Uncertainty and Panic

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

“The best bargains arise when there is fear and uncertainty.” David Marcus

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

“We do not believe in certainty (and anyhow it would be useless as the market would recognize it) and in contrast we like uncertainty (‘debate’) as it scares too many and too much.” James Anderson

“Maximum panic usually coincides with minimum prices.” Howard Marks

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

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

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

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

"There's nothing wrong with worrying and re-examining, but a manager must have the inner poise and toughness not to panic mentally." Barton Biggs

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

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

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

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

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

"Until results surface, few investors can muster the courage to buy down-and-out stocks that evoke blank stares more often than envy. Once results become visible, the opportunities usually have passed." John Neff

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

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

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

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

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

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

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

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

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

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

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

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

"Where there is panic, there is also opportunity." John Neff

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

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

When to Sell a Great Company?

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

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

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

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

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

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

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

"Our favorite holding period is forever." Warren Buffett

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

“I have also learnt that selling a stake in a good company is almost always a mistake... Selling good companies is rarely a good move. The good news is that we don’t do it very often.” Terry Smith

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

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

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

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

“If we have identified a great business, a compounding machine that we’ve purchased well, we want not to interrupt that compounding unnecessarily by curtailing it with a sell target. We want these businesses to continue to compound and we want to own that as long as they continue to be exceptional. So no sell targets, only buy targets.” John Neff, Akre

“If you own a business that really is a true genuine compounder where you have a ramp to grow and particularly for re-investment at high rates of return, don’t sell it, and definitely don’t sell it all. I get cute with a lot of other things that aren’t your classic compounders but any time I’ve sold shares in one of the handful of businesses that I think we can own forever it has proven to be a mistake.” Chris Bloomstran

“The key thing is when you find an outstanding company not only do you have to buy it but also learn to hold it. And that’s the hard part because you have some inclination of wanting to manage the risk when it becomes a little expensive or ends up occupying a larger weight in your portfolio. That can be a mistake.” Francois Rochon

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

“When you find a truly wonderful business, stick with it. Patience pays, and one wonderful business can offset the many mediocre decisions that are inevitable.” Warren Buffett

"The only good reason to sell shares in a successful common stock of high quality is if its share price gets “maniacal” or if it no longer meets our eight criteria for stock selection." Bill Smead

“Selling fabulous businesses is something we should be wary of doing on a regular basis. Or as Philip Fisher wrote the time to sell is ‘almost never.’” James Anderson

"The real thing to do with a great business is just hang on for dear life." Warren Buffett

“Finding the really outstanding companies and staying with them through all the fluctuations of a gyrating market [has] proved far more profitable to far more people than did the more colorful practice of trying to buy them cheap and sell them dear.” Phil Fisher

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

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

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

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

“The short-term investor is intensely focused on the present. But this focus puts one at extreme risk of missing out on the future. If a short-term manager’s best holding is 10% overvalued on a given day, he sells it. For good reason: it might underperform next quarter. But since the best companies deliver the nicest surprises over time, that business may never be undervalued again. In fact, the manager who loves to trade around his positions might be right more often than he’s wrong; but the ones he trims that never come back to him cause more damage than all the smallscale trading successes. If your performance is driven by home runs, why bunt?” David Poppe

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

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

“I think it’s usually a bad mistake to sell your interest in wonderful businesses. I don’t think people find them that often. And I think they get hung up, if they’ve sold them at X that they want to buy them back at 90 percent of X, or 85 percent of X, so they’ll never go back in at 105 percent of X. I think, on balance, if you are in a business that you understand and you think it’s a really outstanding business, that the presumption should be that you just hold it and don’t worry. And if it goes down 25 percent in price or 30 percent in price, if you have more money available, buy more. And if you don’t, you know, so what? Just look at the business and judge how it’s doing.” Warren Buffett

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

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

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

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

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

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

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

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

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

“In the crashes that follow most bubbles, enormous interim markdowns can befall good companies as well as bad, requiring sharp analysis to differentiate between them, and high conviction and an iron stomach to hold on.” Howard Marks

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

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

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

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

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

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

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

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

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

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

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

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

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

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

“It was our companies that protected us [in the downturns]. It was not because we were clever at buying and selling stocks during the day time.” Chuck Akre

