Mental Models - Middlemen

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Middlemen have historically been essential to success for most supply chains. Traditionally, manufacturers have relied on these businesses to assist in distribution, to develop their markets (or to leverage existing ones), especially when the manufacturer has lacked either the resources or the customer base to 'go it alone.'

I recently read a great interview with John Huber of Saber Capital on, where he opined on the changing role of middlemen in the value chain. Mr Huber's investment focus has evolved over the years to the point where, like many great investors, he seeks only quality businesses or 'compounding machines'. These are businesses whose value is likely to grow over the years. This investing style is in contrast to those investors who try to buy stocks cheaply regardless of whether the company's value is likely to grow or shrink. Those shrinking businesses are often referred to as 'melting ice cubes' - think yellow pages, newspapers, free-to-air-TV companies, etc.

Mr Huber recognises new technology is disrupting existing business models. Businesses are changing, and the internet is disrupting almost all businesses as old moats get filled in and barriers to entry are broken down. In many cases it is the middleman who face existential risk. Think of the cable-TV-company being disrupted by Netflix, the retailer disrupted by Amazon, the music store disrupted by I-tunes, the travel agent disrupted by Expedia, etc. 

Mr Huber gives the example of Footlocker, whose role as a middleman to buyers, is being marginalised by the internet. I'll let him explain...

".. Foot Locker still has a value of around $4.5 billion, even after a 60% decline in its stock price. The risk to the business is significant for a number of reasons. Fewer customers are visiting malls, and more significantly, brands like Nike are rapidly expanding their sales directly to customers, which reduces the value of Foot Locker’s reason for existence. A middleman adds value when he acts as a source of customers for suppliers and/or a source of product for customers. When the suppliers and customers can easily find each other on their own, the middleman has no purpose.

Foot Locker’s markup on any given product is no longer justified if it exceeds the cost of Nike selling it directly to customers. Foot Locker still might be adding incremental volume for some brands, but to the extent that the biggest suppliers can cut out their retail partners without a negative long-term impact to volume, then Foot Locker’s overall value proposition will be seriously impaired. Instead of adding value to each transaction by creating a sale that wouldn’t have occurred without them, they are now operating on borrowed time - extracting value from each sale that could have occurred without them.

But the company’s balance sheet and free cash flow is adequate enough that these risks won’t likely come to fruition over the next couple years, and with the stock trading at a very low multiple of cash flow, it appears cheap. But the value of that business, at least in my view, is slowly eroding. And in business, slow erosion can give way to a landslide without much warning. It is possible to buy this stock and sell it at a profit after a short period, but I think if we look back in five years, we are unlikely to see a situation where Foot Locker is a much more valuable enterprise than it is now." John Huber

The most obvious example of technological advancement impacting distribution channels is the internet. Last year, I picked up an interesting new 'mental model' from Jeffrey Ubben of ValueAct. In an investor letter, Mr Ubben detailed his new focus on businesses that were using the internet to bypass middlemen.

"We often describe ourselves as business model-centric, not industry-centric. This is evidenced by the amount of time we spend analyzing business models, including how companies produce goods and services, how they interact with customers and how they get paid. These dynamics change slowly, but their impacts are profound on the companies' returns on capital, and can very often overwhelm macro-economic cycles and be more long-lasting in effect.

One common theme we have explicitly chosen to invest in across multiple industries is direct customer engagement and disintermediation. Said another way, we look for opportunities where a company can remove intermediaries that distribute, resell, install, service and maintain their products. In the case of a company with diffused customers and limited internal resources, the "middlemen" can be extremely helpful. However, this help comes with a cost as the middlemen need to get paid, extracting economics from the industry. They also own the customer relationships, often leaving the supplier in the dark as to the customers' identities, locations, behaviours, preferences and level of activity. In the case of intangible goods, such as software or media, this loss of control can lead to widespread piracy. A direct relationship with the customer can enable more specific market intelligence, fostering faster, iterative product development cycles that work to further align interests between companies and their customers." Jeffrey Ubben

Jeffrey Ubben specifically mentioned SAS businesses which now benefit from having a "direct connection with the end-users, allowing a real time study of usage patterns, near-continuous product updates and a host of other features.  This was not possible when their software was indirectly distributed and ran on the island or a PC or a corporate data centre."

Its not all bad news for middlemen however.

Mr Ubben's analysis led me to an interesting medical device company who, rather than cutting out the middleman, has implemented cloud-connectivity which is creating a win-win environment for the business, the end customer and the middleman. By internet-enabling their medical device, for the first time the business has a direct relationship with the customer [a patient] which was previously the exclusive domain of the middleman [a home-care services provider]. 

This new customer connectivity is a win-win for all parties involved. The medical device has been cloud-connected and sends the patient's engagement and health data directly to the device manufacturer. This data is also made available to the home-care services provider via an on-line data analytics package and to the patient via an internet application.  When a patient engages with the app the company has found patient engagement levels significantly improve - to the point where one country's Government recently allowed higher reimbursement for cloud-connected devices.  

The medical device uses durable add-on equipment (consumables) which needs regular replacement. By accessing patient data via cloud-connectivity, the medical device manufacturer is able to automate the replenishment cycle resulting in a 50%-60% labor saving for the home-care provider. This has led to increased sales of the high-margin consumables and allowed the home-care provider to both focus more time on non-engaged/non-compliant patients and also to find new patients in what is a largely under-penetrated end market. 

The home-services provider is more productive, the level of patient care improved, and more patients are being located to purchase the medical device. Not only that, but the home-care provider is now far less likely to opt for a new competitor product given the alignment with the medical device manufacturer's data management system. Ultimately, the company's moat has been significantly widened.

The other mental model I like, and one that Jeffrey Ubben recognises above, is a model with a 'diffused' customer base. These are most attractive when the product has a reputation for reliability, where quality control is paramount, the product is a small cost versus the end cost [i.e. interior wall paints vs labour cost, small plumbing components, aeronautical parts, etc], the end market is fragmented and the product's use is service-based. Allan Mecham of Arlington Value Capital expanded on this concept in an interview with the 'Manual of Ideas'...

"I like the hourglass model, where a distributor stands in the middle of fragmented markets. That model allows a well managed distributor to enjoy strong bargaining power in both buying and selling while occupying a niche that’s valuable to customers and difficult for competitors to dislodge. I also like when there’s a high-touch service component that’s valued, which further fosters sticky customers".

Its important to identify with these dynamic changes to industries and middlemen, particularly when they relate to either businesses you own or ones you are considering investing in. Whilst not all middlemen are being affected by these changes, many are, resulting in potential 'melting ice-cubes'. Its not a bad idea to add this criteria to your checklists, to ensure you can spot the risk before taking on a company with potentially shrinking value, or even identify the same risk with ones you already own. Your investments could quickly move from the foot locker to the hurt locker if you don't. 

Learning from the Masters

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Have you ever noticed how the great minds of human history are best known for one particular idea, despite having many others to their credit? They're often acknowledged for that one giant breakthrough, the massive leap forward in technology or scientific theory yet the plethora of their other ideas remains largely unknown to most of us. Einstein and his theory of relativity; Newton discovering Gravity; Darwin and Human Evolution; the Wright Brothers and the First Aeroplane; Alan Turing and Computers; all are great people who are regarded with a large amount of respect for each of these creations, yet they have so much more to offer if we would only look.

Investigation into these people and their other ideas can be particularly enlightening, and the study of the Investment Masters is no different.

Over the years, researching the great minds of investing I've found many common threads that define those outstanding investors with long term track records of success. Deconstructing the psychology and play books of these great investors forms the foundation of the Investment Masters Class Tutorials.  Through reading autobiographies, annual letters, interviews and investment books by the Masters, I've found each of the Masters has either taught me a new insight or emphasised a concept or mindset that has helped me in my career navigating markets and advising institutional clients. I've spent my time reading and listening to their insights - which form the basis of the tutorials.

“I’ve been exposed to the most brilliant thinkers in different fields. I’ve studied the patterns behind them and I’ve studied the people who study them and one of the things we have to be wary of in life is studying the people who study the artists as opposed to the artists themselves.... We have to be very careful when we study excellence and we are thinking about our own path to excellence that we are studying and tuning in to the direct experience, to people who have been there as opposed to the armchair critic who are talking about it.” Josh Waitzkin

There is no doubt that Warren Buffett and Charlie Munger have worked out most of the ingredients for successful investing. Every time I re-read a Buffett letter or interview, or one of Charlie's essays I pick up another nugget of wisdom.

Notwithstanding, I've learnt a lot from many of the other Investment Masters: Soros can help you understand how asset bubbles form and why they collapse; Chanos can teach you why shorting stocks on low PE's might be more fruitful than shorting high flyers; Ed Wachenheim will teach you to look beyond the typical investors timeframe; Greenblatt can help you with spin-offs; Francois Rochon will keep you focused on your company's earnings rather than share price, while Ray Dalio will emphasise the value of studying history and learning from mistakes. Michael Steinhardt will put you on the path toward seeking the truth; while Thomas Russo will show the benefits that accrue to companies who invest for the future; accepting short term pain for long term gain. 

Interestingly, all of these Investment Masters have also learnt from other people. And they never stop; learning is endless. The day you decide that you know enough, or worse that you know it all, is the day to stop what you're doing and start again.

“I believe in the discipline of mastering the best that other people have figured out.  I don’t believe in just sitting down and trying to dream it all up yourself.  Nobody’s that smart.”  Charlie Munger

It goes without saying that I recommend continuing to learn from the Investment Masters. They each have other lessons you can utilise to improve your investment results.  Bill Nygren, articulated it nicely in his recent letter....

"I’ve always found it interesting that most value investors like to read only about other value investors. If you ask any value investor about their investment hero, Warren Buffett will be on the top of their list. He is on top of our list too, but once you’ve read seven books on Buffett, is the eighth one going to add more value? Would not reading about somebody else, who did things very differently from you but who also succeeded tremendously, be more valuable? I find that I learnt a lot by reading about some of the hedge fund managers such as Michael Steinhardt, Paul Tudor Jones and George Soros, all of whose approach was very different from what ours is. Perhaps you may find one thing from their approach that is consistent with your own philosophy. 

One of the things that Michael Steinhardt famously relied on was variant perception. On every company he had a position in, he knew what the bulls and bears thought, and why his point of view was different. Sometimes, as value investors, we don’t spend enough time doing that. We assume that if a company has a low P/E, or a low price to book, that’s enough to conclude it’s cheap. But we’ve learnt by studying Steinhardt that we can add value in our process even in a stock that looks statistically cheap by stating our different and distinct point of view. Anybody at Oakmark will be able to tell you what our variant perception is of a stock that we own. 

Source: The Trader Documentary 1987

Source: The Trader Documentary 1987

There is a famous picture of Paul Tudor Jones with a piece of paper on his bulletin board that says ‘Losers average losers’. As value investors, we always want to believe that the stock is overreacting to bad news. A typical analyst report goes: This is a disappointing quarter but my value estimate fell only 5% while the stock fell 15%, so it’s a lot cheaper than what it was yesterday. This led us to do a lot of research into our own ideas. When the fundamentals start deviating from what our analysts had projected, averaging down on those names tend to not work. It made us alter how we thought a little bit more, which for us is certainly more valuable than learning what Warren Buffett eats for breakfast. What Warren does — buying great businesses that are run by good people, buying and holding, thinking about long term — is still the core of our investment approach. Nothing pleases me more than when somebody says that what we do at Oakmark is very similar to Buffett. At the same time, that doesn’t mean we can’t learn from people who do things very differently from what we do."

And learning from others is a privilege. Consider this; many of the greats and their discoveries were made after long years of trial and error, making mistakes and learning from them, starting from scratch a number of times before success came their way. By learning from others we can avoid the pain they went through and yet achieve success of our own. That's got to be a win-win scenario for everyone. I hope I never stop learning; the rich gifts these great people have bestowed upon us is immeasurably valuable. So what have you learnt today?



Further Reading: IM Tutorials: Learning, Imitation Game

Learning from Charles Koch

If you've been reading my recent posts, particularly those about Nucor, Pixar and Starbucks, you may be getting the feeling by now that we seem to be highlighting certain key points of business success over and over.  Well, if you've had that feeling you're not wrong, and here's additional confirmation these particular aspects of business lead to success. 

After putting down the book 'Plain Talk' about Nucor's model for business success, I picked up Charles Koch's book 'Good Profit'. Charles has been the chairman and chief executive of Koch Industries since 1967, a role he assumed from his father, who had built the business into a $21m enterprise. Today, Koch Industries is the second largest private company in the US, worth more than $100b. Koch Industries has outperformed the S&P500 over five decades by an astonishing 27-fold!

So what has allowed Koch Industries to achieve such spectacular performance?

The answer to that questions lies with the characteristics we have found common to other great companies featured in past posts [Nucor, Pixar, Starbucks, etc]. The parallels between how Charles Koch thinks about managing Koch Industries and how Ken Iverson and Ed Catmull managed their successful companies is staggering. The book details Charles' management philosophy, which he calls Market-Based-Management [MBM]. This philosophy is based on Charles' five decades of interdisciplinary studies, experimental discovery, and practical implementation across Koch businesses world wide. The core objective of MBM is to generate good profit, the profit that comes from creating superior value for customers while consuming few resources and always acting lawfully and with integrity.


"Market-Based Management emphasises Principled Entrepreneurship over corporate welfare, virtue over talent, challenge over hierarchy, comparative advantage over job title, and rewards for long-term value creation over managing to budgets"

In an environment of rapid technological disruption, Koch Industries has been able to adapt and prosper, even as the business has grown into a large organisation with more than 100,000 employees. You'll notice most of the sub-titles in this post are both the same as the Nucor post and also titles of tutorials that form the basis of the Investment Masters Class. Great business sense and great investing go hand in hand.

Let's hear from Charles .. 


As with the views of most of the Investment Masters we have reviewed, effective Culture is vital for success in business. Charles agrees and has identified the key elements that combine to create a culture that cultivates true business effectiveness.

"For us, culture is key."

"Every organisation has its own culture. If that culture is not created consciously and purposefully, it will degenerate into a cult or personality, or an "anything goes" environment. Whether good or bad, an organisation's culture is determined by the values, beliefs, and conduct of its members, as well as rules and incentives set by its leaders - and modeled by them behaviourally."

"It requires focus, discipline, and persistence to produce a culture dedicated to superior results."

Koch's culture promotes behaviours and individual conduct over functional competency. This shows out in their hiring policies.

"[MBM places a great focus] on culture and on hiring based not just on skills but on virtues, with the goal of ensuring our businesses and leaders foster integrity, courage, compliance and respect."

"Many companies have principles somewhat similar to Koch's Guiding Principles, but rarely are they the basis for a company's culture. As Koch we strive to hire and retain only those who embrace our principles."

Innovation, accountability and leadership are all integral to a successful culture...

"To build a culture of discovery, we must encourage, not discourage, the passionate pursuit of hunches (no matter their origin)."

"A culture that lacks accountability lacks integrity and cannot survive, let alone thrive."

"Leaders must solicit the best knowledge internally and externally and create a culture in which the best knowledge is used regardless of the source."

"It is particularly important for everyone to embrace a challenge culture, both by soliciting different perspectives and expertise, and by having the courage to constructively speak up when we disagree."

"Because leaders set the standard - both by how they lead and by what they do - they are the guardians of, and must be held accountable for, the culture."


Companies that lack a Vision, lack purpose. They are missing a goal to strive for and a path to growth and greater returns.

"The lack of an effective vision, or, a conflict of vision, is a root cause of the failure of many great businesses."

"Each [businesses vision] needs to be aspirational in order to expand the thinking of leaders and employees throughout the organisation."

"Our vision is to create long-term value by economic means for customers, society, and the company. Customers come first in this list because without them there is no business."

"In deciding which businesses to pursue, Koch looks at how we can make good profit in the long term. This is fundamental to our vision because unless a business creates value for others, it will cease to exist (unless coercion is involved)."


Clearly the idea of customer value is important for Koch. If the customer attains a benefit from its transaction with the business, then that is ideal, because without customers, there is no business.

"We prefer to look at business through a win-win mindset."

"I had a clear understanding that the purpose of business was to create value for customers."

"Our goal was - and still is - to be the best counter-party of choice to our customers, vendors, communities, and employees."

"For a business to survive and prosper in the long term it must develop and use its capabilities to create real, sustainable, superior value for its customers, for society, and for itself. Only by doing so can it continue to inspire and attract customers, suppliers and partners."


Identify a differentiator - what can Koch do differently that gives them an edge in the market?

"We are constantly improving our capabilities, building new ones, and finding new opportunities for which they can create value. This is a departure from the conventional wisdom of most companies, which stick to industries they know well."

"Koch's emphasis on compounding is another difference between the vision of our company and that of many others."

"Koch's vision is different from most because it's focused on value creation and people."

"Other companies typically have a much different business philosophy and management approach."

Long-Term Perspective

The value of retaining long-term thinking...

"We remain private so we can focus on the long term."

"Short term profit created by liquidating assets and avoiding expenditures necessary for long-term success, can be illusory."

"When employees are rewarded only for short-term accounting profits without factoring in what long-term profits were missed, they will tend to make sub-optimal decisions."

"Short term profits, while necessary, are not sufficient for long-term business success. We have always shared the same vision for Koch; to innovate, grow, and reinvest in order to maximise long-term value by applying our core capabilities. If we try to smooth our earnings (as some public companies feel compelled to do to defend their stock price) our future would not be as bright."

"Based on its vision, Koch (and each of its businesses) develops and implements strategies that will maximise long term value."

"When setting priorities, one of the most difficult choice is between short-term optimisation strategies and long-term growth and innovation strategies. The natural tendency is for a business to under-invest in long term strategies. To offset this tendency it needs to commit dedicated resources to growth and innovation. Since long-term strategies won't result in profits for some time, incentives must be designed to reward progress in the interim."

"Another type of perverse incentive is endemic at publicly traded companies: the quarterly earnings report. Management at a public company is under a great deal of pressure to meet quarterly earnings forecasts, because falling slightly short can cause a significant drop in the stock price. Consequently, management is motivated to make decisions that optimise short-term earnings at the expense of maximising real long-term value.  Such decisions may include under-investing in attractive cyclical or long-term opportunities, ignoring needed write-downs, or even manipulating the books. Perverse incentives like these make managing a public company extremely difficult."

Individual Behaviour over Functional Brilliance

Like many other successful business leaders, Koch place an emphasis on people fitting with their values and culture rather than just having functional competency. Its a lot easier to train someone to fill a functional need than it is to change them to fit the culture...

"We focus first on values."

"The best coaches place as much emphasis on virtue as on talent."

"Having skills and intelligence is important, but we can hire all the brightest MBA's in the world, and if they don't have the right values, we will fail. Therefore, we hire based on values first - then talent."

"We increased our efforts to hire first on values, and only then on talent and experience. It is our goal to fill every position with individuals who are equally virtuous and talented, but if forced to choose between one or the other, Koch will choose virtue every time. Why? Because we understand that talented people with bad values can do far more damage to a company than virtuous people with inferior talents."

Information, Knowledge & Sharing

This one speaks for itself.

"There is no stronger form of communication than face-to-face sharing."

"Having a better point of view than our competitors has been a key driver of our success."

"Seek and use the best knowledge and proactively share your knowledge while welcoming challenges."

"In refining, as in all our businesses, developing a superior understanding of our markets has been critical to our approach and to our success."

"We study not only the history of a business or industry, but also existing and potential technologies, competitors, customers, applicable laws, and industry structures, and how all these factors are changing - both for industries we participate and for those we are considering. We then analyse their value chains and cost structures, future demand for their products, competitive positions of participants, and other meaningful factors and trends. We seek to understand the future drivers and level of profitability for the various segments of relevant industries. Even so, we recognise that uncertainty guarantees that any point of view can, at best, only be directionally correct"

"Whether the goal is to cure cancer, build a smaller and faster smartphone, or develop a more efficient and environmentally friendly way of making nylon, disruptive innovation requires creating, acquiring, sharing, and applying knowledge."

"For a culture to create spontaneous order that contributes to discovery, it must constantly seek, nurture, and implement new knowledge."

"Knowledge sharing isn't just important for innovation. Seeking, sharing, discussing, or challenging ideas and plans plays a crucial role in every aspect of an organisation's success."

"Replicating the way the scientific community organises itself, wherein knowledge is shared freely with a commitment to disproving even the most cherished hypothesis, leads to innovation."

Measuring Performance

Koch place value on measuring the things that matter rather than just producing reports for the sake of reporting.

"To guide activity correctly we must measure what leads to results, rather than what is easy to measure."

"A business must develop measures that help it understand the drivers of profitability."

"It is usually wasteful to develop detailed information beyond what is necessary to make good decisions. When evaluating an investment, unnecessary detail just distracts from the key drivers. Since it is impossible to predict outcomes precisely, trying to do so - as in making financial projections to several decimal places is wasteful. Even worse, such attempts create a false sense of confidence."

"A successful organisation should measure - and do its best to understand - the profitability (and profitability drivers) of its assets, products, strategies, customers, agreements, and employees, and anything else for which it is practical to do so."

"We need to ensure we are not wasting time providing information that is nice to have, but doesn't improve results."


And change is eternal, and that Koch have to keep abreast of those changes.

"Consumer needs and desires are constantly evolving."

"Change is ever present in society, the economy, and politics. Companies, products, methods, and individual skills are constantly being replaced by superior alternatives."

"Base on our changing point of view, we modify our thinking about the best opportunities and how to capture them."

Limited Hierarchy and Bureaucracy

Once again leadership and the erosion of bureaucratic empires is vital for growth, innovation and success.

"Command-and-control companies are less innovative and less competitive over time."

"There's a tendency for many successful companies to rest on their laurels, and become complacent, self-protective, and less innovative. In such bureaucratic cultures, employees can survive only by running with the herd. Decline sets in."

"Verbal exchanges lead to the discovery of new and better ways to create value. When such exchanges are hampered by overbearing taboos, bureaucracy, systems, procedures, tenure, knowledge hoarding, egos, or hierarchy, knowledge sharing is stifled."

"At Koch, truth is what gets results. It is what stands the tests of evidence and criticisms - not what someone in the hierarchy declares is true."

