A Dozen Things I’ve Learned from Charlie Munger About Benjamin Graham’s Value Investing System

Charlie Munger has developed a powerful system that is useful in making any type of decision. One notable application of this system by Munger relates to investing and involves another system developed by Benjamin Graham. It is useful to understand what is known as “value investing” not just for its own sake, but to understand how Munger thinks and makes decisions. Even if you find value investing boring or have no intention to follow its principles, you can learn from understanding how it works and has evolved from its original nature based on the ideas of a few people including Munger. For this reason, it is important to understand a little about Graham himself.

“Benjamin Graham was salutatorian of the class of 1914 and, weeks before graduation, was offered teaching positions in three different faculties: Greek and Latin philosophy, English, and mathematics. He was all of 20 years old. Needing to support his siblings and widowed mother, he went to work on Wall Street. In 1934, he wrote Security Analysis, the first book ever to put the study of investments on a systematically logical footing. In 1949, he published The Intelligent Investor, which Warren Buffett has called “the best book about investing ever written.” Warren Buffett….has said that he was struck by the force of Graham’s teachings ‘like Paul on the road to Damascus.’”

What follows are the usual “dozen things” quotations from Charlie Munger stitched together from his writing and statements made at different times and places (in this case over many over decades).

1. “Graham didn’t want to ever talk to management. And his reason was that, like the best sort of professor aiming his teaching at a mass audience, he was trying to invent a system that anybody could use. And he didn’t feel that the man in the street could run around and talk to managements and learn things. He also had a concept that the management would often couch the information very shrewdly to mislead. Therefore, it was very difficult. And that is still true, of course human nature being what it is.” “Warren trained under Ben Graham, who said, ‘Just look at the facts. You might lose an occasional valuable insight, but you won’t get misled.’” The most important word in these quotations from Charlie Munger is “system,” which can be defined as a set of processes or elements that interact in ways that can achieve an objective not obtainable from the processes or elements alone. A second important point made by Charlie Munger is about Ben Graham’s desire to create something an “ordinary person” can potentially use successfully. It is important to note that Charlie Munger believes that only a tiny number of people can actually outperform a market using the value investing system because they lack factors like the necessary work ethic and the right emotional and psychological temperament. It is possible that an ordinary investor can us the value investing systems to outperform that market but it is far from the usual case. If an investor does try to outperform a markets Charlie Munger is also saying that it is easy to be misled by promoters and business managers about the value of a business or other assets. Ben Graham believed that by focusing on a rational appraisal of objective facts fewer investing mistakes will be made than by relying on subjective opinions.

2. “Ben Graham had this concept of value to a private owner – what the whole enterprise would sell for if it were available. And that was calculable in many cases. Then, if you could take the stock price and multiply it by the number of shares and get something that was one third or less of sellout value, he would say that you’ve got a lot of edge going for you. Even with an elderly alcoholic running a stodgy business, this significant excess of real value per share working for you means that all kinds of good things can happen to you. You had a huge margin of safety – as he put it – by having this big excess value going for you.” Ben Graham’s system involves four bedrock principles, two of which Charlie Munger introduces here: 1) a share of stock is a proportional ownership of a business and 2) buy at a significant discount to intrinsic value to create a margin of safety. On the first principle, if a security is not a proportional interest in a business then what exactly is it? It certainly isn’t a piece of paper to be traded like a baseball card or a painting. In terms of the second principle on “margin of safety,” the fundamental idea is to buy an asset at a significant enough bargain price that the result will be good even if a mistakes was made in evaluating the asset. Since risk is always relative to the price paid, buying with a margin of safety is a risk-averse approach. A range of future outcomes can still produce a satisfactory result if you buy an asset at a significant bargain.

3. “Ben Graham [had] his concept of “Mr. Market.” Instead of thinking the market was efficient, he treated it as a manic-depressive who comes by every day. And some days he says, “I’ll sell you some of my interest for way less than you think its worth.” And other days, “Mr. Market” comes by and says, “I’ll buy your interest at a price that’s way higher than you think its worth.” And you get the option of deciding whether you want to buy more, sell part of what you already have or do nothing at all. To Graham, it was a blessing to be in business with a manic-depressive who gave you this series of options all the time. That was a very significant mental construct.” Charlie Munger is introducing the Mr. Market metaphor in making these statements. Mr. Market shows up every day willing to quote you a price. Unfortunately, Mr. Market is, in the words of Warren Buffett, a drunk bipolar psycho. For this reason and others, Mr. Market should always be treated as your servant rather than your master. Why would anyone ever treat someone like this as wise? Mr. Market, in the short term, is a voting machine driven by highly volatile and fickle public opinion instead of a weighing machine measuring return on investment. When Mr. Market offers you a price for an asset you have the option to do nothing. In other words, there are no “called strikes” in investing. There is no premium given in investing for activity and in fact there is a penalty since it results in fees and taxes. For a value investor, it is Mr. Market’s irrationality that creates the opportunity for value investors. As Charlie Munger points out: “For a security to be mispriced, someone else must be a damn fool. It may be bad for world, but not bad for Berkshire.” The best returns accrue to investors who are patient and yet aggressive when they are offered a price for an asset that meets the requirements of value investing.

4. “The idea of a margin of safety, a Graham precept, will never be obsolete. The idea of making the market your servant will never be obsolete. The idea of being objective and dispassionate will never be obsolete. So Graham had a lot of wonderful ideas. Warren worshiped Graham. He got rich, starting essentially from zero, following in the footsteps of Graham.” Charlie Munger introduces final bedrock principle of value investing here: be objective and dispassionate. In other words, be as rational as you can when making investing decisions. Despite this objective, an investor will always make some emotional and psychological mistakes, but if you can do things like learn from your mistakes, use techniques like checklists, have the right emotional temperament, exhibit a strong work ethic and are a “learning machine,” he believes some investors can outperform the market. Only a very small number of “know something” investors can do this. Charlie Munger believes that most everyone is a “know nothing” investor and should instead invest in a diversified portfolio of index funds and ETFs.

5. “The supply of cigar butts was running out. And the tax code gives you an enormous advantage if you can find some things you can just sit with.” “Ben Graham could run his Geiger counter over this detritus from the collapse of the 1930s and find things selling below their working capital per share and so on. But he was, by and large, operating when the world was in shell shock from the 1930s—which was the worst contraction in the English-speaking world in about 600 years. Wheat in Liverpool, I believe, got down to something like a 600-year low, adjusted for inflation. The classic Ben Graham concept is that gradually the world wised up and those real obvious bargains disappeared. You could run your Geiger counter over the rubble and it wouldn’t click. Ben Graham followers responded by changing the calibration on their Geiger counters. In effect, they started defining a bargain in a different way. And they kept changing the definition so that they could keep doing what they’d always done. And it still worked pretty well.” The beauty of some systems is that they have the ability to evolve so as to adapt to new conditions. And that is precisely what happened in the case of value investing. After the Great Depression many people simply gave up on owning stocks. Loss aversion was so strong among potential buyers that they were simply not rational when it came to the stock market. During this period it was possible for businesses to be bought at less than liquidation value. This was a boon for investors like Ben Graham. Unfortunately for them, that period of time only lasted for so long as memories faded and new investors entered the market. Every so often some pundit will drag out one quote from Ben Graham about how it became to do value investing at one point. These pundits not only take the quote out of context buy ignore the fact that the followers of Graham were even before then time taking Graham’s principles and defining a bargain in a new way considering the quality of the business and in some cases considering what are called “catalysts” to the value of a business. Value investing has evolved significantly since the time of Ben Graham and Charlie Munger has played a big part in that evolution.

6. “I don’t love Ben Graham and his ideas the way Warren does. You have to understand, to Warren — who discovered him at such a young age and then went to work for him — Ben Graham’s insights changed his whole life, and he spent much of his early years worshiping the master at close range. But I have to say, Ben Graham had a lot to learn as an investor. His ideas of how to value companies were all shaped by how the Great Crash and the Depression almost destroyed him, and he was always a little afraid of what the market can do. It left him with an aftermath of fear for the rest of his life, and all his methods were designed to keep that at bay.” “I liked Graham, and he always interested and amused me. But I never had the worship for buying the stocks he did. So I don’t have the worship for that Warren does. I picked up the ideas, but discarded the practices that didn’t suit me. I don’t want to own bad businesses run by people I don’t like and say, ‘no matter how horrible this is to watch, it will bounce by 25%.’ I’m not temperamentally attracted to it.” Charlie Munger is always looking for ways to evolve, adopt and even reverse his views. He is a learning machine. Charlie Munger is also excited by great managers running great businesses. And he gets positively ecstatic when every once in a while these managers are running businesses that are available for purchase in whole or in part at bargain prices. This does not happen very often so most of the time he patiently does nothing. But Charlie is prepared to act very aggressively in a big way when the time is right.

7. “I think Ben Graham wasn’t nearly as good an investor as Warren is or even as good as I am. Buying those cheap, cigar-butt stocks was a snare and a delusion, and it would never work with the kinds of sums of money we have. You can’t do it with billions of dollars or even many millions of dollars. But he was a very good writer and a very good teacher and a brilliant man, one of the only intellectuals – probably the only intellectual — in the investing business at the time.” Charlie Munger is in this set of quotations is discussing another reason why the value investing system had to evolve for Berkshire. The amount of money that Berkshire must put to work each year is way too big to hope that enough so-called “cigar butt” businesses with a few remaining puffs left in them can be found to compose a full portfolio. When buying a business anything remotely as big as Heinz or Precision Cast Parts it is very unlikely that they will be buying any cigar butts. Berkshire must find assets that represent a bargain defined in terms of quality. As an example Warren Buffett used $23 billion of Berkshire’s $66.6 billion in cash to buy Precision Castparts. Buffet has said that “We will always have $20 billion in cash on hand.” So they won’t be buying a business as big as Precision Castparts for a while.

8. “Having started out as Grahamites which, by the way, worked fine we gradually got what I would call better insights. And we realized that some company that was selling at 2 or 3 times book value could still be a hell of a bargain because of momentum implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual or other, or some system or other. And once we’d gotten over the hurdle of recognizing that a thing could be a bargain based on quantitative measures that would have horrified Graham, we started thinking about better businesses. We’ve really made the money out of high quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money’s been made in the high quality businesses. And most of the other people who’ve made a lot of money have done so in high quality businesses.” Charlie Munger makes two key points here: 1) some bargains are only visible if you understand qualitative factors and 2) there sometimes are catalysts that can boost the value of the stock even further based on factors like scale advantages, favorable regulatory changes, improving secular phenomenon and better systems or business momentum. Charlie Munger likes to “find a few great companies and then sit on your ass.” When he finds a great business with excellent management like Costco he is like “a pig in slop” and does not want to leave the pig pen.

9. “The great bulk of the money has come from the great businesses. And even some of the early money was made by being temporarily present in great businesses. Buffett Partnership, for example, owned American Express and Disney when they got pounded down. However, if we’d stayed with classic Graham the way Ben Graham did it, we would never have had the record we have.” “Iscar is not a Ben Graham stock – in fact, it would be the ultimate non-Ben Graham stock. It’s located a few miles from the Lebanese border in Israel. It has a high ROE, doing business all over the earth, using a certain technology to produce carbide cutting tools. The reason I got so high on it so fast was that the people are so outstandingly talented.” Charlie Munger has made the point many times that only a few great decisions delivered most of Berkshire’s financial returns. Warren Buffett has said that as few as 20 bets in a lifetime can make you very rich. Charlie Munger has also said repeatedly that a high quality business selling a bargain price is not a common event and that if you are not prepared to act aggressively when that happens the opportunity will be lost. In thinking about the value of a business, Munger also strayed far from a view that looking at the quality of management is not something that should be considered because it is too easy to be misled. When Berkshire buys a business they want the moat and the management (the two M’s) to be in place already. Berkshire does not build moats itself and it does not want to supply management.

10. “We bought [the Washington Post] at about 20% of the value to a private owner. So we bought it on a Ben Graham-style basis – at one-fifth of obvious value – and, in addition, we faced a situation where you had both the top hand in a game that was clearly going to end up with one winner and a management with a lot of integrity and intelligence. That one was a real dream. They’re very high class people – the Katharine Graham family. That’s why it was a dream – an absolute, damn dream.” These quotations list many of the elements that Charlie Munger looks for in a business. At the time it was first bought the business known as the Washington Post had both a strong management team and a moat. A significant partial ownership stake was also available for purchase at a bargain price. Of course, the moat of the Washington Post has significantly atrophied as the Internet has enabled competitors to avoid the need for big printing process and physical distribution systems. All moats are under attack by competitors and change in strength and value over time. It is perhaps not surprising that the Washington Post was purchased by an expert moat builder like Jeff Bezos. The task of the new owner is to rebuild the moat of the Washington Post which is not easy given that the news is non-rival and non-excludable.

11. “Ben Graham said it’s not the bad ideas that do you in. It’s the good ideas that get you. You can’t ignore it and it’s easy to overdo it.” Almost everything can be taken to a point where what is wonderful eventually becomes toxic. The great humorist Mark Twain said once that: “Water, taken in moderation, cannot hurt anybody.” Even water in sufficient quantity is not good for you. The same phenomenon applies to investing. What a wise person does at first, the fool does at the end. This particular quotations was made in the context of the Internet bubble which was an extreme example of good ideas taken way too far.

12. “Warren Buffett came to investing at the knee of Ben Graham, who ran a Geiger counter over the detritus of the 1930s. Stocks were ridiculously cheap. Graham bought companies that were quite mediocre on average, but made 20% when their stock bounced.” “Warren trained under this system and made money, so he was slower to come to the idea I learned that the best way to make money is to buy great businesses that earn high returns on capital over long periods of time. We’re applying Graham’s basic ideas, but now we’re trying to find undervalued GREAT companies. That concept was foreign to Ben Graham. Warren would have morphed into a great investor without Ben Graham. He is a greater investor than Graham was. Warren would have been great had he never met anyone else. He would have excelled at any field that required a high IQ, quantitative skills and risk taking. He wouldn’t have done well at ballet though.” The point about Warren Buffett being an unlikely ballet star is important since it raises the idea of “circle of competence.” Risk comes from not knowing what you are doing, so it is wise to know what you are doing (i.e., stay within your circle of competence). The skill of every human being has limits. Knowing in which situations you are skilled or not is very valuable in life. An important point in all of this is: you are not Charlie Munger and you are not going to be Charlie Munger. Having said that, you can learn from Charlie Munger and make better decisions than you would otherwise. Those decisions may be limited to things like choosing a mutual fund or allocating assets between categories. They also might include selecting a college or a spouse. Charlie Munger is trying to convey the idea that in making decisions in life it is wise to be rational, try to filter out sources psychological dysfunction and apply a range of mental models and worldly wisdom.

A Dozen Things I’ve Learned from Charlie Munger about Mental Models and Worldly Wisdom

1. “I think it is undeniably true that the human brain must work in models. The trick is to have your brain work better than the other person’s brain because it understands the most fundamental models: ones that will do most work per unit.” “If you get into the mental habit of relating what you’re reading to the basic structure of the underlying ideas being demonstrated, you gradually accumulate some wisdom.”

