50c Dollar Bills

Photo Source: Wikipedia

Photo Source: Wikipedia

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 “Valuation is always the best catalyst.” Stan Majcher



The Investment Masters Class - Some Stats

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

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

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

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

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

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

Analysing Investment Performance - Short and Long Term

The Investment Management industry is fixated on short term performance. 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Source: Wikipedia

Source: Wikipedia

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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






Is the Company's Product Attractive?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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




How to Build a Better Investing Mind

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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



Further Recommended Reading:

Media and the Market

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

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

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

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

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

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

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

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

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

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

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

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

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

"Headlines lead to headaches for the unfamiliar" Frank Martin

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Were Munger, Dalio and Soros CIA Trained?

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

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

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

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

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

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

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

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

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

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

Be a Generalist

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

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

Have a Multi-disciplinary mindset

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

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

Focus on Collecting Information that Matters

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

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

Seek out Other Information

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

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

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

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

Test your Investment Ideas

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

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

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

Remain Open Minded

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

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

Bruce Berkowitz: "Facts change, we change

Beware Of Commitment/Confirmation Bias

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

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

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

Analysts Improve with Experience

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

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

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

Deal with Change

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

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

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

Be Creative

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

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

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

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

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

Consider Alternate Hypothesis

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

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

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

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

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

Seek to Disprove Hypothesis Not Confirm Them

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

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

Be Alert to Surprises

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

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

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

Seek out Individuals who Disagree

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

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

Think Backwards

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

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

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

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

Appoint A Devils Advocate

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

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

Watch out for Unexpected events

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

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

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

Keep Questioning

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

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

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

Consider the Interactions Between the Variables

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

Source: Psychology of Intelligence Analysis, CIA

Source: Psychology of Intelligence Analysis, CIA

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

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

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

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

Understand Probability

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

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

Identify Milestones Ahead of Time for Being Wrong

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

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

Establish the Implications of being wrong

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

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

Ensure you Evaluate the Evidence

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

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

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

Avoid Anchoring

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

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

Study Your Mistakes

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

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

Prepare for the Unexpected

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

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

Occasionally Failures Must be Accepted

CIA "Occasional intelligence failures must be expected."

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

CIA Original Headquarters Building

CIA Original Headquarters Building

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

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

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

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

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


Investing Mentors

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Start learning from your mentors..

Ten Years

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Most businesses with longevity require a culture of innovation.

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

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

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

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

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

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

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

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

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

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

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

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

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

How will the companies you own look in ten years?


Great Investors Sleep Well

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

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

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

"Conservative investors sleep well" Phil Fisher

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

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

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

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

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

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

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

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

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

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

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

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

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

Make sure you can sleep well at night!

Pricing Power? Milk and Bread!

Buffett considers the best businesses to buy are the ones with pricing power.  His experience with Berkshire Hathaway's textile business and then See's Candies provided him with a significant contrast in the value of pricing power. In a lecture to students at Notre Dame Facility in 1991, Buffett explained the differences between the two businesses...

"Our textile business - That's a business that took me 22 years to figure out it wasn't very good. Well, in the textile business, we made over half of the men's suit linings in the United States.  You wore a men's suit, chances were that it had a Hathaway lining. And we made them during World War II, when customers couldn't get their linings from other people. Sears Roebuck voted us "Supplier of the Year." They were wild about us. The thing was, they wouldn't give us another half a cent a yard because nobody had ever gone into a men's clothing store and asked for a pin striped suit with a Hathaway lining. You just don't see that. As a practical matter, if some guy's going to offer them a lining for 79 cents, [it makes no difference] who's going to take them fishing, and supplied them during World War II, and was personal friends with the Chairman of Sears. Because we charged 79½ cents a yard, it was "no dice."

See's Candies, on the other hand, made something that people had an emotional attraction to, and a physical attraction you might say. We're almost to Valentine's Day, so can you imagine going to your wife or sweetheart, handing her a box of candy and saying "Honey, I took the low bid." Essentially, every year for 19 years I've raised the price of candy on December 26. And 19 years goes by and everyone keeps buying candy. Every ten years I tried to raise the price of linings a fraction of a cent, and they'd throw the linings back at me. Our linings were just as good as our candies. It was much harder to run the linings factory than it was to run the candy company. The problem is, just because a business is lousy doesn't mean it isn't difficult."

See's Candies was a phenomenal investment for Berkshire. See's cost Berkshire $25m in 1972, and Berkshire invested an additional $32m between 1972 and 2007. The volume of chocolate See's sold grew at just a 2% annual rate between 1972 and 2007, however See's pre-tax earnings grew from less than $5m in 1972 to $82m in 2007, and over the period from 1972 to 2007 they totalled $1.35b.  By today, that number is close to $2b. 

Buffett expanded on the thought process to determine pricing power...

"One of the interesting things to do is walk through a supermarket sometime and think about who's got pricing power, and who's got a franchise, and who doesn't. If you go buy Oreo cookies, and I'm going to take home Oreo cookies or something that looks like Oreo cookies for the kids, or your spouse, or whomever, you'll buy the Oreo cookies. If the other is three cents a package cheaper, you'll still buy the Oreo cookies. You'll buy Jello instead of some other. You'll buy Kool Aid instead of Wyler's powdered soft drink. But, if you go to buy milk, it doesn't make any difference whether its Borden's, or Sealtest, or whatever. And you will not pay a premium to buy one milk over another. You will not pay a premium to buy one of frozen peas over another, probably. It's the difference between having a wonderful business and not a wonderful business. The milk business is not a good business."

In an interview in 2011 Buffett said “The single most important decision in evaluating a business is pricing power..  If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”

Buffett expanded on product differentiation in his 1982 letter ..

"We need to look at some major factors that affect levels of corporate profitability generally. Businesses in industries with both substantial over-capacity and a “commodity” product (undifferentiated in any customer-important way by factors such as performance, appearance, service support, etc.) are prime candidates for profit troubles. If .. costs and prices are determined by full-bore competition, there is more than ample capacity, and the buyer cares little about whose product or distribution services he uses, industry economics are almost certain to be unexciting. They may well be disastrous. Hence the constant struggle of every vendor to establish and emphasize special qualities of product or service. This works with candy bars (customers buy by brand name, not by asking for a “two-ounce candy bar”) but doesn’t work with sugar (how often do you hear, “I’ll have a cup of coffee with cream and C & H sugar, please”). In many industries, differentiation simply can’t be made meaningful.  A few producers in such industries may consistently do well if they have a cost advantage that is both wide and sustainable. By definition such exceptions are few, and, in many industries, are non-existent."

It's important to think about how differentiated a company's products are or at least how differentiated they are perceived to be. Why do people buy the product? Is it an essential item? Are there substitutes? Is the price regulated? Is competition increasing or decreasing? Is it a small part of a larger purchase? Are there risks of obsolescence? Are the buyers consolidated or fragmented? What are the barriers to entry? Whether it's milk, bread or some other item, you need to consider what the buyer's psychological motivations are, their habits and their considerations around price? 

