Buffett's Edge


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

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

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

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

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

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

Reads & Thinks

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


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


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

Loves Investing

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

No Distractions

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

No Ulterior Motives

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


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

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

Learns from Mistakes

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

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

Independent Thinker

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

Contrarian in Nature

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

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


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

Communication Skills

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

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

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

Away from Wall Street

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

Value Approach

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

Generalist / Opportunistic

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

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

Long Term Focus

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

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

Sticks with What he Knows / Defined Filters

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

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

Thinks as a Businessman

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

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

Buys Simple Businesses He Understands

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

Insists on Good Management

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

Conservative assumptions

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

Access to Information

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

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

Looks at Price Last

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

Doesn't Disclose Positions

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

Buys Established, Predictable, Quality Businesses

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

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

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

No Committees / Groupthink

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

Aligned Shareholders

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

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

Avoids Leverage

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

Maintains Significant Cash

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

No Guidance to Hit

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

Zero Cost Permanent Capital

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

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

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

No Mark to Market on Wholly Owned Businesses

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

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

Avoids Potential Blow-Ups / Focuses on Downside

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

Avoids Turnarounds, Start-Ups and IPO's

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

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

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


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

Seeks Win-Win Outcomes

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

Good Home for Businesses

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

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

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

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

[Over time Buffett has attracted more and more quality businesses to join Berkshire. Business founders often prioritize legacy, staff morale, business continuity and management independence above financial gain. Buffett has developed an enviable track record and a reputation as an ethical, discreet, and timely buyer who will maintain a business for the long term. Buffett doesn't participate in auctions (another edge!) and is often the only party to be offered the businesses he buys. The counter to this is that negotiated private asset sales are rarely done at knock-down prices as they occasionally are in the stock market]


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

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



Further Reading: Charlie Munger 50th Anniversary Letter

Follow us on Twitter: @mastersinvest



Learning From Jamie Dimon


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

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

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

  Source: Jamie Dimon Annual Letter [JP Morgan]

Source: Jamie Dimon Annual Letter [JP Morgan]

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

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

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

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

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

How to Consider Banks

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

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

  Source: Jamie Dimon Annual Letter [JP Morgan]

Source: Jamie Dimon Annual Letter [JP Morgan]


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

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

Quarterly Earnings & Stock Price

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

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

  Source: Jamie Dimon Annual Letter [JP Morgan]

Source: Jamie Dimon Annual Letter [JP Morgan]

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

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

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

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

Satisfy Your Customers

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


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


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

Importance of Employees

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

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

Long Term

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

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

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

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

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

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

Fortress Balance Sheet

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

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

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

Stress Testing

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

Consider Alternative Scenarios

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

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

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

Mitigate Risk

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

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

Don't Overly Rely on Models

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

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

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

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

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

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


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

Understand Volatility and Non-Linearity

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

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

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

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

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

Avoid Bureaucracy

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

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


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

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


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

Continue Learning

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


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

US Economy

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

US Tax Changes

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

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

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


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

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

Uncertainty of QE

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

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

Passive Investing and ETF's

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


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

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

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


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

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

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

Trade & Global Engagement

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

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

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

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

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

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

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

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


Sources: Jamie Dimon, Annual Letter 2017, JP Morgan






Learning from Ron Shaich

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

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

 Source: Bloomberg

Source: Bloomberg

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

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


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

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

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

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


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

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

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

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

Three-Step Process

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

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

What Job Clients Hire For

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

Long Term

"I think long term."

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

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

 Source: Ron Shaich IGNITE 2010 Presentation

Source: Ron Shaich IGNITE 2010 Presentation

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

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

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

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

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

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

Importance of Competitive Advantage

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

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

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

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

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

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

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

How to Develop Competitive Advantage

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

"So how do you create competitive advantage?

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

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

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

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

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

Long Term Transformation

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


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

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

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

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

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

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

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

People and Incentives

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


 Source: Ron Shaich IGNITE 2010 Presentation

Source: Ron Shaich IGNITE 2010 Presentation

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

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


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

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

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

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

Contrarian Approach

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

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

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

Stock Prices

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

 Source: Ron Shaich - IGNITE 2010 Presentation

Source: Ron Shaich - IGNITE 2010 Presentation

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

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

Quarterly Earnings

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

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

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

Win-Win Approach

 Source: Ron Shaich 2010 IGNITE presentation

Source: Ron Shaich 2010 IGNITE presentation

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

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


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

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

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


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

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

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

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

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


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

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

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

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



Follow us on Twitter: @mastersinvest



Further Reading on CEO Masters:

The Investment Masters on bonds...

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Let's consider some of those..

Bonds are Expensive

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

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

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

No Upside Participation

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

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

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

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

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

Asymmetry of Bond Yields

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

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

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

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

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

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

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

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

Permanent Capital Loss

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

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

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

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

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

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

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

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

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

  US10Year Yield less Inflation [Source Bloomberg]

US10Year Yield less Inflation [Source Bloomberg]

Inflation Risks

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

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

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

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

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

And Davis was right ...

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

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

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

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

Prices are being Manipulated

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

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

Historic Underperformance

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

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

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

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

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

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

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

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

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

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

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



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

  Source: Masterinvestor

Source: Masterinvestor

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

That's not the case today..

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

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

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

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

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





Further Reading:

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

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


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Chris Bloomstran - Annual Letter [Part II]

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

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

Time for caution?

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

"When the herd stampedes, danger rises."

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

Reversing the Fed's Balance Sheet

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

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

Bond Buyers?

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

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

Rate Hikes and Recessions

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

The Importance of Price

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

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

Time Arb and Patience

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

Dual Margin of Safety: Price and High Quality

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

Low Corporate Debt and Outperformance

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

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

Earnings Yield

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

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

  Source: Semper Augustus 2017 Letter

Source: Semper Augustus 2017 Letter

Portfolio Analysis

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

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

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

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

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

Buy-Backs and Incentives

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

Capital Allocation

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

Great Investors don't always Outperform

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

Acknowledging Fear

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

Recommended Books

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

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

Passing Investing

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

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

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

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

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

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

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

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

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

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

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

  Source: Semper Augustus 2017 Letter

Source: Semper Augustus 2017 Letter

"Capital allocators keep feeding the fat kid"

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

  Source: Semper Augustus 2017 Letter

Source: Semper Augustus 2017 Letter

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

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

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

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


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Learning from Einstein

Screen Shot 2017-09-28 at 10.26.20 PM.png

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

But he was not alone.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

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

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

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

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

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

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

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

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

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

And a few of my favorite quotes ... 

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

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

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

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


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Christopher Bloomstran: The New Super Investors

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

And Christopher Bloomstran's are no exception.

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

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

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

The New Super Investors

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

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

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

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

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

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

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

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

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

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

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

Extreme patience.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

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Learning from Benoit Mandelbrot

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

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

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

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

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

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

 Source: J SHEI

Source: J SHEI

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

"The very heart of finance is fractal."

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Buffett's Annual Letter - 2017

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

On Insurance Float ..

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

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

Thoughts on Hurricane Losses ..

"My guess at this time is that the insured losses arising from the hurricanes are $100 billion or so. That figure, however, could be far off the mark. The pattern with most mega-catastrophes has been that initial loss estimates ran low. As well-known analyst V.J. Dowling has pointed out, the loss reserves of an insurer are similar to a self-graded exam. Ignorance, wishful thinking or, occasionally, downright fraud can deliver inaccurate figures about an insurer’s financial condition for a very long time."

Buffett is holding a lot of Cash ... 

"At year end Berkshire held $116.0 billion in cash and U.S. Treasury Bills (whose average maturity was 88 days), up from $86.4 billion at yearend 2016. This extraordinary liquidity earns only a pittance and is far beyond the level Charlie and I wish Berkshire to have. Our smiles will broaden when we have redeployed Berkshire’s excess funds into more productive assets."

Buffett sees stocks as interests in businesses... 

"Charlie and I view the marketable common stocks that Berkshire owns as interests in businesses, not as ticker symbols to be bought or sold based on their “chart” patterns, the “target” prices of analysts or the opinions of media pundits. Instead, we simply believe that if the businesses of the investees are successful (as we believe most will be) our investments will be successful as well. Sometimes the payoffs to us will be modest; occasionally the cash register will ring loudly. And sometimes I will make expensive mistakes. Overall – and over time – we should get decent results. In America, equity investors have the wind at their back."

Eventually Valuation Matters ... 

"Stocks surge and swoon, seemingly untethered to any year-to-year buildup in their underlying value. Over time, however, Ben Graham’s oft-quoted maxim proves true: “In the short run, the market is a voting machine; in the long run, however, it becomes a weighing machine.”

Stocks can be Volatile, so avoid Debt ...

"Berkshire, itself, provides some vivid examples of how price randomness in the short term can obscure long- term growth in value. For the last 53 years, the company has built value by reinvesting its earnings and letting compound interest work its magic. Year by year, we have moved forward. Yet Berkshire shares have suffered four truly major dips. Here are the gory details:

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This table offers the strongest argument I can muster against ever using borrowed money to own stocks. There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions."

In the next 53 years our shares (and others) will experience declines resembling those in the table. No one can tell you when these will happen. The light can at any time go from green to red without pausing at yellow.

When major declines occur, however, they offer extraordinary opportunities to those who are not handicapped by debt. That’s the time to heed these lines from Kipling’s If:

“If you can keep your head when all about you are losing theirs . . . If you can wait and not be tired by waiting . . .
If you can think – and not make thoughts your aim . . .
If you can trust yourself when all men doubt you . . .
Yours is the Earth and everything that’s in it.”

Buffett tallies his bet against Hedge Funds versus the S&P500 with Protégé Partners..

"Performance comes, performance goes. Fees never falter."

"The bet illuminated another important investment lesson: Though markets are generally rational, they occasionally do crazy things. Seizing the opportunities then offered does not require great intelligence, a degree in economics or a familiarity with Wall Street jargon such as alpha and beta. What investors then need instead is an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals. A willingness to look unimaginative for a sustained period – or even to look foolish – is also essential."

Buffett and the counter-party to his bet, Protege, funded their portion of the prize by purchasing zero-coupon bonds.. 

"Protégé and I originally intended to do no more than tally the annual returns and distribute $1 million to the winning charity when the bonds matured late in 2017.

After our purchase, however, some very strange things took place in the bond market. By November 2012, our bonds – now with about five years to go before they matured – were selling for 95.7% of their face value. At that price, their annual yield to maturity was less than 1%. Or, to be precise, .88%.

Given that pathetic return, our bonds had become a dumb – a really dumb – investment compared to American equities. Over time, the S&P 500 – which mirrors a huge cross-section of American business, appropriately weighted by market value – has earned far more than 10% annually on shareholders’ equity (net worth)."

Buffett sold the zero's in 2012 and put the money into Berkshire .. he also won the bet ... 

"The result: Girls Inc. of Omaha found itself receiving $2,222,279 last month rather than the $1 million it had originally hoped for."

Buffett expands on Bonds as an investment .. 

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

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

And finally keep it simple ... 

"A final lesson from our bet: Stick with big, “easy” decisions and eschew activity. During the ten-year bet, the 200-plus hedge-fund managers that were involved almost certainly made tens of thousands of buy and sell decisions. Most of those managers undoubtedly thought hard about their decisions, each of which they believed would prove advantageous. In the process of investing, they studied 10-Ks, interviewed managements, read trade journals and conferred with Wall Street analysts."

Buffett concludes ... "Come to Omaha – the cradle of capitalism – on May 5th and meet the Berkshire Bunch. All of us look forward to your visit."..  I also hope to see you there!


Source: Berkshire Hathaway 2017 - Warren Buffett Letter


Investment Models - Need to Know


Over the last 20 years or so I've studied the world's greatest investors and I've tried to unpick the characteristics that have made them successful. While business schools all over the world focus an inordinate amount of time on teaching students how to model, I'm yet to find an Investment Master whose made his name by having the most detailed financial models. Consider a few of these gems ...

"If you need to use a computer or calculator to make the calculation, you shouldn't buy it...It should scream at you...we do not sit down with spreadsheets and do all that sort of thing. We just see something that obviously is better than anything else around that we understand — and then we act." Warren Buffett

"We never sit down, run the numbers out and discount them back to net present value ... The decision should be obvious."  Charlie Munger

"In general, I haven't run spreadsheets and I find that, if there is a need to run a spreadsheet, that is a red flag to take a pass." Mohnish Pabrai

Sure it's important to be able to navigate around a balance sheet, cash flow statement and income statement, but the really great investors spend their time reading, thinking, focusing on the qualitative data and testing ideas. I've not once heard an Investment Master say "All I do is sit and model all day."

