A Dozen Things I learned from Craig McCaw

1. “If you aren’t scared you probably aren’t doing anything.”  Life is filled with risk, uncertainty and ignorance.  If you are doing something and aren’t a little scared you are not paying attention. Ben Horowitz made the same point in his new book:   “… being scared didn’t mean I was gutless. What I did mattered and would determine whether I would be a hero or a coward.”

2. “We are trying to make as few mistakes as we can.”  A great way to be smart, is to not be stupid.  This is a highly underrated approach advocated by people like Charlie Munger.

3. “Being first is not always best.” Craig McCaw said to me more than once: “Pioneers often get arrows in the back.” You can learn from the many people who have failed before you.  Nassim Taleb calls this via negativa. Sometimes all of the forces in the business and engineering worlds are perfectly aligned to create financial success and sometimes that is not the case.  Timing can be everything.

4. “Flexibility is heaven.” Having the option to make the best choice at a later point in time when you have more information is valuable. Craig McCaw often spends money to preserve his ability to have multiple options.

 5. “You make decisions on long-term planning, not on short-term changes in the environment.”  The world is unpredictable enough that making decisions based on short term changes in markets is unwise.

 6. “I hate the orchestration of life. Most executives die frustrated (because) they have been orchestrated into boxes.” There is a lot of optionality in serendipity.  Having the option to change your schedule and activities has great value.  Craig McCaw enjoys nothing more than going for a ride in his seaplane to a beautiful spot for lunch. Getting out of the office makes you think differently. Some of the happiest times in my life were afternoons I spent in that seaplane.

7. “I approach things differently than other people.” “A dyslexic tends to be more conceptual and do things which other people wouldn’t see as obvious. So maybe it’s a strategic asset . . . I can’t go to a piece of paper and organize things as most people would in a way that they could understand and come up with a plan. “I have to explain conceptually what we want to accomplish, and then somebody else has to translate that into a concise organized plan.”  “I think the way I look at things gives me a different perspective. I’m most valuable when I work with a team of bright people who complement my weaknesses with their strengths.” “I think I had trouble fitting as a dyslexic. I don’t think like other people, so I don’t fit very well in a clique. As a result of that I have trouble quantifying people as directly as others. I look at their ideas, rather than at them so much as individuals… if you pass autonomy as far down in any grouping of people as you can, you will get extraordinary results if you ask for a lot. The greatest burden you can put on someone is trust.” There is huge value in team diversity in the broadest possible sense and in knowing your limitations. Hiring people who complement your skills is wise. Ben Horowitz said in his book: “Looking at the world through such different prisms helped me separate facts from perception.” I would expand on that to say a diverse group of people on a team accomplishes much the same result.

8. “We have always tried to have the discipline of being over financed so if you had a problem over a period of time you could survive it.”  “Borrowing money was a tool for us because of the businesses we were in –cable television, cellular telephone, paging — all were very capital intensive. In a perfect world, you don’t have that. It’s easier if you don’t have it, but it’s the leverage to make a lot happen, either pro or con. As long as you believe in the pro, and you’ve thought out how not to run out of money if things don’t go as you expect, then indebtedness, as it were, ups the ante and makes everybody work harder, because you know the consequences of failing to deliver on your promises.”  Debt destroys optionality, but if it is non-recourse, debt can give you optionality.

 9. ‘’If you are going to set out on a voyage, remember the Titanic.  The captain took risks he did not have to take, for ego.’’ Hubris can result in big problems. Being humble, especially when outside of your circle of competence, is wise.

 10. ‘’My father was a visionary who did not hire great people. The company was too dependent on one person.’’  Craig McCaw hired extremely able managers to run his businesses and it showed.  John Stanton, Jim Barksdale, Steve Hooper, Wayne Perry, Dan Akerson, Tom Alberg, John Chapple, Peter Currie, Tim Donahue, Maggie Wilderotter are just a few examples.

 11. “When products aren’t right, people won’t buy it… people won’t come until there is something moderately rational. As you begin, you don’t expect it to be viable… This isn’t an AK-47 [holding up a classic large brick phone], it was the original phone. You couldn’t hold it for more than 15 minutes. It had 30 minutes of talk time, but you couldn’t hold it up for that long. Things started slowly. The car phone was even worse because you had to take the car apart, and keep his car for a whole day….” If you give something to people in their interest, they will eventually realize it. If they don’t know it on day one, it really isn’t important. It’s your job to think almost anthropologically about humanity and say, “What would be in their best interest?” “With cellular telephony… we saw an enormous gap between what was and what should be. I mean, [the fixed phone system] makes absolutely no sense. It is machines dominating human beings. The idea that people went to a small cubicle, a six-by-ten office, and sat there all day at the end of a six-foot cord, was anathema to me.” ”Human beings from the time they discovered seeds have been enslaved towards places.” Craig McCaw has a fantastic intuitive sense of what consumers will find valuable.  When you watch him pick up a new product or use a new service for the first time you can see his mind racing.

