible to gaining a false sense of security, which can result in mental slothfulness and neglect. In the case of models, analysts tend to overweight what can be measured in numerical form, even when the key variable(s) cannot easily be expressed in neat, crisp numbers.  The ‘model’ behind our largest investment required nothing more than sixth grade math, and a napkin – not a sophisticated spreadsheet capable of more numbers than I’m capable of counting." Allan Mecham

"You’ve got a complex system and it spews out a lot of wonderful numbers that enable you to measure some factors. But there are other factors that are terribly important and there’s no precise numbering you can put to these factors. You know they’re important, but you don’t have the numbers. Well practically everybody overweighs the stuff that can be numbered, because it yields to the statistical techniques they’re taught in academia, and doesn’t mix in the hard-to-measure stuff that may be more important. Charlie Munger

"In our evolution as investors, one of the things we have discovered is that it is often the things that don’t get measured that have a greater magnitude on investment returns than what is measured. That is to say, the numbers don’t provide all the clues. It is often qualitative factors such as company culture, management’s approach toward capital allocation, or customer service, that can yield critical insights into a company’s sources of competitive advantage. In fact, an advantage premised upon qualitative factors can often be more enduring." Jake Rosser

Missing the Forest for The Trees

Successful investing ordinarily requires determining the few key variables that drive a business' performance. By focusing on collecting all the data to build a more realistic model, the investor risks overlooking those key variables. 

“Every company has 100 things about them you could study and learn. But you have to understand the differences between data and knowledge, and between knowledge and wisdom. Warren Buffett is remarkable in his ability to cut right through. He sees very clearly the three or four or five critical factors that determine whether a company succeeds or fails. It’s not about encyclopedic knowledge, it’s about zeroing in on what truly matters and assessing that. There’s no substitute for that in this business." Howard Marks

"Our approach stresses the importance of wisdom by subtraction. We endeavour to look past the non-essential details and tune out the often deafening noise. We want to identify the “essence” of each business. So, for instance, what is it about MasterCard that enables them to generate after-tax margins approaching forty percent? Why have the Rales brothers, first with Danaher and second with Colfax, been so successful buying and fixing businesses? How has Markel managed to compound book value per share at fifteen percent for the past twenty years despite falling interest rates and a competitive underwriting environment?"  Chris Cerrone

"Are there dangers in getting too caught up in the minutiae of using a computer so that you miss the organised common sense? There are huge dangers. There'll always be huge dangers. People calculate too much and think too little" Charlie Munger

Models aren't Reality

A model is only as good as its inputs and it can never truly reflect reality. The inherent simplification of a model is one of its pitfalls. If the model is missing critical information or the key factors for success or failure, the output will be next to worthless. A good example of this was during the Financial Crisis when the bank analyst where I worked had a buy rating on an Investment Bank. The model and the analysts 'buy' rating went over the cliff when the stock went bust. Critically, the business relied on credit markets remaining open. That wasn't in the model.

"I have seen so many cases where there is a complex model that is exactly wrong. This focus on a model may cause you to move away from thinking about the competitive advantages of the business. Then you are making decisions based on all these numbers rather than thinking about whether this is one of the ten businesses that you would like to own." Glenn Greenberg

"Models are supposed to simplify things, which is why even the best models are flawed.” Philip Tetlock

"This is the virtue of models: They exclude information not directly relevant to the question under consideration, allowing us to focus on the significance of particular variables. This is also the vice of models: If the discarded information proves decisive to the issue being analyzed, the model will fail." Andy Redleaf

Instead of spending their days building financial models, the Investment Masters read, think, focus on qualitative data and test ideas. They keep stock valuations simple. If they do work on models, it's more likely to be mental models as an aid to investment success. Let's cover off on a few of those...

Reading & Thinking

The Investment Masters spend their time reading and thinking about investments and asking themselves questions - Why is this opportunity available? Do I have an edge? Is this a good business? Do I understand the business? What is the business' competitive advantages? Will the business continue to thrive? What could kill the business? Will technology enhance or destroy the business? Could the business be replicated? What is the right price for the business? What don't I know about the business? etc.

