What Farming can teach us about Investing

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

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

Hopefully you would agree with me.

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

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

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

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

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

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

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

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

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

"Nobody buys a farm to make a lot of money next week or next month, or they buy, you know, an apartment house. They buy it based on what they think the long-term future is. And if they make a reasoned calculation of that and the purchase price looks attractive, they buy it and then they don’t get a quote on it every day or every week or every month or even every year, and that’s probably a better way to look at stocks." Warren Buffett

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

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

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

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

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

Fingers of Instability Re-visited

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

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

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

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

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

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

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

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

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

Books to Read... Masters thoughts ...

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

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

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

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

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

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

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

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

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

“My life would have been different if Ben Graham hadn’t gone to the trouble of writing a book, which he had no financial need to do at all. You know, I would have a very different life.” Warren Buffett

"Chapters 8 and Chapters 20 [of the Intelligent Investor] are really all you need to do to get rich in this world." Warren Buffett

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

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

Beyond knowing the value they place on books written by other people, one of the biggest upsides for us is that many of the Investment Masters have also put those same ideas into one of more of their own books. Warren Buffett has long been recognised for his annual letters.

"I actually think by reading Berkshire’s reports, you should be able to get more — I would think you’d get more of our philosophy than in any other manner." Warren Buffett

Many investors, including me, wait hungrily for his latest instalment. And he never disappoints.

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

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

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

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

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

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

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

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

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

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

MARGIN OF SAFETY, By Seth Klarman.

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

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

ONE UP ON WALL STREET, By Peter Lynch.

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

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

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

“I still think ‘One Up on Wall Street’, even written thirty years ago, is a hugely valuable book.” Lindsell Train

“One book that probably made the biggest impact on my career in those early formidable years back in the day was Peter Lynch's ‘One Up on Wall Street.’” David Rolfe

THE DAVIS DYNASTY, By Shelby Davis.

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

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

YOU CAN BE A STOCK MARKET GENIUS, By Joel Greenblatt.

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

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

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

POOR CHARLIE'S ALMANAC, By Peter D. Kaufman.

"I think if you assimilate everything in that simple book [Poor Charlie's Almanac] you will know a lot more than about 95 percent of your compatriots. And it’s not that hard to do." Charlie Munger

"[Poor Charlie's Almanac], it’s a sensational book. And anybody that reads it is going to learn a whole, whole lot about life. And you’ll learn even — to get you to read it, I’ll tell you you’ll even learn something about making money." Warren Buffett

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

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

“Poor Charlie’s Almanack is by far the most comprehensive publication that captures the essence of Charlie’s philosophy. When the first edition was published in 2005, I treated the book as a treasure and read it cover to cover multiple times. Each time I read it, I learned something new.” Li Lu

ALCHEMY OF FINANCE, By George Soros.

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

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

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

COMMON STOCKS AND UNCOMMON PROFITS, By Phil Fisher.

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

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

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

“If I had to narrow it down to my favourite book it would be Phil Fisher’s ‘Common Stocks and Uncommon Profits’.” Kurt Winrich

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

"I was very influenced by Phil Fisher when I first read his two books, back around 1960 or thereabouts. And I think that they’re terrific books, and I think Phil is a terrific guy." Warren Buffett

“Philip Fisher’s book Common Stocks & Uncommon Profits is obviously great.” Bill Stewart

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

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

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

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

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

FOOLED BY RANDOMNESS, By Nassim Nicholas Taleb.

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

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

INFLUENCE, By Robert Cialdini.

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

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

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

SPECULATIVE CONTAGION, By Frank Martin.

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

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

THINKING FAST AND SLOW, By Daniel Kahneman

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

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

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

REMINISCENCES OF A STOCK OPERATOR, By Edwin LeFevre.

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

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

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

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

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

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

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

THE OUTSIDERS, By William Thorndike.

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

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

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

THE MONEY GAME, By Adam Smith.

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

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

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

Further Reading: The Top 12 Investment Books

Betting Against America?

“Remember, my son, that any man who is a bear on the future of this country will go broke.” JP Morgan, 1908.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

“Yes, for better or for worse, we are faced with cyclical swings in our economy, periodic recessions, and even rare depressions. But American capitalism has demonstrated remarkable resilience, plugging along steadily even as times change, driving growth in earnings and paying dividends that have risen apace over time, in step with our growing economy.” John C Bogle

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

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

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

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

It started with free trade and specialization.

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

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

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

“Adam Smith identified that when men and women specialize their skills, and also importantly “trade” with one another, the end result is a rise in productivity and standard of living for everyone. In 1817, David Ricardo expanded upon Smith’s work in developing the theory of comparative advantage. What Ricardo proved mathematically, is that if one country has simply a comparative advantage (not even an absolute one), it still is in everyone’s best interest to embrace specialization and free trade. In the end, everyone ends up in a better place. First and foremost, you need free and open trade. It is quite bizarre to see modern day politicians throw caution to the wind and ignore these fundamental tenants of economic science. Time and time again, the fact patterns show that when countries open borders and freely trade, the end result is increased economic prosperity.” Bill Gurley

In addition, America benefited from knowledge sharing. 

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

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

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

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

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

Abundent resources and geographic protection certainly provided an economic advantage.

“It might sound silly, but having a ton of land endowed with tons of natural resources buffered from long-time foes by the world’s biggest oceans on both coasts is responsible for more of our prosperity than we think. I don’t know how much. But if you know the history of countries who are just as capable as Americans but have been ravaged by battle every few generations you know how devastating the after-effects of war are, in both infrastructure and culture. Things could change, of course. But it is reasonable to assume America will indefinitely have an economic advantage over other nations because of its structural advantages in geography and natural resources?” Morgan Housel

“America is still the most prosperous nation the world has ever seen. We are blessed with the natural gifts of land; all the food, water and energy we need; the Atlantic and Pacific oceans as natural borders; and wonderful neighbors in Canada and Mexico. And we are blessed with the extraordinary gifts from our Founding Fathers, which are still unequaled: freedom of speech, freedom of religion, freedom of enterprise, the sanctity of the individual, and the promise of equality and opportunity for all. These gifts have led to a bold and dynamic economy – one that nurtures vibrant businesses large and small.” Jamie Dimon

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

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

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

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

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

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

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

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

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

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

“It is no exaggeration to say that much of the reason for America’s extraordinary economic greatness is that it has nurtured an environment in which a small entrepreneur can flourish.” Bruce Kovner

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

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

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

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

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

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

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

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

“The same factors that have served the U.S. well in the past are the same that factors I believe will lead us to future prosperity, namely: 1) America is the home of the entrepreneur. 2) The U.S. is the most open/flexible society the world has ever seen. 3) The brightest minds from around the world dream of coming to the U.S. 4) English is the universal language. 5) Americanization remains a powerful and growing — albeit often resented — economic and social trend globally. (To quote my friend, the advertising/marketing giant WPP Group’s CEO, Sir Martin Sorrell, ‘‘Globalization’ is a misnomer. The better word is ‘Americanization.)’’ Shad Rowe

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

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

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

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

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

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

The potential of new technologies is far from exhausted..