"Early in the process.. [we're] making sure we understand how business is really done in the space.  How do customers make purchase decisions? What’s the differentiation between companies’ products? Who, if anyone, has pricing power? What are the key secular trends? What’s going on at competitors? To really understand all this you have to talk to people in the industry” Ricky Sandler

".. among other factors it is about pricing power. You have something that is so attractive to the consumer that they pay a premium to walk into your store and do something." Ted Weschler

In his book "Common Stocks and Common Sense" Ed Wachenheim discusses the bakery industry … 

"I knew that the bakery business is a miserable business, among the worst. Most shoppers do not have a strong preference for one brand of bread over another. White bread pretty much is white bread.  Whole wheat bread pretty much is whole wheat bread. This relative lack of brand preference gives stores bargaining power over bakeries. A store can threaten a bakery that, if it cannot purchase bread at a certain price, it will seek another supplier. Thus, stores can play one bakery off against another, and they do. Warren Buffett likes businesses that are protected by moats. There are no moats surrounding the bakery business. There are not even any fences or "beware of dog" signs. Therefore, the prices received by the bakeries often are driven to levels so low that it is difficult for the bakeries to earn a decent profit, if any profit at all. This is a key reason why the bread business is a miserable business."

Think about it…  milk and bread tend to be commodity products, like Berkshire Hathaway's linings. When you have a commodity product you need to be the low cost producer as commodity products tend to get priced by the marginal producer's cost of production. They also tend to be susceptible to over-capacity. Conversely, a differentiated, essential or unique product's price isn't based on the cost to produce in the absence of competition.  

"The ability to raise prices – the ability to differentiate yourself in a real way, and a real way means you can charge a different price – that makes a great business." Warren Buffett

There are of course exceptions. I know of a milk company with pricing power. The company's milk contains different proteins produced from a certain breed of cow and people pay more than twice the price of standard milk. People will pay more for organic milk. The question to ask is how sustainable is the premium?, and how easy is it for other producers to replicate?.

More recently Buffett expanded on his decision to buy Apple. Buffett saw a product with pricing power and a product intimately integrated into people's lives ....

“It’s amazing where Apple’s ended up with consumers. I can very easily determine the competitive position of Apple now and who’s trying to chase them and how easy it is to chase them. We happen to be well situated in terms of having these massive Home Furnishing stores. I can learn very easily how consumers react to different things there, probably easier than I can try and pick out what is really happening at Amazon at any given time. If you come in to buy a TV set at the Furniture Mart, price is extremely important. Obviously picture is, but they are all good pictures. You can have Samsung and all these different ones. If you put on a sale and you drop the price of Samsung ten percent you can fill that department with people who come out for it. You can’t move people by price in the smart phone market remotely like you can move them in appliances and all kinds of things. People want the product they don’t want the cheapest product. The loyalty is huge. That doesn’t mean somebody can’t come with a product that just jumps the field in some way. And then once you have the product the degree to which it sort of controls your life, it’s a very very very valuable product to the people that build their life around it. That’s true of 8 year olds and its true of 80 years olds”.

“So far you’ve had smart phones and big differences in price categories and if you had an Apple before you can have a much cheaper smart phone selling right next to it and they don’t look at it. If you have a cheaper TV [in the store] with pictures looking at you and you say what’s the difference, you buy the cheaper TV. Most items are price sensitive. That’s not to say an Apple has no price sensitivity, it’s very limited. Someone could come along and leapfrog the technology, and add benefits that would be the more competitive threat than price competition. It would be benefit competition”

Do the businesses you own have pricing power?

Some insights from Ted Weschler and Todd Combs

Ted Weschler and Todd Combs have been anointed to manage Berkshire's equity portfolio when Warren hands over the reigns.  Warren's decision to hire Todd and Ted was based on what they'd done, how they had done it and their character. Both now manage c$10b each of Berkshire capital.  

In a recent rare interview with Yahoo News, Warren, Ted and Todd talk about how they spend their days and how they think about investing.  

I've outlined below my key takeaways from the interview.. 

Reading:  Buffett spends most his day reading. So to does Ted Weschler and Todd Combs. In fact Warren said in the interview "These are the only two guys we could find that read as much as we did". So what do they read? 

Ted Weschler spends half the day reading random things like newspapers and trade periodicals. In a 2016 interview Ted pointed out "Being a successful investor you need to be hungry, intellectually curious, interested, read all the time. Read a lot of newspapers. You need a certain level of randomness in order to connect things that might give you an insight into where a business is going in five years that somebody else might not see." 

Todd Combs reads about 12 hours a day - newspapers, quarterly reports, SEC filings, transcripts and trade magazines. 

Like Buffett, they're hoping to find or confirm an edge - a thought, an idea, insight or trend that's not being recognized by the market. 

Hard Work: Ted and Todd spend most of their day reading.  Successful investing is hard work.  As Peter Lynch noted "The person that turns over the most rocks wins the game. And that's always been my philosophy."

Learning: It's important to be a life long learner. Ted Weschler notes the last 5 years have been the steepest learning curve of his life. Which is a pretty powerful statement at 50 years old. In a large part he believes this is due to the data set from the businesses he's been exposed to at Berkshire [and no doubt learning from Buffett].

Speaking to Corporates: Buffett believes he is a better investor because he has experience in business and a better businessman because he has had experience in investments. Buffett notes that Berkshire is about as good a place as you can find to really understand competitive dynamics. Both Ted and Todd have Berkshire businesses that report into them. As Berkshire owns dozens and dozens of businesses and touches almost every type of industry in one form or another it gives the portfolio managers the opportunity to speak to operating managers who know more about their businesses than an investor can learn in a lifetime. 

Generalists:  There are no rules of any kind on diversification or industries in which Todd and Ted can invest in.


Click here for link to the Yahoo News Interview. 

Click on the yellow links above to link to the Investment Masters Class Tutorials.


The Keys To Successful Equity Investments

Francois Rochon initially graduated as an electrical engineer, but he quickly developed a passion for investing when he came across the book 'One up on Wall Street' by Peter Lynch in 1992.  From this book he became interested in Warren Buffett, 'the greatest investor of all', in Peter Lynch's words.  Francois started managing his own money the next year and by 1996 he had left the engineering profession to work at a mutual fund.  Two years later, in 1998 he left to start Giverny Capital which focuses on 'owning outstanding companies for the long term'.

Mr Rochon's US portfolio has compounded at an average rate of 14.8% pa since 1993 versus 9.2% pa for the S&P500. The 5.6% out-performance over such a period has a large impact on returns, with a $100,000 investment in Mr Rochon's portfolio in July 1993 worth $2.6m as at December 2016 whereas if it were invested in the S&P500 it would be worth just $790,000.

I've always enjoyed reading Mr Rochon's investment letters which are available on the Giverny Capital website.   Giverny Capital has produced a paper titled "The Keys to Successful Investing" which contains eight keys which could help you in increasing your likelihood of success.  

Many of these are common to the Investment Masters.  The links provided in the key topics below connect to the relevant Investment Masters Class Tutorials.

1) Consider stocks as fractional ownership in real businesses

"When we study the great masters of investing and the many decades of available data, we find  a critical point in common: these investors behave like businessmen. When they buy a company’s stock, they first and foremost are buying part of an enterprise. Whether they are purchasing a hundred shares of Johnson & Johnson or several million  shares, these investors consider it no  different than if they were buying the company in its entirety."

