seekrit squirrel
Finance => Shares => Topic started by: galumay on January 09, 2015, 04:00:13 PM
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A collection of wisdom that has caught my eye, starting with one from Oaktree Capital, their memos are always worth a read,
Looking Right Can Be Harder Than Being Right
Fear of looking bad can be particularly debilitating to an investor, client or manager. This is because of how hard it is to consistently make correct investment decisions. Some of this comes from my last memo, on the role of luck.
First, it’s hard to consistently make decisions that correctly factor in all of the relevant facts and considerations (i.e., it’s hard to be right).
Second, it’s far from certain that even “right” decisions will be successful, since every decision requires assumptions about what the future will look like, and even reasonable assumptions can be thwarted by the world’s randomness. Thus many correct decisions will result in failure (i.e., it’s hard to look right).
Third, even well-founded decisions that eventually turn out to be right are unlikely to do so promptly. This is because not only are future events uncertain, their timing is particularly variable (i.e., it’s impossible to look right on time).
This brings me to one of my three favorite adages: “Being too far ahead of your time is indistinguishable from being wrong.”
http://www.oaktreecapital.com/MemoTree/Dare%20to%20Be%20Great%20II.pdf (http://www.oaktreecapital.com/MemoTree/Dare%20to%20Be%20Great%20II.pdf)
Another favourite is from Bob, my dad, and he calls it the Matches Share Strategy - "Look for companies that have ripped you off and buy shares in them". It would have us all holding Telstra for a start so it cant be far wrong! I like Cabcharge for the same reason, any of the big banks, Woolworths...the list goes on!
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just saw this as someones sig on a forum,
A company is worth the PV of all future cashflows (forecast EPS) discounted for time and risk, nothing more or less.
1/PE = ROI. Money in the bank is about 6% ROI or PE of 16, but risk free.
Risk = high debt, commodity price sensitivity etc
I will have to have a think about that! First line is obvious, 2nd line i am a bit lost, 3rd, yep.
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Fascinating, some real learning in there,
http://www.fool.com.au/2015/02/19/the-most-successful-company-in-the-world/
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just saw this as someones sig on a forum,
A company is worth the PV of all future cashflows (forecast EPS) discounted for time and risk, nothing more or less.
1/PE = ROI. Money in the bank is about 6% ROI or PE of 16, but risk free.
Risk = high debt, commodity price sensitivity etc
I will have to have a think about that! First line is obvious, 2nd line i am a bit lost, 3rd, yep.
Ok, a bit more analysis! As I said first line is self explanatory,
1/PE=ROI, well i found this explanation,
"Return on investment (ROI) can be defined as earnings divided by the price of the investment. Thus, ROI is equivalent to the reciprocal of the P/E ratio. For example, the reciprocal of a P/E = 20/1=20, would be E/P=1/20=.05."
So a PE of 14.4 (market average), 1/14.4=0.07 which is 7%.
What he is saying is that the return on the investor's investment is about 7% in that case,
As interest rates are now nearer 3% than 6%, money in the bank has a P/E ratio of about 25 - but risk free.
I am really not sure what value this adds to thinking about an investment. On that basis I am deleting his middle line and saving the thought that,
A company is worth the PV of all future cashflows (forecast EPS) discounted for time and risk, nothing more or less.
Risk = high debt, commodity price sensitivity etc
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Just found this great interview, the philiosophy is so simple and clean, lots to absorb and apply here,
http://www.givernycapital.com/assets/documents/179/TWST_04_15_13_Giverny_Capital_.pdf?1386962107
Here is the most important bit, his IV calculation.
And as I said, we try to see what kind of earnings power they can have in five years, and what kind of p/e ratio would make sense. From there, intrinsic value has to be a very simple calculation. You don’t need computers to do it. For example, we think CarMax can earn $4 a share in five years. You put a 20 p/e ratio on it, so it’s an $80 target price in five years. If we can purchase the stock at $40 today, we should do OK. It’s as simple as that, when things go as planned. Of course, we try to make it a little more precise than that, but that’s the general idea.
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Some good stuff in here too,
http://csinvesting.org/wp-content/uploads/2014/07/090810_Hummingbird_Investment_Strategy_-_final1.pdf
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Buffet, risk & volatilty (beta)
"Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray."
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Risk means more things can happen than will happen
Even if you know whats most likely, many other things can happen instead.
Risk means uncertainty about which outcome will occur and about the possibility of loss when the unfavorable ones do.
“The riskiest things: The greatest risk doesn’t come from low quality or high volatility. It comes from paying prices that are too high. This isn’t a theoretical risk; it’s very real.”
“When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not risky at all. Broadly negative opinion can make it the least risky thing, since all optimism has been driven out of its price.”
“This paradox exists because most investors think quality, as opposed to price, is the determinant of whether something’s risky.”
“So even though the first tenet in Oaktree’s investment philosophy stresses “the importance of risk control,” this has nothing to do with risk avoidance.”
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“• Rule number one: most things will prove to be cyclical.
• Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.”
“In fact, I’ve recently boiled down the main risks in investing to two: the risk of losing money and the risk of missing opportunity. It’s possible to largely eliminate either one, but not both.”
“The desire for more, the fear of missing out, the tendency to compare against others, the influence of the crowd and the dream of the sure thing—-these factors are near universal. Thus they have a profound collective impact on most investors and most markets. The result is mistakes, and those mistakes are frequent, widespread and recurring.”
“from Demosthenes: “Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true.”
“The desire for more, the fear of missing out, the tendency to compare against others, the influence of the crowd and the dream of the sure thing—these factors are near universal. Thus they have a profound collective impact on most investors and most markets. This is especially true at the market extremes. The result is mistakes—frequent, widespread, recurring, expensive mistakes.”
“To buy when others are despondently selling and to sell when others are euphorically buying takes the greatest courage, but provides the greatest profit.
SIR JOHN TEMPLETON”
“Skepticism is usually thought to consist of saying, “no, that’s too good to be true” at the right times. But I realized in 2008—and in retrospect it seems so obvious—that sometimes skepticism requires us to say, “no, that’s too bad to be true.”
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“It’s our job as contrarians to catch falling knives, hopefully with care and skill. That’s why the concept of intrinsic value is so important. If we hold a view of value that enables us to buy when everyone else is selling—and if our view turns out to be right—that’s the route to the greatest rewards earned with the least risk.”
“A high-quality asset can constitute a good or bad buy, and a low-quality asset can constitute a good or bad buy. The tendency to mistake objective merit for investment opportunity, and the failure to distinguish between good assets and good buys, get most investors into trouble.”
Economic forecasts are like a broken watch, most of them, most of the time, will be incorrect by varying amounts, occasionally they will be spot on, but the ones that were correct in one moment will be wrong for the rest of them. Remember a broken clock tells the correct time twice a day.
“In good years in the market, it’s good enough to be average. Everyone makes money in the good years, and I have yet to hear anyone explain convincingly why it’s important to beat the market when the market does well. No, in the good years average is good enough.”
Excerpt From: Howard Marks. “The Most Important Thing Illuminated.” iBooks. https://itun.es/us/NzlKE.l
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The Poor Man’s Guide to Market Assessment
Here’s a simple exercise: I have listed below a number of market characteristics. For each pair, check off the one you think is most descriptive of today. And if you find that most of your checkmarks are in the left-hand column, as I do, hold on to your wallet.