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

Conservative Forecasts - Masters Thoughts

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

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

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

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

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

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

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

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

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

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

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

“These situations are dynamic, so you make the best guess you can and try to be more on the conservative side when figuring out what all these things are likely to be worth.” Bill Stewart

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

“We do a lot of what we call reverse DCF where we actually take the price today and instead of a typical discounted cash flow where you make projections about what the cash flows will be and you discount them back and say this is what it is worth. A reverse is, you actually try to figure out what’s priced in to today’s stock and what would have to happen for it to be worth this." Jason Karp

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

Creativity - Learning from Pixar

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

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

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

“We think we try harder than most to be rational and creative. The combination of the two is important.” Nick Sleep

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

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

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

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

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

TEAM DYNAMICS

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

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

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

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

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

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

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

QUESTIONS

"I've never stopped questioning."

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

MISTAKES

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

"Mistakes are part of creativity."

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

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

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

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

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

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

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

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

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

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

HUMILITY

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

CONFIRMATION-COMMITMENT BIAS

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

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

IDEAS

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

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

TESTING IDEAS

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

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

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

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

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

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

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

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

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

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

CANDOR

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

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

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

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

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

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

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

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

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

CHANGE

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

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

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

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

THE UNEXPECTED & RANDOMNESS

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

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

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

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

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

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

"Randomness doesn't occur in a linear fashion." 

GENIUS?

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

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

WHAT YOU KNOW?

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

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

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

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

MENTAL MODELS

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

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

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

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

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

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

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

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

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

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

INNOVATION

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

RESEARCH TRIPS

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

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

INTUITION & RIGHT BRAIN THINKING

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

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

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

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

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

LEARNING

"I believe no creative company should ever stop evolving."

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

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

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

Learning from Ray

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

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

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

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

Other Investment Masters have also learnt the same lesson.

“I lost my stakes a couple of times, which taught me risk control and risk management. Losing those stakes in my early 20s gave me a healthy dose of fear and respect for Mr. Market and hardwired me for some great money management tools.” Paul Tudor Jones

“My dad was a retail pharmacist and after I started attending law school he said ‘well you have to learn how to be an investor.’ He and I traded tiny amounts of tech stocks and mining stocks together. So I became very interested in markets and trading. In the period of time from 1967-1974 he and I found just about every possible way conceivable to lose money. So when I started Elliot in 1977 I was determined to engage in a trading strategy that made money all the time. So for the first 10 years of Elliot’s existence the primary strategy was convertible bond hedging.” Paul Singer

"And just as in blackjack, my first investment was a loss that contributed to my education." Ed Thorp

"I went into this tech stock with 100% short position, and all the money I saved up because I thought I had this one locked down. We had fully positioned ourselves, myself and all my customers and clients I was advising, and then a technology writer dubbed the company the 'Son of Intel'.  The stock went promptly from about $16 to $40. I got margin called all the way up until I was completely wiped out. I lost all of my money. I was apoplectic. I thought the world was going to end. I remember that like it was yesterday. That was the greatest thing that ever happened to me - losing all of my money on something where I knew I was right. From an investing perspective, getting completely wiped out and thinking it was the end of the world, and thinking I was an abject failure, and this investing thing wasn't for me. Looking back at it, it couldn't have happened at a better time in my life. You want that to happen as early in your career as it can and you want it to be the most devastating blow that could possibly hit you, to teach you, to bring humility into your investing and teach you that you should never set yourself up for the knockout punch. It teaches you never to put 100% into anything. It teaches you a lot about sizing, it teaches you a lot about life, no matter how much you think you have your arms around a situation, you never do." Kyle Bass

“There is nothing like losing all you have in the world for teaching you what not to do. And when you know what not to do in order not to lose money, you begin to learn what to do in order to win. Did you get that? You begin to learn!” Jesse Livermore

"Making money through an early lucky trade is the worst way to win. The bad habits that it reinforces will lead to a lifetime of losses." Naval Ravikant

It was the recognition of the need to learn from mistakes that led to the development of Ray's Principles.

"You have to learn from mistakes to keep getting better. And it's through learning from those mistakes that you learn what reality is and how to deal with it, which is called Principles."