2) Being present

"One of the flaws of many investors in trying to play the market is to attempt to time the market.  To experience returns on the markets, one must first and foremost be present with the market. "

3) Profit from market fluctuations rather than suffer from them

"The  metaphor  of  “Mr.  Market”,  as  taught  by  Warren  Buffett’s  mentor  Benjamin  Graham, illustrates the attitude that the rational investor must adopt when facing the market. In fact, the irrational attitude of Mr. Market is the source of investment opportunities for the investor who knows how  to stay rational and unemotional. This investor knows that stock market prices will reflect the fair value of the underlying enterprise in the long term. So, from this perspective, market fluctuations are your allies and not a source of suffering. "

4) Leaving yourself a margin of safety

"The concept of “margin of safety” is borrowed from the world of engineering. When an engineer is building a bridge that  has a capacity to support a five-ton truck, he will build it so that it can support a truck of eight or ten tons. This represents a margin of safety. When we use this concept within the context of investing in a company’s stock, it is the difference between what we think the company is worth versus the value of its stock price.   

The starting point is the intrinsic value of the company, which we determine theoretically by calculating the current value of the future cash flows generated by the company over the course of its life. Since this is a highly subjective analysis, we must consider a wide margin of error.    

The more the market is irrational about the value of a company during a selloff, the lower the  price we can pay for the company’s shares, thus increasing our margin of safety. 

Furthermore, one should consider that the margin of safety also exists with more qualitative factors as well. For example, the quality of the company’s management team, its competitive  advantages, and its intellectual property to name a few. Finding solid companies at attractive prices is the keystone to our approach.  

5) Stay within your circle of competence

"When it comes to selecting businesses to invest in, Warren Buffett is guided by what he calls his “circle of competence”. What is critically important, he says, is to know the limits of your circle  of competence.   For example, if you don’t know the difference between the atomic number of
Titanium and the one for Uranium, you should probably steer clear of this sector.  
To wander outside of your circle of competence significantly increases your probably of making a poor decision.  In the market, to realize better returns than others, you must have better knowledge regarding the value of the businesses in which you invest (the others are the market).  

To succeed, it is important to stay close to companies that one can understand well and evaluate well."

6) Know when to sell

"Philip Fisher, the famous investor, once said: “if you’ve done your work well when you’re  buying,  the time to sell is... almost  never”. Ideally, we would love to keep our outstanding companies forever, but life is not ideal and a realistic approach is necessary. 

We believe that the reasons for selling a stock should be harmonized with the reasons for buying it. We should consider selling if these reasons are no longer valid. In other words, once the investor becomes aware that he made an error in his analysis or the prospects of the business have deteriorated, it is the time to sell. Our firm evolves and companies evolve just as much, for better or for worse. Our investment approach must be aligned to the nature of the capitalist world within which it participates.   

Another more pragmatic reason for selling is that the majority of investors do not have unlimited sources of capital at their disposal and they may, quite simply, sell in order to invest in another company whose potential seems brighter. "

7) Learn from your mistakes

"Mistakes are inevitable in the investing world.  The key is to recognize them quickly and learn from them.  There are two categories of mistakes: mistakes of commission and mistakes of omission.  The first consists of failing in what you decided to buy, whereas the second consists of  failing to buy a stock that met all your purchasing criteria. Generally speaking, mistakes of omission are often the most costly. To miss a stock that climbed 1000% is ten times more costly than losing 90% of you  capital in a stock that did poorly. 

Other mistakes fall into the category of “psychological biases”, with anchoring and overconfidence being good examples. Anchoring is related to the fact that our human nature is such that we often remain anchored on first impressions or first data points, even when those perceptions become detached with reality.  For example, an investor bought stock ABC at $50 two years ago and it is now trading at $25 following news about the loss of a significant contract and/or lower profits. The investor remains anchored to the notion that his stock is worth $50 simply because this was the purchase price. In reality, there is no link whatsoever between the price paid for a stock and the value of the company. What matters is the future prospects of the company. 

Finally, overconfidence manifests itself often and under different forms. Its only remedy is humility."

8) A constructive attitude

What differentiates successful investors from others is not related to intelligence, but rather related to attitude.  

Warren Buffett often uses the adjective RATIONAL to describe good investors. Rational investors do not let themselves be influenced by fads or crises.  Aside from a rational attitude, another important quality (and one apparent in Warren Buffett) is the capacity to always want to learn and progress.    

The world is in a perpetual state of evolution and it is not easy to for someone to also constantly  evolve. To be in a constant state of learning, one must not only be passionate for their art, but also humble.

Without humility, there is no opening for something new. Therefore, paradoxically, successful  investors must be able to combine both a high confidence in their judgment while also remaining  constantly humble. A difficult and fragile equilibrium." 

An Earnings Miss?

"Estimates miss earnings, not vice versa" Market Veteran

An opportunity to purchase a quality business at an attractive prices often presents when a company misses a quarterly number and analysts downgrade their numbers to reflect the lower new estimate.  This seems to have become more prevalent in recent times with investors and analysts having an increasing focus on short time periods, leading to an over-reaction in the share price. Fear, herding and other behavioural factors come into play. However, the key is to remain unemotional and analyse the situation in a calm and rational manner to form a view as to whether the earnings dip is simply a temporary blip in the business, or is symptomatic of issues that significantly impair the intrinsic value of the business.

“I am particularly interested in buying companies when their long term prospects are intact but they are cheap because they face short term issues”  Robert Vinali

"Companies that "miss" the analysts' consensus estimates can see their stock price decimated. Is the quarter-to-quarter earnings target really more important than a company's ability to increase shareholder value long term”  Christopher Browne

Common causes of an earnings miss include a poor product mix, a lost contract, weather impacts, higher than expected costs, new management re-basing earnings, investment in the business or more aggressive pricing from a competitor.  

It is important to remember, the intrinsic value of a company reflects the present value of the cash that can be taken out of the company over its lifetime.  On this basis, one quarter, or even one years' earnings are unlikely to have a major impact on the long term value of the company.   

“A couple of bad years of earnings shouldn’t determine the intrinsic value of those companies” Matthew McLennan

“The value of a business is determined by the present value of the cash it generates over its lifetime, not based on what next year’s earnings are going to be.  While the first year’s cashflows in a discounted cash flow valuation carry the most weight in the calculation, years two through 20 and thereafter contribute many multiples of year one’s value in determining the present value” Bill Ackman

I am amazed at the number of analyst reports that focus on the upcoming earnings release as opposed to the longer term drivers of a business and its intrinsic value.  

“Information with a long shelf life is far more valuable than advance knowledge of next quarter’s earnings.  We seek insights consistent with our holding period” Marathon Asset Management

"Look beyond the next quarter and the next year and search, instead, for very long term trends" Ralph Wanger

When the analysts are talking about 'lower sales due to fewer days in a quarter', 'recent weather impacts' or 'poor share price momentum' it can be an opportunity for the long term investor to find mis-priced securities.  

“It’s often a good sign when investors and analysts agree that ‘the stock is extremely cheap, but we shouldn’t buy it yet because there might be another bad quarter coming”  Wally Weitz

Many of the Investment Masters spend their time thinking about the longer term business value.  Remember a share is a part ownership of a business.  Would a business owner sell a company on the basis of a poor quarter?

“In a time when financial television keeps score of quarterly “beats” (meaning a company beats estimates) we ignore financial models and are oblivious to consensus estimates.  We don’t think quarterly “beats” are germane to intrinsic value.  We prefer betting on company fundamentals, not investor psychology”  Allan Mecham

Finding mis-priced securities due to short term issues is referred to as 'Time Arbitrage' and is one of the most profitable edges employed by the Investment Masters.  

The next time a company you like, understand and think is high quality misses an earnings estimate, rather than run away it might be worth running towards it.  The share prices of high quality companies will recover to reflect the longer term value residing in the company.  It's just that the timing of any such recovery is unknowable.