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Despite the numerous challenges that America has faced, it consistently demonstrates resilience. Much like the legendary Phoenix, it repeatedly emerges stronger from adversity. Beyond the apparent drama and negativity, one can discern the nation's enduring industriousness and innovative spirit, which define its success. With over 200 years of outstanding performance, and the best years yet to come, it is hard to even contemplate placing a long term bet against those odds. 

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

Connecting the Dots

'Munger' by James Cochran

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

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

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

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

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

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

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

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

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

"Investing is kind of a game of connecting the dots. The nice thing about it is the longer you are in the business, as long as you are intellectually curious, your collection of data points of dots gets bigger and bigger." Ted Weschler

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

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

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

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

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

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

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

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

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

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

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

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

“I’ve always thought of my profession as a challenging three-dimensional chess game that never ends.” William P Stewart

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

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

“I love doing puzzles. Investing to a large extent is trying to look forward at an infinite number of variables and trying to figure out the future. To me that’s inherently interesting. It’s a little world where you get a chance to think really hard about a specific problem.” Tom Steyer

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

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

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

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

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

“Who knows when some little fact stored in the back of your mind pops up and really does make a difference.” Warren Buffett

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

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

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

“We do find, if you just show up every day, like Woody Allen said, and you answer the phone and read the paper, every now and then, you see something that makes sense to do.” Warren Buffett

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

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

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

“We have no standard way of identifying prospective investment ideas. The only common factor in our search is fervent curiosity, which drives us to read voraciously, engage actively with management teams and industry experts, and run down the leads and ideas that result.” John Neff, Akre

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

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

Learning from Leonardo

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

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

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

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

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

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

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

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

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

Likewise, the Investment Masters are driven by curiosity. 

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

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

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

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

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

Leonardo's $450m 'Salvator Mundi'

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

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

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

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

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

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

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

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

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

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

Like Charles Darwin, Leonardo was not afraid to change his mind when the facts warranted it. Isaacson noted, "he engaged in a dialogue between theories and experience, and when they conflicted he was receptive to trying a new theory. That willingness to surrender preconceptions was a key to his creativity".

I hope you are starting to notice the common traits that manifest themselves across history's Intellectual and Investment Masters. Each was not afraid to question conventional wisdom, to remain open-minded, to adopt a child-like curiosity, to work hard, to seek wisdom from other disciplines, to learn from others, to challenge ideas and to be willing to admit and learn from mistakes.

We can all learn from Leonardo. As Isaacson observed "Leonardo's genius was a human one, wrought by his own will and ambition. It did not come from being the divine recipient, like Newton or Einstein, of a mind with so much processing power that we mere mortals cannot fathom. Leonardo had almost no schooling and could barely read Latin or do long division. His genius was of a type we can understand, even take lessons from. It was based on skills we can aspire to improve ourselves, such as curiosity and intense observation." 

While you or I will never paint a Mona Lisa, we can look to Leonardo to help us see the world more clearly and reignite that sense of wonder we all had in our childhood years. We should never stop learning and we should never stop asking why. The word 'why' is one of the most powerful words to have in your vocabulary. Without it, and without its use, we will stagnate, believing we understand all, and that is quite simply absurd when you think about it. Even the greats still ask why, and if they can do it, so should we. And if we do it well, we might even crack the Da Vinci code...

Further Reading:
Ray Dalio - Leonardo's Principles
Broyhill Asset Managment - Bruce Wayne vs Leonardo
How to build a better Investing Mind

Learning from Home Depot’s Arthur Blank

It doesn't really seem to matter how many successful businesses I come across; I'm constantly amazed at the synergies that exist in all of them. By now you'll no doubt see the obvious correlations between them all as well, and the really interesting thing about it all is that in each and every one of them, both the ones I have reported on here as well as others we are yet to review, the lessons we take from them are not to be found in academic institutions. 

They don't teach this stuff at universities, or in prestigious MBA programs; all of the individual success components that go together to make up each of these outstanding businesses came from one or two individuals who dared to think and act differently. 

I love learning from people who have built and run successful businesses. Like the Investment Masters, there are many commonalities across great businesses and great business people. As I've written many times before, to understand a stock you must understand the business. One of my favourite podcasts 'How I Built This - with Guy Raz' recently interviewed Arthur Blank, the co-founder of Home Depot, who stepped down as co-Chairman in 2001.

To say Home Depot has been a phenomenal success would be an understatement. Home Depot was founded in 1978 and went public in 1981. One hundred dollars invested in Home Depot in 1981 would be worth approximately $540,000 today versus $2,300 in the S&P500. I came across Home Depot's phenomenal performance reading one of the annual letters of Arlington Value Capitals' Allan Mecham. Mecham noted that despite it's 49X PE multiple in 1984, Home Depot's share price went on to compound at 20%pa over the following 29 years. 

Prior to co-founding Home Depot, Arthur Blank was running Handy Dan with his colleague Bernie Marcus. Handy Dan was the most most successful home improvement chain in the US at the time and the most profitable subsidiary of an ailing conglomerate, Dylan Inc. Despite the subsidiary's success, Blank and his colleague, Bernie Marcus, were fired after a corporate raider, notorious for retrenching company's incumbent senior management, took control of Dylan Inc.

After reflecting on their newfound situation, Blank and Marcus decided to set up their own hardware business. In doing so, they inverted the typical question a start-up might propose - they asked 'who couldn't we compete with?' 

“I wanted to take my time, as did Bernie, and think through the options we had and didn’t want to rush into anything. I took the better part of the year off, did a lot of running, spent a lot of time with my kids. I was looking at a lot of alternatives. We wanted to think outside the box. Bernie had said ‘If we were ever to leap frog our own business, the Handy Dan home improvement centres, what kind of home improvement centre store could we not compete against?’ We said we could never compete against the big warehouse, no frills, down market, low prices, great service, great services. So instead of taking that Handy Dan model of the Four’s [four million dollars sales, forty percent margin, 40 staff people, etc] we said, 'lets try and leap frog the industry dramatically.'”

