The Munger Series - Learning from Charles Darwin

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

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

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

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

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

Education and Smarts

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

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

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

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

Learning

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

Reading

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

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

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

Love

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

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

Consensus

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

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

Understanding and Patience

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

Commitment/Confirmation Bias

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

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

Collect the Facts

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

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

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

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

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

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

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

Hard Work

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

Writing

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

Intuition

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

Mistakes

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

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

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

Thinking and Age

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

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

Testing ideas

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

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

Avoiding Bias

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

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

Humility in conclusion..

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

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

The Munger Series - Learning from Lee Kuan Yew

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

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

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

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

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

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

China

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

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

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

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

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

America

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

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

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

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

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

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

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

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

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

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

America and China

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

India

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

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

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

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

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

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

Singapore

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

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

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

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

"Standing still is a sure way to extinction."

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

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

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

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

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

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

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

Developing Countries

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

Governing

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

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

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

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

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

Thinking

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

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

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

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

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

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

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

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

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

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

"Realism and pragmatism are necessary to overcome new problems."

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


 

Are You Checking the Portfolio Too Often?

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

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

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

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

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

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

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

Taleb notes ..

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

"I try to be removed from the day-to-day: I don't have a ticker-tape machine in my office. I can read the papers. And there's an office nearby where I can go and watch it, but basically, I try to stay away from the emotions of the market. The market is a very emotional place that appeals to fear and greed. All these unpleasant characteristics that people have." Walter Schloss

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

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

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

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

With regards the trading dentist, Taleb concluded ..

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

Is it time to move that Bloomberg terminal?

The Value of Cash

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Invest Scared

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

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

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

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

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

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

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

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

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

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

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

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

50c Dollar Bills

Photo Source: Wikipedia

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

“Valuation is always the best catalyst.” Stan Majcher

“Value is often its own catalyst” Chris Pavese

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

The Investment Masters Class - Some Stats

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

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

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

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

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

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

Analysing Investment Performance - Short and Long Term

The Investment Management industry is fixated on short term performance. 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Source: Wikipedia

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

Is the Company's Product Attractive?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

“It’s nice to have markets like that that are relatively untapped.” Warren Buffett

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

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

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

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

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

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

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

How to Build a Better Investing Mind

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

"We don’t really use screens. Instead, we use ‘mental models’ which help us find good investments. Some examples of these are the capital cycle, the power of incentives and insider ownership." James Seddon, Hosking Partners

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Further Recommended Reading:

Media and the Market

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

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

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

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

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

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

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

"For 200 years pessimists have had all the headlines even though optimists have far more often been right. Arch-pessimists are feted, showered with honours and rarely challenged, let alone confronted with their past mistakes." Matt Ridley

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

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

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

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

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

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

"Headlines lead to headaches for the unfamiliar." Frank Martin

"Opportunity is a result of people panicking based on news. News is random and it might not look good but it's not exactly easy to analyse how it's all going to work out at that moment. Changing your position because of news is usually not a great idea." Jim Leitner

"We look to value and we don’t look to headlines at all." Warren Buffett

"Ignore the latest dire predictions of the newscasters. Sell a stock because the company's fundamentals deteriorate, not because the sky is falling." Peter Lynch

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

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

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

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

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

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

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

“No matter what happens in the market, people are always on the news spinning here’s why it did what it did. But the reality is I got to tell you, we see a lot of movements that we don’t really know why it moves.” Raife GIovinazzi

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

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

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

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

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

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

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

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

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

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

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

Were Munger, Dalio and Soros CIA Trained?

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

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

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

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

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

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

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

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

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

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

Be a Generalist

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

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

Have a Multi-disciplinary mindset

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

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

Focus on Collecting Information that Matters

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

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

Seek out Other Information

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

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

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

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

Test your Investment Ideas

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

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

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

Remain Open Minded

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

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

Bruce Berkowitz: "Facts change, we change." 