"Like many companies, Georgia Pacific [when acquired by Koch] had a command-and-control structure in which challenge of leaders was discouraged. We broke down this strict hierarchy in which leadership seemed above and apart from other employees."

Humility & Complacency

Humility as always is a fundamental trait of a successful culture and leadership.

"My father, Fred Koch, exemplified much of what is at the core of our culture: the value of hard work, integrity, humility, and a lifelong dedication to learning."

"Guard against self-assuredness. None of us at Koch can ever declare victory and lose focus on what matters."

"Arrogance is one of the most destructive traits of an organisation."

"We all need to exemplify humility and intellectual honesty as vital attributes of our culture."

"I don't consider any work I do "good enough" - because complacency and eventual decline are embedded in that mental model."

"Complacency and defence of the status quo are surefire prescriptions for business failure, because creative destruction is always with us."


Seeking knowledge from others and their experiences...

"I sought to read everything I could on the subject [of societal well-being] from every relevant discipline, including history, economics, philosophy, science, psychology, sociology, and anthropology."

"I am a bona-fide book person. My home contains more books than I'll ever have time to count."

"MBM draws from the wisdom of philosophers, economists and psychologists willing to face reality and use logic."

"Everyone, in every business, and in every position within a company, can be constantly learning and strengthening the values that drive good profit."

"No matter what business we are in, we can all learn a great deal from the best company (internal), the best industry (competitive), and the best in any industry anywhere in the world (world-class)."

Mental Models

The use of mental models appears time and time again within the doctrine of the Investment Masters.

"Mental models are intellectual structures that enable us to simplify and organise the myriad inputs we get from the world around us. They shape and support our thinking, decision making, opinions and beliefs."

"The quality of our mental models determines how well we function in the physical world. The same is true for the economic world, which is why Koch industries invests tremendous time and effort to ensure that our MBM mental models fit reality. Any business with behaviour based on faulty mental models will eventually fail."

"The most reliable signal that a business is using reality-grounded mental models and providing service that customers truly value is a profit made over time under beneficial rules of conduct."

"Theoretical grounding is necessary, but by itself it is not sufficient to obtain results. Success in applying new mental models - and thus acquiring personal knowledge - comes only after correct, frequent, and prolonged practice."


Ideas and innovation are actively encouraged within the organisation...

"Ideas are encouraged and challenged, not destructively criticised."

"Free speech within a company allows the exchange of information and ideas that generate innovation and progress."

"When a workplace culture of respect and trust is promoted, employees share their ideas and seek out the best knowledge to anticipate and solve problems."

"Businesses with good ideas but poor execution ultimately fail."

Challenging and Testing Ideas

And rather than just accept those ideas at face value, they need to be vigorously and constructively agitated to ensure their value.

"The kind of communication that fosters value creation requires constant disagreement."

"One of our top priorities is impressing on new employees that not only is it permissible to challenge their bosses respectfully if they think they have a better answer, but they have an obligation to do so. And supervisors have the obligation to create a culture that invites challenges."

"We are able to create superior value for customers because we attempt to replicate a free community of scientists - constantly sharing knowledge and ideas, testing hypotheses, experimenting and adjusting to what honestly works - rather than succumbing to establishment pressure."

"Continual questioning and brainstorming to find a better way is what we call challenging. It must be seen as an opportunity to learn and improve, not as a chance to kill another person's idea. Leaders should encourage challenges by asking open-ended questions such as "What are we missing here?" or "Is there a better way to do this?"

"The quality of a challenge depends on having the courage and willingness to respectfully question anyones' - up to and including the CEO's - beliefs, ideas, proposals, and actions."

"We need to strive - seeking help when needed - to clearly articulate our hypothesis, which, when made concrete and specific, can be challenged, tested and improved to the point that we believe them to be valid."

"To be most effective, [a] challenge process must include people with different perspectives, kinds of knowledge, and expertise. This is the kind of diversity that is important for innovation and reaching the best decision."

"To drive the process of creative destruction internally, nothing and no-one can be immune to challenge. Each of us, from the front-line supervisors to the CEO, must help foster an open environment that invites challenge and embraces change."

Take Risks and Accept Failure

Failure and its acceptance are integral to growth and learning as well as success.

"Confusing as it might seem, failure and getting results are not mutually exclusive. When driving experimental discovery within a company, failure is not desirable, but should be expected. Sometimes today's positive results can only be derived from lesson's of yesterday's failed experiments. As Einstein observed "Failure is success in progress."

"By not unduly penalising well-planned experiments that fail, we fuel an engine of small and frequent bets that can generate powerful discovery and learning. This is vital to innovation, growth, and long-term profitability."

"Koch's model for growth today is still a trial and error process."

"Perfection is the enemy of progress: Progress - whether in business, an economy, or science - comes through experimentation and failure. Those who favour a 'grand plan' over experimentation fail to understand the role that failed experiments play in creating progress in society."

"Experimental discovery is needed because we cannot know the final destination when our journey begins. Innovation usually involves numerous changes in direction that lead to the discovery of new paths."

"A key factor in our success has been the willingness to admit to mistakes and mitigate our losses in a timely manner. Rather than squandering our scarcest resource (talent) trying to save a marginal business, we've learned to focus that resource on opportunities with real potential."

"Our practice of exiting businesses with limited potential for us and focusing on ones with greater potential has been a key element in our success."

"I can never undo all the damage that has been done [by management failures], but I can commit myself to improving as a result of these management failures and helping others avoid the same mistakes."

Trust, Value and Empower your People

Koch understand that people are their greatest asset, and that being a manager doesn't mean that that person is always right.

"The old cliche is true: Good people are a company's most valuable resource. They are also essential for good profit. I join Jack Clark in feeling grateful for everything and entitled to nothing. I am especially grateful for all our good people."

"Organisations should treat people as individuals, according to their virtue, talents and contributions. Teamwork requires honesty, dignity, respect and sensitivity. Making people feel appreciated leads to better long term results."

"Just like owners usually take better care of their property than renters do, when an employee "owns" well-defined areas at work, she takes greater pride and responsibility for outcomes. This greatly improves results."

"At Koch we have found that each employee can help experiment and improve our ability to get results through MBM. In fact, employee innovations and contributions constitute most of the examples in this book."

"[We follow] a vision that focuses on what our employees can do to seize opportunities to create value for our customers."

"Leaving the particulars to those doing the work encourages discovery and enhances their ability to adapt to changing conditions."

"Freeing people to explore new approaches, within Koch's Guiding Principles, leads to innovation."

"[The concept that] the person with the comparative advantage to make that decision well (not necessarily the highest ranking person) should be the decision maker - leads to greater value creation."

"Granting well defined decision rights flies in the face of hierarchical norms."

"In an environment with clear decision rights, the owners of good decisions reap rewards, just as entrepreneurs in a free society do when they use their private property to create value for their customer and society."

"Decisions should not be made by those in closest proximity, but rather by those with the comparative advantage to make sound decisions, including the best knowledge."

"Too many businesses insist that decisions ought to be made by the highest-ranking person in the company hierarchy. But this should only be the case when that person is the one with the comparative advantage to make that decision. Tenure, credentials, or titles are not reliable predictors of good decision-making ability."

"No matter your role in the company, you should actively seek knowledge and alternative points of view."

"If the goal is to develop a culture that will be competitive in the long term, it's crucial for a company to give its people the right amount of responsibility to seek a better state."

The Right Incentives

Reward should encourage innovation and long term value.

"At Koch, base pay is recognised as an advance payment for the value an employee is expected to create for the company."

"With our approach, when individual employees create more value than their leaders, they are compensated more than their leaders, no matter what title. This is the same philosophy used by sports teams in which the top performers are paid more than the coach."

"Every company should strive to leverage incentives to motivate all employees to fully develop and apply their capabilities to maximise long-term value for the company in a principled way."

"At Koch, we do not reward roles or positions. We reward individuals for specific contributions and results, not for some generalised or averaged result. At Koch, anyone can earn more than his boss if he creates more value. Our goal is to motivate all employees to maximise their contribution, regardless of the role."

"All incentives, whether financial or not, should motivate each employee to fully develop her aptitude to create value, to innovate and drive creative destruction."

"At Koch we use incentives to attempt to align the interests of each employee with the interests of the company, our customers and society. Our philosophy is to pay employees a portion of the value they create for the company."

"If we don't hold employees (especially leaders) accountable for results and instead continue to compensate them the same regardless of their performance, we undermine the whole system."

"We recognise our incentive system is more demanding to administer than budget-, formula-, or hierarchy-base systems. However, in our experience, the effort Koch expends connecting employees to how they can create more value- and rewarding them for it - causes them to greatly increase their contribution."

"We have found that aligning incentives with performance almost always improves outcomes."


And of course, Innovation...

"Now, more than ever, if you don't have a culture of innovation, your days are numbered."

"At Koch, we stress the importance of incessantly embracing innovation and replacing old products, services, and methods with newer and better ones."

"Koch has grown through innovation and by painstakingly identifying and acquiring businesses that are beneficial to our customers and Koch as a whole."

"Anyone who wants to maximise creativity should work as part of multi-disciplinary teams, share ideas - not in isolated silos - and their leaders must provide them sufficient resources and time to do so."

"Koch strives to drive what Schumpeter called creative destruction, creating "the new commodity, the new technology, the new source of supply, the new type of organisation."

"Companies must realise they are not competing just on price and output of existing products. They have to relentlessly strive to come up with new and better products and produce them more efficiently than the alternatives."

"We must continually drive constructive change in every aspect of our company or we will fail."

"We constantly pursue disruptive innovations and opportunities through internal and external development as well as acquisition."

"Koch's reality-grounded MBM mental models, customer focus, and innovation have made us one of the world's largest and most successful private companies, generating exceptional long term performance."

"Even successful companies struggle to keep up because, given human nature, we all tend to become complacent, self protective, and less innovative as we succeed."


Koch's returns are an example of doing the right things rather than just doing things right. Innovation is encouraged, staff can earn more than their boss, titles mean nothing and customers are all. Many businesses fall short of what they could achieve or fail altogether because they fear to allow change within their walls, and prefer structure and hierarchy and regulations to provide them with security and comfort. Koch is another strong example of ideals and values that espouse great investing. If Koch can do it, and the Investment Masters all do it, shouldn't the businesses you own do it also?

Learning from Lou Simpson

One of the fascinating things I have discovered in my studies of the Investment Masters is that almost to a man, the Masters all come from obscure and unique roots. Since those beginnings, most have fought their way to the top, learning from their mistakes and along the way picking up vast reams of knowledge. Success for each of them came from long years of hard work and bitter experiences; a veritable baptism by fire. They are the quiet achievers and through it all have earnt the right to be called an Investment Master.

Among these, Lou Simpson is hardly a household name, even among investment professionals. In 1979 Jack Byrne, the CEO of Geico, was looking for a new chief investment officer to run Geico's investment portfolio. Jack had identified four candidates and had then sent them to Omaha to meet Warren Buffett who was a shareholder. ''I sent three of the four to meet Warren,'' Mr. Byrne recalled. ''And after a four-hour interview with Lou, he called me and said: "Stop the search. That's the fella." Lou stayed on for over 25 years racking up returns that bettered the S&P500 by an astonishing 6.8%pa.

In his 1995 letter Buffett noted "Lou takes the same conservative, concentrated approach to investments that we do at Berkshire, and it is an enormous plus for us to have him on board. One point that goes beyond Lou's GEICO work: His presence on the scene assures us that Berkshire would have an extraordinary professional immediately available to handle its
investments if something were to happen to Charlie and me."
 Eleven years later, in his 2006 letter, Buffett suggested Lou would “fill in magnificently for a short period.” if something happened to either himself or Charlie but given Simpson was just six years his junior, “a different answer” was needed for the long-term. 

Charlie Munger had this to say about Lou Simpson ..

"It's not unheard to beat the averages for a couple of years, maybe even five or ten years. But imagine beating the S&P500 by an average annual gain of 6.8 percent over twenty-five years! This extraordinary track record speaks for itself - Lou has one of the greatest investment minds of our time. He is, as Warren says, "a shoo-in for the Investment Hall of Fame".

Lou left Geico in 2010 and started his own fund, SQ Advisers in 2011. SQ Advisers, which now manages more than $3 billion, has a management strategy [as per the 2016 brochure lodged with the SEC] developed and implemented using the following principles as guidelines:

  • Think independently
  • Invest in-high return businesses run for the shareholders
  • Pay only a reasonable price, even for excellent businesses
  • Invest for the long-term
  • Do not diversify excessively

Like Buffett, Lou is a value investor looking to buy quality businesses below intrinsic value; "Generally, SQ advisers believes that identifying a significant difference between the market value of a security and the intrinsic value of that security is what defines an investment opportunity."

As a Senior Fellow and Adjunct Professor of Finance at the Kellogg Institute [well worth adding their website to your bookmarks..], Lou recently sat down for a rare interview with Robert Korajczyk, a professor of finance. It shouldn't be a surprise that Lou's views on investing parallel those of the other Investment Masters. I've included links to relevant tutorials in Lou's quotes from the Kellogg Institute interview below.

"The essence [of my investment philosophy] is simplicity"

"What we do is run a long-time-horizon portfolio comprised of ten to fifteen stocks. Most of them are U.S.-based, and they all have similar characteristics. Basically, they’re good businesses. They have a high return on capital, consistently good returns, and they’re run by leaders who want to create long-term value for shareholders while also treating their stakeholders right."

"You can only know so many companies. If you're managing 50 or 100 positions, the chances that you can add value are much, much lower.

"... be very careful with each decision you make. The more decisions you make, the higher the chances are that you will make a poor decision."

"One thing a lot of investors do is they cut their flowers and water their weeds. They sell their winners and keep their losers, hoping the losers will come back even. Generally, it’s more effective to cut your weeds and water your flowers. Sell the things that didn't work out, and let the things that are working out run."

"If I’ve made one mistake in the course of managing investments it was selling really good companies too soon. Because generally, if you’ve made good investments, they will last for a long time."

"Of course, things can change. Amazon is changing the retail business quite dramatically."

"I think you need a combination of quantitative and qualitative skills. Most people now have the quantitative skills. The qualitative skills develop over time."

"Everyone talks about modelling—and it’s probably helpful to do modelling—but if you can be approximately right, you will do well."

"One thing you need to determine is: Are the company’s leaders honest? Do they have integrity? Do they have huge turnover? Do they treat their people poorly? Does the CEO believe in running the business for the long term, or is he or she focused on the next quarter’s consensus earnings?"

"There are a few factors that we look at. First, is this the business we thought it was? If you figure out that a business is not what you thought it was, that’s a bad sign."

The second factor is the management, which can also differ from what you thought. Unfortunately, a lot of managements are very short-term oriented, and that can be another reason to sell. This goes back to the basic integrity and the focus of people in charge.

The third factor is an overly high valuation, and this is often the most difficult, because you’re investing in something you wouldn’t buy at current prices, but you don’t want to sell because it’s a really good business and you think it’s ahead of itself on a price basis. It might be worth holding on to it for a while."

"The biggest difference between Warren and me is that Warren had a much harder job. He was managing 20 times the amount of money we were."

"If somebody’s going to invest using hot tips, or listening to CNBC, or investing with so-called wealth managers at brokerage firms, I think it’s a loser’s game for them."

Once again, a successful Investment Master espouses beliefs that mirror those of many others. Keep it Simple. You wont always be right - Learn from your Mistakes. The Value of Good Culture. Don't sell your position in Great Companies. Back yourself. Things Change. And be Humble. Because from humble beginnings, great things can grow...



Source: Image - 'Portrait of a Disciplined Investor - Berkshire 2004 Annual Report'
“One of the Investment Greats” Explains His Portfolio Strategy: A Q&A with renowned investor Lou Simpson - Kellogg Institute - Robert Korajczyk, 2017.


Learning from Ken Iverson

Steelmaking is a tough, capital-intensive business in an industry characterised by booms and busts. Barriers to entry are low, foreign competition can be intense and you're a price taker - it's a commodity product. When looking at a business, Warren Buffett has long espoused pricing power as the most important determinant, which coincidentally is something steel companies don't have.

“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

So how does a small US steel company rise from obscurity to eventually dominate steelmaking in the United States? In large part, the answer to that question resides at the feet of Ken Iverson. The late Ken Iverson took Nucor Steel from its origins as a small-town steel business in the 1960's, to America's third largest steel player in 2002. Today, with the legacy culture instilled by him, Nucor is America's largest steel company.

So what was their secret to success? Interestingly, they had no secret formulas and no intricate management models that others lacked; basically, they simply changed the steel-industry paradigm on how to do business. They became a company that paid its workers more than anyone in the industry, yet was the lowest cost producer; a company that never laid off a worker or shut down a facility for lack of work, and a company that never lost money in any business quarter for more than thirty consecutive years! These simple changes to culture created an organisation that provided sustained returns over long periods and a business that was incredibly difficult to compete against.

I came across Nucor's enviable track record a while back when reading James Heskett's excellent book 'The Culture Cycle'. The book includes a few case studies on companies, Nucor being one of them.  More recently, I stumbled across Ken Iverson's book 'Plain Talk' after it was recommended by one of the Investment Masters.

'Plain Talk' is an easy read, I finished it in a few days. Its a no-nonsense, simple guide to business success by one of America's greatest corporate leaders.

It's fascinating how many of the mental models, thought processes and approaches of successful business leaders like Ken Iverson parallel with the Investment Mastersmindsets. It's little wonder that Buffett encourages investors to think like business people when acquiring stocks and for business people to think like investors when running businesses.

Let's hear from Ken Iverson on the keys to Nucor's success..


"It's helpful to think of corporate culture as all the things that shape interactions among the people in your company, it's customers and suppliers."

"I'm often asked; "How do your explain Nucor's success?" My stock reply: "It is 70% culture and 30% technology." The truth is, I'm not sure if it is 80 to 20 or 60 to 40, but I'm certain our culture accounts for more than half of our success as a business. Equality, freedom, and mutual respect promote motivation, initiative, and continuous improvement."

"Without a doubt, Nucor's culture is its most important source of competitive advantage, and always will be."

"Don't think, though, maintaining such a culture is easy. It demands daily attention to combat our worst human tendencies to divide ourselves into camps of "We vs They."

"Egalitarian business culture is an extraordinary practical way to sustain employee motivation."


"We at Nucor so often chose paths different from those followed by most corporations"


"Simplicity is what makes Nucor successful."

"Mainly we try and focus on what really matters - bottom-line performance and long-term survival."

"Our competitive strategy is to build manufacturing facilities economically, and to operate them efficiently. Period."

"Basically, we ask our employees to produce more product for less money. Then we reward them for doing that well. Simple."

"Nucor is founded on principles so basic, they sound corny. We believe in treating people the way you'd want to be treated."

Long Term Perspective

"Managing with a long term-perspective is just common sense to us. But I'll admit, not everybody sees things as we do. And, like managers in most large businesses, we must sometimes answer to those who froth at the mouth, pound on tables, and yell at us to do whatever it takes to maximise earnings right now! I'm referring, of course to stock analysts."

"Over a three-to-five year period, the success and growth in equity in a business will be reflected in its stock price, rewarding the investor."

"We're not dogs on a leash, doing tricks to manage the stock price or maximise dividend quarter by quarter. We're eagles. We soar. If investors want to soar, they'll invest with us. The speculators, we don't need."

"Every decision we make as managers is rooted in long-term perspective."

"A focus on long-term survival over shorter-term consideration can change every aspect of your business because it drives fundamentally different priorities."

"What we did was push aside the notion that management and employees have inherently separate interests. We've joined with our employees to pursue a goal we can all believe in; long term survival."

PainSharing [everyone took a cut in 1982 downturn]

"Department heads had taken pay cuts of up to 40%, and the general managers and other officers were earning 50-60% less than we had made in preceding years. My own pay dropped that year to about $110,000 from about $450,000 the year before. We not only shared the pain, we doled out the lion's share to people at the top."

"Painsharing" has helped us get through the tough times without ever laying off a single employee or closing a single facility for lack of work, even when the industry was shedding thousands of jobs."

Employment Policy and MBA's

"We're not hung up on recruiting from big, prestigious universities."

"Job descriptions are pretty much the same for everyone here: "Come to work and be productive as heck for twelve hours."

"We haven't had much luck with the MBA's we've hired out of the top business schools."

"Business school curricula should begin with developing managers' ability to understand people and to effectively relate to them."

"The fact is, few business school professors have ever managed anything, and their lack of hands-on experience shows in their students."

Decentralisation and Smallness

"Nucor has consistently required its general managers to generate a return of at least 25% on the assets we place under their control."

"All the other decisions [outside minimum 25% return on assets employed and ethical standards of the company and a few general policies] are left to managers and employees of each division."

"We've tried to keep our divisions small. When a business grows beyond 400 or 500 people, it's hard for management and employees to stay connected."

"Decentralisation isn't good, Centralisation isn't bad. Each is a sound option under the right circumstances."

"Each division operates its one or two plants as an independent enterprise. They procure their own raw materials; craft their own marketing strategies; find their own customers; set their own production quotas; hire, train and manage their own workforce;create and administer their own safety program. In short, all the important decisions are made right there at the division."

"You have to pursue the virtues of smallness, starting from the top of the business down."

"Our headquarters staff, including the clerical personnel, numbers just twenty-two."

"Communicate all the time, with everyone. That's what people in small businesses do. In fact, communication is probably the single greatest virtue of smallness."

"Fortune 500 executives visiting Nucor are intrigued to find that a major business can be so lean, simple and rational - in other words, so much like a small business."

"We prefer small towns. Labour in rural areas is a great untapped resource."


"Delegation without information is suicide."

"Too much information puts you in the same position as too little information - you don't know whats going on."

"The key is to identify the fraction of information that is truly useful to you, so you can concentrate on it."

"Try to focus on the information that tells you what you need to know under ordinary circumstances, and that will give you early warning when something extraordinary is going on."

"Sharing information is another key to treating people as equals, building trust, and destroying the hierarchy."

"At Nucor, our official information policy is to "share everything."

Limited Hierarchy

"Managers don't need or deserve special treatment. We're not more important than anyone else. We just have a different job to do."

"Management's authority comes from the employees."

"You must attack hierarchy. You have to destroy it."

"We think you get a heck of a lot by minimising the distinction between management and any other employee in the company."

