Building an Investment Checklist - Part 2

Checklists are a normal way of life for many people, whether you’re an investor or otherwise. Over the years people from a multitude of industries and fields have utilised the effectiveness of simply making a list. From something as inane as a To Do list, that reminds someone of what they have to accomplish that day, to mandatory checklists that affect safety and ensure compliance; regardless of their use, everyone benefits. There is simply no down side to using one. However, not using a checklist, or failing to build a thorough or complete checklist, can have some rather disturbing consequences.

We know that all investors have biases, it's a function of human nature. When it comes to investing those biases can lead to sub-optimal returns, or worse, the permanent loss of capital. Many of the Investment Masters have turned to basic 'checklists' to help improve investment results.  Charlie Munger, Warren Buffett's partner and one of the world's greatest investors, couldn't have been more definitive when he said: "If you're trying to analyze a company without using an adequate checklist, you may make a very bad investment".

No human is infallible, whatever they might think of themselves to the contrary. The better checklists include not only the things we know we need to investigate or analyse, but also the things we have learnt from past mistakes. This is crucial to success when using checklists; knowing what mistakes you or others have made should be a necessary or even mandatory inclusion. With that in mind, this then should become the first component when building your investment checklist – Start with both your own and any mistakes that others have made.

" …in terms of building checklists, there is no question that the place to go is past mistakes.  Not only one’s own past mistakes, but also to look at other investors’ past mistakes and see what those mistakes were." Guy Spier

The more comprehensive your checklist is, the less likely you will forget things, and the more likely you will be to collect all the information you need. As no human is infallible, likewise no human being has a perfect memory. Even those lucky enough to have eidetic or photographic memories cannot remember everything – if its included in your checklist, and you follow your checklist religiously, quite simply it will ensure you remember to do it. Relying on memory alone is risky. How often have you woken in the middle of the night with a bright idea or a solution to a nagging problem, and then believing that you will remember it in the morning, have gone back to sleep happy and satisfied, only to wake in the morning and have forgotten what is it you thought of? The only sure way to remember it is to write it down. Basically, if it is in your checklist, you cannot forget it.

Compiling a checklist of potential items to systematically review will also help you avoid repeating mistakes. As Josh Waitzkin, noted in his excellent book 'The Art of Learning', "if a student of virtually any discipline could avoid ever repeating the same mistake twice - both technical and psychological - he or she would skyrocket to the top of their field".

The Investment Checklist should be designed to ensure critical information is collected, considered and not overlooked.  It will guide the investor to areas where further research is required. A suitable investment is unlikely to require all check boxes be ticked, some checklist items are likely to be non-negotiable [e.g. too much debt, binary outcome, poor management history, etc.]. 

"…no investment is going to pass every single investment checklist item. What the investment checklist will do is to throw up issues that one should focus on" Guy Spier

'The first time I run the checklist it adds a lot of value because it highlights things that I don't know the answer to, and that leads to more research. The checklist is really good at highlighting the areas that could be problematic - things that I have missed etc, and then I can make a 'go' or 'no go' decision based on that" Mohnish Pabrai

Checklists are an ever evolving tool. Even those who work outside of investment, such as the pilots and surgeons we mentioned in Part 1, periodically add items to their checklists as learning, information or technology becomes available. If an aircraft crashes, the investigators explore the cause and make this known to all people involved with aeronautical safety. “The accident could have been avoided simply by doing X.” With that in mind, the learning is added into current pilot pre-flight and safety checklists, and essentially everyone learns from the mistake.

"Boeing just doesn't sit around in a room and come up with the checklist for take-offs.  That has been created over 60-70 years of failures that have caused things to make the checklist.  Our investment checklist was designed the same way.  I looked at mistakes I made since the time I invested and I looked at mistakes that other people made that I respect like Warren Buffett and Charlie Munger, LongLeaf Partners and so on.  When I look at mistakes, I would figure out what was the reason the investment lost money and was that reason visible at the outset?  Was it visible before the investment was made.  And, in most cases it's extremely obvious" Mohnish Pabrai

Similarly, the Investment Masters learn from their mistakes"I learned that there is an incredible beauty to mistakes, because embedded in each mistake is a puzzle, and a gem that I could get if I solved it, ie a principle that I could use to reduce my mistakes in the future" Ray Dalio

"One learns the most from mistakes, not successes"  Paul Tudor Jones

The checklist should constantly evolve as markets change and investors learn. It is also important that investments are continually reviewed against the checklist to ensure the original thesis remains intact. 

“My good friend, Guy Spier, observed that both of us have a pre-investment checklist, but no in-flight checklist. The pre-investment checklist has proven invaluable. However, it is not enough to just keep up with ongoings in existing investments in an ad hoc manner. It is important to periodically run and re-run the in-flight checklist.” Mohnish Pabrai

Ultimately, the more layers of checklist redundancy an investor has in place, the less likely that the investor will make an error or omission.

Checklists can follow various forms and functions – you could have one to check all the information you need to collect when analysing an investment opportunity, or it could be a comprehensive list of actions which need to be completed prior to making an investment decision. Similarly, your checklist might be a set of benchmark criteria that determines a go/no go decision. You could have several that cover different investment processes such as short selling, risk-arbitrage or spin-offs. Whatever the case, the more checklists you employ in your investment activities, the more likely you will be to succeed.

"We have multiple checklists and processes in place to improve how we think and make decisions" Ken Shubin Stein

"What we’re starting to institute at our firm is for every function, including the investment function, to have a daily checklist” Bruce Berkowitz

Checking off items ensures unsuitable investments are discarded quickly, increasing efficiency and allowing more time for finding/analysing attractive opportunities.

While it is common for investors to lose money by overlooking technical factors [such as operating leverage, too much debt, sovereign risk, technical obsolescence or a combination of factors], often such mistakes are the result of psychological biases. These psychological biases tend to be less obvious, even in hindsight, to an outside observer.  The checklist can be developed to create awareness of, and overcome, common psychological biases such as commitment bias/groupthink/herding/anchoring/recency bias, etc.

"In the checklist, it’s possible to put not only the steps necessary to do the research as well as lists of mistakes or problems that occurred in the past and should be avoided, but also a list of cognitive biases. This allows the investor to check with him or herself and to think about whether there are forces at play that may be activating some cognitive biases, and if so, to consider those."  Ken Shubin Stein

“My checklist is.. is it cheap? is it a good business?  who is running it? and what did I miss?  I go through all the checklist. When I go to ‘what did I miss?’  .. it is hugely important to understand psychology and human cognition”  Li Lu

Whilst checklists are a vital part of any investment activity, they should not replace your own thinking. As we learnt from Part 1 on this topic, the mind plays tricks on us or we are wired to avoid certain information that is contrary to our opinion. With that in mind, you can avoid the mind games by including points in your checklist that encourage you to look beyond what you see, to challenge your opinion or that held by others, and to explore the topics that you might otherwise overlook. In short, to be creative in your thinking. Whilst checklists should not replace your thinking, they should be in place to ensure you think the right way.

"A checklist is no substitute for thinking"  Warren Buffett

"Doing something according to pre-established rules, filters, and checklists often makes more sense than doing something out of pure emotion. But we can't have too many rules, filters or items without thinking. We must always understand what we're trying to accomplish" Peter Bevelin

Below I've included a SIMPLE checklist framework I've built.  It's far from finite but may assist as the foundation for further development. I've added links to the appropriate 'Investment Masters Class' tutorials so you can consider the Investment Masters thoughts on the topics to further expand the checklist items.

EXAMPLE CHECKLIST ITEMS
- Is there risk of permanent loss of capital? [eg debt, fraud, disruption, obsolescence, operating leverage, high valuation, sovereign risk, regulatory risk, patent/lawsuit loss, closed credit markets, systems failure, natural hazards, commodity price collapse/spike, debt re-financing, large risky acquisition, derivative/FX/interest rate risks, project risks, contract loss, brand damage etc].
- Do I understand the business? Does it have a reason for being? Why does the customer buy? Is it within my circle of competence?
- Is the stock liquid? Can it be a reasonable size in the portfolio?
- Is the leverage appropriate?
- Is it cheap/fairly priced? Does it offer asymmetric returns? Downside risk versus upside risk?
- Is it a quality business? moat (expanding?), pricing power, margins, track record/long term?, market share/potential/international, cash flow conversion, high return on capital, reinvestment opportunities, corporate culture, industry structure, rational competitors, innovation, fragmented/concentrated customer/supplier base, single product/commodity/lifecycle? win-win industry, capital requirements to grow?
- Does the crowd love the stock? or is it hated?
- Quality of management - capital allocation, honesty, track record, incentives, skin in game, innovation, conservative accounting?
- Can the business compound capital? Are there opportunities to re-invest capital at attractive returns?
- Can the business grow revenue? What tailwinds/headwinds? What incremental costs?
- Potential for technical disruption/obsolescence?
- How hard is it to replicate the business?
- What is business likely to be doing in next 5-10 years? How has it changed in the last 5-10 years?
- Has the business been stress tested? Track record of earnings, margins? How did company fare in Financial Crisis?
- Does the business have hidden asset value? Is the business under-earning? ex or cum-capex?
- What are the key drivers for the business?
- What does the industry capital-cycle look like, consolidation or expansion?
- Is the stock likely to be mis-priced? Why does the opportunity exist? What is the edge?
- What is the intrinsic value? Is the price reasonable/cheap vs intrinsic value?
- What is private market value? Is the company a potential target?
- What are the implied growth rates in the current share price? How does it compare to peers?
- How confident can you be about earnings in 3-5 years time?
- Is there a margin of safety?
- What does the register look like? Have insiders been active?
- Are there any catalysts?
- Cross-checked/information sought from customers/suppliers/competitors etc?
- Have alternate outcome been considered? What could go wrong/kill the business? What is the counter-argument? What are the consequences of being wrong?
- What cognitive biases could be influencing decision?
- What don't I know?

Once the investment passes the checklist, it's time to consider a portfolio management checklist.  How big should the position be? what will the impact be on portfolio correlation? How will the position impact portfolio liquidity? What will be the impact on portfolio exposures - industry, FX, ETF exposure, geographic diversification? What percentage of the stock will the holding represent?  What are the hidden correlations across the portfolio? etc.

Investors should give consideration for (and continue to adapt) the length and order of their checklist. For better or worse, the more time you spend on an investment the more likely you are to invest. Your time is in finite supply and average investments are in high supply, so have the diligence to move on to the next prospective investment with a preference for investment mistakes of omission rather than commission - be determined to wait for a fatter pitch. One approach may be ranking checklist items, ie. with non-negotiables at the top to act as a quick filter. Another approach, may be taking a first pass at all checklist items with the goal to reject the investment, then if it fails to be rejected, performing a deeper dive on the company.

To get the most out of your own checklist, (recommended for an in depth analysis) items can be written and answered such that;

•      They elicit an ex-ante statement from you for the basis of your investment (you can then compare ex-post for your inflight checks.. or air crash investigation)

•      You are forced to consider both the outside view (industry base rates and competitors) and the inside view (your experience - both vicarious and direct)

•      You must consider the inverse, what would the opposite look like, how could you be precisely wrong

•      You list what psychological forces can affect your conclusion for each item (see Charlie Munger’s two track analysis)

The best investment ideas often come from creative thinking when a combination of ideas develop and combine to provide an insight other haven't considered.  Explicitly considering each checklist item aids this process.

"If you’ve got a full list of tools, and go through them in your mind, checklist-style, you will find a lot of answers that you won’t find any other way.” Charlie Munger

So are you using checklists? If you are, do they include all the necessary points for success in investing? Challenge yourself to review your lists regularly. Don’t fall into the trap of thinking what you have will always serve you well. Evolve your lists, add to them, alter them, delete obsolete or flawed points. The better the lists, the better they will serve you in your investment activity.

 

 

Learning from Ed Thorp

Ed Thorp's track record of returns is astonishing. Not only did Dr. Thorp deliver an average 20% return over thirty plus years, he rarely ever had a month where he lost money. His original fund, Princeton Newport Partners, ran for nineteen years with only three down months [the largest loss was below 1%]. As Jack Schwager so cleverly articulated in his book 'Hedge Fund Market Wizards', if the market was efficient, the odds are a trillion times better of selecting one atom on earth than a trader achieving such a record of positive months.

Dr. Thorp isn't your typical Investment Master. The way he came to investing is unlike any other. His new memoir, 'A Man for All Markets' tells the story of his early curiosity, his background in mathematics, and how he challenged conventional wisdom to beat the casino and the stock market.   

During this time as an MIT professor, Dr Thorp, was the first person to work out that Blackjack, the 'unwinnable' casino card game, could be beaten. He invented the art of card counting which gave the player an edge against the casino. In 1961 he detailed the winning system in the best-selling book, 'Beat the Dealer', after which casinos across America altered the rules of the game. Having overcome the odds in Blackjack, a year later Dr Thorp and Claude Shannon, built the world's first wearable computer to beat Roulette. This contraption provided a 44% edge against the casino by predicting where the ball would land.

Often banned and at times threatened by the casinos, Dr Thorp recognised there was a far safer and greater casino than all of Nevada - Wall Street. Dr Thorp parlayed his knowledge of gambling games to build a system to beat the stock market. After a voracious study he developed a similar formula to the yet undiscovered 'Black-Scholes' option formula, to profit from option exchanges across America.

As one of Wall Street's first quants, Dr Thorp managed his portfolio with mathematical formulas, economic models and computers. His early hedge fund was even vetted and approved by Warren Buffett for one of his investors after the Buffett partnership was closed. Dr Thorp's other accomplishments included inventing and implementing statistical arbitrage, identifying Bernie Madoff as a fraud decades before his ponzi scheme collapsed and being the first investor of Ken Griffin's Citadel.

While Ed Thorp's investment process required a level of mathematical aptitude superior to even the world's greatest investors, you will notice a lot of commonalities in his thinking with the Investment Masters - the use of mental models, the need for an edge and risk management techniques, the consistent testing of ideas and theories etc. The book is a highly engaging read in which I unearthed quotes that paralleled with over a third of the 100 tutorials contained in the Investment Masters Class.  Here are some of my favourites:

"Though we didn't have helpful connections and I went to public schools, I found a resource that made all the difference: I learned how to think"

"I was largely self-taught and that led me to think differently. First, rather than subscribing to widely accepted views - such as you can't beat the casinos - I checked for myself"

"Mathematics taught me to reason logically and to understand numbers, tables, charts, and calculations as second nature. Physics, chemistry, astronomy, and biology revealed wonders of the world, and showed me how to build models and theories to describe and to predict. This paid off for me in both gambling and investing"

"The surest way to get rich is to play only those gambling games or make those investments where I have an edge"

"Assume you may have an edge only when you can make a rational affirmative case that withstands your attempts to tear it down"

"Betting too much, even though each individual bet is in your favor, can be ruinous"

"People mostly don't understand risk, reward and uncertainty. Their investment results could be much better if they did"

"Just as in blackjack, my first investment was a loss that contributed to my education"

"Stories sell stocks: the wonderful new product that will revolutionise everything, the monopoly that controls a product and sets prices, the politically connected and protected firm that gorges at the public trough, the fabulous mineral discover, and so forth. The careful investor, when he hears such tales, should ask a question; at what price is this company a good buy? What price is too high?"

"The stock market also is a game of imperfect information and even resembles bridge in that both have their deceptions. As in bridge, you do better in the market if you get more information sooner and put it to better use. It's no surprise that Buffett, arguably the greatest investor in history, is a bridge addict"

"Though the institutions of society have difficulty learning from history, individuals can do so"

"Over a sufficiently long time, compound growth at a small rate will vastly exceed any rate of arithmetic growth, no matter how large! For instance, if Sam Scared made 100 percent a year and put it in a sock and Charlie Compounder made only 1 percent a year, but reinvested it, Charlie's wealth would eventually exceed Sam's by as much as you please. This is trues even if Sam started with far more than Charlie, even $1 billion to Charlie's $1."

"We analyzed and incorporated tail risk, and considered extreme questions such as, "What if the market fell 25% in one day?" More than a decade later it did exactly that and our portfolio was barely affected"

"[I didn't believe in]  the efficient market theory... We didn't ask, Is the market efficient? but rather, In what way and to what extent is the market inefficient? and How can we exploit this?"

"Bernard Madoff showed, thirteen thousand investors and their advisers didn't do elementary due diligence because they thought the other investors must have done it"

"Every stock market system with an edge is necessarily limited in the amount of money it can use and still produce extra returns"

"I learned to make proper risk management a major theme of my life"

"The lesson of leverage is this: assume the worst imaginable outcome will occur and ask whether you can tolerate it. If the answer is no, then reduce your borrowing"

"I think of each hour spent on fitness as one day less that I'll spend in a hospital

"When J Paul Getty was the richest man in the world and manifestly not fulfilled, he said the happiest time of his life was when he was sixteen, surfing waves off the beach in Malibu, California"

Time to let Ed Thorp help you beat the market!