12. “The industry is commoditizing when you look at one cent a minute. Is it even worth keeping track of?” Like Bill Gates, Craig McCaw understands that supply kills value. He also understands that selling something adjacent to that amazing increase in supply can allow a business to create huge profits.

 

 

 

 

A Dozen Things I’ve Learned about Business from Bill Gates

 

1. “Business isn’t that complicated” and “Take sales, take costs, and try to get this big positive number at the bottom.”  Many people make a living trying to make “business” sufficiently complex that you feel the need to pay for their services. Their business is to make business complex, when it is actually simple. 

 

2. “Of my mental cycles, I devote maybe ten percent to business thinking.” and [John Malone] and I are damn similar.  He worked at Bell Labs and understands both business and technology.” It is not enough to understand just business or the just product or service. Successful entrepreneurs/CEOs understand both in a deep way.  Great entrepreneurs/CEOs spend way more time on the product/service offering than business strategy, structure and operations. There are many ways to succeed but successful entrepreneurs/CEOs are seldom one dimensional. Having said that, entrepreneurs/CEOs which have success which persist over time do typically have a well-defined idea of the limits to their own competence.

 

3. “Being a visionary is trivial.  Being a CEO is hard.  All you have to do to be a visionary is to give the old ‘MIPS to the moon’ speech — everything will be everywhere, everything will be converged.  Everybody knows that.  Which is different from being the CEO of a company and seeing where the profits are.”  Poseur CEOs are often eventually exposed but not always. Some CEOs look skillful and are surfing on the work done by people who were in that position before they arrived. CEOs who have created their company from scratch and it lasts over the years have proven their skill.  Visionary CEO can often be attached to companies which generate revenue but never significant profits.

 

4. “Unless you’re running scared all the time, you’re gone.” Moats (sustainable competitive advantage) don’t last unless you are constantly working to reinforce them since they inevitably atrophy. If you don’t yet have a moat, you are even more exposed to competitors. The technology business is unique in that demand side economies of scale can result in nonlinear changes. In a technology business in particular,  you can get run over by a mistake you made five years before. 

 

5. “Intellectual property has the shelf life of a banana.” Intellectual property can be used to create a moat but it has a limited shelf life. If you are not investing constantly to renew your intellectual property, without a moat from some other source you are dead.  Better yet, invest constantly in creating new intellectual property to replace what will inevitably expire.

 

6. “Supply is the killer of value. That’s why the computer industry is such a strange industry.  We’re dealing with amazing increases in supply.” and “If you look at an industry where you have such a rapid increase in supply, usually that’s pretty bad, like when radial tires were invented, people didn’t start driving their cars a lot more, and so it means the need for production capacity went way down, and things got all messed up.  The tire industry is still messed up.”  Bill’s view on this is the inverse of the George Gilder thesis during the dot com years. Sometimes disruption caused by an increase in supply only benefits consumers and producers end up with nothing. Whether something is “disruptive” is orthogonal to whether it may be a direct source of profit for the producer. Disruption shifts value creation opportunities creating potential opportunities which may or may not benefit producers of a good or service.

 

7. “Word of mouth is the primary thing in our business.  And advertising is there to spur word-of-mouth, to get people really talking about ‘the latest thing.’” Acquiring customers in a cost effective way is the essence of business.  Customers you acquire “organically” are more valuable since they do not leave as often and usually generate more revenue.

 

8. “Your most unhappy customers are your greatest source of learning.” There is no end to how much products and services can improve. Dysfunction inside any company is best measured relative to its competitors.  There is no perfect company without some dysfunction under the decks and that creates opportunities.  

 

9. “It is fine to celebrate success, but it is more important to heed the lessons of failure.” and “There are many lessons about the dangers of success, and Henry [Ford] is one of them.” Failure is an opportunity to learn. The more you learn in life the more you learn that there is even more you don’t know and that some things are unknowable.  What you may attribute to success may be luck and vice versa.  Success in one domain does not equate to success in all domains.  Success  may cause you to succumb to “man with a hammer syndrome (everything looks like a nail).”

 

10. “Perseverance has been characteristic of our great success.” Going up against great competitors requires resilience and a thick skin. Steve Ballmer famously put it this way: “It doesn’t matter if we bang our head and fail. We keep right on banging and banging and banging and banging and banging.”

 

11. “If you look at us from a financial point of view we are wizards, but we have made many products that have faded.”  It is magnitude of correctness not frequency of correctness that matters most. Babe Ruth struck out a lot, but that strike out record was vastly outstripped by his successes. Great entrepreneurs and CEOs think in terms of expected value.