Economy: Outlook: Lenders: Capital markets: Capital:
Terms: Interest Rates: Spreads:
Investors:
Asset owners: Sellers: Markets: Funds:
Recent performance: Asset prices: Prospective returns: Risk:
Popular qualities: The right qualities: Available mistakes:
Vibrant Positive Eager Loose Plentiful Easy Low Narrow
Optimistic Sanguine Eager to buy Happy to hold Few
Crowded
Hard to gain entry
New ones daily
GPs hold the cards on terms
Strong High Low High
Aggressiveness
Broad reach
Caution and discipline Selectivity
Buying too much Paying up
Taking too much risk
Sluggish Negative Reticent Tight Scarce Restrictive High Wide
Pessimistic
Distressed Uninterested in buying Rushing for the exits Many
Starved for attention
Open to anyone
Only the best can raise money LPs have bargaining power
Weak Low High Low
Caution and discipline Selectivity Aggressiveness
Broad reach
Buying too little Walking away Taking too little risk
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Ease of recall suggests that if something is more easily recalled in memory it must occur with a higher probability.
What the human being is best at doing is interpreting all new information so that their prior conclusions remain intact.
Warren Buffett
You are correct. I find it a useful tool for Graham Net/nets and Graham Enterprising Investor type stocks. As for your search for quality companies, the article discusses the new ZETA bankruptcy model, the studies show the importance of cumulative profitability (measured by Retained Earnings/Total Assets) and Stability of Earnings (five to ten year trend of Return on Assets - EBIT/Total Assets), it would be interesting to do a data mining exercise of all companies listed on the ASX, i reckon a if a company scores well on those two tests alone it is probably a quality company without even evaluating the business model.
• How can I lose money? vs How can I make money?
• What is this stock NOT worth? vs What is this stock going to be worth?
• What can go wrong? vs What growth drivers are there?
• What is the market implied discount rate? vs What is a fair discount rate?
• What is market implied growth rate? vs What is the future growth rate?
and a bonus question.
• If this drops 50% today, will I buy more? vs When will I sell?
They’re 8 and 10 now, and they rarely use the word why. If you think about what happens as we go into the education system, as we age and go into the workforce, instead of being about curiosity and questioning, the whole system changes to being about being right, getting good grades, not making mistakes.
All of this is part of the answer to your question. In most organizations, you become successful for doing something very, very well. Therefore, you become really focused on avoiding mistakes and avoiding taking risk, and not losing what you have. All of that builds up, makes learning hard.
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From Tony Hansen,
"I am not really in the business of owning fully priced businesses and hoping for operational excellence. I tend to prefer obviously cheap businesses and hope not to have operational disappointment. The upside can be a little smaller this way, but the downside in the event of an error in strategy execution is much smaller."
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http://www.hussmanfunds.com/wmc/wmc150525.htm
The greatest miscalculation in my career as an investor has been to underestimate the lengths to which the miscalculation of speculators can extend. I’ve had to correct that error twice, and even if the completion of the market cycle ultimately made the error irrelevant, the challenge was excruciating in the midst of the market cycle, at least until it was fully addressed. The fact is that valuations drive long-term returns, but over shorter horizons, stock prices are the result of whatever investors collectively believe, however reckless or detached from historical evidence those beliefs may be. As long as enough market participants are attached to the idea that risk is their friend (or enemy) regardless of the price, there is no natural limit to how overvalued (or undervalued) stocks can become. There is only one way to address this: measure investor risk preferences directly through observable market internals. Don’t expect an overvalued market to crash until internals deteriorate; don’t embrace an undervalued market too aggressively until internals improve.
It’s a lesson that value-investors have learned and re-learned throughout history. Even the legendary value investor Benjamin Graham discovered it, in his case by becoming constructive far too early during the market collapse of the Great Depression. The collective risk preferences of investors rule the short run, but valuations ultimately rule the long run. Graham famously summarized that lesson in one sentence: “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
Investment successes and stumbles largely mirror how closely one's discipline captures that framework. For example, by the mid-1990’s, I had established a reputation not only as a value investor but periodically as a leveraged, raging bull. Unfortunately, my value-conscious bent left me unprepared for the tech bubble, as valuations moved beyond every post-war extreme, and eventually beyond those observed at the 1929 peak. Though value investing had served me well over time, something was missing.
As the tech bubble continued, I shifted my thinking. If overvaluation itself was able to bring the market down, then stocks could never become severely overvalued in the first place. From a research standpoint, the right question wasn’t “how much more overvalued can stocks become?” but rather “What distinguishes an overvalued market that continues to advance from an overvalued market that collapses?”
The feature that distinguishes an overvalued market that continues higher from one that collapses is the preference of investors toward risk. Across a century of historical evidence, the most reliable observable measure of investor risk preferences proved to be the behavior of market internals based on prices, trading volume, and risk-sensitive securities. Put simply, when investors are risk-seeking, they tend to be risk-seeking in everything, which results in a measurable uniformity of speculation across a wide range of risky assets. The best indication of a shift toward greater risk aversion is a gradual deterioration in the “uniformity” of price action and the appearance of "divergences" across a wide range of individual securities, sectors, and risk-sensitive asset classes.
Fortunately, we learned the right lesson, instead of the wrong one that others “learned” during the tech bubble. Too many investors mistakenly “learned” that valuations didn’t matter and that the economy had entered some “new era” where old metrics no longer applied. But recognizing that the uniformity of market internals merely postpones the consequences of extreme overvaluation, I wrote at the March 2000 peak: “The inconvenient fact is that valuation ultimately matters. Trend uniformity helps to postpone that reality, but in the end, there it is… Over time, price/revenue ratios come back into line. Currently, that would require an 83% plunge in tech stocks (recall the 1969-70 tech massacre). The plunge may be muted to about 65% given several years of revenue growth. If you understand values and market history, you know we’re not joking.”
As it happened, the S&P 500 lost half of its value, and the Nasdaq 100 Index lost… well, 83%, by the October 2002 market lows.
Over the following decade, that distinction between a voting machine and a weighing machine was central to successfully navigating both bubbles and crashes. It allowed us to remain modestly constructive until September 2000 (noting the shift to negative uniformity in October 2000), to move back to a constructive position in early 2003 as a new bull market took hold, and identifying the shift back to hostile market internals in July 2007 as the market was peaking before the global financial crisis.
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https://www.farnamstreetblog.com/2016/04/munger-operating-system/
To get what you want, deserve what you want. Trust, success, and admiration are earned.
It’s such a simple idea. It’s the golden rule so to speak: You want to deliver to the world what you would buy if you were on the other end. There is no ethos, in my opinion, that is better for any lawyer or any other person to have. By and large the people who have this ethos win in life and they don’t win just money, not just honors. They win the respect, the deserved trust of the people they deal with, and there is huge pleasure in life to be obtained from getting deserved trust.
Learn to love and admire the right people, live or dead.
A second idea that I got very early was that there is no love that’s so right as admiration-based love, and that love should include the instructive dead. Somehow, I got that idea and I lived with it all my life; and it’s been very, very useful to me.