 

 

Further Information:

I've recently listened to two great Podcast interviews with Ed Thorp ..  click the links to the right [I suggest the Bloomberg/Barry Ritzholtz one first]

You also can check out Ed Thorp's website here

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Building an Investment Checklist - Part 1

Investing can be a daunting task requiring the analysis of complex data which is often in a state of flux. Decisions often must be made in the absence of complete information, under time constraints and emotional pressure.  The investor's role is not dissimilar to a pilot or surgeon, who is also dealing with many unknowns and changing circumstances, and where time is of the essence.  There are often significant consequences for a pilot or surgeon if or when basic errors – such as omitting a key fact – are made.  Likewise, an investor can face negative consequences, thankfully in the form of capital losses and not death, if errors are made.

To assist in the evaluation process both pilots and surgeons have turned to the basic “checklist” to help minimise errors.  In study after study, it has been found that a checklist approach to analysing a complex situation has prevented errors and raised the effectiveness of both amateurs and experts alike. Even the most experienced airline pilot or surgeon with the most advanced equipment would never perform routine tasks in the aircraft or operating room without using a checklist.  

Atul Gawande, a surgeon and associate professor at Harvard Medical School, is a leading proponent of checklists. His book The Checklist Manifesto” discusses the benefits of implementing a checklist procedure:

"We need a different strategy for overcoming failure, one that builds on experience and takes advantage of the knowledge people have but somehow also makes up for our inevitable human inadequacies. And there is such a strategy - though it will seem almost ridiculous in its simplicity, maybe even crazy to those of us who have spent years carefully developing ever more advanced skills and technologies. It is a checklist.

It’s no wonder, many of the Investment Masters have recognised the power of checklists and implemented their adoption in the investment process.

Charlie Munger, Warren Buffett’s partner, and one of the world's greatest investors has spent his life observing, studying and understanding human cognition and its limitations. Mr Munger, like many of the Investment Masters, acknowledges the benefits of checklists and has adopted them in his investing.

"Checklist routines avoid a lot of errors. You should have all this elementary [worldly] wisdom and then you should go through a mental checklist in order to use it. There is no other procedure in the world that will work as well."  Charlie Munger

"No wise pilot, no matter how great his talent and experience, fails to use a checklist." Charlie Munger

"We're big believers in checklists, which are the best tools available to reduce preventable human errors" Joel Hirsch

"I'm a prolific maker of lists, and the more trouble I had in the early 1990s, the more I attacked it and dealt with it by making lists and checking off items as we accomplished them" Sam Zell

Unfortunately investors miss things, it’s human nature. Humans have learnt to survive by taking mental short-cuts. While useful in the wilderness, these can be detrimental to investing. 

"Why are checklists so effective? We think we're very smart; we take shortcuts, especially in investing.  We get euphoric about all the money we're going to make, and we are just a mix of rationality and emotions.  We see a great undervalued business, we ask ourselves a bunch of questions, but we don't go through a systematic process of looking at every nook and cranny to figure out whether we got it right or not" Mohnish Pabrai

One mental short-cut is jumping to conclusions. Often an investor, sees only what they are looking for.  Here is a good example from Richards Heuer, author of the CIA handbook, the 'Psychology of Intelligence Analysts' ..

When you looked at the figure above what did you see?  The simple experiment demonstrates one of the most fundamental principles concerning perception: We tend to perceive what we expect to perceive [note each triangle contains two 'the''s or 'A's']. Mr Heuer noted:

"Many experiments have been conducted to show the extraordinary extent to which the information obtained by an observer depends upon the observer's own assumptions and pre-conceptions."

"Patterns of expectations tell analysts, subconsciously, what to look for, what is important, and how to interpret what is seen.  These patterns form a mind-set that predisposes analysts to think in certain ways.”

Daniel Khaneman, in his highly regarded book on human cognition and biases, "Thinking Fast and Slow" noted :

"Jumping to conclusions is efficient if the conclusions are likely to be correct and the costs of an occasional mistake acceptable, and if the jump saves much time and effort. Jumping to conclusions is risky when the situation is unfamiliar, the stakes are high, and there is no time to collect more information. These are the circumstances where intuitive errors are probable"

A tendency also exists for people to search for confirming evidence and ignore or overlook disconfirming evidence. Given an investors initial decision to analyse a stock is grounded in the perception it may be an attractive 'buy' [or 'short'], all investors tend to carry a bias.

"We tend unconsciously to select evidence that will support our point of view" Bennett Goodspeed

"Contrary to the rules of philosophy of science, who advise testing hypothesis by trying to refute them, people seek data that are likely to be compatible with the beliefs they currently hold" Daniel Khaneman

In his excellent book 'The Tao Jones Averages', Bennett Goodspeed noted:

"Most of our personal, business, and investment problems are not caused because we lack intelligence or are lazy. Rather, the most common cause of failure is that we fail to see and/or otherwise ignore the numerous yellow and red warning signals that are waved before our eyes. One reason is that warning signals are but one of the many information inputs vying for our attention.. Another reason why we see reality so poorly, and often miss the warning signs, is that our logical left hemisphere interferes with the seeing abilities of the right brain."

Mr Goodspeed provides the following example: read carefully the sentence below and count the number of f's in the sentence. Re-read it again carefully:

Did you find all six f's? If not, you shouldn't be surprised, as only 15% of people who take the text get it correct. If you counted less than six (most count three) you likely missed the f's in the words 'of'.  Your error was not that you did not see the f's in the of's (you did), but that you failed to count them. Since 'of'' is phonetically 'ov' the verbal left hemisphere, by taking the verbal clue, overrode the right, 'seeing' hemisphere and thus forced the wrong conclusion.  The checklist will help avoid simple misses.

“Before I make the final decision to buy any stock, I turn to my checklist in a last-ditch effort to prevent my unreliable brain from overlooking any potential warning sign that I might have missed” Guy Spier

“I’m a great believer in solving hard problems by using a checklist. You need to get all the likely and unlikely answers before you; otherwise it’s easy to miss something important.” Charlie Munger

In the example above, you wouldn't have made the mistake if the words had been reversed and you couldn't read the sentence.  Bennnett Goodspeed shares the story of an art teacher who revolutionized the way art was taught. In her six-week drawing class, the improvement of her students was not gradual, but dramatic. Her technique for teaching art served to turn off the left brain hemisphere. She recognised that the left brain interferes with perception because of its simplistic certainty. If it can name and categorize something, it need not look carefully.

One of the instructional drawing exercises the teacher taught was to draw the picture upside down. The idea is to "trick" the left brain so that it is unable to characterize the facial components. In a like manner, forgers commonly copy signatures upside down in order to eliminate the bias of their own writing.  Many famous painters check there work in the reflection of a mirror for the same reason.

In a similar fashion, many of the Investment Masters invert their analysis, something that can be helped with the aid of a checklist.

"Our checklists have been invaluable in helping us reduce pilot error and they have become a platform to remind us of previous lessons learned. These lessons can be soon forgotten when animal spirits and biases emerge to prove a theory. Our checklists were built to invert our thinking the way a scientist would seek to prove the null hypothesis. For example, if we want to know if the investment is mispriced, the checklist seeks to invert the question to solve why the investment is NOT mispriced. We have found that this inversion helps reduce the biases that bleed into any investment process." Christopher Begg

Is it time you considered adopting checklists in your investment process? .... Stay tuned for Part 2 which will detail the attributes of a good checklist and provide the foundation for building your own...

 

Further Reading: 'Checklists Tutorial' - Investment Masters Class

Learning from Jeff Bezos

"I've never seen any person develop two really important industries at the same time. Jeff Bezos is the most remarkable businessperson of our age" Warren Buffett

I remember listening to Warren Buffett complementing Jeff Bezos at Berkshire Hathaway's first live-streamed annual meeting in April 2016. In a more recent interview, Buffett referred to Jeff Bezos and recommended viewers watch the Charlie Rose interview with him [see here].  Below I've summarised some of the aspects of the interview I found most interesting ...

THINK BACKWARDS

".. the thing that connects everything that Amazon does is the number one - our number one conviction and idea and philosophy and principle which is customer obsession, as opposed to competitor obsession. And so we are always focused on the customer, working backwards from the customer's needs, developing new skills internally so that we can satisfy what we perceive to be future customer needs. We have a whole working backward process that starts with the customer needs and works backwards. So that is really, if you look at, seems like we are in a bunch of different businesses" Jeff Bezos

'Thinking backwards' or 'inverting' is a commonly undertaken method of analysis by the Investment Masters.  In a recent Wealthtrack interview, Investment Master Thomas Russo stated... "Amazon is nothing to do with technology, Bezos is all about customer service. All about the consumer experience. Bezos’s job is to reason back from what steps it will take to improve consumer experience and that directs his investment. That is purely the ‘Charlie Munger’ story. Charlie has said at annual meeting for decades, the way to live your life is through the power of ‘inversion’. Think of what it is you want to create, and reason backwards to come up with most efficient way to get there.  That’s Charlie Munger in spades and that’s exactly what Bezos is talking about."

INVENTIVE CULTURE

"We have a very inventive culture, so we like to pioneer invent" Jeff Bezos

The Investment Masters recognise that a common trait amongst successful companies is a culture of innovation. In a study of US firms, James Heskett, a Professor Emeritus at Harvard University's Business School and renowned business culture expert, found "organizations with the best performance were those with values and leadership that encouraged behaviours such as innovation, continuous quality improvement, bench-marking against the world's best, and efforts to import good ideas from anywhere outside the organisation as well as to generate them within". Mr Heskett noted "we deemed these values and behaviours typical of an adaptive culture, one that supports an organisation's ability to adapt to change in the competitive, social and regulatory environment".

THINK LONG TERM

"Willingness to think long-term. I think that is another common thread that runs through every single thing we do" Jeff Bezos

"It's the combination of the risk-taking and the long-term outlook that make Amazon, not unique, but special in a smaller crowd. And then finally, taking real pride in operational excellence, so just doing things well, finding defects, and working backwards." Jeff Bezos

The Investment Masters understand the benefits of taking a long term view.  They look out three to five years or more with a view to figuring out the company's likely competitive position, what it might be earning, and thus likely to be worth, at that time.  Warren Buffett has informed Berkshire's shareholders that he will measure the success of his investments 'by the long term-progress of the companies rather than by the month-to-month movements of their stocks'.

Occasionally, companies may forego near term earnings by investing in longer term initiatives. Thomas Russo makes the point with respect to Berkshire's investment in GEICO .. "when is it sensible to accept lower earnings? When you have the capacity to suffer. Buffett decided to forgo profits at GEICO to take market share from 2% to 11% by spending more on marketing."

Conversely, companies that are subject to short term imperatives, and are unable to adopt a longer term view are likely to suffer over the longer term. The highly successful corporate investor, Henry Kravis of KKR notes .. “The trouble, in my opinion, with corporate America today, is that everything is thought of in quarters. Analysts push them. “What are you going to earn this quarter?” We say to the management of companies, “You are here today. Where do you want to be five years from now, and how are you going to get there?” It may very well mean taking a step backwards. But believe me, in five years, we are going to have a company that is much more productive, efficient, and competitive.

ROOM FOR IMPROVEMENT

"I am never disappointed when we're not good at something because I think, well think how good it's going to work when we are good at it...  There is so much opportunity. Nobody really knows how to do a great job of offering -- apparel online yet.  And we have tons of invention and ideas and working our way through that experimental list." Jeff Bezos

COMPETITION

"One of the most unusual things that happened with Amazon Web Services is the amount of runway that we got, which is a gift, before we faced like-minded competition - it appears to me just empirically that if you invent a new way of doing something, typically if you are lucky, you get about two years of runway before competitors copy your idea. And two years is actually a pretty long time in a fast-moving industry so that's a big head start." Jeff Bezos

"Amazon Web Services got seven years of runway before we faced like-minded competition." Jeff Bezos

Competition is what destroys corporate returns. As Investment Master, Sam Zell has noted "There's no substitute for limited competition. You can be a genius, but if there's lots of competition, it won't matter. I've spent my career trying to avoid it's destructive consequences". Having a runway without competition allowed Bezos to establish a first mover advantage by building scale which allowed pricing at a level which is uneconomical for potential competitors without such scale.

INNOVATE

"every year, 500, 600, 700, 800 new features and services [are added to Amazon Web Services]" Jeff Bezos

Companies must continue to innovate. The Investment Master, Phil Fisher stated .. “The company that doesn’t pioneer, doesn’t take chances, and merely goes along with the crowd is liable to prove a rather mediocre investment in this highly competitive age”. Famous Nobel Prize physicist and renowned thinker Richard Feynman said “I think that to keep trying new solutions is the way to do everything”.

THE POTENTIAL OF AMAZON WEB SERVICES [AWS]

"Amazon.com, the retailer needs these things. But pretty soon everybody is going to need these things. And so with a little extra work, we can turn what we were going to build just for ourselves into a service for the world. And that's what we did." Jeff Bezos

Amazon realised the benefits of turning a cost centre into a revenue generator. Ben Thompson of Stratechery, one of the most insightful commentators on digital businesses and disruption, has noted.. "The incredible potential of Amazon Web Services is as clear as its initial prospects in 2006 were, well, cloudy. AWS only came about after Amazon had experimented with more full-service offerings like powering the websites of Target or Toys-R-Us, and there were plenty of skeptics as to whether companies would entrust critical operations to a 3rd party. It soon became apparent, though, that both economics and simplicity were overwhelmingly in the public cloud’s favor, and Amazon was years ahead of everyone.  

...  the economics of scale achieved by Amazon (and its closest competitors, Google and Microsoft) are so incredible that multi-billion dollar companies like Netflix view it as more efficient to pay Amazon than to build their own data centers. The calculus is even more stark when it comes to any sort of startup: it’s so much easier and cheaper to get started with AWS that the idea of buying your own server infrastructure — an expense that consumed the majority of venture capital in the dot-com bubble era — is preposterous. This is great from Amazon’s perspective: the company effectively has a stake in nearly every significant startup, and for free; if the company succeeds, Amazon will be paid, handsomely, and if they fail, well, Amazon covered their own costs of providing cloud services along the way."

Not only did AWS provide Amazon with a significant revenue opportunity, it highlighted the benefits of opening up parts of Amazon to competition.  In a recent article "Why Amazon is eating the world" author Zack Kanter notes "Because of the timing of Amazon’s unparalleled scaling — hypergrowth in the early 2000s, before enterprise-class SaaS was widely available — Amazon had to build their own technology infrastructure. The financial genius of turning this infrastructure into an external product (AWS) has been well-covered — the windfalls have been enormous, to the tune of a $14 billion annual run rate. But the revenue bonanza is a footnote compared to the overlooked organizational insight that Amazon discovered: By carving out an operational piece of the company as a platform, they could future-proof the company against inefficiency and technological stagnation."

AMAZON PRIME MODEL

"You say to yourself, well, what else -- now that I have paid my $99 a year, how else can I use this membership? And so when people join Prime, they buy more shoes, they buy more diapers, they buy more dish-washing detergent, they buy more books and electronics and toys and so on and so on. And so we really want people to join Prime." Jeff Bezos

Amazon benefits from the psychological bias of sunk costs. Amazon Prime is similar to the Costco model - a subscription service. Amazon Prime has the additional benefit that members gets things for 'free' which is likely to trigger reciprocation tendencies.  The more people buy on Amazon, the more scale benefits Amazon gets and the larger the competitive advantage. In addition, members feel they have made an investment, so are less likely to 'shop around'.

Richard Thaler, Professor of Behavioural Science at the University of Chicago, touched on the cognitive biases that drive the success of a subscription model in his excellent book 'Misbehaving'. He noted "In order to shop at Costco a customer must become a 'member', which currently costs a household $55 a year. It seems likely that members view the annual fee as an 'investment' and make no attempt to allocate that cost over the various purchases they make during the year. Rather, it serves as a sunk cost, offering up yet another reason to shop at Costco. Similarly, Amazon charges customers $99 a year to become a "prime member" which entitles them to "free" shipping. Again the cost of the membership may well be viewed as an investment that does not "count" toward the cost of a particular purchase".

ARBITRAGING OTHER PEOPLES CAPEX

"So Amazon was a tiny, little company that started with four people, and that -- we could only do, we built Amazon because we didn't have to do any of the heavy lifting. The transportation and logistics infrastructure of U.S. Postal Service which would have been hundreds of billions in CapEx, already existed. We didn't have to build the internet, it was run on, on long distance cables that were actually put in the ground for long-distance phone calls. And we didn't have to build a payment system, the credit card system already existed. So all these things would have been tens of billions or hundreds of billions in CapEx and we got to rest on top of them.. On the internet, two kids in a dorm room can take, change an industry completely" Jeff Bezos

Amazon had a first mover advantage that leveraged a combination of technologies to create a business which would not have been possible without other peoples inventions and capital spending.  Amazon falls into a category that Charlie Munger would define as a multi-factor-triggered 'Lollapolooza' effect.

 

Both Charlie Munger and Warren Buffett recognise the brilliance of Jeff Bezos and what he has achieved with Amazon.  Studying successful business people and business models can provide insights into the investment process. As Warren Buffett says "I am a better investor because I am a businessman, and a better businessman because I am an investor."