Buffett takes a similar approach when he analyses businesses ... "One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it."

In the early days, while establishing the business plan, Blank and Marcus realised that if their start-up was to be successful it was going to come down to them to make it so...

“The reality is the investors in our company, 144 of them. Really what they were buying into were myself and Bernie. We had the experience and they looked back at Handy Dan Home Improvements Centres, and they said we’re betting on people here, we are not betting on one small store.”

The opening day of their first two stores was a crushing disappointment. What led to their actual success was listening to the customer and a lot of trial and error..

“We had this grand opening and nobody came. We spent the next year, and one of our core values is to listen and respond. I spent 75% of my time on the floor of the store finding out from customers what is it they like, didn’t like, and we kept changing the mix, adding things, taking things off, changing prices, assortments and vendors, making sure of service levels in areas they wanted them. We kept refining the model. Every competitor came into our store and visited us said ‘you're crazy, the stores are much too big, prices are much too low, you have way too much product and stock, too many services, the math isn’t going to work." Of course the math wasn’t working in 1979. We fine tuned it and got it where it needed to be. It exploded in 1980 and 1981 and the numbers were incredible.”

In a similar fashion to both Nucor and Koch Industries, which we learnt about recently, one of the most important aspects of the success came from their business culture. Home Depot's was built around helping customers and listening to the people on the front line..

“We never really wrote the core values down … I said to Bernie "we’re living these values which by far and away are the most important thing we can do, but they’re not written down . I figured out you and I are going to open a lot of stores in the future that we’ll actually never see."  There were too many new stores. We needed to document and write down our core values which are really focused on our associates, our people, our relationships and communities, and giving back. The people who are serving drive everything we are doing. Those are the ones that we listen to, those are the ones we respond to, those are the ones we care for, those are the ones we nurture, and that’s the mentality of the training we’ve given to all of our associates.”

They managed growth one store at a time, constantly seeking improvements and empowering their people..

“Sam Walton was asked how did you get from $10b to $20b dollars [in sales]. Sam said we opened one store at a time. And that’s all we did. At Home Depot, we had a one year budget, a 5 year plan, but we focused on every single store and our plan was that each store had to be better than the last store we opened up.  So we didn’t have any planograms, we didn’t have any ‘you have to do it this way’, we didn’t let the model get frozen, we made the folks running the store think about ‘this is the last store, how do I make this store better?', 'how do I own it?', 'how do I feel accountable for it?', 'how do I inject my ideas into, and how do I make it better?'. So every store got better.”

After looking back on his successes, Blank gives valuable advice to young folks: "make sure you have balance in your life, because too many young executives' attitude is to work hard, put my career on 5th gear and go, go, go. When you return home in ten years you won't recognise your kids and your spouse will look at you and say 'who are you again?' It's important to find balance in your life."

He also attributes much of his success to intelligence and hard work, versus luck and timing.

"I think that luck and timing is a big deal. I really do. A lot of success is based on timing and luck and being in the right place. But, also about seizing opportunities and being prepared to go out of your comfort zone. I'm a big proponent of Outward Bound; I've done a lot of the course myself. A lot of it is based on their strategy which is to serve, to strive and not to yield. Having that entrepreneurial drive and spirit, to get up every day, to have purpose in your life everyday, to become better every day. I am doing this because I have a passion for doing it and I love being of service to other people in whatever form I can be."

Its clear that innovative thinking, learning from your mistakes, loving what you do, continuous self-improvement, effective culture, listening and humility are common threads for both successful businesses and investors. We've certainly written about these things often enough. Luck has very little to do with it, as does the formulaic approach to operating businesses that we are taught within academic institutions. Success is created through hard work and daring to be different. Easy wins are exactly that, easy; meaning that the expected returns should be commensurately low. Even Home Depot took several years to show the right returns and in those early years the 'nay sayers' were everywhere. The British SAS got it right with their motto; "Who dares wins."



 

Learning From David Einhorn

David Einhorn, the President of Greenlight Capital, has one of the best long term investment track records on the street. From inception in May 1996 to the end of 2016, Greenlight Capital compounded at 16.1% pa net, significantly outperforming the S&P500.  

David is a value investor, but unlike your typical value investor, David takes the traditional value investor’s process and inverts it ... "The traditional value investor asks “Is this cheap?” and then “Why is it cheap?” We start by identifying a reason something might be mis-priced, and then if we find a reason why something is likely mis-priced, then we make a determination whether it’s cheap." Oftentimes there will be a short term structural reason for the cheapness - a special situation such as a merger, a spin-off, a debt issue or significant complexity or uncertainty etc - that is creating an opportunity.  

I enjoyed a recent rare interview with David at the Oxford Union Society. In a similar fashion to inverting the typical value investor's process, David also inverts the natural tendency for investors to think they're right when a position moves against them. I enjoyed hearing David articulate how his natural presumption when a stock goes against him is not that 'he's right', but that 'he's missed something'.  A useful mindset to help overcome confirmation bias.  

David discusses the similarities between poker and investing, why he's maintained his short basket despite his reticence to short stocks solely on valuation and the cultural and behavioural keys to successful investing. 

I've included some of my favourite quotes below [Please click on the links to see the Investment Masters insights into those topics]

Love

“I love it. I love trying to solve puzzles. I love trying to find investments. I love trying to figure out what it is that is motivating a situation where we have a difference of opinion”

Thinking

“If I had to pick one reason [for Greenlight's success] it’s critical thinking skills. It’s the ability to look at a situation and see it for what it is, which isn’t necessarily what is presented to you. When something doesn’t make sense, question it, challenge it, look at from a different way and you often come to the opposite conclusion. You don’t have to do that very often. Most of the time when someone tells you something, it makes sense, but sometimes it really doesn’t make sense and there is another side to it. When you can come to a view, maybe just a few times a year, where you have an important difference of opinion with what everybody else is thinking about a particular situation and you can figure it out and it’s important, we’ve been able to make a small number of large investments that the vast majority of the time have worked out very well. [It’s] because we really have had an important difference of opinion between what we think and whoever is on the other side of the transaction ”

Culture, Humility & Change

“The culture of the firm is a lot of smart nice people.  I think we interact well, there is a lot of humility. People respect one another, they respect one another’s views. People respect me, I respect them. I respect their time which is an unusual management culture for senior management people to truly respect the time of junior people.  You wind up with a group of people who are critical thinkers, that think and reason things out before they speak, that can adjust to new facts, that can adjust to feedback and work well within a culture”