So why don't the Investment Masters spend their time building 5,000 line spreadsheet models like most Wall Street analysts do? In part it's because models have their limitations including:

Stuck in the Rear-View Mirror

Typically an analyst will build a spreadsheet model by plugging in the last five years financials for a company and then building out the future years from there. The problem is historic data is just that, historic. A company is worth the discounted value of its earnings in the future, not the past. The historic data may provide a useful insight into a company's revenue trends, the quality of the balance sheet and how attractive margins are, as well as provide a basis to compare the company with competitors. But problems can arise because the future may look a lot different to the past. Models are good for extrapolating, but dangerous when it comes to changing circumstances. This is as relevant today as ever given the rapid technological changes taking place.

"The qualitative analysis is even more important than the quantitative analysis because quantitative is always a lagging indicator. By the time you see it in the numbers, it's often too late." C.T Fitzpatrick

"One cannot analyse events until they have already happened. Numbers, the 'oxygen' of analysis, lag behind reality. Analytic methodology is ineffective in identifying change in the early stages and thus contributes to what Marshall McLuhan refers to as man's tendency to walk into the future looking in the rear-view mirror." Bennett Goodspeed

"Data is backward looking and it is the future that will determine our returns." Jake Rosser

"Avoid over-relying on numbers and models. Investors often feel comfortable with numbers and models because they appear definitive. However, they can be misleading because they often are based on historical data that may not be repeatable or are based on assumptions that may not prove valid." Ed Wachenheim

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

Over-Confidence and Anchoring

Studies show that the more information someone has the more likely they are to become over-confident. And more information doesn't necessarily mean more profits. Remember, humility is a key ingredient to investment success. An analyst or investor with a detailed model risks becoming over committed to an idea,"I've built a 5,000 line spreadsheet, I must be right!";or becoming anchored to the outcome of a spreadsheet, "The model says it's worth $x, it must be true"

“Having more information doesn’t necessarily improve decision-making. We know from studies of horse racing than when handicappers receive more information about horses and riders, they become proportionately more confident even though they are no more likely to pick the winner. When analysts have too much data, there’s a danger they won’t see the wood for the trees.” Marathon Asset Management

"I’m reminded of a study which showed that as the number of variables requiring analysis increase, the odds of success decline, yet the confidence of participants soar due to extensive time and energy invested." Allan Mecham

"The harder you work, the more confidence you get. But you may be working on something that is false" Charlie Munger

"[Computer] models can lull decision makers into a false sense of security and thereby increase their chances of making a really huge mistake" Warren Buffett

"Far too many people treat numbers like sacred totems offering divine insight. The truly numerate know that numbers are tools, nothing more, and their quality can range from wretched to superb" Philip Tetlock

Difficult To Model

Einstein famously said "Not everything that counts can be counted, and not everything that can be counted counts." It's an apt quote for investing. The brain and financial models tend to operate in a linear fashion. But it's often the case that the best and worst investment outcomes are derived from non-linear situations. Charlie Munger often talks about 'Lollapalooza' effects where a number of forces combine to greatly amplify a positive outcome - more than simple addition. Alternatively, a credit crunch is an example of a non-linear event that can decimate a business but won't show up in a model.

There are plenty of other qualitative factors that are critical drivers of investment success but are hard to model. Corporate culture and innovation, management qualitycapital allocation prowess and incentives would be some examples. Networks effects, product obsolescence, scalability,  first-mover-advantages, industry developments, winner-takes-all, etc are also challenging to model.

"When we analyze a business, we pay close attention to the qualitative and intangible variables –such factors are often difficult to ‘model’. We are uneasy with fancy numerical models .. which have almost ubiquitous acceptance by the high priests of modern finance. We believe one is susceptible to gaining a false sense of security, which can result in mental slothfulness and neglect. In the case of models, analysts tend to overweight what can be measured in numerical form, even when the key variable(s) cannot easily be expressed in neat, crisp numbers.  The ‘model’ behind our largest investment required nothing more than sixth grade math, and a napkin – not a sophisticated spreadsheet capable of more numbers than I’m capable of counting." Allan Mecham

"You’ve got a complex system and it spews out a lot of wonderful numbers that enable you to measure some factors. But there are other factors that are terribly important and there’s no precise numbering you can put to these factors. You know they’re important, but you don’t have the numbers. Well practically everybody overweighs the stuff that can be numbered, because it yields to the statistical techniques they’re taught in academia, and doesn’t mix in the hard-to-measure stuff that may be more important. Charlie Munger

"In our evolution as investors, one of the things we have discovered is that it is often the things that don’t get measured that have a greater magnitude on investment returns than what is measured. That is to say, the numbers don’t provide all the clues. It is often qualitative factors such as company culture, management’s approach toward capital allocation, or customer service, that can yield critical insights into a company’s sources of competitive advantage. In fact, an advantage premised upon qualitative factors can often be more enduring." Jake Rosser

Missing the Forest for The Trees

Successful investing ordinarily requires determining the few key variables that drive a business' performance. By focusing on collecting all the data to build a more realistic model, the investor risks overlooking those key variables. 

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

"Our approach stresses the importance of wisdom by subtraction. We endeavour to look past the non-essential details and tune out the often deafening noise. We want to identify the “essence” of each business. So, for instance, what is it about MasterCard that enables them to generate after-tax margins approaching forty percent? Why have the Rales brothers, first with Danaher and second with Colfax, been so successful buying and fixing businesses? How has Markel managed to compound book value per share at fifteen percent for the past twenty years despite falling interest rates and a competitive underwriting environment?"  Chris Cerrone

"Are there dangers in getting too caught up in the minutiae of using a computer so that you miss the organised common sense? There are huge dangers. There'll always be huge dangers. People calculate too much and think too little" Charlie Munger

Models aren't Reality

A model is only as good as its inputs and it can never truly reflect reality. The inherent simplification of a model is one of its pitfalls. If the model is missing critical information or the key factors for success or failure, the output will be next to worthless. A good example of this was during the Financial Crisis when the bank analyst where I worked had a buy rating on an Investment Bank. The model and the analysts 'buy' rating went over the cliff when the stock went bust. Critically, the business relied on credit markets remaining open. That wasn't in the model.

"I have seen so many cases where there is a complex model that is exactly wrong. This focus on a model may cause you to move away from thinking about the competitive advantages of the business. Then you are making decisions based on all these numbers rather than thinking about whether this is one of the ten businesses that you would like to own." Glenn Greenberg

"Models are supposed to simplify things, which is why even the best models are flawed.” Philip Tetlock

"This is the virtue of models: They exclude information not directly relevant to the question under consideration, allowing us to focus on the significance of particular variables. This is also the vice of models: If the discarded information proves decisive to the issue being analyzed, the model will fail." Andy Redleaf

Instead of spending their days building financial models, the Investment Masters read, think, focus on qualitative data and test ideas. They keep stock valuations simple. If they do work on models, it's more likely to be mental models as an aid to investment success. Let's cover off on a few of those...

Reading & Thinking

The Investment Masters spend their time reading and thinking about investments and asking themselves questions - Why is this opportunity available? Do I have an edge? Is this a good business? Do I understand the business? What is the business' competitive advantages? Will the business continue to thrive? What could kill the business? Will technology enhance or destroy the business? Could the business be replicated? What is the right price for the business? What don't I know about the business? etc.

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

"I just spend all my time thinking, reading, and adapting as best as I can." Thomas Gayner

“We read and think.Ed Wachenheim

“Warren and I do more reading and thinking and less doing than most people in business.” Charlie Munger

"Most individuals, including securities analysts, feel more comfortable projecting current fundamentals into the future than projecting changes what will occur in the future. Current fundamentals are based on known information. Future fundamentals are based on unknowns. Predicting the future from unknowns requires the efforts of thinking, assigning probabilities, and sticking one's neck out - all efforts that human beings too often prefer to avoid." Ed Wachenheim

Focus on Qualitative Factors

Successful investors spend more time understanding the qualitative aspects of their investments. This often involves channel checks with customers, competitors, suppliers, ex-employees and anyone else who might affect the company.

"Numbers alone won’t tell you the answer; instead you must think critically about the qualitative characteristics of your business.” Peter Thiel

“Interesting enough, although I consider myself to be primarily in the quantitative school, the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a 'high probability insight'.  This is what causes the cash register to really sing.  So the really big money tends to be made by investors who are right on qualitative decisions, at least in my opinion.” Warren Buffett

"The quantitative side of what we do is easy, to be honest with you. You don't have to have much more than a sixth-grade mathematics education to spot a potentially interesting investment proposition.... I would say the qualitative side of what we do consumes 95% of our time because that's the hard part." John Harris

"While we can run spreadsheets with the best of them, we really emphasize understanding the qualitative factors that drive the numbers. Market shares. Competitive advantages. The secular and cyclical impacts on the industry. Management’s skill in allocating capital. The goal is to identify companies in which we have a great deal of confidence that their values are going to continue to compound as we own them." C.T Fitzpatrick

"It's tempting when you start out to think your knowledge about finance and valuation will lead you to all the answers, but I now put more emphasis on qualitative than quantitative analysis" Jake Rosser

While building a simple financial model can help us better understand a company, it's clear that the people we refer to as the Investment Masters do not rely on 5,000 line spreadsheets for their ideas. Qualitative investment relies on knowledge, which can be gained from reading and thinking and talking with people. And then pulling all that information together into an idea that is valuable. It's also clear that an over reliance on financial modelling can leave you blind to certain risks. So the question remains as to why people still continue to both create them and then follow them? If the Masters don't use them, and they have the track records to prove their method as the right one, which will you follow? For me, I'll choose qualitative investing over quantitative every day of the week and twice on Sunday, and any investment thesis predicated on a 5,000 line spreadsheet will end up in the trash where it belongs.

What Farming can teach us about Investing

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Many inferences have been drawn over time between the Market and Business. This is nothing new to any of us and we have seen it often. The analogies are always simple, clean and relevant and offer practical value to our investing activities. At the same time, many of the Investment Masters have espoused the value in not only being capable in both arenas, but also in keeping up to date on your knowledge of both. It makes sense right? Sure it does.

But there are also other comparisons out there, ones which might not be as obvious at first glance. If I told you there was also value to be gained from comparing Investing to Farming, what would you say?

Hopefully you would agree with me.

Good ol' farming. It's been there forever, through good times and bad. And the inferences that can be drawn between it and Investing are many. 

Let's start with those good and bad times, because they happen to all of us whether you are digging in the dirt or investing in the market. The last two weeks drop in global markets is solid enough evidence of that, as is the freakish weather conditions in different parts of the world that have had a negative impact on the farming sector. The actual lesson though lies in how we react to the market tanking or when a farmer's crops fail. 

In situations like we have just witnessed in the market, prices dropped and investors rushed to get out, causing a significant level of volatility. But every farmer expects the unexpected and recognises that despite his best efforts, nature doesn't always deliver optimal outcomes - pests descend, rains don't come, commodity prices fall.

But if we were working a farm and had one bad year because of say, adverse weather conditions, would you immediately cut the value of your farm in half? Of course not. The value of the farm is the future value of many many years of crops, one bad season just doesn't have that much impact. In contrast, the stock market often over reacts to poor earnings and slashes good companies prices when the unexpected happens.

“You would not cut the value of a good farm in half just because bad weather conditions caused a crop failure in a single year” Phil Fisher

Farmers exhibit patience. They hold onto good farm property even when they have a bad crop. Farmers don't and aren't expected to trade their paddocks and no-one raises eyebrows when they don't. 

"No reasonable person would expect a farmer to sell his farm in order to buy a different farm every decade, let alone every year or several times a year. As public-market investors, however, this "sitting on our hands" behaviour is unusual." Clifford Sosin

And the value of farm land remains pretty constant. The absence of minute by minute pricing for farmers to obsess over means farmers tend to set prices by analysing what the farm will earn over a long period of time. Contrast that to stock prices which tend to be set by the whim of the most emotional participant watching the constant gyrations of the market. That's a gift for the rational investor.

“Stocks provide you minute-to-minute valuations for your holdings whereas I have yet to see a quotation for either my farm or the New York real estate. It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings – and for some investors, it is. After all, if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his – and those prices varied widely over short periods of time depending on his mental state – how in the world could I be other than benefited by his erratic behaviour? If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.” Warren Buffett

Stock prices go up or down responding to any number of psychological biases as opposed to fundamental developments. Yet, while those prices change, they generally don't impact what a company will earn.

“If Investors' frenetically bought and sold farmland to each other, neither the yields nor prices of their crops would be increased. The only consequence of such behaviour would be decreases in the overall earnings realized by the farm-owning population because of the substantial costs it would incur as it sought advice and switched properties.” Warren Buffett

And farmers don't respond to what other farmers are doing like investors do. If a farm a few paddocks away sells for less than the farmer paid, he's not going to rush to sell his property too.