“I insist on a lot of time being spent, almost every day, to just sit and think. That is very uncommon in American business. I read and think. So I do more reading and thinking." Warren Buffett

"I just spend all my time thinking, reading, and adapting as best as I can." Thomas Gayner

“We read and think.Ed Wachenheim

“Warren and I do more reading and thinking and less doing than most people in business.” Charlie Munger

"Most individuals, including securities analysts, feel more comfortable projecting current fundamentals into the future than projecting changes what will occur in the future. Current fundamentals are based on known information. Future fundamentals are based on unknowns. Predicting the future from unknowns requires the efforts of thinking, assigning probabilities, and sticking one's neck out - all efforts that human beings too often prefer to avoid." Ed Wachenheim

Focus on Qualitative Factors

Successful investors spend more time understanding the qualitative aspects of their investments. This often involves channel checks with customers, competitors, suppliers, ex-employees and anyone else who might affect the company.

"Numbers alone won’t tell you the answer; instead you must think critically about the qualitative characteristics of your business.” Peter Thiel

“Interesting enough, although I consider myself to be primarily in the quantitative school, the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a 'high probability insight'.  This is what causes the cash register to really sing.  So the really big money tends to be made by investors who are right on qualitative decisions, at least in my opinion.” Warren Buffett

"The quantitative side of what we do is easy, to be honest with you. You don't have to have much more than a sixth-grade mathematics education to spot a potentially interesting investment proposition.... I would say the qualitative side of what we do consumes 95% of our time because that's the hard part." John Harris

"While we can run spreadsheets with the best of them, we really emphasize understanding the qualitative factors that drive the numbers. Market shares. Competitive advantages. The secular and cyclical impacts on the industry. Management’s skill in allocating capital. The goal is to identify companies in which we have a great deal of confidence that their values are going to continue to compound as we own them." C.T Fitzpatrick

"It's tempting when you start out to think your knowledge about finance and valuation will lead you to all the answers, but I now put more emphasis on qualitative than quantitative analysis" Jake Rosser

While building a simple financial model can help us better understand a company, it's clear that the people we refer to as the Investment Masters do not rely on 5,000 line spreadsheets for their ideas. Qualitative investment relies on knowledge, which can be gained from reading and thinking and talking with people. And then pulling all that information together into an idea that is valuable. It's also clear that an over reliance on financial modelling can leave you blind to certain risks. So the question remains as to why people still continue to both create them and then follow them? If the Masters don't use them, and they have the track records to prove their method as the right one, which will you follow? For me, I'll choose qualitative investing over quantitative every day of the week and twice on Sunday, and any investment thesis predicated on a 5,000 line spreadsheet will end up in the trash where it belongs.

What Farming can teach us about Investing

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Many inferences have been drawn over time between the Market and Business. This is nothing new to any of us and we have seen it often. The analogies are always simple, clean and relevant and offer practical value to our investing activities. At the same time, many of the Investment Masters have espoused the value in not only being capable in both arenas, but also in keeping up to date on your knowledge of both. It makes sense right? Sure it does.

But there are also other comparisons out there, ones which might not be as obvious at first glance. If I told you there was also value to be gained from comparing Investing to Farming, what would you say?

Hopefully you would agree with me.

Good ol' farming. It's been there forever, through good times and bad. And the inferences that can be drawn between it and Investing are many. 

Let's start with those good and bad times, because they happen to all of us whether you are digging in the dirt or investing in the market. The last two weeks drop in global markets is solid enough evidence of that, as is the freakish weather conditions in different parts of the world that have had a negative impact on the farming sector. The actual lesson though lies in how we react to the market tanking or when a farmer's crops fail. 

In situations like we have just witnessed in the market, prices dropped and investors rushed to get out, causing a significant level of volatility. But every farmer expects the unexpected and recognises that despite his best efforts, nature doesn't always deliver optimal outcomes - pests descend, rains don't come, commodity prices fall.