Humility, Constant Re-assessment & Patience

“It’s not about sticking to our guns [in contrarian positions]. It’s about re-assessing constantly. When positions don’t work and go against you the presumption is not “we’re right, the presumption is “we might have missed something here”. Then you have to go back and think about it again and again and again. You have to understand the other side and see if anything has changed, see if your view has changed and if it has changed to modify the position. You might eliminate it, or you might reduce it or you might sometimes increase it, but very rarely. Generally speaking my inclination is, when the position is not going well, it’s more likely we’ve missed something so the choice is generally either reduce or eliminate or simply keep it if we think its right. On the other hand if we continue to think we’re right, I find patience is the way to go. We have to wait and let the story play out, while we continue to re-asses it to see in fact we were wrong”

What you Know, Can Infer and the Range of Outcomes

“Investing in a poker game and investing in stocks, at least the way I do it, is a very similar skillset. You have certain facts you know, in stock investing it’s whatever objective information you know about a company or a situation - what is the stock price, what the company does, what are their sales etc. Then there are things you can surmise, but you don’t really know. That would be – what is the motivation of the CEO, what is the strategy, what are the interests, what does the competition look like. These aren’t objective but through work you can make educated guesses about, but you don’t really know. And then you have a range of things that you don’t know that are going to come in the future.  These are future events that are fundamentally unpredictable but they live within a range of possible future events. So you combine what you know, with what you think you can surmise, combined with understanding the range of outcome related to the uncertain things and say “is this a good place to commit a fraction of my capital"

And you can translate that to poker. What is it you know; you know how many chips you have, you know what cards you're holding, you know the cards displayed face up on the table as you can see those. Then you can surmise what you opponents cards are likely to be; I can get information from how he is betting the hand or by sitting at the table playing with him for a while I can see his personality, his style, his skill and I can make inferences about the present hand based upon his past behaviours. Those are things you are trying to deduce. Then there is the uncertainty; the range of future cards concealed in the deck that are yet to be displayed that are important and there is a range of those possible outcomes. You take a look at all those things and you say "do I want to play this hand?", do I want to bet chips into this hand”

Understand

“The most exciting part is when you think you’ve figured out the joke. When you get the joke and you understand what it is that you’re doing and why it is you have an opportunity now. You’re going to be able to deploy capital and its very likely to work out. Those situations come up few and far between when you really have it”

Mistakes

“We are wrong often and we have to constantly question whether we are wrong. There are lots of times when you buy a stock and after a certain amount of time a certain event happens and you have to look at it a different way, and say nope that’s not it, we should have done the opposite. Then you change course”

Risk Management

“We take a layer by layer approach [to risk management]. What is our risk on this investment, that investment and the next investment. We tend to think about risk as how much can we lose in our worse case. If it’s a $10 stock the downside is $10. That’s how I think about it”

Developed Markets

“We are invested in developed markets. I have no aspirations to get further away [from developed markets] because I find that once you get into places further away you’re subject to what’s going on with the insiders and there are local rules and customs, and local knowledge. It’s very hard to compete with that sitting in NY even if you get on an aeroplane and go visit once in a while”

Process

“We re-evaluate all of our investments [whether they have worked out good or bad]. Ones that have worked we sell or reduce because they have worked and we are not interested in them anymore. Some that haven’t worked we exit or reduce because we decide that whatever it was we were thinking is no longer true or is unlikely to be born out. We modify the positions accordingly and we do that on a position by position basis and we do that whether things are going well for us or not going well for us. It’s part of our ongoing process.”

What You Know, Concentration & Portfolio Construction

“The way you deal with unknown unknowns is through portfolio construction. We like to run a concentrated portfolio but even our best idea we are not going to put all our money in. You have to set some kind of a limit, have some kind of risk management, some level of diversification. We have some amount of longs and some amount of shorts and have some amount of market risk we are willing to take on a knowing basis. Then you have the idiosyncratic risk relating to the individual investment. When people say there is a stock at $10 with $1 of downside and $10 of upside, I say NO, it has $10 of downside because you can lose your whole investment when you make it.  We manage risk further by the level of investment we make"

Leverage

"We are not levered, we don’t borrow more money to make even more investments. That’s one way you avoid risk. If you don’t have to ever repay anybody you're not subject to lending terms and conditions”

Value at Risk

“One of the things that was most exposed in the financial crisis is the flaw in the mathematical modelling of tail risk. So called Value-At-Risk. It is a method used by all of the large banks  and institutions. What VAR basically does, it basically says, if the risk is something that is going to happen beyond a certain level of frequency, you don’t have to put any capital aside. They put capital aside to cover 95% of all possible outcomes, but not for really remote things beyond the tail”

Short A Bubble Basket - Lots of Small Positions

“We decided if we could look at company[s], none of the companies were profitable or materially profitable, and we didn’t know what the business was, but we knew what the financial statements were and we knew the projected financial statements, and we thought a little bit about the business, but we didn’t even know what the business was - if it was an office supply company, a paper-maker or Netflix - and we closed our eyes and said what would you pay for the stock.  If the answer was 90% less than where it was trading, we created a basket of about 40 or 50 of these and shorted a small amount of a large number of them. Over time, at least until the beginning of this year that basically worked out.  Even though we had 2 or 3 or 4 that really worked against us in a pretty big way, a big number of those 40 or 50 ultimately failed or de-rated and the stocks went down a lot. The gains were roughly enough to offset the ones that appreciated. This year that has not been the case. Pretty much everything that has remained or we put into the basket has continued to go up. But the thesis on all of them is that none of them are actual, viable businesses. And the market might disagree with us on this, but when they start showing real profits then we’ll take a different point of view on particular names”

"We generally don't short stocks just on valuation. But when we came to a point with certain stocks that the valuation was so extremely out of whack it wasn't really a debate about whether the stock was in a range of fair value, in other words it was 90% or so overvalued. You don't need a computer to help you figure that out. Even if you are wrong by 100% instead of it being 90% overvalued its 80% overvalued.