Every human can assimilate only so much information through their senses and has only so much memory and processing power. Humans must make decisions constantly. Charlie Munger’s belief is that by learning and thinking using the big models which have been developed by the very best minds, you can become “worldly wise.” The good news is that you don’t need to have perfect understanding of all these models.  What you will need is greater knowledge and understanding of the models than the other people you compete with in a given activity like investing. You will naturally know some models better than others. Some mental models work better than others in some situations and knowing which models to use and when is a key part of good judgment. For better or worse, having good judgment often comes from making bad judgments. The process of acquiring wisdom is just that – a process. Acquiring wisdom takes time and effort.

 

2. “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.”

Richard Feynman liked to tell this story about something his father taught him: “You can know the name of that bird in all the languages of the world, but when you’re finished, you’ll know absolutely nothing whatever about the bird.” Rather than just knowing the names of various mental models, Charlie Munger is very focused on acquiring a deep understanding of these models so they can help him better understand the world. He believes that it is through the application of models in a varied range of settings in life that genuine learning takes place. Mistakes, folly and foibles are an inevitable part of this process. Robert Hagstrom describes the lattice approach as follows: “each discipline entwines with, and in the process strengthens, every other. From each discipline the thoughtful person draws significant mental models, the key ideas that combine to produce a cohesive understanding.”

For Charlie Munger this approach comes naturally: “For some odd reason, I had an early and extreme multidisciplinary 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.”  Charlie Munger notes that some knowledge and skill acquisition happens based on personal experience and some vicariously through the experiences of other people. Watching other people make big mistakes is a lot less painful than making those mistakes yourself. Reading widely in a range of different domains is the most effective technique to expand the opportunities to learn from the experiences of others. Of course, Charlie Munger reads constantly. A great investor who does not read a lot is rarer than hen’s teeth.

 

3. “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.”

This quotation from Charlie Munger reminds me of the scene in the movie The Paper Chase when a character named Brooks is faced with a need to think and reason during Socratic dialogue a classroom but instead tries to use his photographic memory of facts from the cases to find a response. Perfect recall of facts is not enough and Brooks found himself floundering in the classroom when asked to think and reason. Speaking of memory, I remember well when I first read Robert Hagstrom on this latticework concept which Charlie Munger espouses since it made me feel much better about my curiosity about all aspects of the world: “Those who cultivate this broad view are well on their way to achieving worldly wisdom, that solid mental foundation without which success in the market–or anywhere else–is merely a short-lived fluke. To drive his point home, Charlie used a memorable metaphor to describe this interlocking structure of ideas: a latticework of models. ‘You’ve got to have models in your head,’ he explained, ‘and you’ve got to array your experience-both vicarious and direct-on this latticework of models.’ So immediate is this visual image that latticework has become something of a shorthand term in the investment world, a quick and easily recognized reference to Munger’s approach.”

 

4. “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.”

Charlie Munger is bringing up the tendency of humans to drift into dysfunctional patterns of thought like psychological denial when faced with something unpleasant. There are many sources of psychological and emotional dysfunction which will be discussed throughout Munger Month on this blog and many mental models that can be used to try to prevent mistakes from occurring. Using the right models can help you avoid what Munger calls “the psychology of human misjudgment.” Munger believes that by applying a lattice of models from disciplines like behavioral economics an investor can discover decision-making errors. Perfection is not possible to achieve, but following a better decision making process is possible. Focusing on having a sound decision making process rather than outcomes in any given case is wise. In the long term, it is a better process that will generate the better overall result. Reading too much into a good outcome that results from a bad process or a bad outcome that results from a good process, can create big problems.

 

5. 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.” 

You do not need to know every mental model or even know them all deeply to make better decisions, but you do need to understand how most of them work at a basic level at least. It is also important that you read often and broadly especially since these models do change and are updated over time. The goal is to acquire wisdom and common sense rather than to be an academic expert in one or even a few narrow domains. One piece of good news about this process is that each new model is easier to learn since the other models you already know give you a foundation which makes incremental learning easier.

 

6. “When I urge a multidisciplinary approach- that you’ve got to have the main models from a broad array of disciplines and you’ve got to use them all – I’m really asking you to ignore jurisdictional boundaries. If you want to be a good thinker, you must develop a mind that can jump these boundaries. You don’t have to know it all. Just take in the best big ideas from all these disciplines. And it’s not that hard to do.”  It is important that you read outside of your domain if you want to avoid failing based on man with a hammer syndrome. If all you know is medieval poetry or auto mechanics you are not going to acquire usable wisdom in life. Without worldly wisdom, you end up like a one-legged man in an ass-kicking contest says Charlie Munger. Read widely and be curious. Think for yourself and be open to new ideas. Use many models from many disciplines when thinking about a problem. For example, when thinking about an economy or a business Munger has suggested it is useful to apply models from biology. Munger has said for example “Common stock investors can make money by predicting the outcomes of practice evolution. You can’t derive this by fundamental analysis — you must think biologically” and “I find it quite useful to think of a free market economy—or partly free market economy—as sort of the equivalent of an ecosystem.”

 

7. “You must know the big ideas in the big disciplines, and use them routinely — all of them, not just a few. Most people are trained in one model — economics, for example — and try to solve all problems in one way. You know the old saying: to the man with a hammer, the world looks like a nail. This is a dumb way of handling problems.”  Munger believes that thinking clearly is a trained response. He points out that “if you want to become a golfer, you can’t use the natural swing that broad evolution gave you. You have to learn to have a certain grip and swing in a different way to realize your full potential as a golfer.”

Some people take to this mental models approach and some people don’t. Some people find it interesting and some people don’t. One sure way to fail is to look at the world only through the lens of only one model. The surgeon or nutritionist who only thinks about the world through the lens of their particular discipline is a danger to themselves and others.

 

8.”You have to realize the truth of biologist Julian Huxley’s idea that ‘Life is just one damn relatedness after another'”

“You must have the models, and you must see the relatedness and the effects from the relatedness.”

One of the most enjoyable thing about the lattice approach is when you see how “it all fits together.” When you use a lattice of mental models approach you quickly learn that everything is related including the models themselves. This relatedness often allows an investor to use analogies to solve problems and find opportunities. The more you know about more things in life, the more you see how it all fits together. The process is like solving a huge puzzle that is never fully completed. The last three words in the previous sentence (“never fully completed”) are very important. The more you know, the more you know, that there is more that you do not know.

 

9. “I’ve been searching for lollapalooza results all my life, so I’m very interested in models that explain their occurrence.”

One particularly important phenomenon related to mental models is what are called “complex adaptive systems.” If you adopt the model of complex adaptive systems you accepts the idea that the whole of many things is more than the sum of the arts and that there are many systems that cannot be modeled with certainty. Even after the fact, causation is impossible to prove with certainty when it comes to this phenomenon. Once you accept the idea that some things are simply not predictable, your world view changes. In Munger’s view it is better to have common sense and be Worldly Wise than futz around with a lot of models that are precisely wrong rather than approximately right.  This is in part why Munger likes to say: “People calculate too much and think too little.”

 

10. “You need a different checklist and different mental models for different companies. I can never make it easy by saying, ‘Here are three things.’ You have to derive it yourself to ingrain it in your head for the rest of your life.”

Faced with the tendency of humans to fall down when making decisions based on the use of dysfunctional heuristics, humans can benefit from using tools or nudges to stay rational. Checklist are just such a tool.  Despite the fact that a checklist is helpful in developing a better decision making process there is no formula or recipe for success in investing or most other aspects of life. Even with the best investing systems judgment and wisdom are required since risk, uncertainty and ignorance are constants in life. Life is always throwing new situations at you but they sometimes are quite familiar.

 

11. “Acquire worldly wisdom and adjust your behavior accordingly. If your new behavior gives you a little temporary unpopularity with your peer group … then to hell with them.”

To use worldly wisdom properly you must be prepared to be a contrarian. Being a contrarian will inevitably sometimes make you unpopular or lonely.  Accepting this solitary state of affairs at times is essential since it is mathematically provable that you cannot outperform the crowd if you are the crowd. In the longer term you will ironically be more popular as long as you are right enough in your contrarian views. Of course, being a contrarian and wrong is not helpful and it is magnitude of correctness and not frequency of correctness that should be tracked on your scorecard.

 

12. “If you don’t keep learning, other people will pass you by. Temperament alone won’t do it – you need a lot of curiosity for a long, long time.” 

“The theory of modern education is that you need a general education before you specialize. And I think to some extent, before you’re going to be a great stock picker, you need some general education.”  

“If you skillfully follow the multidisciplinary path, you will never wish to come back. It would be like cutting off your hands.” 

“It’s kind of fun to sit there and outthink people who are way smarter than you are because you’ve trained yourself to be more objective and more multidisciplinary. Furthermore, there is a lot of money in it, as I can testify from my own personal experience.”

Charlie Munger, Robert Hagstrom, Michael Mauboussin and others I admire are advocates of a broad liberal arts education. I am not just talking about what you take as courses in school but what you learn about throughout your life. The best investors never stop learning. I particularly love the original title of Robert Hagstrom’s book Investing: The Last Liberal Art since it is such a true statement. Knowing a lot about a lot in many disciplines and being “a learning machine” are attributes of the best investors.

To sum up this blog post it is useful I think to just quote Charlie Munger on the benefits of his approach: “I constantly see people rise in life who are not the smartest, sometimes not even the most diligent, but they are learning machines. They go to bed every night a little wiser than they were when they got up and boy does that help, particularly when you have a long run ahead of you.…so if civilization can progress only with an advanced method of invention, you can progress only when you learn the method of learning. Nothing has served me better in my long life than continuous learning. I went through life constantly practicing (because if you don’t practice it, you lose it) the multi-disciplinary approach and 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, and it’s made me enormously rich. You name it, that attitude really helps.” 

 

A partial list of some Mental Models used by Charlie Munger, compiled from many sources

Accounting:

Balance Sheet

Cash Flow Statement

Depreciation

Double-Entry

Generally Accepted Accounting Principles

Income Statement

Sunk Cost

 

Biology:

Genetics

Natural Selection

Physiology

 

Business:

Moats

Five Forces

Brand

 

Chemistry:

Autocatalytic reactions

Bohr Model

Kinetics

Thermodynamics:

Uncertainty Principle

Viscosity

 

Computer Science:

Abstractions

Algorithms

If-statements

Recursion

 

Economics:

Agency Problem

Asymmetric Information

Behavioral Economics

Cumulative Advantage

Comparative Advantage

Competitive Advantage

Creative Destruction

Diminishing Utility

Economies of Scale

Elasticity

Externalities

Markets

Marginal Cost

Marginal Utility

Monopoly and Oligopoly

Network effects

Opportunity Cost

Price Discrimination

Prisoner’s Dilemma

Public and Private Goods.

Specialization

Supply and Demand

Switching Costs

Transaction Costs

Tragedy of the Commons

Time Value of Money

Utility

 

Engineering:

Breakpoints

Feedback loops

Margin of Safety

Redundancy

 

Law:

Burden of Proof

Common law

Due Process

Duty of care

Good Faith

Negligence

Presumption of Innocence

Reasonable doubt

 

Management Science:

Occam’s razor

Parkinson’s Law

Process versus Outcome

 

Mathematics, Probability and Statistics:

Agent Based Models

Bayes Theorem

Central Limit Theorem

Complex Adaptive Systems

Correlation versus Causation

Combinations

Compounding

Decision Trees

Inversion

Kelly Optimization Model

Law of Large Numbers

Mean, Median, Mode

Normal Distribution

Permutations

Power Law

Regression Analysis

Return to the Mean

Scaling

Sensitivity Analysis

 

Philosophy, Literature and Rhetoric:

Metaphors

Similes

Abduction

Pragmatism

Realism

Reductionism

 

Physics:

Critical Mass

Electromagnetism

Equilibrium

Inertia

Newton’s Laws

Momentum

Quantum Mechanics

Relativity

Shannon’s Law

Thermodynamics

 

A Dozen Things I’ve Learned from Charlie Munger about Making Rational Decisions

 

I have written a book about Charlie Munger. While the book is written in the context of investing, understanding what Charlie Munger teaches will help you make rational decisions about anything in your life.  Everyone must make decisions and by understanding how Charlie Munger thinks you can improve your decision making skills. Even people who have decided to use an index fund-based approach must chose index funds and allocate between asset classes. Making at least some investment decisions is unavoidable. Learning to make better decisions of any kinds requires that you spend some time thinking about thinking. The good news is that this learning process is fun. Charlie Munger puts it this way: “Learning has never been work for me. It’s play.” Life gets better if you adopt this approach to learning.

  1. “‘Charlie,’ she said, ‘What one word accounts for your remarkable success in life?’ I told her I was rational.” If the actor in the television commercials for the famous beer is “the most interesting man in the world,” then perhaps Charlie Munger is “the most rational investor in the world.” His rationality and honesty in no small part explain why he is so popular. What Charlie Munger says is often so funny because he is perfectly willing to speak the truth in a completely unrestrained and direct manner. In other words, he appeals to so many people because of his honest insight about life, in much the same way as great comics like Louis C.K., Amy Schumer or Chris Rock are so appealing. Individuals who speak the truth openly are often interesting, insightful and funny. To understand Charlie Munger’s appeal it is useful to think about the nature of rationality. Michael Mauboussin explains that there are different forms of rationality: “Cognitive scientists and philosophers talk about “instrumental” and “epistemic” rationality. Instrumental rationality is behaving in such a way that you get what you want the most, subject to constraints. Expected utility theory, which is based on a series of axioms, provides a normative framework for how to do this. You’ll be instrumentally rational if you follow the axioms. Epistemic rationality describes how well a person’s beliefs map onto the world. If you believe in the tooth fairy, for instance, you are showing a lack of epistemic rationality. Here’s a catchier way to remember the two terms: instrumental rationality is “what to do” and epistemic rationality is “what is true.” Charlie Munger understands and is focused on being both “epistemically” and instrumentally rational.

 

  1. “The right way to think is the way [Harvard Professor Richard] Zeckhauser plays bridge. It’s just that simple.” To be “rational” is to think in terms of expected value, which Michael Mauboussin points out “is the weighted average value for a distribution of possible outcomes.”  In the 1989 Berkshire Hathaway Annual Meeting Warren Buffett put it this way: “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.” Michael Mauboussin describes the rational approach perfectly: “Success in a probabilistic field requires weighing probabilities and outcomes — that is, an expected value mindset.” Robert Hagstrom argues http://blogs.cfainstitute.org/insideinvesting/2013/09/03/what-buffett-believes-but-cannot-prove/: “Jon Elster is a Norwegian social and political theorist who has written extensively on rational-choice theory. He tells us that being able to wait and using indirect strategies are central features of human choice. Indeed, Elster argues that human rationality is characterized by the capacity to relate to the future, in contrast to the myopic gradient-climbing organism found in the natural world. Elster’s gradient-climbing organism has eyes fixed to the ground, incapable of seeing what might happen next. Future events for the myopic organism have no effect on decision making. Put differently, for the myopic organism, tomorrow’s events are the same as today’s events. In contrast, Elster claims that man can be seen as a rational, global-maximizing machine capable of relating to the future, choosing the best alternative by scanning several possible moves and then selecting the best choice among them. The irrational investor, the myopic gradient-climber, sees only today and postulates that tomorrow will be much the same. In contrast, Buffett sees stock price declines as temporary. Irrational investors see the same price declines and believe them to be permanent. The cornerstone of rationality is the ability to see past the present and analyze possible scenarios, eventually making a deliberate choice.” As an aside, if you are not reading Robert Hagstrom’s books you are missing out on some very good thinking and writing.