Interestingly, Ray is about to release a new book entitled 'Principles'. This will be an absolute must-read and I have already pre-ordered it. Ray released the first document titled 'Principles' on the Bridgewater Associates website back in 2011. The original 'Principles' focuses on Ray's most fundamental truths about life and in addition, his beliefs and ideals regarding people management. Over the years I've often referred back to the original text, and while Ray has updated it in the new book, the original document remains a favourite of mine.

Bridgewater Associates investment style differs from many of the Investment Masters in so much as they invest across a broad spectrum of asset classes and regions, both long and short, and seek approximately 100 different return streams that are roughly uncorrelated to each other. While there isn't a lot of commentary on investing per se in the original 'Principles' document, it does include the psychological insights and approach to learning that parallel with other great investors and give Bridgewater their edge. 

This is evident in the company's employment philosophies. On the Bridgewater Associates website's career page, they ask potential employees to ask themselves a number of questions before applying to work there. These include:

"Do you want to: Discover your strengths and weaknesses? Work to get better fast? Put aside ego barriers to learning? And, demand others to be truthful and open, and are you prepared to to do the same?"

In conjunction with the release of the new book, Ray has given a very insightful Ted Talk [only 16 minutes ... see below] where he discusses the processes he developed to successfully navigate the markets. Ray describes himself as a hyper-realist; he's a broad thinker who meditates and recognises there are many lessons to be learnt from nature and history. It was by studying history that provided Ray with the insights to anticipate the Global Financial Crisis.  

It's no surprise Ray features prominently throughout the tutorials included in the Investment Masters Class. Here's a taste of some of the Principles which are behind Ray's success..

"I learned that failure is by and large due to not accepting and successfully dealing with the
realities of life, and that achieving success is simply a matter of accepting and successfully
dealing with all my realities."

"I learned that finding out what is true, regardless of what that is, including all the stuff most people think is bad—like mistakes and personal weaknesses—is good, because I can then deal with these things so that they don’t stand in my way."

"I learned that there is nothing to fear from truth. While some truths can be scary—for example, finding out that you have a deadly disease—knowing them allows us to deal with them better. Being truthful, and letting others be completely truthful, allows me and others to fully explore our thoughts and exposes us to the feedback that is essential for our learning."

When investing, it's important to maintain humility, study history, learn from mistakes and test investment ideas - the foundations of both Ray Dalio's, and the Investment Masters success.

Further Reading:
Ray Dalio Principles - 2011
Ray Dalio - Academy of Achievement
Ray Dalio - Charlie Rose Interview
Ray Dalio - Alpha Masters
Ray Dalio - Hedge Fund Market Wizards
Ray Dalio - The New Yorker

The IMportance of Culture

What is 'Culture' and how does it affect the operational success of an organisation?

Without doubt, if there is one aspect of an organisation that will separate the great businesses from the mediocre or the poor, it has to be the company's Culture. Businesses with healthy Cultures tend to be successful and provide attractive investment opportunities whilst those with cultures that are sick or decidedly unhealthy tend to perform poorly, leading to share price under-performance or even worse, the permanent loss of capital. It is for this reason, the Investment Masters recognise the importance of Culture in the investment decision-making process.

“Culture is king.” Sam Zell

"The real glue of investing is understanding what the Cultures are in the businesses." Thomas Russo

"In businesses, culture counts." Warren Buffett

"Culture is a big deal." Mohnish Pabrai

"Culture is everything at Berkshire." Warren Buffett

 “After having invested in so many companies in China and around the world, one lesson we’ve learned is that culture is important above all.” Lei Zhang

A company's intrinsic value is determined by it's future earnings, and while past financial statements may provide clues to the quality of the business, changing conditions can make extrapolation of past results unreliable. In a large part, a company's future success will be a function of the culture.  And culture is difficult to measure given its qualitative rather than quantitative nature.  It is for this reason that culture often gets overlooked in the investment process.  

Marianne Jennings, in her book, 'The Seven Signs of Ethical Collapse' [nb. recommended reading by Jim Chanos, the world's most famous short-seller] noted that "A good analysis of where a company is headed demands a look at the qualitative factors , those touchy-feely, squishy, from-the-gut factors that are ignored despite the fact that they often determine the company's fate".