Seeking Perfection

"We do not sit around all day and try and figure out the precise value of individual stocks. Because those are not relevant to our actual ability to make decisions. So if we have a stock and its $10 the goal is not to figure out if its worth $11 or $11.50 or $12. The goal is to figure out is it worth a lot more than $10 and not being precise about that. If we buy at $10 it doesn't really matter whether its worth $18 or $20 or $25 and there is no point in us trying to figure that out right now. The only decision we have is - do we want to own the stock at $10, and if we think its undervalued by a lot that's good enough for us to decide to own it now. By the time it starts approaching higher values we can re-asses and fine-tuning on an ongoing basis. We do our assessments in a very imprecise way"

Investments as Puzzles

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

Margin of Safety

"Our goal is to find things that are widely misunderstood by a large margin"

Time Arbitrage

"I think one of the inefficiencies in the market is investors are generically too short-term oriented and time arbitrage is one of the best inefficiencies in the market."

Activism

"When we get involved in pushing an agenda, which is very rare, our view invariably is if it doesn't help in the short term, intermediate term and long term, then its not a good solution to what the problem is"

Structural Problems

“As I looked at the global financial crisis as it happened I thought there were three or four or five really obvious structural problems that were exposed. Institutions that were thought to be able to fail, in fact were deemed to be too big to fail. You had structured credit where risk was being transferred but it wasn’t really being transferred or properly evaluated. You had the problem of credit rating agencies, only two or three major ones, so you wound up with a centralised decision maker as to who is creditworthy and who isn’t – that’s a really bad way to allocate credit. You really want a large number of people evaluating each credit to determine the creditworthiness. If you have one or two you create crisis of confidence when the one or two change their mind and you lose the opportunity to go into the market and find other people who might look at it differently from the credit rating agencies. That was separate to the corruption relating to the triple-A ratings. I think there was a lesson learnt about derivatives. They could have been dealt with differently, but instead we’ve created a clearing house for derivatives which has essentially created another too big to fail institution where all the credit is on an undercapitalised entity that everyone assumes will perform under all circumstances which of course it can’t as counter-parties begin to have problems. So from my perspective if you took all of the obvious problems from the financial crisis, we really kind of solved none of them.. I think it has the left basic structure more or less as it was and I think it is susceptible to the same type of event or series of events sometime in the future.”

Further Reading:
Fooling Some of the People All of the Time, David Einhorn
Charlie Rose Interview - David Einhorn

Investment Masterpieces

Have you ever stopped to consider the difference between science and art? How some things fall rather naturally into one or other of the categories, (like the 'science of engineering' or the 'art of film production'), yet many other things remain difficult to categorise. They may even belong to both.

Part of the distinction between the two is that if something is a 'science', then it will naturally follow formulae and rules and can typically be proved or practiced via logical methods. 'Art' on the other hand is a form of expression, and invariably involves some level of creativity or innovation. If you think of music as an example, it can be successfully argued that it is both a science and an art at the same time: if a musician follows the 'science of music', then they will practice classical methodology and you can expect that their performances will be clinically perfect yet potentially lacking in 'soul'. Followers of the 'art of music' by comparison might be more innovative, and typically can improvise and express a wider range of emotions and unique qualities in their playing.

I've always considered investing more 'Art' than 'Science'. If there was a formula for success the world's greatest investors would all be mathematicians. They're not. Successful investing requires more than just analysing numbers, it too requires creativity and innovation. 

When it comes to Investing 'Artisans', Francois Rochon is one. Francois has a passion for both investing and art, he even named his fund Giverny Capital after the city where the famous Impressionist artist, Claude Monet lived. Over the last two-plus decades Giverny Capital has ranked in the top 1% of investors delivering returns c6.7%pa above its benchmark annually. Since 1993 the firm has clocked up a total return of 3,080% versus 686% for the benchmark.

Over the years I've always looked forward to reading the Giverny Capital annual letters. Not only is Francois an Investment Master he's also a master wordsmith.

Francois recently gave an enlightening presentation titled 'The Art of Investing - Analysing Numbers and Going Beyond' as part of the Talks at Google series.

While Francois trained as an engineer, he found the rigidity and precision of engineering to be a handicap to successful investing. Engineering and investing are almost diametrically opposed; there is no precision in investing. As an investor you can be considered successful even when wrong 40% of the time. As an engineer, if you're wrong 0.4% of the time, you're toast. Notwithstanding, at times engineering calls for more than just numbers - be it for a new design or solution to a problem. To emphasise this, Francois draws on a quote by one of the world's greatest engineers, Nikola Tesla:

"Instinct is something which transcends knowledge. We have, undoubtably, certain finer fibers that enable us to perceive truths when logical deduction, or any other willful effort of the brain, is futile." 

The Investment Masters likewise see investing as more art than science.

Accordingly you need to master the 'Art of Investing'. Like mastering any art form, begin with an art form you love. You'll need to study the art's masters, and as a painter paints, you must invest. You'll develop your own unique style, an independent mind, and you'll need to always strive for improvements.

Like most great artists, it's likely you will be seen as a little eccentric, rash and unconventional. If your goal is to obtain better results than the average, you'll have to be able to stand on your own. You cannot achieve this by applying the same logical approaches as the herd.

Investors whose mindset and time horizon mirrors everyone else, those who own lots of companies and believe they are "smarter" and can predict the market, don't beat the market. It's the investors who think for themselves, own very few, carefully selected companies and develop the right behaviours (rationality, humility and patience) that become the Masters of Investment.

Francois outlines the stock selection process that has delivered Giverny Capital's outstanding returns. The firm focuses on the financial strength of a company searching for companies with an ROE greater than 15%, with EPS growth above 10% and a debt to profit ratio below four times.  They search for good business models; those businesses which are market leaders, have competitive advantages and low cyclicality. They then ensure the management teams have skin in the game, capital allocation competency, and are long term thinkers. Finally, Giverny require an acquisition price which affords them the opportunity to double their money over a five year period. To estimate this they need an estimate of what the company can earn in five years time.

As in his art collecting, Francois is attracted to investment 'beauty' or 'corporate masterpieces'. Not surprisingly these are both unique and rare. By studying the investment masterpieces through history - National Cash Register, Ikea, Geico, Apple, McDonalds, Gillette, Google, Starbucks Coffee etc - Francois has discovered the qualities that made them so unique.

The defining character of the uniqueness in either the product, the service or the culture of corporate masterpieces is usually the equivalent of a moat that protects the economic castle from competitors. So in short, you have to find companies with moats.

"Moats always keep changing. There are always new companies with moats; some are expanding, some are shrinking. So we have to follow that closely. If I had to choose one criteria to help me decide what is the direction of the moat - it's the management. Moats aren't built by angels, they are built by human beings. What makes a moat grow is something in the culture of the company, it doesn't come from thin air. It comes from top management that build that culture, then it translates into a moat and high return on equity for shareholders."