 

  1. “[What was] … worked out in the course of about one year between Pascal and Fermat… is not that hard to learn.” “So you have to learn in a very usable way this very elementary math and use it routinely in life ‑ just the way if you want to become a golfer, you can’t use the natural swing that broad evolution gave you. You have to learn to have a certain grip and swing in a different way to realize your full potential as a golfer.”  Charlie Munger is saying that the expected value aspects of investing are relatively simple to learn but that it is not a natural way of thinking. He believes that using this process skillfully in real life is a trained response since aspects of the process will require you to overcome certain biases as well as certain often dysfunctional emotional and psychological tendencies. “Your brain doesn’t naturally know how to think the way Zeckhauser knows how to play bridge. ‘For example’, people do not react symmetrically to loss and gain. Well maybe a great bridge player like Zeckhauser does, but that’s a trained response.” The best way to learn to play bridge or invest is to actually play. You can’t really simulate it. Over a lifetime you can learn from actual direct and indirect experience to overcome different types of dysfunctional thinking. For example, says Munger “If people tell you what you really don’t want to hear what’s unpleasant—there’s an almost automatic reaction of antipathy. You have to train yourself out of it.” 

 

 

  1. “The Fermat/Pascal system is dramatically consonant with the way that the world works. If you don’t get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a one‑legged man in an ass‑kicking contest. You’re giving a huge advantage to everybody else.” Charlie Munger is famous for his view that simple mathematic techniques like algebraic inversion are essential to making wise decisions. Adopting this approach is neither easy or natural but will inevitably pay big dividends. He believes that if you don’t do this work you will inevitably end up being the patsy at the poker table of life.  If you are playing in a poker game and don’t see a sucker, get up and walk away from the table. You’re the sucker. The future is best thought of as a probability distribution so naturally thinking probabilistically puts you are a competitive advantage in relation to competitors.

 

  1. “I now use a kind of two-track analysis. First, what are the factors that really govern the interests involved, rationally considered? The first track is rationality-the way you’d work out a bridge problem: by evaluating the real interests, the real probabilities and so forth.”  Having a system is important says Warren Buffett: “The approach and strategies [in bridge and investing] are very similar. In the stock market you do not base your decisions on what the market is doing, but on what you think is rational. With bridge, you need to adhere to a disciplined bidding system. While there is no one best system, there is one that works best for you. Once you choose a system, you need to stick with it.” The analytical system Charlie Munger uses starts with rationality. But that is only the first step in a two step process that is his systematic approach to investing. He is saying that the rational decision-making track comes first, just like putting on your pants should precede putting on your shoes.

 

  1. “Second, what are the subconscious influences where the brain at a subconscious level is automatically doing these things-which by and large are useful, but which often malfunctions.” Ordinary people, subconsciously affected by their inborn tendencies.”  After an expected value process is completed and you believe your decisions is rational, Charlie Munger suggests that the decision be cross-checked for possible errors. The reality is that no one has a fully rational mindset. It would not be possible to get out of bed in the morning if every human decision had to be made based on careful expected value calculations. Heuristics have been developed by humans to get through a day which sometimes cause decisions to become irrational, especially in a modern world which is very unlike most of history.  In other words, no human is perfectly rational because everyone is impacted by emotional and psychological tendencies when making decisions. As a result, thinking rationally is a trained response. To be as rational in your daily life as Richard Zeckhauser is in playing bridge a person must overcome errors based on emotional or psychological mistakes. Rationality is in practical terms relative.  Charlie Munger believes staying rational is hard work and requires constant practice and lifelong effort. Making mistakes is inevitable and will never stop, but you can learn to make less than your statistical share of mistakes.

 

  1. “Your brain doesn’t naturally know how to think the way Zeckhauser knows how to play bridge. For example, people do not react symmetrically to loss and gain. Well maybe a great bridge player like Zeckhauser does, but that’s a trained response. Thinking in a way that is as rational as possible requires work and training, especially when it comes to avoiding psychological and emotional mistakes. What is the source of these mistakes? The list of factors causing mistakes is very long. Warren Buffett writes: “It’s ego. It’s greed. It’s envy. It’s fear. It’s mindless imitation of other people. I mean, there are a variety of factors that cause that horsepower of the mind to get diminished dramatically before the output turns out. And I would say if Charlie and I have any advantage it’s not because we’re so smart, it is because we’re rational and we very seldom let extraneous factors interfere with our thoughts. We don’t let other people’s opinion interfere with it… we try to get fearful when others are greedy. We try to get greedy when others are fearful. We try to avoid any kind of imitation of other people’s behavior. And those are the factors that cause smart people to get bad results.” What Buffett describes is an example of what Charlie Munger calls decisional inversion. Instead of just trying to be smart, it is wise to focus on not being stupid.

 

  1. What is hard is to get so you use it routinely almost every day of your life.” Training your mind to do what Charlie Munger suggests is the ultimate goal of anyone who wants to emulate his system. Warren Buffett has written: “Chains of habit are too light to be felt until they are too heavy to be broken…At my age, I can’t change any of my habits. I’m stuck. But you will have the habits 20 years from now that you decide to put into practice today. So I suggest that you look at the behavior that you admire in others and make those your own habits, and look at what you really find reprehensible in others and decide that those are things you are not going to do. If you do that, you’ll find that you convert all of your horsepower into output.” One  good aspect of habits is that they can be put to good use if they are the right habits. It’s a bit like Alcoholics Anonymous, which Charlie Munger believes is a cult, but for the good. What an investor needs is a system that includes habits that reinforce rationality. If you want to say that people who follow Munger are a cult for the good, you won’t be far off in too many cases.  Munger himself has referred to people who attend Berkshire shareholder meetings as cult followers.

 

  1. “We have a temperamental advantage that more than compensates for a lack of IQ points.” “A lot of people with high IQs are terrible investors because they’ve got terrible temperaments. And that is why we say that having a certain kind of temperament is more important than brains.” Charlie Munger is making the point that high IQ does not mean you have high rationality quotient (RQ).  Temperament is far more important than IQ. Warren Buffett has said about Charlie Munger: “He lives a very rational life. I’ve never heard him say a word that expressed envy of anyone. He doesn’t waste time on senseless emotions.”  Warren Buffett suggests that some of this aspect of human nature may be innate: “A lot of people don’t have that. I don’t know why it is. I’ve been asked a lot of times whether that was something that you’re born with or something you learn. I’m not sure I know the answer. Temperament’s important.” High IQ can be problematic. What you want is to have a high IQ but think it is less than it actually is. That gap between actual and perceived IQ creates valuable humility and protects against mistakes caused by hubris. It is the person who thinks their IQ is something like 40 points higher than it actually is who creates the most havoc in life.

 

  1. “Personally, I’ve gotten so that I have a full kit of tools … go through them in your mind checklist-style.” Charlie Munger is a big believer is the use of checklist and is fan of Atul Gwande’s book The Checklist Manifesto. Checklists are a foundational part of systems that can help people identify dysfunctional thinking and bias. A checklist is in effect a “nudge” that helps you deal with bias and dysfunction by prodding you in the right direction. As an aside the full kit of tools required when using Charlie Munger’s system requires that you have “worldly wisdom” which will be the topic of another blog post in this series.

 

  1. “Rationality …requires developing systems of thought that improve your batting average over time.” “Luckily, I have selected very easy problems all my life, and I have a reasonable batting average.” “You don’t have to have perfect wisdom to get very rich – just a bit better than average over a long period of time.” No one is going to make the right decision all the time even if they strive to be rational. Howard Marks believes:Most people understand and accept that in their effort to make correct investment decisions, they have to accept the risk of making mistakes.  Few people expect to find a lot of sure things or achieve a perfect batting average.” The important thing is to have a system, but don’t expect it to be perfect. Michael Mauboussin points out: “Constantly thinking in expected value terms requires discipline and is somewhat unnatural. But the leading thinkers and practitioners from somewhat varied fields have converged on the same formula: focus not on the frequency of correctness, but on the magnitude of correctness.”

 

  1. “[Berkshire] is a very rational place.” “Warren and I know better than most people what we know and what we don’t know. That’s even better than having a lot of extra IQ points. Mr. Munger continued: “People chronically mis-appraise the limits of their own knowledge; that’s one of the most basic parts of human nature. Knowing the edge of your circle of competence is one of the most difficult things for a human being to do. Knowing what you don’t know is much more useful in life and business than being brilliant.” IQ is not the primary cause of investing success. Warren Buffett points out that the key to making wise decisions is rationality: “How I got here is pretty simple in my case. It’s not IQ, I’m sure you’ll be glad to hear. The big thing is rationality. I always look at IQ and talent as representing the horsepower of the motor, but that the output–the efficiency with which that motor works–depends on rationality. A lot of people start out with 400-horsepower motors but only get a hundred horsepower of output. It’s way better to have a 200-horsepower motor and get it all into output.” For Buffett and Munger the circle of competence point is critical. Since risk comes from not knowing what you are doing, know what you are doing when you are doing something. If you don’t know what you are doing put it in the too hard pile and move on to something else. The more you know, the more you know, that there is even more than you do not know.

A Dozen Things I’ve Learned from David Einhorn About Investing

 

 

David Einhorn is the President of Greenlight Capital which is “a value oriented investment advisor… that emphasizes intrinsic value will achieve consistent absolute investment returns and safeguard capital regardless of market conditions.” “He learned the hedge fund business from Gary Siegler and Peter Collery, who managed the SC Fundamental Value Fund. David Einhorn is one of the most successful long/short equity hedge fund managers of the past decade.” He is the author of Fooling Some of the People All of the Time: A Long Short Storyhttp://www.amazon.com/Fooling-People-Complete-Updated-Epilogue/dp/0470481544/ref=sr_1_1?s=books&ie=UTF8&qid=1439654903&sr=1-1&keywords=long+short+story+Einhorn

 

  1. “We take the traditional value investor’s process and just flip it around a little bit. We start by identifying situations in which there is a reason why something might be misunderstood, where it’s likely investors will not have correctly figured out what’s going on. Then we do the more traditional work to confirm whether, in fact, there’s an attractive investment to make. That’s as opposed to starting with something that’s just cheap and then trying to figure out why. We think our way is more efficient.”  David Einhorn is at his core a value investor who has developed a twist on the customary process. Finding reasons for a likely mispricing of assets and then doing the traditional value investing analysis is not fundamentally different than doing the traditional value investing analysis first. He feels his approach consumes less of his firm’s resources since they are not doing the work on businesses which are unlikely to see substantial asset appreciation. Reasons for an asset being mispriced include spin-offs, accounting issues and changes in secular or technology trends.

 

  1. “What I like is solving the puzzles. I think that what you are dealing with is incomplete information. You’ve got little bits of things. You have facts. You have analysis. You have numbers. You have people’s motivations. And you try to put this together into a puzzle — or decode the puzzle in a way that allows you to have a way better than average opportunity to do well if you solve on the puzzle correctly, and that’s the best part of the business.” Value investing when done right is a lot of fun if you like to solve puzzles. The process is like being a detective. Sherlock Holmes might have been a good value investor.  The task of a investor is to discover puzzle solutions in situations that involve different combinations of what Richard Zeckhauser calls risk, uncertainty, and ignorance (see the chart below). The process of discovering puzzle answers is inherently probabilistic in nature.

    Escalating Challenges to Effective Investing

 

  1. “Our goal is to make money, or at least to preserve capital, on every investment.” “Securities should be sufficiently mispriced, so that if we are right we will do well, but we are mostly wrong, we will roughly break even.” “The trick is to avoid losers. Losers are terrible because it takes a success to offset them just to get back to even.” Risk is always relative to the price paid for the asset. If you buy at an attractive price you can have a margin of safety. You can see this margin of safety principle at work in Warren Buffett’s two rules of investing: “Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.” Howard Marks and Seth Klarman all espouse this same philosophy. How do you “not lose money?” Always protect the downside.  If you buy at a substantial discount to intrinsic value you can make a mistakes and still end up with a solid investment.

 

  1. “There were three basic questions to resolve: First, what are the true economics of the business? Second how do the economics compare to the reported earnings? Third, how are the interests of the decision makers aligned with the investors?” The best value investors have an investing system that involves asking and answering a series of questions. For example, does the business have a moat? What should the economics of the  business be in a normal situation? Then: Do earnings reports match the strength of the moat? Is there untapped pricing power? Is management underperforming? Are there problems you have not yet seen? Then: Are the incentives of management aligned with the incentives of investors? In the book Fooled By Randomness Nassim Taleb writes:  “… instead of relying on thousands of meandering pages of regulation, we should enforce a basic principle of ‘skin in the game’ when it comes to financial oversight: ‘The captain goes down with the ship; every captain and every ship.’ In other words, nobody should be in a position to have the upside without sharing the downside, particularly when others may be harmed.”

 

  1. “I’m not really good a predicting the market on a very near term kind of basis. So what it does from day-to-day is not within my competency to even hazard a guess at.”  This comment is a blend of Ben Graham’s Mr. Market metaphor and the “circle of competence” concept. When David Einhorn buys assets he does not have a short term timeline in mind for how long he will own the assets. The objective of a value investor is to buy the assets at a bargain price and then wait. this word wait is an important one. What is meant by the value investor is waiting would any short term timing. Trying to make short-term forecasts instead of waiting is folly and value investors instead rely on the combined long term effects of a buying with a margin of safety knowing that over the long terms prices will return to the mean.

 

  1. “We don’t try to solve the most intractable problems. At Greenlight, when we look at investments, some opportunities are just too hard to assess. We pass on those, even though many may work out perfectly well. We prefer situations that play to our strengths, where we can develop a differentiated analytical edge. This enables us to make investments where we are confident that the reward exceeds the risk.” Having what Charlie Munger calls a “too hard pile” is a tremendously valuable thing. If an investment is too hard, just move on to the many other opportunities that are not hard. Why get involved in investments where you do not know what you are doing especially when there are other bets where you do? Playing against weak competitors is not a sin in investing or business. There are no bonus points in investing for doing things that are really hard.