Beware Of Commitment/Confirmation Bias

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

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

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

Analysts Improve with Experience

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

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

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

Deal with Change

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

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

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

Be Creative

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

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

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

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

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

Consider Alternate Hypothesis

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

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

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

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

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

Seek to Disprove Hypothesis Not Confirm Them

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

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

Be Alert to Surprises

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

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

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

Seek out Individuals who Disagree

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

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

Think Backwards

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

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

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

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

Appoint A Devils Advocate

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

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

Watch out for Unexpected events

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

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

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

Keep Questioning

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

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

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

Consider the Interactions Between the Variables

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

Source: Psychology of Intelligence Analysis, CIA

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

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

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

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

Understand Probability

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

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

Identify Milestones Ahead of Time for Being Wrong

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

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

Establish the Implications of being wrong

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

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

Ensure you Evaluate the Evidence

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

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

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

Avoid Anchoring

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

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

Study Your Mistakes

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

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

Prepare for the Unexpected

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

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

Occasionally Failures Must be Accepted

CIA "Occasional intelligence failures must be expected."

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

CIA Original Headquarters Building

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

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

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

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

It's time to implement some CIA tactics into your investment process ...

Investing Mentors

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

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

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

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

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

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

"For young people just getting started, I say apprentice yourself to somebody who's good and knowledgeable, and you'll learn the ropes much more rapidly." Ed Thorp

“In terms of career, take the job you would take if you weren’t getting paid. As Buffett says, go work for someone you like, admire, and trust. Those are the jobs you want. Don’t take the job with the most prestigious firm or offering the most money. Those are both very stupid things.” Mohnish Pabrai

“I think the most important thing [for young people] is to get themselves into a organization, it could be public markets, private markets, it doesn't really matter, where they are mentored by people who teach them really good fundamentals.” Steve Mandel

“When you're young, only take a job that provides you with a steep learning curve and strong training. First jobs are foundational. Don't take a job just because it seems prestigious.” Steven Schwarzman

“I always say to young people that are trying to get jobs, the first job is your hardest job because once you get your first job, you get into the mix, you get to know people, other opportunities will open up to you. That’s the first thing. Then if you have choices, the most important thing is sizing up the very people you’ll be working with, the half a dozen, dozen people you’ll be working with. Those are the people who are going to influence you. That is the key thing. It’s not the prestige of the firm, it’s not whether your parents or your mother-in-law knows, has heard of the place that you work. It’s the people that you’re going to be working with. There are a lot of great people.” David Abrams

“Avoid working directly under somebody you don’t admire and don’t want to be like.”
Charlie Munger

“If you can’t see yourself working with someone for life, don’t work with them for a day.” Naval Ravikant

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

“I had the benefit of working at three different places before I started Lone Pine. I learned a ton and had really good mentors at each of those three places.” Steve Mandel

“Try and find a mentor. Try and find a mentor, somebody who knows how it works and is prepared to take the time and effort and share that with you.” Terry Smith

“Look for people who have your interests and want to move you along – not somebody who thinks that they’re going to chew you up in two or three years and find some more ambitious person. I was determined in my career to have great mentors and I’ve been super fortunate in my life to find them.” Scott Bessent

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

Warren Buffett himself recognises the value of role-models:

“I’ve had half a dozen or so heroes in my life. I think it’s very important to have the right heroes. Now they call them role models or whatever, but you’re going to take your cues from somebody. So I say, choose your heroes carefully, and then figure out what it is about them you admire. Then figure out how to do the same thing. It’s not impossible.”