Francois sets out his psychological edge in investing. The three behavioural competitive advantages he believes an investor can employ are patience, humility and rationality. In terms of humility, Francois recognises he can't predict macro-economic events so he doesn't try. Francois recognises his 'circle of competence', he strives to recognise mistakes, and is always looking for improvements.

"I would say the greatest quality of Warren Buffett is not necessarily intelligence, it's the humility. He is the greatest investor of all time, but he is still very humble. He is always looking to improve and learn. He's 87 years old and he's still striving for new learnings every day. If you have those qualities I think you'll succeed in almost anything you do."

Every year Francois dedicates a chapter of Giverny's annual letter to the year's best mistakes, awarding a bronze, silver and gold medal.

"We make many mistakes and we only choose three to give medals to: bronze, silver and gold. Most of the time the mistakes are omissions. Starbucks is an example, its a company that fits all our criteria. And we decided not to buy for simplistic reasons and you miss a 10,000% gain over 25 years. We try to give medals to the most costly mistakes." 

When it comes to rationality, Francois advocates avoiding fads, even if it means others are making more money than you. And if you don't understand a company, stay away.

"You play an easier game when your'e very selective and you just go for companies you understand."

As hard as it may be, it's critical to be impervious to stock market quotations in the short run. By accepting you don't know the future, you can focus on what's controllable, which is finding companies you can understand and which have a competitive advantage. Then, should you own great companies and markets fall, over time you will still be okay.

"Owning great companies, and not trying to predict the stock market is the key to beating the index over the long run." 

To overcome the psychological pressures on investors to do the wrong thing at the wrong time, Francois has developed the 'Rule of Three'. This set of rules states that; 1) one year out of three the stock market will decline by 10% or more; 2) one stock purchased out of three will not perform as expected, and; 3) one year out of three, you will under perform the index. If you set expectations from the start, when you have some bad years and bad investments, you'll be better prepared psychologically to deal with it.

In terms of patience, Francois points not to the 'ability to wait' but the 'ability to keep a good attitude while waiting'. A 'good attitude' is one where you focus on what is happening to the company, NOT the stock price. Provided the underlying company's earnings are growing, you'll find over time the stock price should reflect those improved earnings. Don't confuse patience however with stubbornness. When an investment doesn't work check to make sure the company's fundamentals aren't deteriorating. If they are, get out.

In his quest to buy investment 'masterpieces', Francois often faces a conundrum. Masterpieces can be expensive and tend to trade at higher price-earnings multiples than widely perceived value stocks. While most investors focus on the current price-earnings ratio, Francois suggests instead to look to the long term and estimate what the company's value might be then. If buying at today's price and selling at that future value can deliver a 15% pa return it's likely to be an attractive investment notwithstanding a higher multiple. This process is also useful in eliminating optically 'cheap' stocks which are actually value traps.

"We try to focus on the very long term, so we try to look five years in the future and come up with our best judgements of what the EPS should be in five years... Having this long term horizon help you to de-focus on the [higher] PE ratio today. It goes the other way; if you find a cheap stock but you look five years in the future and you don't see any growth prospects, there is no real reason to believe the stock will be higher in five years. It can be higher in three months just because the PE has gone from 10 to 12. But we don't try to invest for three months we try to invest for at least five years."

The wise investor must be able to balance the dualities in many human activities. While you want to love the art you must remain rational and not fall in love with stocks. You want as large a field of knowledge as possible while remaining within your circle of competence. You need to be open-minded yet maintain a balance of thought. You need to be able to value the business but be able to go beyond the numbers. You must have patience but not stubbornness. Finally, you need discipline but also the wisdom to break the rules.

In summary, the artistic or unconventional investor focuses on intrinsic value, maintains a long term horizon, is agnostic about many things including where the stock will be in the short term, focuses on what to own as opposed to when to buy and resists fads and popular beliefs.

While the majority of investors underperform, Giverny Capital's results have significantly bettered the stock market. Its clear that while they do things differently to most investors, many of their traits and practices are common to those whom we recognise as Investment Masters. They treat the bulk of their investing as an art form, and trade logic and formula for creative thinking.

So how do you approach your investing? As a science or an art form? Do you try to engineer your results, using a set formula or logic, or do you follow a more artistic approach, utilising innovation and creativity? The differences between the two are vast, and whilst scientific method might provide you with short term success, its only through the 'art of investing' that you can go beyond the numbers and create your own long-term performance masterpiece.

[note: click on any links above for further reading on that topic]

Transcript

Mental Models - Middlemen

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

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

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

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

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

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

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

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

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

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

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

Its not all bad news for middlemen however.

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

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

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

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

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

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

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

Learning from the Masters

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

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

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

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

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

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

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

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

"I have been inspired by many investment practitioners and authors. I started reading the now legendary Berkshire Hathaway annual chairman's letter in the 1980s. I have read literally hundreds of books and studied the investment process of many investors, ranging across almost every style of investment when I was an analyst and head of research. I knew many of the most famous investors, because I provided research to them. To be a success, I think you need to synthesize a lot of sources." Terry Smith

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

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

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

Source: The Trader Documentary 1987

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

Drawing on the lessons of other great investors, particularly when their style contrasts yours, offers the opportunity for new investing insights.

“I think you can and you should try and think about a set of people who come from different areas and there’s some with very different philosophical backgrounds. So, you know, we don’t remotely do the type of macro he does, but I think we’ve tried to learn quite a lot from George Soros.” James Anderson

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

Further Reading: IM Tutorials: Learning, Imitation Game

Learning from Charles Koch

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

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

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

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

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

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

Let's hear from Charles .. 

Culture

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

"For us, culture is key."

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

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

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

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

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

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

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

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

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

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

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

Vision

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

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

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

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

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

Win-Win

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

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

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

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

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

Unconventional

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

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

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

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

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

Long-Term Perspective

The value of retaining long-term thinking...

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

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

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

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

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

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

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

Individual Behaviour over Functional Brilliance

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

"We focus first on values."

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

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

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

Information, Knowledge & Sharing

This one speaks for itself.

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

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

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

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

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

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

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

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

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

Measuring Performance

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

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

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

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

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

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

Change

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

"Consumer needs and desires are constantly evolving."

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

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

Limited Hierarchy and Bureaucracy

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

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

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

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

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

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

Humility & Complacency

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

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

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

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

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

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

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

Learning

Seeking knowledge from others and their experiences...

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

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

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

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

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

Mental Models

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

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

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

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

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

Ideas

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

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

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

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

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

Challenging and Testing Ideas

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

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

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

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

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

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

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

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

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

Take Risks and Accept Failure

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

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

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

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

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

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

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

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

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

Trust, Value and Empower your People

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Right Incentives

Reward should encourage innovation and long term value.