 

  1. “Investing and poker require similar skills. I don’t play a lot of hands. But I don’t just wait for the perfect hand. They don’t come up often enough.” “With poker, you have a resolution of the hand within a couple of minutes.”  “Whereas, even if the thought process in investing is very much the same, you’re looking at an outcome that could be 2, 3, 4, 5 years from when you make the original decision. And the mindset related to that is very different.”  “We find things that we think are exceptional only occasionally.” Markets are far from perfectly efficient.  But they are efficient enough that finding mispriced assets is hard, especially inside your circle of competence, which narrows the possible universe of bets. When the markets do serve up a mispriced bet an investor should act quickly and aggressively to place a bet if it is within their circle of competence. A number of very successful investors are excellent card players. Charlie Munger puts it this way: “The right way to think is the way Zeckhauser plays bridge. It’s just that simple.”  Warren Buffett has a similar view: “Bridge is the best game there is. You’re drawing inferences from every bid and play of a card, and every card that is or isn’t played. It teaches you about partnership and other human skills. In bridge, you draw inferences from everything and that carries over well into investing. In bridge, similar to in life, you’ll never get the same hand twice but the past does have a meaning. The past does not make the future definitive but you can draw from those experiences. I think the partnership aspect of bridge is a great lesson for life. If I’m going into battle, I want to partner with the best. I was playing with a world champion and we were playing against my sister and her husband. We lost, so I took the score pad and I ate it.”

 

  1. “We believe in constructing our portfolio so that we put our biggest amount of money in our highest conviction idea, and then we view our other ideas relative to that.” “I decided to run a concentrated portfolio.”  This statement illustrates that David Einhorn is a “focus” investor like Charlie Munger and that he adopts an opportunity cost approach. At Greenlight 20 percent of capital might be put in a single long bet and up to 60 percent in its five largest long bets. David Einhorn cites Joel Greenblatt as an inspiration for his view. Greenblatt argues that the addition of more stocks in a portfolio that already has six to eight stocks in different industries doesn’t significantly decrease volatility. In any event, volatility is only on type of risk. You can see his recent holdings and his most recent letter here: http://www.octafinance.com/david-einhorns-greenlight-capital-had-a-bad-q2-bringing-2015-ytd-loss-to-3-3/101385/  David Einhorn currently has a significant position in gold.  Some value investors own gold (e.g., Eveillard) and some don’t (e.g., Buffett, Munger).  I have never owned gold since it doesn’t have earnings that can be used to calculate an intrinsic value.  While some value investors may buy gold, buying gold is not value investing since it does not fit with the Ben Graham system. Why buy gold when you can buy a partial ownership interest in a real productive business instead of a lump of inert metal?

 

  1. “On any given day a good investor or a good poker player can lose money.” A good process can lead to a bad outcome in the real world, just as a bad process can lead to a good outcome. In other words, both good andbad luck can play a part in investing results. But the best investors understand that over time a sound process will outperform. The best way to understand this point being made by David Einhorn is to read Michael Mauboussin, who tells this story:  “[A baseball executive] was in Las Vegas sitting next to a guy who has got a 17. So the dealer is asking for hits and everybody knows the standard in blackjack is that you sit on a 17. The guy asked for a hit. The dealer flips over 4, makes the man’s hand, right, and the dealer sort of smiles and says, “Nice hit, sir?”  Well, you’re thinking nice hit if you’re the casino, because if that guy does that a hundred times, obviously the casino is going to take it the bulk of the time. But in that one particular instance: bad process, good outcome. If the process is the key thing that you focus on, and if you do it properly, over time the outcomes will ultimately take care of themselves. In the short run, however, randomness just takes over, and even a good process may lead to bad outcomes. And if that’s the case: You pick yourself up. You dust yourself off. You make sure you have capital to trade the next day, and you go back at it.”

 

  1. “[Our] goal is to achieve high absolute rates of return.” “We do not compare our results to long only indexes. This mean out goal is to try to achieve positive results over time regardless of the environment. Does the reward of this investment outweigh the risk?” The goal David Einhorn sets for himself is not to outperform a benchmark. This section from Seth Klarman’s book Margin of Safety describes a value investor’s desire for “absolute return”: “Most institutional and many individual investors have adopted a relative-performance orientation…They invest with the goal of outperforming either the market, other investors, or both and are apparently indifferent as to whether the results achieved represent an absolute gain or loss. Good relative performance, especially short-term relative performance, is commonly sought either by imitating what others are doing or by attempting to outguess what others will do. Value investors, by contrast, are absolute-performance oriented; they are interested in returns only insofar as they relate to the achievement of their own investment goals, not how they compare with the way the overall market or other investors are faring. Good absolute performance is obtained by purchasing undervalued securities while selling holdings that become more fully valued. For most investors absolute returns are the only ones that really matter; you cannot, after all, spend relative performance. Absolute-performance-oriented investors usually take a longer-term perspective than relative-performance-oriented investors. A relative-performance-oriented investor is generally unwilling or unable to tolerate long periods of underperformance and therefore invests in whatever is currently popular. To do otherwise would jeopardize near-term results. Relative-performance-oriented investors may actually shun situations that clearly offer attractive absolute returns over the long run if making them would risk near-term underperformance. By contrast, absolute-performance-oriented investors are likely to prefer out-of-favor holdings that may take longer to come to fruition but also carry less risk of loss.”

 

  1. “I’m a big believer in not making decisions before they need to be made. Circumstances change, people change, facts change, and options change. Why commit early when you can have the benefit of deciding later with more information?” Having the option to make the best choice at a later point in time when you have more information is valuable since markets are always changing. As an example, Craig McCaw has said to me many times over the years that “flexibility is heaven,” which means that he was willing at times to pay a financial price to keep his options open. When change is constant, having the ability to adapt at a later point in time is a very good thing.

 

  1. “At the top of the bubble, technology stocks seemed destined to consume all the world’s capital. It was not enough for all the new money to go into this sector. In order to feed the monster, investors sold everything from old economy stocks to Treasuries to get fully invested in the bubble. Value investing fell into complete disrepute.” “Market extremes occur when it becomes too expensive in the short-term to hold for the long-term.” “One of the things I have observed is that American financial markets have a very low pain threshold.” David Einhorn is pointing out that people often need to act based on short-term needs. Often that short-term need is to generate liquidity. Sometimes liquidity is needed because some people selling an asset cause a drop in price, which causes more people to sell that asset due to the price drop [repeat]. George Soros calls this phenomenon “reflectivity.” When people start acting in some way because other people are acting in the same or similar ways nonlinear results can happen both to the upside and the downside. For example, cash can quickly move from being available quite easily, to being very scarce. As another example, the price of an asset can suddenly jump in a big way. The speed at which this can happen is often forgotten by people and is underappreciated until that time arises. Market extremes do occur since people do not make decisions independently. They are not perfectly informed rational agents. The longer you investment timeframe and the lumpier the returns you are willing to accept the happier you will be and the better your returns will be.

 

 

Notes:

 

Charlie Rose interview:  http://www.businessweek.com/magazine/content/10_51/b4208052554248.htm

 

CNBC interview http://www.cnbc.com/id/102107346#

 

http://www.valuewalk.com/wp-content/uploads/2014/06/MarchTrial.pdf

 

Value Investing Congress Speech   http://www.grahamanddoddsville.net/wordpress/Files/Gurus/David%20Einhorn/einhornspeech200611.pdf

 

Ira Sohn comment:  http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ayIKbq6xULBA

 

Fooling Some of the People All of the Time, A Long Short Story   http://www.amazon.com/Fooling-People-Complete-Updated-Epilogue/dp/0470481544/ref=sr_1_1?s=books&ie=UTF8&qid=1439654903&sr=1-1&keywords=long+short+story+Einhorn

 

Presentation at Grant’s (Interest Rate Observer) Spring Investment Conference  http://seekingalpha.com/article/73260-things-go-better-with-coke-in-the-market-too  and http://www.naachgaana.com/2008/04/12/grant%E2%80%99s-spring-investment-conference/

 

Risk Mismanagement  http://www.nytimes.com/2009/01/04/magazine/04risk-t.html?pagewanted=all

 

Helping People Get Along Better  http://www.gurufocus.com/news/325793/helping-people-get-along-better–a-lecture-from-david-einhorn

 

 

 

 

 

 

A Dozen Things I’ve Learned from Sam Zell about Investing and Business

 

Sam Zell is the founder and chairman of Equity Group Investments, which started in the real estate business but now owns a range of businesses. Sam Zell’s nickname is “the Grave Dancer” since he is often a distressed asset investor. This is a blog post about Sam Zell the investor.  As is the case with all of my blog posts, if you have an issue with the political views of the featured investor, I suggest that you try another blog.

 

  1. “The first thing you need to understand is how little you know.” The best investors understand that the more you know, the more you know that there is even more you do not know. Creating a taxonomy that categorizes your lack of knowledge is helpful since problems in life most often come from not knowing what you are doing. There are three categories: (1) you may know the potential future states and the probability that those potential future states may come to pass. This is known as “risk” and is rare. (2) you may know the potential future states, but not the probability that any of those potential future states will happen. This is uncertainty and is most common. (3) you may encounter future states that you had no prior idea were even possible. This is the domain of “ignorance.” This third domain (Black Swans) impacts people’s lives way more than they imagine since even though events in this domain do not happen that often, when they do, it produces massive disruptive change.

 

  1. “When everyone is going right, look left.” “I‘ve spent my whole life listening to people explain to me that I just don‘t understand, but it didn‘t change my view. Many times, however, having a totally independent view of conventional wisdom is a very lonely game.” Sam Zell is expressing the same view as investors like Howard Marks who recognize that it is mathematically provable that without being a contrarian in some instances (and being right about that contrarian view in those instances) it is not possible to outperform a market. You simply can’t follow the crowd and beat the crowd. Being contrarian for its own sake is, of course, unwise. Sam Zell is saying that you should “look” left, which does not necessarily mean you should “go” left. But sometimes that look left will give you enough confidence to place contrarian bets since you will see that the odds are substantially in your favor.

 

  1. “Listen, business is easy. If you’ve got a low downside and a big upside, you go do it. If you’ve got a big downside and a small upside, you run away. The only time you have any work to do is when you have a big downside and a big upside.” This statement is all about the value of seeking positive optionality. Every once in a while, if you are looking hard for opportunities, you will find a mispriced bet within your circle of competence with a relatively capped downside and a huge potential upside. It is wise to bet aggressively in these cases since it allows you to harvest positive optionality.  Betting when the optionality of the situation is negative is a fool’s errand. Situations with a big up side and a big downside are by contrast problematic.  This situation is likely to result in the most work and for that reason alone it may be wise to put decisions within it in the “too hard” pile.

 

  1. “At all times, we are keenly aware of what our exposure is.  As a result we are much more of a Benjamin Graham kind of investor.  We are very focused on what the liquidation value is.  Barnard Baruch, who was a very famous financier said ‘Nobody went broke taking a profit.’  In the same manner, I have never suffered from any transaction turning out to be too good.  The real issue is ‘What is the downside’.”  “My own formula is very simple. It starts and ends with replacement cost because that is the ultimate game. In the late 1980s and early 1990s, I was the only buyer of real estate in America. People asked me, ‘How could you buy it?’ How could I project yields? Rents? For me, it came down to these issues: Is the building well built? Is it in a good location? How much less than the cost of replacement is its price? I bought stuff for 30 cents on the dollar and 40 cents on the dollar.” Sam Zell likes to buy assets with a Ben Graham-style margin of safety, even if the asset class is commercial real estate. The value investing formula is simple: buy at a bargain and wait. I suggest that you don’t try to make it more complex than that. Most value investors are happy with a 30% margin of safety, but Sam Zell is saying here that he has sometimes been able to buy real estate at what he considered to be as much as a 70% margin of safety. In doing so Sam Zell is also taking a view similar to Howard Marks in that he is controlling risk.  Howard Marks believes: “Success in investing is not a function of what you buy. It’s a function of what you pay.”

 

  1. “I pound on my people: taking risk is great. You’ve got to be paid to take the risk. The risk/return ratio is probably the most significant determinant of success as an investor.” “Measuring and gauging the risk reward ratio is the biggest [margin of] safety issue every investor has.” Getting paid for any risk you take is a key part of risk control. In my post on Jeffrey Gundlach I wrote:Taking in risk for its own sake is a sucker’s bet. More risk does not necessarily mean more investment return.” Sam Zell is talking about the same principle here. What you want to find is mispriced risk or uncertainty so you get paid for taking that risk or uncertainty since as Howard Marks has pointed out: “If riskier investments necessarily delivered higher returns they wouldn’t be risky.”

 

  1. “You can have all of the assets in the world you want, but if you have no liquidity it doesn’t matter.” “Liquidity equals value. At no time in my career has it ever been more clearly brought home to me than in the (2008)-09 period. If you had liquidity, you had value. … Everything comes down to liquidity, everything comes down to exit strategies, everything comes down to knowing when you get in how you are going to get out.” A repeating theme of this series on my blog is Harold Geneen’s admonition: the only unforgivable sin in business is to run out of cash. Being in a situation where lots of people have lots of assets but no cash is like being in a big earthquake. You can’t believe it is happening, but there it is. Sam Zell pointed out http://scholarship.sha.cornell.edu/cgi/viewcontent.cgi?article=1069&context=crer that once in 1990 he read in a magazine that he was worth a billion dollars and yet he did not know if he had enough liquidity to make payroll the next Friday. 

 

  1. “The problem with leverage is that you need to pay it back. The biggest measure of success or failure is how entrepreneurs address and deal with leverage. If you are in the real estate business without leverage, that’s like being a boxer in the ring without a glove.” Some people are more comfortable with debt than others. Some people sleep well knowing that they or businesses they control owe other people billions of dollars. Others can’t seep while owning anyone much of anything.  Learning how to manage debt and you reaction to being in debt is a valuable skill.  Sam Zell is saying that leverage in his business is a not avoidable so he has learned to be really good at managing leverage. 

 

  1. “Anytime you don’t sell, you buy. So if we had chosen not to sell Equity Office for $39 billion, we would be buying Equity Office for $39 billion.” Sam Zell is talking about what Charlie Munger calls “opportunity cost” thinking. Munger says: “In life, if opportunity A is better than B, and you have only one opportunity, you do A. There’s no one-size-fits-all. If you’re really wise and fortunate, you get to be like Berkshire. We have high opportunity costs. We always have something we like and can buy more of, so that’s what we compare everything to. We know we’ve got opportunity X, which is better than the new opportunity. Why do we want to waste two seconds thinking about the new opportunity?”

 

  1. “I would tell you whatever business I’ve been in — real estate, barges, rail cars — it’s all about supply and demand.” “When there is no supply, real estate performs very well. Almost without regard, within reason to the economic conditions. When there is over supply, it doesn’t matter what’s going on real estate is going to suffer.” Economics is far simpler than most people imagine, especially for a business person.  Your task in business is to create a situation where supply is at least somewhat limited by some phenomenon. successfully deal with competitors a business will need what Harvard Business School Professor Michael calls a “sustainable competitive advantage.” Warren Buffett calls this same characteristic a “moat.” Michael Porter: “That free entry dissipates economic profit is one of the most powerful insights in economics, and it has profound implications for strategy. Firms that base their strategies on products that can be easily imitated or skills and resources that can be easily acquired put themselves at risk. To attain a competitive advantage, a firm must secure a position in the market that protects itself from imitation and entry.”