"Our executives get the same group insurance, same holidays, and same vacations as everybody else. They eat in the same cafeterias. They fly economy class on regular commercial flights. We have no executive suits and no executive cars. At headquarters, our 'corporate dining room' is the deli across the street."

"No one in the company is more than four promotions away from having my job!"

"Adding more layers of management would wreck one of the great strengths of our business - very short lines of communication."

"Strip out a half-dozen or so layers of the management's hierarchy, and employees' information and ideas will find their own way to wherever they need to go."


"When you have power, real power, as Nucor's general managers do, you need to stay humble."

"Be a part of your company. Never set yourself above it."


"You should also try to be genuinely open to the ideas people bring to you."

"I can't stand it when there are no strange new ideas floating around the company."

"Don't study an idea to death with experts and committees. Get on with it and see if it works."

"You should never let someone else - even a so-called expert - tell you if a risk is worth taking. You have to decide for yourself."

"You can become a proponent of spreading more information to employees, giving them more responsibility for generating ideas, and increasing their decision-making powers."

Test Ideas

"I worry when sparks don't fly [at general manager meetings held three times a year]. These meetings are designed to let each of us tap into the collective wisdom of all us. That wisdom won't come out if we're worried about stepping on one another's toes."

"Our general managers say what they think, even if they know I won't like it."

"It's a heck of a lot easier to listen to someone tear down your position when you know the disagreement is honest, objective, and motivated by what they truly believe is good for the company."

"Open debate also safeguards against little problems getting tucked away in some dark corner, where they can grow into big problems."

Take Risks and Accept Failure

"People won't try to accomplish extraordinary things if their managers won't tolerate failure. You should take care never to criticise when things turn out badly. That's a surefire way to stop people taking prudent risks."

"Don't wallow in the failure. Learn from it. Look forward not back. Urge them to try again."

"I have no desire to be perfect. In fact, none of the people I've seen do impressive things in life are perfect. They never settle for latching onto one approach or mastering one way of doing things. They experiment. And they will often fail. But they gain something from every failure. That's what it takes to achieve, I think, in business as well as in life."

"Probably half of the new technologies, approaches, and other ideas we try fail."

"Some risks, even big ones, are worth taking once you've weighted them against appropriate criteria."

"Don't fall into the trap of ruling out failure. Risk, by definition, carries the possibility of failure. See that possibility. Study it, but never, ever hide from it."

"Aversion to risk is deadly in business, especially in industries marked by rapid advances in technology."

"Managers who avoid risk and fear failure spend their entire careers cheating themselves, their people, and their companies."

"You have to know yourself. You have to realise the fears and ambitions are the lenses through which you view and assess risks, and that the image those lenses convey may not always be true."

Trust, Value and Empower your People

"I believe people are our company's most valuable resource."

"I can't imagine staking my success on a group of people and not knowing them."

"Employees - not managers - are the engines of progress."

"If you want to manage autonomously, you'd better stay connected with your people."

"[We list] every Nucor employee, in alphabetical order, on the cover of our annual report. In a lot of companies, that would be seen (justifiably) as a hollow gesture. In ours, it's an expression of what we truly believe, that each and every one of those people is equally important."

"If you really want answers you can use to make the business perform better, ask the people who are doing the actual work of the business. It's that simple. Front-line employees continually amaze me with the capacity to make improvements."

"We built Nucor under the assumption that most of the "genius" in our organisation would be found among the people doing the work."

"Every manager should be something of a psychologist."

"I've found that, as employees, many people want first and foremost to be appreciated for who they are."

The Right Incentives

"People earn according to what they produce, and those earnings are determined simply and objectively."

"Base pay is just a fraction of what our people have the opportunity to earn."

"What must employees do to earn their weekly bonus? Two things; a) work in teams; b) produce!"

"Our employment cost in 1996 was roughly half the total employment cost per ton produced by the big steel companies. Our people earn more because they're more efficient and more productive. We didn't make it that way. We just structured compensation to give them a clear incentive and turned them loose."

"Nucor officers receive a base salary that is typically just 75% of that earned by executives in comparable positions across manufacturing. The remainder of their compensation is variable and entirely at risk, just like the production bonus. At the officer level, Nucor ties bonus compensation to return on shareholder equity."

"Nucor's approach to compensation.. I think is one of the most critical elements of our company's success."

"At a minimum, pay systems should drive specific behaviours that make your business competitive. So much of what other businesses admire in Nucor - our teamwork, extraordinary productivity, low costs, applied innovation, high morale, low turnover - is rooted in how we pay people. More than that, our pay and benefit program tie each employee's fate to the fate of the business."

Cyclicality and Debt 

"Steel making is a cyclical business - a business of booms and busts. Supermarkets offer a classic contrast. People have to buy groceries every week, even when the economy is down. Since grocery store revenues experience relatively mild fluctuations, supermarkets can carry substantial debt most of the time. On the other hand, people can go months or years without steel. Sink a steel company too deep into debt before the industry plunges into a long "bust" cycle, and you may not come out the other side, especially if the technology you invest in flops."

"We have a history of conservative financing, so we won't be too vulnerable to down cycles."


"Good managers are supposed to ponder possibilities beyond their areas of immediate authority. They are supposed to be students of the business."

On M&A

"A lot of corporations jump into new businesses, make acquisitions, and even decide to merge based on very questionable criteria like 'favourable ratios', 'minimal redundancy' and (my personal favourite) "Strategic synergism." Perhaps that's why more than half of such moves eventually fail - "strategic synergism" often turns out to be what I'd call "BS synergism". Ratios or no ratios, the people of the company have no idea how to make the new business or the newly merged organisation work."

"Weigh mergers and acquisitions from an employees' perspective."

"We have made very few acquisitions. We tend to build businesses from the ground up."


It's no coincidence that Nucor's incredible achievements come down to just a few critical traits that all Investment Masters deem fundamental to success in any company - Culture, Humility, Reward, Innovation, Simplicity and the ability to Learn from past Mistakes. They weren't reliant on complicated models or academic theories, they didn't hire the best qualified people or have a proprietary product differentiator, nor did they seek perfection in anything they did. Indeed, they made mistakes like many other businesses, and were able to succeed using rural talent pools. What paid off for them was firstly getting their culture right. The people were efficient and productive because the business allowed them to be.

There's no loyalty in the steel business, but there is steel in the business of loyalty. How does your company compare?

The Sandpile and Fingers of Instability

Screen Shot 2017-11-05 at 4.27.12 PM.png

The markets are complex systems; they can turn on a dime. While things might be travelling along nicely, it doesn't take much for sentiment to take an aggressive turn, the market to become pre-occupied with the negatives and all of a sudden the market is a lot lower. While the market's participants will look back and point to 'this reason' or 'that reason' as the event blamed for the sell-off,  in reality the situation is no more alarming than the negative news snippets that the market would ordinarily take in its stride.

I find a useful 'mental model' for explaining this phenomenon in the markets is the sandpile analogy; where a pile of sand develops from dropping individual grains from above. The sandpile continues to grow until a critical state is reached from which a single grain, no bigger than any of the previous grains, can bring about a collapse in the structure. As I've said before, it only takes one stone to start an avalanche. The real difficulty in this of course is that no one can predict which grain will be the one that triggers that avalanche.

One of the best books I've read on the concept of critical states is 'Ubiquity - Why Catastrophes Happen' by Mark Buchanan. I picked this book up from Bruce Berkowitz's recommended reading list. Mr. Buchanan delves into the unpredictability of complex natural and human cataclysms created by dynamic critical states.  His theory on the 'fingers of instability' that run through sandpiles is a useful construct to work with when thinking about financial markets.

"After the sandpile evolves to its critical state, many grains rest just on the verge of tumbling, and these grains link up into "fingers of instability" of all possible lengths.  While many are short, others slice through the pile from one end to the other. So the chain reaction triggered by a single grain might lead to an avalanche of any size whatsoever, depending on whether that grain fell on a short, intermediate or long finger of instability. The power law simply reflects this situation, and points to the riddling instability that underlies the sandpile's workings. In this simplified setting of the sandpile, the power law also points to something else; the surprising conclusion that even the greatest of events have no special or exceptional causes. After all, every avalanche, large or small starts out the same way, when a single grain falls and makes the pile just slightly too steep at one point. What makes one avalanche much larger than another has nothing to do with its original cause, and nothing to do with some special situation in the pile just before it starts. Rather, it has to do with the perpetually unstable organisation of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size" Mark Buchanan

Like sandpiles, as financial asset prices rise, markets have a tendency to reach a critical state, balanced uneasily from whence anything can happen. An indistinct piece of information or an individual market order can create an unexpected abnormal and exceptional, non-linear reaction.

“As George Soros has pointed out, the proximate cause of a panic is never the real cause any more than the last straw actually breaks the camel’s back” Andy Redleaf

“It’s always hard to know when you are in a bubble, and if you are in a bubble, when it is going to pop. It’s a lot like the chaos theory image of dripping sand onto a little pile that’s shaped like a cone on the beach. The pile gets higher and higher and finally suddenly there will be a little avalanche.” Ed Thorp

“When catastrophes occur, we naturally seek to identify the principal cause so we can avoid another disaster or at least derive some comfort from knowing what happened. We like it best when we can point to one specific, easily identifiable cause, but that is not always possible. Many scientists believe that large scale events in biology, geology, and economics are not necessarily the result of a single large event but rather of the unfolding of many smaller events that create an avalanche—like-effect. Per Bak, a Danish theoretical physicist developed a holistic theory of how systems behave called 'self-organised criticality'. To illustrate the concept of self-criticality, Bak often used the metaphor of a sandpileRobert Hagstrom

Throughout history, each subsequent stock market correction has been characterised by an innovation which has been unique to that period; either it was new, or its adoption was at a level of unprecedented proportion. In the crash of 1929 the blame for the collapse was laid at the foot of 'margin debt'. In the 1987 stock market crash it was 'portfolio risk management tools'. The tech crash was characterised by 'new era valuation methodologies', while the Global Financial Crisis saw exponential growth in 'dis-intermediated opaque structured products'.

Unfortunately, on Wall Street, innovations typically come with unintended consequences. 

"When Wall Street gets innovative, watch out!" Warren Buffett

"In reflecting on the societal impact of various areas of innovation, complexity and connectivity, it is easy to recount examples with mostly positive or mixed consequences. But in the realm of finance, as much as we traders appreciate the opportunity to unpack and trade complexity in securities, structures and markets, we wonder if the overall impact of financial innovation, including derivatives, structured products, high-frequency trading and communication advances, is a net negative, albeit with a possibly long delay before the drawbacks become visible" Paul Singer

Turning to the sandpile as the metaphor for markets, these innovations represent the 'long fingers of instability'Crazy valuations, cheer-leading brokers, unethical salespeople, conflicted ratings agencies, illiquidity, and opaqueness are a few of what I consider the 'shorter' or 'intermediate fingers of instability'. Combined, they resulted in a brittle foundation for asset prices, vulnerable to the next piece of negative news or price action.

So what are the 'fingers of instability' that run through today's markets?

The biggest risk to market structure today is the increasing dominance of 'Passive Investing' [ETF's & Index Funds], High Frequency Trading and Volatility targeting. These strategies are price indiscriminate [ie they have no regard to the underlying fundamental values of the companies] and when combined with increasing Connectivity and Illiquidity pose material risks to markets. I'll cover off on each of these..

High-Frequency Trading [HFT] and Market Illiquidity

HFT has been sold to the regulators and the masses as 'market-makers' or liquidity providers. HFT certainly adds to the volume traded, but volume is not liquidity. Most HFT firms end the day with no net position - whatever they've sold, they've bought, and vice versa. An easy way to understand the difference between liquidity and volume is to imagine the market had only two participants, both HFT firms. Each firm traded 1,000 shares back and forth between themselves 100 times a day. To an outsider, the volume would appear as 100,000 shares of daily volume. Imagine now, a third entrant, a genuine buyer, enters the market to buy 10,000 shares. After they've bought their first 1,000 shares there is no liquidity.

Furthermore, HFT firms access trading flow data with lower latency, meaning they get trading information quicker than other participants. A genuine buyer sends an order into multiple exchanges [as markets are now far more fragmented], and the HFT firm co-locates their own servers within each exchange to interpret and react to that flow data before its onward journey to the next exchange. The original purpose of the exchange, to match genuine buyers and sellers of stocks and promote price discovery for the efficient allocation of capital, no longer holds true. 

HFT is essentially removing liquidity from the market because it knows what you are doing and can do it before you.”  John Burbank

"Seeing someone's order to sell, the High Frequency Trader sells first, causing the stock to fall, and then buys it back at the lower price. How is this different from the crime of front-running?" Ed Thorp

“.. the systemic risk in these High-Frequency Trading systems. We saw this in the flash crash of 2010. The market just fell apart because some computers couldn’t handle the volatility. Technological risk is high, and that’s a problem, a real problem. The cancellation of orders is a real problem. The lack of public information and the lack of transparency are big problems."  John Bogle

"[HFT is] not a liquidity provider. It may create more volume but that's not the same as being a liquidity provider. To the extent that it is front running, I think society has generally been against front running for good reasons... Here they've gained an advantage by figuring out how the system worked and getting there first and that adds nothing" to economic activity." Warren Buffett

When volatility increases, HFT has a tendency to widen spreads or become inactive. The traditional market-makers, the specialists on the NYSE, and proprietary trading desks, have all but vanished. Following the Global Financial Crisis, regulators banned proprietary trading by Investment Banks in an attempt to prevent large losses and mitigate government bailouts. The unintended consequence of that action is less liquidity provision.

"[HFT] Trading creates the appearance of liquidity and depth, but this can and does, vanish with no notice in a millionth of a second. Traditional structures have disappeared, including: specialists who actually made orderly markets, standing ready to buy and sell to keep markets flowing; the big financial firms as partnerships, where executives' net worth was tied to the stability as well as profitability of the firm." Paul Singer

Passive Investing [ETF's and Index Funds]

An increasing number of investors have moved to 'passive' products [albeit the term is a misnomer - investing in an index is an active decision, and which index anyway??] for their ease of access and low cost. The majority of these investors rely on just 'price' as their investment signpost. As passive investing takes a larger share of the investing universe, new money flows to the biggest index components regardless of price. 

"Owners of Index Products have no real interest in the business performance of the underlying portfolio companies, and little or no knowledge or appreciation for what those companies actually do for a living, or how well they do or could do it.  

Nobody knows what this pattern means, and nobody has seen anything like it. It is not capitalism. It is not communism. It does not resemble anything that people have contemplated when thinking about markets, the virtues of private ownership of the means of production, and the prospects of growth and prosperity for masses of citizens.

Moreover, nobody knows how the passive style of investing will play out and evolve. There is a real likelihood that it, and its apparent stability, is unsustainable and brittle. But markets can be "wrong" for a very long time before they decide to change direction." Paul Singer

It is when market participants have no knowledge of the underlying companies they own that risk rises. There is no price point they can tether to in deciding whether to buy, hold or sell. No price is too high for an index fund to buy and no price is too low to sell. 

“It is not liquidity or perfect price discovery that ensures good pricing but it is knowledge of value. It is when we lack this knowledge that we demand liquidity and price discovery as poor substitutes.”  Andy Redleaf

Likewise, investors in ETF's more often than not have no idea what their ETF's own and thus are worth. ETF's are typically constructed to be 'marketed and sold' without regard to their investment merit.

"The inclusion criteria [for index related products] are certainly not what in the past was quaintly referred to as "investment criteria." Paul Singer

ETF’s are very efficient, very easy and very simple. There is no question about that. Therein lies part of the problem. It makes it easy for someone to say I want to buy Germany but doesn’t even look to see what’s in the German ETF or if it’s a good ETF to own.  It could be a terrible ETF but nobody looks anymore.  There are excesses developing in the ETF business. When we have the next bear market a lot of people are going to find out they collapsed and went down more than everything else because that’s what everybody owns.” Jim Rogers

If and when prices decline, it is the price action that becomes the news. Selling begets more selling as no-one knows the right price. It becomes a circular reference; people ask, "why do I own this biotech ETF? I've got no idea what it owns or what it's worth .. get me out!"

“People who buy for non-value reasons are likely to sell for non-value reasons.  Their presence in the picture will accentuate erratic price swings unrelated to underlying business developments.”  Warren Buffett

“Investors with no knowledge of (or concern for profits, dividends, valuation or the conduct of business simply cannot possess the resolve needed to do the right thing at the right time. With everyone around them buying and making money, they can't know when a stock is too high and therefore resist joining in. And with a market in free fall, they can't possibly have the confidence needed to hold or buy at severely reduced prices.”  Howard Marks

“The more investors invest by asset class rather than by picking individual companies, the more the market will tend to move as one, intensifying herd behaviour and the likelihood of panics, making hundred year floods even more likely.” Andy Redleaf

“I also think share prices are increasingly distorted by the collective buying and selling of ETFs. As more and more trading happens without any thought about valuation, price discovery has to be  somewhat less efficient... I have no idea when, but a reckoning will come and people will run away in blind panic.” Peter Keefe

But getting out isn't always that easy. Often the constituent components are far less liquid than the actual ETF. While things go smoothly no-one cares. Like a movie theatre, the exits work fine until someone screams 'fire'.

“With all technology, and all these ETF’s and quantitative systems introduced I do have concern technology has outpaced markets ability to handle it.. and when get into next bear market could be a messy affair. Unravelling of structured issues. Quant trading are momentum based not value based. “A body of motion tends to stay in motion”.Quantitative trading worries me. There is risk of some outsized outcome.” Leon Cooperman

Quant Trading

As active managers have struggled to keep up with the market indices, more and more investors have moved to index products and quant-based strategies. More money is now being managed by computer systems, many of which base their investing decisions on momentum or trend-following systems. This strategy focuses on buying stocks which have outperformed, again with no regard for underlying values. The strategy works until it doesn't. The buying on the way up is incremental. When the market turns down however, the volume of selling increases significantly, as not only the current flow needs to be sold, but all the accumulated stock on the way up as well.

"Quants and their computer models primarily extrapolate the patterns that have held true in past markets. They can’t predict changes in those patterns; they can’t anticipate aberrant periods; and thus they generally overestimate the reliability of past norms. They know all about how things will work if times are normal, but their analysis is of no help when events occur that reside in the far-off, improbable tails of the probability distribution" Howard Marks

Volatility Targeting

Volatility targeting is a strategy that rebalances between risky assets and cash in order to target a constant level of risk [or volatility] over time. Many institutional investors and hedge and mutual funds managers have embraced the strategy in an attempt to improve portfolio returns.

These strategies have introduced unknown risks and may lead to breakdowns where volatility rises, causing such managers to sell shares, which further drives up volatility, requiring the manager to sell even more shares - a circular reference. 

The October 2017 stability report from the IMF note "during volatility spikes, these [volatility targeting] strategies can lead to significant asset sales to pare back leverage. Such an episode took place in August 2015, when a representative volatility-targeting investment strategy cut its global equity exposure drastically. The size of US equity holdings held by volatility-targeting investment strategies may be larger than $0.5 trillion today. Although this is less than 2.5 percent of the market capitalization of all US publicly traded equities, the trading volume related to deleveraging from these trading strategies could be much larger, particularly at times of equity market stress."

Richard Bookstaber recently touched on risks of volatility targeting strategies on Wealthtrack

"A lot of asset managers do what's called volatility targeting, they tell their investors they will manage investments so they have on average a volatility of say 12%. Which means in a typical year, you may see your investments go up or down 5% or 10% or maybe 12%, but you are not going to see 20% moves unless something strange happens.  If volatility now for equities is 12% and you have a billion dollar portfolio you can hold 100% equities. Let's say volatility shoots up to 24%, if you are targeting 12% volatility, now you have to sell half your assets. Suddenly half a billion dollars of equities is going into the market and you're not the only one doing it. There are a lot of strategies like this where as volatility goes up people have to de-risk and reduce exposure. So rising volatility leads to a drop in the market, which add further to volatility and a further drop in the market. You get this cycle between rising volatility and a reduction in prices and returns. The big concern are these strategies that are rule based and have positive feedback, they accentuate moves." Richard Bookstaber


The increasing inter-connectivity of the markets and the speed at which algorithms interpret trade data and execute orders means the safeguard of human common sense is rendered obsolete. Risk management models that draw on historical data can't intuitively make sense of a crisis situation. This can lead to 'flash crashes', where stock prices collapse in a matter of seconds. 

"The stock exchanges have converted from "open outcry" where wild traders face each other, yelling and screaming as in a souk, then go drink together. Traders were replaced by computers, for very small visible benefits and massively large risks. While errors made by small traders are confined and distributed, those made by computerized systems go wild - in August 2010, a computer error made the entire market crash the "flash crash"; in August 2012..  the Knight Capital Group had its computer system go wild and cause $10 million dollars of losses a minute, losing $480 million." Nicholas Nassim Taleb


Today's markets have become increasingly dominated by passive investing, quant trading and volatility targeting strategies, where orders are executed without regard to price. Liquidity is being compromised by disappearing and front-running HFT and the absense of specialists and proprietary traders. This new market structure features trading speeds beyond human comprehension which together with fewer and fewer fundamental active managers [they've lost the money to index funds!] increases the potential for disorder.

If you understand the value of the businesses you own and like you can take advantage of the sell-offs triggered by the 'fingers of instability'. Ultimately, the more participants there are who invest without regard to underlying values the better for long term investors - prices and values do ultimately converge! Recognising the causes of technical corrections helps keep emotions intact while others are panicked and, or paralyzed.

Paul Singer's profound understanding of markets and risk has allowed Elliot Associates to compound capital successfully over 40 years with only two small down years.  He opines that when you witness episodes such as the 'flash crashes' of recent years, it is highly probable you are observing the future. He understands the risks in modern innovations and how they combine to make markets prone to disorder.

"All the innovations and complexity in the modern world of finance combine in different ingredients at different times with different catalysts and triggers, to create fragility, not stability."

Clearly the way the market operates has changed over time, as has the very market itself. Human intervention has been minimalized to make way for so-called technological advancements. Computers now run the show, yet they lack the capability to recognise underlying value. And while continued change in this regard is inevitable, new innovations can have far reaching negative impacts on the market, leading to further avalanches, collapses or crashes. So knowing what your investment portfolio contains and its worth is fundamental to success, as is a working knowledge of the 'fingers' that can destabilise entire markets. Because who knows? Your next trade could be that single grain of sand...