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

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

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

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

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

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

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

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

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

Innovation

And of course, Innovation...

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

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

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

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

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

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

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

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

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

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

Conclusion

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

Learning from Lou Simpson

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

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

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

Charlie Munger had this to say about Lou Simpson ..

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

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

• Think independently

• Invest in-high return businesses run for the shareholders

• Pay only a reasonable price, even for excellent businesses

• Invest for the long-term

• Do not diversify excessively

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Learning from Nucor’s Ken Iverson

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

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

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

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

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

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

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

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

Culture

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

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

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

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

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

Unconventional

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

Simplicity

"Simplicity is what makes Nucor successful."

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

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

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

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

Long Term Perspective

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

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

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

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

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

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

PainSharing and No Layoffs

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

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

Employment Policy and MBA's

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

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

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

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

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

Decentralisation and Smallness

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

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

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

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

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

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

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

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

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

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

Information & Transparency

"Delegation without information is suicide."

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

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

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

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

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

Limited Hierarchy

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

"Management's authority comes from the employees."

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

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

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

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

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

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

Walk The Floors

“Whenever I’ve run a plant, I’ve made it a practice to get around and talk with every manager in the plant each morning. I’d sit and chat and drink coffee with people all over the facility. I might not get back to my own office and my own pile of work until late in the morning, and I’d arrive there with my caffience quota for the day. But it was always worth it. During my morning stroll, I might talk with a dozen or more people. I’d get an up-to-the-minute picture of what was going on in each and every part of the operation. Even more, I’d find out if people were feeling confident or anxious; see first-hand how well our technology was working; and get a sense which managers were struggling and which might be ready to take on more responsibility. This was also a good way to get people used to seeing me, so I wouldn’t scare them when the day came (as it surely would) that I needed information from somebody honestly and quickly. By taking those strolls, I always knew what people thought. I had a strong sense of who they were, what they could do, and what they cared about. They knew the same things about me. I can’t imagine staking my success on a group of people and not knowing them. It would be like trying to fly a plane with one wing.”

Humility

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

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

Ideas

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

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

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

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

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

Test Ideas

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

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

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

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

Take Risks and Accept Failure

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

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

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

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

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

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

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

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

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

Trust, Value and Empower your People

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

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

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

Nucor Annual Report 2002 - All Employees listed

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

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

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

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

"Every manager should be something of a psychologist."

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

The Right Incentives

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

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

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

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

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

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

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

Cyclicality and Debt 

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

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

Innovation

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

On M&A

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

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

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

Summary

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

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

The Sandpile and Fingers of Instability

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

High-Frequency Trading [HFT] and Market Illiquidity

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

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

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

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

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

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

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

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

Passive Investing [ETF's and Index Funds]

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Quant Trading

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

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

Volatility Targeting

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

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

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

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

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

Connectivity

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

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

Summary

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

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

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

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

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

Buffett on Insurance

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

Insurance.

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

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

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

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

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

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

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

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

What is Insurance?

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

Limited Obsolescence

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

Low Historic Correlation

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

Float

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

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

Combined Ratio

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

Cost of Float

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

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

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

Capped Insurance

"There’s a couple things you can’t cap in insurance. You can’t cap workers’ compensation losses. I mean, they —you can as a reinsurer, but I mean, the primary insurer can’t do that. I believe in auto, for example, in the U.K., that it’s uncapped. And I think that nobody thought that was very serious until they had a recent accident that caused — I think it involved a car doing something that — an auto doing something to a train that was unbelievable. So there are a few areas where insurance is written on an uncapped basis. And in our case, we write some auto insurance in the U.K. and we write some workers’ compensation, primarily in California. But generally, in the reinsurance business, you are capping the liabilities you take on."

What Gives an Insurance Business Value?

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

How to Evaluate an Insurance Company

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

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

Four Disciplines to a Sound Insurance Operation

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

Where Most Insurers Go Wrong

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

Good Underwriting

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

Growth

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

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

“Anybody can generate float. I mean, if we gave our managers a goal of generating 5 billion of float next year, they could do it in a minute, you know, and we would be paying the price for decades to come. You can write dumb insurance policies, you know. There’s an unlimited market for dumb insurance policies. And they’re very pleasant, because the first day the premium comes in and that’s the last time you see any new money. From then on, it’s all going out. And that’s not our aim in life.”

Losses

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

Pricing

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

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

“The reaction of other people when premiums are wrong is to take more risk. And our reaction when premiums are wrong is just to go play golf or something and tell somebody to call us when premiums get right again.”

“You can do enormous damage in the insurance business with a pen.”

Interest Rates

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

Surprises

"Virtually all surprises in insurance are unpleasant ones."

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

Unlimited Policies

"We write huge limits. We’re the biggest — you know, if somebody wants to write a huge limit, or an unusual limit, they should call us. Because there’s no one else in the world that will act as big or as promptly as we will. But we don’t write things that are unlimited.

Now, the interesting thing is that the biggest exposures, in our view, are the people that write a lot of primary business and don’t have the catastrophe cover they need. I mean, if you write 10 percent of all the business in homeowners on — or 15 percent — on Long Island or in Florida, I mean, you are writing a catastrophe cover that would blow your mind.

If you’re Freddie Mac or Fannie Mae and you’re guaranteeing mortgages, you know, for millions of people in areas like that, and they don’t have insurance — earthquake in California or property insurance in Florida — they’d be less likely to have earthquakes someplace — you are taking on enormous risks.

I mean, huge risks, far beyond what we would ever take on. They just — but you don’t get paid for them, unfortunately... So, there are all kinds of risks that can aggregate in huge ways that companies are not thinking about at all. In insurance, the unthinkable always happens.”

P&C Businesses

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

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

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

“Surprises in the P/C business – which can occur decades after six-month or one-year policies have expired – are almost always negative. The industry’s accounting is designed to recognize this reality, but estimation mistakes can be huge. And when charlatans are involved, detection is often both slow and costly. Berkshire will always attempt to be accurate in its estimates of future loss payments but inflation – both monetary and the “legal” variety – is a wild card.”

Casualty vs Property Lines of Insurance

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

Long vs Short Tail

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

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

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

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

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

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

No Optimists

“We have learned – too often, painfully – a good deal about what types of insurance business and what sort of people to avoid. The most important lesson is that our underwriters can be thin, fat, male, female, young, old, foreign or domestic. But they can’t be optimists at the office, however desirable that quality may generally be in life.”