"Instead of focusing on what businesses will do in the years ahead, many prestigious
money managers now focus on what they expect other money managers to do in the days ahead.  For them, stocks are merely tokens in a game, like the thimble and flatiron in Monopoly.... an extreme example of what their attitude leads to is "portfolio insurance," a money-management strategy that many leading investment advisors embraced in 1986-1987 ... After buying a farm, would a rational owner next order his real estate agent to start selling off pieces of it whenever a neighbouring property was sold at a lower price?  Or would you sell your house to whatever bidder was available at 9:31 on some morning merely
because at 9:30 a similar house sold for less than it would have brought on the previous day?" Warren Buffett 1987

Per the lessons gained from the Fingers of Instability posts, learning from this farming analogy is just as important. We know that many investors react to market conditions without really knowing or understanding the intrinsic worth of the stocks they hold. Farming is a long term game and investing should be considered the same way. We should not expect great yields every year from either, rather sometimes we can expect to have to 'weather a storm', and in doing so we can expect a bumper crop.


Fingers of Instability Re-visited


No doubt you will have noticed that in the last week or so we've experienced a significant spike in market volatility. There's a common saying that markets go 'up the escalator, and down the elevator,' and that has certainly been evident of late. During the period of volatility we've witnessed stock markets being sold and bond prices falling, and through it all we've also watched investors all over the world react

Historic correlations have also become unhinged, as the market's participants start to question the implications of global central banks normalizing interest rates. Whether this volatility will continue and the markets will decline further, no-one actually knows. But what is evident is that the market moves were largely unexpected.  

The recent blog post titled 'Fingers of Instability' highlighted the more recent changes in market structure that has created fragility in the system. As more assets are held by people with zero comprehension of what they actually own, it's no surprise volatility spiked when the unexpected happens. These investors have no idea of the underlying worth of their investments and therefore no price to anchor to. No price is too high or low for an index fund to sell or buy. And when there is fear they all try to run out the gate at the same time. Throw in HFT and momentum strategies and in the end you've got a recipe for absolute disaster. But while its a disaster for uninformed investors, its also a potential opportunity for unemotional investors who have done the hard work and can take advantage of indiscriminate selling.

So, given what has occurred in the markets of late, I thought it would be a good idea to revisit a few of the important lessons that emanate from all of this. 

Common Sense - good investing requires common sense. Buying something that's expensive in the hope someone will pay more for it, is speculating, it's not investing. I can't see any rational reason why someone would think buying bonds as an investment makes any sense given ultra-low or negative yields . Historically bonds have provided a real return, but since the Financial Crisis bonds have moved from NOT providing a real return to in some cases giving a negative return. If you're holding to maturity you're going to be losing money after inflation in the first instance, and losing money full-stop in the second. That's an asymmetric bet the wrong way around.

Rear-View Mirror - Investors have a tendency to chase performance. One example of this is the bitcoin frenzy we've been witnessing lately. From time to time, I put a few things up on my Linkedin account, but if you follow it you'll note that I haven't written a lot about bitcoin as I don't see it as a legitimate investment. Its speculation, not an investment. I certainly have a view on the topic, but I'll also take note of the likes of Buffett, Munger, and Druckenmiller; they've been around the block a few times and their collective opinions are valuable to me. Despite my reticence to write about bitcoin, what's interesting is the number of my acquaintances who've asked me whether they should invest in it. And why do they care? Because it's gone up a lot, and they're wanting to chase performance. My Linkedin post on Bitcoin included a chart with a Warren Buffett quote on bubbles. It got 10,000+ hits.. that's an attention bubble right there!

Understand - if you don't understand something don't invest. Some investors learnt some tough lessons last week when the Inverse Volatility [XIV] ETF blew up. I'd say most investors in the fund were chasing performance. Selling volatility is a dangerous strategy if you don't know what you're doing and even more so when you don't know how the fund you're investing in works.

Expect the Unexpected - Don't set your portfolio up for that perfect outcome. Winning in the investment game is not losing. In a bull market all you need is an index fund. The difficult part is timing your exit. And no one knows when a market turns; they can and will turn on a dime. Don't be disappointed in lagging a bull market, it's often the price to pay for admission to long-term market-beating results. It's the outperformance in down markets which drive long term gains. You can't run a portfolio optimized for a bull market that will perform well in a down market. It's important to stress test your portfolio. How will the different assets perform under alternative investment scenarios?

I can't tell you with 100% conviction where the markets are going and neither can you. But you can give yourself the best chance of attractive long term returns by using common sense, understanding what you own and not chasing performance, and then building a portfolio of quality companies that are likely to continue growing over the next five or ten years. If you remain unemotional, focus on the intrinsic worth of your companies rather than market gyrations, the renewed increase in volatility is an opportunity, not a threat.




Books to Read... Masters thoughts ...


We've spent some time in recent posts going over many of the similarities that exist between the methodology and practices of the great Investors. Most of these people have been enshrined in our minds because of their outstanding track records, and their exemplary approach to creating innovative investment ideas. 

One of the things that holds them apart from others is how they can pull all that disparate information together and corral it into a new idea.

But where do they get the information from? From whence comes those brilliant insights? It has to be said the details come from many sources, like talking and watching and listening, but one of the most common is also one of the most humble. A book.

I love to read and you've no doubt seen how many of the great Investors do the same. And the benefits are many with very little downside.  If we read widely, our Vocabulary, Comprehension, Awareness, Intuitive Capabilities, Intelligence and Wisdom all end up on the right side of the ledger - basically the more we read the more we grow and develop. But the biggest benefit lies in the growth of our knowledge base.

Every Investment Master has learnt from a book, or more than one. They all talk about the the little gems they uncovered in this book or that, or how another person's writing challenged their perceptions on an important business or investment paradigm. In almost every case, the authors are invariably providing their knowledge and in many cases the secrets to their success. This is invaluable to us all.

"I have been accused of telling all my secrets. I have written a number of books, and I reveal them all in these books." Benjamin Graham

I also find it fascinating that so many of the great Investors find similar value in much the same authors, such as Benjamin Graham and his brilliant book, The Intelligent Investor.

"By far the best book on investing ever written." Warren Buffett

"I read The Intelligent Investor. Right away, I Said, "Voila!, this is the investment concept I've been looking for." Jean-Marie Eveillard

"Since 1993, the cornerstone of our investment philosophy is based on Benjamin Graham’s book 'The Intelligent Investor', first published in 1949." Francois Rochon

"I can’t remember what I paid for that first copy of The Intelligent Investor. Whatever the cost, it would underscore the truth of Ben’s adage: Price is what you pay, value is what you get. Of all the investments I ever made, buying Ben’s book was the best (except for my purchase of two marriage licenses)." Warren Buffett

Beyond knowing the value they place on books written by other people, one of the biggest upsides for us is that many of the Investment Masters have also put those same ideas into one of more of their own books. Warren Buffett has long been recognised for his annual letters. Many investors, including me, wait hungrily for his latest instalment. And he never disappoints.

"I have read everything I could on Buffett. He is our business/investment role model." Frank Martin

“I think I have read almost everything Warren Buffett has written and I agree with more than 95% of his thinking.” Lee Ainslee

“You should read the Berkshire Hathaway ‘Letters to Shareholders’ which are on the Berkshire website so they are free. That will be a great start.” Mohnish Pabrai

"By far, the best investor of all time is Warren Buffett. I have read everything I could find (past and present) about him." Francois Rochon

"Going back and reading Berkshire Hathaway annual reports is worth the time." Arnold Van Den Berg.

"In my opinion, Warren Buffett’s group of annual letters is the best teaching anyone could find in the history of business." Francois Rochon

"I started reading [Buffett’s shareholder letters etc.] and I’ve read over the years, just about everything, I think, Warren’s put out there." Ted Weschler

Every single Investment Master reads widely. Biographies, History, Philosophy, Psychology, Investment and Business Journals; all are examples of the breadth of genres that are consumed almost daily by these people. I've mentioned how they are able to pull disparate bits of information together - finding the information in the first place would not always be possible without their reading such a wide variety of books.

"Personal biographies, the histories, are the most interesting. I have Benjamin Graham’s personal biography, also the biography of Leon Levy, The Mind of Wall Street. These are all great. It’s not that they’re uncovering something that no one knows about, but these are personal stories about things that they actually experienced in the investment world. How did they deal with the 1973 to 1974 bear market? What did they invest in that worked? What did they invest in that didn’t work? What were the mistakes they made? What did they learn? You’re basically absorbing all of this knowledge that’s out there and you can learn from it and apply it to your own experiences." Chris Mittleman

Beyond Benjamin Graham's treatise which many seem to favour, other books appear frequently in the recommended lists from each Investment Master. Here are some of the more commonly recommended treatises on Investing...

MARGIN OF SAFETY, By Seth Klarman.

“I had very few actual mentors in this business because I didn’t really know anyone. I bought Seth Klarman’s book Margin of Safety which was published my first year of business school.” Bill Ackman

"Seth Klarman's 'Margin of Safety' is a good book about risk." Arnold Van Den Berg


"Peter Lynch's books have some great insights [and] would be great for anyone to read." Julian Robertson

"I came across a book titled 'One up on Wall Street' by Peter Lynch. I found it so exciting I read it straight into the night. I have found the the book to be, along with Benjamin Graham's 'The Intelligent Investor', the best ever written on investment. The book helped me discover a passion for the stock market that has never left me." Francois Rochon

"I still remember when the book came out in 1989, and I read a review in BusinessWeek. I went out and bought it, and it changed my life forever." Francisco Garcia Parames


"One of the great investors I've tried to learn from is Shelby Davis." Thomas Gayner

“When John Rothchild combines history and biography with investing in one package, history illuminates the biography and investing, biography illuminates the history and investing, and investing illuminates the history and biography. This is a sparkling book on each level, but even more so as an adroitly mixed cocktail of all three.” Peter Bernstein


“Joel Greenblatt wrote probably the best book ever ’You can be a Stock Market Genius.” Dan Loeb

"Joel Greenblatt's 'You Can be a Stock Market Genius' is tactical and includes some very specific and interesting strategies." Seth Klarman

"Joel Greenblatt’s How to be a Stock Market Genius is required reading for all new Third Point employees. On the topic of spin-offs, Greenblatt writes: “When a business and its management are freed from a large corporate parent, pent-up entrepreneurial forces are unleashed. The combination of accountability, responsibility and more direct incentives take their natural course.”  Dan Loeb


"Poor Charlie’s Almanac - I rate that as the best book I’ve ever read. If your looking for one book, Poor Charlie’s Almanac is loaded with a lot of wisdom. If you spend some time on that book, it’s pretty much all the wisdom picked up in 82 years of living, so there’s a lot of it digested and condensed in that book.” Mohnish Pabrai

"Another book that should be in the hall of fame is Poor Charlie’s Almanac by Peter D. Kaufman. This book is about Charlie Munger, the long-term business partner of Warren Buffett. This great book goes well beyond the field of finance and into philosophy and life values. It highlights the extraordinary mind of Charlie Munger, and I can guarantee hours of fun." Francois Rochon


“And then I read The Alchemy of Finance because I’d heard about this guy Soros. And when I read The Alchemy of Finance, I understood very quickly that he was already employing an advanced version of the philosophy I was developing in my fund.” Stanley Druckenmiller

"There are a few books - really not that many which I believe are indispensable reading for every serious investor in whatever facet of investment practice they may favour - The Alchemy of Finance." Peter Cundill

"The Alchemy joins Reminiscences of a Stock Operator as a timeless instructional guide to the marketplace." Paul Tudor Jones


"I am an eager reader of whatever Phil has to say, and I recommend him to you." Warren Buffett

"I owe a lot to Mr Fisher. He wrote books out of pure altruism (he was already wealthy at that time) to simply share his experience with us. I thanked him then and I thank him again. Giverny Capital owes a part of its existence to him." Francois Rochon

"I sought out Phil Fisher after reading his 'Common Stocks and Uncommon Profits'. When I met him, I was impressed by the man and his ideas. A thorough understanding of a business, by using Phil's techniques … enables one to make intelligent investment commitments." Warren Buffett

"I always like it when someone attractive to me agrees with me, so I have fond memories of Phil Fisher." Charlie Munger

"The late Philip Fisher wrote several books that are very good [including] Common Stocks and Uncommon Profits." A Van Den Berg

"A book that ranks behind only 'The Intelligent Investor' and 'Security Analysis' in the all-time best list for the serious investor." Warren Buffett

SO FAR, SO GOOD: THE FIRST 94 YEARS, By Roy Neuberger.