 

12.  “I spend a lot of time reading.” The best way to accelerate learning (which often comes from understanding the mistakes and successes of others) is to read widely and *a lot.* Learning from the mistakes of others scales far better than making those mistakes on your own.

 

 

The Best Venture Capitalists Harvest Optionality (Dealing with Risk, Uncertainty and Ignorance)

Venture capitalists must deal with systems which are, in the words of Nassim Taleb, “more like a cat than a washing machine.”  A start up and the markets in which they operate are  quintessential complex adaptive systems. Michael Mauboussin nails the challenge here:

“Increasingly, professionals are forced to confront decisions related to complex systems, which are by their very nature nonlinear…Complex adaptive systems effectively obscure cause and effect.  You can’t make predictions in any but the broadest and vaguest terms. … complexity doesn’t lend itself to tidy mathematics in the way that some traditional, linear financial models do.”

People talking about the challenges of being a venture capitalist in this environment will often use a taxonomy created by Frank Knight:

  1. Risk: future states of the world known and probabilities of those future states known.  An example of a something involving risk would be roulette.
  2. Uncertainty: future states of the world known, but probabilities of those future states are not known.
  3. Ignorance:  future states of the world unknown, probabilities therefore not computable.

Nassim Taleb pointed out in The Black Swan that Knight’s category 1 is massively more rare that humans realize.   Nassim Taleb wrote:  “these ‘computable” risks [in category 1] are largely absent from real life! They are laboratory abstractions!”

What happens in real life is that people make decisions assuming category 1 is involved when the reality is that it is category 2 or 3. How then does the Wise VC or entrepreneur operate given this reality?

Nassim Taleb provides a quadrant-based model as a guide to decision making. Michael Maubousin provides a summary of what Nassim Taleb has created:

“a two-by-two matrix, where the rows distinguish between activities that have extreme outcomes and those that have more bunched outcomes, and the columns capture simple and complex payoffs. He allows that statistical methods work in the First Quadrant (simple payoffs and bunched outcomes), the Second Quadrant (complex payoffs and bunched outcomes), and the Third Quadrant (simple payoffs and extreme outcomes). But statistical methods fail in the Fourth Quadrant (complex payoffs and extreme outcomes).

The nature of the venture capital business is that what drives financial return comes from what Nassim Taleb calls the Fourth Quadrant. The wise person operates in the Fourth Quadrant by seeking to become “antifragile” rather than trying to predict outcomes that are not computable. My blog post on fragility and optionality is here: http://25iq.com/2013/10/13/a-dozen-things-ive-learned-from-nassim-taleb-about-optionalityinvesting/ In short, the wise venture capitalist seeks optionality. The poseur venture capitalist tries to predict the future by using extrapolation.

Once a venture capitalist recognizes that optionality/antifragility is the objective they understand that there is no formula for being a wise venture capitalist.  Nassim Taleb believes the wise venture capitalist is a flaneur:

“Someone who, unlike a tourist, makes a decision opportunistically at every step to revise his schedule (or his destination) so he can imbibe things based on new information  obtained. In research and entrepreneurship, being a flaneur is called “looking for optionality.”

Acquiring optionality is best accomplished via tinkering and a process that Taleb calls via negativa.

“If you ‘have optionality,’ you don’t have much need for what is commonly called intelligence, knowledge, insight, skills, and these complicated things that take place in our brain cells. For you don’t have to be right that often. All you need is the wisdom to not do unintelligent things to hurt yourself (some acts of omission) and recognize favorable outcomes when they occur. (The key is that your assessment doesn’t need to be made beforehand, only after the outcome.)”

This approach is straight up consistent with the ideas of Charlie Munger. In short, the best way to achieve success is often “to not be stupid.” Wise VCs and entrepreneurs which they invest with engage in tinkering in domains which tend to produce a small down side and potentially massive upside.   One of the best ways I have ever heard the idea behind Charlie Mungers’s philosophy expressed was by the famed investor Sam Zell:

“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.”

Nassim Taleb describes what the smart investor is looking for in this way: “Payoffs [which] follow a power law type of statistical distribution, with big, near unlimited upside but because of optionality, limited downside.” Venture capitalists who are What Nassim Taleb calls “antifragile” benefit from optionality.  Investment bankers, who are “fragile” still are able to do this by being too big to fail and therefore socializing the big downside tail risk (i.e., get the taxpayers to pick up the losses from tail risk). Optionality also explains why there is a power law inside the portfolio of a venture capital investor in addition to the power law that explains the distribution of financial returns between venture capital firms..

Nassim Taleb sums up much of what I have written above in this passage from Antifragile:

“the idea present in California, and voiced by Steve Jobs at a famous speech: “Stay hungry, stay foolish.” He probably meant “Be crazy but retain the rationality of choosing the upper bound when you see it.” Any trial and error can be seen as the expression of an option, so long as one is capable of identifying a favorable result and exploiting it…”

 

 

The fundamental difference between Venture Capital and Value Investing

“Active management has to be seen as the search for mistakes.” Howard Marks

Venture capital and value investing share many different elements but each system is based on a different mispricing. This is a critically important point for an investor to understand. If an asset is not mispriced, market outperformance is not mathematically possible. It is also important to understand that investments can be mispriced for different reasons.