Buffett on Insurance

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What's the one commodity that we all want to have, but desperately hope we never have to use? That one product that provides a sense of reassurance and peace of mind, yet in many instances remains untouched by us for its life? That one safety net that we are happy to continue to pay large for, yet rarely implement?


On a Saturday in January, 1951, a young Warren Buffett caught the train from New York to Washington DC and headed to the Government Employees' Insurance Company's [GEICO] downtown headquarters. He had learnt that his hero from Columbia University, Ben Graham, was the Chairman. I'll let Buffett finish the story .... 

"To my dismay, the building was closed, but I pounded on the door until a custodian appeared. I asked this puzzled fellow if there was anyone in the office I could talk to, and he said he'd seen one man working on the sixth floor.

And thus I met Lorimer Davidson, Assistant to the President, who was later to become CEO. Though my only credentials were that I was a student of Graham's, "Davy" graciously spent four hours or so showering me with both kindness and instruction.  No one has ever received a better half-day course in how the insurance industry functions nor in the factors that enable one company to excel over others.  As Davy made clear, GEICO's method of selling - direct marketing - gave it an enormous cost advantage over competitors that sold through agents, a form of distribution so ingrained in the business of these insurers that it was impossible for them to give it up.  After my session with Davy, I was more excited about GEICO than I have ever been about a stock."

It was a fortuitous meeting ... Buffett tells the Berkshire shareholders .. "Berkshire would not be where it is today if Davy had not been so generous with his time on a cold Saturday in 1951."

Like any type of investing, investing in insurance companies requires a solid understanding of the intricacies of the industry. Given it's specialised nature, it generally sits outside most investors circle of competence.  

An insurance company differs from your typical manufacturer or service corporation. The positive differentiating characteristics were well encapsulated by John Rothchild, in the book 'The Davis Dynasty', which chronicles another of the last centuries' great insurance investors - Shelby Davis

"Insurance companies enjoyed some terrific advantages, as compared to manufacturers. Insurers offered a product that never went out of style. They profited from investing their customers' money. They didn't require expensive factories or research labs. They didn't pollute. They were recession-resistant. During hard times, consumers delayed expensive purchases (houses, cars, appliances, and so on), but they couldn't afford to let their home, auto, and life insurance policies lapse. When a sour economy forced them to economize, people drove fewer miles, caused fewer accidents, and filed fewer claims-a boom to auto insurers. Because interest rates tend to fall in hard times, insurance companies' bond portfolios become more valuable. These factors liberated insurers' earnings from the normal business cycle, and made them generally recession-proof "

That's not to say it's all positive; there are plenty of pitfalls to be aware of.  Over the last half century Warren Buffett has himself generously shared his wisdom on the insurance industry in the annual Berkshire letters. While far from all encompassing, this post draws on those letters to highlight some of the nuances and the positive and negative aspects of the insurance industry.

What is Insurance?

"Simply put, insurance is the sale of promises. The “customer” pays money now; the insurer promises to pay money in the future if certain events occur. Sometimes, the promise will not be tested for decades. (Think of life insurance bought by those in their 20s.)" 

Limited Obsolescence

"Insurance will always be essential for both businesses and individuals"

Low Historic Correlation

"[Our insurance groups produces earnings] that are not correlated to those of the general economy [delivering] outstanding results in 2008 and have excellent prospects"


"Float arises because premiums are received before losses are paid, an interval that sometimes extends over many years. During that time, the insurer invests the money."

"There is very little “Berkshire-quality” float existing in the insurance world." 

Combined Ratio

"The combined ratio represents total insurance costs (losses incurred plus expenses) compared to revenue from premiums: A ratio below 100 indicates an underwriting profit, and one above 100 indicates a loss."

Cost of Float

"Our cost of float is determined by our underwriting loss or profit. In those years when we have had an underwriting profit, our cost of float has been negative. In effect, we have been paid for holding money."

"Because loss costs must be estimated, insurers have enormous latitude in figuring their underwriting results, and that makes it very difficult for investors to calculate a company's true cost of float. Errors of estimation, usually innocent but sometimes not, can be huge. The consequences of these miscalculations flow directly into earnings."

"Since our float has cost us virtually nothing over the years, it has in effect served as equity."  

What Gives an Insurance Business Value?

"An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is higher than market rates for money."

How to Evaluate an Insurance Company

"How to evaluate an insurance company - The key determinants are: (1) the amount of float that the business generates; (2) its cost; and (3) most important of all, the long-term outlook for both of these factors."

"Only by making an analysis that incorporates both underwriting results and the current risk-free earnings obtainable from float can one evaluate the true economics of the business that a property-casualty insurer writes."

Four Disciplines to a Sound Insurance Operation

"At bottom, a sound insurance operation needs to adhere to four disciplines. It must (1) understand all exposures that might cause a policy to incur losses; (2) conservatively assess the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) set a premium that, on average, will deliver a profit after both prospective loss costs and operating expenses are covered; and (4) be willing to walk away if the appropriate premium can’t be obtained."

Where Most Insurers Go Wrong

"Many insurers pass the first three tests [above] and flunk the fourth. They simply can’t turn their back on business that is being eagerly written by their competitors. That old line, “The other guy is doing it, so we must as well,” spells trouble in any business, but in none more so than insurance."

Good Underwriting

"A good underwriter needs an independent mindset akin to that of the senior citizen who received a call from his wife while driving home. “Albert, be careful,” she warned, “I just heard on the radio that there’s a car going the wrong way down the Interstate.” “Mabel, they
don’t know the half of it,” replied Albert, “It’s not just one car, there are hundreds of them.”


"Any insurer can grow rapidly if it gets careless about underwriting."

'We shrank - and we will do so again from time to time in the future.  Our large swings in volume do not mean that we come and go from the insurance marketplace.  Indeed, we are its most steadfast participant, always standing ready, at prices we believe adequate, to write a wide variety of high-limit coverages."


"There are a lot of ways to lose money in insurance, and the industry is resourceful in creating new ones."


"No matter what others may do, we will not knowingly write business at inadequate rates."

"Appropriate prices don’t guarantee profits in any given year, but inappropriate prices most certainly guarantee eventual losses. 

Interest Rates

"As interest rates have fallen, however, the value of float has substantially declined."


"Virtually all surprises in insurance are unpleasant ones."

"Surprises in insurance are far from symmetrical. You are lucky if you get one that is pleasant for every ten that go the other way."

P&C Businesses

"One reason we were attracted to the P/C business was its financial characteristics: P/C insurers receive premiums upfront and pay claims later. In extreme cases, such as those arising from certain workers’ compensation accidents, payments can stretch over many decades. This collect-now, pay-later model leaves P/C companies holding large sums – money we call “float” – that will eventually go to others. Meanwhile, insurers get to invest this float for their own benefit. Though individual policies and claims come and go, the amount of float an insurer holds usually remains fairly stable in relation to premium volume. Consequently, as our business grows, so does our float."

"Unfortunately, the financial statements of a property/casualty insurer provide, at best, only a first rough draft of earnings and financial condition."

"The determination of costs is the main problem.  Most of an insurer’s costs result from losses on claims, and many of the losses that should be charged against the current year’s revenue are exceptionally difficult to estimate. Sometimes the extent of these losses, or even their existence, is not known for decades."

Casualty vs Property Lines of Insurance

"Because our business is weighted toward casualty and reinsurance lines, we have more problems in estimating loss costs than companies that specialize in property insurance. (When a building that you have insured burns down, you get a much faster fix on your costs)"

Long vs Short Tail

"The industry calls malpractice and certain other kinds of liability insurance "long- tail" business, in recognition of the extended period during which insurers get to hold large sums that in the end will go to claimants and their lawyers"

"In long-tail situations a [higher] combined ratio can prove profitable, since earnings produced by the float will exceed the [amount] by which claims and expenses overrun premiums. The catch, though, is that "long-tail" means exactly that: Liability business written in a given year and presumed at first to have produced a [acceptable] combined ratio may eventually smack the insurer with 200, 300 or worse when the years have rolled by and all claims have finally been settled."

"We write lots of "long-tail" business - that is, policies generating claims that
often take many years to resolve.  Examples would be product liability, or directors and officers liability coverages. With a business mix like this, one year of reserve development tells you very little."

"The unpredictability of our legal system makes it impossible for even the most conscientious insurer to come close to judging the eventual cost of long-tail claims."

"In a given year, it is possible for an insurer to show almost any profit number it wishes, particularly if it (1) writes “long-tail” business (coverage where current costs can be only estimated, because claim payments are long delayed), (2) has been adequately reserved in the past, or (3) is growing very rapidly. 

"Where "earnings" can be created by the stroke of a pen, the dishonest will gather.  For them, long-tail insurance is heaven."

Proper Reserves

"When insurance executives belatedly establish proper reserves, they often speak of "reserve strengthening," a term that has a rather noble ring to it.  They almost make it sound as
if they are adding extra layers of strength to an already-solid balance sheet.  That’s not the case: instead the term is a euphemism for what should more properly be called "correction of
previous untruths" (albeit non-intentional ones)."

Commodity Product

"The insurance industry is cursed with a set of dismal economic characteristics that make for a poor long-term outlook: hundreds of competitors, ease of entry, and a product that cannot be differentiated in any meaningful way.  In such a commodity-like business, only a very low-cost operator or someone operating in a protected, and usually small, niche can sustain high profitability levels. 

"Many insureds, including the managers of large businesses, do not even know the names of their insurers.) Insurance, therefore, would seem to be a textbook case of an industry usually faced with the deadly combination of excess capacity and a “commodity” product."

"Most insureds don’t care from whom they buy. Customers by the millions say “I need some Gillette blades” or “I’ll have a Coke” but we wait in vain for “I’d like a National Indemnity policy, please.”

"Insurers have generally earned poor returns for a simple reason: They sell a commodity-like product." 

"Insurance companies offer standardized policies which can be copied by anyone. Their only products are promises. It is not difficult to be licensed, and rates are an open book. There are no important advantages from trademarks, patents, location, corporate longevity, raw material sources, etc., and very little consumer differentiation to produce insulation from competition."

Industry Economics

"Market share is not an important determinant of profitability: In this business, in
contrast to the newspaper or grocery businesses, the economic rule is not survival of the fattest.  Second, in many sectors of insurance, including most of those in which we operate, distribution channels are not proprietary and can be easily entered: Small volume this year does not preclude huge volume next year.  Third, idle capacity - which in this industry largely means people - does not result in intolerable costs.  In a way that industries such as printing or steel cannot, we can operate at quarter-speed much of the time and still enjoy long-term prosperity."

Industry Pricing

"Pricing behaviour in the insurance industry continues to be exactly what can be expected in a commodity-type business.  Only under shortage conditions are high profits achieved, and such conditions don’t last long.  When the profit sun begins to shine, long-established insurers shower investors with new shares in order to build capital.  In addition, newly-formed insurers rush to sell shares at the advantageous prices available in the new-issue market (prices advantageous, that is, to the insiders promoting the company but rarely to the new shareholders).  These moves guarantee future trouble: capacity soars, competitive
juices flow, and prices fade.

Demand & Supply

"Unfortunately, there can be no surge in demand for insurance policies comparable to one that might produce a market tightness in copper or aluminium.  Rather, the supply of available insurance coverage must be curtailed.  “Supply”, in this context, is mental
rather than physical: plants or companies need not be shut; only the willingness of underwriters to sign their names need be curtailed.

"The amount of industry capacity at any particular moment primarily depends on the mental state of insurance managers"

"Major capacity withdrawals require a shock factor such as a natural or financial “mega-disaster”

Risk of Courts Orders on Casualty Insurance

"We have far underestimated the mushrooming tendency of juries and courts to make the “deep pocket” pay, regardless of the factual situation and the past precedents for establishment of liability.  We also have underestimated the contagious effect that publicity regarding giant awards has on juries. "

Insolvent Competitors Can stay in Business

"In most businesses, of course, insolvent companies run out of cash.  Insurance is different: you can be broke but flush.  Since cash comes in at the inception of an insurance policy and losses are paid much later, insolvent insurers don’t run out of cash until long after they have run out of net worth.  In fact, these “walking dead” often redouble their efforts to write business, accepting almost any price or risk, simply to keep the cash flowing in."

Low Costs

"The most important ingredient in GEICO’s success is rock-bottom operating costs, which set the company apart from literally hundreds of competitors that offer auto insurance.  The difference between GEICO’s costs and those of its competitors is a kind of moat that protects a valuable and much-sought-after business castle."

Driverless Cars

"At some point in the future – though not, in my view, for a long time – GEICO’s premium volume may shrink because of driverless cars – but even the most casual follower of business news has long been aware of them. None of these problems, however, is crucial to Berkshire’s long-term well-being"

Super-Cat [Catastrophe] Business

"In this operation, we sell policies that insurance and reinsurance companies purchase in order to limit their losses when mega-catastrophes strike."

"Since truly major catastrophes are rare occurrences, our super-cat business can be expected to show large profits in most years -- and to record a huge loss occasionally."

"Berkshire is sought out for many kinds of insurance, both super-cat and large single-risk, because: (1) our financial strength is unmatched, and insureds know we can and will pay our losses under the most adverse of circumstances; (2) we can supply a quote faster than anyone in the business; and (3) we will issue policies with limits larger than anyone else is prepared to write. Most of our competitors have extensive reinsurance treaties and lay off much of their business."

Climate Change

"We do know that it would be a huge mistake to bet that evolving atmospheric changes are benign in their implications for insurers."


"The saying, "a fool and his money are soon invited everywhere," applies in spades in
reinsurance, and we actually reject more than 98% of the business we are offered."

"A bad reinsurance contract is like hell:  easy to enter and impossible to exit."

"Choosing the wrong reinsurer, however – one that down the road proved to be financially strapped or a bad actor – would put the original insurer in danger of getting the liabilities right back in its lap."


"[It is] vital that the interests of the people who write insurance business be aligned - on the downside as well as the upside - with those of the people putting up the capital.  When that kind of symmetry is missing, insurers almost invariably run into trouble, though its existence may remain hidden for some time."

Importance of Management

"There is no question that the nature of the insurance business magnifies the effect which individual managers have on company performance."

"[The Insurance business] tends to magnify, to an unusual degree, human managerial talent - or the lack of it"

Insurance Cycle

"Commentators frequently discuss the "underwriting cycle" and speculate about its next turn. If that term is used to connote rhythmic qualities, it is in our view a misnomer that leads to faulty thinking about the industry's fundamental economics."


It's evident that while insurance companies have attractive characteristics, there are plenty of risks for the inexperienced. Berkshire's competitive advantages include culture, very low cost, a fortress balance sheet and the willingness to walk away from mis-priced business. It's the latter point where most insurers go wrong.  

The right management is absolutely critical to success in this industry. The skillset of a good underwriter parallels many of the skills of a the successful investor. Both must think long term, be conservative, be open-minded and creative in considering potential risks. Alignment of interests, is also essential. 

"[Given the time lag between revenues and costs and the risk of under reserving] management quality becomes critical - perhaps more so than other industries. Marathon looks for a long history of stable returns, conservative reserving and the ability to resist growing premiums when profitable opportunities are scarce. Indeed rapid growth of premiums at any time is a red flag, as it is often a precursor to reserving problems. Inorganic growth should also be viewed with caution given the asymmetry of information between the buyer and seller over reserving risk.

.. The way management incentives are structured can be an important way to avoiding these pitfalls - a focus on return on equity over earnings growth is preferable, with return targets ideally set over time period longer than a year

It is important to tread with caution, as the time lag between revenue and costs means it is all the more important to invest alongside those rare management teams who can put long-term value creation above more short-term concerns" Marathon Asset Management

I'll leave the closing remarks to Charlie Munger, who sums it all up so well ... 

“I’m glad we have insurance, though it’s not a no-brainer, I’m warning you. We have to be smart to make this work.” Charlie Munger

"Berkshire’s marvellous outcome in insurance was not a natural result. Ordinarily, a casualty insurance business is a producer of mediocre results, even when very well managed. And such results are of little use. Berkshire’s better outcome was so astoundingly large that I believe that Buffett would now fail to recreate it if he returned to a small base while retaining his smarts and regaining his youth." Charlie Munger 2014 , Golden Anniversary Letter


Further Recommended Reading:
Berkshire Hathaway Letters
'The Davis Dynasty' by John Rothchild
'General Insurance Fundamentals' IAG


Learning from Josh Waitzkin

Do you remember the first investment you ever made? How nervous you were? Worrying about whether the stock would grow or tank? What things you had missed or whether the information you had was outdated? We've all been there; that perilous moment when you first dip your toe into the investment pool, all while asking yourself whether a piranha lurks just out of sight beneath the surface.

Now, as a comparison, take an investment you made recently and compare how you felt. I bet your comfort levels are much higher these days. As is your confidence. So what's the difference? Knowledge and Experience, that's what. You're more confident now because you know more and have experienced more. Many parts of your investment activity have become intuitive, or second nature. 

One of my favourite books that deals with this type of thinking, and one coincidentally recommended by numerous Investment Masters, is Josh Waitzkin's 'The Art of Learning'. Josh was the US National Chess Champion at age nine and later became World Champion in the martial art, Tai Chi Chuan. 

As an adult, Josh now trains high level performers as well as many successful investment managers. I recently watched an interview with Josh on the Alan Howard Series, which prompted me to write a post on this subject that I've been thinking about for a long time. Like the financial markets, chess is a dynamic endeavour involving complexity, uncertainty and emotions. It follows that Josh's approach to chess and martial arts have striking parallels with the approach of many of the Investment Masters [refer study notes for more detail].

Two powerful concepts Josh discusses in his book are the focus on the 'end-game' and the concept of 'the study of numbers to leave numbers'.  

Josh tells the story of how, as a child competing in chess tournaments, he would confront other children who had been drilled in the 'opening variations' of the game.  These children had been taught to memorise strong opening positions to overcome their opponents early in the game. In contrast, Josh spent his time looking at'end-games'. He would study chess with just two or three pieces on the board, learning the subtlety of pieces, and gaining an intuitive feel for their power. Layer by layer, he learnt the principles of opposition and the hidden potency of empty space and built up the knowledge to transform axioms into fuel for creative thought. At first, he practiced with just the pawn and the king, and then moved to rook endings, bishop endings, and knight endings.  By focusing on what was essential he internalised a methodology of learning - the inter-play between knowledge, intuition and creativity.

"Bruce and I also spent a lot of time studying endgames, where the board is nearly empty and high-level principles combine with deep calculations to create fascinating battles. While my opponents wanted to win in the openings, right off the bat, I guided positions into complicated middle games and abstract endings" Josh Waitzkin

"Bruce began our study with a barren chessboard. We took positions of reduced complexity and clear principles. Our first focus was king and pawn against king - just three pieces on the table. Over time, I gained an excellent intuitive feel for the power of the king and the subtlety of the pawn .. Most of my rivals, on the other hand, began by studying openings .. Why not begin from the beginning, especially if it leads to instant success? The answer is quicksand. Once you start with openings, there is no way out. Lifetimes can be spent memorizing and keeping up with the evolving Encyclopedia of Chess Openings. They are an addiction, with perilous psychological effects." Josh Waitzkin

Such a deep understanding of the pieces and their inter-connectedness gave Josh an edge once the opening variations developed into complex random and chaotic game-play. By spending time studying end-games Josh would be at ease as the game unfolded. In contrast, his opponents would crumble if the game was not won quickly, as both their memories and confidence would fail them as the game ventured into the unpredictable and unexpected. 

Josh's success came from adopting a different perspective from the typical chess player. Likewise, many of the Investment Masters have succeeded by adopting a different perspective and focussing on the end-game.

In investing, like chess, most players are focused on the opening game. They spend their time deciphering the factors impacting the stock right now, and trying to answer questions such as - will next quarters earnings meet expectations? In contrast, the Investment Masters lengthen their time horizons, move away from the current stock market noise and spend more time focusing on the end-game. They learn the subtlety of what makes a company strong, the factors that have allowed the company to thrive in the past and the two or three key factors that will ensure a profitable future. They lengthen the time horizon to an area where other investors aren't focused. They ask - how will the business look in three to five years? Will the company be able to maintain its competitive position? Will the earnings be significantly higher and how will the market value those earnings? This process of looking towards the future is often referred to as time arbitrage.

"The forecasting horizon trap lures you into spending all your time on what's more knowable - the same immediate horizon that occupies everyone else. If you fall into the trap, competing with all the other investors concentrating on these short term events, it is impossible to outperform the market. You have to escape to a longer term horizon"  Ralph Wanger

"Over the last few decades, investors' timeframes have shrunk. They've become obsessed with quarterly returns.  In fact, technology now enables them to become distracted by returns on a daily basis, and even minute-by-minute. Thus one way to gain an advantage is by ignoring the "noise" created by the manic swings of others and focussing on the things that matter in the long term" Howard Marks

The Investment Masters also work backwards from the end-game. They try and imagine that the company has failed and then ask - what could have been the contributing factors that led to failure? Inverting the questioning process opens up avenues of creativity to identify potential investment risks that others may miss. By putting themselves into the future they create different perspectives that may not be obvious to those anchored in the present.

"Charlie Munger is famous for the pioneering concept of inverting as an investor, of thinking backwards to find one's way to the beginning of an idea or concept.  In our application, an advantage can be gained in the competitive world of active investment management by preparing for the unknown by inverting, reasoning backwards to attempt to learn how others in the past have coped with the unforeseeable and the unpredictable"  Frank Martin

"When Charlie [Munger] thinks about things, he starts by inverting. To understand how to be happy in life, Charlie will study how to make life miserable; to examine how business become big and strong, Charlie first studies how businesses decline and die; most people care more about how to succeed in the stock market, Charlie is most concerned about why most have failed in the stock market. His way of thinking comes from the saying in the farmer’s philosophy: All I want to know is where I’m going to die, so I will never go there." Li Lu

The second insightful concept Josh discusses is the 'study of numbers to leave numbers'. In essence this refers to mastering a discipline to the extent that it becomes intuitiveor second nature.