 

  1. “Arthur Miller did a huge disservice to entrepreneurship by writing Death of a Salesman. Salesmen are not scummy and dirty – people you would not want to ring your doorbell. In fact, all successful entrepreneurs are salesmen.” Selling is a highly underrated skill in life. Everyone can benefit from learning how to sell better since in addition to products and services people must sell ideas, causes and many other things in life. Salespeople tend to be highly compensated since the activity is (1) hard and (2) requires real skill. Sam Zell has gone as far as to say: “Nothing is bought and everything is sold.”

 

  1. “Business schools are beginning to change, but particularly in the ‘80s the business schools focused on if you could just turn the page there’s the formula that tells you how to do it. And the answer is there are no formulas and – and success and failure are – are a combination of judgment and an external event. But it starts and ends with a simple idea.”  “Don’t get confused by education: Simpler solutions are most often better solution!” Sam Zell is talking about a point made by Ben Horowitz in his book The Hard Things About Hard Things which I wrote a post about recently http://25iq.com/2015/07/05/a-dozen-things-ive-learned-from-ben-horowitz-about-management-investing-and-business/.  The real world of business cannot be navigated successfully simply by applying simple formulas or following a recipe for success. There is no substitute for things like learning from experience, good judgment and hard work in life.

 

  1. “Entrepreneurs basically not only see the opportunities, but also the solutions.” “A critical element to a successful entrepreneur- he or she thinks in themes, not in single events.”  “I don’t know too many insecure successful entrepreneurs.” “Fear and courage are very closely related. Anybody who does not understand fear does not know courage.” “Entrepreneurs don’t fail – things sometimes just don’t work out. But, that’s it.” “Entrepreneurs don’t just deal with risk, they have risk appetite. They look for change that will make the difference.” “An entrepreneur is a guy who thinks outside of the box, a person who does not accept the conventional. He constantly asks ‘what if?’, ‘could I?’, or ‘should I?’”  “There is a Confucian saying: ‘The definition of a schmuck is someone who reached his goal.’ Entrepreneurs always keep going – they never stop.   “It is lonely being an entrepreneur. Often, you turn around and ask: where is everybody?” This set of quotes makes an number of important points about being an entrepreneur including the idea that courage is a highly underappreciated driver of the success of entrepreneurs. If you don’t get in the game, you can’t win. Perhaps the best way to end this post is with a joke Sam Zell once told:  I’ll tell you a story that I think is probably the most significant advice that I give young entrepreneurs. A pious Jew is facing bankruptcy, and he beseeches God repeatedly each week to let him win the lottery to save his livelihood. The first week, he doesn’t win. The second week, he doesn’t win. But the third time, a flash of light appears, and from up high, comes a voice — and it’s the voice of God — and he says ‘You’ve got to buy a ticket!’”

 

Notes:

 

Rough Rider http://www.newyorker.com/magazine/2007/11/12/rough-rider

 

Entrepreneurship Talk http://innovateblue.umich.edu/memorable-quotes-from-sam-zells-entrepreneurship-talk-by-thomas-zurbuchen/

 

Kellog School http://kelloggschool.tumblr.com/post/77181962926/a-packed-auditorium-welcomed-equity-group

 

Bloomberg Interview http://genius.com/Sam-zell-2-5-2014-bloomberg-interview-annotated

 

Grave Dancer http://www.valuewalk.com/2015/06/grave-dancers-sam-zell/

 

Wharton: http://knowledge.wharton.upenn.edu/article/real-estate-developer-and-grave-dancer-sam-zell-its-all-about-supply-and-demand/

 

Interview: http://knowledge.ckgsb.edu.cn/2012/09/26/finance-and-investment/investment-guru-sam-zell-any-time-you-dont-sell-you-buy/

 

Forbes: http://www.forbes.com/sites/kerenblankfeld/2011/01/27/billionaire-sam-zells-advice-to-entrepreneurs/

 

Ackman and Zell: http://www.ibtimes.com/bill-ackman-and-sam-zell-turnarounds-opportunities-and-success-440096

 

A Dozen Things Charlie Munger has said about Reading

 

  1. “In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time – none, zero.”

 

  1. “You’d be amazed at how much Warren reads – at how much I read. My children laugh at me. They think I’m a book with a couple of legs sticking out.” 

 

  1. “As long as I have a book in my hand, I don’t feel like I’m wasting time.”

 

  1. “I’ve gotten paid a lot over the years for reading through the newspapers.”

 

  1. “I don’t think you can get to be a really good investor over a broad range without doing a massive amount of reading. I don’t think any one book will do it for you.”

 

  1. “For years I have read the morning paper and harrumphed. There’s a lot to harrumph about now.”

 

  1. “We read a lot.  I don’t know anyone who’s wise who doesn’t read a lot.  But that’s not enough: You have to have a temperament to grab ideas and do sensible things.  Most people don’t grab the right ideas or don’t know what to do with them.”    

 

  1. “By regularly reading business newspaper and magazines I am exposed to an enormous amount of material at the micro level.  I find that what I see going on there pretty much informs me about what’s happening at the macro level.”  

 

  1. “Warren and I do more reading and thinking and less doing than most people in business. We do that because we like that kind of a life. But we’ve turned that quirk into a positive outcome for ourselves. We both insist on a lot of time being available almost every day to just sit and think. That is very uncommon in American business. We read and think.”

 

  1. “If you get into the mental habit of relating what you’re reading to the basic structure of the underlying ideas being demonstrated, you gradually accumulate some wisdom.”

 

  1. “Develop into a lifelong self-learner through voracious reading; cultivate curiosity and strive to become a little wiser every day.”

 

  1. “I met the towering intellectuals in books, not in the classroom, which is natural. I can’t remember when I first read Ben Franklin. I had Thomas Jefferson over my bed at seven or eight. My family was into all that stuff, getting ahead through discipline, knowledge, and self-control.”

 

p.s., “Obviously the more hard lessons you can learn vicariously, instead of from your own terrible experiences, the better off you will be. I don’t know anyone who did it with great rapidity. Warren Buffett has become one hell of a lot better investor since the day I met him, and so have I. If we had been frozen at any given stage, with the knowledge we had, the record would have been much worse than it is. So the game is to keep learning.”

A Dozen Things I’ve Learned from Paul Tudor Jones About Investing and Trading

Paul Tudor Jones is the founder of the hedge fund Tudor Investment Corporation. The New York Times reported in March of 2014: Mr. Jones can “claim long-term annual returns of close to 19.5 percent in his $10.3 billion flagship fund, Tudor BVI Global.”

 

1. “Certain people have a greater proclivity for [macro trading] because they don’t have the need to feel intellectually superior to the crowd. It’s a personality thing. But a lot of it is environmental. Many of the successful macro guys today, they’re all kind of in my age range. They came from that period of crazy volatility, of the late ’70s and early ’80s, when the amount of fundamental information available on assets was so limited and the volatility so extreme that one had to be a technician. It’s very hard to find a pure fundamentalist who’s also a very successful macro trader because it is so hard to have a hit rate north of 50 percent. The exceptions are in trading the very front end of interest rate curves or in specializing in just a few commodities or assets.”

There are many ways to make a profit by trading and investing. For example, venture capitalists buy mispriced optionality and traders buy mispriced assets based on factors like momentum. Comparing value investing with what Paul Tudor Jones does for a living is interesting.  What could be more anti-Ben Graham and value investing than a statement like:  “We learned just to go with the chart. Why work when Mr. Market can do it for you?”

“While I spend a significant amount of my time on analytics and collecting fundamental information, at the end of the day, I am a slave to the tape and proud of it.”

Set out below are some statements by Paul Tudor Jones that reveal a bit about his trading style:

When I think of long/short business, to me there’s 5 ways to make money: 2 of those are you either play mean reversion, which is what a lot of long/short strategies do, or you can play momentum/trend, and that’s typically what I do.  We’ve seen cheap companies get cheaper many, many times.  If something’s going down, I want to be short it, and if something’s going up, I want to be long it.  The sweet spot is when you find something with a compelling valuation that is also just beginning to move up.  That’s every investor’s dream.”

 

“I love trading macro. If trading is like chess, then macro is like three-dimensional chess. It is just hard to find a great macro trader. When trading macro, you never have a complete information set or information edge the way analysts can have when trading individual securities. It’s a hell of a lot easier to get an information edge on one stock than it is on the S&P 500. When it comes to trading macro, you cannot rely solely on fundamentals; you have to be a tape reader, which is something of a lost art form. The inability to read a tape and spot trends is also why so many in the relative-value space who rely solely on fundamentals have been annihilated in the past decade. Markets have consistently experienced “100-year events” every five years. “

 

“These days, there are many more deep intellectuals in the business, and that, coupled with the explosion of information on the Internet, creates the illusion that there is an explanation for everything and that the primary task is simply to find that explanation. As a result, technical analysis is at the bottom of the study list for many of the younger generation, particularly since the skill often requires them to close their eyes and trust the price action. The pain of gain is just too overwhelming for all of us to bear!”

 

“I believe the very best money is made at the market turns. Everyone says you get killed trying to pick tops and bottoms and you make all your money by playing the trend in the middle. Well for twelve years I have been missing the meat in the middle but I have made a lot of money at tops and bottoms.”

 

“One principle for sure would be: get out of anything that falls below the 200-day moving average.”

 

“I teach an undergrad class at the University of Virginia, and I tell my students, “I’m going to save you from going to business school.  Here, you’re getting a $100k class, and I’m going to give it to you in two thoughts, okay?  You don’t need to go to business school; you’ve only got to remember two things.  The first is, you always want to be with whatever the predominant trend is. My metric for everything I look at is the 200-day moving average of closing prices.  I’ve seen too many things go to zero, stocks and commodities.  The whole trick in investing is: “How do I keep from losing everything?”  If you use the 200-day moving average rule, then you get out.  You play defense, and you get out.”

 

“It’s just the nature of a rip-roaring bull market. Fundamentals might be good for the first third or first 50 or 60 percent of a move, but the last third of a great bull market is typically a blow-off, whereas the mania runs wild and prices go parabolic.” 

 

My takeaway: Paul Tudor Jones is timing non-rational human behavior based primarily on his pattern recognition skills. He does things like “spend an entire day watching a projection of his hedge fund’s positions blinking as they change.” What he does is interesting, but I am not interested in trying to replicate it myself. It does not suit my temperament, interests or skills. In other words, I am temperamentally unsuited to adopt his trading approach. I would rather drop a 100 pound stone on my toe than to watch blinking lights on a screen for a living. I put what Paul Tudor Jones does in what Charlie Munger might call the “not interested” pile. Would I put money in a hedge fund Paul Tudor Jones ran?  That is a moot question since he has no need or desire to raise money from people like me just as David Tepper would not invest money for me if I asked him. Would I invest with someone else who said he or she would replicate what they do? I doubt it, and certainly not anyone I know of right now. Whether I would invest in a tweaked index fund that considered a factor like momentum is a different question. I have not done this so far and it would certainly depend on the fees charged by the manager. Outperformance that is less than the manager’s fees is not interesting to me.

Understanding a factor like momentum is a big part of what Paul Tudor Jones does. Ben Carlson gives an excellent summary of the momentum approach to trading here which reads in part:

“The momentum factor is based on buy high, sell higher or alternatively, cut your losses and let your winners run. Value investing is based on a long-term reversion to the mean. Momentum investing is based on that gap in time that exists before mean reversion occurs. Value is a long game, while momentum is usually seen in the short- to intermediate-term… And it is a terrible idea to chase performance if you don’t know what you’re doing or why you’re doing it. Momentum is chasing performance, but in a systematic way, with an entry and exit strategy in place. Momentum tries to take advantage of performance chasers who are making emotional decisions. This is why the best momentum investors use a rules-based approach, to avoid those emotions.”

It is worth noting that momentum has been on a favorable roll lately. That does not mean the performance of momentum as a strategy will continue, but that momentum can work to outperform the market is a fact.

Despite his unique system, Paul Tudor Jones shares many approaches and methods with other great investors who have adopted different systems. I describe some of these commonalities below.

 

2. “I am always thinking about losing money as opposed to making money.”

“Don’t focus on making money; focus on protecting what you have.” 

“At the end of the day, the most important thing is how good are you at risk control.”

“Where you want to be is always in control, never wishing, always trading, and always, first and foremost protecting your butt.”

“I look for opportunities with tremendously skewed reward-risk opportunities. Don’t ever let them get into your pocket – that means there’s no reason to leverage substantially. There’s no reason to take substantial amounts of financial risk ever, because you should always be able to find something where you can skew the reward risk relationship so greatly in your favor that you can take a variety of small investments with great reward risk opportunities that should give you minimum draw down pain and maximum upside opportunities.”

“[I’m looking for] 5:1 (risk /reward).  Five to one means I’m risking one dollar to make five.  What five to one does is allow you to have a hit ratio of 20%.  I can actually be a complete imbecile. I can be wrong 80% of the time, and I’m still not going to lose.”

The focus of great investors on not losing money is universal. Warren Buffett says the same thing, as do Seth Klarman and Howard Marks. This desire not to lose money is another way of saying that great investors and traders want to find bets with a lot more upside than downside. In other words, they are looking for asymmetry of potential outcomes: big upside and small downside. That’s optionality. They want to find bets that are very substantially in their favor. Great investors and traders are not gamblers since they seek positive expected value when making a bet.

 

3. “If you have a losing position that is making you uncomfortable, the solution is very simple: Get out, because you can always get back in. There is nothing better than a fresh start.”

Only bet when the odds are substantially in your favor. Don’t bet unless you have a margin of safety. If you are not feeling certain and comfortable with your bet, then don’t bet. Put differently by Charlie Munger: “the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time they don’t. It is just that simple.”

 

4. “I think one of my strengths is that I view anything that has happened up to the present point in time as history. I really don’t care about the mistake I made three seconds ago in the market. What I care about is what I am going to do from the next moment on. I try to avoid any emotional attachment to a market.”

Treating past decisions as sunk and looking at each position on that basis is a great skill for an investor to have. Researchers put it this way: “People have trouble cutting their losses: They hold on to losing stocks too long, they stay in bad relationships, and they continue to eat large restaurant meals even when they’re full. This behavior, often described as ‘throwing good money after bad’, is driven by what behavioral scientists call the ‘sunk-cost bias’” What has been spent is spent. Once it is gone it is gone.

 

5. “By watching [my first boss and mentor] Eli [Tullis], I learned that even though markets look their very best when they are setting new highs, that is often the best time to sell. He instilled to me the idea that, to some extent, to be a good trader, you have to be a contrarian.”

That you can’t perform the market if you are doing just the same things as the market is a mathematical fact. You must sometimes be a contrarian and sometimes be right about that view in a way that makes the magnitude of what you do right outperform the crowd.  Paul Tudor Jones said once: “I also said that my contrarian trading was based on the fact that the markets move sideways about 85 percent of the time. But markets trend 15 percent of the time and you need to follow the trend during those times.” How he does this is a mystery to me. It’s pattern recognition, but what’s the pattern?