James Heskett, a leading authority on corporate culture, noted that culture can be a better indicator of a company's future financial performance than hard numbers... "The decline of an organization's culture may well precede financial decline".

Great companies have great cultures. Ed Catmull, co-founder of Pixar, discussed culture in the first paragraph of his great book 'Creativity Inc' [new blogpost on this book coming soon!]. The book's introductory paragraph highlighted that what made Pixar was 'the unique culture that defines this place'.

So why is it so important?

A company could have the greatest products, a robust brand and reputation, effective policies and processes and a long history of trading, but if the culture is poor, it is much less likely to succeed when compared with a business that has a healthy culture.

Despite those great products, you might find that many customers have complained about slow delivery, or poor service, or rude employees in that business. These are all indicators of the health of a company's culture.

Companies with great service and employees that go the extra mile rarely have complaints made against them. And if they are not making complaints, then customers will return to the better businesses, leading of course to better business results. Its that simple. 

"As much as half the difference in operating profit between organisations can be attributed to effective cultures." James Heskett

“A rotten culture can be a firm’s undoing.” Marathon Asset Management

"Cultures self-propagate. Winston Churchill once said, “You shape your houses and then they shape you.” That wisdom applies to businesses as well." Warren Buffett

"Long term, culture is enormous in terms of one business doing better than another." Paul Black

“Culture is truly the most vital ingredient in business. People are the most important asset in every business and the primary determinant of success or failure.” Richard Handler

“Perhaps the best known study on the subject is Corporate Culture and Performance by John Kotter and James Heskett. This work examines the relationship between corporate culture and company performance in over 200 firms during the 1980’s. The authors asked employees their opinions of attitudes to customers and shareholders at competitor firms. Shares in companies exhibiting strong and positive cultures outperformed rivals by more than 800% during the study period.” Marathon Asset Management

A successful culture is a competitive advantage that can be difficult to compete with and challenging to replicate.

"In many organisations, culture is the most potent and hard-to-replicate source of competitive advantage - far more important, for example than technological innovation." James Heskett

“[We] pay close attention to leadership and company culture as a source of competitive advantage.” Jake Rosser

"Your competitors can copy everything but they cannot copy your culture no matter how much they try." Mohnish Pabrai

“A strong corporate culture constitutes an intangible asset, potentially as valuable as a high profile brand or network of customer relationships.” Marathon Asset Management

"Organisations with strong, adaptive and open cultures that foster employee loyalty and productivity are not concerned that competitors may find it possible to borrow policies, methods and processes. They are convinced that the real key to making those policies, methods and processes, and yes, strategies work is something much more difficult to emulate - culture." James Heskett

“Peter Drucker used to say that culture eats strategy for breakfast.” Mohnish Pabrai

How do you describe what an organisation's Culture is?

Look at it this way: if we are asked to 'describe' a person, the answer lies in their personality and behaviours sets. They could be confident, assertive, organised, decisive, and pragmatic as an example.

If you then consider the Culture of an organisation to be much the same thing, when we describe it, we will be outlining how we see the business' 'personality'. By the same standard, it could be defined as competitive, aggressive, customer-focused, mature, cost-conscious and well-respected. On the other hand, a company with a poor culture could be described as lacking in Leadership or Integrity, and with a non-customer centric focus.

How is a company's Culture created?

In a nutshell, there are two things that determine a company's Culture. These are either 1/. a Company's Vision and Values, and/or 2/. the Behaviours of the Management/Leadership Team.

Company Values have long been touted by some companies as HR rubbish, or soft and fluffy BS that wastes everyone's time. The reality is actually something else entirely. If a company goes to the effort of creating a set of Values, it is essentially defining the organisation's Code of Conduct.

So taking this one step further, if the company's Vision and Purpose determines What it wants to be in the future, and the Strategies outline How it will get there, think of the Values as the Manner in which it will behave along the way. Values could also be seen as the company's behaviour set.

In the case of Vision, Amazon's vision is “to be Earth’s most customer-centric company, where customers can find and discover anything they might want to buy online.” or Southwest Airlines vision to be the "Airline for the Common Man".  Google has a purpose "to organise and make accessible all the world's information". Successful companies have a purpose and vision other than 'making money'. In all cases, these Visions will contribute to each of these company's behaviour sets. 