Proper Reserves

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

Investment Assets

“It’s always struck me as terribly illogical, the way property-casualty insurance companies are run, because they’ve been dominated by the underwriting side of the business. And here they have this important investment side, but it’s always been — virtually every company’s been subservient to the underwriting.”

Commodity Product

“The ordinary insurance company is not a good business.”

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

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

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

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

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

Industry Economics

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

Industry Pricing

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

Demand & Supply

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

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

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

Risk of Courts Orders on Casualty Insurance

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

Insolvent Competitors Can stay in Business

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

Low Costs

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

Driverless Cars

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

Super-Cat [Catastrophe] Business

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

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

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

Climate Change

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

Re-Insurance

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

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

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

Alignment

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

Importance of Management

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

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

Insurance Cycle

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

Summary

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

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

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

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

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

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

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

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

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

Learning from Josh Waitzkin

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Learning from Howard Schultz

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Starbucks did things differently, they still do ... 

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

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

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

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

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

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

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

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

Howard stepped down as CEO in 2000 ...

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

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

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

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

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

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

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

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

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

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

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

So what did Howard learn from the mistakes?

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

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

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

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

And we can learn from this.

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

Seeking Perfection

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

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

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

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

Even the CEO of a company cannot be aware of every detail within the organization. Moreover, even if they were, leveraging this information for profit would require an understanding of how it will affect market participants.

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

I recall collaborating with a remarkably astute junior analyst who consistently sought additional information regarding the companies under our scrutiny. Hailing from a corporate finance background, he was accustomed to having ample data at his disposal to craft corporate documents and forecasts—ranging from company budgets and management accounts to debt schedules and contracts. However, when it came to delving into market dynamics and stock insights, he found himself grappling with a scarcity of readily available information. Consequently, he became immobilized by the absence of data, unable to formulate recommendations based on probabilistic assessments.

And this is a common trend. Yet, accepting that we cannot know everything is an essential psychological mindset for successful investment.

“One thing I’ve learned is, people can be unbelievably smart. But if they're very linear thinkers, it will never work as an analyst. We are always dealing in shades of gray, probabilities. If somebody has to know the answer to a math problem or whatever, if they have to know the answer, there is never the answer in our world. Those people can be incredibly smart and might be winning Nobel prizes or whatever, but they can't work in our world because our world is all about probabilities and weighing outcomes. If that makes you uncomfortable, it's just not going to work.” Steve Mandel

One of my favourite books “The Art of Learning” by the US Chess Master, Josh Waitzkin, highlights the need to be able to operate without perfection.

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

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

“Perfection doesn’t exist in this world. All of my choices involve various degrees of compromise and tradeoffs.” Thomas Gayner

"This is not a perfect game." Steve Cohen

"There is never perfect knowledge about the world. Simply put, we don't know what we don't know." Leon Levy

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

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

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

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

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

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

“I don't know any certain way of arriving at the 'correct' value of any asset. What I do know though is that I've been asking the right questions about the attraction of any equity asset.” Nick Train

“The more you know, you start to realise there is a lot more than you don’t. That’s an enlightened place to be. You can study and study companies but you’re never going to know everything you’d like to know. You’re going to know a fraction of what an insider knows and they don’t know everything either. You have to be careful because you’re never going to know everything. So for us it’s a never ending quest for knowledge on our companies. Everyday you have to try to keep finding more and more about the companies you want to know more about.” Jeff Mueller

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

“I’ve always thought it was important to remember that there is no absolute truth. Everything is a working hypothesis, and from there it’s about reacting to data points.” Rajiv Jain

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

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

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

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

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

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

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

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

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

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

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

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

Investment errors typically stem from shortcomings in analysis rather than deficiencies in data collection. Rather than allocating excessive time gathering every possible piece of information, it is more beneficial to focus on critical thinking and reasoning processes. Is the collected information genuinely practical? Are there underlying psychological biases influencing the interpretation? Have consultations been conducted with competitors, customers, and suppliers? Has the concept been thoroughly tested? What assumptions underpin the analysis, and can they be challenged? Are alternative scenarios considered? What potential oversights exist? What gaps in knowledge need to be addressed?

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

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

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

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

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

"Conventional wisdom suggests that, for investors, more information these days is a blessing and more competition is a curse. I'd say the opposite is true. Coping with so much information runs the risk of distracting attention from the few variables that really matter." John Neff

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

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

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

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

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

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

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

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

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

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

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

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

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

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

TURN-AROUNDS AND RETAIL

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

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

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

“There’s more safety and optionality in businesses that don’t need to be rescued.” Vinson Walden

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

"We require strong balance sheets and a long record of profitability, so we’re not usually investing in classic turnarounds." Alexander Roepers

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

“Companies rarely go through a transformational improvement (a phrase involving leopards and spots springs to mind) and these events are also difficult to predict. But in our view the main problem with this investment strategy, other than the fact that we have no expectation we could make it work, is that whilst fund managers await the kiss that will turn their corporate frogs into princes, they steadily erode value.” Terry Smith

“I’ve got a friend who always wants to buy lousy companies with the idea he’s going to change them into wonderful companies. And I just ask him, you know, “Where in the last hundred years have you seen it happen?” Warren Buffett

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

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

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

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

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

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

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

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

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

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

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

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

"Charlie and I try and distinguish between businesses where you have to have been smart once and businesses where you have to stay smart. And, I mean, retailing is a good case of a business where you have to stay smart. You are under attack all of the time. People are in your store. If you’re doing something successful, they’re in your store the next day trying to figure out what it is about your success that they can transplant and maybe add a little something on in their own situation. So, you cannot coast in retailing." Warren Buffett

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

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

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

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

In retailing good management is essential  ...

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

But sometimes even that isn't enough ..

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

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

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

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

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

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

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

Particularly with the arrival of Amazon...

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

In 2016, Buffett sold his position in Walmart .. he decided to look for an easier game.. 

".. Amazon in particular is an entity that’s gonna have everybody in their sights. And they’ve got delighted customers. And it’s extraordinary what they’ve accomplished. And a lot of people, the delivery, you know, and that is a tough, tough, tough, competitive force. Now, Walmart’s pushing forward online themselves and they’ve got all kinds of strengths. But I just decided that I’d look for a little easier game.”

Turn around business situations, particularly those in retail are hard going. Lots of capital, lots of hard work and almost constant management intervention are required. Is it really worth it, though? The Investment Masters have determined there are far easier fish to fry out there....