Acquiring wisdom is a moral duty as well as a practical one.
And there’s a corollary to that proposition which is very important. It means that you’re hooked for lifetime learning, and without lifetime learning you people are not going to do very well. You are not going to get very far in life based on what you already know. You’re going to advance in life by what you’re going to learn after you leave here…if civilization can progress only when it invents the method of invention, you can progress only when you learn the method of learning.
Learn to fluency the big multidisciplinary ideas of the world and use them regularly.
What I noted since the really big ideas carry 95% of the freight, it wasn’t at all hard for me to pick up all the big ideas from all the big disciplines and make them a standard part of my mental routines. Once you have the ideas, of course, they are no good if you don’t practice — if you don’t practice you lose it.
So I went through life constantly practicing this model of the multidisciplinary approach. Well, I can’t tell you what that’s done for me. It’s made life more fun, it’s made me more constructive, it’s made me more helpful to others, it’s made me enormously rich, you name it, that attitude really helps.
Now there are dangers there, because it works so well, that if you do it, you will frequently find you are sitting in the presence of some other expert, maybe even an expert that’s superior to you, supervising you. And you will know more than he does about his own specialty, a lot more. You will see the correct answer when he’s missed it.
[…]
It doesn’t help you just to know them enough just so you can give them back on an exam and get an A. You have to learn these things in such a way that they’re in a mental latticework in your head and you automatically use them for the rest of your life.
Learn to think through problems backwards as well as forward.
The way complex adaptive systems work and the way mental constructs work, problems frequently get easier and I would even say usually are easier to solve if you turn around in reverse.
In other words if you want to help India, the question you should ask is not “how can I help India?”, you think “what’s doing the worst damage in India? What would automatically do the worst damage and how do I avoid it?” You’d think they are logically the same thing, but they’re not. Those of you who have mastered algebra know that inversion frequently will solve problems which nothing else will solve. And in life, unless you’re more gifted than Einstein, inversion will help you solve problems that you can’t solve in other ways.
Be reliable. Unreliability can cancel out the other virtues.
If you’re unreliable it doesn’t matter what your virtues are, you’re going to crater immediately. So doing what you have faithfully engaged to do should be an automatic part of your conduct. You want to avoid sloth and unreliability.
Avoid intense ideologies. Always consider the other side as carefully as your own.
Another thing I think should be avoided is extremely intense ideology, because it cabbages up one’s mind. You’ve seen that. You see a lot of it on TV, you know preachers for instance, they’ve all got different ideas about theology and a lot of them have minds that are made of cabbage.
But that can happen with political ideology. And if you’re young it’s easy to drift into loyalties and when you announce that you’re a loyal member and you start shouting the orthodox ideology out what you’re doing is pounding it in, pounding it in, and you’re gradually ruining your mind. So you want to be very careful with this ideology. It’s a big danger.
In my mind I have a little example I use whenever I think about ideology, and it’s these Scandinavian canoeists who succeeded in taming all the rapids of Scandinavia and they thought they would tackle the whirlpools in the Grand Rapids here in the United States. The death rate was 100%. A big whirlpool is not something you want to go into and I think the same is true about a really deep ideology.
I have what I call an iron prescription that helps me keep sane when I naturally drift toward preferring one ideology over another. And that is I say “I’m not entitled to have an opinion on this subject unless I can state the arguments against my position better than the people do who are supporting it. I think that only when I reach that stage am I qualified to speak.” Now you can say that’s too much of an iron discipline..it’s not too much of an iron discipline. It’s not even that hard to do.
Get rid of self-serving bias, envy, resentment, and self-pity.
Generally speaking, envy, resentment, revenge and self pity are disastrous modes of thought. Self-pity gets pretty close to paranoia, and paranoia is one of the very hardest things to reverse. You do not want to drift into self-pity.
I have a friend who carried a big stack of index cards about this thick, and when somebody would make a comment that reflected self pity, he would take out one of the cards, take the top one off the stack and hand it to the person, and the card said, “Your story has touched my heart, never have I heard of anyone with as many misfortunes as you”. Well, you can say that’s waggery, but I suggest that every time you find you’re drifting into self pity, I don’t care what the cause — your child could be dying of cancer — self-pity is not going to improve the situation. Just give yourself one of those cards.
It’s a ridiculous way to behave, and when you avoid it you get a great advantage over everybody else, almost everybody else, because self-pity is a standard condition and yet you can train yourself out of it.
And of course self-serving bias, you want to get that out of yourself; thinking that what’s good for you is good for the wider civilization and rationalizing all these ridiculous conclusions based on the subconscious tendency to serve one’s self.
At the same time, allow for the self-serving bias in others who haven’t removed it.
You also have to allow for the self serving bias of everybody else, because most people are not going to remove it all that successfully, the human condition being what it is. If you don’t allow for self serving bias in your conduct, again you’re a fool.
I watched the brilliant Harvard Law School trained general counsel of Salomon lose his career, and what he did was when the CEO became aware that some underling had done something wrong, the general counsel said, “Gee, we don’t have any legal duty to report this but I think it’s what we should do it’s our moral duty.”
Of course, the general counsel was totally correct but of course it didn’t work; it was a very unpleasant thing for the CEO to do and he put it off and put if off and of course everything eroded into a major scandal and down went the CEO and the general counsel with him.
The correct answer in situations like that was given by Ben Franklin, he said, “If you want to persuade, appeal to interest not to reason.” The self serving bias is so extreme. If the general counsel had said, “Look this is going to erupt, it’s something that will destroy you, take away your money, take away your status…it’s a perfect disaster,” it would have worked!
Avoid being part of a system with perverse incentives.
Incentives are too powerful a controller of human cognition and human behavior, and one of the things you are going to find in some modern law firms is billable hour quotas. I could not have lived under a billable hour quota of $2,400 a year. That would have caused serious problems for me — I wouldn’t have done it and I don’t have a solution for you for that. You’ll have to figure it out for yourself but it’s a significant problem.
Work with and under people you admire, and avoid the inverse when at all possible.
And that requires some talent. The way I solved that is, I figured out the people I did admire and I maneuvered cleverly without criticizing anybody, so I was working entirely under people I admired. And a lot of law firms will permit that if you’re shrewd enough to work it out. And your outcome in life will be way more satisfactory and way better if you work under people you really admire. The alternative is not a good idea.
Learn to maintain your objectivity, especially when it’s hardest.
Well we all remember that Darwin paid special attention to disconfirming evidence particularly when it disconfirmed something he believed and loved. Well, objectivity maintenance routines are totally required in life if you’re going to be a correct thinker. And there we’re talking about Darwin’s attitude, his special attention to disconfirming evidence, and also to checklist routines. Checklist routines avoid a lot of errors. You should have all this elementary wisdom and then you should go through and have a checklist in order to use it. There is no other procedure that will work as well.
Concentrate experience and power into the hands of the right people – the wise learning machines.
I think the game of life in many respects is getting a lot of practice into the hands of the people that have the most aptitude to learn and the most tendency to be learning machines. And if you want the very highest reaches of human civilization that’s where you have to go.
You do not want to choose a brain surgeon for your child among fifty applicants all of them just take turns during the procedure. You don’t want your airplanes designed that way. You don’t want your Berkshire Hathaways run that way. You want to get the power into the right people.