Further Recommended Reading:

"Why Amazon is eating the world" - Tech Crunch -  Zack Kanter
"Amazon's New Customer [Whole Foods]", 'The Amazon Tax", "The AWS IPO" - Stratechery - Ben Thompson
"Invert, Always Invert" Investment Masters Class Tutorial
 



 

 

 

 

Investment Wisdom - Sam Zell style

I enjoy reading books about the world's greatest investors, particularly autobiographies. Usually I find I learn something new, discover a different angle to investing or rekindle an interesting past idea. And I find so many common threads that run through the thinking and processes employed by the Investment Masters

Prompted by recommendations from some of my clients, as well as one of the Investment Masters (Mohnish Pabrai, who is sending a copy to Warren and Charlie) I just finished reading Sam's Zell's autobiography, "Am I being too Subtle".

Sam Zell is a self-made American billionaire businessman and investor whose nickname the 'grave dancer' originates from his highly profitable large scale property acquisitions after the commercial property crash of the mid-1970s.

I've known of Sam Zell for the last couple of decades and have enjoyed listening to his speeches at various global property conferences during the early days of property securitisation - what was the beginnings of today's global REIT market.

I'll never forget the day the Blackstone Group bid for his listed company Equity Office Properties [EOP]. It was early 2007, and despite our REIT research team's best efforts to convince me otherwise,  I was bearish on the REIT market at the time. The morning the bid became public our REIT analyst exclaimed "I told you property was cheap, Blackstone have bid for EOP" to which I responded "They don't call him the 'grave dancer' for nothing". Needless to say, Sam Zell came out on top in that transaction, as it was only a matter of months before the Global Financial Crisis was upon us.

The book, 'Am I being too Subtle' details how the EOP transaction unfolded and why Sam sold.  The offer was too good to refuse, "A Godfather Offer" as Sam called it. 

The book is an engaging read which details Sam's early childhood, his parent's brave escape from the Nazi's in Poland and the devastation that wreaked havoc on the family that remained. His parent's escape from Poland and his early upbringing in Chicago had a deep influence on his philosophy and outlook. 

The book takes the reader on a journey through Sam's positive and not-so positive investments. It serves as a useful guide to successful investing. Sam Zell comes across as a highly likeable, open-minded, hard working and opportunistic investor who searches beyond conventional wisdom for ideas.

I've included some of my favourite quotes from the book below.  Not surprisingly, I've unearthed almost fifty quotes that parallel with the 100 tutorials in the Investment Masters Class. There are, after all, many commonalities between the world's most successful investors.

"Conventional wisdom is nothing to me but a reference point. In fact, I believe it can be a horribly debilitating concept"

"I have an insatiable curiosity, and as a kid I thrived on wandering around my Chicago neighborhood on my own"

"I spend almost my entire day listening to other people, I ask questions, I probe, I raise possibilities"

"I am a voracious consumer of information"

"I look for clarity, and if something's not clear, I get more information"

"Think beyond the norm"

"I don't make assumptions"

"Reputation is your most important asset"

"Everything I've done has been because I've loved doing it"

"I fully realized the value of tenacity. I just had to assume there was a way through any obstacle, and then I'd find it. This is perhaps my most fundamental principle of entrepreneurialism, and to success in general"

"My focus is always on the downside"

"Liquidity equals value"

"I realized that the basics of business are straightforward. It's largely about risk. If you've got a big downside and a small upside run the other way. If you got a big upside and a small downside, do the deal"

"I rely on a macro perspective to identify opportunities and make better decisions"

"Where there is scarcity, price is no object. This basic tenet of supply and demand would later become a governing principle of my investment knowledge"

"I often went back - and still do - to what was written up there on the blackboard when I first walked into Econ 101: Supply and Demand. In fact, much of my career has been about understanding and acting on this basic tenet - whether it's in real estate, oil and gas, manufacturing, or whatever. Opportunity is very often embedded in the imbalance between supply and demand. It could be rising demand against flat or diminishing supply, or flat demand against shrinking supply"

"There's no substitute for limited competition. You can be a genius, but if there's lots of competition, it won't matter. I've spent my career trying to avoid it's destructive consequences"

"The exponential value of scale would influence my assessment of investment opportunities - in and outside of real estate - throughout my career"

"I like to invest below replacement cost, thereby creating a competitive advantage"

"Replacement cost mattered more to me than rents or comparable prices or vacancies or economic growth or stock price. This was because replacement cost determined the price of future competition"

"We liked asset-intensive investments because if the world ended, there would be something to liquidate"

"Jay [Pritzker] taught me to use simplicity as a strategy. He had an uncanny ability to grasp an extremely complex situation and immediately locate the weakness. He says that if there were twelve steps in a deal, the whole thing depended on just one of them. The others would work themselves out or were less important. He had a laser focus on risk"

"To me risk-taking rests on the ability to see all the variables and then identify the ones that will make or break you"

"Some of the best deals of course, are the ones you don't do"

"Among my most salient takeaways was the value of optionality"

"I have always believed that every day you choose to hold an asset, you are also choosing to buy it"

"Sentimentality about an asset leads to a lack of discipline"

"I am industry agnostic"

"No matter how much time you put into addressing risk, sometimes there are unforeseen events that blindside you"

"Being global, if not in business then in mind-set, isn't really a choice, in my opinion. It's a mandate, a responsibility, and a thrill"

"I've always believed in buying into in-place demand rather than trying to create it"

"As a risk-taker my greatest fear is not having information that might protect me from making a mistake. The only way I can do that is to create an atmosphere where there are no silos"

"I'm a great believer in aligned interests, skin in the game"

"Trying to be right 100% of the time leads to paralysis"

"You can never be truly successful unless you give to others"

It's time to invest, 'grave dancer' style ....

The Munger Series - Learning from Charles Darwin

"The life of Darwin demonstrates how a turtle may outrun the hares, aided by extreme objectivity, which helps the objective person end up like the only player without a blindfold in a game of Pin the Tail on the Donkey" Charlie Munger

Charlie Munger, one of the most successful Investment Masters, has referred to the brilliance of Charles Darwin on numerous occasions. This prompted my interest in the 'Autobiography of Charles Darwin'. I found it insightful, and as fresh and relevant today despite almost 150 years passing since its writing. At just 120 pages, it's an easy read.

"[Darwin] is precisely the type of example you should learn nothing from if bent on minimizing your results from your own endowment" Charlie Munger

"One of the most successful users of an antidote to first conclusion basis was Charles Darwin. He trained himself, early, to intensively consider any evidence tending to disconfirm any hypothesis of his, more so if he thought his hypothesis was a particularly good one. The opposite of what Darwin did is now called confirmation bias, a term of opprobrium.  Darwin's practice came from his acute recognition of man's natural cognitive faults arising from Inconsistency-Avoidance Tendency. He provides a great example of psychological insight used correctly to advance some of the finest mental work ever done" Charlie Munger

I've included some of the more interesting observations below. You'll notice nearly all of the headings I've chosen are tutorial topics from the Investment Masters Class and have as much relevance to investing as they do to Darwin's grand discovery. Whether you are looking to make the next scientific breakthrough or seeking investment wisdom, like Charlie Munger, you can learn a lot from Charles Darwin.

Education and Smarts

"I have been told that I was slower in learning than my younger sister Catherine, and I believe that I was in many ways a naughty boy"

"When I left school I was for my age neither high nor low in it; and I believe that I was considered by all my masters and by my Father as a very ordinary boy, rather below the common standard of intellect"

"During the three years which I spent at Cambridge my time was wasted, as far as academical studies were concerned"

"I have deeply regretted that I did not proceed far enough at least to understand something of the great leading principles of mathematics"

Learning

"I had strong and diversified tastes, much zeal for whatever interested me, and a keen pleasure in understanding any complex subject or thing"

Reading

"I was fond of reading various books, and I used to sit for hours reading the historical plays of Shakespeare, generally sitting in an old window in the thick wall of the school"

"During my last year at Cambridge I read with care and profound interest Humboldt's Personal Narrative. This work and Sir J. Herschel's Introduction to the Study of Natural Philosophy stirred up in me a burning zeal to add even the most humble contribution to the noble structure of Natural Science. No one or a dozen other books influenced me nearly so much as these two"

"When I see the list of books of all kinds which I read and abstracted, including whole series of Journal and Transactions, I am surprised at my industry"

Love

"Looking backwards, I can now perceive how my love for science gradually preponderated over every other taste"

"My love of natural science has been steady and ardent"

Consensus

"On this [first geology] tour I had a striking instance how easy it is to overlook phenomena, however conspicuous, before they have been observed by anyone"

"As far as I can judge, I am not apt to follow blindly the lead of other men.

Understanding and Patience

"From my early youth, I have had the strongest desire to understand or explain whatever I observed - that is, to group all facts under some general laws. These causes combined have given me the patience to reflect or ponder for any number of years over any unexplained problem"

Commitment/Confirmation Bias

"I have steadily endeavoured to keep my mind free, so as to give up any hypothesis, however much beloved (and I cannot resist forming one on every subject) as soon as facts are shown to be opposed to it. Indeed I have had no choice but to act in this manner"

"I cannot remember [with the exception of the Coral Reefs] a single formed hypothesis which had not after a time to be given up or greatly modified"

Collect the Facts

"On first examining a new [geological] district nothing can appear more hopeless than the chaos of rocks, but by recording the stratification and nature of the rocks and fossils at many points, always reasoning and predicting what will be found elsewhere, light soon begins to dawn on the district, and the structure of the whole becomes more or less intelligible"

"I think I am superior to the common run of man in noticing things which easily escape attention, and in observing them carefully"

"I was very glad to learn from him [H. Spencer] his system of collecting facts. He told me that he bought all the books which he read, and made a full index to each, of the facts which he thought might prove serviceable to him, and that he could always remember in what book he had read anything, for his memory was wonderful. I then asked how at first he could judge what facts would be serviceable and he answered that he did not know, but that sort of instinct guided him. From this habit of making indices, he was enabled to give the astonishing number of references on all sorts of subjects, which may be found in his History of Civilization"

"In several of my books facts observed by others have been extensively used"

"I keep thirty to forty large portfolios, in cabinets with labelled shelves, into which I can at once put a detached reference or memorandum. I have bought many books and at their ends I make an index of all the facts that concern my work; or, if the book is not my own, write out a separate extract, and of such abstracts I have a large drawer full. Before beginning on any subject I look to all the short indexes and make a general and classified index, and by taking the one or more portfolios I have all the information collected during my life ready for use"

".. it appeared to me that by following the example of Lyell in Geology, and by collecting all facts which bore in any way on the variation of animals and plants under domestication and nature some light might perhaps be thrown on the whole subject"

"I worked on true Baconian principles, and without any theory collected facts on a wholesale scale, more especially with respect to domesticated productions, by printed enquiries, by conversation with skilful breeders and gardeners, and by extensive reading"

Hard Work

".. no importance compared with the habit of energetic industry and of concentration to whatever I was engaged in"

Writing

"I wrote my Journal, and took much pains in describing carefully and vividly all that I had seen; and this was good practice"

Intuition

"My mind seems to have become a kind of machine for grinding general laws out of large collections of facts"

Mistakes

"This paper [published on a geological formation] was a great failure, and I am ashamed of it... my error has been a good lesson to me to never trust in science to the principle of exclusion"

"It was necessary for science that [such] mistakes should be exposed"

"Whenever I have found out that I have blundered, or that my work has been imperfect, and when I have been contemptuously criticized, and even when I have been overpraised, so that I have felt mortified, it has been my greatest comfort to say hundreds of times to myself that "I have worked as hard and as well as I could, and no man can do more than this"

Thinking and Age

"A man after a long interval can criticize his own work, almost as well as if it were that of another person"

"I think I have become a little more skilful in guessing right explanations and in devising experimental tests; but this may probably be the result of mere practice, and a larger store of knowledge. I have as much difficulty as ever expressing myself clearly and concisely; and this difficulty has caused me a very great loss of time; but it has had the compensating advantage of forcing me to think long and intently about every sentence, and this I have been often led to see errors in reasoning and in my own observations or those of others"

Testing ideas

"I saw more of Lyell than any other man both before and after my marriage. His mind was characterized, as it appeared to me, by clearness, caution, sound judgement and a good deal or originality. When I made any remark to him on Geology, he never rested until he saw the whole case clearly and often made me see it more clearly than I had done before. He would advance all possible objections to my suggestion; and even after these were exhausted would long remain dubious"

"While in thought, he [Lyell] would throw himself into the strangest attitudes, often resting his head on the seat of a chair, while standing up"

Avoiding Bias

"Fifteen months after I began my systematic enquiry, I happened to read for amusement Malthus on Population, and being well prepared to appreciate the struggle for existence which everywhere goes on from long-continued observation of the habits of animals and plants, it at once struck me that under these circumstances favourable variations would tend to be preserved, and unfavourable ones to be destroyed. The result of this would be the formation of new species. Here then I had last got a theory to work with, but I was so anxious not to avoid prejudice, that i determined not for some time to write even the briefest sketch of it."

"I had, also during many years, followed a golden rule, namely whenever a published fact, a new observation or thought came across me, which was opposed to my general results, to make a memorandum of it without fail and at once; for I had found by experience that such facts and thoughts were far more apt to escape from memory than favorable one. Owing to this habit, very few objections were raised against my views which I had not at least noticed and attempted to answer"

Humility in conclusion..

"Therefore, my success as a man of science, whatever this may have amounted to, has been determined, as far as I can judge, by complex and diversified mental qualities and conditions. Of these the most important have been - the love of science - unbounded patience in long reflecting over any subject - industry in observing and collecting facts - and a fair share of invention as well as common sense. With such moderate abilities as I possess, it is truly surprising that thus I should have influenced to a considerable extent the beliefs of the scientific men on some important points

Let Charles Darwin give you an edge in the struggle for investment survival ...

The Munger Series - Learning from Lee Kuan Yew

“If you will make a study of the life and work of Lee Kuan Yew, you will find one of the most interesting and instructive political stories written in the history of mankind. This is better than Athens, this is an unbelievable history. And you will learn a lot that will be useful in life. Study the life and work of Lee Kuan Yew, you are going to be flabbergasted” Charlie Munger

I often choose books to read from recommendations of the Investment MastersI wanted to learn more about the late Lee Kuan Yew, the Prime Minster of Singapore for three decades, given Charlie Munger often praises him. Lee Kuan Lew took a swampland and turned it into a developed country in one generation.

The book 'Lee Kuan Yew - The Grand Master's Insights on China, the United States, and the World' gathers key insights from interviews, speeches, and Lee's voluminous published writings and presents them in an engaging question and answer format.

Lee Kuan Yew thought deeply about how to take Singapore up the ladder of economic prosperity and had incredible insights into how the world worked.

I was fascinated by the extent to which the lessons and insights of this great leader and his country overlap with those of great businesses and their CEOs. In many ways Lee Kuan Yew thought about, and ran his country, like a business. His thinking process mirrors many of the great investors.

It's a very easy book to read, I finished it over a weekend. I've included some of the more interesting observations..

China

"The Chinese have calculated that they need 30 to 40, maybe 50 years of peace and quiet to catch up, build up their system, change it from the communist system to the market system"

"I believe the Chinese leadership has learnt that if you compete with America in armaments you will lose. You will bankrupt yourself. So avoid it, keep your head down, and smile, for 40 or 50 years"

"China will inevitably catch up to the US in absolute GDP. But it's creativity may never match Americas, because its culture does not permit free exchange and contest of ideas"

"Technology is going to make their system of governance obsolete."


"[Not having English as a first language] is a serious handicap.. Talent will not go to China"

America

"The US is the most militarily powerful and economically dynamic country in the world. It is the engine for global growth through its innovation and consumption"

"Throughout history, all empires that succeeded have embraced and included in their midst people of other races, languages, religions and cultures"

"What has made the US economy preeminent is its entrepreneurial culture .. Entrepreneurs and investors alike see risk and failure as natural and necessary for success"

"In an era of rapid technological change, Americans have shown that those countries with the largest number of start-ups, especially in the IT sector, which venture capitalists finance, will be winners in this next phase"

"Many American practices go against the grain of the more comfortable and communitarian cultural systems of their own societies [the European and Japanese]"

"The Americans have succeeded as against the Europeans and the Japanese because they have more extremes of random behaviour"

"America has a clear advantage over China, because its use of the English language enables America to attract millions of English-speaking foreign talent from Asia and Europe"

"Security, prosperity, and the consumer society plus mass communications have made for a different kind of person getting elected as a leader .. who can present himself and his programs in a polished way... From such a process, I doubt if a Churchill, a Roosevelt, or a de Gaulle can emerge"

"The US must not let is fiscal deficits come to grief"

"The world has developed because of the stability America established. If that stability is rocked, we are going to have a different situation"

America and China

"There will be a struggle for influence, I think it will be subdued because the Chinese need the US, need US markets, US technology, need to have students going to the US to study ways and means of doing business so they can improve their lot. It will take them 10,20, 30 years"

India

"India has wasted decades in state planning and controls that have bogged it down in bureaucracy and corruption'. The caste system has been the enemy of meritocracy"

"India has poor infrastucture, high administrative and regulatory barriers to business, and large fiscal deficits, especially at the state level which are a drag on investment and job creation"

"It is not one nation, but 32 different nations speaking 330 different dialects"

"India's private sector is superior to China's .. Indian companies follow international rules of corporate governance and higher return on equity as against Chinese companies. And India has transparent and functioning capital markets"

"The moment India has the infrastructure in place, investments will come in, and it will catch up very fast"

"India's system of democracy and rule of law gives it a long-term advantage over China, although in the early phases, China has the advantage of faster implementation of its reforms"

Singapore

"My definition of Singapore.. is that we accept that whoever joins us is part of us"

"[How did] Singapore make a living against neighbours who have more natural resources, human resources, and bigger space? How did we differentiate ourselves from them? They are not clean systems; we run clean systems. Their rule of law is wonky, we stick to the law. Once we come to an agreement or make a decision, we stick to it. We become credible to investors."