"As I struggled for a more precise grasp of my own learning process, I was forced to retrace my steps and remember what had been internalized and forgotten. In both my chess and martial arts lives, there is a method of study that has been critical to my growth. I sometimes refer to it as the study of numbers to leave numbers, or form to leave form. A basic example  of this process, which applies to any discipline, can easily be illustrated through chess: A chess student must initially become immersed in the fundamentals in order to have any potential to reach a high level of skill. He or she will learn the principles of endgame, middlegame, and opening play. Initially one or two critical themes will be considered at once but over time the intuition learns to integrate more and more principles into a sense of flow. Eventually the foundation is so deeply internalized that it is no longer consciously considered, but is lived. This process continuously cycles along as deeper layers of the art are soaked in." Josh Waitzkin

“It is important to understand that by numbers to leave numbers, or form to leave form, I am describing a process in which technical information is integrated into what feels like a natural intelligence”  Josh Waitzkin

"Most people would be surprised to discover that if you compare the though process of a Grandmaster to that of an expert (a much weaker, but quite competent chess player), you will often find that the Grandmaster consciously looks at less, not more. That said the chunks of information that have been put together in his mind allow him to see much more with much less conscious thought. So he is looking at very little and seeing quite a lot. The Grandmaster looks at less and sees more, because his unconscious skill set is much more highly evolved" Josh Waitzkin

"In my opinion intuition is our most valuable compass in the world" Josh Waitzkin

Studying broadly and consistently produces a detailed database of information that an individual can draw upon.  Creativity is provoked by the association and integration of disparate pieces of information. So to the Investment Masters recognise the role of intuition in successful investing.

"[Intuition, instinct, hunch] .. it's critical. And it's also, by the way, what the computer can't do well. In other words, it's the subconscious. As you know, man, although it's only 200,000 years old, the brain is much older. And we came programmed with many of these things in our brain, intuition and those things. And they're in our subconscious. And so by opening up one's subconscious to one's consciousness so they come up, you know, creativity comes from not working hard at it, it comes from relaxation. It bubbles up from the subconscious. Transcendental meditation has been invaluable to me because it helps to do that. But that intuition, that creativity, man is still unique at being able to do those things. So you let that bubble up, but you have to reconcile it with your logic. So when the subconscious creativity and intuition comes up and replicate it with your logic, it's fabulous." Ray Dalio

"Superior results generally require insight, judgement and intuition" Howard Marks

One of the greatest investment minds of all time, Charlie Munger, certainly understands the concept of 'the study of numbers to leave numbers' ... 

“The deep structure of the human mind requires that the way to full scope competency of virtually any kind is to learn it all to fluency—like it or not.” Charlie Munger

So how does your thinking look by comparison? Are you anchored in the present and distracted by the noise in the market? Focused on quarterly earnings and the price of the stock today? Or are you inverting; deciphering the future by working backward from potential outcomes? It's time to leave the now behind and study the end-game, looking at what's to come and using your intuition to the right advantage. And if you do it right, then its check-mate to you...  

Further Reading:
'The Art of Learning" Josh Waitzkin Study Notes - 'Art of Learning'
Alan Howard Series Interview - Josh Waitzkin
Tim Ferris Podcast - Josh Waitzkin Interview

Learning from Howard Schultz

It goes without saying that business and investment are linked. To be able to do one effectively, you need to understand the other. And understanding the ingredients of a great business most certainly helps the investment process become great in itself.

"I am a better investor because I am a businessman, and a better businessman because I am an investor." Warren Buffett

While I enjoy studying great investors, I also enjoy learning about great business people and hearing how they've developed their companies. One of my favourite podcast series is 'How I Built This', hosted by Guy Raz. He's had some great guests on his show including Southwest Airline's Herb Kelleher, Airbnb's Joe Gebbia, Spanx's Sara Blakely, Whole Food's John Mackay, 1800-Got-Junk's Brian Scudmore, Kickstarter's Perry Chen and Buzzfeed's Jonah Peretti to name just a few. In listening to all of these great people, I've noticed lots of commonalities around their cultures, innovation, customer focus and management philosophy.

"When investing, we view ourselves as business analysts - not as market analysts, not as macroeconomic analysts, and not even as security analysts." Warren Buffett

A recent episode featured Howard Shultz, one of America's most successful entrepreneur's and the man behind Starbucks. The interview begins with Howard telling the story of growing up in a two-bedroom apartment with his parents and two siblings in a housing project in Brooklyn, where a real sense of community and diverse neighbours of like-minded values were prevalent. His dad, a blue collar worker, was injured on the job in the 1960's, and found himself without healthcare or workers compensation. This incident fractured Howard's belief in the American dream. However these experiences would play a key role in determining the culture that would ultimately define Starbucks.

Howard Shultz wasn't a great student.. but he was competitive..

"I was a not good student, I don't think I applied myself very well"

"I was an athlete because in the Projects where the entire day was spent in the school yard, a concrete school yard, playing any sport you could invent or organise. You would dive on concrete to win.  My competitiveness was born out of being that kid in the school yard"

In both business and investing, competitiveness and perseverance often trumps intelligenceMichael Steinhardt, one of the most successful investors of all time, noted “I don’t think those people who have very special records in the stock markets are necessarily brighter or have more cerebral abilities than the next person.  I think it’s a matter of competitive intensities". 

As we mentioned in many previous posts, success in business, as in investing, requires a sense of humility. Howard Schultz developed a sense of humility at an early age..

"I was very fortunate, I finished school I somehow convinced people at Xerox to hire me. I didn't have a business degree. I got a sales job at Xerox. This was 1976. At Xerox first they sent you to a sales training school and then for six months after that all you do is make 50 cold calls a day. Not on the phone, you have to make physical cold calls to an office. I think the rejection of cold calling, the humility that comes with the disappointment of someone not saying yes to you, I went through a steep learning curve and I started having a higher level of self esteem"

We can see this humble approach mirrored by many other successful people. William Thorndike's book, 'The Outsider CEOs', finds that the leaders of America's most successful companies all shared the characteristic of humility in common. Donald Keogh, the sixty year business veteran and two decade CEO of Coca-Cola, cited the assumption of infallibility as one of the 'The Ten Commandments for Business Failure'.

When Howard Schultz stepped into the first Starbucks store he was impressed..

"This is the kind of environment and product and young company I would like to be part of. Over the course of a year I kept banging the door to say to the founders,"If you expand the company I think I can help you"

Howard left Xerox and joined the tiny Starbucks company in 1982. Upon a trip to Italy to source coffee he realised that Starbucks should get into the business of selling coffee in cups, not just coffee beans by the pound ...

"What struck me [in Italy on my first tour of coffee stores] was the sense of community. I would go to the store at the same time every day and I would start seeing the same people. I realised when I was in Italy that Starbucks was in the coffee business, perhaps the wrong part of the business. There was no service of any cup of coffee at any Starbucks. It was just pounds of coffee for home use".

The Italian coffee houses weren't just selling coffee, they were selling an experience..

"A lot of people said it was a crazy idea to roll out coffee stores, but we believed early on that what we had seen in Italy was replicable in America, through an American lens, it was thinking let's create a store not only just a store for coffee but produces this sense of community between home and work. Early on we realised the brand we were going to build was going to be experiential

After parting with the original owners and buying the Starbucks business in 1987, Howard realised that to grow, he needed to invest and that losses were inevitable..

"We weren't profitable [in the first few years after I bought the company] but in order to grow the company and raise the money, we said kind of metaphorically, we want to build a one hundred story skyscraper, we're going to have to invest to build the foundation. We started investing heavily. Like any other start up - investing in people, processes, IT and infrastructure - the company lost money almost from the day I bought it. Investors understood early on, we were going to lose money in order to build a much bigger company"

This is no different to many businesses today, in spite of most market participants' demands for short term profitability. As Charlie Munger says “Almost all good businesses engage in ‘pain today, gain tomorrow activities".

Starbucks continues to invest for growth; In a recent podcast I listened to, Investment Master Thomas Russohighlighted why he likes businesses that show 'A willingness to suffer'. He touched on Starbucks' foray into China...

“Companies that can make the trade off [to invest in growth] are much more powerful in their position to secure permanent and enduring franchises. The companies that choose to not swing for the long term fence leave themselves exposed.  A company that faces this question of how to invest for the long term is Starbucks. I met the chairman of Starbucks recently and he was being grilled by a young analyst as to why he wasn’t showing profits in China. He expressed the trade-off so well when asked “when will you give us profits from China?" His answer was “How big do you want us to be?” And they asked again, back and forth. And finally the CEO said “It’s quite simple, We are profitable at the store level and we could easily be profitable at the country level. But we think China offers a vast opportunity and if we invest enough upfront, we will own the dominant brand in the category we create".

If you’re the first-mover, in a category that is created by your brand, you have the first-mover advantage for eternity. And if Starbucks were permitted to invest for that type of profitable future they would have to be permitted to show losses at the start as they build warehouses, manufacturing, distributions and advertise aggressively. All with the idea of building an enduring franchise and in doing so generating reported losses for quite a considerable amount of time. They are willing to do it and as a result they won’t end up as one of thirty coffee companies sharing a market, but they have the chance of becoming quite powerful.

That’s the mindset you look for as a long term investor – brand, capacity to invest behind the brand and then the willingness to suffer from the investment until scale is reached. Then you have the benefit of that strong brand, created over that build up period, affording you pricing flexibility and price elasticity relative to consumer incomes because of the strength of the brand.”

Starbucks did things differently, they still do ... 

"Even today Starbucks is not a traditional marketing company. It sounds really old fashioned but we built the company one customer of a time, one cup at a time"

And like Jeff Bezos more recent experience in building Amazon Web Services, Starbucks was lucky enough to have a long runway without competition..

"I think the large companies [like Nestle] never believed you could build a national company and brand around selling coffee in a cup. I think they were naive, maybe arrogant and they gave us a lot of runway."

In 1996, Howard convinced the board to expand internationally and open the first store in Japan. Consultants hired by the board recommended against investing in Japan, believing it would be a disaster .. it wasn't. 

“The board said we should probably hire an outside resource, a consultant – a word that really gives me hives. If we have to hire a consultant it means we don’t really know our business.” 

Interestingly, the Seventh 'Commandment of Business Failure' in Donald Keogh's book is 'Put all Your Faith in Experts and Outside Consultants'. It should come as no surprise that both Buffett and Munger are on the same page ..

'“We never hired a consultant in our lives; our idea of consulting was to go out and buy a box of candy and eat it.” Warren Buffett

“I have never seen a management consultant’s report in my long life that didn’t end with the following paragraph: “What this situation really needs is more management consulting.” Never once. I always turn to the last page. Of course Berkshire doesn’t hire them, so I only do this on sort of a voyeuristic basis.  Sometimes I’m at a non-profit where some idiot hires one." Charlie Munger

Howard stepped down as CEO in 2000 ...

"I felt like I was repeating myself, I no longer felt engaged in the fun, creative part of the business where I get the most joy. I was not having fun. I decided I needed a break. I did step away. I was Chairman and as Chairman I should of been paying more attention to the company."

Eight years later, in 2008, Schultz returned after Starbucks had lost its way and the share price hit a record low..

"Two things hurt the company, the country was heading into a cataclysmic financial crisis. I would describe those years as the years of hubris. Starbucks was growing at a pace at which growth and success began to cover up a lot of mistakes. Too many stores cannibalising other stores, financial controls and discipline not being leveraged. The big mistakes was Wall Street and the share price became an albatross on the company's neck.  Growth became the strategy and growth is not a strategy. Growth meant too many stores, growing in areas that should not have had a Starbucks and the experience, which had defined the essence of the company was being compromised by efficiency. The management team started measuring yield, sales per hour and doing things that were so dilutive to the essence of the foundation of the company. I began going into the stores and not recognising what we had built."

Warren Buffett expanded upon just such an issue in his 2005 letter to shareholders..

"If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible;  cumulatively, though, their consequences are enormous.

"When our long-term competitive position improves as a result of these almost unnoticeable
actions, we describe the phenomenon as “widening the moat.” And doing that is essential if we are to have the kind of business we want a decade or two from now. We always, of course, hope to earn more money in the short-term. But when short-term and long-term conflict, widening the moat must take precedence. If a management makes bad decisions in order to hit short-term earnings targets, and consequently gets behind the eight-ball in terms of costs, customer satisfaction or brand strength, no amount of subsequent brilliance will overcome the damage that has been inflicted."

Howard decided to return as CEO because he loved the business ...

"I came back for two reasons, what it means to love something and the responsibility that goes with it"

Like great investors, great business people love what they do. Donald Keogh, with more than sixty years' business experience observed "I have never met a successful person who did not express love for what he did and care about it passionately."

Howard closed 900 stores and retrained every employee on how to make quality coffee. Every store manager, ten thousand in total, were brought together in an auditorium and told they each needed to take every customer interaction personally and to act as if it was their own store. Failure to correct the situation would mean they were not going to be able to feed their families. Within a year, the downward spiral that almost engulfed Starbucks, was a memory.

Howard referred to his employees as partners and introduced free college tuition, health care, and stock options. Like him, many people in the company were not born with a silver spoon and he wanted to offer them a work environment not available to someone in his fathers' day. Soon customers began to realise workers had ownership and the intimacy built between baristas and customer began to build. Starbucks enjoyed much lower staff turnover than the rest of the industry. He had created a win-win culture.

So what did Howard learn from the mistakes?

"The question was what did we learn? We were so hungry and so driven when we started the company. But when we were that successful people got sloppy and lazy. This is so vitally important.. Success in any business, no matter what it is, is not an entitlement, it has to be earned. And we stopped earning it and that is why we got in trouble"

"Building a company is a lonely place sometimes, your imprinted, especially as a man, of not demonstrating vulnerability. I think one of the most undervalued characteristics of leadership is vulnerability and asking for help. I've done that a number of times. When you're vulnerable and ask for help people come towards you, I have tried to do that every step of the way and be honest and truthful about what I know and don't know and most importantly what I believe."

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As we learnt in the last post, turning a business around is rarely successful.  Nancy Koehn, a professor and historian at Harvard Business School, noted that Howard Schultz is “one of the few globally recognized CEOs who turned around a multibillion-dollar enterprise when growth stalled. The probability of a company coming back after it stalls like that is very low.”

Against the odds, Starbucks managed to turn around. Howard built a successful culture, focused on ensuring his staff and customers were relevant and that their experience was both positive and assured. He retrained his employees, gave them ownership and offered them rewards that few other companies have bothered with. He resuscitated the company after it had stalled.

And we can learn from this.

The Investment Masters are firstly good business people. An understanding of business and the businesses they invest in is paramount to success. And humility and a willingness to learn from the errors of the past are integral things that success demands. Howard Schultz learned this and Starbucks survived and thrived – one person, one cup and one neighborhood at a time.

Seeking Perfection

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Perfection is an aspiration. It is something to strive for, an ideal so high that its nigh on impossible to achieve. Perfectionists are those that seek flawless outcomes, sublime achievements and impeccable results. And the reality is that if you're seeking perfection in Investment, you'll never get there.

The stock market is a complex system where an almost infinite number of variables can influence stock prices in any multitude of ways. Information is often ambiguous, participants are often irrational and those variables are in a state of flux. The future is unknown. In this environment you can’t possibly expect to know all the information that will impact a company or it's share price.

Complex systems are full of interdependencies—hard to detect—and nonlinear responses. In such an environment, simple causal associations are misplaced; it is hard to see how things work by looking at single parts. Man-made complex systems tend to develop cascades and runaway chains of reactions that decrease, even eliminate, predictability and cause outsized events.” Nassim Nicholas Taleb

"The stock market, at least in the short run, responds to many factors besides profits and dividends. Inflation and interest rates, the supply of new stock underwritings, the money supply, investor confidence, government actions, and international events are all factors that interact with one another in subtle, changing and unpredictable ways. What we have, really, is a complex system with lags and multiple feedback loops. All such systems share certain characteristics that hinder predictive accuracy." Ralph Wanger

Even the company CEO cannot know everything going on in a company.  And even if she could, to profit from it, she would then need to be able to understand how that information will impact market participants. 

"First, no matter how much research is performed, some information always remains elusive: investors have to live with less than complete information.  Second, even if an investor could know all the facts about an investment, he or she would not necessarily profitSeth Klarman

I remember working with a highly intelligent junior analyst who was always seeking more information about the companies we were analysing. He had come from a corporate finance background where he was used to having an abundance of information to prepare corporate documents and forecasts - company budgets, management accounts, debt schedules, contracts, etc. When it came to the markets and stock ideas, and he was confronted with having much less available information, he became paralyzed by the absence of data and was unable to make recommendations on the basis of probabilities.

And this is a common trend. Yet, accepting that we cannot know everything is an essential psychological mindset for successful investment. One of my favourite books “The Art of Learning” by the US Chess Master, Josh Waitzkin, highlights the need to be able to operate without perfection..

“We must be prepared for imperfection. If we rely on having no nerves, on not being thrown off by a big miss, or on the exact replication of a certain mindset, then when the pressure is high enough, or when the pain is too piercing to ignore, our ideal state will shatter” Josh Waitzkin

The current breed of 'Rocket Scientists' created by the Financial Industry want to set standards for Investment that are impossibly high. They want to have a 'clean sheet', an investment record so perfect that the Masters of the Finance Game bow in homage to it. But they're focusing on 'doing things right', rather than 'knowing the right things'; even the Investment Masters understand that striving for perfection is a futile exercise..

Perfection doesn’t exist in this world. All of my choices involve various degrees of compromise and tradeoffsThomas Gayner

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

“You can’t be 100% certain but try to look for weaknesses in your thinking” Walter Schloss

"I’ve never been 100% certain and I’m never seeking to be stubborn. There are many possible outcomes, and there’s a large range of profitable outcomes" Bruce Berkowitz

“Investing is about predicting the future, and the future is inherently unpredictable. Therefore the only way you can do better is to assess all the facts and truly know what you know and know what you don’t know. That’s your probability edge.  Nothing is 100%, but if you always swing when you have an overwhelming better edge, then over time, you will do very well” Li Lu

“I am always searching 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 in 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

“Any time you’re investing, pretty much any style of investing, there is no such thing as a 100% sure bet. You can always have the asteroid come and take everything out – everything is probabilitiesMohnish Pabrai

“My conclusions are the result of my reasoning, applied with the benefit of my experience, but I never consider them 100% likely to be correct, or even 80%. I think they’re right, of course, but I always make my recommendations with trepidation” Howard Marks

Many investors and analysts rely on financial and mental models to understand and predict how a company operates and how it may perform in the future. But models are exactly that, models - they are not reality. Even the best models are imperfect.

“All models are wrong, some are useful” George Box

“Every scientific law, every scientific principle, every statement of the results of an observation is some kind of a summary which leaves out details, because nothing can be stated precisely”  Richard Feynman

"No model captures the richness of human nature. Models are supposed to simplify things, which is why even the best models are flawed” Philip Tetlock

"All models have an inherent limitation on their validity" Ralph Wanger

Models, including financial models, work only because they shed certain information in order to highlight or analyze other information. This is necessarily true. A great physicist once summed up the situation: "To build a perfect model of the universe would require all the matter and energy in the universe because the only perfect model, the only model that sheds no information and made no compromises in order to achieve its object, would be the universe itself." This is the virtue of models: They exclude information not directly relevant to the question under consideration, allowing us to focus on the significance of particular variables. This is also the vice of models: If the discarded information proves decisive to the issue being analyzed, the model will fail. If the model fails in a critical situation, and the people using the model cannot recover or even identify the critical lost information, they may not be able to react rationally to events; they may panic” Andy Redleaf

While models can’t possibly include all the variables that may impact a company, what's important is that they do consider the limited number of critical factors that are key to a company’s performance.

"In my early years, I ended up too much in the weeds. I had to know everything about a company and its industry. I’ve since learned that knowing less is okay as long as you have identified the one to three things that will drive the company. We believe exactness offers little so we prefer to establish a potential range of outcomes instead. We’d rather be directionally right rather than precisely wrong. " Steven Romick

"I believe that there's no need to know every detail, rather there's a need to understand the three, four or five factors affecting the company" Charles De Vaulx

"If you are an investment analyst or investment manager, to be successful and to do well, a couple of things have to happen. Number one, in most businesses, the results are driven by three or four factors that control let’s say 80 percent of the outcome and most entrepreneurs are honed in on those three or four factors. They understand those factors and they focus on those factors. If the factors you focus on do not match the factors that the guy running the business is focused on, you’ve not understood the business and there’s a problem over there." Mohnish Pabrai

“Every company has 100 things about them you could study and learn. But you have to understand the differences between data and knowledge, and between knowledge and wisdom. Warren Buffett is remarkable in his ability to cut right through. He sees very clearly the three or four or five critical factors that determine whether a company succeeds or fails. It’s not about encyclopedic knowledge, it’s about zeroing in on what truly matters and assessing that. There’s no substitute for that in this business." Howard Marks

Investment mistakes are usually caused by failures of analysis, not failures of collection. In lieu of time spent collecting all the available information, time is better spent on thinking and the reasoning processes.  Is the information collected practically useful? What psychological biases could be at play? Have competitors/customers/suppliers been consulted? Has the idea been tested? What assumptions are being relied upon? Can they be disproved? Can you imagine alternative scenarios? What could have been missed? What don't we know?  

"There are only a few things you have to get right about a company for it to be successful investment. Our view is that if you can get 85% of the way there by answering the big questions, don't waste your time on the last 15% because the marginal utility isn't worth it" Steve Morrow

“The value of in-depth fundamental analysis is subject to diminishing marginal returns” Seth Klarman

By focusing on the things that matter as opposed to seeking every last detail means you’re less prone to over-confidence and confirmation bias

Information tends to beget information, as users become addicts. “Perfect information”, the saying goes, “leads to perfect decisions.” But more and more information gathered in the name of the wrong context leads to worse and worse decisions”.  ‘Ceo’s and the CIA: Lessons Learned’  Inferential Focus 1998

“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” Dave Dreman

"When forecasters have too much information, they often become even more inaccurate than when there is too little" Bennett Goodspeed

"Once an experienced analyst has the minimum information necessary to make an informed judgement, obtaining additional information generally does not improve the accuracy of his or her forecasts. Additional information does, however, lead the analyst to become more confident in the judgement, to the point of over-confidence" Richards Heuer

Although the ability to collect all the information will always remain elusive, investors can still achieve solid returns even if mistakes are made. You don’t need a perfect batting average.