In venture capital the mispricing occurs because very few investors or asset owners understand optionality. This allows a VC to buy what are essentially long-dated, deeply-out-of-the-money call options from companies at prices which are a bargain. By purchasing a portfolio of these options, a VC who understands optionality and who has the right deal flow due to “cumulative advantage” can substantially outperform the market. The basic formula is simple for a top 5% VC with the requisite cumulative advantage and deal flow. A VC invests in ~30 companies per fund and the distribution of returns among those companies will reflect a power law. One to three of the companies in the VC’s portfolio will overwhelmingly drive financial returns and 50% of the companies will be a total or near total loss.

In value investing the mispricing occurs because the market is bipolar (i.e., neither always rational nor always efficient). This allows an investor to sometimes buy assets at a price which  reflects a discount to intrinsic value (i.e., a bargain) and to wait for a good result rather than trying to “time” the market. Avoiding mistakes is a focus of the value investor. There is no trick to value investing other than being smart by avoiding stupidity.

Value investing and venture capital investing are not the only ways to invest, but they share many elements like fundamental analysis, circle of competence, rationality, margin of safety and most importantly a search for a mispriced asset. Both value investing and venture capital investing require unique skills and very few people have that skill. Almost everyone (~97% of people) should buy a portfolio of low fee index funds/ETFs.

Many successful value investors do not like to buy an asset which does not generate cash flow since the “intrinsic value” calculation requires cash flow. It is important to note that intrinsic value is a very specific type of value. Intrinsic value is not the only type of value. For example, gold has commodity value, but no intrinsic value. There is nothing wrong with commodity value per se, but for some value investors gold is not their “cup of tea” (i.e., it is not their preference to acquire that type of value). For example, if you want to give Warren Buffett  gold he will be appreciative of the gift, but don’t ask him to buy it as an investment since to do so would be what he calls speculation.

Factor investing, a type of tweaked index investing is yet another way to invest, but it is not value investing. A value stock for a factor investor is not necessarily a stock a value investor would buy.

When different types of investors disagree the disagreement is often based on different taxonomies and their chosen investing thesis. Investors have more in common than they may imagine. What Leo Tolstoy should have said was:

“All successful investors are alike; each unhappy speculator is unhappy in their own way.”

 

Notes: 

“not mathematically possible” Item #1 here: http://25iq.com/2013/09/28/a-dozen-things-ive-learned-from-john-bogle-about-investing/

“venture capital” http://25iq.com/2013/07/05/a-dozen-things-i-have-learned-about-venture-capital/

“optionality”   http://25iq.com/2013/10/13/a-dozen-things-ive-learned-from-nassim-taleb-about-optionalityinvesting/

“cumulative advantage” http://25iq.com/2012/10/06/the-matthew-effect-and-vc-performance/

“value investing” http://25iq.com/2013/09/15/a-dozen-sentences-explaining-what-ive-learned-from-warren-buffett-about-investing/

‘intrinsic value” http://www.berkshirehathaway.com/owners.html

“speculationhttp://25iq.com/2013/03/02/investment-vs-speculation/

“factor investing”: http://25iq.com/2014/03/16/ben-grahams-value-investing-%E2%89%A0-famafrenchs-factor-investing/

 

 

Ben Graham’s Value Investing ≠ Fama/French’s Factor Investing

Ben Graham and his disciples like Warren Buffett, Howard Marks and Seth Klarman have developed a system called “value investing.” Eugene Fama and Ken French developed a completely different factor investing approach which identifies “value stocks.”  Although Ben Graham’s system and Fama/French’s approach share the word “value,” they are vastly and fundamentally different.

A very smart friend recently said to me that it is important to: “draw a clear and simple definitional distinction between value as a statistical factor (Fama/French) and value as an analytical style or goal (Ben Graham).  The two methods are solving for different questions: Fama/French is solving for what creates a persistent disparity of return across large numbers of stocks, while Graham-style value investors are solving for where can I find low risk of permanent impairment of capital and a high probability of an attractive return?”

As a result of the fundamental differences in investing style, value stocks as identified by Fama/French’s factor investing model may not be attractive at all to a value investor as practiced by the disciples of Ben Graham and that a fund constructed using factor investing has nothing to do with Ben Graham’s value investing system.