"I offered every parent a choice of English and their mother tongue, in whatever order they chose"

"The quality of a nation's manpower resources is the single most important factor determining competitiveness. It is people's innovativeness, entrepreneurship, team work, and their work ethic that give them that sharp keen edge in competitiveness"

"Standing still is a sure way to extinction"

"Our education system is being revamped to nurture innovation and creativity, from kindergarten to university, and on to lifelong learning"

"The internet makes markets more contestable, businesses in Asia must compete on this platform or be swept aside"

"Societies that succeed are those which easily assimilate foreigners. Silicon valley is such a place"

"For a modern economy to succeed, a whole population must be educated"

"We have to start experimenting. The easy things - just getting a blank mind to take knowledge in and become trainable - we have done. Now comes the difficult part. To get literate and numerate minds to be more innovative, to be more productive, is not easy. It requires a mindset change, a different set of values"

"Once established, like a language a society speaks, the habits tend to become a self-reproducing, self perpetuating cycle"

"In one generation (1965-1990) we made it from the third world to the first"

Developing Countries

"One 'X' factor remains a key differentiator, especially for developing countries; that is ethical leadership. A clean, efficient, rational, and predictable government is a competitive advantage"

Governing

"I learned to ignore criticism and advice from experts and quasi-experts, especially academics in the social and political sciences"

"If you want to be popular all the time, you will misgovern"

"One person, one vote is a most difficult form of government. From time to time, the results can be erratic. People are sometimes fickle. They get bored with stable, steady improvements in life, and in a reckless moment, they vote for change for change's sake"

"If everybody gets the same rewards.. nobody strives to excel; society will not prosper, and progress will be minimal"

"[The most common public policy mistakes are when leaders sometimes] succumb to hubris and over-confidence"

Thinking

"We may have conquered space, but we have not learned to conquer our own primeval instincts and emotions that were necessary for our survival in the Stone Age, not in the space age"

"We read many things. The fact that it is in print and repeated by three, four authors does not make it true. They may all be wrong"

"You must not overlook the importance of discussion with knowledgeable people. I would say it is much more productive than absorbing or running through masses of documents"

"I do not work on a theory. Instead I ask: what will make this work? If after a series of solutions, I find that a certain approach worked, then I try to find out what was the principle behind the solution"

"Our test was: does it work? Does is bring benefits to the people?"

"I do not believe that because a theory sounds good, looks logical on paper, or is presented logically, therefore that is the way it will work out. The final test is life"

"If you do not know history, you think short term. If you know history you think medium and long term"

"To understand the present and anticipate the future, one must know enough of the past, enough to have a sense of the history of a people"

"Do not try to impress by big words. Impress by the clarity of your ideas. I speak as a practitioner. If I had not been able to reduce complex ideas into simple words and project them vividly for mass understanding, I would not be here today"

"To create wealth, high motivation and incentives are crucial to drive people to achieve, to take risks for profit, or there will be nothing to share"

"Realism and pragmatism are necessary to overcome new problems"

"[Of all my Cabinet colleagues, Goh Keng Swee made the greatest difference to the outcome of Singapore ..] he had a capricious mind and a strong character. When he held a contrary view, he would challenge my decisions and make me re-examine the premises on which they were made. As a result we reached better decisions for Singapore. In the middle of a crisis, his analysis was always sharp, with an academic detachment and objectivity that reassured me"


 

 

 

Are You Checking the Portfolio Too Often?

Warren Buffett doesn't have a computer on his desk. He buys stocks for the long run and he doesn't let short term stock prices impact his investing decisions. He advises investors "Don't watch the market closely" highlighting that when investors are "trying to buy and sell stocks, and worry when they go down a little bit - and think they should maybe sell them when they go up - they're not going to have very good results".  

While it's important to keep abreast of developments at a company, it's important not to let a company's short term stock price move unduly influence investment decision-making. In many cases, short term stock moves are purely random phenomena.

"Some investors attach great importance to the daily or even hourly ups and downs, while others, like the undersigned, pay them no heed except when they present us with mouth-watering opportunity to do something" Frank Martin

As humans have evolved to feel losses significantly more than gains an investor who experiences a stock price decline maybe liable to make sub-optimal investment decisions.

“When directly compared or weighted against each other, losses look larger than gains.  This asymmetry between the power of positive and negative expectations or experiences has an evolutionary history.  Organisms that treat threats as more urgent than opportunities have a better chance to survive and reproduce”  Daniel Kahneman

“When an investor focuses on short-term increments, he or she is observing the variability of the portfolio, not the returns – in short, being “fooled by randomness”.  Our emotions are not designed to understand this key point, but as investors, we need to come to grip with our emotional liabilities.”  Barton Biggs

Nicholas Taleb, in his profound book, 'Fooled by Randomness', talks about the difference between noise and meaning. He uses the example of the happily retired dentist who builds himself a nice trading desk in his attic, aiming to spend every business day watching the market while sipping decaffeinated coffee.  He watches his inventory of stocks via a spreadsheet with live price updates. 

Taleb notes ..

"A 15% return with a 10% volatility (or uncertainty) per annum translates into a 93% probability of success in any given year.  But seen at a narrow time scale, this translates into a mere 50.02% probability of success over any given second as shown in the table.  Over the very narrow time increment, the observation will reveal close to nothing. Yet the dentist's heart will not tell him that. Being emotional, he feels a pang with every loss, as it shows in red on his screen. He feels some pleasure when the performance is positive, but not in equivalent amount as the pain when the performance is negative"

Screen Shot 2017-06-19 at 9.21.45 PM.png


"Viewing it from another angle, if we take the ratio of noise to what we call non-noise (ie left column/right column), which we have the privilege of examining quantitatively, then we have the following.  Over one month, we observe roughly 2.32 parts noise for every one part performance. Over one hour, 30 parts noise for every one part performance, and over a second 1,796 parts noise for every one part performance"

"Over a short time increment, one observes the variability of the portfolio, not the returns"

Allan Mecham of Arlington Value Capital [AVM] addressed the issue in his 2011 annual letter where he cited the historical odds of their fund outperforming the S&P500 in any given month over the preceding five years ...

"The data confirmed our suspicions: AVM performed 55% of the time - nearly a coin flip. This offers an interesting takeaway when combined with investors' inert psychology; had we reported monthly results, investors would have had the bizarre experience of disliking their exposure to top-notch gains (AVM's five year annualised return of 18.7% net of fees, versus -0.4% for the S&P500 would rank second out of 6,000 US equity funds tracked by Morningstar"

Many of the Investment Masters recognize the adverse psychological effects constant monitoring of a stock portfolio can have on investment returns.

“Almost all investors experience more pain and anguish from losses than they do pleasure from gains.  The agony is greater than the ecstasy. I don’t know why this is true, but it is. Maybe it’s because the investment business breeds insecurity.  But to the extent that the investor is focused on daily or even minute-by-minute performance of his or her portfolio, the time of pain is inadvertently increased and the time of pleasure reduced.  The problem is that the investment pain leads to anxiety, which in turn can cause investors to make bad decisions.  In other words continual performance monitoring is not good for your mental health or for your portfolio’s well-being, even though contemporary portfolio management systems and their suppliers, strenuously promote it” Barton Biggs

“Well-worn studies confirm the financial utility of long-term viewpoints; however, behavioural psychologists augment the case by showing investors dislike losses two to three times more than they like gains. If short-term gains/losses carry 50/50 odds, then the disdain for losses implies that infrequent monitoring and long-term horizons aide both mental health and financial wealth. In short, Winston Churchill's quip on revenge may aptly apply to myopic investment habits: "Nothing costs more and yields less."  Allan Mecham

"To be sure, the future is very abstract and provides little in the form of near-term emotional rewards. I've spent 40 years surrounded by people who watch the prices of the stocks they own as they fluctuate on a daily, or heaven forbid, hourly basis. Speeding through time on an emotional roller-coaster that ends where it starts is like envy: nothing good comes from the expenditure of enormous energy" Frank Martin

To counter this psychological bias, some of the Investment Masters, like Buffett, try to keep away from quote screens during the day.

"If I have a Bloomberg on, I find I am looking what the market is doing. I am looking at every news story.  I really like to be the one who is parsing the information, rather than having a lot of irrelevant information thrown at me"  Lou Simpson

"I don't have my computer or Bloomberg monitor set up to show me the price of all my holdings on one screen; if I need to check the price of a stock, I do it individually so that I won't see the price of all my other stocks at the same time. I don't want to see these other prices unnecessarily and to subject myself to this barrage of calls to action. It's worth thinking a little more about the effect of all this gratuitous noise on my poor brain. Checking the stock price too frequently uses up my limited willpower since it requires me to expend unnecessary mental energy simply resisting these calls to action. Given that my mental energy is a scarce resource, I want to direct it in more constructive ways. We also know from behavioural finance research by Daniel Kahneman and Amos Tversky that investors feel the pain of loss twice as acutely as the pleasure of gain. So I need to protect my brain from the emotional storm that occurs when I see that my stocks or the market are down. If there's average volatility, the market is typically up in most years over a 20-year period. But if I check it frequently, there's a much higher probability that it will be down at that particular moment. (Nassim Taleb explains this in detail in his superb book Fooled by Randomness.) Why, then, put myself in a position where I may have a negative emotional reaction to this short-term drop, which sends all the wrong signals to my brain?  " Guy Spier

By avoiding the impact of seeing short term losses an investor is more likely to be able to take a longer term perspective - a key edge in investing.

“Kahneman and Tversky were able to prove mathematically that individuals regret losses more than they welcome gains of the exact same size – two to two and one-half times more. It was a stunning revelation … If you don’t check your portfolio every day, you will be spared the angst of watching daily price gyrations; the longer you hold off, the less you will be confronted with volatility and therefore the more attractive your choices seem.  Put differently, the two factors that contribute to an investor’s unwillingness to bear the risks of holding stocks are loss aversion and a frequent evaluation period.  Using the medical word for short-sightedness, Thaler and Bernartzi coined the term myopic loss aversion to reflect a combination of loss aversion and the frequency with which an investment is measured… In my opinion, the single greatest obstacle that prevents investors from doing well in the stock market is myopic loss aversion”  Robert Hagstrom

“The more often people look at their portfolios, the less willing they will be to take on risk, because if you look more often, you will see more losses”  Richard Thaler

With regards the trading dentist, Taleb concluded ..

"Now that you know that the high-frequency dentist has more exposure to both stress and positive pangs, and that these do not cancel out, consider that people in lab coats have examined some scary properties of this type of negative pangs on the neural system (the usual expected effect: high blood pressure; the less expected: chronic stress leads to memory loss, lessening of brain plasticity, and brain damage). To my knowledge there are no studies investigating the exact properties of trader's burnout, but a daily exposure to such high degrees of randomness without much control will have physiological effects on humans (nobody studied the effect of such exposure on the risk of cancer). What economists did not understand for a long time about positive and negative kicks is that both their biology and their intensity are different. Consider that they are mediated in different parts of the brain that the degree of rationality in decisions made subsequent to a gain is extremely different from the one after a loss."

Is it time to move that Bloomberg terminal?

The Value of Cash

The typical equities investment mandate and most mutual funds are required to be fully invested in stocks. The mindset being that the asset allocation decision is a separate function from stock selection. So for instance in the case of a balanced fund, the asset allocator determines the percentage of total assets allocated to each asset class - cash, fixed income, bonds, alternatives etc. The equity manager gets the equities allocation and must remain fully invested in equities regardless of whether or not he or she can find quality assets at attractive prices.

In such an approach, the individual tasked with the stock picking is prohibited from holding cash even at times when they perceive valuations as unattractive or macro risks as elevated. It's not whether an investment makes or loses money that is important (ie absolute returns), their concern is the investment's performance relative to the stock market.

Most top-down asset allocation models place the greatest weight on an investors risk profile when determining appropriate asset exposures. Commonly, this is on the basis of age, ie young age = more risk tolerance = more equities exposure, less bonds. So there is little or no consideration to the relative attractiveness of each asset class at the time of it being set. While it sounds good in theory, the downside was blatantly obvious in the global financial crisis. In broad market sell-offs, it can be impossible for an equities manager to deliver attractive returns when they have to remain fully invested.

“For most people, the most dangerous self-delusion is that even a falling market will not affect their stocks, which they bought out of a canny understanding of value” Leon Levy

“Unfortunately, an emotionally inspired selling wave snowballs and carries with it the prices of all issues, even those that should be going up rather than down.” J Paul Getty

“I used to hold Berkshire stock as a proxy for cash and that was a mistake.  During times of distress, everything will go down, including Berkshire” Mohnish Pabrai

“When the market falls sharply, it doesn’t distinguish between the good girls and the bad girls”  Peter Cundill

“You're deluding youself if you believe your stocks, however cheap they are, won't temporarily go down when Mr Market decides to correct " Charles de Vaulx

The individual picking the stocks doesn't get to decide if stocks are attractive.  And, the asset allocator is rarely held accountable for a sub-optimal outcome and tends to hide behind the notion of historical asset class returns. If the balanced fund loses money in equities, the equity manager says "don't blame me I had to be fully invested" and the asset allocator responds "don't blame me, the ultimate fund investor is 20 years old and that means 45% [blah blah blah] was the right percentage to have in equities". Pass the buck! Conversely, the Investment Masters recognize that the optimal allocation to equities at a particular point in time is a function of relative price levels at that time, and relative pricing is constantly changing.

Contrary to this approach, the Investment Masters maintain a flexible approach to investing where they can hold cash if attractive opportunities aren't available. They don't compromise on their pricing criteria because they insist on operating flexible mandates that do not require them to be fully invested. In addition the Investment Masters recognize the benefits of having financial firepower to buy assets when opportunities arise.

Despite Warren Buffett advocating index funds to Joe Public his largest current holding is cash. In a recent CNBC interview Buffett stated ..

"Now unfortunately right now the largest 'business' we own-- we've got about $95 billion in and it's selling at a 100 times earnings. And the earnings can't go up, which sounds like a pretty dumb investment and it is. But that's what we get on treasury bills basically and-- we literally have-- it's not all in bills. But we have $95b in cash including mostly bills and we are paying a 100 times earnings for something like I say whose earnings can't go up. You get 1% and that does not make me happy. And I like to buy businesses. We will buy businesses. But it makes it much tougher-- when there's 1% money around and the people who-- many of the people who buy businesses use as much borrowed money as they can. And when they get that-- at rates that are based off that very low rate of 1%-- they can pay a lot more money than we can - using what-- pretty much all equity money 'cause that's the way we look at money. So-- we have not—made significant acquisition now for 15 months or thereabouts"

While Buffett says he doesn't consider the macro environment or the level of the stock market per se when making investments he will only invest when he can identify attractively priced opportunities. It makes sense that there are less attractively priced opportunities when markets are elevated than weak.

“It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.” Charlie Munger

The lesson from the Investment Masters is not to be afraid of holding cash. Cash is an asset which allows you to take advantage of opportunities when asset prices are subdued.

“Cash combined with courage in a time of crisis is priceless.” Warren Buffett

"In many different ways, cash gives you options.  It offers wonderful downside protection and upside optionality"  Mohnish Pabrai

"Because we are focussed on absolute returns, we will hold cash in the absence of values and a margin of safety. We view cash as an opportunity fund" Arnold Van Den Berg

The ability to hold cash provides investors with the flexibility to avoid buying unattractive assets. It is better to receive little or no returns from cash than exposing the fund to the risk of permanent loss of capital. 

“Holding cash is uncomfortable, but not as uncomfortable as doing something stupid” Warren Buffett

"Thinking outside the box about the optionality of cash gives quiet but resolute credence to the contention that this seemingly benign asset is in reality a double edged sword, defending against loss on one hand and arming for gain on the other." Frank Martin

 

Further Reading: Tutorial - Investment Masters 'The Value of Cash'
Frank Martin: 'An Enterprising Thought - Cash as an Option'

 

 

 

Invest Scared

 

The stock market has a long history of humbling investors.  The Investment Masters understand the need for humility. Ordinarily, when investors have had a good run they risk getting over-confident and letting down their guard, only to have the stock market deliver them losses.

Many of the Investment Masters maintain a psychology of fear..

“It is better if you invest scared, if you worry about losing money, if you worry about being wrong, if you worry about being overconfident because these are the things you want to avoid. They should be foremost in your mind.” Howard Marks

“We are big fans of fear, and in investing it is clearly better to be scared than sorry.”  Seth Klarman

“I know that to be successful, I have to be frightened. My biggest hits have always come after I have had a great period and I started to think that I knew something.”  Paul Tudor-Jones

“Our goal is to maintain that sceptical attitude about how the world is run, that concern bordering on fear for what might happen, but also to remain functional and able to make decisions while maintaining a portfolio”  Paul Singer

"We have a fear all the time. But that's what keeps us going, that's what keeps us focused. People who say 'I have no fear. I'm not afraid of ever failing,' are kidding themselves. It's the fear of failure, of not wanting to fail, that makes people as great as they are. I know that's what pushes me." Henry Kravis

It's impossible for an investor to know everything there is to know about a company, industry or situation. Investors are dealing with incomplete information and changing circumstances.  