“I am a professional mistake maker. One third of my trades are probably wrong” Ray Dalio

“If you’re terrific in this business, you’re right six out of 10Peter Lynch

“If an investor is right 2 out of 3 times in the investment decisions they make, they would hit the ball so far out of the park, it would be amazing” Mohnish Pabrai

The important thing is not to dwell on mistakes. Learn from them and move on.

“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 mistakesGeorge Soros

“Since actual perfection and 100% satisfaction with a position are impossible, we must learn from results and not dwell on past outcomes, either good or bad. Moving forward, even from large errors, is required.” Paul Singer

“I may try to minimise my errors, but I'm not one to dwell on them.  It isn't worth it. You have to put mistakes behind you and not look back.  Tomorrow is another day.  Just go on to the next thing and strive to do your best." Warren Buffett

Remaining open-minded, accepting and learning from mistakes and adopting a sense of humility by acknowledging you can't know everything will improve investment results in an environment of impossible perfection. 

“The humility required for good judgment is not self-doubt—the sense that you are untalented, unintelligent, or unworthy. It is intellectual humility. It is a recognition that reality is profoundly complex, that seeing things clearly is a constant struggle, when it can be done at all, and that human judgment must therefore be riddled with mistakes.Philip Tetlock

"The more you learn, the more you will realize how little you know - and armed with this humility, you will never lose sight of the distance that separates self-confidence and self-importance" Jim Rogers

Even the Investment Masters make mistakes. It's human nature. And whilst perfectionism is also a fundamental human behaviour, striving for it in Investment is a mistake. We can learn from our mistakes, whereas if we are always seeking that perfect 'batting average', the chances of learning and adapting are minimal indeed. So before you buy your next stock, keep open the possibility you may be wrong ... 


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If, you, like me have been observing many of the great investors over time, no doubt you will have noticed that most prefer to invest in businesses that have been operating with long track records of success.  Consistent profitability, excellent brands and market share and products and processes that require little in the way of constant management intervention. These types of businesses are likely to be doing the same thing in ten years that they are doing now.  

While its inevitable that many businesses will hit bumps in the road along the way - product launches may not go quite as expected, management unexpectedly changes, competitors gain a short-term edge, etc. - most of the Investment Masters stay well away from those businesses that need to be 'turned around'. These are organisations that need significant management input and skillful execution to return them to profitability.

“Both our operating and investment experience cause us to conclude that 'turn-arounds' seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than a poor business at a bargain price”  Warren Buffett

“There’s more safety and optionality in businesses that don’t need to be rescuedVinson Walden

“We generally don’t invest in broken businesses that need to be straightened out .. It’s just not what we do” Chuck Akre

"We actually don’t do turnarounds. What attracts us to the whole concept of value investing is the idea of having a margin of safety, in terms of value over price. That margin of safety only exists if values are stable and it only improves if value increases.  With turnarounds, you’re making a bet – maybe a very intelligent one, but still a bet – that something broken can be fixed. Even in the best case, you may be looking at years when value declines or stagnates. Our experience is that we’re better off investing in a good business that is constantly compounding value from the beginning of our ownership, without what to us is the unacceptable risk that the turnaround doesn’t work. We just don’t think we need to take that kind of risk to earn strong returns” CT Fitzpatrick

Some management teams are well-known for their capabilities in rescuing businesses. Inevitably though, the return to successful operations is a painstaking and often frustratingly long exercise with no guarantee of success. Whilst they initially may look like a very attractive bargain at the beginning, the road to rescue can often cost a lot more than was anticipated.

“Managements of weak companies often announce plans to improve earnings and other fundamentals, but my experience is that turning around entire companies usually is a difficulty process that rarely meets with satisfactory success”  Ed Wachenheim

Turnarounds are exceedingly rare and bargain stocks often wind up costing a good deal”  Scott Fearon

Many Investment Masters cut their teeth on turn around companies. Very few can show the benefits from what they initially saw as a wise investment. Most have learnt their lesson.

“I was tempted in my youth by turnaround stories or betting on new product or service offers, where you could hit the ball out of the park if things got fixed or the new product took off. But I’ve had enough failures pursuing those types of ideas that I’ve for the most part lost the stomach for them. From a performance standpoint, I’m more focused on what something is than what it can be” Thomas Gayner

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

Businesses that require significant capital expenditure to get back to profitability require a leap of faith that is often too far. Unless the business has a strong competitive advantage, the benefits of additional capital ordinarily end up with the customers and not the shareholders.

"We react with great caution to suggestions that our poor businesses can be restored to satisfactory profitability by major capital expenditures.  The projections will be dazzling, and the advocates sincere, but, in the end, major additional investment in a terrible industry usually is about as rewarding as struggling in quicksand.” Warren Buffett

One area the Investment Masters are particularly cautious about is poor performing retailers that need turning around.  Even at the best of times retailing is a tough business .. consumer tastes can be fickle, competition is usually intense, barriers to entry are low, margins are thin and fixed costs are high. The industry has a history of significant disruption and is a wasteland of corporate bankruptcies.

"Retailing is a tough, tough business, partly because your competitors are always attempting and very frequently successfully attempting to copy anything you do that's working. And so the world keeps moving. It's hard to establish a permanent moat that your competitor can't cross. And you've seen the giants of retail, the Sears, the Montgomery Wards, the Woolworth's, the Grants, the Kresges. I mean, over the years, a lot of giants have been toppled." Warren Buffett

“Warren [Buffett] is super smart and highly disciplined, but he has made lots of mistakes in other industries. Berkshire has bought many loser retail operations over the years. Other than Nebraska Furniture Mart and Borsheim’s, most of the rest of them have not worked out so well.” Mohnish Pabrai

“I don’t do retail because you have to recreate the demand every day.” Jeffrey Ubben

Retail is a tougher place to make money than most people realise.” Guy Spier

"I think Warren and I can match anybody's failures in retail." Charlie Munger

Retailing is a difficult business.  It involves large investments for a thin margin.” Marathon Asset Management

Retailing is a tough business.  During my investment career, I have watched a large number of retailers enjoy terrific growth and superb returns on equity for a period, and then suddenly nosedive, often all the way into bankruptcy.  This shooting-star phenomenon is far more common in retailing than it is in manufacturing or service businesses.  In part, this is because a retailer must stay smart, day after day.  Your competitor is always copying and then topping whatever you do.  Shoppers are meanwhile beckoned in every conceivable way to try a stream of new merchants.  In retailing, to coast is to fail.” Warren Buffett

In retailing good management is essential  ...

“Buying a retailer without good management is like buying the Eiffel Tower without an elevator.” Warren Buffett

But sometimes even that isn't enough ..

"Every day retailers are constantly thinking about ways to get ahead of what they were doing the previous day. Retailing is like shooting at a moving target. In the past, people didn't like to go excessive distances from the street cars to buy things. People would flock to those retailers that were near by. In 1996 we bought the Hochschild Kohn department store in Baltimore. We learned quickly that it wasn't going to be a winner, long-term, in a very short period of time. We had an antiquated distribution system. We did everything else right. We put in escalators. We gave people more credit. We had a great guy running it, and we still couldn't win. So we sold it around 1970. That store isn't there anymore. It isn't good enough that there were smart people running it" Warren Buffett

And turning around a poor performing retailer rarely works...

“Turning around a retailer that has been slipping for a long time would be very difficult. Can you think of an example of a retailer that was successfully turned around? Broadcasting is easy; retailing is the other extreme." Warren Buffett

“In general I don’t like retailers, and I have a bias against turnaround of struggling retailers.  Those are very hard things to pull off”  Mohnish Pabrai

"How many retailers have really sunk, and then come back? Not many. I can't think of any. Don't bet against the best. Costco is working on a 10-11% gross margin that is better than the Wal-Mart's and Sams'. In comparison, department stores have 35% gross margins. It's tough to compete against the best deal for customers." Warren Buffett

It's easier, less risky and likely more profitable to find other things to do...

"We would rather look for easier things to do. The Buffett grocery stores started in Omaha in 1869 and lasted for 100 years. There were two competitors. In 1950, one competitor went out of business. In 1960 the other closed. We had the whole town to ourselves and still didn't make any money." Warren Buffett

Particularly with the arrival of Amazon...

"[Amazon is] one of the most powerful models that I've seen in a lifetime, and it's being run by a fellow that has had a very clear view of what he wants to do, and does it every day when he goes to work, and is not hampered by external factors like people telling him what he should earn quarterly or something of the sort. And ungodly smart, focused. He's really got a powerful business, and he's got satisfied customers. That's hugely important." Warren Buffett

In 2016, Buffett sold his position in Walmart .. he decided to look for an easier game.. 

".. Amazon in particular is an entity that’s gonna have everybody in their sights. And they’ve got delighted customers. And it’s extraordinary what they’ve accomplished. And a lot of people, the delivery, you know, and that is a tough, tough, tough, competitive force. Now, Walmart’s pushing forward online themselves and they’ve got all kinds of strengths. But I just decided that I’d look for a little easier game.”

Turn around business situations, particularly those in retail are hard going. Lots of capital, lots of hard work and almost constant management intervention are required. Is it really worth it, though? The Investment Masters have determined there are far easier fish to fry out there....


Uncertainty and Panic

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You've no doubt recognised that human psychology is a dominating factor when it comes to a company's share price and the market in general. Key to this, of course, is both our own and the collective participants' confidence in that market and our desire that stocks will always go up in price.

Unfortunately you don't have to scratch too deeply into history to see the effect on individual stocks, sectors and the market when that confidence is shaken. At those times, stock prices plummet and we are surrounded by uncertainty. And as naturally as you expect the sun to rise in the east each day, panic follows closely on its heels.

People prefer certainty. Certainty comes when Mr Market is playing ball, the market indices are invariably gaining in value, and our share portfolios are producing great returns. The longer this happens, the greater our certainty will be that it will continue. People feel comfortable, assured, confident in their beliefs that things are going according to plan. It is in these times that people also often delude themselves into thinking they are great investors. "Look at my returns! They speak for themselves!"

Reality often bites hard, however, when Mr Market decides, for whatever reason to stop playing ball. In these situations, those same people have their confidence shaken; uncertainty reigns and many will find it hard to see a way out of the mess. It is quite often that in their desperation they will look to others to see what they are doing, and end up invariably following the crowd. Unfortunately, most of that same group of people are panicking themselves. It only takes one stone to start an avalanche, and the sad fact of the matter is that the crowd doesn't necessarily know any better. 

“In general, when we are unsure of ourselves, when the situation is unclear or ambiguous, when uncertainty reigns, we are most likely to look to and accept the actions of others as correct” Robert Cialdini

“Psychologists have demonstrated that the vaguer and more complex a situation, the more we rely on other people, both for clarification and as touchstones for our own views.  This helps us reduce our uncertainty toward our own beliefs”  David Dreman

“When people are free to do as they please they usually imitate each other.  We are social animals, influenced by what we see other people doing and believing.  We believe others know more than we do. .. We avoid what others avoid.  We imitate without thinking. Especially when many or similar people do it, when we are uncertain, in an unfamiliar environment, in a crowd, lack knowledge, or if we suffer from stress or low self-esteem” Peter Bevelin

"Man is extremely uncomfortable with uncertainty. To deal with his discomfort, man tends to create a false sense of security by substituting certainty for uncertainty. It becomes the herd instinct" Bennett Goodspeed

It is in our very nature to follow others and we often do it unconsciously. Have you ever walked past someone, or even a group of people on the street, who are all looking up at something and stopped to look for yourself? Sometimes we don't even stop to think before we imitate others.

“First, we seem to assume that if a lot of people are doing the same thing, they must know something we don’t.  Especially when we are uncertain, we are willing to place an enormous amount of trust in the collective knowledge of the crowd.  Second, quite frequently the crowd is mistaken because they are not acting on the basis of any superior information but are reacting, themselves, to the principle of social proof” Robert Cialdini

It is also human nature to place more weight on stories and anecdotes than statistical data. People's inferences and behaviour are much more influenced by vivid, concrete information, than by pallid and abstract propositions of substantially greater probative and evidential value.

In the book 'Human Inference: Strategies and Shortcomings of Social Judgement', Richard Nesbitt and Lee Ross define vivid information as information that is likely to attract and hold our attention to the extent it is (a) emotionally interesting, (b) concrete and image-provoking, and (c) proximate in a sensory, temporal or spatial way - characteristics that should be familiar to every investor! 

The authors note the emotional interest of an event is influenced by the degree to which it affects the participants' needs, desires, motives and values. They conclude that "the most disconcerting implications of the principle that information is weighed in proportion to its vividness is that certain types of highly probative information will have little effect on inferences merely because they are pallid.  Aggregated, statistical, data-summary information is often particularly probative, but it is also likely to lack concreteness and emotional interest." 

Is it any wonder people panic when they read headlines predicting a market crash, they see and hear of other people losing money and selling or they read of a company's recent problems - all without considering the probability that the information has value or the company's problems will be resolved.

“In a crisis, carefully analyse the reasons put forward to support lower stock prices – more often than not they will disintegrate under scrutiny” David Dreman

When people panic, the shares price often becomes the 'news'. Other investors assume those selling know more than they do and decide to sell. A self-reinforcing cycle begins where selling begets more selling. 

More often than not however, when everyone is aware of a risk, it is already reflected in the market or stock price. 

"As a general observation, markets tend to over-discount the uncertainty related to identified risks. Conversely, markets tend to under-discount risks that have not yet been expressly identified" Jamie Mai

Having a solid understanding of what you own is a strong countervailing force against the crowd. In a market correction, investors who have no clue as to why they own stocks [outside of 'because they have/and will continue to go up'] or what the intrinsic value of the stocks they own are, use price as their guide in decision making.  They have no anchor upon which to assess the correct price for a stock. These investors sell in a non-discriminatory manner with no reference to value.

With the increasing popularity of ETF's and Index Funds it's likely even more investors in the future will be basing their decisions on the movement of 'market prices' as opposed to company fundamentals. If you've bought a biotech ETF for example, and have no idea of its composition or the underlying value of the constituent portfolio, how can you possibly know what the right price is to buy, hold or sell? It's no wonder, the CDO market went 'no bid' at the height of the Global Financial Crisis -  investors had no idea about the worth of the underlying assets sitting in the CDO's, let alone the CDO's squared or cubed!

“One way to think about panic is a general, nonspecific response to a poorly understood particular and specific problem.  As in the fight or flight reflex, sometimes this response is helpful, and sometimes it isn’t.”  Andy Redleaf

“In a situation characterised by uncertainty, said Keynes, our knowledge is based on a 'flimsy foundation' and is 'subject to sudden and violent changes'”  Frank Martin

Panic is provoked by information failure..  Ignorance is the father of panicIgnorance makes for credulous and overconfident buyers on the way up.  But it really takes over on the way down when investors suddenly realize they have not a clue what they ownAndy Redleaf

We all know that the worst times to make decisions are when we are stressed or emotional. Panic and uncertainty are both emotions that will inhibit our ability to rationalise a problem. Those people who say they make great decisions when stressed or otherwise emotional are lacking in fundamental self-awareness. Because people tend to follow others in times of panic, the crowd makes dumb decisions. So they all make dumb decisions. When there is panic and uncertainty in the market, ordinarily it is the time to BUY stocks, not sell them. 

“The best bargains arise when there is fear and uncertaintyDavid Marcus

Uncertainty is actually the friend of the buyer of long-term values”  Warren Buffett

“Maximum panic usually coincides with minimum prices” Howard Marks

“To sell in a panic is not a winning strategy"  Francois Rochon

"If you are susceptible to selling everything in a panic, you ought to avoid stocks and stock mutual funds altogether" Peter Lynch

It's important in these situations to remain rational, and to always remember that the crowd is often doing the wrong thing.

“Losing your perspective in the midst of a market panic is equivalent to losing your money in that market” Jim Rogers

“Another valuable investment secret is that the owners of sound securities should never panic and unload their holdings when prices skid. Countless individuals have panicked during slumps, selling out when their stocks fell a few points, only to find that before long the prices were once more rising” J Paul Getty

If you've been part of the panic and sold out of your positions because of it, by the time the uncertainty has been resolved you will have largely missed the opportunity.

“High uncertainty is frequently accompanied by low prices. By the time the uncertainty is resolved, prices are likely to have risen. Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty. The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.” Seth Klarman

“The uncertainty is what creates the opportunity. It’s the fact that nobody knows whats going on.  So our view is things will be fine, it’s going to get a little bit worse but you want to take advantage of that when there is great uncertainty.  Everyone whose nervous wants out so you can take advantage of that fact.” Marc Lasry

"If you wait for problems to disappear before investing in stocks, you'll never commit - or earn - penny" Ralph Wanger

“Political and financial crises lead investors to sell stocks.  This is precisely the wrong reaction.  Buy during a panic, don’t sell”  David Dreman

Markets have a tendency to correct themselves after a panicked situation. At the bottom, 'the bears have no shares'.

“A panic may bring a temporary collapse in the market price of an investment, but the stock is bound to recover if the company meets a genuine need and is under good management”  Bernard Baruch

“Declining stock prices can ultimately cause people to panic and sell.  But the moment they join the panic and sell stock, they also relieve the cause of their fears and become potential buyers.  The act of selling removes the anxiety, restores equanimity, and gives them the cash to buy”  Leon Levy

"Even though bad things happen to companies, industries, even the economy as a whole for a time, somehow society as a whole still moves forward. Problems usually get solved. Recessions end. Somehow the country stumbles on and companies continue to make a profit" Ralph Wanger

Understanding the psychology of crowds can provide an edge by giving you the confidence to step apart from the crowd.

"With a little help from an obscure Frenchman [Gustav Le Bon], years ago I concluded that investment success is more likely to come to those who have some clue about the counter-intuitive way that the thought processes and subsequent behaviors of crowds differ from individuals in isolation.  Individuals who submit to the will of a crowd are effectively hypnotized, and behaviours become emotional, impulsive, and difficult to terminate." Frank Martin

“It is always easiest to run with the herd; at times, it can take a deep reservoir of courage and conviction to stand apart from it.  Yet distancing yourself from the crowd is an essential component of long-term investment success” Seth Klarman

If you have done the work to understand you're own and crowd psychology, understand the companies that you own and their underlying values, you should embrace uncertainty. It is at these times that opportunities present themselves for the long-term investor.

"I came across a quote from Warren Buffett...and he says: 'We pay a high price for certainty.' In other words, when people are confident, asset prices escalate. That's a bad time to invest. The confident times feel like a good time to invest, but people who want to buy bargains should prefer uncertainty." Howard Marks

"You know the prose : "Maintain buying reserves until current uncertainties are resolved," etc.  Before reaching for that crutch, face up to two unpleasant facts: The future is never clear; you pay a very high price for a cheery consensus.  Uncertainty actually is the friend of the buyer of long-term values"  Warren Buffett

“It turns out that I've made some of my best purchases during crises” Francois Rochon

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

A friend of mine has a saying. "When you're at work, leave your religion, politics and emotions at home. If you're a lawyer, then leave your conscience." Uncertainty, more than anything, creates panic. And following the crowd in a panic is an emotional response. If you know your market and the value of your stocks, then you need not panic and jump on the herd's bandwagon. Opportunity lies within these situations and letting uncertainty and emotions run their course will ensure you miss it every time.








When to Sell a Great Company?

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Let's face it, it's hard to find great companies. It's the veritable needle in a haystack conundrum; there are hundreds of thousands of businesses out there but only very few can be called 'great.' 

Great companies are those that will be worth a lot more many years from now; those with solid balance sheets and cashflow, great management, high returns on capital, pricing power,  excellent cultures, and with strong competitive advantages that keep competition at bay with minimal risk of disruption or obsolescence.

I'm sure you've noticed that most of the Investment Masters have a preference for buying high quality businesses. These businesses are typically capital light organisations which can reinvest their cashflows at high rates of return. They are often referred to as 'compounding machines'.

Like many investors, Buffett started out looking for cheap stocks. Over time, with the insights from his See's Candies acquisition and of course a little help from Charlie Munger, he realised the best returns were to be found in owning the great businesses

The questions at hand are should you sell a great business? And, if so, when?

The answer for a long-term investor may actually be never ...  

Selling great companies with large growth potential, even at seemingly rich valuations, is usually a mistake.” Allan Mecham

"Our favourite holding period is forever" Warren Buffett

“If the job has been correctly done when a common stock is purchased, the time to sell it is almost never" Phil Fisher

“The question about selling a really great business is never.  Because to sell off something that is a really wonderful business because the price looks a little high or something like that is almost always a mistake. It took me a lot of time to learn that. I haven’t fully learned it yet.  It’s rare it makes sense.  If you believe the long term economics of the business are terrific, it’s rarely makes any sense to sell it”  Warren Buffett

“Some of our biggest mistakes have been in selling down positions in great businesses when we thought they were fairly valued, or even a bit overvalued.  In our experience, compounders tend to keep compounding, so we’re slow to sell unless something in the business or company has fundamentally changed or if the valuation has just become extreme" Peter Keefe

“The reason I wanted to include my adventures with Ferrari in this letter was to try to reinforce in my brain the importance of just sitting on your ass when you own great businesses run by great managers. It is not a good idea to sell them unless they are egregiously overvalued.” Mohnish Pabrai

"We continue to think that it is usually foolish to part with an interest in a business that is both understandable and durably wonderful.  Business interests of that kind are simply too hard to replaceWarren Buffett

"If I’ve made one mistake in the course of managing investments it was selling really good companies too soon. Because generally, if you’ve made good investments, they will last for a long time." Lou Simpson

Even when great companies trade at an expensive multiple, it doesn't necessarily mean they won't deliver attractive returns.

"If a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result." Charlie Munger

Many an investor has made the mistake of selling a great business at a high price in anticipation of buying it back cheaper. Getting the timing right is problematic and great companies are hard to find. 

"If we believe the business model is going to continue to compound our capital at high rates, and we recognise that number will go up and down for normal business experiences, we want to hang on to the business, because the really great ones are, A, too hard to find, and B, too hard to replace. Every now and again we fool around with taking a little bit of something off of the table because we think it’s gotten too rich. My sort of life experience is that if I sell a stock at $30 because it’s too rich, and I set in my mind that I’m going to buy it back at $23, inevitably, it trades to $23 and an eighth, or $23 and one, or whatever it is. Oh yeah, whereas if it trades at $22.98, you know it trades 300 shares there, or something like that, and I never get it back. And then the next time I look, instead of being $30, it’s $300. And I messed it up." Chuck Akre

It can be psychologically difficult to buy back in at a higher price if you're wrong. Even Buffett acknowledges this bias impacts him.. 