Values will also differ from business to business. When setting their Code of Conduct, many use words like Integrity, Customer, Quality, Profitability, etc to define what it is important to that company. Basically, the list of potentials is endless. And they're also just words, unless definitions and measures are put in place beside them to ensure they are 'lived' within the business. In the end, words don't define a Culture, people and their behaviours do.

“Culture, more than rule books, determines how an organisation behaves.” Warren Buffett

"In a 2004 study from the Journal of Business ethics, employees stunned most academics by saying that code of ethics for their company had very little influence on whether they make ethically correct choices. It was the culture of their companies and the examples set by their leaders that influenced their conduct." Marianne Jennings

Where organisations measure and reward staff for living company Values, the cultures are typically healthy and consistent - i.e. everyone behaves in the same way. If there is a Value of 'Integrity', the staff behave honestly and professionally. If they Value 'Customers', then they will treat every client as a valuable commodity that they do not want to lose. 

Inversely, I have seen many organisations with sets of Values that are framed in reception or have been placed on the back of every employee's business cards, yet when staff are asked to name them, virtually no one can remember what the Values are. This typically defines businesses that do not measure their Values and therefore do not place any importance in them. They have gone to the effort and expense of creating the list in the first place, and then have never followed up to ensure their staff and management are living the behaviours. This is very common unfortunately. One example I have seen was a Sales Director who lied and cheated customers, yet the Company had a Value of 'Customer'. And in another, a CEO of a company touted 'Respect' and 'Professionalism' as key Values in that organisation, yet openly vilified minority staff in front of their peers. I have often seen Employees showing confusion in these instances - "If the company wants me to behave professionally, then why can't the CEO set the example?"

"Behaviours count only if they are monitored and if the measures trigger corrective action when behaviours are out of alignment with values." James Heskett

Where Values fail to drive the Culture however, or they have never been put in place, then the set of Behaviours exhibited by the Management and Leadership team will fill the void. Once again, if the leadership is sound, you'll generally find the business' Culture to be healthy.

"Credibility is a key component of an ethical culture, and hypocrisy is its death knell." Marianne Jennings

In a business with a healthy Culture, you might see behaviours of Respect and Accountability, or of Reward and Recognition; in all cases like this staff want to work there and so will inevitably push harder for greater results. Basically if management set the right example then a healthy Culture will surely follow. And if the Culture is right, then the business will typically be a successful one.

“To me culture is everything. It’s the glue that holds people in the firm together and it also provides the vision for all the people in the firm to know just what they’re driving to. Culture is really important. Tone at the top matters a lot. No one person can drive or create that culture, it’s more like a Oiji board where a lot of people have a handle on it, but what comes out of it is very important.” Jim Tisch

"I think culture has to come from the top, it has to be consistent, it has to be part of written communications, it has to be — you know, has to be lived, and it has to be rewarded when followed, and punished when not. And then it takes a very, very long time to really become solid." Warren Buffett

“The culture of a company is one of the major keys to its success.” Stephen Errico

“Culture is the most important thing to understand about a company, and to understand about one’s self.”  Simeon Wallis

On the other hand, poor Cultures are driven by ineffective management or leadership behaviours. This could be exhibited by zero accountability by those in charge (meaning everyone else is to blame for the results), high staff turnover, absenteeism or apathy; all are examples of where the leaders have created a poor Culture.

Poor cultures can lead to ethical, and then corporate collapse. Revisiting Marianne Jennings' 'The Seven Signs of Ethical Collapse', she observed that companies with an excessive focus on meeting quantitative goals at all costs [eg profit guidance] or oppressive cultures of fear and silence are tell-tale signs of potential ethical collapse.

"Cultures of fear and silence nurture the team player concept, borrowing the buy-in and stronghold that comes from groupthink and the inability, as Solomon Asch's studies on social conformity pressure concluded, of most of us to speak up when we see something wrong, if those around us either do not see the problem or have chosen to remain silent. Even the most honorable people are submissive in a culture of fear and silence." Marianne Jennings

Another aspect that is important when reviewing Values and Management Behaviours is to ensure the two are aligned. Setting the right example starts with the Leaders of the business, and if they are not showing the way, it is wrong to expect that the staff will follow. I have seen businesses that set Values reflecting Teamwork and Recognition and Fun, while the managers are reclusive, negative and independent. How likely is it, do you think, that this business' Culture is effective? And just as importantly, how likely is it that the business will be delivering sound results?