“I am always search for the underlying truth, based on insufficient information.. it’s simply not possible to have a complete understanding of anything. We’re never truly going to get to the bottom of what’s going on inside a company, so we have to make probabilistic inferences” Guy Spier

“One of the things I do very well investing is, I gather a lot of information but I never know the whole picture. I have a lot of inputs but never everything and I have to make a decision on incomplete information" James Dinan

As an investor it's important to recognise what you know and don't know. Stick within your circle of competence and buy with a margin of safety. Investing scared makes you worry about loss, fear the things you don't know, and prepare for the unexpected.

 

50c Dollar Bills

Photo Source: Wikipedia

Photo Source: Wikipedia

The majority of the Investment Masters are value investors.  One of the common attributes of their investment style is to endeavour to  'buy dollar bills for fifty cents' or less.  If a company's intrinsic value is estimated at $1 and you can buy it at a substantial discount you lower the risk of losing money by establishing a so-called 'Margin of Safety'. The lower the price you pay for the dollar bill, the more upside and the less downside - a good asymmetric bet.

“We define value investing as buying dollars for 50 cents.” Seth Klarman

“There will always be events micro or macro – that periodically lead to distressed prices for some stocks. It’ll be lumpy, but 50c dollars are not going away as long as humans vacillate between fear and greed” Mohnish Pabrai

“It is extraordinary to me that the idea of buying dollar bills for 40c takes immediately with people or it doesn’t take at all. It’s like an inoculation. If it doesn’t grab a person right away, I find you can talk to him for years, and show him records, and it just doesn’t make any difference. They just don’t seem able to grasp the concept, simple as it is…I’ve never seen anyone who became a gradual convert over a ten-year period to this approach. It doesn’t seem to be a matter of I.Q. or academic training. It is instant recognition or it is nothing.” Warren Buffett

"There are plenty of things I don’t know but they don’t factor into the purchase because I am using a huge margin of safety. Buying a dollar at 50 cents. So if things turn against you, you will be okay." Li Lu

“Nobody can predict the market. Take that premise to heart and look to invest in  dollar bills selling for 50¢.” Irving Kahn

“We want to buy dollar bills at 50 cents or less” Mohnish Pabrai

“If a business is worth a dollar and I can buy it for 40 cents, something good may happen” Water Schloss

“I typically try to buy things for fifty cents or less and I start to think about selling them when they get to be worth ninety cents or more. When things are above ninety percent of intrinsic value, they become candidates to be sold.” Mohnish Pabrai

“All we try to do is buy a dollar for 40 cents” Peter Cundill

“I have previously written that I strive to discover the proverbial dollar bill selling for 50 cents, preferably with enough volatility such that I have the opportunity to buy at 40 cents or less” Michael Burry

“Our long-term wealth management record affirms the efficacy of the belief that if you can’t find a dollar for 50 cents you should pass” Frank Martin

"I'm always trying to buy a dollar's worth of assets for 50 cents, which helps limit the downside"  Kevin Daly

"Value investing is straight forward: it does not require a superhuman set of brain cells.  The average person can understand the logic of it all.  Buy a dollar for 60 cents from some unsuspecting seller and wait until the person wants it back for a dollar"  Chris Browne

Many of the Investment Masters look for opportunities where a catalyst may assist the stock price reaching the 'dollar bill' value.  While a catalyst is helpful, if the 'dollar bill' is cheap enough, that in itself can be it's own catalyst.

“Ultimately, a sufficiently low price becomes its own valuation catalyst”  Murray Stahl

"We’ve always felt that value is its own catalyst”  Mohnish Pabrai

“Valuation is always the best catalyst.” Stan Majcher

"Specific, known catalysts are not necessary. Sheer, outrageous value is enough" Michael Burry

 

 

 

The Investment Masters Class - Some Stats


"I decided also early on that I would file away any good quotes I came across in my reading and share them with my investor family at appropriate moments"  Ralph Wanger

Over the years I've collected thousands of quotes from the world most successful investors, both past and present. These quotes have come from investor interviews, videos, letters and lots of investment books. 

I've arranged the quotes into various subjects that together form the basis of the '100 Tutorials' in the Investment Masters Class.

In total there are over 3,400 quotes which equates to an average of 34 quotes per topic.

Not surprisingly Warren Buffett tops my list of quotes, and Charlie Munger is in the Top 5.  Over the years, I've found there isn't a lot that Warren and his partner Charlie Munger haven't already worked out. The top 5 quoted investors are Warren Buffett, Seth Klarman, Howard Marks, Charlie Munger and Frank Martin.

In terms of the Most Common categories of quotes I've collected, the Top Five topics are Education & Smarts, Thinking about Management, Investing Mistakes, Preserving Capital and Herds Crowds and Contrarians. 

Analysing Investment Performance - Short and Long Term

The Investment Management industry is fixated on short term performance. 

Oaktree's Howard Marks has said "short term performance is an imposter - "The investment business is full of people who got famous for being right once in a row.” 

Unlike most professions, a rookie investor can do better than a professional over the short term. You'd never expect an amateur to beat Roger Federer in a tennis match but plenty of amateur's portfolios will outperform Warren Buffet over the short to medium term.  It's only over the longer term that you can ascertain the skill of each investor.

"In the short term, there will always be winners and losers. But in the long term, there are very few winners. " Li Lu

The majority of investment managers, asset consultants and investors obsess over short term performance.  As many individuals cannot access their pension funds until retirement it would make more sense to analyze a style of investing or an asset class that outperforms over the long term.

“If you know one style does best in the long run, maybe you shouldn’t care about short term performance comparisons” Chris Browne

Investment Managers that underperform the market over short periods are vulnerable to having their funds taken away. 

"Many mainstream portfolio managers, judged as they are on short-term performance, feel they must be swinging all the time. They must focus on the present, on survival. If they don't meet the relentless present demands, they'll have no corner office from which to build a great long-term track record" Frank Martin

"Most of our competitors feel intense pressure from their clients to generate short term performance and have trouble maintaining a truly long-term perspective, whether in bad or good markets" Seth Klarman

“It’s still true that the biggest players in the public markets – particularly mutual funds and hedge funds – are not good at taking short-term pain for long-term gain. The money’s very quick to move if performance falls off over short periods of time" Jeffrey Ubben

Having permanent capital or investors with a long-term mindset allows investment managers to focus their attention on longer term opportunities or 'time arbitrage' which tend to be less crowded.

“That is the secret sauce: permanent capital. That is essential. I think that’s the reason Buffett gave up his partnership. You need it, because when push comes to shove, people run" Bruce Berkowitz

No investment style can guarantee outperformance all the time. Even the Investment Masters, who are renowned for their long term investment performance, have short to medium term periods where they have underperformed or lost money.

“I’m 76 years of age.  I've been through a number of down periods.  If you live a long time, you’re going to be out of investment fashion some of the time” Charlie Munger

“To capture superior long-term results you have to be willing to endure short-term underperformance” CT Fitzpatrick

“We expect to have negative years on occasion (and our record makes that point clear!). Those who take a longer term perspective – and their shorter term fluctuations in stride – tend to be amply rewarded in the long run (our record makes that clear as well)” Frank Martin

"We have underperformed in ten of our 49 years, with all but one of our shortfalls occurring when the S&P gain exceeded 15%" Warren Buffett

Francois Rochon has beaten the index by 6.1%pa since 1993 (Remember a few extra percentage points compounded over a long period leads to significant outperformance).  Yet Francois historically has, and expects to, underperform the index on average every three years.

"Over the 22 years of its track record, our US portfolio has underperformed the S&P 500 on six occasions (or 27% of the time). This is in line with our "Rule of Three" which stipulates that we accept to underperform the index one year out of three on average. This average, if we can maintain it, would be far superior to the overall performance of portfolio managers. It is a difficult task to maintain outperforming the S&P 500 but it is our mission. We must accept the fact that we will sometimes underperform the index over the short term when our investment style or specific companies are out of favor with mainstream thinking. And we try to welcome rewarding periods of portfolio outperformance with humility." Francois Rochon

"To be aware of this fact ['Rule of Three'] is vital so we can be psychologically prepared for the inevitable periods when we will have results that are worse than average. We have to accept from the start that it is impossible to be always the best in that field even if one is competent and loaded with motivation and efforts." Francois Rochon

The key is to ensure any negative returns reflect short term volatility rather than the permanent loss of capital due to deteriorating underlying business fundamentals.

"In my view, the biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital." Li Lu

When evaluating an investment manager it is important to analyze long term performance to ensure it wasn't a result of luck.

“Short term results often benefit from luck and have no connection with skill. For example, take a short period, not even one or two years long. At any time, even one or two weeks, there will always be some rock stars." Li Lu

"Since a multitude of variables move stock prices around, particularly in the short run, it is virtually impossible to distinguish skill from luck without a large sample size, i.e., a long record." Tweedy Browne & Co

"In a bad year, defensive investors lose less than aggressive investors.  Did they add value?  Not necessarily.  In a good year, aggressive investors make more than defensive investors.  Did they do a better job? Few people would say yes without further investigation.  A single year says almost nothing about skill, especially when the results would be expected on the basis of the investor's style" Howard Marks

Short term outperformance doesn't imply a well constructed and low risk portfolio.

“Any asset class or strategy can have its moment in the sun, yet as time passes we learn what risks were employed to achieve those periods of outperformance” Christopher Begg

Investment consultants and investors have a tendency to place excessive emphasis on past results.  More often than not, short term out performance is followed by a period of subpar performance. 

“Most people seem to think outstanding performance to date presages outstanding future performance. Actually, it’s more likely that outstanding performance to date has borrowed from the future and thus presages subpar performance from here on out.” Howard Marks

So funds can have good performance for the long run yet still be a dangerous investment.  A brilliant long term track record of returns will turn to nothing if the portfolio suffers a zero or significant loss.

“And 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

A classic example of this was the hedge fund Long Term Capital Management. The fund, managed by legendary traders, a former vice chairman of the Federal Reserve and two Nobel prize winning economists, delivered exceptionally stable positive returns with low volatility until it all came crashing down. 

Source: Wikipedia

Source: Wikipedia

LTCM's performance is analogous to the 'Thanksgiving Turkey' in Nicholas Taleb's book 'Fooled by Randomness'. 

"A turkey is fed for a thousand days by a butcher, every day confirms to its staff of analysts that butchers love turkeys "with increased statistical confidence".  That is until Thanksgiving.  It is mistaking absence of evidence (of harm) for evidence of absence."

Similarly, the absence of volatility and losses in Madoff's Ponzi scheme was not evidence the strategy was a sound investment. LTCM and Madoff highlight that an impressive long track records does not shelter you from the risk of terminal destruction. It's paramount to understand the risks behind the returns.

As Buffett has long said he would not take any risk of permanent loss of capital.

“We will never play financial Russian roulette with the funds you’ve entrusted to us, even if the metaphorical gun has 100 chambers and only one bullet. In our view, it is madness to risk losing what you need in pursuing what you simply desire.”

The Investment Masters acknowledge the folly of being focused on short term performance. 

“We think fixating on short-term results is bound to harm investment managers and investors alike. High scores are rarely shot while being critiqued mid-swing on each and every hole” Allan Mecham

“We place no weight on short-term results, good or bad, and neither should you. In fact, we have and will continue to willingly make decisions that negatively impact short-term performance when we think we can lower risk and improve our long-term returns.” CT Fitzpatrick

"While it’s not always easy, we try to remain unaffected by short term results, both good and bad." Francois Rochon

"We never take the one-year figure very seriously. After all, why should the time required for a planet to circle the sun synchronize precisely with the time required for business actions to pay off? Instead, we recommend not less than a five year test as a rough yardstick of economic performance" Warren Buffett

Instead of focusing on short term performance the Investment Masters tend to focus on the underlying performance of the companies they own.

"The best way to track the development [of the fund] is through the development of the earnings of the underlying businesses. Share prices can do pretty crazy things from time to time. The earnings by contrast provide a reliable indication of progress after taking into account the overall economic picture." Robert Vinali

"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

Don't forget successful investing is hard work and Long term outperformance is difficult.

“Preserving private capital for long periods of time is the exception, not the rule, in history” Paul Singer

 

 

 





 

 

Is the Company's Product Attractive?

Screen Shot 2017-06-12 at 8.19.56 PM.png

Charlie Munger has long reiterated the need to have multiple mental models to aid the investment process. This short essay looks at some of the product attributes that appeal to the Investment Masters.

A company which produces a single product faces a higher risk should that product become obsolete. 

“If it’s a company with a single product and it’s a product that you have some sense might just have in it the possibility it could be leapfrogged, that is someone is going to come up with a better mouse-trap. That’s risk. Your business dissolves pretty quickly” William Browne

“Another issue would be where there’s a major concentration in one product line. That would be something that I would be hesitant to do again. I had a couple of experiences where I invested in a business with revenues that were overly concentrated in one product line and that product line was ultimately usurped by something else; a better mouse trap. I would be better off avoiding those situations.” Chris Mittleman

Warren Buffett considered the risk of a product being leapfrogged after his recent purchase of a stake in Apple ..  "Someone could come along and leapfrog the technology, and add benefits that would be the more competitive threat than price competition. It would be benefit competition”.

It appears Buffett considered significant consumer loyalty outweighed the risk stating "Apple strikes me as having quite a sticky product and enormously useful product that people would use ... the stickiness really is something. I mean, they do build their lives around it, just like you were describing. And the interesting thing is, when they come into ... when they come into get a new one, they're gonna get they overwhelmingly get the same product. I mean, they got their photos on it and, I mean, yeah, I know you can ... you can make some shifts and all that. But they love it.

It's important to consider if the product is unique.  If a product has no differentiating features or is a commodity then the only competitive advantage is to be the lowest cost producer.

"Products are not islands. There is an indirect competition, for example, for consumer's dollars.  As prices change, some products may lose attractiveness even in well-run, low cost companies"  Phil Fisher

“When relatively non-differentiable products are sold on their price, the manufacturers of the products normally need to have low cost structures if they wish to be competitive and earn reasonable profits” Ed Wachenheim

"When a company is selling a product with commodity-like economic characteristics, being the low-cost producer is all-important"  Warren Buffett

Companies selling specialized products which are a small part of a customer's cost structure, but crucial for performance, can be attractive investment opportunities.

“If it’s an industrial business what you want to own is the company that makes the valve that goes into the $100,000 pump which goes into the billion dollar refinery. They’re not going to scrimp on the valve. They want the very best valve they can get. If you’re the valve supplier you’ve got a good business.   They’re going to buy your product and you’re going to be able to price your product aggressively because it’s a very low cost component to the end product. So you look for these businesses” William Browne

“The cost of the product should only be quite a small part of the customer's total cost of operations such that moderate price reductions yield only very small savings for the purchaser relative to the risk of taking a chance on an unknown supplier. “ Phil Fisher

“What are the key elements of what you consider a high-quality business? At a basic level, the product or service being sold is critical to customers but is only a small part of their cost structure, and the customer relationship tends to be sticky and recurring." Jeffrey Ubben

“Businesses selling a product or service that’s mission critical, yet is a small fraction of total costs, like you find in some aerospace businesses (or rating agencies in some ways) , are always interesting with long-lived advantages due to switching costs” Allan Mecham

A product with brand strength that is purchased by 'name' can command a price related to usage value rather than the cost of production limiting the potential for competition.

“Buy commodities, sell brands has long been a formula for business success. It has produced enormous and sustained profits for Coca-Cola since 1886 and Wrigley since 1891. On a smaller scale, we have enjoyed good fortune with this approach at See’s Candy since we purchased it 40 years ago.”  Warren Buffett

“You really want something where, if they don’t have it in stock, you want to go across the street to get it. Nobody cares what kind of steel goes into a car. Have you ever gone into a car dealership to buy a Cadillac and said “I’d like a Cadillac with steel that came from the South Works of US Steel.” It just doesn’t work that way, so that when General Motors buys they call in all the steel companies and say “here’s the best price we’ve got so far, and you’ve got to decide if you want to beat their price, or have your plant sit idle.” Warren Buffett

When a product is enmeshed in a customer's workflow or the customer benefits from network effects it can lead to high sustainable rates of return and this can provide an attractive investment opportunity.

“Sometimes a product is so embedded in a customer's workflow that the risk of changing outweighs any potential cost savings – for instance in subscription based services like computer systems (Oracle) or payroll processing (ADP, Paychex.) Networks, where the customer benefits from a company's scale, as in the security business (Secom), industrial gases (Praxair, Air Liquide), car auctions (USS) or testing centres (Intertek) are another example. Finally, technological leadership (Intel, Linear Technology) can be another important intangible asset although this is perhaps one of the less durable sources of pricing power, unless combined with others. The very best economics appear when some of the above characteristics combine in a situation in which the cost of the product or service is low relative to its importance. For example, the analog semiconductor chip which activate the car airbag, yet costs little more than a dollar.” Marathon Asset Management

Some companies will sell a product at low margins to deter competition yet collect high returns from servicing/parts revenue into the future.  Examples include large equipment manufacturers [eg commercial jet engine manufacturers, earthmoving equipment, mainframe computers etc].