But if we were working a farm and had one bad year because of say, adverse weather conditions, would you immediately cut the value of your farm in half? Of course not. The value of the farm is the future value of many many years of crops, one bad season just doesn't have that much impact. In contrast, the stock market often over reacts to poor earnings and slashes good companies prices when the unexpected happens.

“You would not cut the value of a good farm in half just because bad weather conditions caused a crop failure in a single year” Phil Fisher

Farmers exhibit patience. They hold onto good farm property even when they have a bad crop. Farmers don't and aren't expected to trade their paddocks and no-one raises eyebrows when they don't. 

"No reasonable person would expect a farmer to sell his farm in order to buy a different farm every decade, let alone every year or several times a year. As public-market investors, however, this "sitting on our hands" behaviour is unusual." Clifford Sosin

And the value of farm land remains pretty constant. The absence of minute by minute pricing for farmers to obsess over means farmers tend to set prices by analysing what the farm will earn over a long period of time. Contrast that to stock prices which tend to be set by the whim of the most emotional participant watching the constant gyrations of the market. That's a gift for the rational investor.

“Stocks provide you minute-to-minute valuations for your holdings whereas I have yet to see a quotation for either my farm or the New York real estate. It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings – and for some investors, it is. After all, if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his – and those prices varied widely over short periods of time depending on his mental state – how in the world could I be other than benefited by his erratic behaviour? If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.” Warren Buffett

Stock prices go up or down responding to any number of psychological biases as opposed to fundamental developments. Yet, while those prices change, they generally don't impact what a company will earn.

“If Investors' frenetically bought and sold farmland to each other, neither the yields nor prices of their crops would be increased. The only consequence of such behaviour would be decreases in the overall earnings realized by the farm-owning population because of the substantial costs it would incur as it sought advice and switched properties.” Warren Buffett

And farmers don't respond to what other farmers are doing like investors do. If a farm a few paddocks away sells for less than the farmer paid, he's not going to rush to sell his property too.

"Instead of focusing on what businesses will do in the years ahead, many prestigious
money managers now focus on what they expect other money managers to do in the days ahead.  For them, stocks are merely tokens in a game, like the thimble and flatiron in Monopoly.... an extreme example of what their attitude leads to is "portfolio insurance," a money-management strategy that many leading investment advisors embraced in 1986-1987 ... After buying a farm, would a rational owner next order his real estate agent to start selling off pieces of it whenever a neighbouring property was sold at a lower price?  Or would you sell your house to whatever bidder was available at 9:31 on some morning merely
because at 9:30 a similar house sold for less than it would have brought on the previous day?" Warren Buffett 1987

Per the lessons gained from the Fingers of Instability posts, learning from this farming analogy is just as important. We know that many investors react to market conditions without really knowing or understanding the intrinsic worth of the stocks they hold. Farming is a long term game and investing should be considered the same way. We should not expect great yields every year from either, rather sometimes we can expect to have to 'weather a storm', and in doing so we can expect a bumper crop.


Fingers of Instability Re-visited


No doubt you will have noticed that in the last week or so we've experienced a significant spike in market volatility. There's a common saying that markets go 'up the escalator, and down the elevator,' and that has certainly been evident of late. During the period of volatility we've witnessed stock markets being sold and bond prices falling, and through it all we've also watched investors all over the world react

Historic correlations have also become unhinged, as the market's participants start to question the implications of global central banks normalizing interest rates. Whether this volatility will continue and the markets will decline further, no-one actually knows. But what is evident is that the market moves were largely unexpected.  

The recent blog post titled 'Fingers of Instability' highlighted the more recent changes in market structure that has created fragility in the system. As more assets are held by people with zero comprehension of what they actually own, it's no surprise volatility spiked when the unexpected happens. These investors have no idea of the underlying worth of their investments and therefore no price to anchor to. No price is too high or low for an index fund to sell or buy. And when there is fear they all try to run out the gate at the same time. Throw in HFT and momentum strategies and in the end you've got a recipe for absolute disaster. But while its a disaster for uninformed investors, its also a potential opportunity for unemotional investors who have done the hard work and can take advantage of indiscriminate selling.