Remember it's just an estimate.  And estimates miss earnings - not vice versa.

“We think short-term earnings should be treated like appetizers at dinner: avoid overindulging or you’ll miss the main course.” Allan Mecham




The Buffett Series - The Science of Hitting

"Everybody knows how to hit - but very few really do" Ted Williams

Warren Buffett has long recognised the importance of exercising patience and sticking within your circle of competence when investing. Buffett regularly uses the analogy of the baseball player who only strikes the ball when it's in his or her sweet-spot.   Unlike baseball there are no called strikes in investing.  An investor can wait for the day a good pitch comes along.

Buffett often refers to the Hall-of-Fame slugger Ted Williams who played for the Boston Red Sox and is arguably the greatest batter of all time.   

Ted Williams approached batting in a methodical way, he worked out his optimal strike zone where the odds were in his favour and he maintained the discipline to only swing if the ball was in that zone.  By the time Ted Williams retired he had a .344 batting average, 521 home runs, and a 0.482 on-base percentage, the highest of all time

Buffett referred to Ted Williams in his 1997 letter .... "We try to exert a Ted Williams kind of discipline. In his book The Science of Hitting, Ted explains that he carved the strike zone into 77 cells, each the size of a baseball. Swinging only at balls in his "best" cell, he knew, would allow him to bat .400; reaching for balls in his "worst" spot, the low outside corner of the strike zone, would reduce him to .230. In other words, waiting for the fat pitch would mean a trip to the Hall of Fame; swinging indiscriminately would mean a ticket to the minors.

If they are in the strike zone at all, the business "pitches" we now see are just catching the lower outside corner. If we swing, we will be locked into low returns. But if we let all of today's balls go by, there can be no assurance that the next ones we see will be more to our liking. Perhaps the attractive prices of the past were the aberrations, not the full prices of today. Unlike Ted, we can't be called out if we resist three pitches that are barely in the strike zone; nevertheless, just standing there, day after day, with my bat on my shoulder is not my idea of fun."

In the recent HBO Documentary 'Becoming Warren Buffett', Buffett notes ..

"The trick in investing is just to sit there and watch pitch after pitch go by and wait for the one right in your sweet spot, and if people are yelling, 'Swing, you bum!' ignore them."

Having recently read "The Science of Hitting" I was fascinated by the common threads between a baseball great and the world's Investment Masters.   Below I've collated quotes from the book with the Investment Masters Class Tutorials.

Ted Williams noted "Everybody knows how to hit—but very few really do."  I think the same can be said for investing.

The Profit is in the Buying

"Hitting is the most important part of the game, it is where the big money is."  

Thinking is Key

"Something you must always take up there with you: proper thinking"

Patience is Critical to Successful Investing

"The longer a batter can wait on pitch, the less chance there is that he will be fooled"

Stick within your Circle of Competence

"You can see in the strike zone picture what I considered my happy areas, where I consistently hit the ball hard for high averages, and the areas graded down to those spots I learned to lay off, especially that low pitch on the outside 3½ inches of the plate. Ty Cobb once said, “Ted Williams sees more of the ball than any man alive—but he demands a perfect pitch. He takes too many bases on balls.”

"I gave the pitcher the outer 2 or 3 inches of the plate on pitches over the low-outside corner"

Continue to Learn

"Hitting is self-education—thinking it out, learning the situations, knowing your opponent, and most important, knowing yourself."

Work Hard

"Practice, practice, practice. I said I hit until the blisters bled, and I did, it was something I forced myself to do to build up those hard, tough calluses."

Its not an Exact Science

"If there is such a thing as a science in sport, hitting a baseball is it. As with any science, there are fundamentals, certain tenets of hitting every good batter or batting coach could tell you. But it is not an exact science."

Control your Emotions

"Hitting a baseball—I’ve said this a thousand times, too—is 50 per cent from the neck up"

Understand Psychology

"Most hitting faults came from a lack of knowledge, uncertainty and fear—and that boils down to knowing yourself. You, the hitter, are the greatest variable in this game, because to know yourself takes dedication."

Find your Edge

"Now, you can sit on the bench, pick your nose, scratch your bottom, and it all goes by, and you’re the loser. The observant guy will get the edge. He’ll take advantage of every opening."

Stick with your Own Style

"Now, there are all kinds of hitting styles. The style must fit the player, not the other way around. It is not a Williams or a DiMaggio or a Ruth method. It is a matter of applying certain truths of hitting to a player’s natural makeup."

Be a Generalist

"They had an article in one of the magazines one year, quoting pitchers on how they pitched to Mantle and me.  Billy Pierce said he hoped for “minimum damage” and that he varied his pitches as much as possible—sliders, fast balls, slow-breaking stuff and prayers... What they all were saying was that there was no accurate “book” on me, and that’s what a batter strives for"

Love what you do

"I feel in my heart that nobody in this game ever devoted more concentration to the batter’s box than Theodore Samuel Williams, a guy who practiced until the blisters bled, and loved doing it, and got more delight out of examining by conversation and observation the art of hitting the ball."

Understand History

"I honestly believe I can recall everything there was to know about my first 300 home runs—who the pitcher was, the count, the pitch itself, where the ball landed. I didn’t have to keep a written book on pitchers—I lived a book on pitchers."

Human Nature Doesn't Change

"After two years of managing the Washington Senators, the one big impression I got was that the game hasn’t changed. It’s the same as it was when I played. I see the same type pitchers, the same type hitters."

Keep it Simple

"It’s not really so complicated. It’s a matter of being observant, of learning through trial and error, of picking up things."

Understand Batting Average

"... you are going to fail at your job seven out of ten times"

Learn from your Mistakes

"A great hitter isn’t born, he’s made. He’s made out of practice, fault correction and confidence.”

Focus on the Factors that Matter

"Have you done your homework? What’s this guy’s best pitch? What did he get you out on last time?"

Speak to People in the Know

"Where was the pitch that Frank Howard hit? What was it? Curve ball? Slider? Ask the guys on the bench, the pitchers, everybody. Get in the game, know what’s going on, know the reason when that pitcher takes the bread out of your mouth. That makes sense to me."

Test Investment Ideas

"I was a pain in the neck asking the older guys about pitchers. I was always asking about pitchers: What kind of pitcher is Bobo Newsom? What kind of pitcher is Red Ruffing? What about Tommy Bridges? Ted Lyons? Lefty Gomez? Schoolboy Rowe? I wanted the information, and I wanted to put it to use."

Stick to What you Know

"My strike zone, almost to the inch, was 22 by 32, or 4.8 square feet. Add two inches all around and it becomes 26 by 36, a total of 6.5 square feet—35 per cent more area for the pitcher to work on. Give a major league pitcher that kind of advantage and he’ll murder you."

Buy with a Margin of Safety

"The single most important thing for a hitter was “to get a good ball to hit.

Avoid Permanent Loss

"Now, if a .250 hitter up forty times gets 10 hits, maybe if he had laid off bad pitches he would have gotten five walks. That’s five fewer at-bats, or 10 hits for 35, or .286. And he would have scored more because he would have been on base more." 

Stick with a Process

"What I had more of wasn’t eyesight, it was discipline, and isn’t it funny? I took so many “close” pitches I wound up third in all-time bases-loaded home runs, among the top five in all-time home runs, in the top three in runs batted in per time at bat, and I drove in more than a fifth of the Red Sox’ runs in my twenty years in Boston. I averaged .344 for a career."