So how do you measure Culture?

Measuring a company's culture is vital and of course is one of the easiest things to overlook. Because it can't be seen on a balance sheet, and it certainly isn't evident in any marketing or PR activities a company may undertake, when analysing investments we tend to only look at the hard business results, the fiscal capabilities of the business rather than its behaviours.

“Factors such as culture, because they are hard to quantify, often go undervalued by investors.” Nicholas Sleep

Because Culture is formed by people, the answers to measuring it lie with the same group. You need to TALK to all the appropriate stakeholders. These could include Staff, Suppliers, Customers, Management, Shareholders or the Board, and of course the Community it exists within. If you're only talking to one group, you are likely to skew your information and present a bias when looking at your investment opportunity. Management will only present one side of the argument, and if there is a potential upside to them in the investment, then they are likely to only reflect on the positive aspects of the Culture, or what they believe is there. By talking with Staff, Suppliers, Customers and the local Communities, you will attain the big picture. It is the ONLY way you can ensure you have applied appropriate due diligence with regards to investigating a company's Culture.

"Give me a one-on-one with an employee and I can tap a vein. I always offer companies: After I do my research, using the [seven signs of ethical collapse] give me just five minutes alone with a frontline employee and I can tell you the culture of your organisation and whether it is at risk" Marianne Jennings

It's no wonder the Investment Masters talk to those who manage and interact with the company ...

“Understanding culture before we acquire a business could be the most important thing we do.  And it’s been one of the hardest things to do. You have to talk to the employees, customers, and suppliers.  You learn a lot about how the company treats them”  Steve Feilmeier, Koch

“I do talk to management of many companies. I like to figure out their human values, the culture they nurture and their long-term goals.” Francois Rochon

So what should you be looking for when talking to the stakeholders? 

Beyond successful business results, positive Cultures are typically indicated by the following: Strong Leadership, Long Standing Employees, Collaboration and Team Work, Accountability, an excellent Customer Service Ethic, Strong Repeat Business, Role Clarity, Integrity, Transparency, Effective Reward Systems and Recognition Programs, Staff Engagement, Genuine Respect, Humility, Innovative Thinking, Staff Development Programs, Learning, Community Standing and Social Responsibility, Values that are Measured and 'Lived', Quality Products, Diversity of Workforce and Strong Ethics. Just to name a few. 

“The three best operating companies I’m aware of are Costco, Kiewit and Glenair.  There is nothing remarkable about the product or field for any of these.  But there is something remarkable about the culture of all three.” Charlie Munger

“There is one thing I have been doing for many years now and has in my view been absolutely central to the fund’s performance. I mention it not in the spirit of self-congratulation, but because there is far too little attention paid to it and it would be far better for society, not to mention individual fund’s performance, if this was not the case. I am referring to building an understanding of and conviction around a company manager’s integrity and more broadly speaking a firm’s culture (the two are closely connected as the tone basically comes from the top). Nothing has been more important to managing the fund over the last years than understanding management character.” Robert Vinall

“We believe that finding companies with a distinctive culture provides us with a source of edge over other investors. Indeed, in spite of evidence to support the contention that culture is a critical driver of long-term stock returns, it is routinely ignored by most investors.” Baillie Gifford

You can see how important Culture is to the Investment Masters in determining the success of an Investment. Don't simply rely on the business results and balance sheet; the answer to your investment question could well lie with the people and the Culture....

Building an Investment Checklist - Part 2

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

"A checklist is no substitute for thinking." Warren Buffett

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

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

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

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

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

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

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

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

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

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

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

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

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

Learning from Ed Thorp

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Time to let Ed Thorp help you beat the market!