“It’s a little hard when you looked at something at X and it sells at 10X to buy it. It shouldn’t be, but I can just tell you psychologically it’s harder - if you looked at it in the first place and passed at X to buy at 10X.  It’s cost people a lot of money. It cost people in Berkshire. People saw it at a lower price and they say 'if it gets back there I’ll buy it,' but that’s a terrible way to think.” Warren Buffett

To highlight this point, in his 1995 annual letter, Buffett referenced his experience with Disney shares...

"One more bit of history: I first became interested in Disney in 1966, when its market valuation was less than $90 million, even though the company had earned around $21 million pre-tax in 1965 and was sitting with more cash than debt. At Disneyland, the $17 million Pirates of the Caribbean ride would soon open. Imagine my excitement - a company selling at only five times rides!" 

Impressed with his findings, the Buffett Partnership bought a large amount of Disney stock at a split adjusted price of 31 cents per share. If you look back on this, you may think this was an outstanding move, given that the stock now sells for more than $90 per share. In his 1995 letter however, Buffett acknowledged he 'nullified' the brilliant buying decision in 1967 when he sold out for 48 cents per share!

Sometimes it might feel like the right thing to do is to sell on bad news. Provided the investment thesis remains intact and the longer term business outlook hasn't changed, it's probably best to hold on. 

“Selling fine businesses on “scary” news is usually a bad decision” Warren Buffett

That's not to suggest the share prices of great businesses will be immune to a stock market correction. They more than likely will.  Unfortunately, Mr Market won't necessarily distinguish between the good and bad businesses - even the great businesses can expect to have their prices knocked down.

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

“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

“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

“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

Don't let a market correction scare you out of holding a great business for the long term. Remember, 'quoted' prices can and often do reflect the emotions of the crowd, not the true underlying value of the business.  

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

Many of the Investment Masters adopt the mindset of a business owner as opposed to a share market trader to help filter out the noise of stock market fluctuations.

"In our view, what makes sense in business also makes sense in stocks: An investor should ordinarily hold onto a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business" Warren Buffett

In light of the above, you have to make sure you can survive the short term fluctuations to achieve high long-term returns. This requires patience, a solid understanding of the underlying business to give you the conviction to hold, the recognition that values and prices can get out of kilter, and an absence of leverage.  As Charlie Munger advises, if you're not willing to experience a 50% decline in a stock you probably shouldn't be in the stock market.

"This is the third time that Warren and I have seen our holdings in Berkshire Hathaway go down, top tick to bottom tick, by 50%. I think it's in the nature of long term shareholding of the normal vicissitudes, in worldly outcomes, and in markets that the long-term holder has his quoted value of his stocks go down by say 50%. In fact, you can argue that if you're not willing to react with equanimity to a market price decline of 50% two or three times a century you're not fit to be a common shareholder, and you deserve the mediocre result you're going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations." Charlie Munger 2009

You'll note Charlie Munger said that Berkshire shares had dropped in value by 50% for the third time. Had an investor sold out of Berkshire Hathaway during any one of those declines they would have done themselves a major disservice. 

The share prices of great businesses also tend to recover from downturns faster as they often emerge in a stronger position - weaker competitors either fail or lose market share through measures taken to survive the downturn.

"From 1932 to nearly the present, the studies confirm that when bad things happen to good companies, they recover - and usually quite nicely in a reasonable amount of time" Chris Browne

"At the end of the day, in order to build wealth, there is a simple approach which we have followed for 17 years at Giverny Capital: investing for the long term in high-quality companies purchased at attractive valuations—investing in companies that will survive the crises of our civilization and the short-term irrationally of our economic system." Francois Rochon

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

"We think a rigorous discipline of buying quality companies, when priced right and run by honest, intelligent management teams, offers the best defence against challenging macro conditions" Allan Mecham

Clearly the Investment Masters understand the value of holding ownership in great businesses for the long term. Selling at the wrong time can mean forgoing the gains from share prices that recover to levels that dwarf their prior peaks. Those that continue to provide great returns and weather the unpredictable periodic storms that Mr Market tends to throw at us are worth holding, and the idea of selling ownership in a 'great' company is usually a mistake. 

Conservative Forecasts - Masters Thoughts

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Forecasting, or more importantly, accurate Forecasting is an art which has long been considered akin to crystal ball gazing. Many think they can do it well, but when you really get down to it you'll often find that those self professed 'seers' are no better at it than anyone else.

Our opinions on the worth of certain investments are also affected by the intellectual biases we have been talking about in recent blogs. Basically, if you want an investment that you really like to perform, then naturally, your belief is that it will. And if you are attempting to forecast that business' future results, invariably it will have significant upside potential.

In realistic terms, the value of an investment is determined by the future cash flows a business will generate, not what it has earned in the past.  Given no-one knows what's going to happen in the future, determining a company's worth requires making an estimate of what those future cashflows may be. This of course, is where it gets hard.

Given the number one rule of investing is not losing money, the Investment Masters manage this difficulty by focusing on buying stocks with a 'margin of safety'.  Should future events unfold in a manner you weren't expecting, a margin of safety will help minimise the downside.

"Investing is inherently about predicting the future. But predictions can never reach 100% accuracy; they can only fall between zero and something approaching 100%. So when we make a judgement, we need a large buffer. This is called margin of safety.  Because there is no way to ever be sure, you must always remember the margin of safety no matter how many other things you grasp" Li Li

“The best investments have a considerable margin of safety. This is Benjamin Graham’s concept of buying at a sufficient discount that even bad luck or the vissitudes of the business cycle won’t derail an investment. As when you build a bridge that can hold 30-ton trucks but only drive ten-ton trucks across it, you would never want your investment fortunes to be dependent on everything going perfectly, every assumption proving accurate, every break going your way.” Seth Klarman

To build this margin of safety, you'll find the Investment Masters take a conservative approach to forecasting future earnings. Simply assuming a company can grow earnings at high rates into the future, and then relying on a valuation based on those optimistic forecasts, exposes the investor to undue capital risk should those optimistic forecasts not be met.

“How do value investors deal with analytical necessity to predict the unpredictable?  The only answer is conservatism.  Since all projections are subject to error, optimistic ones tend to place investors on a precarious limb.  Virtually everything must go right, or losses may be sustained.  Conservative forecasts can be more easily met or even exceeded.  Investors are well advised to make only conservative projections and then invest only at a substantial discount from valuations derived there from.” Seth Klarman

“Typically, when I’m making investments, I’m not making them with assumptions in terms of futures, which are anything more than conservative. I am not banking on massive amounts of demand or any growth rates. I want to make them in a manner where, in virtually any circumstance that I can think of, the odds are heavily in our favour.” Mohnish Pabrai

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

“Over the years, we have always positioned ourselves so that if we err, it will generally be on the side of excessive conservatism”  Frank Martin

“When weighing whether or not to purchase a security, we usually make assumptions that hopefully will prove conservative”  Ed Wachenheim

“Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount.  We try, therefore, to keep our estimates conservative.” Warren Buffett

“We strive to be conservative and realistic in assessing opportunities, paying close attention to our own limitations” Allan Mecham

“We only want to buy when we can pay less than 60% of a conservative appraisal of a company’s value .…. trying to create a big margin of safetyMason Hawkins

It's important to recognise that very few companies are actually able to grow at very high rates over the long term.  Not only that, it's also very difficult to estimate which companies will be the fast growers ahead of time. While analysts and investors sometimes have a tendency to project double-digit growth for years into the future, in reality this rarely eventuates. Companies become too large and succumb to the 'law of large numbers': competition is attracted by the high growth rates, or they get disrupted by new technology. The Investment Masters recognise few companies can grow at double-digit rates over the medium to long term.

"In a finite world, high growth rates must self-destruct.  If the base from which the growth is taking place is tiny, this law may not operate for a time.  But when the base balloons, the party ends; a high growth rate eventually forges its own anchor." Warren Buffett

"As well as being difficult to manage and also attracting competition, high rates of growth are, in any case, unsustainable.  Eventually, even the most successful business models must face the law of large numbers - all markets are of finite size (even Coca-Cola's despite it's mid-90's slogan: "The closer we get to infinity, the better it looks!").   Empirically, very few companies can sustain anything like double-digit growth for a decade or more." Marathon Asset Management

"Once a fast grower gets too big, it faces the same dilemma as Gulliver and Lilliput.  There's simply no place for it to stretch out." Peter Lynch

"Since analysts consistently overestimate growth rates, disasters happen all the time.  A 20% growth rate is a nice round number, easy for an analyst to pencil in, and that gets people excited.  It should, because 20% growth over time would be spectacular.  And at some point impossible to sustain." Ralph Wanger

“It’s unrealistic to expect companies to grow at 15% for extended periods. Most great companies can’t do it.” Chris Davis

“The notion that any business can grow at 20% per year forever is a fallacy. It doesn’t happen. In fact, if you go back in time. Let’s say I go back 50 years and I look at the best businesses of the era 50 years back, the bluest of blue chips which were the Amex of the time. Most of them are not around today. They don’t even exist. They have gone bankrupt or they have been acquired or gone.  You cannot get long, long runs on most of these businesses” Mohnish Pabrai

"Examine the record of, say, the 200 highest earnings companies from 1970 or 1980 and tabulate how many have increased per-share earnings by 15% annually since those dates.  You will find only a handful have.  I would wager you a very significant sum that fewer than 10 of the 200 most profitable companies in 2000 will attain 15% annual growth in earnings per-share over the next 20 years" Warren Buffett

"Over time, the growth rate of almost all technologies, products, and services slow because of saturation, obsolescence, or competition.  Many investors tend to project high growth rates far into the future without fully considering forces that eventually will lead to slower growth" Ed Wachenheim

Over time companies change and naturally, so industries also change. It's important therefore that when considering the future, we must ask ourselves what the economic and competitive landscape may look like.

"Everything is in a constant state of change, and the wise investor recognises that success is a process of continually seeking answers to new questions" Sir John Templeton

Simply predicting the future by looking into the past is one of the most dangerous pitfalls of investing. Even though this fact is largely known, many people still practice this approach. Because forecasting the future is so inaccurate, they feel the only safe way to predict what will happen is to look at past results. Successful investing requires that you think about the factors that will impact upon a business in the future. 

"The investor of today does not profit from yesterday's growth." Warren Buffett

“Typically, analysts evaluating the future prospects of a company look at its past. Where else can you look after all? And yet, even if they had a perfect snapshot of the past, they would be mistaken to assume that the conditions that held in the past will hold in the present or future” Leon Levy

"Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do"  Howard Marks

Over time I've witnessed many analysts change their earnings forecasts and tweak their price targets for companies by minuscule amounts. Yet, in the case of most companies, its almost impossible to predict future earnings with any level of precision. Rather than spending the time labouring over precise forecasts, time is better spent thinking about, and understanding the key quantitative and qualitative factors that are likely to impact on the business in the future.

“It is better to be approximately right, than precisely wrong” Warren Buffett

"The cost of obsessing on precision is to often miss the forest for the trees" Frank Martin

"Avoid over-relying on numbers and models. Investors often feel comfortable with numbers and models because they appear definitive. However, they can be misleading because they often are based on historical data that may not be repeatable or are based on assumptions that may not prove valid.  We need numbers and models, but their utility should be paired with judgment and common sense" Ed Wachenheim

Talking to customers, suppliers and competitors is likely to be more fruitful than burying yourself in a 5,000 line spreadsheet model.

"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

One method I find useful in analysing a company is inverting the analytical process. Rather than forecasting how fast a company's earnings will grow, look to estimate the growth rates that are implied by the current share price. This can be done by building a basic discounted cash flow model of the company's earnings.  If you use the current EPS and a growth rate of 'n' for future years, you can calculate future annual EPS estimates and a terminal EPS estimate for the year beyond the forecast period [say 3-6 years]. You can then apply an appropriate PE ratio to the terminal EPS to calculate a notional terminal value. You can then discount the annual EPS estimates and the future terminal value back to the present value by using an appropriate discount rate.  If you solve for 'n' such that the present value of the cash flows is equal to the share price you get an indication of the growth rate implied in the stock price.  This can then be considered in terms of reasonableness.  

“Reverse engineering the expectations embedded in a stock price is usually more fruitful than trying to foretell the future.”  Marathon Asset Management

“If you are wedded to the use of discounted cash flow valuations, then you may well benefit from turning the process in its head.  Rather than trying to forecast the future, why not take the current market price and back out what it implies for future growth”  James Montier

Successful investment decisions are made through a combination of using conservative forecasts, thinking about the future and understanding that high-growth rates tend to be unsustainable in the medium to longer term. So how do your forecasts look? 


Creativity - Learning from Pixar

I recently read Creativity Inc, a book by Ed Catmull, who is co-founder of Pixar. Ed is a deep thinker, who after a two decade goal produced the first computer-animated feature film 'Toy Story'. Upon achieving this goal, and after recognising the missteps of other successful companies run by smart people, Ed devoted himself to the challenge of building a successful company with a sustainable creative culture that could outlast its founders. 

Most of the books I read have been recommended by the Investment Masters, and Creativity Inc is no different. I can't recall which Investor recommended it, but I have seen it on quite a few recommended reading lists over time. I thoroughly enjoyed the book and it's no surprise it's highly recommended, the parallels in thinking between Ed Catmull and the Investment Masters are striking. Successful investing after all, requires creativity.

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

 “It’s imperative to be creative because a stock currently is selling at a price that the average investor thinks is the right price, so you have to come to a decision that that price is wrong and that the stock deserves to sell at a higher price for some reason. That reasoning is creative thinking because other people aren’t thinking that way because if other people were thinking that way, the stock would be at a higher price. Every idea is a creative idea.”  Ed Wachenheim

Creativity Inc, provides insights into how to enhance creativity and develop a creative culture. In many ways, Ed Catmull reminds me of Ray Dalio of the world's largest and arguably most profitable hedge fund, Bridgwater Associates. Both Ed and Ray have developed cultures that require high levels of transparency, seeking multiple viewpoints and consistently testing ideas. You'll notice many of the quotes below could have as easily been spoken by Ray Dalio as Ed Catmull.  It's probably no surprise that both Ed and Ray cite Einstein as one of their idols.  

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

"Albert Einstein [was a boyhood hero]. I read every Einstein biography I could get my hands on as well as a little book he wrote on his theory of relativitiy. I loved how the concepts he developed forced people to change their approach to physics and matter, to view the universe from a different perspective. Wild-haired and iconic, Einstein dared to bend the implications of what we thought we knew. He solved the biggest puzzles of all, and in doing so, changed our understanding of reality" Ed Catmull

I've included some of the my favourite quotes below. Many of the sub-headings are topics from the Investment Masters Class tutorials [click on sub-headings to read tutorials].


"The leaders of my department understood that to create a fertile laboratory, they had to assemble different kinds of thinkers and then encourage their autonomy"

"My world view, forged in academia, that any hard problem should have many good minds simultaneously trying to solve it"

"I've made a policy of trying to hire people who are smarter than I am"

"When it comes to creative inspiration, job titles and hierarchy are meaningless"

"The responsibility for finding and fixing problems should be assigned to every employee, from the most senior to the lowliest person on the production line"

"What is more valuable, good ideas or good people? .. Ideas come from people .. To reiterate, it is the focus on people - their work habits, their talents, their lives - that is absolutely central to any creative venture"

"Find develop, and support good people, and they in turn will find, develop, and own good ideas"


"I've never stopped questioning"

"To foster a creative culture continually ask questions. Questions like : If we had done some things right to achieve success, how could we ensure that we understood what those were? Could we replicate them on our next project? Perhaps as important, was replication of success even the right thing to do?"


"What makes Pixar special is that we acknowledge we will always have problems, many of them hidden from our view, that we work hard to uncover these problems, even if it means making ourselves uncomfortable"

"Mistakes are part of creativity"

"Mistakes aren't a necessary evil. They aren't evil at all. They are an inevitable consequence of doing something new (and, as such, should be seen as valuable; without them, we'd have no originality)"

"Failure is a manifestation of learning and exploration. If you aren't experiencing failure, then you are making a far worse mistake: You are being driven by a desire to avoid it"

"In a fear-based culture, people will consciously or unconsciously avoid risk. They will seek instead to repeat something safe that's good enough in the past. Their work will be derivative, not innovative. But if you can foster a positive understanding of failure, the opposite will happen"

"Iterative trial and error - has long-recognized value in science. When scientists have a question, they construct hypothesis, test them, analyze them, and draw conclusions - and they they do it all over again. The reason behind this is simple. Experiments are fact-finding missions that, over time, inch scientists towards greater understanding. That means any outcome is a good outcome, because it yields new information"

"There are two parts to any failure: there is the event itself, with all its attendant disappointment, confusion and shame, and then there is our reaction to it. It is the second part we can control"

"Failure gives us chances to grow, and we ignore those chances at our own peril"

"We get worried if a film is not a problem child right away. It makes us nervous" 

"Discussing failure and all its ripple effects is not merely an academic exercise. We face it because by seeking better understanding, we remove barriers to full creative engagement"

"Companies, like individuals, do not become exceptional by believing they are exceptional but by understanding the ways in which they aren't exceptional. Post-mortems are one route into that understanding"

"The key to solving problems is finding ways to see what's working and what isn't, which sounds a lot simpler than it is"


"The most compelling mechanisms [we follow] are those that deal with uncertainty, instability, lack of candor and the things we cannot see. I believe the best managers acknowledge and make room for what they do not know - not just because humility is a virtue but because until one adopts that mindset, the most striking breakthroughs cannot occur"


"The more time you spend mapping out an approach, the more likely you are to get attached to it. The nonworking idea gets worn into your brain, like a rut in the mud. It can be difficult to get free of it and head in a different direction"

"There is nothing quite as effective, when it comes to shutting down alternative viewpoints, as being convinced you are right"


"Our job is to protect our [new ideas] from being judged too quickly. Our job is to protect the new.”

"At too many companies, the schedule (that is the need for product) drives the output, not the strength of the ideas at the front end"


"If someone disagrees with you, there is a reason. Our first job is to understand the reasoning behind their conclusions"

"The Braintrust [primary delivery system for straight talk] is one of the most important traditions at Pixar - It's premise is simple: Put passionate people in a room together, charge them with identifying and solving problems, and encourage them to be candid with one another"

"Most crucially, they [the Braintrust] never allowed themselves to be thwarted by the kinds of structural or perceived issues that can render meaningful communication in a group setting impossible"

"We are true believers in the power of bracing, candid feedback and the iterative process - reworking, reworking, and reworking again, until a flawed story finds its throughline or a hollow character finds its soul"

"We believe that ideas - and thus films - only become great when they are challenged and tested"

"The film itself - not the filmmaker - is under the microscope. This principle eludes most people, but it is critical: You are not your idea, and if you identify too closely with your ideas, you will take offence when they are challenged"

"People need to be wrong as fast as they can. In a battle, if you're faced with two hills, and you're unsure which one to attack. The right course of action is to hurry up and choose. If you find out it's the wrong hill, turn around and attack the other one"

"The key is to look at the viewpoints being offered, in any successful feedback group, as additive, not competitive"

"Seek out people who are willing to level with you, and when you find them, hold them close".

"There's a difference between criticism and constructive criticism. With the latter, you're constructing at the same time that your criticizing. You're building as you're breaking down, making new pieces to work with out of the stuff you've just ripped apart. That is an art form in itself"


"Telling the truth is difficult, but inside a creative company, it is the only way to ensure excellence"

"A fundamental Pixar belief: Unhindered communication was key, no matter what your position"

"Societal conditioning discourages telling the truth to those perceived to be in higher positions"

".. replace the word honesty with another word that has a similar meaning but fewer moral connotations - candor. No one thinks that being less than candid makes you a bad person (while no-one wants to be called dishonest)"

"I truly believed that self-assessment and constructive criticism had to occur at all levels of a company, and I tried my best to walk the talk"

"A hallmark of a healthy creative culture is that its people feel free to share ideas, opinions, and criticisms. Lack of candor, if unchecked, ultimately leads to dysfunctional environment"

"Candor could not be more crucial to our creative process. Why? Because early on, all of our movies suck"

"Filmmakers must be ready to hear the truth; candor is only valuable if the person on the receiving end is open and willing, if necessary, to let go of things that don't work"

"Candor isn't cruel. It does not destory. On the contrary, any successful feedback system is built on empathy, on the idea that we are all in this together, that we understand your pain because we've experienced it ourselves"


"We are always changing, because change is a good thing"

"It's folly to think you can avoid change, no matter how much you want to. But also, to my mind, you shouldn't want to. There is no growth or success without change"

"I think the person who can't change his or her mind is dangerous"

"Everything is changing. All the time. And you can't stop it. And your attempts to stop it actually put you in a bad place. It causes pain., but we don't learn from it. Worse than that, resisting change robs you of your beginner's mind - your openness to the new"


"Some people see random, unforeseen events as something to fear. I am not one of those people. To my mind, randomness is not just inevitable, it is part of the beauty of life. Acknowledging it and appreciating it helps us respond constructively when we are surprised"

"Randomness remains stubbornly difficult to understand. The problem is that our brains aren't wired to think about it. Instead, we are built to look for patterns in sights, sounds, interactions, and events in the world"

"How can we think clearly about unexpected events that are lurking out there that don't fit any of our existing models?"

"No matter how intensely we desire certainty, we should understand that whether because of our limits or randomness or future unknowable confluences of events, something will inevitably come, unbidden, through that door. Some of it will be uplifting and inspiring, and some of it will be disastrous"

"We must always leave the door open for the unexpected"

"The mechanisms that keep us safe from unknown threats have been hardwired into us since before our ancestors were fighting saber-toothed tigers with sticks. But when it comes to creativity, the unknown is not our enemy. If we make room for it instead of shunning it, the unknown can bring inspirations and originality."