"We really like businesses where you sell a big piece of OEM equipment at a low margin and then collect a 40-year stream of high-margin service revenues that the customer is essentially locked into." Bill Nygren

Once you've established the attractiveness of a product it's important to consider how big the runway for future sales could be.

“Any time you look at an investment, you want to look at what percentage of its market it has and how big it can get”  Rory Priday

It's important to remember that markets, industries and consumer tastes can change rapidly and these changes can significantly alter the demand for a company's products. In a recent letter, Steve Romick of FPA Funds noted:

"Innovative technology is driving business transformation faster than ever before. As a result, the expected tenure of a company in the S&P 500 is expected to drop from 25 years to 14 years. We want to avoid those companies whose businesses are existentially challenged."

Jeff Bezos, has talked about the shifting power from companies to consumers ...

“The balance of power is shifting toward consumers and away from companies. The right way to respond to this if you are a company is to put the vast majority of your energy, attention and dollars into building a great product or service and put a smaller amount into shouting about it, marketing it.” Jeff Bezos

Phil Fisher recognized these risks more than 50 years ago, in 'Common Stocks and Uncommon Profits' ..

"For a company to be a truly worthwhile investment, it must not only be able to sell its products, but also be able to appraise the changing needs and desires of its customers" Phil Fisher

Don't lose sight of the fact that a company that sells a great product can always be a bad investment if you pay too much.  Notwithstanding, having a checklist of mental models related to product attributes such as these, which the Investment Masters focus on, is likely to improve your investment returns.  Good luck!

 

 

 

How to Build a Better Investing Mind

The Investment Masters recognize the benefits of having mental models to help understand the key characteristics of a business, the factors driving it's success and the likelihood of maintaining a competitive advantage to drive future growth. In the book, the Psychology of Intelligence Analysis, Richards Heuer noted "little attention is devoted to improving how analysts think". In the book's opening chapter, entitled "Thinking about Thinking", he notes:

"[Analysts] construct their own version of "reality" on the basis of information provided by the senses, but this sensory input is mediated by complex mental process that determine which information is attended to, how it is organized, and the meaning attributed to it…To achieve the clearest possible image .. analysts need more than information ..They also need to understand the lenses through which this information passes. These lenses are known by many terms - mental models, mind-sets, biases or analytic assumptions"

Charlie Munger is a huge advocate of the need for a wide array of mental models for sound judgement. In a speech to Stanford Law School titled "A Lesson on Elementary, Wordly Wisdom, Revisited" he asserted:

"I've long believed that a certain system - which almost any intelligent person can learn - works way better than the systems that most people use… What you need is a latticework of mental models in your head. And you hang your actual experience and your vicarious experience (that you get from reading and so forth) on this latticework of powerful models.  And, with that system, things gradually get to fit together in a way that enhances cognition."

Charlie Munger recognized the need to take the big ideas from other faculties such as science, mathematics, psychology, history, behavioural economics and biology and have them at hand to draw inferences from in the investment process.

"If you want to be a good thinker, you must develop a mind that can jump the jurisdictional boundaries.  You don't have to know it all.  Just take the big ideas from all the disciplines. And it's not that hard to do."

“For some odd reason, I had an early and extreme multi-disciplinary cast of mind. I couldn’t stand reaching for a small idea in my own discipline when there was a big idea right over the fence in somebody else’s discipline. So I just grabbed in all directions for the big ideas that would really work. Nobody taught me to do that; I was just born with that yen.” 

"You must routinely use all the easy-to-learn concepts from the freshman course in every basic subject. Where elementary ideas will serve, your problem solving must not be limited, as academia and many business bureaucracies are limited, by extreme balkanisation into disciplines and sub disciplines, with strong taboos against any venture outside assigned territory"

Studying broadly and applying different models from outside the realms of finance can help an investor better understand a business. Concepts such as networks effects, non-linearity, economies of scale, psychological biases, winner-takes-all, leverage, first-mover-advantage, Darwinian evolution, complex adaptive systems, self-organised criticality, incentives/agency costs and autocatalysis are just a few.

Charlie Munger considers there are about one hundred mental models to learn and different models are relevant to different businesses.

"You've got to learn one-hundred models and a few mental tricks and keep doing it all your life. It's not that hard"  Charlie Munger

"You have to learn the models so that they become part of your ever-used repertoire" Charlie Munger

"You need a different checklist and different mental models for different companies" Charlie Munger

It's more than likely if you studied a typical finance course, you missed a large part of what's important in investing [Columbia is a rare exception]. Most finance courses don't cover human psychology, philosophy, financial history nor do they spend the time teaching the lessons behind the Investment Masters success. In fact, most finance courses focus on building investment spreadsheet models, analyzing financial ratios and understanding the capital asset pricing model and efficient market theory. The latter two are mental models considered laughable by most of the Investment Masters.

It's important to continue the learning process and broaden your education to enhance multi-disciplinary thinking to increase the odds of investment success.

"As I look back on it now, it's obvious that studying history and philosophy was much better preparation for the stock market than, say, studying statistics"  Peter Lynch

"The neat theories I had learned at university didn't come close to describing the true complexities of the economy or financial markets" Guy Spier

“If I’ve learned anything over the past decade it is this: The art of stock picking is more about synthesizing information across disciplines and making decisions than a strict devotion to finance” Allan Mecham

"If your professors won't give you an appropriate multi-disciplinary approach, if each wants to overuse his models and underuse the important models in other disciplines, you can correct that folly yourself" Charlie Munger

"Professor Newcomb taught [me] not only political economy, but philosophy, logic ethics, and psychology - all in one course.  Today these subjects would be fragmented among several professors.  I believe there was considerable advantages in being taught all these subjects by the same man.  Too many educators seem to have forgotten that you cannot teach good economics, good politics, good ethics, or good logic unless they are considered together as parts of one whole.  Colleges as a rule teach economics badly.  With over-specialisation has also come a tendency to mistake information for education, to turn out "quiz experts" who are crammed full of useful detail but who have not been trained how to think"  Bernard Baruch

The value of mental models are embraced by many of the world's greatest investors..

“You’ve got to learn everything. I started with physics and mathematics and I got into economics, history, law and politics. I like everything and that’s what you need. You might need models from biology.” Li Lu

“Our core philosophy starts with the belief that making intelligent, rational decisions requires a multi-disciplinary framework that informs broad and deep understanding” Christopher Begg

"Some people think in words, some use numbers, and still others work with visual images.  I do all of these, but I also think using models"  Ed Thorp

“You’ve got to mesh many different disciplines into one. That’s our edge” Marc Lasry

“When we have enticed the college graduate into our graduate schools, we at once encourage him to grow professional blinders which will confine his vision to the narrow research track, and we endeavour – often successfully – to make out of him a truffle-hound, or if you prefer, a race-horse, finely trained for a single small purpose and not much good for any other ... Jacob Viner, in 1950, argued that academic departments needed to encourage their students in broader intellectual fields since solving real world problems was likely to involve skills learned in several different disciplines. Charlie Munger, long-time Vice Chairman of Berkshire Hathaway, has encouraged a similarly multi-disciplinary approach to investment, a proposal which Marathon has consistently echoed” Marathon Asset Management

“You have to realize the truth of biologist Julian Huxley’s idea that ‘Life is just one damn relatedness after another’ So you must have the models, and you must see the relatedness and the effects from the relatedness.” Charlie Munger

“I have been in the business since 1973, so I have been looking at companies for a long time.  There are a lot of things in my head. There are a number of different models of the kinds of business or situations that can work. It may be the local monopoly concept, the low-cost commodity producer concept, the consolidated industry that has come down to a few competitors, a basic essential service that isn’t going to stop growing, or an industry that may be growing too slowly to attract any competition. So, there are a lot of different models.” Glenn Greenberg

A latticework of mental models improves creativity as Richards Heuer noted in the 'Psychology of Intelligence Analysis':

"Talking about breaking mind-sets, or creativity, or even just openness to new information is really talking about spinning new links and new paths through the web of memory. New ideas result from association of old elements in new combinations. Previously remote elements of thought suddenly become associated in a new and useful combination. When the linkage is made, the light dawns. This ability to bring previously unrelated information and ideas together in meaningful ways is what marks the open-minded, imaginative, creative artist"

The application of different mental models and multidisciplinary thinking can provide an edge by opening up investment insights that others haven't considered and hence are yet to be reflected in a security's price. 

"If you have the patience and if you have the interest to really dig deep, then what you're going to find is if it's commonly held information or known information, you may come up with insights that others have not.  This is what Charlie Munger talks about the latticework of mental models.  You look at things through a different lens to try to see what can be different"  Mohnish Pabrai

“You have to be naturally interested and curious about everything – any kind of businesses, politics, science, technology, humanities, history, poetry, literature, everything really effects your business. It will help you. And then occasionally you will find a few insights out of those studies that will give you tremendous opportunities that other people couldn’t think of” Li Lu

"It's a multi- disciplinary habit that fosters some creative thinking. Throughout the week between conversations about business- specific objectives we will tend to revisit further questions and insights somebody has read on the subject. Subjects are typically in the large data sets of physics, biology, and human history." Christopher Begg

It's one of the reasons the Investment Masters spend more time thinking about businesses in preference to building huge spreadsheet models.  The most important thing is to identify the key factors that are going to drive the business in the future and establish where a business will be over the medium to long term as opposed to next quarter's earnings.  

“The best way to think about investments is to be in a room with no one else and just think. And if that doesn‘t work, nothing else is going to work.” Warren Buffett

“It’s not about the numbers.  For most investments the factors that will drive long term success don’t have much to do with spreadsheets.  They have to do with something other, either understanding human nature or understanding nuances about how certain aspects of how things work rather than running spreadsheets”  Mohnish Pabrai

The ultimate investments arise when a multitude of big ideas combine to create what Charlie Munger refers to as 'Lollapalooza Effects'. Consider a business such as Facebook which has benefited from the combination of a multitude of factors: winner-takes-all, network effects, economies-of-scale, human psychology [classical conditioning [pavlov], reciprocation, virtual empathy, habit/addiction etc], tailwinds from increased internet penetration/improved global bandwidth to name just a few.

“The most important thing to keep in mind is the idea that especially big forces often come out of these one hundred models. When several models combine, you get lollapalooza effects; this is when two, three, or four forces are all operating in the same direction. And, frequently, you don’t get simple addition. It's often like a critical mass in physics where you get a nuclear explosion if you get to a certain point of mass - and you don't get anything much worth seeing if you don't reach the mass" Charlie Munger

“Investment decisions are more likely to be correct when ideas from other disciplines lead to the same conclusions. That is the top most payoff – broader understanding makes us better investors… True learning and lasting success come to those who make the effort to first build a latticework of mental models and then learn to think in an associative, multi-disciplinary manner” Robert Hagstrom

One you've started to build a repertoire of mental models it's important to keep learning and refining your models. There will be times when old models need to be discarded. To do so you must remain open minded.

"There's no rule that you can't add another model or two even fairly late in life.  In fact, Ive clearly done that.  I got most of the big ones quite early [however]" Charlie Munger

"In a system of multiple models across multiple disciplines, I should add as an extra rule that you should be very wary of heavy ideology"  Charlie Munger

"Minds are like parachutes. They only function when they are open" Richards Heuer

It's time to put some mental models on the latticework ….

 

 

Further Recommended Reading:

Media and the Market

The Investment Masters understand the need to maintain an independent thought process and not get swept up in the emotions of the market at any one point in time.

As humans have evolved to register pain more sensitively than any other emotion our fear of loss is much greater than our desire to gain.  Peter Bevelin in 'Seeking Wisdom - from Darwin to Munger' noted:

"Research shows that we feel more pain from losing than we feel pleasure from gaining something of equal value and that we work harder to avoid losing than we do to win" 

"Our brain is wired to perceive before it thinks - to use emotions before reason. As a consequence of our tendency for fear, fast classifications come naturally. Limited time and knowledge in a dangerous and scarce environment make hasty generalisations and stereotyping vital for survival. Waiting and weighing evidence could mean death."

Newspapers embellish bad news to sell papers. It's no wonder investors panic when they read front page news stories about Brexit, Trade Wars, Double Dip Recessions, European collapse etc. The average investor gets caught up in the emotion of the crowd and sells in panic.

In the 'Psychology of Intelligence Analysis', Richards Heuer noted "Information presented in vivid and concrete detail often has unwarranted impact, and people tend to disregard abstract or statistical information that may have greater evidential value.  Statistical data, in particular, lack the rich and concrete detail to evoke images, and they are often overlooked, ignored or minimized". It's often why investors act on negative news stories without considering the actual probability of an outcome, such as the historical probability of a market crash.

“People are always predicting the end of the world, but the only things that end are the people; the world keeps going” Arnold Van Den Berg

"For 200 years pessimists have had all the headlines even though optimists have far more often been right.  Arch-pessimists are feted, showered with honours and rarely challenged, let alone confronted with their past mistakes"  Matt Ridley

The bias against fear is amplified when we have experienced losses or market declines in the recent past. Known as 'Recency Bias' humans have a better memory for recent events, events in which they were personally involved, events that had important consequences, and so forth.  This fear of loss is one of the key reasons the average investor significantly under-performs the index - they sell at the bottom and they buy near the top when things feel comfortable again. 

Warren Buffett touched on the topic in his 2004 letter when he noted that investors should have earned juicy returns over the preceding 35 years just by piggy-backing corporate America's terrific results.  Instead many investors had experiences ranging from mediocre to disastrous.  In part, this was due to untimely entries after an advance had been long underway and exits after periods of stagnation or decline [looking in the rear-view mirror].

The Investment Masters recognize that the best time to buy stocks is when everyone is pessimistic as bargains are going to be more abundant.  Buying quality businesses with good franchises and solid balance sheets should ensure long term success regardless of market volatility.  It is weak markets that set the stage for high future returns.  When the headlines are screaming SELL it's a good time to look for bargains.

"Because bad news sells, the media has a pessimistic bias. Over many years, a large percentage of the severe problems predicted by the media never materialised, or proved to be far less severe than predicted" Ed Wachenheim

"Media outlets are quick to present us with one crisis after another, along with constant economic and political worries. With the help of the Internet and many television stations, bad news circles the planet in no time. With the right twist, plain old bad news begins to look more and more like an imminent catastrophe and for many investors, the perfect reason to sell their stocks! Good news, on the other hand, remains largely unnoticed since it seems to represent a less valuable source for ratings and clicks." Francois Rochon

“I’d suggest you not read the newspaper [headlines].” William Browne

"Headlines lead to headaches for the unfamiliar" Frank Martin

"The media has an interest in translating the improbable into the believable. There is a difference between the real risk and the risk that sells papers. A catastrophe like a plane crash makes a compelling news story. Highly emotional events make headlines but are not an indicator of frequency. Consider instead all the times nothing happens” Peter Bevelin

"Financial crisis are like thunder storms - you hear stomach-jolting thunder after lightening has struck; rarely do the media and masses telegraph financial catastrophes in advance" Allan Mecham

On most occasions the media commentary is just noise.  Stocks move for all sorts of reasons and at times no reason at all.  Humans have a bias to attribute reason to random phenomena. Richards Heuer noted:

"If no pattern is apparent, our first thought is that we lack understanding, not that we are dealing with random phenomena that have no purpose or reason.. Because of a need to impose order on their environment, people seek and often believe they find causes for what are actually random phenomena ... Events will almost never be perceived intuitively as being random; one can find an apparent pattern in almost any set of data or create a coherent narrative from any set of events'. 

It's important to not be trapped into the blind belief that all price movements convey noteworthy news.

“Ignoring the maelstrom of the media – perhaps nothing is more preposterous than the explanations commentators give for price movements on Wall Street on any given day – makes it easier to focus on what is important” Leon Levy

“Markets often do things that defy logical explanation – but people keep explaining them anyway. Why don’t we ever hear, “The market rose today, but no-one knows why?” Howard Marks

“It’s a rare day when a journalist says, “The market rose today for any one of a hundred different reasons, or a mix of them, so know one knows” Philip Tetlock

"So much of what happens in the market, in the short run, is just random, but this is seldom acknowledged. There has to be a reason the market went up or down yesterday, so the Wall Street Journal and the other papers call up analysts and money managers and ask them why. What you usually read in the paper is simply a logical fallacy" Ralph Wanger

"It's important not to prioritise news stories, since they give my brain reasons to act, often without providing real substance" Guy Spier

Often, by the time the media are onto a story, it's already gone mainstream and the crowd is involved, the herd has already acted.  It's important to not get caught up in groupthink and maintain an independent point of view.