So, given what has occurred in the markets of late, I thought it would be a good idea to revisit a few of the important lessons that emanate from all of this. 

Common Sense - good investing requires common sense. Buying something that's expensive in the hope someone will pay more for it, is speculating, it's not investing. I can't see any rational reason why someone would think buying bonds as an investment makes any sense given ultra-low or negative yields . Historically bonds have provided a real return, but since the Financial Crisis bonds have moved from NOT providing a real return to in some cases giving a negative return. If you're holding to maturity you're going to be losing money after inflation in the first instance, and losing money full-stop in the second. That's an asymmetric bet the wrong way around.

Rear-View Mirror - Investors have a tendency to chase performance. One example of this is the bitcoin frenzy we've been witnessing lately. From time to time, I put a few things up on my Linkedin account, but if you follow it you'll note that I haven't written a lot about bitcoin as I don't see it as a legitimate investment. Its speculation, not an investment. I certainly have a view on the topic, but I'll also take note of the likes of Buffett, Munger, and Druckenmiller; they've been around the block a few times and their collective opinions are valuable to me. Despite my reticence to write about bitcoin, what's interesting is the number of my acquaintances who've asked me whether they should invest in it. And why do they care? Because it's gone up a lot, and they're wanting to chase performance. My Linkedin post on Bitcoin included a chart with a Warren Buffett quote on bubbles. It got 10,000+ hits.. that's an attention bubble right there!

Understand - if you don't understand something don't invest. Some investors learnt some tough lessons last week when the Inverse Volatility [XIV] ETF blew up. I'd say most investors in the fund were chasing performance. Selling volatility is a dangerous strategy if you don't know what you're doing and even more so when you don't know how the fund you're investing in works.

Expect the Unexpected - Don't set your portfolio up for that perfect outcome. Winning in the investment game is not losing. In a bull market all you need is an index fund. The difficult part is timing your exit. And no one knows when a market turns; they can and will turn on a dime. Don't be disappointed in lagging a bull market, it's often the price to pay for admission to long-term market-beating results. It's the outperformance in down markets which drive long term gains. You can't run a portfolio optimized for a bull market that will perform well in a down market. It's important to stress test your portfolio. How will the different assets perform under alternative investment scenarios?

I can't tell you with 100% conviction where the markets are going and neither can you. But you can give yourself the best chance of attractive long term returns by using common sense, understanding what you own and not chasing performance, and then building a portfolio of quality companies that are likely to continue growing over the next five or ten years. If you remain unemotional, focus on the intrinsic worth of your companies rather than market gyrations, the renewed increase in volatility is an opportunity, not a threat.




Books to Read... Masters thoughts ...


We've spent some time in recent posts going over many of the similarities that exist between the methodology and practices of the great Investors. Most of these people have been enshrined in our minds because of their outstanding track records, and their exemplary approach to creating innovative investment ideas. 

One of the things that holds them apart from others is how they can pull all that disparate information together and corral it into a new idea.

But where do they get the information from? From whence comes those brilliant insights? It has to be said the details come from many sources, like talking and watching and listening, but one of the most common is also one of the most humble. A book.

I love to read and you've no doubt seen how many of the great Investors do the same. And the benefits are many with very little downside.  If we read widely, our Vocabulary, Comprehension, Awareness, Intuitive Capabilities, Intelligence and Wisdom all end up on the right side of the ledger - basically the more we read the more we grow and develop. But the biggest benefit lies in the growth of our knowledge base.

Every Investment Master has learnt from a book, or more than one. They all talk about the the little gems they uncovered in this book or that, or how another person's writing challenged their perceptions on an important business or investment paradigm. In almost every case, the authors are invariably providing their knowledge and in many cases the secrets to their success. This is invaluable to us all.

"I have been accused of telling all my secrets. I have written a number of books, and I reveal them all in these books." Benjamin Graham

I also find it fascinating that so many of the great Investors find similar value in much the same authors, such as Benjamin Graham and his brilliant book, The Intelligent Investor.