Buy Quality Companies

"There isn’t a hitter living who can hit a high ball as well as he can a low, or vice-versa, or outside as well as inside. All hitters have areas they like to hit in. But you can’t beat the fact that you’ve got to get a good ball to hit."

Avoid Value Traps

"More often than not, you hit a bad pitch in a tough spot and nothing happens."

"The greatest hitter living can’t hit bad balls good."

Watch Others

"I was forever trying a new stance, trying to hit like Greenberg or Foxx or somebody"

How Big to Position

"Well, it was obvious to me the first time I saw him play, when he was with the Dodgers in a World Series in 1963. I knew then exactly what I would say to him if I ever got the chance: the value of knowing the strike zone. The value of proper thinking at the plate. The importance of getting a good ball to hit. Of knowing when not to be too big with his swing."


"Ideally, for maximum power and efficiency, you want your stronger hand closer to the point of impact"

Be Adaptable

"The reason hitting a baseball is so tough is that even the best can’t hit all the balls just right. To do so is a matter of corrections every minute, in practice as well as in the game."

Dealing with Losses

"There is no question that some strikes are called balls, and some balls are called strikes, but you’re far better off forgetting the calls that hurt you and concentrating on that next pitch, or that next turn at bat."

"If you’ve struck out on a ball you thought was bad, don’t argue. Talk to a teammate, somebody you know pays as much attention to the game as you do. Ask him if the ball was low or outside or wherever you thought it was, and if he agrees with the umpire, file it in your memory. You’ve got some work to do on that particular pitch. You might even make a diagram for yourself to pinpoint the problem areas. Paul Waner did that, and I did it."

Using Intuition

"Guess? Yes! “Proper thinking” is 50 per cent of effective hitting, and it is more than just doing your homework on a pitcher or studying the situation in a game. It is “anticipating,” too, when you are at the plate, and a lot of hitters will say that is college talk for “guessing” and some will be heard to say in a loud voice, “don’t do it!” They’re wrong. Guessing, or anticipating, goes hand in hand with proper thinking"

"Well, you’ve got to guess, you’ve got to have an idea. All they ever write about the good hitters is what great reflexes they have, what great style, what strength, what quickness, but never how smart the guy is at the plate, and that’s 50 per cent of it. From the ideas come the “proper thinking,” and the “anticipation,” the “guessing.”

"I had 20-10 vision. A lot of guys can see that well. I sure couldn’t read labels on revolving phonograph records as people wrote I did. I couldn’t “see” the bat hit the ball, another thing they wrote, but I knew by the feel of it. A good carpenter doesn’t have to see the head of the hammer strike the nail but he still hits it square every time."

Improving with Age

"I think there are things you learn growing older in the game which practice brings out."

"At eighteen I might not have been quite as strong as I was at twenty-eight or thirty-eight, but I had better eyesight, better reflexes, could run faster, etc. But at seventeen or eighteen I wasn’t thinking as clearly at the plate as I was later on. When I came up with San Diego in 1937, I hit .271, then .291. My average went up steadily thereafter because in those formative years I was exposed to experienced players who knew the game between the pitcher and batter."

Be Aware of the Macro

"The batter who is alert will consider the environment, the park, the background. What kind of a day is it? Is the wind blowing a gale from centerfield? If so, it will be silly to try to hit the ball 480 feet...  Is it damp and rainy? The ball you hit won’t go as far because on a damp day the air is heavier. A curve-ball pitcher will be even more effective on a heavy day. Be alert to these things."

Balancing Confidence with Humility

"Oh, I can’t say I never had that little fear at the plate, especially in those early days when I’d be hitting against some guy who was a little out of my class. But I remember the time in Minneapolis, my third year as a professional, when a pitcher named Bill Zuber hit me in the head with a pitch. Knocked me out and put me in the hospital for two days. When I got back in the lineup, I dug in as hard as I could and said to myself, “Boy, this isn’t going to stop me. Not a bit.”

"I know there are hitters who can be intimidated, and pitchers who believe in keeping you loose. Jimmy Piersall told me he was afraid at the plate when he was with the Red Sox, and I tried to needle him out of it. “If you’re afraid, you might as well go sell insurance. But why be afraid?” He worked himself out of it. His confidence grew. If you stay intimidated, you’re done."

Investment Misconceptions - Volatility is Risk - Efficient Markets

"Much of it has been poorly defined, or not defined at all, and some things have been told wrong for years.  The consequence is a collection of mistaken ideas that batters parrot around"

Goal is to Make Money

"I think that every player should have goals, goals to keep his interest up over the long haul, goals that are realistic and that reflect improvement. For me, if I couldn’t hit 35 home runs, I was unhappy. If I couldn’t drive in 100 runs, if I couldn’t hit at least .330, I was unhappy. Goals keep you on your toes, make you bear down, give you objectives at those times when you might otherwise be inclined to just go through the motions."

Let's hit the ballpark… 

References:  'The Science of Hitting' by Ted Williams and John Underwood, 1970
Photo sources: HBO Documentary - 'Becoming Warren Buffett', 2017
Further Reading: The Science of Hitting [video]

The Truth About Investing

Howard Marks recently presented at the CFA Society in India. His presentation was titled "The Truth about Investing".  

The 40 page presentation covers the core foundations of Howard Mark's investment philosophy. For those looking for more on Howard Mark's investment thoughts I highly recommend his book "The Most Important Thing - Uncommon Sense for the Thoughtful Investor" which is in my Top 5 recommended books. The book draws on many of the investing themes that Mr Marks has written about over the years in his investment memos.  These memos are available on the Oaktree Capital Management website. Click here to to access the memo archive.  

The video from the CFA Society can be accessed below:

Investment Thesis - Pen to Paper

Many of the Investment Masters recognise the benefits of writing to improve thinking and identify potential pitfalls and/or psychological biases that may have crept into the investment decision making process.  

“I find this very useful when I write my annual report. I learn while I think when I write it out. Some of the things I think I think, I find don’t make any sense when I start tying to write them down and explain them to people. You ought to be able to explain why you’re taking the job you’re taking, why you’re making the investment you’re making, or whatever it may be. And if it can’t stand applying pencil to paper, you’d better think it through some more.” Warren Buffett

“Beginning around 1980, I developed a discipline that whenever I put on a trade, I would write down the reasons on a pad.  When I liquidated the trade, I would look at what actually happened and compare it with my reasoning and expectations when I put on the trade.” Ray Dalio

“I always write down when I make a purchase. I usually update those notes once a quarter on what the intrinsic value is.  Why we bought? What are the drivers?  I update those thoughts every three to six months.  Those are useful because I can go back to the notes and say “hey there was a method to the madness”.  Mohnish Pabrai

“Why do we bother with this?” When nobody reads it?”… It’s not for the readers, It’s for us.  We write it for ourselves.  Putting ideas on paper forces you to think through things”  Shelby Davis

“We publish these fifteen-page quarterly letters because it forces us to write down and communicate in a very clear fashion what we think and why we think it.  There are a lot of crumpled up pieces of paper that end up next to the garbage can when we do that.  Yet, a lot of times they are a reminder that there are a couple of questions that we still have about an investment that we really should be addressing.  It also helps because by synthesizing it, you sometimes realize just how good the investment that you have is” Larry Robbins.

“I was greatly helped by the discipline of having to write down my thoughts” George Soros

While writing down a thesis helps thinking, it's important to recognise the act of writing will increase a person's commitment to an idea, particularly if it is made public.  Experiments show that people are more loyal to choices they make when they are written down.