The backbone of Fama/French’s top-down factors model is the assumption that markets are efficient and therefore returns that outperform the market can only be achieved by taking on greater risk. But when Fama/French looked at the real returns of investors they found anomalies. Since they did not want to abandon the efficient markets hypothesis Fama/French augmented their construct with the idea that there must be that there must be undiscovered systematic “risk factors.” Fama/French are now up to five such factors, one of which is the ratio of a company’s Book Equity (Shareholders’ Equity) to Market Equity (Market Capitalization).  Thus, “Book to Market” was christened the “value factor.”

In contrast to Fama/French’s top-down approach, the Ben Graham value investing system is based on the premise that to value the stock you must value the specific business on a bottoms-up basis. The value investor’s goal is to estimate a company’s future distributable cash flows and buy it when its share price is trading significantly lower that the intrinsic value implied by these cash flows. For example, the value investor might estimate that a company’s long term cash flows will be $100M per year and buy it because the company’s enterprise value is $500M. It doesn’t take a rocket scientist to see that if you bought something for $500M and it returned $100M per year you would be getting a fantastic return on your investment (20% in this case). The value investing system can outperform the market over the long term, but only if the investor can do the significant work required to implement the four value investing principles:  (1) value shares like a proportional interest in a business, (2) have a margin of safety when purchasing shares; (3) understand Mr. Market is bi-polar rather than wise and should be your servant not your master and (4) be rational. The fourth principle is the hardest of all for investors.

Factor-investing does not involve doing any of these things.  When someone uses Book to Market as a ratio to measure the inexpensiveness of a stock, he or she is effectively saying there is no difference between a pile of cash in a bank account and an operating company. To such a person, product, customers, production capacity, brand, and operating ability mean absolutely nothing. That’s because Book Value in the ratio is being used a proxy for intrinsic value and Book Value tells you nothing about a company’s earnings power.

True value investors view the world in reverse. They are concerned with what a company’s operating characteristics tell you about that company’s likely future cash flows. Companies with greater future cash flows are intrinsically worth more than those with less, regardless of what the Book Value of the companies may be. 

The bridge between Book Value and earnings/cash flow can be found in a company’s Return on Equity.  That is:

Earnings Yield = Return on Equity * Book To Market

Although Fama would concede that the value of business is its discounted future cash flows, he assumes that no one can be better than average at discerning how well a company is likely to perform in the future.  The implication in Fama’s framework is that you might as well assume all companies have the same Return on Equity. If all companies have the same Return on Equity then Book to Market tells you everything you need to know about a company’s value. But to the value investor, it is absurd to assume that there is no basis for conservatively estimating companies’ future Returns on Equity.

Value investors spend a lot of time thinking about Return on Equity and Return on Capital. These are the concepts that allow them to differentiate the earnings power of one company vs. another. To Fama/French, value is determined strictly by a database screen that sorts based on book value and price.  To a value investor, value is a function of margin of safety, which can be established only by measuring market price against a range of intrinsic values, constructed through a conservative estimation of future cash flows.

Here is a simple way to think about this difference using an analogy. Suppose you want to put together a basketball team (let’s call it Team A). The Fama/French approach would be to recruit 100 of tallest males in town. This team would do better than average since there is a correlation between height and ability. In the same way there is going to be a statistical correlation between an undervalued company (e.g., a real value investment) and a company with low Book to Market.

Another approach to building the team would be hold tryouts and actually evaluate everyone’s basketball skills (as a Ben Graham style investor might evaluate a company). Someone using this style would pick the top 15 players for this Team B. Team B is probably going to better than Team A by a large margin even though Team A is better than average. In the same way, a properly constructed portfolio of value investments is going to be better (by a large margin) than a portfolio with several hundred stocks with high Book to Market.

When all is said and done the factor investing approach is essentially a tweak, perhaps an enhancement, on index investing. In contrast, the goal of a value investor is to achieve returns which are significantly higher than a 1 to 2% premium. In other words, factor investing is trying to scrape out a slight statistical edge by tweaking an index fund approach, while the value investor is seeking more significant returns.  The proof of each approach’s success is “in the doing.”  Investors would benefit from reflecting on the results shared in Warren Buffett’s famous essay The SuperInvestors of Graham and Doddsville
to appreciate the superior results value investors have historically achieved and can prospectively aspire to and the updating those results with actual market performance of investors like Seth Klarman and Howard Marks.

Perhaps this is why many funds do their best to encourage confusion about how value investing differs from factor investing.  They want “value” funds that are really factor investing funds to benefit from the halo of value investing system as successfully practiced by the “superinvestors” descended from the school of Benjamin Graham.

One less known descendent resembles Fama in their use of data, but comes to starkly different conclusions.  The firm is named Euclidean Technologies and they use machine learning to do a bottoms-up comparison of the entire operating histories of current companies against thousands of other companies across the past 50 years.  They do this to build a foundation for estimating the range of future cash flows a company, with a given set of operating characteristics, might deliver.  Then, they invest with an uber-rational systematic process that is protected from the human psychological barriers to buying good companies when Mr. Market offers them at great prices.  This approach aligns much more closely with the value investing system and is nothing like buying a collection of companies with the highest book-to-market ratio.