"By far the best book on investing ever written." Warren Buffett

"I read The Intelligent Investor. Right away, I Said, "Voila!, this is the investment concept I've been looking for." Jean-Marie Eveillard

"Since 1993, the cornerstone of our investment philosophy is based on Benjamin Graham’s book 'The Intelligent Investor', first published in 1949." Francois Rochon

"I can’t remember what I paid for that first copy of The Intelligent Investor. Whatever the cost, it would underscore the truth of Ben’s adage: Price is what you pay, value is what you get. Of all the investments I ever made, buying Ben’s book was the best (except for my purchase of two marriage licenses)." Warren Buffett

Beyond knowing the value they place on books written by other people, one of the biggest upsides for us is that many of the Investment Masters have also put those same ideas into one of more of their own books. Warren Buffett has long been recognised for his annual letters. Many investors, including me, wait hungrily for his latest instalment. And he never disappoints.

"I have read everything I could on Buffett. He is our business/investment role model." Frank Martin

“I think I have read almost everything Warren Buffett has written and I agree with more than 95% of his thinking.” Lee Ainslee

“You should read the Berkshire Hathaway ‘Letters to Shareholders’ which are on the Berkshire website so they are free. That will be a great start.” Mohnish Pabrai

"By far, the best investor of all time is Warren Buffett. I have read everything I could find (past and present) about him." Francois Rochon

"Going back and reading Berkshire Hathaway annual reports is worth the time." Arnold Van Den Berg.

"In my opinion, Warren Buffett’s group of annual letters is the best teaching anyone could find in the history of business." Francois Rochon

"I started reading [Buffett’s shareholder letters etc.] and I’ve read over the years, just about everything, I think, Warren’s put out there." Ted Weschler

Every single Investment Master reads widely. Biographies, History, Philosophy, Psychology, Investment and Business Journals; all are examples of the breadth of genres that are consumed almost daily by these people. I've mentioned how they are able to pull disparate bits of information together - finding the information in the first place would not always be possible without their reading such a wide variety of books.

"Personal biographies, the histories, are the most interesting. I have Benjamin Graham’s personal biography, also the biography of Leon Levy, The Mind of Wall Street. These are all great. It’s not that they’re uncovering something that no one knows about, but these are personal stories about things that they actually experienced in the investment world. How did they deal with the 1973 to 1974 bear market? What did they invest in that worked? What did they invest in that didn’t work? What were the mistakes they made? What did they learn? You’re basically absorbing all of this knowledge that’s out there and you can learn from it and apply it to your own experiences." Chris Mittleman

Beyond Benjamin Graham's treatise which many seem to favour, other books appear frequently in the recommended lists from each Investment Master. Here are some of the more commonly recommended treatises on Investing...

MARGIN OF SAFETY, By Seth Klarman.

“I had very few actual mentors in this business because I didn’t really know anyone. I bought Seth Klarman’s book Margin of Safety which was published my first year of business school.” Bill Ackman

"Seth Klarman's 'Margin of Safety' is a good book about risk." Arnold Van Den Berg


"Peter Lynch's books have some great insights [and] would be great for anyone to read." Julian Robertson

"I came across a book titled 'One up on Wall Street' by Peter Lynch. I found it so exciting I read it straight into the night. I have found the the book to be, along with Benjamin Graham's 'The Intelligent Investor', the best ever written on investment. The book helped me discover a passion for the stock market that has never left me." Francois Rochon

"I still remember when the book came out in 1989, and I read a review in BusinessWeek. I went out and bought it, and it changed my life forever." Francisco Garcia Parames


"One of the great investors I've tried to learn from is Shelby Davis." Thomas Gayner

“When John Rothchild combines history and biography with investing in one package, history illuminates the biography and investing, biography illuminates the history and investing, and investing illuminates the history and biography. This is a sparkling book on each level, but even more so as an adroitly mixed cocktail of all three.” Peter Bernstein


“Joel Greenblatt wrote probably the best book ever ’You can be a Stock Market Genius.” Dan Loeb

