Over the last 20 years or so I've studied the world's greatest investors and I've tried to unpick the characteristics that have made them successful. While business schools all over the world focus an inordinate amount of time on teaching students how to model, I'm yet to find an Investment Master whose made his name by having the most detailed financial models. Consider a few of these gems ...
"I don't use a computer or a calculator. If you need to use a computer or calculator to make the calculation, you shouldn't buy it...It should scream at you...we do not sit down with spreadsheets and do all that sort of thing. We just see something that obviously is better than anything else around that we understand — and then we act." Warren Buffett
"We never sit down, run the numbers out and discount them back to net present value ... The decision should be obvious." Charlie Munger
"In general, I haven't run spreadsheets and I find that, if there is a need to run a spreadsheet, that is a red flag to take a pass." Mohnish Pabrai
"I'd say some of the worst business decisions I've ever seen are those that are done with a lot of formal projections and discounts back" Charlie Munger
Sure it's important to be able to navigate around a balance sheet, cash flow statement and income statement, but the really great investors spend their time reading, thinking, focusing on the qualitative data and testing ideas. I've not once heard an Investment Master say "All I do is sit and model all day."
So why don't the Investment Masters spend their time building 5,000 line spreadsheet models like most Wall Street analysts do? In part it's because models have their limitations including:
Stuck in the Rear-View Mirror
Typically an analyst will build a spreadsheet model by plugging in the last five years financials for a company and then building out the future years from there. The problem is historic data is just that, historic. A company is worth the discounted value of its earnings in the future, not the past. The historic data may provide a useful insight into a company's revenue trends, the quality of the balance sheet and how attractive margins are, as well as provide a basis to compare the company with competitors. But problems can arise because the future may look a lot different to the past. Models are good for extrapolating, but dangerous when it comes to changing circumstances. This is as relevant today as ever given the rapid technological changes taking place.
"The qualitative analysis is even more important than the quantitative analysis because quantitative is always a lagging indicator. By the time you see it in the numbers, it's often too late." C.T Fitzpatrick
"One cannot analyse events until they have already happened. Numbers, the 'oxygen' of analysis, lag behind reality. Analytic methodology is ineffective in identifying change in the early stages and thus contributes to what Marshall McLuhan refers to as man's tendency to walk into the future looking in the rear-view mirror." Bennett Goodspeed
"Data is backward looking and it is the future that will determine our returns." Jake Rosser
"Avoid over-relying on numbers and models. Investors often feel comfortable with numbers and models because they appear definitive. However, they can be misleading because they often are based on historical data that may not be repeatable or are based on assumptions that may not prove valid." Ed Wachenheim
"Typically, analysts evaluating the future prospects of a company look at its past. Where else can they look, after all? And yet, even if they had a perfect snapshot of the past, they would be mistaken to assume that the conditions that held in the past will hold in the present or future" Leon Levy
Over-Confidence and Anchoring
Studies show that the more information someone has the more likely they are to become over-confident. And more information doesn't necessarily mean more profits. Remember, humility is a key ingredient to investment success. An analyst or investor with a detailed model risks becoming over committed to an idea,"I've built a 5,000 line spreadsheet, I must be right!";or becoming anchored to the outcome of a spreadsheet, "The model says it's worth $x, it must be true"
“Having more information doesn’t necessarily improve decision-making. We know from studies of horse racing than when handicappers receive more information about horses and riders, they become proportionately more confident even though they are no more likely to pick the winner. When analysts have too much data, there’s a danger they won’t see the wood for the trees.” Marathon Asset Management
"I’m reminded of a study which showed that as the number of variables requiring analysis increase, the odds of success decline, yet the confidence of participants soar due to extensive time and energy invested." Allan Mecham
"The harder you work, the more confidence you get. But you may be working on something that is false" Charlie Munger
"[Computer] models can lull decision makers into a false sense of security and thereby increase their chances of making a really huge mistake" Warren Buffett
"Far too many people treat numbers like sacred totems offering divine insight. The truly numerate know that numbers are tools, nothing more, and their quality can range from wretched to superb" Philip Tetlock
"I think an enormous false precision gets into things when you program computers to make forward projections for a long period of time" Charlie Munger
"Investors like modelling because it appears scientific (the more spreadsheet tabs, the greater the effect). Investment models, however, encourage anchoring. Most models are calibrated to produce a current value for a company within a reasonable range of the current price" Marathon Asset Management
Difficult To Model
Einstein famously said "Not everything that counts can be counted, and not everything that can be counted counts." It's an apt quote for investing. The brain and financial models tend to operate in a linear fashion. But it's often the case that the best and worst investment outcomes are derived from non-linear situations. Charlie Munger often talks about 'Lollapalooza' effects where a number of forces combine to greatly amplify a positive outcome - more than simple addition. Alternatively, a credit crunch is an example of a non-linear event that can decimate a business but won't show up in a model.