"Roy never fails to amuse and enlighten. Over the years, he's taught me many things I didn't know I didn't know." Jim Rogers

"I sometimes reread older books like “So Far, So Good - the First 94 Years,” written by Roy Neuberger in 1997. It always fascinates me how things are basically the same on Wall Street. Sound principles do not change. And so is human nature towards money and markets." Francois Rochon

FOOLED BY RANDOMNESS, By Nassim Nicholas Taleb.

"Fooled by Randomness - I consider it one of the most important books an investor can read." Howard Marks

"Fooled by Randomness is a serious, intellectually sophisticated book, well worth reading carefully. At times, the book is condescending as though the author had discovered the holy grail of investing. There ain't no holy grail, and the cosmopolitan tone can be somewhat off-putting. Nevertheless, there are some great insights." Barton Biggs

INFLUENCE, By Robert Cialdini.

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

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

"There are a couple of valuable resources when it comes to behavioral biases: Cialdini's work on the influence of psychology in human decisions and Charlie Munger’s speech on the “Psychology of Human Misjudgment.” Christopher Begg


"For many years I've enjoyed reading Frank Martin's letters. This collection contains much investment wisdom and, just as important, sets a standard for advisor-client relationship." Warren Buffett

"What a unique opportunity to traverse the Bubble and post-Bubble years with Frank Martin, exactly as he described them to his clients in real time. Here is market history from the disciplined perspective of a value investor, as he wrestles with the financial beast. Speculative Contagion is sure to enlighten aspiring value investors for years to come." Seth Klarman


“Daniel Kahneman, a psychologist who won the Nobel Prize in Economic Sciences for his work that challenged a rational model of judgement and decision-making, recently published a remarkable account of his intellectual journey; Thinking Fast and Slow.” Seth Klarman

“I just read Daniel Kahneman’s Thinking, Fast and Slow, and I think that he and the late Amos Tversky are some of the great behavioural scientists. Since nobody in our industry thinks about this very much, I think about it a lot.” Frank Martin

"Daniel Kahneman’s books should be read." Charles de Vaulx


"It is a textbook for trading. I hand a copy to every new trader we have." Paul Tudor Jones

“When I was 17 I was backpacking across Europe. I was in Rome and had run out of books to reads. I went to a local open market where there was a book vendor, and literally, the only book they had in English was Reminiscences of a Stock Operator. It was an old tattered copy. I still have it. It’s the only possession in the world I care about. The book is amazing. It brought everything in my life together.” Colm O’Shea

“As the book states very early on, there is nothing new under the sun in the art of speculation, and everything that was said then completely applies to the markets of today. My guess is that the same will hold true for time eternal as long as man’s basic emotions remain intact.” Paul Tudor Jones

“The finest trading book ever written is Reminiscences of a Stock Operator by Edwin LeFevre. This book is not a “how I made a billion in the stock market” nauseating ego trip or self-serving fiction. Instead it is colloquial reminiscences by a legendary speculator of the mistakes and lessons he learned over a trading lifetime.” Barton Biggs.

“Reminiscence of a Stock Operator is a book that up until a couple of years ago I read every year because it is such a great lesson in psychology, how psychology works through the markets and how markets behave.” Bill Miller

“Everyone had to read, because its such great history, Edwin Lefevre’s Reminiscences of a Stock Operator.” Dan Loeb

"My favourite book on investing is Reminiscences of a Stock Operator. It was first published in 1923, and is filled with the jargon of the day, so you have to learn the language. But once you do, it is a fascinating book about trading and speculation. You realize that nothing has changed. Everything is the same. Even though the markets are global today, and there is so much more regulation, it is still just speculation and human nature." Jeffrey Gundlach

THE OUTSIDERS, By William Thorndike.

"An outstanding book about CEO's who excelled at capital allocation." Warren Buffett

“A book like the Outsiders is a good example of what I like to read. It uses eight case studies to illustrate how unconventional managers can make a huge difference in creating per share value for shareholders." Wally Weitz

"The Outsiders is a terrific book by William Thorndike that profiles eight cases of terrific CEOs and their “radically rational blueprint for success." The book highlights the importance of capital allocation and should be a benefit to both investors and executives." Francois Rochon

THE MONEY GAME, By Adam Smith.

“For a magnificent account of the current financial scene, you should hurry out and get a copy of “The Money Game” by Adam Smith. It is loaded with insights and supreme wit.” Warren Buffett

"One of the great books about investing is Adam Smith's 'The Money Game' which was published in 1967." Barton Biggs

These are merely some of the recommended books from the Investment Masters. Thousands of books exist out there, each with their own piece of wisdom. So let's get reading! Which books are on your recommended list for 2018?


Further Reading: The Top 12 Investment Books

Betting Against America?

In the history of mankind, no single nation has developed, grown and innovated like the United States of America. No other country on Earth can boast what they have achieved; either over long or short time spans, through good times and adverse, war and prosperity, no other empire, kingdom or republic has been able to match their level of industrious activity or ingenuity. And in more modern times this phenomenon has only been exacerbated.

Its an amazing story if you look back at it. A civil war, two world wars and other conflicts, political upheavals, corporate scandals, energy crises, and a plethora of asset bubbles; despite all of this and more, American industry has prospered and the US equity market has delivered attractive long-term returns. 

"One US dollar in stocks, after discounting for inflation, experienced an appreciation of 1 million times the original value over the past 200 years! Its value today would be 1.03MN US dollars. Even the remainder of this number is bigger than the return on every other class of assets." Li Lu

   Source: ‘The Prospect of Value Investing in China’, Li Lu,  2015.

Source: ‘The Prospect of Value Investing in China’, Li Lu,  2015.

Of course, its nice to be able to view historical data on a market going back 200 years. The opportunity to review historical performance on that scale doesn't come about that often. But remember, history aside, investing involves outlaying money today in the expectation you will receive more back in the future. And whilst it's true that the stock market has delivered attractive returns in the past, as an investor your returns are determined by the future, not the past. If you think the future will be less prosperous than today, it follows that stock market returns are likely to be less favourable also. So in addition to studying the past, having a general view on what the future might look like is an important foundation for investment. The Investment Master, Li Lu, summed it up nicely...

"In order to understand stock performance in the past 200 years, and the next 20 years, we must be able to understand and explain the basic trajectory of human civilization. Otherwise, it will be hard for us to remain rational when a stock market crash occurs. We will think the world is coming to an end whenever we encounter a crisis similar to that of 2008 and 2009. Predicting the future lies at the heart of investing." Li Lu

The theme of the latest Time magazine, edited by Bill Gates, focuses on the fact the world is getting better. Much better. In the present day we are blessed by an unprecedented level of peaceful co-existence, prosperity and health. 

"All families in my upper middle-class neighborhood regularly enjoy a living standard better than that achieved by John D. Rockefeller Sr. at the time of my birth. His unparalleled fortune couldn’t buy what we now take for granted, whether the field is – to name just a few – transportation, entertainment, communication or medical services. Rockefeller certainly had power and fame; he could not, however, live as well as my neighbors now do." Warren Buffett

Yet despite the growth and prosperity available to us now, people today remain pessimistic. But why? If ingenuity and innovation have delivered prosperity and longer life spans for example, why is it that we can only see the bad? The answer is that we are surrounded by drama. And I mean totally surrounded. You cannot pick up a newspaper, turn on the news, watch a TV show or talk with other people these days without regularly hearing the bad stuff that happens in the world. Microsoft's Bill Gates noted the media's tendency to focus on the negatives.

"So why does it feel like the world is in decline? I think it is partly the nature of news coverage. Bad news arrives as drama, while good news is incremental—and not usually deemed newsworthy. A video of a building on fire generates lots of views, but not many people would click on the headline “Fewer buildings burned down this year.” It’s human nature to zero in on threats: evolution wired us to worry about the animals that want to eat us." Bill Gates

As Gates recognises, in the first instance humans have evolved to feel fear above any other emotion; it's all about survival.. 'noise in the bush, you better run or risk being eaten by a tiger.'

Humans have also evolved to think visually, not in numbers. We are wired to believe more in a story than we are in statistics. Stories carry much more impact, negative stories even more so. Steven Pinker, an American cognitive psychologist and linguist also points out... 

“You can’t get an accurate picture of the world by looking at media headlines. The headlines are about things that happen, they’re not about things that don’t happen. As long as the rate of violence hasn’t fallen to zero, there are always going to be enough violent instances to fill the news. And we can lose sight of the vast amounts of the world that are at peace.”

The latest Time edition contains an article entitled, 'Warren Buffett Shares the Secrets to Wealth in America.'  Buffett has long espoused the dangers of betting against America. He's not alone. Throughout time, many of the Investment Masters have recognized the same dangers.

"America is America and it’s always wrong to bet against her.” Barton Biggs

"You don't see any Fifth Avenue mansions built by bears." Bernard Baruch

"Who has ever benefited during the past 238 years by betting against America? If you compare our country’s present condition to that existing in 1776, you have to rub your eyes in wonder. In my lifetime alone, real per-capita U.S. output has sextupled. My parents could not have dreamed in 1930 of the world their son would see." Warren Buffett

"One of the things I think that's really important is we should never underestimate the resilience of the US economy. It's very powerful. And no matter how much the politicians try and screw it up, there's an underlying strength there. And I never want to bet against that." David Swenson

“The American spirit is a factor which no quantitative model can properly account for, yet it has been such an important factor throughout our history. My closing comments today are that in the midst of all our problems; do not underestimate the American people.Charles Akre 2009

And despite the negativity that abounds today, over the last few hundred years America has experienced a growth rate unprecedented in the history of mankind.

“It is important to remember, the American system is a six-sigma event like the world has never seen. In the last 100 years America has enjoyed a 7-fold increase in productivity – unprecedented in modern history. What is new and cutting edge in one’s youth is outdated and obsolete by the time one reaches middle age, if not sooner – a development that was unheard of before the mid 1800’s." Allan Mecham

"When we examine the past 200 years, we see a continuous upward trajectory [in US GDP]. If we take a year as the unit of measurement, GDP grew almost every year. This is real, long-term, cumulative and compounding growth... The economic pattern of sustained, long-term compounding growth is a modern phenomenon, which had never previously occurred in the recorded human history of the past 16,000 years." Li Lu

In many ways, the characteristics that make a great country are the same characteristics that define successful companies and investors. After all, a large company is essentially a small society. In previous blogs we've recognised those parallels that exist between great businesses and great investors. And given this, it's worth spending some time understanding how America evolved from an agrarian society to a flourishing modern economy.

It started with free trade and specialization.

"The division of labor is responsible for the world's greatly increased standard of living, despite its huge population growth." Charles Koch

“So long as human exchange and specialisation are allowed to thrive somewhere, then culture evolves whether leaders help it or hinder it, and the result is that prosperity spreads, technology progresses, poverty declines, disease retreats, fecundity falls, happiness increases, violence atrophies, freedom grows, knowledge flourishes, the environment improves and wilderness expands.” Matt Ridley

“It is irrefutable that billions of people around the world, including most Americans, have benefitted from the massive increases in global trade over decades. An ever expanding upward spiral of innovation, entrepreneurship, production, exports, imports and exchange of goods and services has produced massive accretions of wealth, together with billions of new consumers, producers and increasingly skilled workers” Paul Singer

In addition, America benefited from knowledge sharing. 

"In the age of the modern civilisation, the value created by the division of labor and by exchange is further increased because human knowledge can be accumulated. Compared to goods and services, human knowledge is easier to accumulate. Exchanges of ideas often result in a 1+1>4 equation. When different ideas are exchanged, the parties not only retain their own ideas, they also obtain the ideas of others. Moreover, sparks can fly during exchanges, creating entirely new ideas. When ideas are having sex with each other, they become very productive." Li Lu

The US Declaration of Independence provided a constitutional and limited government, whose fundamental goal was to protect property rights and whose legitimacy came from empowerment by the people.

“This country is unique. Why is this country unique? For many different reasons. We have a Constitution put together in a four month period of time by 55 white males who came to Philadelphia. While the constitution has had 27 amendments or so, it has stood the test of time, and over 240 years has become a role model as a way of government to work as it has problems. It has been a stable government and been an incredible opportunity." David Rubenstein

The American Constitution led to political unification; it set the framework for a large unified population. Prior to this, it was medieval China that had led the world in technology, with a long list of major technological firsts including cast iron, the compass, gun powder, paper, and printing. But it lost that position. Jared Diamond, in 'Guns, Germs and Steel,’ posits that once China unified in 221 BC, “No other independent state ever had a chance of arising and persisting for long in China”. However China’s connectedness eventually became a disadvantage, because a major decision by one despot could, and repeatedly did, halt innovation.