"We are most consistent when we have made a public, effortful or voluntary commitment.  The more public a decision is, the less likely we will change it.  Written commitments are strong since they require more effort than verbal commitments and can also be made public" Peter Bevelin

"Yet another reason that written commitments are so effective is that they require more work than verbal ones.  And the evidence is clear that the more effort that goes into a commitment, the greater is its ability to influence the attitudes of the person who made it" Robert Cialdini

It's therefore paramount to remain open minded, to continually re-test the thesis and be prepared to exit a position if the original thesis is no longer valid.  

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

"We try not to have many investing “rules,” but there is one that has served us well: If we decide we were wrong about something, in terms of why we did it, we exit, period. We never invent new reasons to continue with a position when the original reasons are no longer available." David Einhorn

"You can't avoid wrong decisions.  But if you recognise them promptly and do something about them, you can frequently turn the lemon into lemonade" Charlie Munger

It is a delicate balance between maintaining confidence in an idea and having the humility to recognise you may be wrong. 

"We know that we are fallible and must therefore consider the possibility that for every investment we make we may be wrong"  Seth Klarman

Its time to start writing … 

Lessons from Valeant

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Pershing Square's 2016 Annual report was released recently.  While Bill Ackman's long term track record is impressive, he lost a substantial amount of money in Valeant.  He wasn't alone as other high profile investors like ValueAct and Sequoia also took significant losses.   Like all good investors, Mr.Ackman acknowledged his mistakes and highlighted the lessons he learnt.

The Investment Masters recognise the importance of analyzing past mistakes, so as not to repeat them.  In most cases we can learn more from our mistakes than our successes.  We can also learn from the mistakes of other.

“When we make mistakes, we always try to do post-mortems.”  Lou Simpson

"The big difference between those who are successful and those who are not is that successful people learn from their mistakes and the mistakes of others" Sir John Templeton

Mr.Ackman recently exited the Valeant position.  While he acknowledged he may have sold at a price that may look cheap with the benefit of hindsight he explained his rationale for the sale.  Valeant had plunged more than 90% from it's peak.  It was a permanent loss of investor's capital.

At the time of sale, Valeant was just 3% of the portfolio's assets.  Even if the stock price increased substantially, Ackman felt the impact on the overall portfolio would have been modest and wouldn't compensate for the human resources and substantial mind-share the investment would have consumed.

Ackman stated "Clearly, our investment in Valeant was a huge mistake.  The highly acquisitive nature of Valeant's business required flawless capital allocation and operational execution, and therefore, a larger than normal degree of reliance on management.  In retrospect, we misjudged the prior management team and this contributed to our loss."

Ackman noted the many lessons from the investment and raised a few important reminders:

  • Management’s historic ability to deploy capital in acquisitions and earn high rates of return is not a sufficiently durable asset that one can assign material value to when assessing the intrinsic value of a business
  • Intrinsic value can be dramatically affected by changes in regulations, politics, or other extrinsic factors we cannot control and the existence of these factors is a highly important consideration in position sizing
  • A management team with a superb long-term investment record is still capable of making significant mistakes
  • A large stock price decline can destroy substantial amounts of intrinsic value due to its effects on morale, retention and recruitment, and the perception and reputation of a company

I remember reading Ackman's 110-page presentation titled "The Outsider" where Ackman detailed his thesis on Valeant and why it was such a compelling opportunity.   Ackman saw similarities between Valeant and the highly successful companies profiled in William Thorndike's book 'The Outsider CEO's'.   It was a pretty compelling sales pitch. 

So with the benefit of hindsight, I've outlined some red flags that may help avoid the next Valeant disaster?

Highly Acquisitive Company

Valeant was a highly acquisitive company, effectively a 'roll-up'.  Such companies always carry more risks.  Ackman has acknowledged past performance in acquisitions is not a durable asset.   In the "Outsiders" presentation Ackman noted "Management has completed 100+ acquisitions and licenses, investing $19b+ since 2008" .. "Acquisitions have been highly accretive" .. "Valeant management expects the majority of the company's future free cash flow will be allocated to its value-creating acquisition strategy"

"There may be quite a high degree of investment risk in a company that as a matter of basic investment policy is constantly and aggressively trying to grow by acquisition.. It is my own belief that this investment risk is significantly still further increased when one of two conditions exist in a company's organisational make-up. One is when the top executive officer regularly spends a sizeable amount of his time on mergers and acquisitions.  The other is when a company assigns one of its top officer group to making such matters one of his principal duties.  In either event powerful figures within a company usually soon acquire a sort of psychological vested interest in completing enough mergers or acquisitions to justify the time they are spending." Phil Fisher 1960

High Guidance

Valeant had a track record of providing aggressive guidance.  Guidance in 2012 was 40-45% EPS growth, 2013 was c35%, 2014 was c40% and 2015 was c21-25%.

“Be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no surprise environment, and earnings simply don't advance smoothly (except, of course, in the offering books of investment bankers). Charlie and I not only don't know today what our businesses will earn next year we don't even know what they will earn next quarter. We are suspicious of those CEOs who regularly claim they do know the future and we become downright incredulous if they consistently reach their declared targets, Managers that always promise to "make the numbers will at some point be tempted to make up the numbers” Warren Buffett

 “Having a person running a company to please Wall Street can really be problematic” Jim Chanos

“Rejecting guidance is rare among public companies, though it’s a practice we applaud. We worry that providing quarterly guidance may tempt companies to publish aggressive growth targets to appease Wall Street. Our concern is not that the aggressive forecasts won’t be met, but rather that they will, at any cost! Earnings growth should be a consequence of sound strategy, not the object of it." Allan Mecham


Valeant business model in part comprised buying pharmaceutical companies, stripping R&D costs out and aggressively raising prices on older drugs.  Valeant certainly wasn't a win-win proposition for consumers.

"There was a lot wrong with Valeant.  It was so aggressive and it was drugs people needed…  I don’t think capitalism requires you to make all the money you can.  I think there times when you should be satisfied with less.  Valeant looked at it like a game of chess, they didn’t think of any human consequences.  They just stepped way over the line and in the end of course they were cheating” Charlie Munger

"We want our operations and the businesses we invest in to pass the “Win-Win Test” with all six counterparties: customers, employees, suppliers, stewards, shareholders, and the community. Win-Win is the only system that is sustainable over the long-term – any fatal flaw with any counterparty will inevitably self-correct. We believe by striving to eliminate Win-Lose, Lose-Win, and Lose-Lose situations we can go far in removing many of the blind spots that those unsustainable relationships nurture."  Christopher Begg

Corporate Debt

Valeant's acquisition spree was funded via a massive increase in corporate debt.  Fortune magazine note "Its debt-to-equity ratio, a measure of a company's financial leverage, is nearly eight times that of other big pharma companies like Pfizer, Novartis and Merck".

"I turn down many otherwise down attractive investments because of their weak balance sheets, and I believe that this discipline is a material reason for our success over the years. " Ed Wachenheim

"Staying away from excessive leverage cures a lot of ills"  Thomas Gayner

Position Size

Ackman reflected that given the risks facing Valeant that were outside of his control, the position size was too large.   Ackman had previously acknowledged in Pershing Square's 2015 Interim Report that Valeant was at odds with the usual principles he applied to investments. In part this was because Valeant required continued access to capital markets to achieve accelerated growth.  With lower conviction and higher risks it's important to structure position sizes accordingly.