 

6. “[Eli] was the largest cotton speculator in the world when I went to work for him, and he was a magnificent trader. In my early 20s, I got to watch his financial ups and downs and how he dealt with them. His fortitude and temperament in the face of great adversity were great examples of how to remain cool under fire. I’ll never forget the day the New Orleans Junior League board came to visit him during lunch. He was getting absolutely massacred in the cotton market that day, but he charmed those little old ladies like he was a movie star. It put everything in perspective for me.”

“I want the guy who is not giving to panic, who is not going to be overly emotionally involved, but who is going to hurt when he loses. When he wins, he’s going to have quiet confidence. But when he loses, he’s gotta hurt.”

Having control over your emotions is a very valuable thing since most mistakes are emotional or psychological. I believe this anecdote is making the point that people who can keep emotions and actions in spate buckets have a big advantage. Self-control and self-awareness are very valuable.

 

7. “My guiding philosophy is playing great defense. If you make a good trade, don’t think it is because you have some uncanny foresight. Always maintain your sense of confidence, but keep it in check.”

“Don’t be a hero. Don’t have an ego. Always question yourself and your ability. Don’t ever feel that you are very good. The second you do, you are dead.”

This is a series of statements about the dangers of hubris. Oscar Lavant put it this way: “What the world needs is more geniuses with humility; there are so few of us left.” The best investors and traders are humble. They know they have made, and will continue to make, some mistakes.

 

8. “I got out of the brokerage business because I felt there was a gross conflict of interest: If you are charging a client commissions and he loses money, you aren’t penalized. I went into the money management business because if I lost money, I wanted to be able to say that I had not gotten compensated for it. In fact, it would probably cost me a bundle because I have an overhead that would knock out the Bronx Zoo. I never apologize to anybody, because I don’t get paid unless I win.”

This is a quote about having “skin in the game.” Advisors with skin in the game perform better and are more accountable. What is good for the advisor or manager is good for you which lowers conflicts of interest. Aligned incentives are a very good thing, not just in investing but in life generally.  The more aligned interests are the more you can base a relationship on trust. The more trust that exists the fewer resources need to be devoted to compliance. The optimal outcome is what Charlie Munger calls “a seamless web of deserved trust.”

 

9. “This skill is not something that they teach in business school.”

That Paul Tudor Jones can do it does not mean that you can do it: “I get very nervous about the retail investor, the average investor, because it’s really, really hard.  If this was easy, if there was one formula, one way to do it, we’d all be zillionaires.” The danger of writing something like this blog post is that many knuckleheads will surely say “Oh, I can be just like Paul Tudor Jones.” No, the chances of that being true are vanishingly small. There is only one Paul Tudor Jones. You are not Paul Tudor Jones. But his record exists. It can’t be ignored.

 

10. “I’ve done really well on the short side.  There’s nothing more exciting than a bear market.  But it’s not a wonderful way for long-term health and happiness.”

“I spent 20 years doing it, it’s not the right way to make a living trading.  It’s simply not.”

Shorting stocks has negative optionality. Mohnish Pabrai says:  “When you are long on a stock, as it goes down in price, the position is going against you and it becomes a smaller portion of your portfolio. In shorting, it is the other way around: if the short goes against you, it is going to become a larger position of your portfolio. When you short a stock, your loss potential is infinite; the maximum you can gain is double your value. So why will you take a bet where the maximum upside is a double and the maximum downside bankruptcy?” Warren Buffett points out: “You’ll see way more stocks that are dramatically overvalued than dramatically undervalued. It’s common for promoters to cause a stock to become valued at 5-10 times its true value, but rare to find a stock trading at 10-20% of its true value. So you might think short selling is easy, but it’s not. Often stocks are overvalued because there is a promoter or a crook behind it. They can often bootstrap into value by using the shares of their overvalued stock. For example, it it’s worth $10 and is trading at $100, they might be able to build value to $50. Then, Wall Street says, “Hey! Look at all that value creation!” and the game goes on. [As a short seller,] you could run out of money before the promoter runs out of ideas.”

 

11. “The single most important things that you can do is diversify your portfolio.  Diversification is key, playing defense is key, and, again, just staying in the game for as long as you can.”

It may seem odd that what some people call a gut trader like Paul Tudor Jones is focused on diversification.  What he and other investors are saying is that if you don’t play defense and you lose, you are out of the game. They know that you can’t win unless you remain in the game.  Diversification also allows you to “practice patience.” Paul Tudor Jones said on one occasion “if you don’t see anything, don’t trade.” He adds: “there’s no reason to leverage substantially. There’s no reason to take substantial amounts of financial risk ever, because you should always be able to find something where you can skew the reward risk relationship so greatly in your favor that you can take a variety of small investments with great reward risk opportunities that should give you minimum draw down pain and maximum upside opportunities.”

 

12. “The secret to being successful from a trading perspective is to have an indefatigable and an undying and unquenchable thirst for information and knowledge.”

Paul Tudor Jones may be a momentum trader but he is also an investor who looks at fundamentals.  You can’t find mispriced assets unless you have an investing edge and that edge can come from better information and knowledge.

 

 

Notes:

Market Wizards:  http://www.amazon.com/Market-Wizards-Interviews-Weinstein-High-Percentage/dp/1592802761

 

Buckley School Graduation Speech: http://dealbreaker.com/2009/06/paul-tudor-jones-gets-ridiculously-real-with-ninth-graders/

 

WSJ interview: http://turtletrader.com/paul-tudor-jones-interview/

 

Notes on a talk at UVA: http://www.marketfolly.com/2013/06/notes-from-virginia-investment.html#ixzz3dotoQ7Bn

 

Meb Faber: http://mebfaber.com/2014/11/06/paul-tudor-jones-on-the-200-day-moving-average/

 

Ivanhoff:  http://ivanhoff.com/2012/12/09/13-insights-from-paul-tudor-jones/

 

A Dozen Things I’ve Learned from Sam Altman about Venture Capital, Startups and Business

Sam Altman is the president of Y Combinator. He was also the cofounder of Loopt, a location-based social networking app. Altman studied computer science at Stanford University.

1. “The best companies are almost always mission oriented.”

“Eventually, the company needs to evolve to become a mission that everyone, but especially the founders, are exceptionally dedicated to. The ‘missionaries vs. mercenaries’ soundbite is overused but true.”

If the founders of a startup are not passionate about solving a customer problem which they care deeply about, the odds are small that they will be able to successfully create a business generating financial returns that are attractive to a venture capitalist.  I am not talking about launching a new business like a car wash or a pizza restaurant but rather a startup that might be attractive to a venture capitalist. Creating a scalable, repeatable and defensible business that generates hyper growth and a large profitable business is a rare event. The best way to create passion in a founding team is to create a mission-driven culture within the business. Venture capitalists love founders with passion because missionaries endure in situations where mercenaries often quit.

 

2. “In general, it’s best if you’re building something that you yourself need. You’ll understand it better than if you have to understand it by talking to a customer.”

Passion and a mission are more likely to exist if the business is proving solutions that the founders want for themselves. Deep understanding of a customer problem and potential solutions is rather obviously fostered if the founders are themselves potential customers for the solution. Not only is this more efficient and cost effective, but there is less likely to be communications “path loss” between the potential customers who have the problem and the business trying to solve that problem. Yes, it is helpful to have “beginners mind” about potential new solutions. No, having relevant domain expertise is not necessarily a handicap.

 

3. “You want an idea that not many other people are working on, and it’s okay if it doesn’t sound big at first.”

“The truly good ideas don’t sound like they’re worth stealing.”

“You want to sound crazy, but you want to actually be right.” 

“We are the most successful when we fund things that other people don’t yet think are going to be a really big deal but two years later become a big deal. And it’s really hard to predict that.”

“A lot of the best ideas seem silly or bad initially—you want an idea at the intersection of ‘seems like bad idea’ and ‘is a good idea’.”

Both a founder of a startup and a venture capitalist are trying to find mispriced optionality.  The probability of finding opportunity that is mispriced is far greater if the startup is not working on the same problem as many other businesses. In other words, less competition with other businesses seeking mispriced optionality in a given area of business is a valuable thing. Ideas that are “half-crazy” are far more likely to reflect mispricing since most businesses love the safety of conventional wisdom. Big companies in particular tend to be afraid of half-crazy ideas and tend to overinvest in ideas that are at the peak of a hype cycle. There were a few people who recently concluded that since some VCs passed on investing in Airbnb that the process of picking startups to invest in is random. This is probably incorrect due to the power laws that exist in VC and the persistent outperformance of the top VC firms over decades.

The nature of VC involves optionality, which requires failure to work. Again, some degree of failure is essential to optionality, especially mispriced optionality.  No one, even the very best VCs can predict which of  ~30 startups will be the one or two unicorns. The job of the VC is to pick the best unicorn candidates knowing full well that most startups will fail. Many startups that look half-crazy and may for that reason possess the necessary optionality are crazy or too early. Which of the best will be a unicorn, if any, is sorted out over time. My posts on optionality and venture capital go into greater depth on this topic.

 

4. “No growth hack, brilliant marketing idea, or sales team can save you long term if you don’t have a sufficiently good product.”

“Make something people want.  You can screw up most other things if you get this right; if you don’t, nothing else will save you.”

“All companies that grow really big do so in only one way: people recommend the product or service to other people. What this means is that if you want to be a great company someday, you have to eventually build something so good that people will recommend it to their friends–in fact, so good that they want to be the first one to recommend it to their friends.”

“Figure out a way to get users at scale (i.e. bite the bullet and learn how sales and marketing work).  Incidentally, while it is currently in fashion, spending more than the lifetime value of your users to acquire them is not an acceptable strategy. Obsess about your growth rate, and never stop. The company will build what the CEO measures.  If you ever catch yourself saying ‘we’re not really focused on growth right now’, think very carefully about the possibility you’re focused on the wrong thing.  Also, don’t let yourself be deceived by vanity metrics.”

There is no substitute for solving a real customer problem.  Bill Campbell doesn’t mince words about the importance of the right product: “If you don’t have the right product and you don’t time it right… you are going to fail.” Without a valuable customer value proposition the customer acquisition cost (CAC) of the sales-driven effort will inevitably be fatal. Companies that don’t deliver compelling value end up having to pay too much to acquire customers. Paying too much to acquire customers is not a solvable problem since churn, COGs, ARPU and a cost of money can all kill any chance you have of creating shareholder value. Bill Campbell also says: “When I work with startups, the last thing I work with them on is marketing. I don’t want to overestimate marketing. Apple’s marketing is having great products.”

 

5. “It’s worth some real up front time to think through the long term value and the defensibility of the business.”

“Have a strategy.  Most people don’t.  Occasionally take a little bit of time to think about how you’re executing against your strategy.”

Every business must find at least one barrier-to-entry (a moat) to generate a profit. Moats can take many forms and must constantly be refreshed since they are always under attack by competitors. Without a moat of some kind, competitors will increase supply of the offering to a point where financial return is equal to the opportunity cost of capital. It is worth repeating this point: competitors increasing the supply of what you sell kills value for you. Without some limit on supply you will not earn an economic profit. On moats, read Michael Porter. Porter teaches:  “if customers have all the power, and if rivalry is based on price… you won’t be very profitable.”

 

6. “Every company has a rocky beginning.”

“You have to have an almost crazy level of dedication to your company to succeed.”

The process of creating and managing a business will never go completely according to plan. There is no manual you can follow that will create business success. There are no fool proof recipes and formulas that founders and CEOs can follow. For these reasons it is the ability of the Founders, the CEO and the team to make wise decisions given an uncertain future that will determine success. Courage, perseverance and determination will be needed to produce positive outcomes. My blog post on VC Ben Horowitz that will dig more deeply into this set of issues.

 

7. “If you’re not an optimist, you make a very bad venture capitalist.”

Great entrepreneurs and venture capitalists are supernaturally optimistic despite the fact that most of what they do will result in financial failure as measured by frequency of success. What matters in the world of startups and venture capital is not frequency of success but rather magnitude of success.  Even one unicorn in a lifetime of starting companies investing can justify the efforts and struggles of a founder. Maintaining an optimistic attitude in the face of uncertainty and repeated failure is a challenge. Which reminds me of a joke. An optimist entrepreneur and a pessimist entrepreneur were sitting in a café talking. The pessimist turns to the optimist and says: “Things can’t possibly get worse. The optimist replies: ‘Sure they can!”

 

8. “Great execution is at least 10 times more important and 100 times harder than a good idea.”

“Remember that you are more likely to die because you execute badly than get crushed by a competitor.”

While having the great idea should be the starting point in any business, that idea will result in little or nothing if great business execution is missing. Watching a great team execute under the leadership of someone like Jim Barksdale or John Stanton is a valuable experience. Trains running on time is a beautiful things to see. Ralph Waldo Emerson pointed out the obvious when he said: “Good thoughts are no better than good dreams, unless they be executed.” After all “However beautiful the strategy, you should occasionally look at the results” (Sir Winston Churchill).  Mark Twain famously expressed a similar view: “There are basically two types of people. People who accomplish things, and people who claim to have accomplished things. The first group is less crowded.”

 

9. “Stay focused and don’t try to do too many things at once.” 

“Eliminate distractions.”

“The hard part of running a business is that there are a hundred things that you could be doing and only five of those actually matter and only one of them matters more than all of the rest of them combined. So figuring out there is a critical path thing to focus on and ignoring everything else is really important.”

Any business, but especially startups, will face many challenges and much uncertainty. There will always be more things that could possibly be done than people and resources to do them.  Great founders and entrepreneurs know the difference between what could be done and should be done. Setting priorities and staying focused is critical. Jim Barksdale put it this way:  “The main thing is to keep the main thing, the main thing.”

 

10. “At the beginning, you should only hire when you have a desperate need to.”

“Later, you should learn to hire fast and scale up the company, but in the early days the goal should be not to hire.”

“Hiring is the most important thing you do; spend at least a third of your time on it.”

When a business is just getting started, small teams are very efficient and translate to cash burn rates that can be kept relatively low until key milestones are achieved.  Low cash burn rates allow the business more time to build something that customers really love. If the cash burn rate of the startup is high, a business is under pressure to commit to an idea and doing that prematurely is often fatal.

When the time comes to scale the business recruiting becomes a huge priority. Great founders spend far more time recruiting than people imagine. As Keith Rabois says: “The team you build is the company you build.”

 

11. “One thing that founders always underestimate is how hard it is to recruit.”

“You think you have this great idea that everyone’s going to come join, but that’s not how it works.”

“A great team and a great market are both critically important—you have to have both.  The debate about which is more important is silly.”

“Don’t let your company be run by a sales guy.  But do learn how to sell your product.”

Experienced venture capitalists are looking for evidence that founders have strong sales skills. One early test of a founder’s sales skill is when they make a fundraising pitch. The idea is simple: If the founders can’t sell the idea to a venture capitalist, how are they going to be able to recruit great people, sell the product, and find great distribution?  The ability to sell the offering to investors, sell the potential of the business to employees and sell products to customers is core to any business. If you don’t like to sell these things starting a business is probably not the right path for you.