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

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

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

One of the greatest investors of our age, Buffett’s partner, Charlie Munger, studied the great minds from history.:

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

"I would say that you’re not restricted to living people when picking your mentors. Some of the very best people are dead." Charlie Munger

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

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

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

“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

"Berkshire Hathaway annual reports - one has to not only read them, but re-read them." Charles de Vaulx

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

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

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

“Warren Buffett is one of my investing heroes... I admire Warren Buffett and would say if you are going to read about only one investor, pick him.” Bill Nygren

“Warren Buffett, he has been a wonderful role model even though I know him only a very tiny bit. He was a role model long before I ever met him. What I think he’s done wonderfully, in the tradition of Benjamin Graham, is he is a brilliant investor, and he’s a teacher. He teaches us through his writings, through his interviews, and through his behavour. I think some of the best things that any investor today can read are his early partnership letters. The world is totally different, but there’s wisdom in them for the ages.” Seth Klarman

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

"Warren Buffett is a hero. Pick some good heroes and read everything you can about them." Thomas Gayner

“Warren Buffett [is] my hero.” Bruce Karsch

“I got into this business because someone tipped me off about Warren Buffett early on. So he’s certainly, he’s obviously a hero… A big part of my education as an investor came from reading everything Buffett’s written.” Bill Ackman

“I can’t say I walked with any individual investor who has mentored me, but obviously you learn a lot from reading Buffett. Anything Buffett has written is worth reading and re-reading.” Rajiv Jain

"Warren Buffett is in a league by himself, I would say, in terms of his business skills and so forth." David Rubenstein

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

"I started reading the now legendary Berkshire Hathaway annual chairman's letter in the 1980s.” Terry Smith

"Warren Buffett has been a major influence on my life because he's so brilliant and I've read a lot of what Buffett has said and memorized many of the things that he said." Ed Wachenheim

“Like millions of Warren Buffett and Charlie Munger admirers around the world, the teachings of these two teachers and Berkshire Hathaway’s amazing performance have shaped my investment career… I found all the books written about Buffett, including his annual letters to Berkshire shareholders and articles about him. I also learned that Charlie Munger was Buffett’s decades-long partner. I spent nearly two years studying them.” Li Lu

“About 20 years ago I began studying the lessons of the masters — both Benjamin Graham and his star student in the 1950s up at Columbia University, Warren Buffett — and through the study of the writings of and speeches by, and books that have been written by and about those two gentlemen, I was able to develop a certain investment philosophy.” David Polen

“I read an article in a newspaper and they talked about Warren Buffett and I had never heard of him. So pretty quickly, I wrote him a letter, so probably early ‘93, and I told him I was interested in investing, and I would like to read his Annual Letters, so that was before the internet. So he sent me a big package in the mail of all of the Annual Letters since I think 1977. And I read that, and had a vision of investing in the stock market change overnight.” Francois Rochon

"Like many other investors, Marathon never tires of quoting Warren Buffett." Marathon Asset Management

“Like so many others, Munger and Buffett have been the inspiration behind my general investment philosophy and the way I've structured my firm.” John Huber

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

“When people ask me, ‘I’d love to be an investor, who should I read? what are the books?’ I say go and get all the Buffett letters and read them because he has re-defined the way to think about investing for the world, for much more than this generation. He is our Benjamin Franklin. People don’t realise that. He has said so many things that have changed the way people think. He is a brilliant writer, but he is a much more brilliant thinker.” Tom Steyer

“I owe more gratitude to the two gentlemen running Berkshire as mentors than to any others by a country mile.” Christopher Bloomstran

“The lessons [Benjamin Graham taught] are fresh and pertinent every single day of our lives as investors — as is the philosophy of Warren Buffett. And you can’t leave out Mr. Charles Munger. What they’ve done and said and laid out for us over the years is all we really need.” David Polen

“As a young(ish) man there is something slightly depressing about thinking things through for a while, arriving at a somewhat reasoned conclusion only to find that others have been there before, and years earlier. In some respects we are fifty years behind Buffett, but that’s ok so long as the average investor is at least fifty-one years behind!” Nick Sleep

“One of the things we learned [from studying Warren Buffett]: invest in great businesses; let them continue to compound so they pay you cash flow; and allocate that cash back [to] new investments. That's one of those insights [from] looking at what Buffett's done.” Scott Nuttall, KKR

Start learning from your mentors..