This was in contrast to Europe which resisted unification by determined conquerors such as Charlemagne, Napoleon and Hitler. Jared Diamond notes, “even the Roman Empire at its peak never controlled more than half of Europe’s area.”  While “Europe’s geographic balkanisation resulted in dozens or hundreds of independent, competing statelets and centres of innovation. If one state did not pursue some particular innovation, another did, forcing neighbouring states to do likewise or else be conquered or left economically behind. Europe’s barriers were sufficient to prevent political unification, but insufficient to halt the spread of technology and ideas.”

The constitution's design was intended to expand and maintain order in the free market, provide freedom of speech, safeguard individual liberties and protects business interests. 

“[Throughout history] a large, interconnected population meant faster cumulative invention – a surprising truth even to this day, as Hong Kong and Manhattan islands demonstrate.” Matt Ridley

“An open economy always delivers a more prosperous future. This has been one of America’s chief advantages for several centuries.” Michael Mandel

"Societies are most prosperous when knowledge is most plentiful, accessible, relevant, and inexpensive. These conditions are best bought about by freedom of speech and association, and trade based on mutual gain." Charles Koch

America also offered the prospect of wealth and a new beginning to immigrants. America was unencumbered by social classes, operated with a common language and had an incentive system based on meritocracy.

"America is the great equalizer. You can come from nothing, you can come with no pedigree, you can be the son or daughter of immigrants, and you have the opportunity to be successful. There's no other country that doesn't require some kind of birth heritage, or inheritance, or ingrown advantage. Here, everybody has a shot at being the lead dog." Sam Zell

"America's strengths include [the fact it is a] society that attracts talent from around the world and assimilates them comfortably as Americans; and a language that is the equivalent of an open system that is clearly the lingua franca of the leaders in science, technology, invention, business, education, diplomacy and those who rise to the top of their own societies around the world." Lee Kuan Yew

"Another thing that is unique is we had a melting pot; the country has welcomed people from all over the world and many people have bought different talents. There has also been a sense you can rise from the bottom. Now there is a problem today in income inequality and social mobility, maybe its getting worse. But there is no doubt the American dream is one I believed in. You can, in this country, make a difference. Your life outcome isn’t determined by who you were born to, but what you do on your own merits. No doubt you have a chance to rise up." David Rubenstein

America's open society drives an entrepreneurial culture of risk taking, is accepting of failure, leading to creativity and innovation. Characteristics necessary for companies to succeed also. 

"America loves the entrepreneur who failed. I kid you not. Because they will back that person again in a heartbeat. And it’s one of the great things about America; you can fail in America time and time again; it’s a country that forgives. And each time you go through a failure, there’s a valuable life experience you will carry your entire life. I remember some of the early things I did at Citadel where abysmal failures.Ken Griffin

"America's asset is, simply risk taking and the use of optionality, this remarkable ability to engage in rational forms of trial and error, with no comparative shame in failing, starting again, and repeating failure.  In modern Japan, by contrast, shame comes with failure, which causes people to hide risks under the rug, financial or nuclear, making small benefits while sitting on dynamite, an attitude that strangely contrasts with their traditional respect for fallen heroes and the so-called nobility of failure."  Nicholas Nassim Taleb

"What has made the U.S. economy pre-eminent is its entrepreneurial culture. Entrepreneurs and investors alike see risk and failure as natural and necessary for success. When they fail, they pick themselves up and start afresh. The Europeans and the Japanese now have the task of adopting these practices to increase their efficiency and competitiveness. But many American practices go against the grain of the more comfortable and communitarian cultural systems of their own societies - the Japanese with life-long employment for their workers, the Germans with their unions having a say in management under co-determination, and the French with their government supporting the right of unions to pressure business from retrenching, by requiring large compensation to be paid to laid-off workers." Lee Kuan Yew

“It is the ever increasing exchange of ideas that causes the ever-increasing rate of innovation in the modern world.” Matt Ridley

"The wealth of this country over the last 240 years is due to the economic wealth created by entrepreneurs, businesses, skills and talents that have come together to create the envy of the world in various parts of our country - Silicon Valley and Wall Street.” David Rubenstein

And the future looks bright. The characteristics that contributed to the America's success remain it's competitive advantage.

"The US has endured all kinds of difficulties in the past and ultimately prospered – I believe the future will be similar." Allan Mecham

"Human potential is far from exhausted, and the American system for unleashing that potential – a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War – remains alive and effective." Warren Buffett

"The dynamism embedded in our market economy will continue to work its magic. Gains won’t come in a smooth or uninterrupted manner; they never have. And we will regularly grumble about our government. But, most assuredly, America’s best days lie ahead." Warren Buffett

With the advent and broad-scale adoption of the internet, America and the world are on the cusp of a potential massive leap in productive potential. The world has never been so connected.

“Human cultural progress is a collective enterprise and it needs a dense collective brain.Matt Ridley

“The secret of the modern world is its gigantic inter-connectedness.” Matt Ridley

“Every generation has perceived the limits of growth that finite resources and undesirable side effects would pose if no new recipes or ideas were discovered. And every generation has under-estimated the potential for finding new recipes and ideas. We consistently fail to grasp how many ideas remain to be discovered. Paul Romer

“There is not even a theoretical possibility of exhausting the supply of ideas, discoveries and inventions. This is the biggest cause for all my optimism.” Matt Ridley

“It will be hard to snuff out the flame of innovation because it is such an evolutionary, bottom-up, phenomenon in such a networked world.Matt Ridley

The potential of new technologies is far from exhausted..

"With the arrival of powerful new technologies, we stand on the verge of a productivity boom. Just as networking computers accelerated productivity and growth in the 1990s, innovations in mobility, sensors, analytics, and artificial intelligence promise to quicken the pace of growth and create myriad new opportunities for innovators, entrepreneurs, and consumers." Michael Mandel

While America's best days no doubt lie ahead, foreign governments need to adapt to promote creativity, innovation and productivity. It's little wonder the powerhouses of the last 20 years like Amazon, Facebook and Google have all developed in the US.

“When you have freedom of speech and freedom of expression and don’t get thrown in jail by criticizing a bad idea, it’s more likely bad ideas will get exposed, and it’s not a coincidence oppressive regimes are also oppressive in clamping down on free speech.” Steven Pinker

"Societies with beneficial incentives - those that reward creating the most value in society - have tended to enjoy the greatest and most widespread well-being. Societies with perverse incentives have suffered from waste and corruption, and the vast majority of their citizens have languished in poverty." Charles Koch

“When you have ideas being brought together and people debating them and arguing over them, bad ideas tend to get filtered out.” Steven Pinker

"China will inevitably catch up to the US in absolute GDP. But its creativity may never match America's, because its culture does not permit a free exchange and contest of ideas. How else to explain how a country with four times as many people as America and presumably four times as many talented people not come up with technological breakthroughs?" Lee Kuan Yew

“A nationalised industry stagnates: monopoly rewards caution and discourages experiment, the income is gradually captured by the interests of the producers at the expense of the interests of consumers and so on. The list of innovations achieved by the pharaohs is as thin as the list of innovations achieved by British Rail or the US Postal Service” Matt Ridley

It's little wonder, most of the Investment Masters either don't short or they run long-biased portfolios. They also focus on stocks, not bonds [That's a post for another time!].

"We're always long. You guys should know one thing: the markets go up over time.  If you try to play the short game at the wrong time, you'll lose money. You don't want to be short markets over a long period of time" Craig Effron

"The 9.5% long term upward bias of the stock market is one reason that shorting stocks generally is a bad business." Ed Wachenheim

"[We] maintain net long exposure typically between 30% and 60%.…. Shorting is more challenging for several reasons, one of which is that the market tends to appreciate over time." Lee Ainslee

“In practice, we have more long exposure than short exposure... the market tends to rise over time and we wish to participate.  It is psychologically challenging to manage a portfolio that outperforms only a falling market, I have no desire to spend my life hoping for a market crash”  David Einhorn

"The economy overall has been really growing at a compounding rate for 200-300 years, ever since the modern science technology era. So, naturally, the economic trend favors long positions rather than short." Li Lu

“We are always long-biased, such that our long exposure is typically at least three times our short exposure." Zeke Ashton

So why is betting against America likely to prove a dumb trade?

Despite every adverse conditions that have been thrown at it, America always seems to bounce back. Like the veritable Phoenix from the ashes, it rises again and again and again. If you can sift through all the drama and negativity you will only see the industriousness and innovation that is the hallmark of the country's success. With over 200 years of outstanding performance, and the best years yet to come, it is hard to even contemplate placing a long term bet against those odds. 



Further Reading:
The Rational Optimist - How Prosperity Evolves - Matt Ridley
Guns, Germs & Steel - The Fates of Human Societies - Jared Diamond
A Discussion on Modernization - Li Lu
The Prospect of Value Investing in China - Li Lu
Media and The Market - Mastersinvest
The Coming Productivity Boom - Michael Mandel/Bret Swanson


Connecting the Dots

   'Munger' by  James Cochran

'Munger' by James Cochran

Creative challenges are something we all face from an early age. Whether its learning to colour-in between the lines, or discovering that art work belongs on paper rather than on your parents' walls, being creative as a kid allows us to develop our skills at the same time as having fun.

One of the first real creative challenges we face as children is the Connect the Dots exercise. This is the first time we are forced to integrate a number of concepts at the same time - visual, numerical and conceptual. We are required to follow a numerical sequence, draw straight lines with a degree of accuracy and skill and somehow also believe that once complete we will have created something we would never have been able to draw on our own. "Look at me dad! I drew a bird!"

As we get older, our need to integrate different disciplines simultaneously becomes more common in our daily lives, and never more so than in Investment. Often we are faced with disparate information, incomplete data, only parts of the puzzle rather than the whole, or hints and innuendo rather than verifiable fact, and then are required to make important investment decisions where the downside if we get it wrong can be quite painful.

"Investing invariable requires making judgements with incomplete or often inaccurate data" Michael Steinhardt

"The stock market is a game of imperfect information and even resembles bridge in that both have their deceptions" Ed Thorp

Even the great Investment Masters see this as one of the most important attributes for success. The ability to gather a wide range of abstract informational pieces, and then string them together to identify a trend or investment opportunity is invaluable if you want to remain ahead of the game.

"Over the years I have spent a great deal of time pouring a lot of stuff into my head. It is all part of a big, three-dimensional puzzle that is always changing."  Jim Rogers

I find that quite often my best ideas, or the most valuable opportunities I can identify, come from a variety of sources which I need to integrate. It could be things I have read, heard, listened to or saw; all of it is important when gathering context for my investing. I read extensively; even Warren Buffett digests over 500 pages of information a week. As human beings we can't know it all, and only through a constant thirst for information and learning can we achieve something valuable in this arena.

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

"I combine lots of information coming at me from all directions" Steve Cohen

"It is important to know that idea generation comes from having a consistent understanding of the world and synchronizing it will all the information you have accumulated. It is a disciplined process, and the sooner you begin this exercise, the more prepared you will be when opportunities arise. Ideas are not generated simply by waking up one day and saying, "Let's look for an idea!" They require the accumulation of investment experience and the desire to learn over time." Francisco Garcia Parames

“Tremendous insight is built from intense curiosity and study for your whole life.” Li Lu

As I have said before, rarely will the information be presented in a form which is easily understandable. All the pieces are abstract, and taken by themselves mean very little. It only makes sense when they are corralled in a manner which allows you to truly see.

"As Thoreau said, "It's not what you look at that matters, it's what you see." Warren Buffett

"Visionaries are not people who see things that are not there, but who see things that others do not. As Einstein quipped, "Why do some people see the unseen?" Bennett Goodspeed

"You really have to keep your eyes open" Peter Lynch

I look at the market as a great big puzzle, and every day I try to solve another aspect of it to make a difference and add value to my investment activities. Others look at it in similar fashion, but all agree its not something that can be easily understood - it needs research and analysis and curiosity before we get to the solutions.

"For me, market analysis is like a tremendous multi-dimensional chess board. The pleasure is purely intellectual." Bruce Kovner

“I tried to understand the market as it was a puzzle, not with a presupposition of 'this is what it is.”  John Burbank

"The money game is played in the third and fourth dimension." Barton Biggs

"I enjoyed using mathematics to solve certain interesting puzzles, which I found first in the world of gambling, then in the world of investing. Making money confirmed my theories by showing that they worked in the real world." Ed Thorp

"We view investments as puzzles. There are a few things you can know but they are not the most important things as everybody knows them. The most important thing is what is it you can infer and how good you are at assessing a possible range of outcomes, either the known unknowns and the unknown unknowns and how you can construct that into a portfolio." David Einhorn

"It‘s an intellectual puzzle with partial information. The process is messy and imprecise." Howard Marks

Information has become more readily available these days, and one of the issues with that is that everyone has access to the same material. So how do you differentiate? How do you take that same information and turn it into investment gold? Through curiousity and imagination. First by being interested enough to look for the information, and then imaginative enough to turn it into something so different that its valuable.