“The idea that people affiliated with Wall Street know something. My mother is a classic example. She watches “Wall Street Week” and she takes everything they say with almost a religious fervour. I would bet that you could probably fade ‘Wall Street Week’” Paul Tudor Jones

"Whenever something is really pounded or when something is skyrocketing and it is on the front page of the New York Times, no matter how much you agree with it in the long term, you have to reverse yourself for a while.  The dollar for instance, was on the front page of the New York Times three or four time recently.  I am terribly bearish on the dollar, as you have heard, but I have enough sense to know that when it is in the popular press, I should not be selling dollars"  Jim Rogers

“The rest of the print and TV business press are notorious pilers on. A classic case was during 1979 and 1981 as oil prices and inflation surged. Numerous books were published by experts forecasting hyperinflation, depression, and a collapse of the dollar. At one point, 7 of the top 10 books on the bestseller list were about inflation and how to survive it. Even wise investors like John Templeton gave speeches saying 7% to 8% inflation was inevitable. Of course, decades of disinflation, not inflation, were about to occur, during which both stocks and bonds would soar” Barton Biggs

You'll often see front page news about some analyst or fund manager predicting a market crash, out of control inflation or some other geopolitical event that will de-stabilise markets.  Most forecasts are wrong.  I'd always suggest checking the forecaster's track record of success before taking a further step.  And it's worth remembering someone always predicted the last catastrophe - most likely not the same person who'll predict the next.  Don't be fooled by randomness.

"One of my greatest complaints about forecasters is that they seem to ignore their own records. The amazing thing to me is that these people will go on making predictions with a straight face, and the media will continue to carry them" Howard Marks

"When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle's scathing comment: "You don't know how easy this game is until you get into that broadcasting booth." Warren Buffett

Most of the Investment Masters do read the papers however they keep an independent mind and don't get caught up in the emotions of the media.

Were Munger, Dalio and Soros CIA Trained?

I was recently reading about Hertz, the rental car company in which the stock price had been decimated, falling 92% from its highs in 2014. I came across a note titled “How Hertz became the perfect contrarian short in 2014”. The article interviewed Tom Fogarty, an analyst, who had identified Hertz as a short. This was a very contrarian idea at the time given the rental car market was consolidating [from nine to three major competitors], a smart activist investor [Carl Icahn] had just bought a stake and the company was spinning-off a division. At the time of Mr Fogarty's report, of the Wall Street analysts that covered the stock, 8 had buys, 2 had holds and only 1 recommended selling.  The average price target was around $118 and it was trading around $109.  Today it trades at around $10.

Mr Fogarty noted “This Hertz call isn’t a situation I’d encountered before so I’d guess it’s a pretty unusual situation. I had a mentor who used to say “there’s no silver bullet in investing, you just have to think it through. Every time.” That was sort of preaching to the choir. Given the choice, I prefer to start from first principles and routinely check to make sure conventional wisdom has empirical support." 


Mr Fogerty cited “ The Psychology of Intelligence Analysis’ from the CIA’s website by Richards J. Heuer [CIA Book] as guiding his investment principles. Always interested in finding an edge I printed out a copy. I think Mr Fogarty has stumbled across one of the most useful guides an investment analyst could find on improving one's investment decisions. While the book deals with CIA intelligence analysis, most of the principles are applied by the Investment Masters.

Like intelligence analysts, investment analysts are dealing with incomplete and ambiguous information, often trying to connect the dots in a fluid environment where time is of the essence.  The same human biases that impairs CIA agents' decision making process can impair an investment analyst. 

The book could have as easily been written by Munger, Soros, Dalio and Steinhardt. Daniel Kahneman, whose book 'Thinking Fast and Slow' is commonly referenced by the Investment Masters, is quoted throughout the book. There are also many commonalties with the work of Nassim Nicholas Taleb [Black Swan/Fooled by Randomness] and Philip Tetlock [Super-Forecasting]. 

The book highlights that "when analytical judgements are wrong, it usually was not because the information was wrong. It was because an analyst made one or more faulty assumptions that went unchallenged”.

One of my favorite sayings is “Make the assumption there can be no assumptions”. I had it written on a post-it note on my computer monitor through the Financial Crisis which itself had its origins in the mother of all false assumptions“US house prices won’t fall on a national basis”. 

The book “aims to help intelligence analysts achieve a higher level of performance. It shows how people make judgements based on incomplete and ambiguous information, and it offers simple tools and concepts for improving analytical skills”. If it’s good enough for the CIA, it’s likely to be useful for the average investor.

You can download a copy of the CIA Book for free at their website here..

I've included some of the key points below .. the first quotes are from the CIA Book and following are quotes in italics from the Investment Masters. 

Be a Generalist

CIA: "To the extent that an experienced specialist may be among the last to see what is really happening when events take a new and unexpected turn. When faced with a major paradigm shift, analysts who know the most about a subject have the most to unlearn." 

Bruce Berkowitz: “We’re generalists, but we need to find the non-Wall Street people who have lived and breathed and suffered in the industries and business we’re now looking at.”

Have a Multi-disciplinary mindset

CIA: "If analysts’ understanding of events is greatly influenced by the mind-set or mental model through which they perceive those events, should there not be more research to explore and document the impact of different mental models?" 

Charlie Munger: “For some odd reason, I had an early and extreme multi-disciplinary cast of mind. I couldn’t stand reaching for a small idea in my own discipline when there was a big idea right over the fence in somebody else’s discipline. So I just grabbed in all directions for the big ideas that would really work. Nobody taught me to do that; I was just born with that yen.” 

Focus on Collecting Information that Matters

CIA: "The reaction of the Intelligence Community to many problems is to collect more information, even though analysts in many cases already have more information than they can digest. What analysts need is more truly useful information to help them make good decisions. Or they need a more accurate mental model and better analytical tools to help them sort through, make sense of, and get the most out of the available ambiguous and conflicting information."

David Dreman: “Investment experts continue to be convinced that their major problems could have been handled if only those extra few necessary facts had been available. They thus tend to overload themselves with information, which usually does not improve their decisions but only makes them more confident and more vulnerable to serious errors”. 

Seek out Other Information

CIA: "Relying only on information that is automatically delivered to you will probably not solve all your analytical problems. To do the job right, it will probably be necessary to look elsewhere and dig for more information." 

Phil Fisher: "Reading the printed financial records about a company is never enough to justify an investment. One of the major steps in prudent investment must be to find out about a company's affairs from those who have some direct familiarity with them" Phil Fisher

Julian Robertson: "I think the main thing is management, getting good management, and checking with their competitors, checking with their compatriots, their suppliers, and finding out, really, if they are good"  

Ray Dalio: “I dealt with my not knowing by either continuing to gather information until I reached a point I could be confident or by eliminating my exposure to risks of not knowing” 

Test your Investment Ideas

CIA: "Objectivity is achieved by making basic assumptions and reasoning as explicit as possible so that they can be challenged by others and analysts can, themselves, examine their validity."

Ray Dalio: “I stress tested my opinions by having the smartest people I could find challenge them so I could find out where I was wrong. “ 

Charles Koch: "I have a lot of ideas. Most of them are terrible. But what saved me – well, to the extent I’ve been saved – is that… I want to get people with the best knowledge and insights in each one of those key aspects and get a challenge from them." 

Remain Open Minded

CIA: "People form impressions on the basis of very little information, but once formed, they do not reject or change them unless they obtain rather solid evidence. Analysts might seek to limit the adverse impact of this tendency by suspending judgment for as long as possible as new information is being received."

Seth Klarman: "We strive to eliminate biases in our decision making that could cause us to reject new information or cling to erroneous beliefs

Bruce Berkowitz: "Facts change, we change

Beware Of Commitment/Confirmation Bias

CIA: "Once an observer thinks he or she knows what is happening, this perception tends to resist change. New data received incrementally can be fit easily into an analyst’s previous image. This perceptual bias is reinforced by organizational pressures favoring consistent interpretation; once the analyst is committed in writing, both the analyst and the organization have a vested interest in maintaining the original assessment."

Warren Buffett: “What the human being is best at doing is interpreting all new information so that prior conclusions remain intact” 

Todd Combs: "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" 

Analysts Improve with Experience

CIA: "Substantive knowledge and analytical experience determine the store of memories and schemata the analyst draws upon to generate and evaluate hypotheses. The key is not a simple ability to recall facts, but the ability to recall patterns that relate facts to each other and to broader concepts—and to employ procedures that facilitate this process."

Ken Shubin Stein: "This is an accretive business. The longer you do it, the more you learn, the better you get at it because you see more things. We see more cycles, we see more industries, we learn more business models. We learn how more business models fail. And all of us in business tend to get better as we get older

Glenn Greenberg: “I have been in the business since 1973, so I have been looking at companies for a long time. There are a lot of things in my head. There are a number of different models of the kinds of business or situations that can work. It may be the local monopoly concept, the low-cost commodity producer concept, the consolidated industry that has come down to a few competitors, a basic essential service that isn’t going to stop growing, or an industry that may be growing too slowly to attract any competition. So, there are a lot of different models.” 

Deal with Change

CIA: "The intelligence analyst, however, must cope with a rapidly changing world."

John Burbank: "Markets change radically, every five years that I've seen.  Markets aren't nearly as good at discounting the future as people think"  

Stanley Druckenmiller: "Probably one of my greatest assets over the last 30 years is that I’m open-minded and I can change my mind very quickly."  

Be Creative

CIA - "New ideas result from the association of old elements in new combinations. Previously remote elements of thought suddenly become associated in a new and useful combination. When the linkage is made, the light dawns. This ability to bring previously unrelated information and ideas together in meaningful ways is what marks the open-minded, imaginative, creative analyst." 

CIA: "Creativity is required to question things that have long been taken for granted."

CIA: "Creativity, in the sense of new and useful ideas, is at least as important in intelligence analysis as in any other human endeavour."

Leon Levy: "If intelligence is the ability to integrate, creativity is the ability to integrate information from seemingly unconnected sources, and a measure of both abilities is necessary for long-term success in the markets" 

Seth Klarman: “We put great emphasis on a consistent investment process that demands enormous creativity, energetic sourcing, outside-the-box thinking, intellectual honesty, and vibrant debate”  

Consider Alternate Hypothesis

CIA: "The simultaneous evaluation of multiple, competing hypotheses permits a more systematic and objective analysis than is possible when an analyst focuses on a single, most-likely explanation or estimate. The simultaneous evaluation of multiple, competing hypotheses entails far greater cognitive strain than examining a single, most-likely hypothesis. Retaining multiple hypotheses in working memory and noting how each item of evidence fits into each hypothesis add up to a formidable cognitive task."

CIA: "Research on hypothesis generation suggests that performance on this task is woefully inadequate. When faced with an analytical problem, people are either unable or simply do not take the time to identify the full range of potential answers. Analytical performance might be significantly enhanced by more deliberate attention to this stage of the analytical process."

CIA: "Exploring alternative hypotheses that have not been seriously considered before often leads an analyst into unexpected and unfamiliar territory."

George Soros: “The financial markets generally are unpredictable. So that one has to have different scenarios... The idea that you can actually predict what's going to happen contradicts my way of looking at the market."

Paul Singer: "What actually happens in markets is never the only scenario that could have taken place. Elliot's portfolio has been designed to maintain stability in a range of different outcomes, some more difficult than what actually occurs at various times in the ebb and flow of markets. Being set up for the broadest scope of market scenarios has been one of the principal reasons for Elliot's high level of stability in almost every period of adversity for the past 38 1/2 years"

Seek to Disprove Hypothesis Not Confirm Them

CIA: "Focus on developing arguments against each hypothesis rather than trying to confirm hypotheses."

Charlie Munger: "Constantly take your own assumptions and try to disprove them"  

Be Alert to Surprises

CIA: "A surprise or two, however small, may be the first clue that your understanding of what is happening requires some adjustment, is at best incomplete, or may be quite wrong"

Leon Levy: "Investors also have to be alert to changes in the market that could change their original assumptions" 

Warren Buffett: "Charlie and I believe that when you find information that contradicts your existing beliefs, you've got a special obligation to look at it - and quickly" 

Seek out Individuals who Disagree

CIA: "Analysts should try to identify alternative models, conceptual frameworks, or interpretations of the data by seeking out individuals who disagree with them rather than those who agree. Most people do not do that very often. It is much more comfortable to talk with people in one’s own office who share the same basic mind-set."

Bill Ackman: “One of the best ways to get confidence in an idea is to find a smart person who has the opposing view and listen to all their arguments. If they have a case that you haven’t considered, then you should get out. But they can also help give you more conviction” 

Think Backwards

CIA: "One technique for exploring new ground is thinking backwards. As an intellectual exercise, start with an assumption that some event you did not expect has actually occurred. Then, put yourself into the future, looking back to explain how this could have happened"

CIA: "Thinking backwards changes the focus from whether something might happen to how it might happen. Putting yourself into the future creates a different perspective that keeps you from getting anchored in the present. Analysts will often find, to their surprise, that they can construct a quite plausible scenario for an event they had previously thought unlikely. Thinking backwards is particularly helpful for events that have a low probability but very serious consequences should they occur."

Leon Levy: "One of the virtues of envisioning the present from a different time is that it underscores the important role of the intangibles, such as mood and psychology, that govern the way we perceive and interpret the supposedly hard numbers on which investors base their decisions.  My attempt to imagine the present as it would look from a different time helps me sort the real from the illusions that blind us to what is before our eyes" 

Charlie Munger: “Invert, always invert” Jacobi said. He knew that it is in the nature of things that many hard problems are best solved when they are addressed backwards

Appoint A Devils Advocate

CIA: "A devil’s advocate is someone who defends a minority point of view. He or she may not necessarily agree with that view, but may choose or be assigned to represent it as strenuously as possible. The goal is to expose conflicting interpretations and show how alternative assumptions and images make the world look different."

Lee Ainslie: "I play devil's advocate and make sure the level of analysis has been complete and thorough and that all the relevant resources have been brought to bear" 

Watch out for Unexpected events

CIA: "Analysts should keep a record of unexpected events and think hard about what they might mean, not disregard them or explain them away."

Bill Nygren: "Throughout the time we hold a stock, the analysts will challenge each other as to whether or not our sell target correctly incorporates all the new information we’ve seen subsequent to our purchase."

Leon Levy:"Investors have to be alert to changes in the market that could change their original assumptions" 

Keep Questioning

CIA: "A questioning attitude is a prerequisite to a successful search for new ideas. Any analyst who is confident that he or she already knows the answer, and that this answer has not changed recently, is unlikely to produce innovative or imaginative work."

CIA: "If you find yourself thinking you already know the answer, ask yourself what would cause you to change your mind; then look for that information."

Chris Mittleman: “If you allow yourself to start thinking you’ve got it all figured out, that’s probably the beginning of the end” 

Consider the Interactions Between the Variables

CIA: "The number of possible relationships between variables grows geometrically as the number of variables increases."

Source: Psychology of Intelligence Analysis, CIA

Source: Psychology of Intelligence Analysis, CIA

CIA: "Serious analysis of probability requires identification and assessment of the strength and interaction of the many variables that will determine the outcome of a situation."

Warren Buffett: “Our failure here illustrates the importance of a guideline – stay with simple propositions – that we usually apply in investments as well as operations. If only one variable is key to a decision, and the variable has a 90% chance of going your way, the chance for a successful outcome is obviously 90%. But if ten independent variables need to break favorably for a successful result, and each has a 90% probability of success, the likelihood of having a winner is only 35%. In our zinc venture, we solved most of the problems. But one proved intractable, and that was one too many. Since a chain is no stronger than its weakest link, it makes sense to look for – if you’ll excuse an oxymoron – mono-linked chains.” 

Allan Mecham: "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." 

Marty Whitman: “Based on my own personal experience – both as an investor in recent years and an expert witness in years past – rarely do more than three or four variables really count. Everything else is noise.” 

Understand Probability

CIA: "Most people do not have a good intuitive grasp of probabilistic reasoning."

Charlie Munger: "If you don' t get elementary probability into your repertoire, you go through a long life like a one-legged man in an ass-kicking contest" 

Identify Milestones Ahead of Time for Being Wrong

CIA: "Identify milestones for future observation that may indicate events are taking a different course than expected"

Craig Effron: "When one of my analysts comes up with an idea I say, “First of all, one to ten, how much do you like it?” If it's not at least a seven, I don’t do it. If it’s a nine or a ten I say, “Okay, I want to know right now at what price you’re selling it and at what price you’re admitting you’re wrong.” I want to do this when we are unemotional. Investors have a tendency, and so do I, to marry positions." 

Establish the Implications of being wrong

CIA: "Analyze how sensitive your conclusion is to a few critical items of evidence. Consider the consequences for your analysis if that evidence were wrong, misleading, or subject to a different interpretation."

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

Ensure you Evaluate the Evidence

CIA: "Evaluation of evidence is a crucial step in analysis, but what evidence people rely on and how they interpret it are influenced by a variety of extraneous factors. Information presented in vivid and concrete detail often has unwarranted impact, and people tend to disregard abstract or statistical information that may have greater evidential value. We seldom take the absence of evidence into account."

CIA: "Case histories and anecdotes will have greater impact than more informative but abstract aggregate or statistical data."

Barton Biggs: "Be obsessive in making sure your facts are right and that you haven't missed or misunderstood something" 

Avoid Anchoring

CIA: "With the “anchoring” strategy, people pick some natural starting point for a first approximation and then adjust this figure based on the results of additional information or analysis. Typically, they do not adjust the initial judgment enough."

Charlie Munger: “We try and avoid the worst anchoring effect which is always your previous conclusion. We really try and destroy our previous ideas.” 

Study Your Mistakes

CIA - Analysts interested in improving their own performance need to evaluate their past estimates in the light of subsequent developments."