Ten Years

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

“You’ve got to make sure that the business will be around for the longer-term. If you’re not sure how the business is going to look like five years out, you probably shouldn’t be investing. It doesn’t mean you own it for five years, but you’ve got to be careful because markets anticipate a turn in fundamentals a lot faster than we like to think.” Rajiv Jain

“When we are looking at these businesses before we decide to purchase one, we’re trying to figure out what this businesses is going to look like five years from now and ten years from now, not what’s going to happen in the next quarter or the next year. Our ability to focus on the long-term strategy and growth of the business allows us to eliminate a lot of the noise that’s in the marketplace that causes a lot of short-term stock price swings. This allows us to keep our turnover low and allows the companies’ earnings growth to do the investment compounding for us.” Daniel Davidowitz

“Of course, most companies will not survive for 30 years or more. Most companies fail. So just applying this filter -'will such and such a company likely be around in 30 years?' - savagely reduces the universe of potential investments for me. But every so often you come across a business with a brand or a franchise that has survived and thrived over many decades and where it doesn't seem totally absurd to expect it to continue to do so.” Nick Train

Most businesses with longevity require a culture of innovation.

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

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

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

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

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

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

"We share a passion to buy, build, and hold large businesses that satisfy basic needs and desires." Warren Buffett

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

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

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

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

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

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

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

How will the companies you own look in ten years?

Great Investors Sleep Well

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

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

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

"Conservative investors sleep well.” Phil Fisher

"If you want to sleep well at night, do your own homework. Don't be hasty.” John Neff

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

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

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

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

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

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

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

“Our ‘sleep-at-night test’ is a critical risk management tool.” Bill Ackman

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

“I think it may have been JP Morgan that someone asked this question -  they said ‘I’m worried about how high things are, should I sell? The advice he gave was ‘sell down to the sleeping point.” Ed Thorp

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

“I want to sleep well at night. Focusing on underlying values and allowing the power of time and compounding to work for me was appealing when I was in my teens, and it’s even more appealing now.” Christopher Tsai

“I set my own VAR. My value at risk limit is can I sleep at night.” David Tepper

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

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

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

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

Make sure you can sleep well at night!

Pricing Power? Milk and Bread!

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

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

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

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

“When we bought See’s Candy, we didn’t know the power of a good brand. Over time, we just discovered that we could raise prices 10% a year and no one cared. Learning that changed Berkshire. It was really important.” Charlie Munger

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

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

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

Buffett expanded on product differentiation in his 1982 letter ..

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

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

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

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

“We want to own businesses with pricing power vis-à-vis their customers and suppliers – those that sell unique, highly valued products or services to customers who have little desire to switch to a competitor.” Brian Vollmer

“Buy businesses with pricing flexibility. For several years our investment philosophy has been based on the assumption that inflation over the next ten years will be the major enemy of capital. We assume that inflation may equal or exceed 7%. If this proves to be wrong, we will be delighted as the lower rate will lead to a much healthier stock market. If our assumption is borne out, the pricing flexibility of companies with dominant market positions will provide an important hedge against inflation.” Bill Ruane

“Nothing makes the job of a portfolio manager easier & happier than owning a basket of companies with untapped pricing power at discounted prices. If he is patient, he needs no other virtue.” Li Lu

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

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

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

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

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

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

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

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

Notwithstanding the above, it’s untapped pricing pricing power that’s most valuable. Companies that abuse pricing power ordinarily end up attracting competition or regulatory backlash [eg. Valeant].