You’ll be most successful where you’re most intensely interested.
Another thing that I found is an intense interest of the subject is indispensable if you are really going to excel. I could force myself to be fairly good in a lot of things, but I couldn’t be really good in anything where I didn’t have an intense interest. So to some extent, you’re going to have to follow me. If at all feasible you want to drift into doing something in which you really have a natural interest.
Learn the all-important concept of assiduity: Sit down and do it until it’s done.
Two partners that I chose for one little phase of my life had the following rule: They created a little design/build construction team, and they sat down and said, two-man partnership, divide everything equally, here’s the rule; “Whenever we’re behind in our commitments to other people, we will both work 14 hours a day until we’re caught up.”
Well, needless to say, that firm didn’t fail. The people died rich. It’s such a simple idea.
Use setbacks in life as an opportunity to become a bigger and better person. Don’t wallow.
Another thing of course is life will have terrible blows, horrible blows, unfair blows, doesn’t matter. And some people recover and others don’t. And there I think the attitude of Epictetus is the best. He thought that every mischance in life was an opportunity to behave well, every mischance in life was an opportunity to learn something, and your duty was not to be submerged in self-pity but to utilize the terrible blow in a constructive fashion. That is a very good idea.
The highest reach of civilization is a seamless system of trust among all parties concerned.
The last idea that I want to give you as you go out into a profession that frequently puts a lot of procedure and a lot of precautions and a lot of mumbo jumbo into what it does, this is not the highest form which civilization can reach. The highest form which civilization can reach is a seamless web of deserved trust. Not much procedure, just totally reliable people correctly trusting one another. That’s the way an operating room works at the Mayo Clinic.
If a bunch of lawyers were to introduce a lot of process, the patients would all die. So never forget when you’re a lawyer that you may be rewarded for selling this stuff but you don’t have to buy it. In your own life what you want is a seamless web of deserved trust. And if your proposed marriage contract has 47 pages, my suggestion is do not enter.
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https://www.farnamstreetblog.com/mental-models/
Acquiring knowledge may seem like a daunting task. There is so much to know and time is precious. Luckily, we don’t have to master everything.
To get the biggest bang for our buck we can study the big ideas from the big disciplines: physics, biology, psychology, philosophy, literature, sociology, history, and a few others. We call these big ideas mental models.
Our aim is not to remember facts and try to repeat them when asked, the way you studied for your high school history exams. We’re going to try and hang these ideas on a latticework of mental models, with vivid examples in our head to help us remember and apply them.
The latticework of mental models puts them in a useable form to analyze a wide variety of situations and enables us to make better decisions. And when big ideas from multiple disciplines all point towards the same conclusion, we can begin to conclude that we’ve hit on an important truth.
The idea for building such a latticework comes from Charlie Munger, Vice Chairman of Berkshire Hathaway and one of the finest cross-disciplinary thinkers in the world.
Here, Charlie Munger explains his approach to worldly wisdom:
Well, the first rule is that you can’t really know anything if you just remember isolated facts and try and bang ’em back. If the facts don’t hang together on a latticework of theory, you don’t have them in a usable form.
You’ve got to have models in your head. And you’ve got to array your experience both vicarious and direct on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and in life. You’ve got to hang experience on a latticework of models in your head.
What are the models? Well, the first rule is that you’ve got to have multiple models because if you just have one or two that you’re using, the nature of human psychology is such that you’ll torture reality so that it fits your models, or at least you’ll think it does…
It’s like the old saying, “To the man with only a hammer, every problem looks like a nail.” And of course, that’s the way the chiropractor goes about practicing medicine. But that’s a perfectly disastrous way to think and a perfectly disastrous way to operate in the world. So you’ve got to have multiple models.
And the models have to come from multiple disciplines because all the wisdom of the world is not to be found in one little academic department. That’s why poetry professors, by and large, are so unwise in a worldly sense. They don’t have enough models in their heads. So you’ve got to have models across a fair array of disciplines.
You may say, “My God, this is already getting way too tough.” But, fortunately, it isn’t that tough because 80 or 90 important models will carry about 90% of the freight in making you a worldly wise person. And, of those, only a mere handful really carry very heavy freight.(1)
John T. Reed, author of Succeeding offers an important additional insight:
When you first start to study a field, it seems like you have to memorize a zillion things. You don’t. What you need is to identify the core principles – generally three to twelve of them – that govern the field. The million things you thought you had to memorize are simply various combinations of the core principles.
Mental Models
The central principle of the mental model approach is that you must have many of them. Ideally, all the ones you need to solve the problem at hand. As with physical tools, lacking a mental tool at the crucial moment can lead to a bad result.
This seems self-evident, but it’s an unnatural way to think. Without the right training, your brain takes the other approach, which is to say: Which models do I already know and love, and how can I apply them here? Munger’s analogy for this is the man with a hammer, to whom everything looks a bit like a nail. Such narrow-minded thinking feels entirely natural to us, but it leads to far too many misjudgments.
As an example, Tim Wu writes about Chris Anderson, who wrote The Long Tail, a popular 21st century business book. Here is what happens when you rely on one (powerful) mental model to solve everything.
Chris Anderson’s The Long Tail does something that only the best books do—uncovers a phenomenon that’s undeniably going on and makes clear sense of it. Anderson, the Wired editor-in-chief who first wrote about the Long Tail concept in 2004, had two moments of genius: He visualized the demand for certain products as a “power curve,” and he came up with a catchy phrase to go with his observation. Like most good ideas, the Long Tail attaches to your mind and gets stuck there. Everything you take in—cult blogs, alternative music, festival films—starts looking like the Long Tail in action. But that’s also the problem. The Long Tail theory is so catchy it can overgrow its useful boundaries. Unfortunately, Anderson’s book exacerbates this problem. When you put it down, there’s one question you won’t be able to answer: When, exactly, doesn’t the Long Tail matter?
This insight goes only so far, but like many business books, The Long Tail commits the sin of overreaching. The tagline on the book’s cover reads, “Why the Future of Business Is Selling Less of More,” which is certainly wrong or at least exaggerated. Inside we learn about “the Long Tail of Everything.” Anderson’s book, unlike his original Wired article, threatens to turn a great theory of inventory economics into a bad theory of life and the universe. He writes that “there are now Long Tail markets practically everywhere you look,” calling offshoring the “Long Tail of labor,” and online universities “the Long Tail of education.” He quotes approvingly an analysis that claims, improbably, that there’s a “Long Tail of national security” in which al-Qaida is a “supercharged niche supplier.” At times, the Long Tail becomes the proverbial theory hammer looking for nails to pound.
What the book doesn’t get at is the relationship between these standards-driven industries where the Long Tail doesn’t matter, and the content industries where it does. There aren’t Long Tails everywhere.
The truth is that the good ideas are just as dangerous as the bad ones. Warren Buffett’s mentor, Ben Graham, used to put it as such:
You can get in way more trouble with a good idea than a bad idea, because you forget that the good idea has limits.
The best antidote to this sort of overreaching is to add more colors to your mental palette; to expand your repertoire of ideas, make them vivid and available, and watch your mind grow.