"Our lack of strong convictions about these businesses [Salomon, USAir Group, Champion International], however, means that we must structure our investments in them differently from what we do when we invest in a business appearing to have splendid economic characteristics"  Warren Buffett 1989

“Make your position size more a function of not how much you can make, but really how much you can lose. So manage your position based on your downward loss perspective not your upward potential.” James Dinan

Consistency Bias

With the benefit of hindsight, it's easy to suggest Ackman should have cut his position earlier.  Ackman's close proximity to the company may have blinded him to the problems that were starting to surface within the company.  The "Outsiders" presentation noted Pershing Square had executed a confidentiality agreement with Valeant in 2014 which allowed them to conduct "substantial due diligence" including in-person meetings with the board, extensive management interviews, review of R&D pipeline, selective local due diligence at the country level and review of bear thesis.   Ackman was all-in.

"One of the most difficult intellectual confessions is to admit you are wrong.  Behaviourally we know we are subject to confirmation bias.  Eagerly we wrap our minds around anything and everything than concurs with our statement.  Too often, we misjudge stubbornness for conviction.  We are willing to risk the appearance of being wrong long before a willingness to personally confess our own errors"  Robert Hagstrom

Falling In Love

When investors have made a large commitment to a position and gone on the public record as to why it's such a great investment it can be psychologically challenging to change tack.  It's paramount to stay open minded and not fall in love with a position or management.  As Ackman acknowledged, even a management team with a superb track record can make a mistake.

“If we only confirm our beliefs, we will never discover if we’re wrong. Be self-critical and unlearn your best-loved ideas. Search for evidence that dis-confirms ideas and assumptions. Consider alternative outcomes, viewpoints and answers.” Peter Bevelin

"One thing my father taught me at a young age was not to fall in love with companies or the people running them"  Lloyd Khaner

Get Out

Valeant had collapsed dramatically before Ackman finally sold.  Sometimes when investing, the best option can be to sell.  Running concentrated positions in a multi-billion dollar portfolio reduces flexibility.  In the end, Ackman acknowledged the position was taking an emotional toll on the firm and it was in the best interest to move on.  The small position size after the stocks collapse meant it's contribution to future returns was going to be marginal.  Profits and losses are not symmetrical.  If you lose 80% of your money you need to earn 400% to get back to break even.  Better to cut your losses and focus your energies elsewhere.

"Large permanent losses can dampen the confidence of an investor - and I sternly believe that a good investor needs to be highly confident about his ability to make decisions, because investment decisions seldom are clear and usually are muddled with uncertainties and unknowns" Ed Wachenheim

"Even the most conservative investors can be paralysed by large losses, whether due to mistakes, premature judgements, or the effects of leverage.  If losses impair your future decision making, then the cost of a mistake is not just the loss from that investment alone, but the impact that loss may have on the future chain of events.  If a loss freezes you from taking full advantage of a great opportunity, or pressures you to make it a smaller position than it should or would otherwise be, then the cost may be far greater than the initial loss itself" Seth Klarman

All investors make mistakes, even the great ones.  The key is to address them early and take action.  Then learn from the mistake.

“In every great stock market disaster or fraud, there is always one or two great investors invested in the thing all the way down. Enron, dot-com, banks, always ‘smart guys’ involved all the way down.” Jim Chanos

“Quickly identify mistakes and take action.” Charlie Munger

"If you feel you have made a mistake, get out fast" Roy Neuberger

“Whatever the outcome, we will heed a prime rule of investing; you don’t have to make it back the way you lost it” Warren Buffett

Ultimately an investor is only as good as his or her next investment.  Being on the lookout for red flags can help an investor from taking undue risks and impairing capital.  It's important to remain open minded and continually test a thesis to ensure the outlook hasn't changed.  Remember the first rule of investing is don't lose money.  And rule number 2 …. don't forget rule number one.

The Buffett Series - Buffett on Book Value

The Buffett Series explores some of the interesting and timeless investment concepts discussed by Mr. Buffett in his annual Berkshire letters.  Over the years I've found there isn't a lot that Mr. Buffett and his partner Mr. Munger haven't worked out when it comes to investing. I am constantly discovering hidden investment gems, and new ways of thinking about businesses and the investment process.  

This Series contains ten short essays on concepts that have featured in Mr. Buffett's annual letters since the early 1980's [click here to read the other essays].  It's amazing how timeless and universal they are.  This short essay touches on the concept of "Book Value".

From the teachings of his mentor Ben Graham, Buffett focussed on book value early in his career.  In later years he recognised is was intrinsic value, not book value, that was the key to finding outstanding investments.  He recognised that a business can be worth multiples of book value.  Berkshire paid 4X book for See's Candy, 2X book for Scott Fetzer and more recently 2.8X book for Precision Cast Parts and 5X book for Iscar.

Over the years Buffett has written extensively about 'book value'.  I remember at different times over the last few decades when the markets had become focused on book value.  Investors talked of assets like steel mills, paper companies, mining stocks and shipping lines being attractive solely on the basis that they were trading at big discounts to book value.  In many cases, they were 'value traps'.  The industries had changed and the future returns just weren't what they used to be.   

One must remember book value is a historic number and provides little information about the future prospects for a business.  The best businesses are those with high returns on capital which need little further capital to grow earnings. 

I've included below some extracts from Buffett's letters which may assist your thinking when it comes to book value. 

"In past reports I have noted that book value at most companies differs widely from intrinsic business value - the number that really counts for owners." Berkshire 1986 Letter

"Book value’s virtue as a score-keeping measure is that it is easy to calculate and doesn’t involve the subjective (but important) judgments employed in calculation of intrinsic business value.

It is important to understand, however, that the two terms - book value and intrinsic business value - have very different meanings. Book value is an accounting concept, recording the accumulated financial input from both contributed capital and retained earnings. Intrinsic business value is an economic concept, estimating future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out.

An analogy will suggest the difference. Assume you spend identical amounts putting each of two children through college. The book value (measured by financial input) of each child’s education would be the same. But the present value of the future payoff (the intrinsic business value) might vary enormously - from zero to many times the cost of the education. So, also, do businesses having equal financial input end up with wide variations in value." Berkshire 1983 Letter

"Some investors weight book value heavily in their stock-buying decisions (as I, in my early years, did myself). And some economists and academicians believe replacement values are of considerable importance in calculating an appropriate price level for the stock market as a whole.

Those of both persuasions would have received an education at the auction we held in early 1986 to dispose of our textile machinery. The equipment sold (including some disposed of in the few months prior to the auction) took up about 750,000 square feet of factory space in New Bedford and was eminently usable. It originally cost us about $13 million, including $2 million spent in 1980-84, and had a current book value of $866,000 (after accelerated depreciation). Though no sane management would have made the investment, the equipment could have been replaced new for perhaps $30-$50 million.

Gross proceeds from our sale of this equipment came to $163,122. Allowing for necessary pre- and post-sale costs, our net was less than zero. Relatively modern looms that we bought for $5,000 apiece in 1981 found no takers at $50. We finally sold them for scrap at $26 each, a sum less than removal costs.

Ponder this: the economic goodwill attributable to two paper routes in Buffalo - or a single See’s candy store - considerably exceeds the proceeds we received from this massive collection of tangible assets that not too many years ago, under different competitive conditions, was able to employ over 1,000 people." Berkshire 1985 Letter

"Of course, it's per-share intrinsic value, not book value, that counts. Book value is an accounting term that measures the capital, including retained earnings, that has been put into a business. Intrinsic value is a present-value estimatee of the cash that can be taken out of a business during its remaining life. At most companies, the two values are unrelated." Berkshire  1993 Letter

"We define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life. Anyone calculating intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move. Despite its fuzziness, however, intrinsic value is all- important and is the only logical way to evaluate the relative attractiveness of investments and businesses.