"Joel Greenblatt's 'You Can be a Stock Market Genius' is tactical and includes some very specific and interesting strategies." Seth Klarman

"Joel Greenblatt’s How to be a Stock Market Genius is required reading for all new Third Point employees. On the topic of spin-offs, Greenblatt writes: “When a business and its management are freed from a large corporate parent, pent-up entrepreneurial forces are unleashed. The combination of accountability, responsibility and more direct incentives take their natural course.”  Dan Loeb


"Poor Charlie’s Almanac - I rate that as the best book I’ve ever read. If your looking for one book, Poor Charlie’s Almanac is loaded with a lot of wisdom. If you spend some time on that book, it’s pretty much all the wisdom picked up in 82 years of living, so there’s a lot of it digested and condensed in that book.” Mohnish Pabrai

"Another book that should be in the hall of fame is Poor Charlie’s Almanac by Peter D. Kaufman. This book is about Charlie Munger, the long-term business partner of Warren Buffett. This great book goes well beyond the field of finance and into philosophy and life values. It highlights the extraordinary mind of Charlie Munger, and I can guarantee hours of fun." Francois Rochon


“And then I read The Alchemy of Finance because I’d heard about this guy Soros. And when I read The Alchemy of Finance, I understood very quickly that he was already employing an advanced version of the philosophy I was developing in my fund.” Stanley Druckenmiller

"There are a few books - really not that many which I believe are indispensable reading for every serious investor in whatever facet of investment practice they may favour - The Alchemy of Finance." Peter Cundill

"The Alchemy joins Reminiscences of a Stock Operator as a timeless instructional guide to the marketplace." Paul Tudor Jones


"I am an eager reader of whatever Phil has to say, and I recommend him to you." Warren Buffett

"I owe a lot to Mr Fisher. He wrote books out of pure altruism (he was already wealthy at that time) to simply share his experience with us. I thanked him then and I thank him again. Giverny Capital owes a part of its existence to him." Francois Rochon

"I sought out Phil Fisher after reading his 'Common Stocks and Uncommon Profits'. When I met him, I was impressed by the man and his ideas. A thorough understanding of a business, by using Phil's techniques … enables one to make intelligent investment commitments." Warren Buffett

"I always like it when someone attractive to me agrees with me, so I have fond memories of Phil Fisher." Charlie Munger

"The late Philip Fisher wrote several books that are very good [including] Common Stocks and Uncommon Profits." A Van Den Berg

"A book that ranks behind only 'The Intelligent Investor' and 'Security Analysis' in the all-time best list for the serious investor." Warren Buffett

SO FAR, SO GOOD: THE FIRST 94 YEARS, By Roy Neuberger.

"Roy never fails to amuse and enlighten. Over the years, he's taught me many things I didn't know I didn't know." Jim Rogers

"I sometimes reread older books like “So Far, So Good - the First 94 Years,” written by Roy Neuberger in 1997. It always fascinates me how things are basically the same on Wall Street. Sound principles do not change. And so is human nature towards money and markets." Francois Rochon

FOOLED BY RANDOMNESS, By Nassim Nicholas Taleb.

"Fooled by Randomness - I consider it one of the most important books an investor can read." Howard Marks

"Fooled by Randomness is a serious, intellectually sophisticated book, well worth reading carefully. At times, the book is condescending as though the author had discovered the holy grail of investing. There ain't no holy grail, and the cosmopolitan tone can be somewhat off-putting. Nevertheless, there are some great insights." Barton Biggs

INFLUENCE, By Robert Cialdini.