You’ll know you’re on to something when the ideas start to compete with one another. At first, this is mildly uncomfortable. One idea says X and the other idea says the reverse of X: How do I decide which is right?
This process of letting the models compete and fight for superiority and greater fundamentalness is called thinking! It’s a little like learning to walk or ride a bike; at first you can’t believe all that you’re supposed to do at once, but eventually you wonder how you ever got along without it. As Charlie likes to say, going back to any other method would feel like cutting off your hands.
Good luck, and let’s explore the models.
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Tony Hansen from EGP,
"A business that is trying to build scale should show characteristics of operating leverage, or in simple terms, a 10% increase in revenue should lead to more than a 10% increase in profits for the business."
(particularly relevant in roll ups - SGH!)
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Idea from http://www.givernycapital.com/en/doc/206/Giverny_Capital_-_Annual_Letter_2015_web_.pdf
I will work to adding this measure to my benchmarking.
Since 1996, we have presented a chart depicting the growth in the intrinsic value of our companies using a measurement developed by Warren Buffett: “owner’s earnings”. We arrive at our estimate of the increase in intrinsic value of our companies by adding the growth in earnings per share (EPS) of our entire group of companies and the average dividend yield of the portfolio. We believe that this analysis is not exactly precise but approximately correct. In the non-scientific world of the stock market, we believe in the old saying: “It is better to be roughly right than precisely wrong.”
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https://www.tilsonfunds.com/superinvestors.html
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https://www.cnbc.com/2017/08/24/the-investing-secrets-of-hedge-fund-legend-seth-klarman.html
1. Analyze the potential for loss before gain: "You want to focus on risk before you focus on returns. … A lot of it is focusing on multiple scenarios, what can go wrong? How much can you lose?"
2. Absolute over relative returns: "The world is oriented to relative performance. Everybody is an asset gatherer. ... By contrast we think wealthy individuals and established institutions because of their risk aversion are interested in absolute returns. If you're focused on absolute returns the idea of losing people's money becomes fairly abhorrent. … Your goal is not to lose less, your goal is to try to make money all the time, protect capital on the downside and still do well enough on the upside."
3. Forget macro investing, instead focus on individual investment ideas: "Most of the investment world has a top down orientation. They think about how is the economy going to do? And how are foreign currencies going to do? How are interest rates going to do? … My view is that is incredibly difficult to do. I don't know anybody with a really good long-term demonstrated record of success of macro forecasting."
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Worth reading the whole article, but this is the gist of it, http://www.collaborativefund.com/blog/future-self/
An underpinning of psychology is that people are poor forecasters of their future selves. There is all kinds of research backing this up. Imagining a goal is easy and fun. Imagining a goal in the context of the realistic life stresses that grow with competitive pursuits is hard to do, and miserable when you can.
This impacts business and investing, where most actions require not just anticipating rewards, but anticipating how you’ll react to future challenges.
The whole idea of investing risk is imagining a future filled with potholes and assuming you will either see it coming and avoid it – “I won’t be greedy” – or anticipating your ability to accept and exploit it – “I’ll see it as an opportunity.”
I’m here to tell you: This is really hard to do. And it bedevils our decision-making.
Best Buy stock is up more than Amazon stock in the last five years.
Blackberry stock is up more than Apple stock in the last four years.
Hawaiian Airlines stock is up more than Facebook stock over the last five years.
If you’re surprised by these numbers it’s because it’s natural to think in away that follows the most logical path of least resistance. Here that means assuming outcomes are driven by underlying events. Apple’s products have done well. Best Buy’s services have not. The investing outcome should look the same.
What this misses – and this is as obvious as it is easy to forget – is that investing outcomes are driven not just by business results, but business results within the context of expectations. Five years ago we expected nothing from Best Buy and everything from Apple. So Best Buy gets a bigger trophy for showing up to the game than Apple gets for being MVP.
The point is it’s easy to oversimplify a forecast because important context can be counterintuitive and easy to ignore.
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This article by Peter Guy is great reading for an analysis of big v small in the context of SMSF's v large industry funds, it also covers issues with ETF's.
https://theconstantinvestor.com/big-versus-small/
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A fabulous commentary by Seth Klarman, a few page PDF which is basically all you need to know about investing!
http://1-2knockout.typepad.com/12_knockout/files/Seth_Klarman_MIT_Speech.pdf
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from Morgan Housel's presentation to Ian Cassel's MicroCap Club, a few graphics that caught my eye,
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Here is the whole presentation if you are interested,
https://www.youtube.com/watch?v=wml0xO4cG8g
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https://www.longriverinv.com/blog/the-practice-of-value-investing-by-li-lu
Particularly good in defining speculating v investing
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More Li Lu, his investment checklist,
Checklist:
Is that cheap?
Is it a good business?
Whos running it?
What did I miss?
Interesting because it starts with price.
Value investor -
Business owner mentality
Difference in time horizon
Demand huge margin of safety
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Terry Smith from Fundsmith.
https://www.youtube.com/watch?v=YZM9dhiDbzI
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Terry Smith cont.
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ALice Shroeder, author of Snowball, about Buffett. This was posted on Reddit, how she understood Buffett's process,
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https://drive.google.com/file/d/0B5AhopgMAgqubFlmLTBOZWRXRjQ/view?resourcekey=0-pgHy29CmFOnrEoiXULIeRA
Bluegrass Capital
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Greenlea Lane
https://emergingmanagers.org/josh-tarasoff-interview
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The insanity of bubble-like valuations was well captured by Scott McNealy in a 2002 interview in Business Week when he was still CEO of Sun Microsystems (source: James Montier, Société Générale, Cross Asset Research Group),
“But two years ago we were selling at ten times revenues when we were at U$64. At ten times revenues, to give you a ten-year payback, I have to pay you 100% of revenues for ten straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes that, with zero R&D for the next ten years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at U$64? Do you realize how ridiculous those basic assumptions are? You don’t need transparency. You don’t need footnotes. What were you thinking?”
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The Nomad letters to investors,
https://www.igyfoundation.org.uk/wp-content/uploads/2021/03/Full_Collection_Nomad_Letters_.pdf
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Peter Bernstein
In general, survival is the only road to riches. Let me say that again: Survival is the only road to riches. You should try to maximize return only if losses would not threaten your survival and if you have a compelling future need for the extra gains you might earn.
The riskiest moment is when you’re right. That’s when you’re in the most trouble, because you tend to overstay the good decisions. Once you’ve been right for long enough, you don’t even consider reducing your winning positions. They feel so good, you can’t even face that. As incredible as it sounds, that makes you comfortable with not being diversified. So, in many ways, it’s better not to be so right. That’s what diversification is for. It’s an explicit recognition of ignorance.
And I view diversification not only as a survival strategy but as an aggressive strategy, because the next windfall might come from a surprising place. I want to make sure I’m exposed to it. Somebody once said that if you’re comfortable with everything you own, you’re not diversified.
Pascal’s Wager doesn’t mean that you have to be convinced beyond doubt that you are right. But you have to think about the consequences of what you’re doing and establish that you can survive them if you’re wrong. Consequences are more important than probabilities.