The biggest challenge in today’s world is that knowledge has increasingly become a commodity. How do you find that kernel of information, that anomaly that enables you to generate alpha?  When I began in the business, a Quotron provided market quotes on screen as opposed to the ‘tape,’ and enabled the aggregation of portfolios. These were advantages. Bloomberg has very deep analytical tools available. Today most people have a smartphone and can access masses of information and analysis. The key is to be able to place knowledge in context and to have imagination and judgement to gain insight. Clearly, you then need to construct an investment, trade it and then risk manage it.” Michael Hintze

"I believe that being a stock market investor is a lifestyle. A capitalist’s antennas must always be tuned and receptive. Being interested and passionate about the business world provides a continuous source of new ideas, while staying in front of your computer or a Bloomberg Terminal is not enough. You learn much more in movie houses, in restaurants, in shopping centres and even by going to a library." Francois Rochon

And ideas are hard to come by. Even though information is readily available, those great ideas remain like hens' teeth to most of us. Most of the ideas that the Investment Masters come up with spring from sometimes unexpected sources. Constant searching, reading, learning, talking and listening are all invaluable for providing the springboard to innovation and imagination.

“You can never tell from where an idea will spring, whether from an ancient historian, an art critic, an economist, a journalist or even a politician.” Leon Levy

Ideas come to me from all sources, principally from reading and talking.  I don’t discriminate how they come, as long as they are good ideas. You can recognize good ideas by reading a great deal and also by studying a lot of companies and constantly learning from intelligent people – hopefully more intelligent than you, especially in their field. I try to read as much as I can.”  Li Lu

"Our game is to recognise a big idea when it comes along, when one doesn't come along very often.  Opportunity comes to the prepared mind."  Charlie Munger

"Our ideas come from reading newspapers, books, magazines, analyst reports, and even our competitors' investment holdings. We also frequently brainstorm with people from different industries." Francisco Garcia Parames

"Where do we find our investment ideas? There’s no one answer to that. It comes down to reading, a lot of reading, be it SEC filings, conference-call transcripts, Street research and a variety of industry publications. Our network of professional contacts also serves as a good source for new ideas, and clients even have contributed some of the better names that we’ve come out with. So when people ask where we get these ideas, I don’t have one answer because they come from all different places." Chris Mittleman

"The way you find things to buy low and sell high is to look for unrecognised or undiscovered concepts or changes" Jim Rogers

"The further you look for ideas the greater the chance you will see a unique idea.”  Jim Chanos

Like Buffett and Munger, and Da Vinci before them, being versatile in your knowledge and thinking disciplines create more opportunities. 

True creativity and imagination is very rare, which is why the world is full of mediocre investors, while only a few truly great Investment Masters exist. It is vital to seek information, and to continue to seek it, and then integrate that knowledge using multi-disciplinary skills. Its not enough to know a lot about finance and investment; you need to know about the businesses and industries you are investing in as well. Having a variety of sources that provide you with information on a regular basis is important, too, as is the imagination to pull it all together. Only then will you be connecting the dots and revealing your truly creative potential.


Learning from Leonardo

And that's Da Vinci, not DiCaprio, although I'm sure many believe the latter to be a master of his craft as well. Leonardo Da Vinci has long been recognised as a genius across many modalities, not only in his art. In his life he was also an inventor, philosopher, architect, sculptor, engineer, scientist, astronomer, writer and mathematician, and all of that with little formal education behind him. What drove him to success in all these fields was one simple trait - curiousity.

Charlie Munger has long espoused the benefits of making friends with the eminent dead. He's an avid reader, affectionately characterised by his own children as a 'book with a couple of legs sticking out.' Charlie has spent a lifetime learning lessons from history's storied intellectual powerhouses. 

As arguably the greatest Investing Mind of the last century, I've taken a leaf out of Charlie's book and picked up biographies on some of his heroes over the last year including Lee Kuan Yew, Albert Einstein and Charles Darwin. In a similar fashion to the commonalities between the Investment Masters, I've recognised many commonalities that run through the habits, traits and character of these Intellectual Masters.

Having just put down Walter Isaacson's wonderful biography on Albert Einstein, the recent news of the record breaking $450m sale of Leonardo Da Vinci's 'Salvator Mundi' painting prompted me to start Isaacson's latest tome, 'Leonardo Da Vinci'. A truly beautiful book that gave me a momentous appreciation for Da Vinci's ground-breaking discoveries, and allowed me to look at not only his masterpieces such as the Mona Lisa and Salvator Mundi, but nature for that matter, in a completely new light.

Isaacson was drawn to Da Vinci as the ultimate example of the main thematic of his previous biographies, many of which, coincidentally are heroes of Charlie Munger - Einstein, Lincoln and Newton. Isaacson describes that thematic as "How the ability to make connections across disciplines - arts and sciences, humanities and technology - is a key to innovation, imagination, and genius."  

What distinguished Leonardo's genius was its universal nature. Like Einstein, Leonardo was better at visualisations than equations. While the world has produced other thinkers who were more profound or logical, and many who were more practical, there have been none as creative in so many different fields. Some people are geniuses in a particular arena, such as Mozart in music and Euler in math, but Leonardo's brilliance spanned multiple disciplines. Leonardo had a profound feel for nature's patterns and cross currents.

Many of histories greatest thinkers draw on diverse disciplines to make creative leaps that lead to innovative breakthroughs. Of all the Investment Masters I've studied, it's Charlie Munger who is the most vocal advocate of developing a mutli-disciplinary mindset.

It was Leonardo's love of learning and his intense, relentless and insatiable curiosity that led to many of his ground-breaking discoveries, inventions and innovations. Many of which were hundreds and hundreds of years ahead of their time and in some cases 500 years!  Isaacson noted that "by allowing himself to be driven by intense curiosity, he got to explore more horizons and see more connections than anyone else of his era."

Leonardo constantly asked why, why, why? He had a child-like sense of wonder. He sought knowledge from others and delved incredibly deeply into subjects and experiments in a quest to find answers. Whether it was answers to the body and movement of water, the mechanics of the human heart and body, the motion of the planets or to discover why birds fly, or how the human eye perceives light and distant images, or why fossils are found on mountains, his quest for knowledge was extraordinary.

Likewise, the Investment Masters are driven by curiosity. 

"You want to have a curiosity about business." Warren Buffett

Curiosity is the engine of civilisation.  If I were to elaborate it would be to say read, read, read and don’t forget to talk to people, really talk, listening with attention and having conversations, on whatever topic, that are an exchange of thoughts. Keep the reading broad, beyond just the professional.” Peter Cundill

“Most of your time being a value investor is as an academic, a researcher, a journalist actually, to have insatiable curiosity and try and figure out how just about everything works. Because in investing the more you know the better off you are.” Li Lu

“I’m curious; I want to know how things work" Seth Klarman

"A few major opportunities, clearly recognisable as such, will usually come to one who continuously searches and waits, with a curious mind, loving diagnosis involving multiple variables." Charlie Munger

 Leonardo's $450m 'Salvator Mundi'

Leonardo's $450m 'Salvator Mundi'

Isaacson noted Da Vinci's "willingness to challenge received wisdom would lead him to craft an empirical approach for understanding nature that foreshadowed the scientific method developed more than century later... His method was rooted in experiment, curiosity, and the ability to marvel at phenomena that the rest of us rarely pause to ponder after we've outgrown our wonder years". Charles Darwin's autobiography similarly noted "I think that I am superior to the common run of men in noticing things which easily escape attention, and in observing them carefully."

Isaacson noted Leonardo's acuteness of his observational skill was not some superpower he possessed. Instead it was a product of his own effort. 

Leonardo drew on diverse disciplines seeking to understand and explain natural phenomena.. "Analogies and spotting patterns became for him a rudimentary method of theorizing".

Like Charles Darwin, Leonardo had an instinct for keeping records, "jotting down observations, lists, ideas and sketches came naturally. He had "a lifelong practice of keeping notebooks on a regular basis." From this emerged his creativity ... "His creativity came from his combinatory imagination." Darwin, too, collected information. He explains in his autobiography "I keep thirty to forty large portfolios, in cabinets with labelled shelves, into which I can at once put a detached reference or memorandum. I have bought many books and at their ends I make an index of all the facts that concern my work; or, if the book is not my own, write out a separate abstract, and of such abstracts I have large drawers full."

In a similar fashion, Buffett consumes masses of information, reading 500 pages per day. It is connecting the disparate information that sometimes provides the insight for a successful investment. Buffett explains "Look, my job is essentially just corralling more and more and more facts and information, and occasionally seeing whether that leads to some action."

Leonardo also read widely. Isaacson wrote that "his appetite for soaking up information from books was voracious and wide-ranging." He also collaborated with others to develop his theories and thoughts. Isaacson explains; "Conceiving ideas was for Leonardo, as it has been throughout history for most other cross-disciplinary thinkers, a collaborative endeavour. In his notebook, we find scores of people with whom he wanted to discuss ideas. The process of bouncing around thoughts and jointly formulating ideas was facilitated by hanging around a Renaissance court like the one in Milan."

Leonardo was a seeker of truth. He was not afraid to challenge conventional wisdom and he used observations to formulate general principles and then used those principles to predict outcomes. Da Vinci's curiosity and deep study led to an intuitive feel for nature... "because of his intuitive feel for the unity of nature, his mind and eye and pen darted across disciplines, sensing connections."

And Leonardo was imaginative. Isaacson recognised that "true creativity involves the ability to combine observation with imagination, thereby blurring the border between reality and fantasy." He recognised painting was both an art and a science. To convey three-dimensional objects on a flat surface, the painter needs to understand perspective and optics. Therefore painting is a creation of the intellect as well as the hands. Leonardo advised young artists that "the mind is stimulated to new inventions by obscure things."

In markets, it's often the accumulation and integration of information from varied sources that leads to investment success. One of my favourite investors, the late Leon Levy explains .. "If intelligence is the ability to integrate, creativity is the ability to integrate information from seemingly unconnected sources, and a measure of both abilities is necessary for long term success in markets."

And Leonardo himself recognised the need to take the time to think. Leonardo once explained to a Duke, who was complaining a painting was not progressing, "Men of lofty genius sometimes accomplish the most when they work the least, for their minds are occupied with their ideas and the perfection of their conceptions, to which they afterwards give form."

Like Charles Darwin, Leonardo was not afraid to change his mind when the facts warranted it. Isaacson noted, "he engaged in a dialogue between theories and experience, and when they conflicted he was receptive to trying a new theory. That willingness to surrender preconceptions was a key to his creativity".

I hope you are starting to notice the common traits that manifest themselves across history's Intellectual and Investment Masters. Each was not afraid to question conventional wisdom, to remain open-minded, to adopt a child-like curiosity, to work hard, to seek wisdom from other disciplines, to learn from others, to challenge ideas and to be willing to admit and learn from mistakes.

We can all learn from Leonardo. As Isaacson observed "Leonardo's genius was a human one, wrought by his own will and ambition. It did not come from being the divine recipient, like Newton or Einstein, of a mind with so much processing power that we mere mortals cannot fathom. Leonardo had almost no schooling and could barely read Latin or do long division. His genius was of a type we can understand, even take lessons from. It was based on skills we can aspire to improve ourselves, such as curiosity and intense observation." 

While you or I will never paint a Mona Lisa, we can look to Leonardo to help us see the world more clearly and reignite that sense of wonder we all had in our childhood years. We should never stop learning and we should never stop asking why. The word 'why' is one of the most powerful words to have in your vocabulary. Without it, and without its use, we will stagnate, believing we understand all, and that is quite simply absurd when you think about it. Even the greats still ask why, and if they can do it, so should we. And if we do it well, we might even crack the Da Vinci code...



Further Reading:
Ray Dalio - Leonardo's Principles
Broyhill Asset Managment - Bruce Wayne vs Leonardo
How to build a better Investing Mind

Learning from Arthur Blank

It doesn't really seem to matter how many successful businesses I come across; I'm constantly amazed at the synergies that exist in all of them. By now you'll no doubt see the obvious correlations between them all as well, and the really interesting thing about it all is that in each and every one of them, both the ones I have reported on here as well as others we are yet to review, the lessons we take from them are not to be found in academic institutions. 

They don't teach this stuff at universities, or in prestigious MBA programs; all of the individual success components that go together to make up each of these outstanding businesses came from one or two individuals who dared to think and act differently. 

I love learning from people who have built and run successful businesses. Like the Investment Masters, there are many commonalities across great businesses and great business people. As I've written many times before, to understand a stock you must understand the business. One of my favourite podcasts 'How I Built This - with Guy Raz' recently interviewed Arthur Blank, the co-founder of Home Depot, who stepped down as co-Chairman in 2001.