Further Information:

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

You also can check out Ed Thorp's website here

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Building an Investment Checklist - Part 1

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Further Reading: 'Checklists Tutorial' - Investment Masters Class

Learning from Jeff Bezos

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

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

THINK BACKWARDS

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

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

INVENTIVE CULTURE

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

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

THINK LONG TERM

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

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

The Investment Masters possess a profound appreciation for the advantages of adopting a long-term perspective. They extend their gaze over three to five years, if not further, in order to discern the prospective competitive stance of a company, project its potential earnings, and consequently estimate its future value. Warren Buffett has informed Berkshire's shareholders that he will measure the success of his investments 'by the long term-progress of the companies rather than by the month-to-month movements of their stocks.’

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

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

ROOM FOR IMPROVEMENT

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

COMPETITION

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

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

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

INNOVATE

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

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

THE POTENTIAL OF AMAZON WEB SERVICES [AWS]

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

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

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

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

AMAZON PRIME MODEL

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

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

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

ARBITRAGING OTHER PEOPLES CAPEX

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

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

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

Further Recommended Reading:

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

Investment Wisdom - Sam Zell style

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

Prompted by recommendations from some of my clients, as well as one of the Investment Masters, I just finished reading Sam's Zell's autobiography, "Am I being too Subtle".

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

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

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

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

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

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

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

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

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

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

"I am a voracious consumer of information."

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

"Think beyond the norm."

"I don't make assumptions."

"Reputation is your most important asset."

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

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

"My focus is always on the downside."

"Liquidity equals value."

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

"I am industry agnostic."

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

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

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

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

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

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

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

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

The Munger Series - Learning from Charles Darwin

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

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

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

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

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

Education and Smarts

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

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

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

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

Learning

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

Reading

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

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

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

Love

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

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

Consensus

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

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

Understanding and Patience

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

Commitment/Confirmation Bias

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

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

Collect the Facts

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

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

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

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

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

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

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

Hard Work

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

Writing

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

Intuition

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

Mistakes

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

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

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

Thinking and Age

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

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

Testing ideas

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

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

Avoiding Bias

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

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

Humility in conclusion..

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

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

The Munger Series - Learning from Lee Kuan Yew

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

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

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

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

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

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

China

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

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

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

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

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

America

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

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

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

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

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

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

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

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

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

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

America and China

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

India

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

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

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

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

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

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

Singapore

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

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

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

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

"Standing still is a sure way to extinction"

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

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

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

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

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

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

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

Developing Countries

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

Governing

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

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

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

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

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

Thinking

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

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

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

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

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

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

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

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

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

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

"Realism and pragmatism are necessary to overcome new problems"

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


 

Are You Checking the Portfolio Too Often?

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

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

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

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

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

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

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

Taleb notes ..

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

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

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

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

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

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

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

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

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

“Dick Thaler’s got a phrase, instead of watching CNBC, you should be watching ESPN. The idea being that tracking how you’re doing every day is going to cause tremendous unhappiness and it’s going to lead to more biases. Actually, we worked with one of our academic advisors, Professor Joey Engelberg who’s a UCSD and he’s done research that when the market goes down, there’s more admittances for heart attacks at the hospitals around the country.” Dr Raife Giovinazzo

“I try not to actually log in to the account unless I know I want to do something. I don’t want the daily blow-by-blow on prices. It’s bad for the investing psyche; it makes you impatient and lose perspective.” Chris Mayer

“When people can check their returns 30 times a minute on the internet, time horizons shrink, investors are impatient and sell at any sign of underperformance, so they fail to participate in periods of overperformance.” Joel Greenblatt

“The frequency with which an investor checks his investments plays a significant part in his or her level of risk aversion. As stocks go down on nearly as many days as they go up according to De Bondt and Thaler, stocks can be highly unattractive if they are observed on a daily basis. Other behavioralists have estimated that if an investor’s time horizon was 20 years, the equity premium would fall to 1.5% from 6% as there is very little chance an investor would experience a loss after so many years, and stocks would be a much more appealing investment.” Christopher Browne

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

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

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

“If you don’t like what’s happening to your shares, switch off the screen. The price of the shares you buy may vary for reasons which have nothing to do with the fundamentals of the business. So movements in share prices are not necessarily a guide to whether your investment is good or bad. If you have chosen shares in good companies or a fund at reasonable prices, and you find gyrations in their prices unsettling, then simply stop looking at the share price.” Terry Smith

“None of us have a Bloomberg terminal. We have an outsourced trader, in Vancouver. We don’t generally trade the same day we make decisions.” Yen Liow

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

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

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

"You know, I think people’s investment would be more intelligent, you know, if stocks were quoted about once a year." Warren Buffett

With regards the trading dentist, Taleb concluded ..