[For the first time in history,] stocks began to yield less than bonds, and it was not something tentative. The lines crossed without any period of hesitation and just kept on going. It was just, zzzoop! All my older associates told me that it was an anomaly and it could not last. To understand why that happened and what that meant — and to recognize that what was accepted wisdom for a couple hundred years could turn out to be wrong — was very important. It really showed me that you don’t know. That anything can happen. There really is such a thing as a “paradigm shift,” when people’s view of the future can change very dramatically and very suddenly. That means that there’s never a time when you can be sure that today’s market is going to be a replay of a familiar past.
Markets are shaped by what I call “memory banks.” Experience shapes memory; memory shapes our view of the future. In 1958, younger people were coming in who had a different memory bank, who did not carry all that extra baggage of depression and world war and tariffs. The bond market went down and the stock market didn’t go down, because people with a different memory bank didn’t know that wasn’t “supposed” to occur. That’s also what happened [in 1999] when tech stocks were enormously exciting; most of the new participants in the market had no memory of what a bear market is like, and so their sense of risk was muted.
A: It’s hard to improve on that. In the 1960s, in “A Modest Proposal,” I suggested that companies should be required to pay out 100% of their net income as cash dividends. If companies needed money to reinvest in their operations, then they would have to get investors to buy new offerings of stock. Investors would do that only if they were happy both with the dividends they’d received and the future prospects of the company. Markets as a whole know more than any individual or group of individuals. So the best way to allocate capital is to let the market do it, rather than the management of each company. The reinvestment of profits has to be submitted to the test of the marketplace if you want it to be done right.
https://jasonzweig.com/a-long-chat-with-peter-l-bernstein/
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https://www.valuewalk.com/2015/07/peter-lynchs-investing-principles-and-25-golden-rules/
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Razors.
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Great post.
https://jimoshaughnessy.tumblr.com/post/158366040139/successful-active-stock-investing-is-hard-here
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Great article, not sure I agree that these traits can't be learned.
https://moiglobal.com/wp-content/uploads/mark-sellers_you-want-to-be-the-next-warren-buffett.pdf
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Dare To Be Naïve with Chris Mayer from Woodlock house family capital
https://www.woodlockhousefamilycapital.com/post/dare-to-be-naïve?utm_campaign=6770ce5a-99d0-43b5-8486-619aa055f7f8&utm_source=so&utm_medium=mail&cid=afca71ff-1471-4e1c-9d35-6ed15ecc7346
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Secular Winners and Value Investing
https://www.albertbridgecapital.com/post/secular-winners-and-value-investing (https://www.albertbridgecapital.com/post/secular-winners-and-value-investing)
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Truly one of the best things I have ever read about my style of investing, @LazyBeavers
interview (https://docs.google.com/document/d/e/2PACX-1vSURmS6McduVtQzZFGoHS7YnEfBEVgwzrnwF8ibUyZkUVOodSfcN5ubp8BPuPmtowxbJnFEMlnFdJpi/pub)
Interview with Twitter @TheLazyBeavers
July 2022
Introduction
Well thank you. I'm afraid you flattered me a bit with that introduction. I certainly don't aim for those levels of return -- doing so would be quite reckless, in fact. But what’s Buffett say? It's not necessary to do extraordinary things to get extraordinary results. In all seriousness, I think it's important to recognize that 14 years is actually a pretty short track record, and I started from a small capital base, so there's little evidence to suggest a 40% IRR is repeatable or scalable.
Background
So I got my start investing in college about 20 years back. I really knew nothing about finance but did know a bit about the railroad industry from prior work and hobbies. I purchased shares in a small US railroad Genesee & Wyoming, they have long since been acquired, back when it was probably about a $100M microcap. They were consolidating shortline and regional freight railroads across the US at a time when the large Class Is were looking to spin off many such routes. And this is an industry where there truly were great synergies to be had following a roll-up strategy, particularly in operational efficiency by clustering these acquisitions into various regions. Anyway, I sold several years later for a sizeable return from what I'm sure was more luck than skill, but it did seed some capital to do this full-time since 2008. It also, fortunately, gave me an appreciation of the return potential in microcaps.
Investment Approach
My general investment philosophy comes from a realization years ago, somewhat depressing at first, that there are millions of people out there smarter, better educated, more narrowly focused, and frankly more ambitious than me. And while it's great to learn from such people, it's not so great to compete with them, so I gravitate toward less competitive assets that are easy for a layperson to understand and then I try to apply an unusually long time horizon.
While I would say I'm fairly industry agnostic, I am limited to a pretty small circle of competence. I'm not smart enough to identify the next medical breakthrough, or assess the risks in a financial services company, or to know if and when some junior miner is going to strike gold. Likewise, I'm not able to forecast when a cash-burning enterprise will make their final capital raise and reach profitability, and have no interest in trying to understand complicated cap tables and financial instruments. So I do tend to gravitate toward tangible consumer products and other simple business strategies with straightforward financials. As Buffett says, it's usually far more profitable to stick with the easy and obvious than it is to resolve the difficult.
I suppose the best way to describe what I look for is small public companies that shouldn't be public. Their P&L is usually too small to really justify the expense of being public. They're largely owned by founders or current management so they have very illiquid securities. Their capitalization is too small to attract institutional interest. Most importantly, even if they could raise equity capital, they have no need or interest in doing so because they are sustainably cash-flow positive and self-funding their growth. And, as a result of all these aforementioned factors, you probably won't find them with top tier IR firms, or at investor conferences, or probably with sell-side coverage of any kind. And they're certainly not issuing quarterly guidance or any such distractions.
So one may already be quite reasonably asking themselves, what's so attractive about a subscale public company that should probably be private? Well, most of the factors I mentioned cause these companies to be quantitatively or qualitatively excluded by most potential investors. You're essentially left with the opportunity to make a pseudo private investment, with all of the liquidity constraints that entails, but with potential public market mispricing.
To step back for a minute, if you purchase a minority interest in a private business, you're probably buying from someone who knows more than you do. That may be the company itself, or a founder, or an exiting seed investor. And you're likely paying at least fair value for the privilege. Not to mention that most individual investors lack access to the best dealflow so they’re disadvantaged before they even begin.
With illiquid public securities, everyone has generally the same access and you may be able to buy one, two, three, even five percent of a business at a price well below that which you could purchase the entire firm. As an example, just a couple years ago I acquired nearly 5% of a public US microcap for about $500K. Market cap at the time was around $10M. I can promise you the company wouldn't issue shares at 10 million. I can promise you the management that owns nearly half the company wouldn't sell a single share at 10 million. In fact not a single share was sold until the price went up about 15x the next year. And while the stock is still rather illiquid, it now often trades 100 times the dollar volume it did a couple years ago.
So why was that opportunity available? Well, I'm just a small retail investor and it took me years to purchase that position, and many months my buys were 80% or more of the stock's trading volume. The investment was really only suitable for those who were small and patient and had a long time horizon to be partnered with that business until a potential liquidity event. That being said, these opportunities probably don't come around very often. Of course if someone's minimum position size is 8-figures then they probably don't come around much at all. But, if someone can have a meaningful position at 6-figures? Well then the opportunity set becomes larger.