 

12. “Keep an eye on cash in the bank and don’t run out of it.”

“Do reference checks on your potential investors. Ask other founders how they are when everything goes wrong.”

“Good investors are worth a reasonable premium. Go for a few highly involved investors over a lot of lightly engaged ones.”

If the founders have a great idea and a strong team, money is not the scarce ingredient in creating a successful business. What is scarce is value-added capital (investors who supply the business with more than money). Even scarcer is value-added capital that will be a big help when things are going wrong (which is inevitable as noted above). The last thing founders need are fair weather investors. Taking the time to research potential investors is wise since the relationship will last for many years. Among the questions that should be asked:  What are the investors like when things don’t go according to plan? Are they fun to work with? Do the investors pitch in to help on things like recruiting when asked? Taking a higher valuation from an investor who is a known jerk is unwise. Why would you ever want to do that?  Life is short. Happiness and having fun are underrated.

 

Notes:

How to Start a Startup – Lecture 1

blog.SamAltman.com – The Only Way to Grow Huge

 

SVBJ Interview – Founder Lessons

Esquire Interview

 

blog.SamAltman.com – Startup Advice

Medium – What You Need to Know about Hiring

 

blog.SamAltman.com – The Days are Long but the Decades are Short

blog.SamAltman.com – Startup Advice Briefly

Techcrunch Interview – Elements of a Successful Startup

A Dozen Things I’ve Learned from Ben Horowitz about Management, Investing and Business

Ben Horowitz is a co-founder of the venture capital firm Andreessen Horowitz.  Prior to being a venture capitalist,  he co-founded Loudcloud, a managed services provider which became Opsware, a data center automation software provider.  He is the author of The Hard Thing About Hard Things: Building a Business When There Are No Easy Answers.  Horowitz earned a BA in Computer Science from Columbia University in 1988 and a MS in Computer Science from UCLA in 1990. On his blog Ben suggests that if you want to learn more about him you read his entry in Wikipedia.

 

1. “You read these management books that say ‘these are the hard things about running a company’. But those aren’t really the hard things.”

“My old boss Jim Barksdale said that most management consultants have never managed a hot dog stand.” 

“Wartime CEO is too busy fighting the enemy to read management books written by consultants who have never managed a fruit stand.”

“When I was a CEO, the books on management that I read weren’t very much help after the first few months on the job. They were all designed to give you directions on how not to screw up your company. But it doesn’t take long before you get beyond that and you’re like OK I’ve screwed up my company; now what do I do? Most books on management are written by management consultants, and they study successful companies after they’ve succeeded, so they only hear winning stories.” 

People who write about management tend to follow a formula that Michael Mauboussin has described: “The most common method for teaching business management is to find successful businesses, identify their common practices, and recommend that managers imitate them.…This formula is intuitive, includes some compelling narrative, and has sold millions of books. [The reality is that]  attributing a firm’s success to a specific strategy may be wrong if you sample only the winners.…When luck plays a part in determining the consequences of your actions—as is often the case in business—you don’t want to study success to identify good strategy but rather study strategy to see whether it consistently led to success.” Ben Horowitz decided to write a different sort of book that rejects the approach described by Michael Mauboussin in favor of a reality-based approach. He decided to write about what he calls “the Struggle” which is “basically what you feel like when your world is caving in.”

Ben Horowitz adds to the point made by Michael Mauboussin by saying, you can do things recommended by these books like setting a “big, hairy, audacious goal” and still have the business flounder. What do you do then? Running a business isn’t the equivalent of a well-planned garden party. As my late friend Keith Grinstein told me years ago, once a business gets beyond the planning stage: “stuff breaks.” Things will go haywire at unexpected times and places. And when that happens, having great managers who have the ability and willingness to adapt pays big dividends.

 

 

2. “Management turns out to be really dynamic and situational and personal and emotional. So it’s pretty hard to write a formula or instruction book on it.”

“There isn’t one lesson that solves everything.”

“Any advice you give is based on your [experience]; it’s not general advice. People try to generalize it — and I try to generalize it, too — but without knowing where it comes from it’s not nearly as useful.”

“Nobody is born knowing how to be a CEO. It’s a learned skill and unfortunately you learn it on the job.”

“The only thing that prepares you to run a company, is running a company.”

When a CEO is engaged in the Struggle there are no formulas to follow. Being a CEO is like being an investor in that experience can’t be simulated. In both cases you learn by doing, just as everyone else who has come before you.

Having said that, just because the skills required to be a successful CEO must be learned on the job doesn’t mean that you can’t learn something by observing another CEO.  For example, Ben Horowitz had the opportunity while working at Netscape to observe Jim Barksdale who many people I know feel is one of the best CEOs of all time. Ben has identified Bill Campbell and Ken Coleman as having been his mentors. There are no formulas to follow in being a CEO, but you can still learn things like the types of decisions that a CEO must make to be a success by looking as what other CEOs have done. For example, one conclusion I have reached over several decades of working with different CEOs is that the best CEOs are not cut from the same mold. Each CEO I have encountered in my life has had different strengths and weaknesses, but the really great CEOs all know how to surround themselves with people who complement their weaknesses.  I have no way of knowing whether the strong supporting cast surrounding the CEO in any given case arrived mostly due to luck. But without exception they all had a great supporting team around them. As another example, some CEOs use profanity and some don’t,  some yell sometimes and some don’t, but all of them are effective communicators in their own way.

 

 

3. “In reality companies are what they are and nobody has ever worked anywhere where everything is perfect. And so pretending that things are perfect isn’t actually very effective.”

“I don’t know that I’m drawn to conflict; you don’t necessarily in these businesses want conflict with other companies, though you get it a fair amount. But, and this is one of the best management pieces of advice I ever got from Marc Andreessen: he was quoting Lenin, who was quoting Karl Marx, who said: ‘sharpen the contradictions.’ Marx was talking about labor and capital, which is not generally what you’re talking about when you’re running a company. But the conflict is where the truth is. And so when there’s a conflict in the organization, you do not want to smooth it over. You want to sharpen the contradictions, heat up both opinions, and resolve it. Good CEOs are really good at doing that. And it’s miserable to work for someone who tries to smooth things over.” 

The key words in this set of quotes from Ben Horowitz are “conflict is where the truth is.” Every business and almost everything in life is not perfect.  Identifying the things that should be changed to improve a business is fostered if you identify conflict and work to resolve it. Hiding conflict causes problems to fester and grow. Here’s Ben again: “You do not want to smooth over conflicts. You want the conflicts to surface and you want to resolve them. If you don’t, you have got problems. If you do surface and resolve them you will be a pretty good manager.”

 

 

4. “When a company goes astray, you talk to employees and they say, ‘We have no strategy. We don’t know where we’re going.’ The strategy is the story. They’re not different. The strategy is the story you tell. It’s the why. If you can’t tell that in a massively compelling way, who’s going to follow you? That’s what makes people get up in the morning and do stuff.”

“The story must explain at a fundamental level why you exist. Why does the world need your company? Why do we need to be doing what we’re doing and why is it important?”

“You can have a great product, but a compelling story puts the company into motion. If you don’t have a great story it’s hard to get people motivated to join you, to work on the product, and to get people to invest in the product.”

“The mistake people make is thinking the story is just about marketing. No, the story is the strategy. If you make your story better you make the strategy better.”

“Storytelling is the most underrated skill.”

In Ben’s view the CEO and founders must own the story of the business.  It is their responsibility to keep it up to date and compelling. The CEO and founder’s task is made easier by the fact that humans love a good story. Because they often have trouble understanding or remembering ideas and instructions, stories help people stay on track and motivated. It is important to emphasize that Ben Horowitz is making a point here about strategy, which as Michael Porter points out, is driven by what a company does differently than its competitors. The story must convey what the business does that is uniquely valuable and how that will create a sustainable competitive advantage (a moat).

As an example of the importance of a story, I had a conversation recently with a person who is a venture capitalist and owns a winery. We agreed that when talking about an industry in which the story is key to the product, wine should be font and center.  The terrain, the grapes, the winemaker etc. are all about story telling. Many people seem to enjoy the story of the wine more than the wine itself, or at least the former drives the latter. The food television personality Andrew Zimmern said once: “Food tastes good. Food with a story tastes better.” Of course, that is mostly a statement about marketing. Ben Horowitz believes that the story should drive the strategy. For example, how will the wine business run their business in a unique ways that creates a moat? How can it create sustainable differentiation in what is a very competitive industry? What can be done to create barriers to entry in the part of the market the winery has decided to serve?

 

 

5. “Thinking for yourself …the distinguishing characteristic of the great entrepreneurs.”

“The trouble with innovation is that truly innovative ideas often look like bad ideas at the time.”

“Innovation is almost insane by definition: most people view any truly innovative idea as stupid, because if it was a good idea, somebody would have already done it. So, the innovator is guaranteed to have more natural initial detractors than followers.” 

Founders who deliver great new value to the world think differently. That value comes from believing or recognizing something as true that other people do not see. The founders are inevitably breaking one important assumption that others have made. AirBnB is a classic example of founders thinking differently. Ben’s partner Marc Andreessen said once that the conventional wisdom about AirBnB was to ask things like: “People staying in each other’s houses without there being a lot of axe murders?” Great founders and CEOs don’t outperform the market by following the crowd. As is the case with investing, it is mathematically impossible to follow the crowd and perform better than the crowd.

No one puts it better than Howard Marks:  “To achieve superior investment results, your insight into value has to be superior. Thus you must learn things others don’t, see things differently or do a better job of analyzing them – ideally all three.” Not only must the founder and CEO occasionally be contrarian, but they must be sufficiently right about a contrarian view in a way that drives outperformance. In measuring outperformance it is magnitude of success and not frequency of success that matters. The best way to be a successful contrarian is, as Ben Horowitz points out, to think for yourself. Being a contrarian by definition means that you must be prepared to sometimes be lonely with respect to some of your views. Thinking differently separates you from the warmth of the crowd.

 

 

6. “People say that the CEO should be ‘the best salesman at the company’ or the ‘product visionary’ or all these things. No. The CEO is the CEO. They’ve got to deliver very quality decisions at a very high rate of speed. And if they don’t make a decision, the company freezes up.  In order to do that, you need to be talking to everybody. You need to figure out what’s going on with your finance people, and your engineering people. Because by the time this s–t comes to you, you won’t have time to do that. You won’t have time to make your decision.”

The ability of a person to make timely and wise decisions is the mark of a great CEO.  As an analogy, the best defensive baseball players are standing there waiting for the ball when it arrives. They are already in great position before the ball is hit. Great business decision makers similarly are ready to make decisions when the time comes because they have done the necessary preparation. That preparation allows them to make timely and more accurate decisions. Charlie Munger talks about this same idea in investing.  Most of the time Charlie Munger is reading and thinking. He is getting ready to act quickly and aggressively when the time comes. It looks like nothing is happening but the reality is that Munger is working hard to be ready when the right time arrives. When Charlie Munger makes an investment he has been preparing to make that investment for a long time. He knows the business and the market. Great managers are prepared and ready to act, standing in just the right place when the equivalent of the baseball drops into their glove.

 

 

7. “Sometimes an organization doesn’t need a solution; it just needs clarity.” 

“Often any decision, even the wrong decision, is better than no decision.”

Not making decisions is, of course, making a decision – as is not making a decisions quickly and decisively. Too often the answer executives provide a company when faced with a decision is like the old joke about the psychiatrist who asks his patient if he has trouble making decisions? The patient says, “Well, doctor, yes and no.”

I have a friend who is a venture capitalist and one day, during a press interview in his office he was asked by a journalist, “What is the secret of your success?” He said, “Two words.” “And, what are they?” asked the journalist. “Right decisions.” “But how do you make right decisions?” asked the journalist. “One word,” he responded. “And, what is that? Asked the journalist” “Experience.” “And how do you get experience?” “Two words.” “And, what are they?” “Wrong decisions.”

A related common problem is that sometimes, when we are presented with several options, they may blind us to other choices — including the simplest and most sensible one.  During a visit to a psychiatric hospital, a visitor asked the doctor how they determine whether or not a patient should be institutionalized. “Well,” said the doctor, “We fill up a bathtub, then we offer a teaspoon, a teacup and a bucket to the patient, and ask them to empty the bathtub.” “I see,” said the visitor. “A normal person would use the bucket because it is bigger than the spoon or the teacup.” “No,” said the doctor, “a normal person would pull out the plug. Do you want a bed near the window?”

 

 

8. “The primary thing that any technology startup must do is build a product that’s at least ten times better at doing something than the current prevailing way of doing that thing. Two or three times better will not be good enough to get people to switch to the new thing fast enough or in large enough volume to matter.”

“If you don’t have winning product, it doesn’t matter how well your company is managed, you are done.”

The essence of business is to cost-effectively acquire a customer. The greater the value delivered by the business, the less time and money that will be required to sell the product or service. Given that humans suffer from inertia, it takes a compelling value to get people to switch to a new product or service. If you pay too much for sales and marketing to acquire that customer you can quickly (or slowly) go broke. In a customer lifetime value model too much acquisition costs can be fatal. Sam Altman puts its simply: “Be suspect about buying users.” The better approach is to have customers who are attracted by a better product or service.

 

 

9. “Figuring out the right product is the innovator’s job, not the customer’s job. The customer only knows what she thinks she wants based on her experience with the current product. The innovator can take into account everything that’s possible, often going against what she knows to be true. This requires a combination of knowledge, skill, and courage.”

The famous relevant Steve Jobs quote is, of course: “It’s really hard to design products by focus groups. A lot of times, people don’t know what they want until you show it to them.” If something is going to be 10x better the product or service is going to need to be different than what the customer has seen before. A “me too” product or service is not going to move the needle for a startup.

 

10. “There are only two priorities for a start-up: Winning the market and not running out of cash. Running lean is not an end.”

“The only mistake you cannot make is running out of cash.”

Several times in this blog series I have quoted Harold Geneen as having said: “The only unforgivable sin in business is to run out of cash” but it is such an important point that it is worth repeating. Earnings are an opinion. Cash is a fact. Should a business spend every penny wisely? Absolutely. But don’t run of out of cash.  Is equity dilution something to be avoided? Sure. But don’t run out of cash. Can too much cash cause a business to solve problems with money rather then culture? Yep, but don’t run out of cash.  Can innovation be greater when a company has less capital on hand? Yes, but don’t run out of cash. Oh, and did I mention: don’t run out of cash. Horowitz and A16Z have a helpful guide to raising funds here.

 

 

11.  “What do you get when you cross a herd of sheep with a herd of lemmings? A herd of venture capitalists.”

“The most important rule of raising money privately: Look for a market of one. You only need one investor to say yes, so it’s best to ignore the other thirty who say ‘no.’”

The best venture capitalists think for themselves just like the best CEOs think for themselves. Anyone who is paying attention knows that venture capital is a cyclical business. This results for the same reason as economic cycles happen: people do not make decisions independently. Venture capitalists who do think independently generate better financial returns.  For example, the best venture capitalists have left social media focused startups when the hype cycle hits its peak but then may circle back once the poseurs are gone. Bargains are most often found where others are not looking, particularly when it comes to the optionality that drives venture capital returns.