There are plenty of other qualitative factors that are critical drivers of investment success but are hard to model. Corporate culture and innovation, management quality, capital allocation prowess and incentives would be some examples. Networks effects, product obsolescence, scalability, first-mover-advantages, industry developments, winner-takes-all, etc are also challenging to model.
"When we analyze a business, we pay close attention to the qualitative and intangible variables –such factors are often difficult to ‘model’. We are uneasy with fancy numerical models .. which have almost ubiquitous acceptance by the high priests of modern finance. We believe one is susceptible to gaining a false sense of security, which can result in mental slothfulness and neglect. In the case of models, analysts tend to overweight what can be measured in numerical form, even when the key variable(s) cannot easily be expressed in neat, crisp numbers. The ‘model’ behind our largest investment required nothing more than sixth grade math, and a napkin – not a sophisticated spreadsheet capable of more numbers than I’m capable of counting." Allan Mecham
"You’ve got a complex system and it spews out a lot of wonderful numbers that enable you to measure some factors. But there are other factors that are terribly important and there’s no precise numbering you can put to these factors. You know they’re important, but you don’t have the numbers. Well practically everybody overweighs the stuff that can be numbered, because it yields to the statistical techniques they’re taught in academia, and doesn’t mix in the hard-to-measure stuff that may be more important.” Charlie Munger
"In our evolution as investors, one of the things we have discovered is that it is often the things that don’t get measured that have a greater magnitude on investment returns than what is measured. That is to say, the numbers don’t provide all the clues. It is often qualitative factors such as company culture, management’s approach toward capital allocation, or customer service, that can yield critical insights into a company’s sources of competitive advantage. In fact, an advantage premised upon qualitative factors can often be more enduring." Jake Rosser
Missing the Forest for The Trees
Successful investing ordinarily requires determining the few key variables that drive a business' performance. By focusing on collecting all the data to build a more realistic model, the investor risks overlooking those key variables.
“Every company has 100 things about them you could study and learn. But you have to understand the differences between data and knowledge, and between knowledge and wisdom. Warren Buffett is remarkable in his ability to cut right through. He sees very clearly the three or four or five critical factors that determine whether a company succeeds or fails. It’s not about encyclopedic knowledge, it’s about zeroing in on what truly matters and assessing that. There’s no substitute for that in this business." Howard Marks
"Our approach stresses the importance of wisdom by subtraction. We endeavour to look past the non-essential details and tune out the often deafening noise. We want to identify the “essence” of each business. So, for instance, what is it about MasterCard that enables them to generate after-tax margins approaching forty percent? Why have the Rales brothers, first with Danaher and second with Colfax, been so successful buying and fixing businesses? How has Markel managed to compound book value per share at fifteen percent for the past twenty years despite falling interest rates and a competitive underwriting environment?" Chris Cerrone
"Are there dangers in getting too caught up in the minutiae of using a computer so that you miss the organised common sense? There are huge dangers. There'll always be huge dangers. People calculate too much and think too little" Charlie Munger
Models aren't Reality
A model is only as good as its inputs and it can never truly reflect reality. The inherent simplification of a model is one of its pitfalls. If the model is missing critical information or the key factors for success or failure, the output will be next to worthless. A good example of this was during the Financial Crisis when the bank analyst where I worked had a buy rating on an Investment Bank. The model and the analysts 'buy' rating went over the cliff when the stock went bust. Critically, the business relied on credit markets remaining open. That wasn't in the model.