To say Home Depot has been a phenomenal success would be an understatement. Home Depot was founded in 1978 and went public in 1981. One hundred dollars invested in Home Depot in 1981 would be worth approximately $540,000 today versus $2,300 in the S&P500. I came across Home Depot's phenomenal performance reading one of the annual letters of Arlington Value Capitals' Allan Mecham. Mecham noted that despite it's 49X PE multiple in 1984, Home Depot's share price went on to compound at 20%pa over the following 29 years. 

Prior to co-founding Home Depot, Arthur Blank was running Handy Dan with his colleague Bernie Marcus. Handy Dan was the most most successful home improvement chain in the US at the time and the most profitable subsidiary of an ailing conglomerate, Dylan Inc. Despite the subsidiary's success, Blank and his colleague, Bernie Marcus, were fired after a corporate raider, notorious for retrenching company's incumbent senior management, took control of Dylan Inc.

After reflecting on their newfound situation, Blank and Marcus decided to set up their own hardware business. In doing so, they inverted the typical question a start-up might propose - they asked 'who couldn't we compete with?

“I wanted to take my time, as did Bernie, and think through the options we had and didn’t want to rush into anything. I took the better part of the year off, did a lot of running, spent a lot of time with my kids. I was looking at a lot of alternatives. We wanted to think outside the box. Bernie had said ‘If we were ever to leap frog our own business, the Handy Dan home improvement centres, what kind of home improvement centre store could we not compete against?’ We said we could never compete against the big warehouse, no frills, down market, low prices, great service, great services. So instead of taking that Handy Dan model of the Four’s [four million dollars sales, forty percent margin, 40 staff people, etc] we said, 'lets try and leap frog the industry dramatically.'”

Buffett takes a similar approach when he analyses businesses ... "One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it."

In the early days, while establishing the business plan, Blank and Marcus realised that if their start-up was to be successful it was going to come down to them to make it so...

“The reality is the investors in our company, 144 of them. Really what they were buying into were myself and Bernie. We had the experience and they looked back at Handy Dan Home Improvements Centres, and they said we’re betting on people here, we are not betting on one small store.”

The opening day of their first two stores was a crushing disappointment. What led to their actual success was listening to the customer and a lot of trial and error..

“We had this grand opening and nobody came. We spent the next year, and one of our core values is to listen and respond. I spent 75% of my time on the floor of the store finding out from customers what is it they like, didn’t like, and we kept changing the mix, adding things, taking things off, changing prices, assortments and vendors, making sure of service levels in areas they wanted them. We kept refining the model. Every competitor came into our store and visited us said ‘you're crazy, the stores are much too big, prices are much too low, you have way too much product and stock, too many services, the math isn’t going to work." Of course the math wasn’t working in 1979. We fine tuned it and got it where it needed to be. It exploded in 1980 and 1981 and the numbers were incredible.”

In a similar fashion to both Nucor and Koch Industries, which we learnt about recently, one of the most important aspects of the success came from their business culture. Home Depot's was built around helping customers and listening to the people on the front line..

“We never really wrote the core values down … I said to Bernie "we’re living these values which by far and away are the most important thing we can do, but they’re not written down . I figured out you and I are going to open a lot of stores in the future that we’ll actually never see."  There were too many new stores. We needed to document and write down our core values which are really focused on our associates, our people, our relationships and communities, and giving back. The people who are serving drive everything we are doing. Those are the ones that we listen to, those are the ones we respond to, those are the ones we care for, those are the ones we nurture, and that’s the mentality of the training we’ve given to all of our associates.”

They managed growth one store at a time, constantly seeking improvements and empowering their people..

“Sam Walton was asked how did you get from $10b to $20b dollars [in sales]. Sam said we opened one store at a time. And that’s all we did. At Home Depot, we had a one year budget, a 5 year plan, but we focused on every single store and our plan was that each store had to be better than the last store we opened up.  So we didn’t have any planograms, we didn’t have any ‘you have to do it this way’, we didn’t let the model get frozen, we made the folks running the store think about ‘this is the last store, how do I make this store better?', 'how do I own it?', 'how do I feel accountable for it?', 'how do I inject my ideas into, and how do I make it better?'. So every store got better.”

After looking back on his successes, Blank gives valuable advice to young folks: "make sure you have balance in your life, because too many young executives' attitude is to work hard, put my career on 5th gear and go, go, go. When you return home in ten years you won't recognise your kids and your spouse will look at you and say 'who are you again?' It's important to find balance in your life."

He also attributes much of his success to intelligence and hard work, versus luck and timing.

"I think that luck and timing is a big deal. I really do. A lot of success is based on timing and luck and being in the right place. But, also about seizing opportunities and being prepared to go out of your comfort zone. I'm a big proponent of Outward Bound; I've done a lot of the course myself. A lot of it is based on their strategy which is to serve, to strive and not to yield. Having that entrepreneurial drive and spirit, to get up every day, to have purpose in your life everyday, to become better every day. I am doing this because I have a passion for doing it and I love being of service to other people in whatever form I can be."

Its clear that innovative thinking, learning from your mistakes, loving what you do, continuous self-improvement, effective culture, listening and humility are common threads for both successful businesses and investors. We've certainly written about these things often enough. Luck has very little to do with it, as does the formulaic approach to operating businesses that we are taught within academic institutions. Success is created through hard work and daring to be different. Easy wins are exactly that, easy; meaning that the expected returns should be commensurately low. Even Home Depot took several years to show the right returns and in those early years the 'nay sayers' were everywhere. The British SAS got it right with their motto; "Who dares wins."


Learning From David Einhorn


David Einhorn, the President of Greenlight Capital, has one of the best long term investment track records on the street. From inception in May 1996 to the end of 2016, Greenlight Capital compounded at 16.1% pa net, significantly outperforming the S&P500.  

David is a value investor, but unlike your typical value investor, David takes the traditional value investor’s process and inverts it ... "The traditional value investor asks “Is this cheap?” and then “Why is it cheap?” We start by identifying a reason something might be mis-priced, and then if we find a reason why something is likely mis-priced, then we make a determination whether it’s cheap." Oftentimes there will be a short term structural reason for the cheapness - a special situation such as a merger, a spin-off, a debt issue or significant complexity or uncertainty etc - that is creating an opportunity.  

I enjoyed a recent rare interview with David at the Oxford Union Society. In a similar fashion to inverting the typical value investor's process, David also inverts the natural tendency for investors to think they're right when a position moves against them. I enjoyed hearing David articulate how his natural presumption when a stock goes against him is not that 'he's right', but that 'he's missed something'.  A useful mindset to help overcome confirmation bias.  

David discusses the similarities between poker and investing, why he's maintained his short basket despite his reticence to short stocks solely on valuation and the cultural and behavioural keys to successful investing. 

I've included some of my favourite quotes below [Please click on the links to see the Investment Masters insights into those topics]


“I love it. I love trying to solve puzzles. I love trying to find investments. I love trying to figure out what it is that is motivating a situation where we have a difference of opinion”


“If I had to pick one reason [for Greenlight's success] it’s critical thinking skills. It’s the ability to look at a situation and see it for what it is, which isn’t necessarily what is presented to you. When something doesn’t make sense, question it, challenge it, look at from a different way and you often come to the opposite conclusion. You don’t have to do that very often. Most of the time when someone tells you something, it makes sense, but sometimes it really doesn’t make sense and there is another side to it. When you can come to a view, maybe just a few times a year, where you have an important difference of opinion with what everybody else is thinking about a particular situation and you can figure it out and it’s important, we’ve been able to make a small number of large investments that the vast majority of the time have worked out very well. [It’s] because we really have had an important difference of opinion between what we think and whoever is on the other side of the transaction ”

CultureHumility & Change

“The culture of the firm is a lot of smart nice people.  I think we interact well, there is a lot of humility. People respect one another, they respect one another’s views. People respect me, I respect them. I respect their time which is an unusual management culture for senior management people to truly respect the time of junior people.  You wind up with a group of people who are critical thinkers, that think and reason things out before they speak, that can adjust to new facts, that can adjust to feedback and work well within a culture”

Humility, Constant Re-assessment & Patience

“It’s not about sticking to our guns [in contrarian positions]. It’s about re-assessing constantly. When positions don’t work and go against you the presumption is not “we’re right, the presumption is “we might have missed something here”. Then you have to go back and think about it again and again and again. You have to understand the other side and see if anything has changed, see if your view has changed and if it has changed to modify the position. You might eliminate it, or you might reduce it or you might sometimes increase it, but very rarely. Generally speaking my inclination is, when the position is not going well, it’s more likely we’ve missed something so the choice is generally either reduce or eliminate or simply keep it if we think its right. On the other hand if we continue to think we’re right, I find patience is the way to go. We have to wait and let the story play out, while we continue to re-asses it to see in fact we were wrong”

What you Know, Can Infer and the Range of Outcomes

“Investing in a poker game and investing in stocks, at least the way I do it, is a very similar skillset. You have certain facts you know, in stock investing it’s whatever objective information you know about a company or a situation - what is the stock price, what the company does, what are their sales etc. Then there are things you can surmise, but you don’t really know. That would be – what is the motivation of the CEO, what is the strategy, what are the interests, what does the competition look like. These aren’t objective but through work you can make educated guesses about, but you don’t really know. And then you have a range of things that you don’t know that are going to come in the future.  These are future events that are fundamentally unpredictable but they live within a range of possible future events. So you combine what you know, with what you think you can surmise, combined with understanding the range of outcome related to the uncertain things and say “is this a good place to commit a fraction of my capital"

And you can translate that to poker. What is it you know; you know how many chips you have, you know what cards you're holding, you know the cards displayed face up on the table as you can see those. Then you can surmise what you opponents cards are likely to be; I can get information from how he is betting the hand or by sitting at the table playing with him for a while I can see his personality, his style, his skill and I can make inferences about the present hand based upon his past behaviours. Those are things you are trying to deduce. Then there is the uncertainty; the range of future cards concealed in the deck that are yet to be displayed that are important and there is a range of those possible outcomes. You take a look at all those things and you say "do I want to play this hand?", do I want to bet chips into this hand”

Screen Shot 2016-05-26 at 6.38.28 PM.png


“The most exciting part is when you think you’ve figured out the joke. When you get the joke and you understand what it is that you’re doing and why it is you have an opportunity now. You’re going to be able to deploy capital and its very likely to work out. Those situations come up few and far between when you really have it”


“We are wrong often and we have to constantly question whether we are wrong. There are lots of times when you buy a stock and after a certain amount of time a certain event happens and you have to look at it a different way, and say nope that’s not it, we should have done the opposite. Then you change course

Risk Management

“We take a layer by layer approach [to risk management]. What is our risk on this investment, that investment and the next investment. We tend to think about risk as how much can we lose in our worse case. If it’s a $10 stock the downside is $10. That’s how I think about it”

Developed Markets

“We are invested in developed markets. I have no aspirations to get further away [from developed markets] because I find that once you get into places further away you’re subject to what’s going on with the insiders and there are local rules and customs, and local knowledge. It’s very hard to compete with that sitting in NY even if you get on an aeroplane and go visit once in a while”


“We re-evaluate all of our investments [whether they have worked out good or bad]. Ones that have worked we sell or reduce because they have worked and we are not interested in them anymore. Some that haven’t worked we exit or reduce because we decide that whatever it was we were thinking is no longer true or is unlikely to be born out. We modify the positions accordingly and we do that on a position by position basis and we do that whether things are going well for us or not going well for us. It’s part of our ongoing process.”