Look, I'm in my late 30s, I've been doing this since college, and I've seen less than a dozen similar opportunities that were truly actionable for me. It shouldn’t surprise you to hear my circle of competence is sadly quite small, to the point I don't even look in most industries and geographies. There are surely hundreds of similar opportunities in other regions that I’ve missed, and that’s fine. It's probably always a good idea to stick within one's circle, but I would suggest there's perhaps even less room for error dealing with concentrated illiquid positions. I've had a couple lessons learned the hard way there and would be happy to get into that at some point.
Failures
There's one in particular I bought back in 2012, 2013, a small Canadian home security company, Avante Logixx. They're still public actually and going through quite a disruptive management change. In full disclosure I haven’t owned the firm for several years ago now.
The founder had built up a high-end security business in wealthy neighborhoods of Toronto. They had the best technology, best service, and highly recurring revenue. But they were burning significant cash on technology projects competing against the likes of Honeywell and really risking insolvency. So in steps a private equity guy as co-CEO with a promise of financial discipline. Most importantly, they pitched an enticing roll-up strategy of adjacent security services, a strategy I had some prior success with and perhaps had been blinded to the execution risks.
So, expenses were cut to reach profitability, but then core business stagnated, and then the acquisitions were slow to come, and when they did they were small and produced little synergy. Of course the roll-up strategy was dependent on a liquid public currency. Issue shares at 12x EBITDA to purchase subscale private businesses for 5x EBITDA. These roll-ups of fragmented industries often sound great in theory. But when they go wrong they can go really wrong because you lose the ability to raise cheap capital and the multiple arbitrage they're dependent on.
Now I don't want to get into all that went wrong with the business strategy. In fact there was no spectacular blow-up, but the value accretion just never materialized. If you look at the long-term stock chart you could even wonder how this was such a failure for me. Well it was opportunity cost, both mentally and monetarily. That was prior to a reverse split and I was sitting on maybe 2.5 million shares of a stock that was trading maybe 30 thousand a day? So when I lost confidence in 2016 and wanted out, it was a long painful exit. I actually had to wait over a year until an activist, and actually the company's next CEO, bought a large stake in the open market.
Of course this is a problem with illiquid positions. I sometimes own 100 times or more of the average daily trading volume in a security. It's not easy to get in, and it's not easy to get out prematurely. So applying the strategy to just any asymmetric risk/reward opportunity is foolish. There was little risk that Avante would blowup -- it was a profitable, high recurring revenue business. That minimal downside risk really drove my overconfidence. But I was outside my circle of competence investing with an industry and people I didn't know, with a business strategy dependent on the financial engineering of a roll-up. The likelihood that this would be an investment I could hold for 5, 10, 15 years and see through to an ultimate liquidity event just wasn't there, so sizing it as such was really an act of embarrassing hubris on my part.
cont..
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cont from above....
Idea Sourcing
I would say that my best investments are typically situations that actually screen quite poorly. These companies are not only ignored by most investors for being small and illiquid, but the opportunity tends not to be readily apparent with a cursory glance at their past financials.
I should be clear. I’ve never invested pre-revenue and very rarely invested without positive cash flow. I leave that to venture capitalists and people much smarter than me. What I’m talking about are established, sustainable businesses with positive trends available for all to see that are simply masked in their current financials. This can be caused by an R&D project, or legal costs, or goodwill amortization from recent M&A, or really any number of short-term factors. It’s often just a business with relatively high fixed costs that has recently reached an inflection point of scale. Operating leverage can be vastly underappreciated in its early stages.
I would say I’ve had the most success in businesses where declines in one segment or product have been offsetting another. Take a multi-segment business with vastly different growth or margin profiles. Or, even better, combine the two. You have a high margin product in decline and a lower margin product in growth. So for a number of years the top line is flat and blended margins decline. Sounds horrible and is excluded from nearly any screen. Probably trades pretty cheap, right? But these can be very simple situations to analyze. You don’t need to run a DCF to realize that the higher margin product can’t decline forever. Give it a zero and analyze the other segment on a standalone basis for what it is. Then it’s just a matter of time horizon.
Buffett likes to say it's very hard to know WHEN something will happen and it's very easy to know WHAT will happen. I think I often see opportunities present themselves simply because other market participants are waiting around for the WHEN, the catalyst if you will, whereas the ultimate WHAT is actually quite clear.
I’ve sometimes described what I do as making decisions with incomplete information. It’s not always going to be obvious, but it doesn’t have to be. People usually think of the investing profession as one of rigorous mathematics and statistics and precise analysis. The reality is that what I do is more about possibility and probability. The range of possibilities is typically so wide that I can't render an actionable decision. These go in my "too hard pile" if you will. But I’ve looked at thousands of companies and only invested in dozens, so you can afford to dismiss 99% of the ideas that come across your desk.
I should emphasize that I rarely feel compelled to find a new actionable idea. You let them come to you on their own timeline. As Buffett has said, and this may unfortunately be the only way in which my mind works similar to his, my decision-making acuity fades with lots of cash. There is a compulsion to do something with a bunch of cash sitting around. So, I try to operate with very little cash so that the threshold for a new opportunity must always be greater than an existing one. I’m admittedly less nimble this way, but a lack of liquidity also reinforces a long-term focus.
Long Term Focus
I often hear people talk about long-term investing and the difficulty of holding through the drawdowns. I don't know the stats, but I've seen the number of 20% or is it even 50% drawdowns in Amazon and others, and how so few investors had the conviction to hold through such periods. Frankly if an asset appreciates 10x and then falls 20% I'm not sure why anyone would panic.
Personally I find the bigger challenge is to hold through the good times, the really good times. I guess it's kind of hip in long-term investing circles, particularly with microcaps, to talk about how one only invests in opportunities to 3x, 5x, 10x their money, and we might scoff at those lowly 20% or 50% opportunities. And that's great until one sells out six months later with a 50% gain because the stock "got ahead of itself.” I used to do this all the time and suffered great opportunity cost for it. I'd do all the research to identify a long-term opportunity and then turn it into a short-term trade.
I’ll give you an example. I owned a company XPEL, a maker of protective films primarily for automotive applications. It became a rather popular microcap, now a $2 billion smallcap, and was actually my largest position for a number of years. I owned it at 50 cents and I owned it at 50 dollars. Hey, my first 100 bagger, right? But I sure didn't make 100 times my money on it. My thesis was long-term but I let trading get in the way of compounding. Constantly trimming and adding with some ridiculous assessment of fair value and expected IRR.
Look, I'm not suggesting there's only one way to make money. Plenty of people make stellar returns flipping assets for 10 and 20% gains, and that's great if you have a constant funnel of such opportunities. But to limit your investing universe to long-term compounders and then cut the ride short, well that just can't be the ideal strategy. I guess in a perfect world, long-term compounders would appreciate at the same rate as one's assessment of their fair value. The valuation would never "get ahead of itself" and you could sit back and comfortably hold through years of compounding. Unfortunately that's never been my experience.
I have a thought exercise I like to do. And this may be the only original investing thought I have to share with you today. Before I buy anything new, or add to an existing position, I ask myself -- if this security goes up 30% or 50% next month on no fundamental change, would I consider myself lucky and sell? If I would sell on a 50% gain, I would never hold it to 5x or 10x, so I don't buy no matter how optimistic I am about the company's long-term prospects. The very fact that I would run to the exit for a quick gain tells me I don't have the conviction to hold this asset. That simple thought experiment has dramatically reduced portfolio turnover because I limit myself to long-term ideas of the highest conviction. Then I can happily ignore short-term volatility to both the upside and downside.