Charlie Munger: “One of the reasons 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” 

Prepare for the Unexpected

CIA: "Analysts are often reluctant, on their own initiative, to devote time to studying things they do not believe will happen. This usually does not further an analyst’s career, although it can ruin a career when the unexpected does happen."

Seth Klarman: “Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse. “ 

Occasionally Failures Must be Accepted

CIA "Occasional intelligence failures must be expected."

George Soros: “To others, being wrong is a source of shame; to me, recognizing my mistakes is a source of pride.  Once we realize that imperfect understanding is the human condition there is no shame in being wrong, only in failing to correct our mistakes” 

CIA Original Headquarters Building

CIA Original Headquarters Building

You can see from the above examples the Investment Masters already implement the key recommendations of the CIA.  

Understanding psychology and human biases provides the opportunity for better decision making and better investment results.  Having more mental models improves your perception. Getting back to Hertz … Tom Fogarty debunked the assumption that all investments where activists are involved are profitable and that consolidating industries always lead to improved profitability. This opened his eyes to the problems facing Hertz that the market had overlooked. He questioned assumptions in the search for the truth.

As the CIA motto states "And Ye Shall Know the Truth and the Truth Shall Make You Free" – John 8:32 

"In my judgment, all great traders are seekers of truth" Michael Steinhardt

It's time to implement the CIA tactics ...

 

Investing Mentors

Many of the Investment Masters had the opportunity to work under great investors.  Larry Robbins worked with Leon Cooperman, Warren Buffett and Walter Schloss with Benjamin Graham, Stanley Druckenmiller with George Soros, Lee Ainslie & Steve Mandel with Julian Robertson to name just a few.

When starting your professional life it's important you choose the right career and the right people to work with - where you can learn.  It shouldn't be about the money.  To be successful you're going to have to love what you do, and that's a lot easier if you enjoy who you're working with.

"If you're early on in your career and they give you a choice between a great mentor or higher pay, take the mentor every time.  It’s not even close.  And don't even think about leaving that mentor until your learning curve peaks." Stanley Druckenmiller

“Don’t worry about making the most money this week or next month.  When I went and offered to work for Ben Graham, I said I’d work for nothing and I meant it.  Just the idea of being turned on, look for the job that is going to turn you on”  Warren Buffett

“In terms of starting something right out of business school… I wouldn’t worry very much about how much money you make.  I’d worry much less about compensation than I would about what you can learn” Bill Ackman

“It is important to find a decent, successful person to mentor you.  If you work with the right people and do what you like to do, then you’ve got it made”  Bruce Berkowitz

“.. one of the things about good mentors is you can learn on someone else's nickel. It's something you don't realize when you’re younger. But it struck me at a very early age to try to go find people that were the best in their particular businesses”  John Phelan

If you can't land the exact job you want you can continue your investing journey by learning from the Investment Masters.  If you take the time to go through the Investment Masters Class tutorials you'll notice many common threads between the Investment Masters.  

Many of the Investment Masters also find heroes outside of investing...

“I have a mentor wall that is the first thing you see in my small office.  By identifying men who you really admire, you shortcut your learning curve tremendously” Frank Martin

"It is important to have a mentor and/or great heroes. If you don't have the former, the latter is really important. Pick the right heroes in investing, and in life, and then learn as much as you can from them. Over my career, I have been lucky and grateful to have mentors, but heroes are available to everyone and the reservoir of their wisdom is infinite." Christopher Begg

One of the greatest investors of our age, Charlie Munger, studied the great minds from history...

"I am a biography nut myself, and I think when you’re trying to teach the great concepts that work, it helps to tie them into the lives and personal ties of the people who developed them. I think that you learn economics better if you make Adam Smith your friend. That sounds funny, making friends among the eminent dead, but if you go through life making friends with the eminent dead who had the right ideas, I think it will work better in life and work better in education. It’s way better than just giving the basic concepts." Charlie Munger

A great place to start is with the most successful investor of our time, Warren Buffett. Buffett shares his wisdom through his annual letters, Berkshire meetings and interviews. Many of the Investment Masters have studied him.  Over the years I and many others have learnt a great deal from Buffett. I don't think there's much he and Charlie haven't worked out.

"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

"Berkshire Hathaway annual reports - one has to not only read them, but re-read them." Charles de Vaulx

"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

“I consider him [Buffett] a mentor, but while we see each other from time to time, I have learned mainly from watching what he does with Berkshire and reading his letters.” Wally Weitz

"Over the years, I have been most significantly influenced by the writings of Warren Buffett" Chuck Akre

"Warren Buffett is a hero. Pick some good heroes and read everything you can about them" Thomas Gayner

"Warren Buffett influenced me tremendously. I'm an expert in his writings and his views." Leon Cooperman

"Another cornerstone of my re-education involved studying Buffett's investment strategy with even greater intensity.  There's no better way to do this than to read Berkshire Hathaway's annual reports... This wasn't a matter of idol worship. It was about choosing a teacher who had already discovered the truths that I still needed to learn" Guy Spier

Start learning from your mentors..

Ten Years

Many of the Investment Masters focus on businesses with longevity and which are likely to be doing the same thing in ten years' time as they are doing today. Often these are simple and boring businesses that have some form of competitive advantage which makes it hard for other businesses to compete with them. What Warren Buffett would call a moat.  

"The number one idea is to view a stock as an ownership of the business and to judge the staying quality of the business in terms of competitive advantage" Charlie Munger

“The durability and strength of the franchise is the most important thing in figuring out [whether it’s a good business].  If you think a business is going to be around in ten or twenty years from now, and if they’re going to be able to price advantageously, that’s going to be a good business” Warren Buffett

“The value of a company is derived from what it produces for owners over its lifetime – usually many years, often decades.  This supports a mindset calibrated towards longevity, forcing us to hone in on variables related to durability; barriers to entry, technological obsolescence risk, bargaining power, value being provided to customers, and threats of all kinds." Allan Mecham

It is getting harder to identify businesses with longevity given the increasing pace of disruption  to business models. What once were bullet-proof businesses - such as cable TV, low cost retailers, fixed-line telcos, newspapers and strong brand-name consumer goods companies are now experiencing eroding moats. The emerging field of artificial intelligence is likely to further disrupt once stable businesses.

Consider the case of the branded consumer goods company. Ten years ago, the TV companies, newspapers and magazines had a monopoly over information distribution. Those businesses with the scale and cost efficiency to access these channels had a huge competitive advantage in creating awareness and demand for their products.

Munger expanded on the benefits of television advertising in his lecture on 'Wordly Wisdom as it relates to Investment Management and Business' in 1994:

"You can get advantages of scale from TV advertising.  When TV advertising first arrived - when talking colour pictures first came into our living rooms - it was an unbelievably powerful thing.  And in the early days we had three networks that had whatever it was - say ninety percent of the audience.

Well if you were Proctor & Gamble, you could afford to use this new method of advertising. You could afford the very expensive cost of the network television because you were selling so damn many cans and bottles.  Some little guy couldn't.  And there was no way of buying it in part.  Therefore, he couldn't use it. In effect, if you didn't have big volume, you couldn't use network TV advertising - which was the most effective technique.

"So when TV came in, the branded companies that were already big got a huge tailwind"

Contrast that situation with today, where information and entertainment has been massively fragmented. Young people spend time watching home-made Youtube videos, Facebook, Snapchat and Instagram on their mobile phones.  What was previously an impossibility - an individual or small company reach the masses - nowadays anyone can set up a website for almost no cost and/or attract followers to an Instagram page.

Consider the following recent comments by Snap's Chief Strategy Officer, Imran Khan:

“…Nielsen found that 45% of 18- to 34-year-olds in the U.S. are reached by Snapchat on any given day. This is nine times more than the average daily reach of the top 15 TV networks and nearly 5 times more than the top TV network. 87% of our U.S. daily active users between the ages of 18 and 34 cannot be reached by any top 15 TV network.” 

In one of the best notes I've read on disruption, Ben Thompson from Stratechery, explains how Dollar Shave Club disrupted Gillette with the help of Amazon.

"AWS and Amazon itself, having both normalized e-commerce amongst consumers and incentivized the creation of fulfilment networks, made the creation of standalone e-commerce companies more viable than ever before. This meant that Dollar Shave Club, hosted on AWS servers, could neutralize P&G’s distribution advantage: on the Internet, shelf space is unlimited. More than that, an e-commerce model meant that Dollar Shave Club could not only be cheaper but also better: having your blades shipped to you automatically was a big advantage over going to the store. " Ben Thompson

I recently read a quote from Jeff Bezos of Amazon where he discusses change...

“I very frequently get the question: ‘What’s going to change in the next 10 years?’ And that is a very interesting question; it’s a very common one. I almost never get the question: ‘What’s not going to change in the next 10 years?’ And I submit to you that that second question is actually the more important of the two — because you can build a business strategy around the things that are stable in time. … [I]n our retail business, we know that customers want low prices, and I know that’s going to be true 10 years from now. They want fast delivery; they want vast selection. It’s impossible to imagine a future 10 years from now where a customer comes up and says, ‘Jeff I love Amazon; I just wish the prices were a little higher,’ [or] ‘I love Amazon; I just wish you’d deliver a little more slowly.’ Impossible. And so the effort we put into those things, spinning those things up, we know the energy we put into it today will still be paying off dividends for our customers 10 years from now. When you have something that you know is true, even over the long term, you can afford to put a lot of energy into it.” ― Jeff Bezos

A business's value is derived from the free cash flow it earns over its lifetime.  If its lifetime is uncertain it maybe impossible to reasonably estimate future cash flows to calculate a value so it can be purchased with a margin of safety.  If a company's lifetime is shortened by deteriorating industry dynamics or technological disruption it's likely to lead to poor returns.

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

“It’s no surprise that the best returning stocks over time have been in areas like consumer goods where change is relatively incremental” Marathon Asset Management

“Making predictions about the future is also very difficult.  Investing is the ability to predict the future.  You really need to understand a company and its industry and assess their outlook for the next five or ten years.  It isn’t easy.  Before investing, we need to know at a minimum what a company will look like in ten years and how it will behave in a downturn.  Otherwise, how can you judge that the value of this company won’t decline? To know what a company’s future cash flows are worth today, we must know approximately what those cash flows will be in ten or twenty years.” Li Lu

The Investment Masters try to invest in business which will look similar in ten years.  

“At Berkshire we will stick with businesses whose profit picture for decades to come seems reasonably predictable.  Even then, we will make plenty of mistakes” Warren Buffett

“We look for simple businesses that we can understand and where we believe the companies ten years from now will be selling the same basic products and services they are today.” Francois Rochon

"We focus on very basic things. Is the business model understandable and is it likely to be essentially the same ten years from now?" Francisco Garcia Parmes

“I am not going to be able to figure what the moat is going to look like for Oracle, Lotus or Microsoft, ten years from now. Gates is the best businessman I have ever run into and they have a hell of a position, but I really don‘t know what that business is going to look like ten years from now. I certainly don‘t know what his competitors will look like ten years from now. I know what the chewing business will look like ten years from now. The Internet is not going to change how we chew gum and nothing much else is going to change how we chew gum.” Warren Buffett

Most businesses with longevity require a culture of innovation.

"Severe change and exceptional returns usually don't mix.  Most investors, of course, behave as if just the opposite were true.  That is, they usually confer the highest price-earnings ratios on exotic-sounding businesses that hold out the promise of feverish change.  That prospect lets investors fantasize about future profitability rather than face today's business realities.  For such investor-dreamers, any blind date is preferable to one with the girl next door, no matter how desirable she may be.  Experience, however, 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.  That is no argument for managerial complacency. Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously these opportunities should be seized.  But a business that constantly encounters major change also encounters many chances for major error.  Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise.  Such a franchise is usually the key to sustained high returns." Warren Buffett

"Not only individual firms, but also entire industries must be judged as to their ability to keep pace with the needs of the future. The investor has to be certain that neither the products of the company in which he invests nor the particular industry itself will become obsolete in a few years." J Paul Getty

Businesses change, but companies which sell essential items that are unlikely to undergo significant change have more durability than products with short life cycles.

“I define risk as the probability that a business trajectory will change dramatically for the worse.  First of all, you choose your businesses carefully. By picking businesses that have very few competitors and that are basic, essential-type businesses, you mitigate the possibility of that happening.  It tends to be a more boring business.  Glenn Greenberg

"A computer company can lose half its value overnight when a rival unveils a better product, but a chain of donut franchises in New England is not going to lose business when somebody opens a superior donut franchise in Ohio. It may take a decade for the competitor to arrive, and investors can see it coming" Peter Lynch

"I stick to businesses we understand and for which there is an ongoing need" Christopher Browne

“We’d like to believe any business is analysable, but when you have product cycles of only twelve months, as an investor you’re very reliant on the company hitting that window exactly right. If they don’t and somebody else does, you can buy low all you want, but you find out pretty quickly that you were buying a future income stream that was a mirage. We haven’t sworn off technology entirely, but we’ve essentially sworn off investing in short-product-cycle technology.” Larry Robbins

“I like businesses with long product cyclessay, cornflakes as opposed to cell phones – where there’s less risk of technological obsolescence” Murray Stahl

It's important to understand the business, the need for which the business is solving and the qualitative characteristics of the business.  How will technology influence the business? Will there always be demand for the product? Does the business have characteristics that make it hard for competitors to compete with - brand name, culture, scale, network effects, patents, regulation, switching costs etc?

"If you focus on near-term growth above all else, you miss the most important question you should be asking: will this business still be around a decade from now?  Numbers alone won’t tell you the answer; instead you must think critically about the qualitative characteristics of your business” Peter Thiel

While any business with a long term track record can be at risk from change, the longer the track record the more likely the business has been stress-tested by adverse conditions.

"In addition to the comfort provided by a long history of corporate survival and growth, performance during the most recent crisis may prove something of a touchstone for investors seeking security as well as income.  Nowadays, one doesn't have to guess what happens when the wheels of capitalism briefly stop turning; one can check empirically.  In reality, despite the stock market panic, many companies continued to see revenues and profits rise, or decline only modestly, during the breakdown of 2009; Coca-Cola grew organic sales by 5%, McDonalds by 4%, P&G by 2%. Even amongst the cyclicals, 3M's revenues fell by only 8% and margins were stable."  Marathon Asset Management

It's one of the reasons many of the Investment Masters avoid turnarounds, tech companies and newly minted businesses.

How will the companies you own look in ten years?

 

Great Investors Sleep Well

The Investment Masters recognise the need to be well rested which means correctly structuring a portfolio and not taking on too much risk…

"Lack of sleep.. causes stress.  The more stress we experience, the more we tend to make decisions that are short term" Peter Bevelin

“The financial calculus that Charlie and I employ would never permit our trading a good night’s sleep for a shot at a few extra percentage points of return” Warren Buffett

"Conservative investors sleep well" Phil Fisher

“When it comes to investing, my suggestion is to first understand your strengths and weaknesses, and then devise a simple strategy so that you can sleep at night!" Walter Schloss

“It is important for a portfolio manager to sleep well at night” Ed Wachenheim

“In my younger days I heard someone, I forgot who, remark “sell to the sleeping point”. This is a gem of wisdom of the purest ray serene. When we are worried it is because our subconscious mind is trying to telegraph us some message of warning. The wisest course is to sell to the point where one stops worrying ” Bernard Baruch

“Wealth management, the markets in their own perverse way occasionally remind us, is not just about eating well, it’s also about sleeping well” Frank Martin

“Investors should always keep in mind that the most important metric is not the returns achieved, but the returns weighed against the risks incurred. Ultimately, nothing should be more important to investors than the ability to sleep soundly at night” Seth Klarman

“We are fundamental investors and we tend to worry more than most. As a result, are willing to trade some upside during good times for the ability to sleep better at night. Holding cash in the absence of compelling opportunities helps us sleep. At the right price, and under certain conditions, hegding a portion of our risk through the purchase of put options helps us sleep even better” Christopher Parvese

"We sleep better at night knowing that we are focused on investing in true bargains." Bruce Berkowitz

“Successful investing goes hand in hand with productive worrying. Worried that a stock you hold might fall sharply? Reduce your holdings or buy some puts. Concerned that interest rates may rise or the dollar fall? Establish an appropriate hedge. Worried that the stock you bought on a tip might be a bad idea? Sell it and move on. Worry enough during the day and you can, in fact, sleep justifiably well at night” Seth Klarman

“I think it may have been JP Morgan that someone asked this question -  they said ‘I’m worried about high things are, should I sell? The advice he gave was ‘sell down to the sleeping point” Ed Thorp

“Our approach to risk management at Pershing Square relies in part on what I have deemed the 'Sleep at Night Test” Bill Ackman

Sleeping well at night requires constructing a portfolio that can tolerate unexpected adverse events and isn't going to result in the permanent loss of capital. It requires deep thought as opposed to relying on a risk model.

Avoiding the '7 Deadly Sins of Portfolio Management' will go a long way to ensuring a portfolio's longevity.  

"We try to "reverse engineer" our future at Berkshire, bearing in mind Charlie's dictum: "All I want to know is where I'm going to die so I'll never go there" Warren Buffett

"If we can't tolerate a possible consequence, remote though it may be, we steer clear of planting it's seeds" Warren Buffett

Make sure you can sleep well at night!