It is an unfortunate fact that many investors appear to assume that what Warren Buffett and other value investors are doing is a form of what Fama talks about when he discusses the value factor. If more investors actually read Ben Graham’s The Intelligent Investor and other books on value investing they would in realize that the approaches are fundamentally different.

A Dozen Things I’ve Learned from Mason Hawkins about Investing (Plus Tren on Value Investing)

I’ve done more than 25 of these “Dozen Things” posts now and I feel the commentary by me is getting repetitive.  If you want commentary on what Mason Hawkins said below, read what I said on the other posts.   I thought that instead of specific commentary on these quotations below from Mason Hawkins I would write a more general paragraph of commentary on value investing trying to “omit needless words.”

Value investing has just four core principles: (1) buy at a discount to intrinsic value (margin of safety); (2) a share of stock is a partial interest in a business;  (3) make the market your servant and not your master; and (4) be rational.  The “core of the core” of value investing is the first principle (margin of safety).  The hardest thing about value investing is  the fourth principle (be rational). Value investing is simple, but not easy (in no small part since the struggle to be rational is a life long endeavor). There are other aspects of value investing beyond the four core principles which depend on the value investor’s individual style which can vary somewhat from investor to investor.  Value investing is more of an art than a science since any valuation involves risk, uncertainty and ignorance.   The future is never predictable with certainty.

Mason Hawkins:

1. “We want to own companies with the following qualitative characteristics. 1) Unique assets having distinct and sustainable competitive advantages that enable pricing power, long-term earnings growth, and stable or increasing profit margins. 2) High returns on capital and on equity as measured by free cash flow rather than earnings. 3) Capable management teams.”

2. “[In] commodity businesses, being a low cost provider is not enough of an advantage for an overweight position since the commodity price is subject to going below the cost of production for an unpredictable period of time.

3. “We only want to buy when we can pay less than 60% of a conservative appraisal of a company’s value, based on the present value of future free cash flows, current liquidation value and/or comparable sales…. trying to create a big margin of safety

 4. “About 85% of the time, the markets are in some close proximity to central value. It’s that other 15% of the time that you need to concern yourself with.”

5. “We sell for four primary reasons: when the price reaches our appraised value; when the portfolio’s risk/return profile can be significantly improved by selling, for example, a business at 80% of its worth for an equally attractive one selling at only 40% of its value; when the future earnings power is impaired by competitive or other threats to the business; or when we were wrong on management and changing the leadership would be too costly or problematic.”

6. “It is very important to pass on opportunities when you can’t calculate a conservative assessment of the business’s value.”

7. “Statistical analysis shows that security-specific risk is adequately diversified after 14 names in different industries, and the incremental benefit of each additional holding is negligible. We own 18-22 companies to allow us to be amply diversified but have the flexibility to overweight a name or own more than one business within an industry.”

8. “Limiting the portfolios to our 20 most qualified investments allows us to know the companies we own and their managements extremely well while providing ample security-specific diversification.”

9. “From the third quarter of 2008 through the first quarter of 2009, we were given an opportunity to own best-in-class companies at price levels I’ve never seen in my experience…. If you were forced to sell because you were fearful, and if you liquidated in the fourth quarter of 2008 as opposed to buying, which we were doing, you took a permanent loss, and you used Mr. Market to your detriment.  As we have said often, Mr. Market is there to serve you, not to determine your outcome.  When he is fearful, you should be greedy, as Mr. Buffett has said.  When Mr. Market is greedy, you should be cautious and use those times to sell businesses at full appraisal if they get there.” 

10.  “The great investors throughout history – the Medicis, the Morgans, the Rothschilds, and Buffett recently.  Those great investors with terrific long-term records were always in a position to be liquidity providers.  Each was willing to hold cash until someone was in distress, under duress, and they could provide that liquidity at very attractive prices.”
 
11. “Capitalism has a way of turning a good idea at a low price into a bad idea at a high price. It makes sense to buy at 6x operating cash flow, but at 14x operating cash flow it is very problematic and harmful to do so using massive leverage.”

12. “If you are not willing to look stupid in the short run, you are not likely to be a successful investor in the long-run.”

A Dozen Predictions from Tren Griffin for 2014

 

1. CNBC will continue to lose viewers by trying to make its programming similar to ESPN’s Sports Center, even though that approach is *exactly* what sends ordinary investors to their financial doom and *ensures* that ordinary investors will stop watching CNBC (i.e., the CNBC ratings death spiral will continue).

2. The Zero Hedge blog will continue to push people to buy precious metals even though it is particularly well qualified to tear apart the folly of speculation in precious metals and the promoters who profit from that speculation. In other words, for ideological reasons, precious metals promoters will get a “free pass” from Zero Hedge despite the fact that they are a natural target for the web site.  What other promoters get such a free pass from Zero Hedge?