“We like to find businesses with pricing power. But to say that something has pricing power and to leave it there is really an incomplete line of thinking because nobody has unlimited pricing power.” David Abrams

“Growth in profits from increasing prices can simply build an umbrella beneath which competitors can flourish. We are more interested in companies which have physical growth in the merchandise or service sold than simple pricing power, although that’s nice too.” Terry Smith

“It’s tempting for great businesses to leverage their strong market position through high price increases to the benefit of near-term earnings. We often hear terms such as ‘pricing power’ or ‘high switching costs’ as justification for asking customers to pay more for the same product or service. Increasing prices at a rate well above inflation is common in businesses with short-term–minded management who define success based on this year’s profit number. In squeezing customers through pricing, great businesses often compromise their future. As the value of what they deliver relative to the price they charge becomes a little less attractive, customers are more likely to seek out alternatives and the door for competitors opens a little wider. Price increases also diminish a customer’s appetite to take additional products or services from a supplier, or to recommend a supplier to a friend. Revenue per customer today may increase, but the lifetime value of each customer relationship moves in the opposite direction. Aggressive pricing increases the likelihood of fade. Businesses that successfully fight the fade don’t just preserve the value they deliver relative to the cost they charge over time; they improve it. Taking this approach, they keep their customers for longer, sell more products and services to them, progressively win more customers and keep competition at bay.” Stephen Arnold

Do the businesses you own have pricing power?

Some insights from Ted Weschler and Todd Combs

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

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

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

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

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

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

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

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

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

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

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

Click here for link to the Yahoo News Interview. 

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

The Keys To Successful Equity Investments

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

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

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

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

1) Consider stocks as fractional ownership in real businesses

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

2) Being present

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

3) Profit from market fluctuations rather than suffer from them

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

4) Leaving yourself a margin of safety

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

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

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

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

5) Stay within your circle of competence

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

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

6) Know when to sell

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

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

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

7) Learn from your mistakes

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

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

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

8) A constructive attitude

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

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

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

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

An Earnings Miss?

"Estimates miss earnings, not vice versa." Market Veteran

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

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

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

“If you are selling because of a missed earnings report or the trend of the market or something, you’ve stopped looking at the rate of return the company can achieve over time.” Chuck Akre

“You rarely get to purchase high quality businesses at cheap prices unless there is a ‘glitch’ which provides an opportunity to do so.” Terry Smith

“Usually company specific issues provide opportunities.” Chris Bloomstran

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

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

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

“It seems to us that one quarter’s missed earnings target rarely has a significant impact on the intrinsic value of companies. Warren Buffett makes no comment on the quarterly earnings of Berkshire Hathaway because he finds it ‘difficult to say anything new or meaningful each quarter about events of long-term significance.’” Marathon Asset Management

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

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

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

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

“We are usually asking much longer term questions as we want to understand long term strategy. We don’t care about this quarter or next quarters earnings. We care about where the company is going over the long term.” Jeff Mueller

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

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

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

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

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

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

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

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

The Buffett Series - The Science of Hitting

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

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

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

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

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

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

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

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

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

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

The Profit is in the Buying

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

Thinking is Key

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

Patience is Critical to Successful Investing

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

Stick within your Circle of Competence

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

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

Continue to Learn

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

Work Hard

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

Its not an Exact Science

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

Control your Emotions

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

Understand Psychology

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

Find your Edge

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

Stick with your Own Style

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

Be a Generalist

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

Love what you do

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

Understand History

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

Human Nature Doesn't Change

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

Keep it Simple

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

Understand Batting Average

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

Learn from your Mistakes

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

Focus on the Factors that Matter

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

Speak to People in the Know

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

Test Investment Ideas

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

Stick to What you Know

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

Buy with a Margin of Safety

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

Avoid Permanent Loss

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

Stick with a Process

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

Buy Quality Companies

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

Avoid Value Traps

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

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

Watch Others

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

How Big to Position

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

Concentrate

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

Be Adaptable

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

Dealing with Losses

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

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

Using Intuition

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

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

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

Improving with Age

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

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

Be Aware of the Macro

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

Balancing Confidence with Humility

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

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

Investment Misconceptions - Volatility is Risk - Efficient Markets

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

Goal is to Make Money

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

Let's hit the ballpark… 

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