What You Know, Concentration & Portfolio Construction

“The way you deal with unknown unknowns is through portfolio construction. We like to run a concentrated portfolio but even our best idea we are not going to put all our money in. You have to set some kind of a limit, have some kind of risk management, some level of diversification. We have some amount of longs and some amount of shorts and have some amount of market risk we are willing to take on a knowing basis. Then you have the idiosyncratic risk relating to the individual investment. When people say there is a stock at $10 with $1 of downside and $10 of upside, I say NO, it has $10 of downside because you can lose your whole investment when you make it.  We manage risk further by the level of investment we make"


"We are not levered, we don’t borrow more money to make even more investments. That’s one way you avoid risk. If you don’t have to ever repay anybody you're not subject to lending terms and conditions”

Value at Risk

“One of the things that was most exposed in the financial crisis is the flaw in the mathematical modelling of tail risk. So called Value-At-Risk. It is a method used by all of the large banks  and institutions. What VAR basically does, it basically says, if the risk is something that is going to happen beyond a certain level of frequency, you don’t have to put any capital aside. They put capital aside to cover 95% of all possible outcomes, but not for really remote things beyond the tail”

Short A Bubble Basket - Lots of Small Positions

“We decided if we could look at company[s], none of the companies were profitable or materially profitable, and we didn’t know what the business was, but we knew what the financial statements were and we knew the projected financial statements, and we thought a little bit about the business, but we didn’t even know what the business was - if it was an office supply company, a paper-maker or Netflix - and we closed our eyes and said what would you pay for the stock.  If the answer was 90% less than where it was trading, we created a basket of about 40 or 50 of these and shorted a small amount of a large number of them. Over time, at least until the beginning of this year that basically worked out.  Even though we had 2 or 3 or 4 that really worked against us in a pretty big way, a big number of those 40 or 50 ultimately failed or de-rated and the stocks went down a lot. The gains were roughly enough to offset the ones that appreciated. This year that has not been the case. Pretty much everything that has remained or we put into the basket has continued to go up. But the thesis on all of them is that none of them are actual, viable businesses. And the market might disagree with us on this, but when they start showing real profits then we’ll take a different point of view on particular names”

"We generally don't short stocks just on valuation. But when we came to a point with certain stocks that the valuation was so extremely out of whack it wasn't really a debate about whether the stock was in a range of fair value, in other words it was 90% or so overvalued. You don't need a computer to help you figure that out. Even if you are wrong by 100% instead of it being 90% overvalued its 80% overvalued.

Seeking Perfection

"We do not sit around all day and try and figure out the precise value of individual stocks. Because those are not relevant to our actual ability to make decisions. So if we have a stock and its $10 the goal is not to figure out if its worth $11 or $11.50 or $12. The goal is to figure out is it worth a lot more than $10 and not being precise about that. If we buy at $10 it doesn't really matter whether its worth $18 or $20 or $25 and there is no point in us trying to figure that out right now. The only decision we have is - do we want to own the stock at $10, and if we think its undervalued by a lot that's good enough for us to decide to own it now. By the time it starts approaching higher values we can re-asses and fine-tuning on an ongoing basis. We do our assessments in a very imprecise way"

Investments as Puzzles

"We view investments as puzzles. There are a few things you can know but they are not the most important things as everybody knows them. The most important thing is what is it you can infer and how good are you at assessing a possible range of outcomes, either the known unknowns and the unknowns unknowns and how can you construct that into a portfolio" 

Margin of Safety

"Our goal is to find things that are widely misunderstood by a large margin"

Time Arbitrage

"I think one of the inefficiencies in the market is investors are generically too short-term oriented and time arbitrage is one of the best inefficiencies in the market."


"When we get involved in pushing an agenda, which is very rare, our view invariably is if it doesn't help in the short term, intermediate term and long term, then its not a good solution to what the problem is"

Structural Problems

“As I looked at the global financial crisis as it happened I thought there were three or four or five really obvious structural problems that were exposed. Institutions that were thought to be able to fail, in fact were deemed to be too big to fail. You had structured credit where risk was being transferred but it wasn’t really being transferred or properly evaluated. You had the problem of credit rating agencies, only two or three major ones, so you wound up with a centralised decision maker as to who is creditworthy and who isn’t – that’s a really bad way to allocate credit. You really want a large number of people evaluating each credit to determine the creditworthiness. If you have one or two you create crisis of confidence when the one or two change their mind and you lose the opportunity to go into the market and find other people who might look at it differently from the credit rating agencies. That was separate to the corruption relating to the triple-A ratings. I think there was a lesson learnt about derivatives. They could have been dealt with differently, but instead we’ve created a clearing house for derivatives which has essentially created another too big to fail institution where all the credit is on an undercapitalised entity that everyone assumes will perform under all circumstances which of course it can’t as counter-parties begin to have problems. So from my perspective if you took all of the obvious problems from the financial crisis, we really kind of solved none of them.. I think it has the left basic structure more or less as it was and I think it is susceptible to the same type of event or series of events sometime in the future.”


Investment Masterpieces

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Have you ever stopped to consider the difference between science and art? How some things fall rather naturally into one or other of the categories, (like the 'science of engineering' or the 'art of film production'), yet many other things remain difficult to categorise. They may even belong to both.

Part of the distinction between the two is that if something is a 'science', then it will naturally follow formulae and rules and can typically be proved or practiced via logical methods. 'Art' on the other hand is a form of expression, and invariably involves some level of creativity or innovation. If you think of music as an example, it can be successfully argued that it is both a science and an art at the same time: if a musician follows the 'science of music', then they will practice classical methodology and you can expect that their performances will be clinically perfect yet potentially lacking in 'soul'. Followers of the 'art of music' by comparison might be more innovative, and typically can improvise and express a wider range of emotions and unique qualities in their playing.

I've always considered investing more 'Art' than 'Science'. If there was a formula for success the world's greatest investors would all be mathematicians. They're not. Successful investing requires more than just analysing numbers, it too requires creativity and innovation. 

When it comes to Investing 'Artisans', Francois Rochon is one. Francois has a passion for both investing and art, he even named his fund Giverny Capital after the city where the famous Impressionist artist, Claude Monet lived. Over the last two-plus decades Giverny Capital has ranked in the top 1% of investors delivering returns c6.7%pa above its benchmark annually. Since 1993 the firm has clocked up a total return of 3,080% versus 686% for the benchmark.

Over the years I've always looked forward to reading the Giverny Capital annual letters. Not only is Francois an Investment Master he's also a master wordsmith.

Francois recently gave an enlightening presentation titled 'The Art of Investing - Analysing Numbers and Going Beyond' as part of the Talks at Google series.

While Francois trained as an engineer, he found the rigidity and precision of engineering to be a handicap to successful investing. Engineering and investing are almost diametrically opposed; there is no precision in investing. As an investor you can be considered successful even when wrong 40% of the time. As an engineer, if you're wrong 0.4% of the time, you're toast. Notwithstanding, at times engineering calls for more than just numbers - be it for a new design or solution to a problem. To emphasise this, Francois draws on a quote by one of the world's greatest engineers, Nikola Tesla:

"Instinct is something which transcends knowledge. We have, undoubtably, certain finer fibers that enable us to perceive truths when logical deduction, or any other willful effort of the brain, is futile." 

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The Investment Masters likewise see investing as more art than science.

Accordingly you need to master the 'Art of Investing'. Like mastering any art form, begin with an art form you love. You'll need to study the art's masters, and as a painter paints, you must invest. You'll develop your own unique style, an independent mind, and you'll need to always strive for improvements.

Like most great artists, it's likely you will be seen as a little eccentric, rash and unconventional. If your goal is to obtain better results than the average, you'll have to be able to stand on your own. You cannot achieve this by applying the same logical approaches as the herd.

Investors whose mindset and time horizon mirrors everyone else, those who own lots of companies and believe they are "smarter" and can predict the market, don't beat the market. It's the investors who think for themselves, own very few, carefully selected companies and develop the right behaviours (rationality, humility and patience) that become the Masters of Investment.

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Francois outlines the stock selection process that has delivered Giverny Capital's outstanding returns. The firm focuses on the financial strength of a company searching for companies with an ROE greater than 15%, with EPS growth above 10% and a debt to profit ratio below four times.  They search for good business models; those businesses which are market leaders, have competitive advantages and low cyclicality. They then ensure the management teams have skin in the game, capital allocation competency, and are long term thinkers. Finally, Giverny require an acquisition price which affords them the opportunity to double their money over a five year period. To estimate this they need an estimate of what the company can earn in five years time.

As in his art collecting, Francois is attracted to investment 'beauty' or 'corporate masterpieces'. Not surprisingly these are both unique and rare. By studying the investment masterpieces through history - National Cash Register, Ikea, Geico, Apple, McDonalds, Gillette, Google, Starbucks Coffee etc - Francois has discovered the qualities that made them so unique.

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The defining character of the uniqueness in either the product, the service or the culture of corporate masterpieces is usually the equivalent of a moat that protects the economic castle from competitors. So in short, you have to find companies with moats.

"Moats always keep changing. There are always new companies with moats; some are expanding, some are shrinking. So we have to follow that closely. If I had to choose one criteria to help me decide what is the direction of the moat - it's the management. Moats aren't built by angels, they are built by human beings. What makes a moat grow is something in the culture of the company, it doesn't come from thin air. It comes from top management that build that culture, then it translates into a moat and high return on equity for shareholders."

Francois sets out his psychological edge in investing. The three behavioural competitive advantages he believes an investor can employ are patience, humility and rationality. In terms of humility, Francois recognises he can't predict macro-economic events so he doesn't try. Francois recognises his 'circle of competence', he strives to recognise mistakes, and is always looking for improvements.

"I would say the greatest quality of Warren Buffett is not necessarily intelligence, it's the humility. He is the greatest investor of all time, but he is still very humble. He is always looking to improve and learn. He's 87 years old and he's still striving for new learnings every day. If you have those qualities I think you'll succeed in almost anything you do."

Every year Francois dedicates a chapter of Giverny's annual letter to the year's best mistakes, awarding a bronze, silver and gold medal.

"We make many mistakes and we only choose three to give medals to: bronze, silver and gold. Most of the time the mistakes are omissions. Starbucks is an example, its a company that fits all our criteria. And we decided not to buy for simplistic reasons and you miss a 10,000% gain over 25 years. We try to give medals to the most costly mistakes." 

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When it comes to rationality, Francois advocates avoiding fads, even if it means others are making more money than you. And if you don't understand a company, stay away.

"You play an easier game when your'e very selective and you just go for companies you understand."

As hard as it may be, it's critical to be impervious to stock market quotations in the short run. By accepting you don't know the future, you can focus on what's controllable, which is finding companies you can understand and which have a competitive advantage. Then, should you own great companies and markets fall, over time you will still be okay.

"Owning great companies, and not trying to predict the stock market is the key to beating the index over the long run." 

To overcome the psychological pressures on investors to do the wrong thing at the wrong time, Francois has developed the 'Rule of Three'. This set of rules states that; 1) one year out of three the stock market will decline by 10% or more; 2) one stock purchased out of three will not perform as expected, and; 3) one year out of three, you will under perform the index. If you set expectations from the start, when you have some bad years and bad investments, you'll be better prepared psychologically to deal with it.

In terms of patience, Francois points not to the 'ability to wait' but the 'ability to keep a good attitude while waiting'. A 'good attitude' is one where you focus on what is happening to the company, NOT the stock price. Provided the underlying company's earnings are growing, you'll find over time the stock price should reflect those improved earnings. Don't confuse patience however with stubbornness. When an investment doesn't work check to make sure the company's fundamentals aren't deteriorating. If they are, get out.

In his quest to buy investment 'masterpieces', Francois often faces a conundrum. Masterpieces can be expensive and tend to trade at higher price-earnings multiples than widely perceived value stocks. While most investors focus on the current price-earnings ratio, Francois suggests instead to look to the long term and estimate what the company's value might be then. If buying at today's price and selling at that future value can deliver a 15% pa return it's likely to be an attractive investment notwithstanding a higher multiple. This process is also useful in eliminating optically 'cheap' stocks which are actually value traps.

"We try to focus on the very long term, so we try to look five years in the future and come up with our best judgements of what the EPS should be in five years... Having this long term horizon help you to de-focus on the [higher] PE ratio today. It goes the other way; if you find a cheap stock but you look five years in the future and you don't see any growth prospects, there is no real reason to believe the stock will be higher in five years. It can be higher in three months just because the PE has gone from 10 to 12. But we don't try to invest for three months we try to invest for at least five years."

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The wise investor must be able to balance the dualities in many human activities. While you want to love the art you must remain rational and not fall in love with stocks. You want as large a field of knowledge as possible while remaining within your circle of competence. You need to be open-minded yet maintain a balance of thought. You need to be able to value the business but be able to go beyond the numbers. You must have patience but not stubbornness. Finally, you need discipline but also the wisdom to break the rules.

In summary, the artistic or unconventional investor focuses on intrinsic value, maintains a long term horizon, is agnostic about many things including where the stock will be in the short term, focuses on what to own as opposed to when to buy and resists fads and popular beliefs.

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While the majority of investors underperform, Giverny Capital's results have significantly bettered the stock market. Its clear that while they do things differently to most investors, many of their traits and practices are common to those whom we recognise as Investment Masters. They treat the bulk of their investing as an art form, and trade logic and formula for creative thinking.

So how do you approach your investing? As a science or an art form? Do you try to engineer your results, using a set formula or logic, or do you follow a more artistic approach, utilising innovation and creativity? The differences between the two are vast, and whilst scientific method might provide you with short term success, its only through the 'art of investing' that you can go beyond the numbers and create your own long-term performance masterpiece.



[note: click on any links above for further reading on that topic]

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 Forbes.com, 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.