3. Maria Bartiromo will continue to fawn over certain CEOs on Fox Business as long as they “make money” regardless of what their firms have done to “make” that money (e.g., the “Volker” legislation is evil since it gets in the way of “making money”).

4. Business reporters in general will continue to ignore the difference between revenue and profit and will talk generically about “making money.”   What business reporters say a company “earns” will mostly be revenue rather than profit, but that will not be made clear in the article.  Reporters will make no attempt to understand what “items” are actually being excluded from financial results or whether these “items” are excluded by the company every single quarter. Business reporters will continue to pretend that depreciation is not associated with a real cash expense paid up front when they use terms like EBITDA/OIBDA. Survivorship bias will continue to be a completely foreign concept to business reporters.

5. Sell-side Wall Street analysts will continue to put out highly fictional reports about the future performance of companies they cover (mostly motivated by a desire to obtain business for their investment bank in other areas like M&A). Can they repeat this performance? “A MarketWatch analysis reveals that the stocks that analysts hated the most a year ago produced spectacular investment returns in 2013. They beat the overall market indexes, and the stocks that analysts most loved, by a country mile.”

6. Analysts for Wall Street will continue their antics. For example, Piper Jaffray analyst Gene Munster will continue to do “channel checks” (the rumor is that he is so focused on channel checks that his friends and family will never let him use the remote control when watching TV with him). Maybe this year Munster will finally be able to do a channel check on an Apple TV.  Topeka Capital will continue to put absurd target valuations on stocks since it is the only way they can get some attention. Thankfully, Meredith Whitney is now running her own hedge fund and no longer providing any “analysis”/getting lucky once in a row.  Analysts will not forget: “If you’re a bull and you’re wrong, you’re forgiven. If you’re a bull and you’re right, they love you. If you’re a bear and you’re right, you’re respected. If you’re a bear and you’re wrong, you’re fired.”

7. The press will find people in the technology industry who have political views which do not even come close to representing the technology industry, but will claim that they are typical of the technology industry (i.e., stoking the fires of political polarization/generating click bait will continue to be “job #1″ for the press). Of course, it is not possible to find a few people with odd political views in other industries like real estate, construction or manufacturing or the educational sector.  Not.

8. Economists will continue to make assertions about the economy without actually talking to *anyone* who actually runs a business. They will continue to talk extensively with each other in small warring cabals within the profession being careful to exclude anyone who is not “empirical” (the ultimate insult for a economist) from the conversation. The crew of economists who believe (1)  the economy is composed of perfectly informed rational agents and (2) the hard version of the Efficient Market Hypothesis, will continue living in their fantasy world.

9. Online options brokers will continue to advertise heavily to convince new people to trade options, including but not limited to at sports events and at stop lights, since their “clients/marks” will continue to get hurt financially and cease being clients/marks.  Online options trading firms face a shrinking supply of new muppets.  Given this problem they will likely attend “motivational” seminars for what Charlie Munger calls “compliance professionals” given by people like Jordan Belfort.

10. Bill Gross will continue to “talk his book” (just like everyone else, but his “book” is bigger than nearly everyone else). When Gross says publicly that people/firms should do X, he will be already fully positioned on X and will already be thinking about his next move (just like everyone else who is talking their book).

11. Warren Buffett and Charlie Munger will make zero short term predictions about the economy or interest rates.  None whatsoever. Even when they make long term predictions they will make fewer predictions than almost anyone, but bet big when they do.

12. People will continue to make predictions and muppets will believe them (especially if the person making the prediction appears highly confident).  As an aside, I am *highly* confident about each of these predictions.

 

A Dozen Things I’ve Learned from Marty Whitman/Third Avenue about Investing

1. “The cheaper you buy, the greater the potential investment reward.”  This is a simple idea which many investors do not understand since they are driven to buy when “Mr. Market” is euphoric since the human instinct is to follow the crowd.  Fighting this herding instinct is a trained response. As James Montier of GMO said his past week: “The golden rule of investing: no asset (or strategy) is so good that you should invest irrespective of the price paid.”  Re Montier see: http://25iq.com/2013/09/22/a-dozen-things-ive-learned-from-james-montier-about-investing/

2. “The cheaper you buy, the less the inherent risk.” Life is easier and more profitable as an investor if you avoid making mistakes. Too many people think that dialing up risk is the best way to increase returns.  If you buy at a discount you have a margin of safety which will help protect you from making mistakes and will improve your odds of success.  Walter Schloss took this idea to the limit: http://25iq.com/2013/10/27/a-dozen-things-ive-learned-from-philip-fisher-and-walter-schloss-about-investing/