To see how historical input (book value) and future output (intrinsic value) can diverge, let's look at another form of investment, a college education. Think of the education's cost as its "book value." If it is to be accurate, the cost should include the earnings that were foregone by the student because he chose college rather than a job.

For this exercise, we will ignore the important non-economic benefits of an education and focus strictly on its economic value. First, we must estimate the earnings that the graduate will receive over his lifetime and subtract from that figure an estimate of what he would have earned had he lacked his education. That gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to graduation day. The dollar result equals the intrinsic economic value of the education.

Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for the education didn't get his money's worth. In other cases, the intrinsic value of an education will far exceed its book value, a result that proves capital was wisely deployed. In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value." Berkshire 1994 Letter


The Buffett Series - A Changing Media Landscape

The Buffett Series explores some of the interesting and timeless investment concepts discussed by Mr. Buffett in his annual Berkshire letters.  Over the years I've found there isn't a lot that Mr. Buffett and his partner Mr. Munger haven't worked out when it comes to investing. I am constantly discovering hidden investment gems, and new ways of thinking about businesses and the investment process.  

This Series contains ten short essays on concepts that have featured in Mr. Buffett's annual letters since the early 1980's.  It's amazing how timeless and universal they are.  This short essay touches on the concept of "A Changing Media Landscape".

While everyone now recognises the changes going on in the media landscape due to disruption from the advent of high speed internet and the likes of Netflix and YouTube, this is not a new phenomenon.  In fact, way back in 1990 Buffett recognised that media businesses were unlikely to be as profitable in the future as they had been in the past.  Media businesses were transforming from quality franchises to ordinary businesses.

In his 1990 letter, Buffett acknowledged he was surprised at developments in the media industry that year and questioned whether the poor results of Berkshire's media investments was "just part of an aberration cycle - to be fully made up in the next upturn - or whether the business has slipped in a way that permanently reduces intrinsic business values".  He concluded the latter … 

"Since I didn't predict what has happened, you may question the value of my prediction about what will happen. Nevertheless, I'll proffer a judgment: While many media businesses will remain economic marvels in comparison with American industry generally, they will prove considerably less marvellous than I, the industry, or lenders thought would be the case only a few years ago.

The reason media businesses have been so outstanding in the past was not physical growth, but rather the unusual pricing power that most participants wielded. Now, however, advertising dollars are growing slowly. In addition, retailers that do little or no media advertising (though they sometimes use the Postal Service) have gradually taken market share in certain merchandise categories. Most important of all, the number of both print and electronic advertising channels has substantially increased. As a consequence, advertising dollars are more widely dispersed and the pricing power of ad vendors has diminished. These circumstances materially reduce the intrinsic value of our major media investments and also the value of our operating unit, Buffalo News - though all remain fine businesses."

Buffett revisited the challenges facing the industry in his 1991 letter titled "A change in media economics and some valuation math"

"In last year's report, I stated my opinion that the decline in the profitability of media companies reflected secular as well as cyclical factors. The events of 1991 have fortified that case: The economic strength of once-mighty media enterprises continues to erode as retailing patterns change and advertising and entertainment choices proliferate. In the business world, unfortunately, the rear-view mirror is always clearer than the windshield: A few years back no one linked to the media business - neither lenders, owners nor financial analysts - saw the economic deterioration that was in store for the industry. (But give me a few years and I'll probably convince myself that I did.)

The fact is that newspaper, television, and magazine properties have begun to resemble businesses more than franchises in their economic behavior. Let's take a quick look at the characteristics separating these two classes of enterprise, keeping in mind, however, that many operations fall in some middle ground and can best be described as weak franchises or strong businesses.

An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company's ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital.

Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise's profitability, but they cannot inflict mortal damage. In contrast, "a business" earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low- cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management.

Until recently, media properties possessed the three characteristics of a franchise and consequently could both price aggressively and be managed loosely. Now, however, consumers looking for information and entertainment (their primary interest being the latter) enjoy greatly broadened choices as to where to find them. Unfortunately, demand can't expand in response to this new supply: 500 million American eyeballs and a 24-hour day are all that's available. The result is that competition has intensified, markets have fragmented, and the media industry has lost some - though far from all - of its franchise strength".

Buffett uses an example to show that a hypothetical media business which earns $1m a year that can grow at 6% per annum in perpetuity is worth $25m.  This is in contrast to a business earning the same $1m with no growth which is worth only $10m.  While a multiple of twenty-five times earnings is appropriate for the first company the second company fetches ten times earnings.  

"The industry's weakened franchise has an impact on its value that goes far beyond the immediate effect on earnings. For an understanding of this phenomenon, let's look at some much over- simplified, but relevant, math.

A few years ago the conventional wisdom held that a newspaper, television or magazine property would forever increase its earnings at 6% or so annually and would do so without the employment of additional capital, for the reason that depreciation charges would roughly match capital expenditures and working capital requirements would be minor. Therefore, reported earnings (before amortization of intangibles) were also freely-distributable earnings, which meant that ownership of a media property could be construed as akin to owning a perpetual annuity set to grow at 6% a year. Say, next, that a discount rate of 10% was used to determine the present value of that earnings stream. One could then calculate that it was appropriate to pay a whopping $25 million for a property with current after-tax earnings of $1 million. (This after-tax multiplier of 25 translates to a multiplier on pre-tax earnings of about 16.)

Now change the assumption and posit that the $1 million represents "normal earning power" and that earnings will bob around this figure cyclically. A "bob-around" pattern is indeed the lot of most businesses, whose income stream grows only if their owners are willing to commit more capital (usually in the form of retained earnings). Under our revised assumption, $1 million of earnings, discounted by the same 10%, translates to a $10 million valuation. Thus a seemingly modest shift in assumptions reduces the property's valuation to 10 times after-tax earnings (or about 6 1/2 times pre-tax earnings).

Dollars are dollars whether they are derived from the operation of media properties or of steel mills. What in the past caused buyers to value a dollar of earnings from media far higher than a dollar from steel was that the earnings of a media property were expected to constantly grow (without the business requiring much additional capital), whereas steel earnings clearly fell in the bob-around category. Now, however, expectations for media have moved toward the bob-around model. And, as our simplified example illustrates, valuations must change dramatically when expectations are revised."

Buffett recognised back in 1990 that the media industry had changed and was likely to continue to do so.  Today, the equity value of many of the traditional media companies have been decimated by change.  The fall in value in many cases has been a slow burn.  The internet destroyed the newspapers classified sections.   The advent of high speed internet has allowed Netflix and YouTube to access a global audience unavailable to traditional TV licence and cable operators providing economies of scale not available to the incumbents.

When evaluating businesses it's important to think about how conditions are changing and whether the changes are structural or cyclical.  Today, new technology can allow competitors to penetrate a business's 'moat' and change the industry economics for the better or worse.  It's important to think about how the businesses in your portfolio are placed to survive an ever changing world.



Further Suggested Reading - Tutorials - Quality Businesses, Change, Rear-View Mirror, Alternative Scenarios, Tech Invest, Thinking about Management, Permanent Loss, Intrinsic Value.