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

Is it time to move that Bloomberg terminal?

The Value of Cash

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

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

Many prominent top-down asset allocation models predominantly emphasize an investor's risk profile as the primary factor in establishing suitable asset exposures. Typically, this assessment is based on age, where a younger age corresponds to higher risk tolerance and, consequently, a higher allocation to equities and a lower allocation to bonds. However, these models often overlook the consideration of the relative attractiveness of each asset class at the time of allocation. This oversight was starkly evident during the global financial crisis.

In practice, adhering strictly to age-based allocation without weighing the current market conditions can lead to significant drawbacks. The flaw becomes apparent, particularly during broad market sell-offs, making it challenging for equity managers to generate attractive returns when compelled to remain fully invested.

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

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

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

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

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

The person responsible for selecting stocks lacks the authority to determine their attractiveness. Moreover, accountability for suboptimal outcomes seldom falls on the asset allocator, who often shelters behind historical asset class returns. When a balanced fund experiences losses in equities, the equity manager deflects blame, asserting, "I had to remain fully invested." Simultaneously, the asset allocator points to age-based guidelines, stating, "The ultimate fund investor is 20 years old, justifying the prescribed percentage in equities." It becomes a game of passing the buck.

In contrast, the Investment Masters acknowledge that the ideal allocation to equities at any given moment hinges on the relative price levels prevailing then, recognizing that these relative prices are in a perpetual state of flux.

In contrast to the aforementioned strategy, the Investment Masters adopt a flexible approach to investing. They are willing to retain cash if appealing opportunities are scarce, steadfastly refusing to compromise on their pricing criteria. Operating with flexible mandates that don't necessitate full investment, they acknowledge the advantages of maintaining financial firepower. This reserve allows them to seize opportunities and acquire assets when the right moments present themselves.

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

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

Although Buffett asserts that he doesn't base his investment decisions on the macro environment or the specific level of the stock market, he emphasizes the importance of only investing when he can discern attractively priced opportunities. It makes sense that there are less attractively priced opportunities when markets are elevated rather than weak.

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

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

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

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

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

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

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

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

Further Reading: Tutorial - Investment Masters 'The Value of Cash'
Frank Martin: 'An Enterprising Thought - Cash as an Option'
John Neff [Akre]: ‘How We Think About Cash - by John Neff’

Invest Scared

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

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

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

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

"I always start from a position of fear. And then when I see something that looks attractive, I start getting greedy.... But I'm always looking at the downside on something first. I mean, if you can't lose money, you're going to make money.." Warren Buffett

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

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

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

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

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

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

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

50c Dollar Bills

Photo Source: Wikipedia

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 try to buy a dollar for 60 cents, and if I think I can get that, I don't worry to much about when" Warren Buffett

“Our aim is to make investments at prices we consider to be fifty cents on the dollar of what a typical firm is worth.” Nicholas Sleep

“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

“Value is often its own catalyst” Chris Pavese

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

The Investment Masters Class - Some Stats

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

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

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

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

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

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

Analysing Investment Performance - Short and Long Term

The Investment Management industry is fixated on short term performance. 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Source: Wikipedia

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?

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, medical devices etc] and even coffee merchants and video game companies..

"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

“Gillette’s practice of effectively giving away razors for free and charging for consumables – “A few billion blades later, this business model is now the foundation of entire industries: Give away the cell phone, sell the monthly plan; Make the video game console cheap and sell expensive games; Install fancy coffee machines in offices...” Yes – this is the model generating profits for Canon and Mondelez (coffee) and for Nintendo (increasingly so as Nintendo moves to distributing “free” smart phone games then selling upgrades to hooked customers). Intuit too is giving away access to its basic service, then looking to make profit on upgrades. Despite all the hoo-ha about a “New Economy” there are fewer things new under the sun than you might think.” Nick Train

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 nice to have markets like that that are relatively untapped.” Warren Buffett

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!