Evolution of Strategy
There's something rather humbling about the investing game. I guess I’ve had a decent track record but I still always look back at what I was doing just a few years ago and cringe at my analysis and my decision making. I'm not very active on Twitter but a couple months back posted a complete list of every stock I've owned over the past 20 years, and that was a reminder of some painful experiences in there. But hey, what's the saying, experience is what you get when you don't get what you want, right? I would like to think I won't make the same bad decisions again in the future, but I'm sure I'll find some new ones.
Perhaps the most positive development I've made is simply reducing the sheer quantity of decisions. I would previously make several new investments every year but now I'll go years at a time without a change. I've really tried to restructure my investing processes to create a bias toward inactivity. And that inactivity suits my lifestyle and goals. There are many ways to make money investing or trading that require that one spend 12 hours a day at their Bloomberg terminal, and that's great if someone enjoys it for the activity in and of itself. But I know for me I want investing to be just one of many areas where I can to choose to spend my time, and I think I've settled on an approach I'm well suited to. And as Buffett says, when there is nothing to do, do nothing. Investing is unique that way. You don't get paid for activity or effort. You ultimately just have to be right.
Macro Concerns
Well, no one buys or sells a farm based on whether they think it’s going to rain next year. Sound familiar? I'm really not too worried about the economic cycle.
Before I invest in any business I ask myself not only can this business withstand an eventual recession, but is it managed in such a way that it will come out in a stronger competitive position than it went in. When investing for the long-term you have to expect to go through the lows of the cycle. That should be self-evident really.
That being said, I don't generally invest in highly cyclical industries. I got my start investing in 2002 and for the first decade the vast majority of my capital was in railroads. There's a cyclical industry I understood fairly well, and it was still unloved by Wall Street in those years prior to Buffett buying BNSF. That said, I would not touch the railcar builders of the time -- Freightcar America, Greenbrier, American Railcar. Lots of money was made there, and lots of money was lost, but they were no place for long-term investment through the market cycles.
I would put most macro questions – the future of interest rates, inflation, geopolitics, energy prices, foreign exchange – sure they’re all important in one way or another, but they’re simply unknowable. I look for businesses that can thrive in any reasonably foreseeable environment. Certain industries require macroeconomic opinions. I never really have an opinion so I can't participate.
Risk & Diversification
There’s a Howard Marks quote I love. Never forget the fate of the six foot tall man that drowned crossing the river that was five feet deep on average.
We can't live on averages. We must survive the extremes. Put another way, a long string of large numbers multiplied by a single zero is always zero. You simply can't allow a single failure to knock you out of the game. But, that threshold is completely different for different people. This is why any universal asset allocation theory is academic nonsense.
Most people, and by that I mean non-investors, should probably own an index because they would have no sound basis by which to rank their 1st, 10th, or even 100th best idea. Some casual investors may own a diversified portfolio because they can find a couple dozen good ideas but don’t have any unique insights in which to differentiate one from another. There’s nothing wrong with admitting that. What’s the saying? There’s only two kinds of people that lose money -- those who know nothing and those who know everything. Just respect what you know and recognize whether or not you have differential insight.
In my case, largely in illiquid microcaps, my investable universe is quite small so my number of positions is also quite small. But I sleep well at night knowing that if any individual position goes to zero it won't take me out of the game or impact my lifestyle or future opportunities. Beyond that, I really don’t believe in any fixed allocation limits. There have been a handful of times over 20 years where I’ve purchased a 30% position at-cost. For some that would be unthinkable. Others would be fine with 30% but would quickly trim if it appreciated into 40% or 50%. I must say I disagree with this concept of automatic trimming. Sales should be based on fundamental changes, or valuation changes, or new opportunities, not arbitrary portfolio limits. If you purchase a 30% position and could have survived on the other 70% of your portfolio if it went to zero, what changed simply because your top position outperformed the rest? Isn’t that what you wanted? I guess I find it helpful to think more in absolute dollar terms rather than percentages when considering risk.
I do want to add one caution that I learned the hard way early on. It’s very easy to start micromanaging a portfolio based on variations in expected returns. I see people with spreadsheets of their investments and target prices and IRRs for each. A stock moves up from $10 to $15 and suddenly the expected return to their $30 target drops from 200% to 100%, so they sell and reallocate into another that they expect to return 150% or 200%. This comes back to what I said before. You have to know your game. If your objective is long-term compounding, you probably shouldn’t view a stock at $15 so differently than you did at $10. In an attempt to maximize IRR in a spreadsheet, you may very quickly end up with a portfolio filled with your weakest recent performers.
Commonly Accepted Wisdom You Disagree With
That there’s a positive correlation between “risk” and return. I’ll blatantly plagiarize Howard Marks here. Risk simply means that more things can happen than will happen. If a risky asset could be counted on to deliver high returns, it wouldn't be risky.
Cryptocurrency
I’m sure you know far more about this than I do. I’ve always wondered how, even if you believe in the premise and technology, you can pick the long-term winner? Bitcoin? Ethereum? What’s the Elon dog thing? Dogecoin? I’m already showing my ignorance here.
It’s certainly working out well for the believers thus far. But I’m reminded of Charlie Munger’s reaction. If you jump out the window of the 42nd floor and you’re still doing well when you pass the 20th, it doesn’t mean you don’t still have a problem.
Seriously, though, I have no opinion on this.
Favorite Quote
Haven’t I been quoting Buffett and Munger all hour? I guess I’ll go with Mark Twain. It's not what you don't know that gets you into trouble. It's what you know for sure that just ain't so.
Overconfidence and confirmation bias are always a danger.
Investor You Want To Meet
Buffett, Munger, Marks? I don’t know. They all significantly shaped my investment philosophy, but have also been interviewed by such talent that I can't imagine what I would ask that they haven't already publicly answered.
Tony Deden of Edelweiss Holdings, an investment manager in Switzerland interviewed by Grant Williams a few years back for, what was it, RealVision. It's still available on YouTube in fact, and they later recorded a second part that aired on Grant's podcast. To be clear, our execution couldn't be more different. His focus on endurance above all else. He has a very large position in gold. Even the fact that he's managing vast family fortunes while I cringe at the very notion of intergenerational dynastic wealth. But his self reflection and thoughtfulness of process really resonated with me. Not to mention his way with his words, a gift I lack but envy. He could answer any question with vivid illustration. So, yes, I would have much to ask Tony Deden.
Interview with Twitter @TheLazyBeavers, July 2022
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short & Succinct!
https://novelinvestor.com/skill-vs-luck-failing-to-lose/
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How to think about owning micro caps.
https://focusedcompounding.com/how-warren-buffett-thinks-about-micro-cap-stocks/
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Seth Klarman.
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Todd Combs from BRK
https://investmentmanagementinsights.substack.com/p/graham-and-dodd-annual-breakfast
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More Wisdom from Howard Marks from Oaktree, November 2022. Back to his best after a couple of lost years.
https://www.oaktreecapital.com/insights/memo/what-really-matters