"Randomness doesn't occur in a linear fashion" 


"The puzzle of trying to understand randomness: Real patterns are mixed in with random events, so it is extraordinarily difficult for us to differentiate between chance and skill"

"We must acknowledge random events that went our way, because acknowledging our good fortune - and not telling ourselves that everything we did was some stroke of genius - lets us make more realistic assessments and decisions"


"When faced with complexity, it is reassuring to tell ourselves that we can uncover and understand every facet of every problem if we just try hard enough. But that's a fallacy. The better approach, I believe, is to accept that we can't understand every facet of a complex environment and to focus, instead, on techniques to deal with combining different viewpoints"

"Creativity demands that we travel paths that lead to who-knows-where. That requires us to step up to the boundary of what we know and what we don't know"

"While we know more about a past event than a future one - our understanding of the factors that shaped it is severely limited. Not only that, because we think we see what happened clearly - hindsight being 20-20 and all - we often aren't open to knowing more"

"Acknowledging what you can't see - getting comfortable that there are a large number of two-inch events occurring right now, out of sight, that will effect us for better or worse, in a myriad of ways - helps promote flexibility"


"Only about 40% of what we think we "see" comes in through our eyes. The rest is made up from memory or patterns that we recognise from past experience"

"We do have to function, so simultaneously, the brain fills in the details we miss. We fill in or make up a great deal more than we think we do. What I'm really talking about here are our mental models, which play a role in our perception of the world"

"All we need is a tiny bit of information to make huge leaps of inference based on our models - as I say, we fill it in"

"We have to learn, over and over again, that the perceptions and experiences of others are vastly different than ours"

"Successful leaders embrace the reality that their models may be wrong or incomplete"

"When humans see things that challenge our mental models, we tend not just to resist them but to ignore them. This has been scientifically proven. The concept of confirmation bias"

"If our mental models are mere approximations of reality, then, the conclusions we draw cannot help but be prone to error"

"Our mental models aren't reality. They are tools, like the models weather forecasters use to predict the weather. But as we know, all too well, sometimes the forecast says rain, and boom, the sun comes out. The tool is not reality. The key is knowing the difference"

"Our models of the world so distort what we perceive that they can make it hard to see what is right in front of us"

"I am constantly rethinking my own mental models for how to deal with uncertainty and change and how to enable people"


"While experimentation is scary to many, I would argue we should be far more terrified of the opposite approach. Being too-risk averse causes many companies to stop innovating and to reject new ideas, which is the first step on a path to irrelevance"


"You'll never stumble upon the unexpected if you stick only to the familiar. In my experience when people go out on research trips, they always come back changed"

"Research trips challenge out pre-occupied notions and keep cliche's at bay. They fuel inspiration. They are, I believe, what keeps us creating rather than copying"


"I've heard some people describe creativity as 'unexpected connections between unrelated concepts or ideas'. If that's at all true, you have to be in a certain mindset to make those connections"

"To have a "not know mind" is a goal of creative people. It means you are open to the new, just as children are"

"Paying attention to the present moment without letting your thoughts and ideas about the past and the future get in the way is essential. Why? Because it makes room for the views of others"

"Focusing on something can make it more difficult to see. The goal is to learn to suspend, if only temporarily, the habits and impulses that obscure your vision"

"While many activities use both L-mode [left brain] and R-mode [right brain], drawing required shutting the L-mode off. This amounted to learning to suppress that part of your brain that jumps to conclusions, seeing an image as only an image and not as an object... Artists [that] have learned to employ these ways of seeing [using techniques to engage only the right brain] does not mean they don't also see what we see. They do. They just see more because they've learned how to turn off their mind's tendency to jump to conclusions. They've added some observational skills to their toolboxes"


"I believe no creative company should ever stop evolving"

"Send a signal about how important it is for every one of us to keep learning new things. That, too, is a key part of remaining flexible: keeping our brains nimble by pushing ourselves to try things we haven't tried before"

When PIXAR embarks on a new film they are heading into the unknown. Similarly, an investor's results will be determined by the future. Both crafts demand creativity.  It's no surprise Ed Catmull and Ray Dalio are both at the top of their field, and that they hold to similar ideals and virtues in their craft. Many of their life experiences have been similar but different - learning from their own mistakes and those of others, employing smart teams, changing the thinking paradigm and allowing innovative thoughts and creativity to be integral parts of their operations, being honest and open with yourself and others and above all to never stop learning - the day you think you know it all is the day you either need to stop, or start again from scratch.

We can use Ed Catmull as an example of how to go to 'infinity and beyond' ..... 

Learning from Ray

Ray Dalio is without doubt a member of the master class of the world's investors. He runs Bridgewater Associates, one of the most successful and the largest Hedge Fund in the world. 

Similarly, like many of the Investment Masters, Ray believes in seeking the truth by testing investment ideas, learning from mistakes and remaining humble. This was never more evident than in his experience in predicting the Debt Crisis in the early 1980's. Whilst his prediction was uncannily accurate, Ray also predicted that the stock market would fall at the same time. The reality was something different, however, and when the market actually rose instead, Ray lost so much of his own and client's capital that he was forced to let go all of his staff, and had to borrow $4,000 from his father to simply pay his household bills. It's fair to say that Ray felt the pain of his mistake deeply. Ray stated that the pain of this error allowed him to change his attitude towards mistakes, and to see them as puzzles that needed to be solved instead. It also allowed him to start asking himself what he would do differently in the future to avoid the pain.

“I believe that anyone who has made money in trading has had to experience horrendous pain at some point. Trading is like working with electricity; you can get an electric shock.  With the pork belly trade and other trades, I felt the electric shock and the fear that comes with it. That led to my attitude: let me show you what I think, and please knock the hell out of it” Ray Dalio

"I met a number of great people and learned that none of them were born great. They all made lots of mistakes and had lots of weaknesses - and that great people become great by looking at their mistakes and weaknesses and figuring out how to get around them." Ray Dalio

Other Investment Masters have also learnt the same lesson.

“I lost my stakes a couple of times, which taught me risk control and risk management. Losing those stakes in my early 20s gave me a healthy dose of fear and respect for Mr. Market and hardwired me for some great money management tools.” Paul Tudor-Jones

“My dad was a retail pharmacist and after I started attending law school he said “well you have to learn how to be an investor”. He and I traded tiny amounts of tech stocks and mining stocks together. So I became very interested in markets and trading. In the period of time from 1967-1974 he and I found just about every possible way conceivable to lose money. So when I started Elliot in 1977 I was determined to engage in a trading strategy that made money all the time. So for the first 10 years of Elliot’s existence the primary strategy was convertible bond hedging” Paul Singer

"I went into this tech stock with 100% short position, and all the money I saved up because I thought I had this one locked down. We had fully positioned ourselves, myself and all my customers and clients I was advising, and then a technology writer dubbed the company the 'Son of Intel'.  The stock went promptly from about $16 to $40. I got margin called all the way up until I was completely wiped out. I lost all of my money. I was apoplectic. I thought the world was going to end. I remember that like it was yesterday. That was the greatest thing that ever happened to me - losing all of my money on something where I knew I was right. From an investing perspective, getting completely wiped out and thinking it was the end of the world, and thinking I was an abject failure, and this investing thing wasn't for me. Looking back at it, it couldn't have happened at a better time in my life. You want that to happen as early in your career as it can and you want it to be the most devastating blow that could possibly hit you, to teach you, to bring humility into your investing and teach you that you should never set yourself up for the knockout punch. It teaches you never to put 100% into anything. It teaches you a lot about sizing, it teaches you a lot about life, no matter how much you think you have your arms around a situation, you never do" Kyle Bass

It was the recognition of the need to learn from mistakes that led to the development of Ray's Principles.

"You have to learn from mistakes to keep getting better. And it's through learning from those mistakes that you learn what reality is and how to deal with it, which is called Principles"

Interestingly, Ray is about to release a new book entitled 'Principles'. This will be an absolute must-read and I have already pre-ordered it. Ray released the first document titled 'Principles' on the Bridgewater Associates website back in 2011. The original 'Principles' focuses on Ray's most fundamental truths about life and in addition, his beliefs and ideals regarding people management. Over the years I've often referred back to the original text, and while Ray has updated it in the new book, the original document remains a favourite of mine.

Bridgewater Associates investment style differs from many of the Investment Masters in so much as they invest across a broad spectrum of asset classes and regions, both long and short, and seek approximately 100 different return streams that are roughly uncorrelated to each other. While there isn't a lot of commentary on investing per se in the original 'Principles' document, it does include the psychological insights and approach to learning that parallel with other great investors and give Bridgewater their edge. 

This is evident in the company's employment philosophies. On the Bridgewater Associates website's career page, they ask potential employees to ask themselves a number of questions before applying to work there. These include:

"Do you want to: Discover your strengths and weaknesses? Work to get better fast? Put aside ego barriers to learning? And, demand others to be truthful and open, and are you prepared to to do the same?"

In conjunction with the release of the new book, Ray has given a very insightful Ted Talk [only 16 minutes ... see below] where he discusses the processes he developed to successfully navigate the markets. Ray describes himself as a hyper-realist; he's a broad thinker who meditates and recognises there are many lessons to be learnt from nature and history. It was by studying history that provided Ray with the insights to anticipate the Global Financial Crisis.  

It's no surprise Ray features prominently throughout the tutorials included in the Investment Masters Class. Here's a taste of some of the Principles which are behind Ray's success..

"I learned that failure is by and large due to not accepting and successfully dealing with the
realities of life, and that achieving success is simply a matter of accepting and successfully
dealing with all my realities."

"I learned that finding out what is true, regardless of what that is, including all the stuff most people think is bad—like mistakes and personal weaknesses—is good, because I can then deal with these things so that they don’t stand in my way."

"I learned that there is nothing to fear from truth. While some truths can be scary—for example, finding out that you have a deadly disease—knowing them allows us to deal with them better. Being truthful, and letting others be completely truthful, allows me and others to fully explore our thoughts and exposes us to the feedback that is essential for our learning."

When investing, it's important to maintain humility, study history, learn from mistakes and test investment ideas - the foundations of both Ray Dalio's, and the Investment Masters success.


Further Reading:
Ray Dalio Principles - 2011
Ray Dalio - Academy of Achievement
Ray Dalio - Charlie Rose Interview
Ray Dalio - Alpha Masters
Ray Dalio - Hedge Fund Market Wizards
Ray Dalio - The New Yorker

The IMportance of Culture

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What is 'Culture' and how does it affect the operational success of an organisation?

Without doubt, if there is one aspect of an organisation that will separate the great businesses from the mediocre or the poor, it has to be the company's Culture. Businesses with healthy Cultures tend to be successful and provide attractive investment opportunities whilst those with cultures that are sick or decidedly unhealthy tend to perform poorly, leading to share price under-performance or even worse, the permanent loss of capital. It is for this reason, the Investment Masters recognise the importance of Culture in the investment decision-making process.

Culture is king” Sam Zell

"The real glue of investing is understanding what the Cultures are in the businesses" Thomas Russo

"In businesses, culture counts." Warren Buffett

A company's intrinsic value is determined by it's future earnings, and while past financial statements may provide clues to the quality of the business, changing conditions can make extrapolation of past results unreliable. In a large part, a company's future success will be a function of the culture.  And culture is difficult to measure given its qualitative rather than quantitative nature.  It is for this reason that culture often gets overlooked in the investment process.  

Marianne Jennings, in her book, 'The Seven Signs of Ethical Collapse' [nb. recommended reading by Jim Chanos, the world's most famous short-seller] noted that "A good analysis of where a company is headed demands a look at the qualitative factors , those touchy-feely, squishy, from-the-gut factors that are ignored despite the fact that they often determine the company's fate".

James Heskett, a leading authority on corporate culture, noted that culture can be a better indicator of a company's future financial performance than hard numbers... "The decline of an organization's culture may well precede financial decline".

Great companies have great cultures. Ed Catmull, co-founder of Pixar, discussed culture in the first paragraph of his great book 'Creativity Inc' [new blogpost on this book coming soon!]. The book's introductory paragraph highlighted that what made Pixar was 'the unique culture that defines this place'.

So why is it so important?

A company could have the greatest products, a robust brand and reputation, effective policies and processes and a long history of trading, but if the culture is poor, it is much less likely to succeed when compared with a business that has a healthy culture.

Despite those great products, you might find that many customers have complained about slow delivery, or poor service, or rude employees in that business. These are all indicators of the health of a company's culture.

Companies with great service and employees that go the extra mile rarely have complaints made against them. And if they are not making complaints, then customers will return to the better businesses, leading of course to better business results. Its that simple. 

"As much as half the difference in operating profit between organisations can be attributed to effective cultures" James Heskett

“A rotten culture can be a firm’s undoing”  Marathon Asset Management

"Cultures self-propagate. Winston Churchill once said, “You shape your houses and then they shape you.” That wisdom applies to businesses as well" Warren Buffett

"Long term, culture is enormous in terms of one business doing better than another" Paul Black

“Perhaps the best known study on the subject is Corporate Culture and Performance by John Kotter and James Heskett.  This work examines the relationship between corporate culture and company performance in over 200 firms during the 1980’s.  The authors asked employees their opinions of attitudes to customers and shareholders at competitor firms.  Shares in companies exhibiting strong and positive cultures outperformed rivals by more than 800% during the study period”  Marathon Asset Management

A successful culture is a competitive advantage that can be difficult to compete with and challenging to replicate.

"In many organisations, culture is the most potent and hard-to-replicate source of competitive advantage - far more important, for example than technological innovation" James Heskett

“A strong corporate culture constitutes an intangible asset, potentially as valuable as a high profile brand or network of customer relationships”  Marathon Asset Management

"Organisations with strong, adaptive and open cultures that foster employee loyalty and productivity are not concerned that competitors may find it possible to borrow policies, methods and processes. They are convinced that the real key to making those policies, methods and processes, and yes, strategies work is something much more difficult to emulate - culture," James Heskett

How do you describe what an organisation's Culture is?

Look at it this way: if we are asked to 'describe' a person, the answer lies in their personality and behaviours sets. They could be confident, assertive, organised, decisive, and pragmatic as an example.

If you then consider the Culture of an organisation to be much the same thing, when we describe it, we will be outlining how we see the business' 'personality'. By the same standard, it could be defined as competitive, aggressive, customer-focused, mature, cost-conscious and well-respected. On the other hand, a company with a poor culture could be described as lacking in Leadership or Integrity, and with a non-customer centric focus.

How is a company's Culture created?

In a nutshell, there are two things that determine a company's Culture. These are either 1/. a Company's Vision and Values, and/or 2/. the Behaviours of the Management/Leadership Team.

Company Values have long been touted by some companies as HR rubbish, or soft and fluffy BS that wastes everyone's time. The reality is actually something else entirely. If a company goes to the effort of creating a set of Values, it is essentially defining the organisation's Code of Conduct.

So taking this one step further, if the company's Vision and Purpose determines What it wants to be in the future, and the Strategies outline How it will get there, think of the Values as the Manner in which it will behave along the way. Values could also be seen as the company's behaviour set.

In the case of Vision, Amazon's vision is “to be Earth’s most customer-centric company, where customers can find and discover anything they might want to buy online.” or Southwest Airlines vision to be the "Airline for the Common Man".  Google has a purpose "to organise and make accessible all the world's information". Successful companies have a purpose and vision other than 'making money'. In all cases, these Visions will contribute to each of these company's behaviour sets. 

Values will also differ from business to business. When setting their Code of Conduct, many use words like Integrity, Customer, Quality, Profitability, etc to define what it is important to that company. Basically, the list of potentials is endless. And they're also just words, unless definitions and measures are put in place beside them to ensure they are 'lived' within the business. In the end, words don't define a Culture, people and their behaviours do.

Culture, more than rule books, determines how an organisation behaves” Warren Buffett

"In a 2004 study from the Journal of Business ethics, employees stunned most academics by saying that code of ethics for their company had very little influence on whether they make ethically correct choices. It was the culture of their companies and the examples set by their leaders that influenced their conduct" Marianne Jennings

Where organisations measure and reward staff for living company Values, the cultures are typically healthy and consistent - i.e. everyone behaves in the same way. If there is a Value of 'Integrity', the staff behave honestly and professionally. If they Value 'Customers', then they will treat every client as a valuable commodity that they do not want to lose. 

Inversely, I have seen many organisations with sets of Values that are framed in reception or have been placed on the back of every employee's business cards, yet when staff are asked to name them, virtually no one can remember what the Values are. This typically defines businesses that do not measure their Values and therefore do not place any importance in them. They have gone to the effort and expense of creating the list in the first place, and then have never followed up to ensure their staff and management are living the behaviours. This is very common unfortunately. One example I have seen was a Sales Director who lied and cheated customers, yet the Company had a Value of 'Customer'. And in another, a CEO of a company touted 'Respect' and 'Professionalism' as key Values in that organisation, yet openly vilified minority staff in front of their peers. I have often seen Employees showing confusion in these instances - "If the company wants me to behave professionally, then why can't the CEO set the example?"

"Behaviours count only if they are monitored and if the measures trigger corrective action when behaviours are out of alignment with values" James Heskett

Where Values fail to drive the Culture however, or they have never been put in place, then the set of Behaviours exhibited by the Management and Leadership team will fill the void. Once again, if the leadership is sound, you'll generally find the business' Culture to be healthy.

"Credibility is a key component of an ethical culture, and hypocrisy is its death knell" Marianne Jennings

In a business with a healthy Culture, you might see behaviours of Respect and Accountability, or of Reward and Recognition; in all cases like this staff want to work there and so will inevitably push harder for greater results. Basically if management set the right example then a healthy Culture will surely follow. And if the Culture is right, then the business will typically be a successful one.

“To me culture is everything. It’s the glue that holds people in the firm together and it also provides the vision for all the people in the firm to know just what they’re driving to. Culture is really important. Tone at the top matters a lot. No one person can drive or create that culture, it’s more like a Oiji board where a lot of people have a handle on it, but what comes out of it is very important.” Jim Tisch

“The culture of a company is one of the major keys to its success” Stephen Errico

Culture is the most important thing to understand about a company, and to understand about one’s self”  Simeon Wallis

On the other hand, poor Cultures are driven by ineffective management or leadership behaviours. This could be exhibited by zero accountability by those in charge (meaning everyone else is to blame for the results), high staff turnover, absenteeism or apathy; all are examples of where the leaders have created a poor Culture.

Poor cultures can lead to ethical, and then corporate collapse. Revisiting Marianne Jennings' 'The Seven Signs of Ethical Collapse', she observed that companies with an excessive focus on meeting quantitative goals at all costs [eg profit guidance] or oppressive cultures of fear and silence are tell-tale signs of potential ethical collapse.

"Cultures of fear and silence nurture the team player concept, borrowing the buy-in and stronghold that comes from groupthink and the inability, as Solomon Asch's studies on social conformity pressure concluded, of most of us to speak up when we see something wrong, if those around us either do not see the problem or have chosen to remain silent. Even the most honorable people are submissive in a culture of fear and silence" Marianne Jennings

Another aspect that is important when reviewing Values and Management Behaviours is to ensure the two are aligned. Setting the right example starts with the Leaders of the business, and if they are not showing the way, it is wrong to expect that the staff will follow. I have seen businesses that set Values reflecting Teamwork and Recognition and Fun, while the managers are reclusive, negative and independent. How likely is it, do you think, that this business' Culture is effective? And just as importantly, how likely is it that the business will be delivering sound results?

So how do you measure Culture?

Measuring a company's culture is vital and of course is one of the easiest things to overlook. Because it can't be seen on a balance sheet, and it certainly isn't evident in any marketing or PR activities a company may undertake, when analysing investments we tend to only look at the hard business results, the fiscal capabilities of the business rather than its behaviours.

Because Culture is formed by people, the answers to measuring it lie with the same group. You need to TALK to all the appropriate stakeholders. These could include Staff, Suppliers, Customers, Management, Shareholders or the Board, and of course the Community it exists within. If you're only talking to one group, you are likely to skew your information and present a bias when looking at your investment opportunity. Management will only present one side of the argument, and if there is a potential upside to them in the investment, then they are likely to only reflect on the positive aspects of the Culture, or what they believe is there. By talking with Staff, Suppliers, Customers and the local Communities, you will attain the big picture. It is the ONLY way you can ensure you have applied appropriate due diligence with regards to investigating a company's Culture.

"Give me a one-on-one with an employee and I can tap a vein. I always offer companies: After I do my research, using the [seven signs of ethical collapse] give me just five minutes alone with a frontline employee and I can tell you the culture of your organisation and whether it is at risk" Marianne Jennings

It's no wonder the Investment Masters talk to those who manage and interact with the company ...

“Understanding culture before we acquire a business could be the most important thing we do.  And it’s been one of the hardest things to do. You have to talk to the employees, customers, and suppliers.  You learn a lot about how the company treats them”  Steve Feilmeier, Koch

“I do talk to management of many companies. I like to figure out their human values, the culture they nurture and their long-term goals.” Francois Rochon

So what should you be looking for when talking to the stakeholders? 

Beyond successful business results, positive Cultures are typically indicated by the following: Strong Leadership, Long Standing Employees, Collaboration and Team Work, Accountability, an excellent Customer Service Ethic, Strong Repeat Business, Role Clarity, Integrity, Transparency, Effective Reward Systems and Recognition Programs, Staff Engagement, Genuine Respect, Humility, Innovative Thinking, Staff Development Programs, Learning, Community Standing and Social Responsibility, Values that are Measured and 'Lived', Quality Products, Diversity of Workforce and Strong Ethics. Just to name a few. 

“The three best operating companies I’m aware of are Costco, Kiewit and Glenair.  There is nothing remarkable about the product or field for any of these.  But there is something remarkable about the culture of all three.” Charlie Munger

“There is one thing I have been doing for many years now and has in my view been absolutely central to the fund’s performance. I mention it not in the spirit of self-congratulation, but because there is far too little attention paid to it and it would be far better for society, not to mention individual fund’s performance, if this was not the case. I am referring to building an understanding of and conviction around a company manager’s integrity and more broadly speaking a firm’s culture (the two are closely connected as the tone basically comes from the top). Nothing has been more important to managing the fund over the last years than understanding management character.” Robert Vinali

You can see how important Culture is to the Investment Masters in determining the success of an Investment. Don't simply rely on the business results and balance sheet; the answer to your investment question could well lie with the people and the Culture....


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.

- 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

Join other Investment Professionals who share the posts with their colleagues at LinkedIn below....

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