"I have seen so many cases where there is a complex model that is exactly wrong. This focus on a model may cause you to move away from thinking about the competitive advantages of the business. Then you are making decisions based on all these numbers rather than thinking about whether this is one of the ten businesses that you would like to own." Glenn Greenberg
"Models are supposed to simplify things, which is why even the best models are flawed.” Philip Tetlock
“Nobody’s got a lock on what’s right, a model is only a model and it’s not fixed in stone.” Bill Stewart
"This is the virtue of models: They exclude information not directly relevant to the question under consideration, allowing us to focus on the significance of particular variables. This is also the vice of models: If the discarded information proves decisive to the issue being analyzed, the model will fail." Andy Redleaf
Instead of spending their days building financial models, the Investment Masters read, think, focus on qualitative data and test ideas. They keep stock valuations simple. If they do work on models, it's more likely to be mental models as an aid to investment success. Let's cover off on a few of those...
The Investment Masters spend their time reading and thinking about investments and asking themselves questions - Why is this opportunity available? Do I have an edge? Is this a good business? Do I understand the business? What is the business' competitive advantages? Will the business continue to thrive? What could kill the business? Will technology enhance or destroy the business? Could the business be replicated? What is the right price for the business? What don't I know about the business? etc.
“I insist on a lot of time being spent, almost every day, to just sit and think. That is very uncommon in American business. I read and think. So I do more reading and thinking." Warren Buffett
"I just spend all my time thinking, reading, and adapting as best as I can." Thomas Gayner
“We read and think.” Ed Wachenheim
“Warren and I do more reading and thinking and less doing than most people in business.” Charlie Munger
"Most individuals, including securities analysts, feel more comfortable projecting current fundamentals into the future than projecting changes what will occur in the future. Current fundamentals are based on known information. Future fundamentals are based on unknowns. Predicting the future from unknowns requires the efforts of thinking, assigning probabilities, and sticking one's neck out - all efforts that human beings too often prefer to avoid." Ed Wachenheim
Focus on Qualitative Factors
Successful investors spend more time understanding the qualitative aspects of their investments. This often involves channel checks with customers, competitors, suppliers, ex-employees and anyone else who might affect the company.
"Numbers alone won’t tell you the answer; instead you must think critically about the qualitative characteristics of your business.” Peter Thiel
“Interesting enough, although I consider myself to be primarily in the quantitative school, the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a 'high probability insight'. This is what causes the cash register to really sing. So the really big money tends to be made by investors who are right on qualitative decisions, at least in my opinion.” Warren Buffett
"The quantitative side of what we do is easy, to be honest with you. You don't have to have much more than a sixth-grade mathematics education to spot a potentially interesting investment proposition.... I would say the qualitative side of what we do consumes 95% of our time because that's the hard part." John Harris
"[My] only evolution .. in my own framework of looking at businesses, is that I pay more attention to the qualitative factors around a business than the quantitative. In the past I used to be much more focused on the quantitative." Mohnish Pabrai
"While we can run spreadsheets with the best of them, we really emphasize understanding the qualitative factors that drive the numbers. Market shares. Competitive advantages. The secular and cyclical impacts on the industry. Management’s skill in allocating capital. The goal is to identify companies in which we have a great deal of confidence that their values are going to continue to compound as we own them." C.T Fitzpatrick
"It's tempting when you start out to think your knowledge about finance and valuation will lead you to all the answers, but I now put more emphasis on qualitative than quantitative analysis" Jake Rosser
"It is easy to drown in the ocean of available facts while underestimating the few important qualitative aspects of a business that should enable it to do well going forward." Larry Pitkowski
While building a simple financial model can help us better understand a company, it's clear that the people we refer to as the Investment Masters do not rely on 5,000 line spreadsheets for their ideas. Qualitative investment relies on knowledge, which can be gained from reading and thinking and talking with people. And then pulling all that information together into an idea that is valuable. It's also clear that an over reliance on financial modelling can leave you blind to certain risks. So the question remains as to why people still continue to both create them and then follow them? If the Masters don't use them, and they have the track records to prove their method as the right one, which will you follow? For me, I'll choose qualitative investing over quantitative every day of the week and twice on Sunday, and any investment thesis predicated on a 5,000 line spreadsheet will end up in the trash where it belongs.