Founders who are raising money must keep in mind that venture capital firms commit errors of omission all the time. Many venture capitalists passed on Uber and AirBnB and other big financial successes. That they pass on your pitch does not mean you will not find success with another firm. No one knows for sure which investments will succeed. Raising money requires that you have a thick skin. People who successfully raise money never give up. A great example of this from Ben’s own life was the so-called “IPO from Hell” when LoudCloud raised funds in a market that many believed was dead. The Wall Street Journal noted that on March 8, 2001 LoudCloud had “just completed a backbreaking, initial public offering road show that landed (Horowitz) in 70 meetings in 16 days with moneymen scattered across North America and Europe.” They may have been the last tech IPO out the door in that cycle but they got it done and that was what mattered.

Ben and Marc also raised funds for their first a16z fund in 2009 – which was not an easy time to raise money. A journalist wrote about that time period: “in a market where LPs are fastidiously avoiding new VC fund commitments, I’m a bit amazed that LPs would consider placing a $250 million bet on a first-time fund with this type of profile.”

 

 

12. “All the returns in venture capital go to a tiny number of firms and the same firms every year….this is not true in mutual funds or hedge funds or anything else. You don’t have persistent returns across decades.”

I have raised this topic in several of my posts including on Marc Andreessen and Fred Wilson. Some people go as far as to say that venture capital can’t really be an asset class if the difference between the top 10 venture capital firms and the bottom quartile of venture capital firms reflects a power law (the argument is that the difference in financial returns is too great to group them together; considering a16z, Benchmark, Sequoia etc. with firms in the bottom quartile of venture capital performance is apples and oranges). What this means as a practical matter for a founder is that whether you are able to raise funds from one of those firms will have a great deal to do with whether you are successful. Why? Path dependence. Potential employees, investors, consumers and distributors take cues from previous success in making decisions. Past success in this way feeds back on itself, and the best firms get the best results in a distribution of income that reflects a power law.

Notes:

Horowitz on the Future of the Internet Economy

‘The Struggle,’ According to Ben Horowitz

 

The Consigliere of Silicon Valley

Ben Horowitz Gets Real: You Laid Off People Because You F—ed Up

 

Super Investor Ben Horowitz On Abandoning Your Formulas For Success

The Case for the Fat Startup

 

A Q&A With Ben Horowitz On His New Book, The Hard Thing About Hard Things

Ben Horowitz on Conflict

 

“Why We Prefer Founding CEOs”

The Keys to Success

 

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A Dozen Things I’ve Learned from Leon Cooperman About Investing

Leon Cooperman is the founder of the multi-billion dollar hedge fund Omega Advisors. Cooperman founded the firm after a 25 year career at Goldman Sachs where he was a partner and served as chairman and CEO of Goldman Sachs Asset Management. His biography is extensive. The fund’s approach to investing is described as: “We are a value-based, catalyst driven investor, focused on a variant perception of company fundamentals. Our disciplined, fundamental approach to company analysis allows us to estimate a company’s business value and compare it to market value. Once the investment decision has been made, we determine the appropriate exposure/sizing in the context of prudent risk control and liquidity of the investment.”

1. “We are trying to look for the straw hats in the winter. In the winter, people don’t buy straw hats, so they’re on sale.”

“We’re looking for things that are mispriced, where opportunity for achieving excess returns exists.”

The primary job of any value investor is to find assets that are sufficiently mispriced so they can be bought at enough of a bargain that the purchase price provides a margin of safety. When Mr. Market is greedy about owning more hats, don’t buy hats.  When Mr. Market is fearful about owning hats, it can be a good time to buy hats. The “best time to buy straw hats is in the winter” principle is simple, but actually following it is hard. John Kenneth Galbraith said once that “The conventional view serves to protect us from the painful job of thinking” and this is often applicable to investing. Seneca adds: “When a mind is impressionable and has none too firm a hold on what is right, it must be rescued from the crowd: it is so easy for it to go over to the majority.” It is mathematically the case that  you can’t outperform a crowd by following it. It is also the case that always avoiding what is popular is folly. The goal is to sometimes be contrarian and to be right when doing so.  That requires work and thinking. Cooperman has also said: “With an average IQ, a strong work ethic and a heavy dose of good luck, you can go very far.” And “The harder I worked, the luckier I got.” If you don’t want to work and think, buy a low cost index fund.

2. “[In July 2008.] To some degree, I feel like a kid in a candy store.”

2008 was the last time in recent memory when were loads of assets in many asset classes available for purchase at a substantial discount to their intrinsic value. Many great value investors had cash to buy assets that year because that cash was a residual of there being few bargains when the market was euphoric. It may look like people with cash in 2008 successfully timed the market turn around, but in fact they kept their focus on the prices of individual stocks. A value investor fundamentally works from the bottom up when making investment decisions and that means starting from the fundamentals of the specific business.

When a value investor like Warren Buffett says: “I felt like an oversexed guy on a desert island. I didn’t find anything to buy,” it is a time like 1973. Just a year later Buffett was saying: “This is the time to start investing.” A fundamental difference between value investors and many other investors is that value investors say things like “this stock is attractively priced” rather than “I think the market will go up soon.”

3. “I am very knowledgeable and cognizant of what the S&P represents; [in 2015] it’s an index of 500 companies, on an average they are growing about 5 percent a year, they yield about 2 percent, they trade a little under three times their book value. They have got 35 or 36 percent of debt in their capital structure and for those financial statistics you pay on an average today about 16.5–17 times earnings. So, I look for, as a value investor, I am looking for either more growth at a lower multiple, I am looking for more asset value or more yield. Some combination that says, ‘Buy me,’ and my team and I spend all day long, 7 days a week, 24/7 trying to look for things that are mispriced to the market.”

“As a value investor, I’m looking for more, but for less. I‘m looking for more growth at a lower multiple. I‘m looking for more yield versus what I can get from the S&P.  Or, I’m looking for more asset value.”

“About 95% of publicly traded companies have two values. One is the auction market value, which is the price you and I would pay for one hundred shares of a company. The other is the so called private market value, which is the price a strategic or financial investor would pay for the entire business.”

Leon Cooperman is explaining that what you pay (price) is not always what you get (value). You need to look very hard and be very patient as well. When you see the opportunity you must also act quickly and aggressively.  Few investors have the temperament to do this since they panic when the crowd is fearful. “Inverting” your emotions in an opposite direction from the crowd is not an easy thing to do. Most everyone is better served by sticking to a low cost diversified portfolio of index funds.

4. “We’re very confident in the companies we own because they incorporate a margin for error.”

He is referring here to the margin of safety principle of value investing. If you buy at a substantial discount to intrinsic or private market value you can make a mistake and still do just fine. And if things work out better than you thought you get an additional bonus. Cooperman points out: “We have a very narrow assignment, and that’s to know the companies we know better than anyone else and own the right companies.”  You can’t do the former without the latter since to understand the stock you must understand the business. Since risk comes from not knowing what you are doing, know what you are doing when doing. It’s that simple.

5. “I look for a stock in the public market that is selling at a significant discount to private market value where I can identify catalysts for a potential change.”

This approach is similar to Mario Gabelli, who I have profiled previously. Gabelli places so much importance on catalysts that his firm actually filed for a trademark on the phrase (Private Market Value with a Catalyst™). For example, a catalyst exist if an investor believes that a business selling at a discount also possesses a possible value accelerant that the market does not recognize. This catalyst approach is a tweak on value investing that is optional. Some investors seek an catalyst and some don’t. Bruce Greenwald and his co-author’s write:

“There are two kinds of catalysts: specific and environmental. Specific catalysts are those changes, either anticipated or recently occurring, that alter the prospects of a particular company. The grimly labeled ‘death watch’ stocks are attractive to investors who believe that the departure of the CEO or a large shareholder will allow the company, once freed from re­straints, either to improve its performance or to restructure itself, includ­ing here selling the whole thing. … Other company-specific catalysts include all types of financial or operational restructurings, such as the spin-off of a di­vision or a significant repurchase of shares, a change in management, and investments in new business developments….In many instances, the environment in question is the government, in its legislative, administrative, and regulatory roles. Even in the most free market of countries, governments cast enormous shadows over the econ­omy and the companies operating within it…. Other environmental catalysts emerge as the consequences of disrup­tive shifts in technology that facilitate the reorganization of whole indus­tries. The most unavoidable one in our time is the Internet…”

6. “We’re a value-oriented, research-driven firm that buys undervalued stocks, shorts overvalued ones, and participates in selected overseas debt and equity markets. May not be an exciting approach, but it works.”

Boring “get rich slow” approaches attract fewer competitors which is helpful in the competitive world of investing. Investing where the competition is dumb, misinformed and lazy is an excellent way to boost financial returns. The good news here is that get rich quick type people these are who you are competing against. If other investors and traders were not muppets sometimes, value investing would not work. Turning their dysfunctional behavior into profit is your opportunity.

7. “If you don‘t have the free cash flow, you don‘t have anything.” 

The only unforgivable sin is to run out of cash. Charlie Munger points out that “There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there’s never any cash. It reminds me of the guy who looks at all of his equipment and says, ‘There’s all of my profit.’ We hate that kind of business.” On another occasion Charlie Munger added: “There are worse situations than drowning in cash and sitting, sitting, sitting. I remember when I wasn’t awash in cash —and I don’t want to go back.”

8. “A lot of companies Warren Buffett owns would not be considered value in the classical sense. A company can be growing at an extremely high rate but happens to be trading at a very reasonable multiple.”

“[You want] a business that has a moat around it, where it’s competitively insulated to some large degree.”

What Leon Cooperman is referring to here is that Warren Buffett, with the help of Charlie Munger, was able to evolve his value investing style when Ben Graham style cigar butts companies trading at less than liquidation value disappeared after the Great Depression. In other words, Buffett and investors like Cooperman began to look for quality as an element in the bargain that creates the margin of safety. In the second quote Cooperman is talking about one particularly  key elements in the quality of any business which is a moat. Without a sustainable competitive advantage (a moat) competition among suppliers will cause price to drop to a point where there is no long term industry profit greater than the cost of capital. Greater supply kills value. So you want some aspect of the business that puts a limit on supply and the duration of that limit on supply is a key part of what defines the value of the moat.

9. “Analysts tend to be cheerleaders for corporate repurchase programs. In my view, these programs only make sense under one condition – the company is buying back shares that are significantly undervalued. Most management teams have demonstrated the total inability to understand what their businesses are worth. They‘re buying back shares when the stock is up, and have no courage to buy when the stock is down.”

This view is very consistent with both Warren Buffett and Henry Singleton. Businesses buying shares back when prices are high instead of low is driven by short-term investing myopia. Company management has the same opportunity as any investor to do the reverse, which is to buy low instead of high. The best time to be buying back shares are times like 2008 when Mr. Market was fearful.

10. “What the wise man does in the beginning, the fool does in the end.”

It is easy to get caught up in the movement of a herd. And it is easiest of all to follow the herd when it is close to the end of a cycle. Even the wisest investors can fall victim to crowd folly. The basic underlying force at work is that people rarely make decisions independently.  Fear of missing out (FOMO) and laziness make people follow the lead of other people and that process can snowball. Or not. And it will continue until it doesn’t.

11. “There are roughly speaking 10,000 mutual funds that are happy to manage your funds for 1% or less. And roughly 10,000 hedge funds that have the chutzpah to ask for 2 and 20. If clients are going to pay 2 and 20, they have a right to expect more. You’re always on the balls of your feet.” 

“If you are paying somebody two and 20, as opposed to 1%, you basically have the right to expect more from that person.”

Since it is possible to invest based on what John Bogle calls the ‘low fee hypothesis’, if you are paying hedge fund style fees or even 1% just for assets allocation or stock picking you have a right to expect outperformance. One thing you should definitely do if you decide to seek that outperformance is write down actual performance. With an actual pen and paper. Force yourself to consider your real world after fee results. I have several friends who did this and not are index fund investors. Always consider that you may not want to be a member of any fund that will have you as a member. The number of investors profiled in this blog that will not take you on as an investor is huge.

12.  “I think it was my discovery of Teleydne and its extraordinary CEO Henry E. Singleton. In my opinion Dr. Singleton was one of the greatest managers in the annals of modern business history. No less an authority than Warren Buffett called Dr. Singleton “the best operating manager and capital deployer in American business.” Dr. Singleton started buying up his company’s own shares and from 1972 to 1984 he tendered eight times and reduced his share count by some 90%. His ability to buy his stock cheaply and correctly and time the short and long-term troughs is truly extraordinary.”

Cooperman can claim lot of credit for discovering the investing and business genius of Henry Singleton, who I’ve previously profiled here. Charlie Munger has interesting things to say about Singleton that I can’t say better:

“We respect Henry Singleton for a very simple reason: He was a genius. Henry Singleton never took an aptitude test where he didn’t score an 800 and leave early. He was a major mathematical genius. Even when he was an old man, he could play chess blindfolded, at just below the Grand Master level. He had an awesome intellect, well into the top 1/1,000 of one percent. This was an extreme analytic. Of course, he did create a conglomerate because it was legally allowed at the time. He did it the way everybody else was doing it, he did it better, and he made a lot of money. When they ran out of favor, the stock went way down, he bought it all back for less than it was worth.

Of course, he died a very wealthy man. He was a totally rational human being in things like finance. What I found interesting about Henry Singleton, which has interesting educational implications, is that in watching both Henry and Warren invest and operate at the same time, we had two great windows of opportunity to examine human nature. Henry was very rational. He was quite similar to Berkshire in some ways. Henry never issued a stock option. He had certain commonalities with Warren that were just logical outcomes. What was interesting to me was how much smarter Warren was at investing money than Henry. Henry was born a lot smarter, but Warren had thought about investments a lot longer. Warren just ran rings around Henry as an investor even though Henry was a genius, and Warren was a mere almost-genius.”

Notes:
Bloomberg: http://www.bloomberg.com/news/articles/2012-06-28/cooperman-says-earning-13-in-stocks-takes-average-iq-

CNBC: http://www.cnbc.com/id/101823194

Interview: http://www.valueinvestorinsight.com/Nov_06Trial.PDF

Interview: http://wagsome1.rssing.com/chan-1906771/all_p22.html

Interview: http://www.bloomberg.com/news/articles/2012-02-22/cooperman-shuns-treasuries-favors-stocks-transcript-

Graham and Doddsville: http://www8.gsb.columbia.edu/rtfiles/Heilbrunn/Graham%20%20Doddsville%20-%20Issue%2014%20-%20Fall%202011.pdf

Graham and Doddsville: http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Leon%20Cooperman/cooperman.pdf

Business Insider: http://www.businessinsider.com/leon-cooperman-observations-on-life-hedge-funds-and-the-investment-outlook-2012-9?op=1
2015 Daily Journal Meeting  http://www.forbes.com/sites/phildemuth/2015/04/27/charlie-mungers-2015-daily-journal-annual-meeting-part-4/