"Academic psychology has some very important merits alongside its defects. I learnt this eventually, in the course of general reading, from a book, 'Influence', aimed at a popular audience, by a distinguished psychology professor, Robert Cialdini… I immediately sent copies of Cialdini's book to all my children. I also gave a share of Berkshire stock [A share] to thank him for what he had done for me and the public." Charlie Munger

"Fairly late in life I stumbled into this book, Influence, by a psychologist named Bob Cialdini.. Well, it’s an academic book aimed at a popular audience that filled in a lot of holes in my crude system. In those holes it filled in, I thought I had a system that was a good-working tool." Charlie Munger

"There are a couple of valuable resources when it comes to behavioral biases: Cialdini's work on the influence of psychology in human decisions and Charlie Munger’s speech on the “Psychology of Human Misjudgment.” Christopher Begg


"For many years I've enjoyed reading Frank Martin's letters. This collection contains much investment wisdom and, just as important, sets a standard for advisor-client relationship." Warren Buffett

"What a unique opportunity to traverse the Bubble and post-Bubble years with Frank Martin, exactly as he described them to his clients in real time. Here is market history from the disciplined perspective of a value investor, as he wrestles with the financial beast. Speculative Contagion is sure to enlighten aspiring value investors for years to come." Seth Klarman


“Daniel Kahneman, a psychologist who won the Nobel Prize in Economic Sciences for his work that challenged a rational model of judgement and decision-making, recently published a remarkable account of his intellectual journey; Thinking Fast and Slow.” Seth Klarman

“I just read Daniel Kahneman’s Thinking, Fast and Slow, and I think that he and the late Amos Tversky are some of the great behavioural scientists. Since nobody in our industry thinks about this very much, I think about it a lot.” Frank Martin

"Daniel Kahneman’s books should be read." Charles de Vaulx


"It is a textbook for trading. I hand a copy to every new trader we have." Paul Tudor Jones

“When I was 17 I was backpacking across Europe. I was in Rome and had run out of books to reads. I went to a local open market where there was a book vendor, and literally, the only book they had in English was Reminiscences of a Stock Operator. It was an old tattered copy. I still have it. It’s the only possession in the world I care about. The book is amazing. It brought everything in my life together.” Colm O’Shea

“As the book states very early on, there is nothing new under the sun in the art of speculation, and everything that was said then completely applies to the markets of today. My guess is that the same will hold true for time eternal as long as man’s basic emotions remain intact.” Paul Tudor Jones

“The finest trading book ever written is Reminiscences of a Stock Operator by Edwin LeFevre. This book is not a “how I made a billion in the stock market” nauseating ego trip or self-serving fiction. Instead it is colloquial reminiscences by a legendary speculator of the mistakes and lessons he learned over a trading lifetime.” Barton Biggs.

“Reminiscence of a Stock Operator is a book that up until a couple of years ago I read every year because it is such a great lesson in psychology, how psychology works through the markets and how markets behave.” Bill Miller

“Everyone had to read, because its such great history, Edwin Lefevre’s Reminiscences of a Stock Operator.” Dan Loeb

"My favourite book on investing is Reminiscences of a Stock Operator. It was first published in 1923, and is filled with the jargon of the day, so you have to learn the language. But once you do, it is a fascinating book about trading and speculation. You realize that nothing has changed. Everything is the same. Even though the markets are global today, and there is so much more regulation, it is still just speculation and human nature." Jeffrey Gundlach

THE OUTSIDERS, By William Thorndike.

"An outstanding book about CEO's who excelled at capital allocation." Warren Buffett

“A book like the Outsiders is a good example of what I like to read. It uses eight case studies to illustrate how unconventional managers can make a huge difference in creating per share value for shareholders." Wally Weitz

"The Outsiders is a terrific book by William Thorndike that profiles eight cases of terrific CEOs and their “radically rational blueprint for success." The book highlights the importance of capital allocation and should be a benefit to both investors and executives." Francois Rochon

THE MONEY GAME, By Adam Smith.

“For a magnificent account of the current financial scene, you should hurry out and get a copy of “The Money Game” by Adam Smith. It is loaded with insights and supreme wit.” Warren Buffett

"One of the great books about investing is Adam Smith's 'The Money Game' which was published in 1967." Barton Biggs

These are merely some of the recommended books from the Investment Masters. Thousands of books exist out there, each with their own piece of wisdom. So let's get reading! Which books are on your recommended list for 2018?


Further Reading: The Top 12 Investment Books