3. “Market prices do not determine business value.” Price is what you pay and value is what you get. More generally, Bob Shiller is right (people are often not rational) and Eugene Fama is wrong (because he has confirmation bias).  Ben Graham is the creator of the Mr. Market idea and my post on him is here:  http://25iq.com/2013/09/29/a-dozen-things-ive-learned-from-benjamin-graham/”> http://25iq.com/2013/09/29/a-dozen-things-ive-learned-from-benjamin-graham/

4. “[Buy] companies with very strong financial positions whose securities are priced at significant discounts to private market value.” Acquiring a margin of safety by buying the asset at a discount to the price an informed private investor would pay is essential to the value investing “system.”  It is important to understand that value investing is a system and the elements of the system are not optional. The value nvesting system has evolved since the time of Ben Graham to include elements of Phil Fisher as I explain here: http://25iq.com/2013/10/27/a-dozen-things-ive-learned-from-philip-fisher-and-walter-schloss-about-investing/”> http://25iq.com/2013/10/27/a-dozen-things-ive-learned-from-philip-fisher-and-walter-schloss-about-investing/

5. “Concentrate on ‘what is’ in terms of understanding a business, in contrast to ‘what the market thinks.’” It is best to focus on what is going on now in a business and not what you think/predict may happen in the future.  “Predicting the present” is infinitely easier than predicting the future. Understanding the present is easier if you know what you are doing and the underlying business is understandable. Read Jeremy Gratham on this: http://25iq.com/2013/11/10/a-dozen-things-ive-learned-from-jeremy-grantham-about-investing/ and Bruce Greenwald too.

6. “Value investing means being price conscious rather than outlook conscious.” Prices of assets will be taken up and down by the always bipolar Mr. Market.  If you are patient and rational and otherwise follow the value investing “system”, Mr. Market will inevitably deliver his financial gifts to you. You can’t predict when it will happen, but you can certainly wait patiently for the gift to eventually be presented.  If you always bet with the crowd you cannot beat the market, especially after fees. To outperform the market sometimes you must be a contrarian and you must be right on those occasions. Read Seth Klarman on this subject and you will benefit: http://25iq.com/2013/07/15/a-dozen-things-ive-learned-from-seth-klarman/

7. “Value investing just does not work for people deeply involved in trying to predict near-term stock prices or general trends for securities markets or commodities markets.” It is fun to make predictions! People love to buy lottery ticket stocks! But don’t confuse that fun with something that makes financial sense.  A value investor wants to make bets where the odds are substantially in his or her  favor. Bet seldom, but when the odds substantially favor, you must bet big. Being ready to bet big when the situation presents itself is critical. Reading Howard Marks is arguably best on this: http://25iq.com/2013/07/30/a-dozen-things-ive-learned-about-investing-from-howard-marks/

8. “We ignore outlooks and forecasts… we’re lousy at it and we admit it… everyone else is lousy too, but most people won’t admit it.” Understanding the limits of your own competence is valuable. Everyone can use colleagues who can give them perspective on decisions. Don’t go near the edges of your own competence especially if you don’t know precisely where they are.  Only bet when you are not the patsy. If you do not know who the patsy is, it is you. Michael Price speaks well on this “avoid making forecasts” topic: http://25iq.com/2013/10/20/a-dozen-things-ive-learned-from-michael-price-abut-investing/

9.  “We deal in probabilities, not predictions.” Investing is a probabilistic exercise. The frequency of an investor’s correctness should not be the focus but rather magnitude of correctness. There is risk, uncertainty and ignorance involved in investing.  Process matters in investing and on that and everything about investing read Michael Mauboussin. My post on that is here:  http://25iq.com/2013/07/11/a-dozen-things-ive-learned-from-michael-mauboussin-about-investing/

10. “We attracted a lot of market timers and asset allocators. I don’t need those … amateurs in my fund.” Market returns will always be lumpy. Drops in the prices of stocks are inevitable and it is then when people tend to panic and want to sell. Whitman does not want investors who panic and want to sell when prices are low. My Bruce Berkowitz post elaborates on this point:  http://25iq.com/2013/11/24/a-dozen-things-ive-learned-from-bruce-berkowitz-about-investing/

11. “Based on my own personal experience – both as an investor in recent years and an expert witness in years past – rarely do more than three or four variables really count. Everything else is noise.” Occam’s Razor is a favorite idea of many value investors. Wikipedia states regarding Occam’s Razor: “among competing hypotheses, the hypothesis with the fewest assumptions should be selected.”  Einstein is famous for saying, “Everything should be made as simple as possible, but no more simple.”  On this point, read everything Charlie Munger related (which investors should do anyway).  Read Jason Zweig on this and everything regarding investing and prosper: http://25iq.com/2013/12/08/a-dozen-things-ive-learned-from-jason-zweig-about-investing-3/

12. “In the financial world, it tends to be misleading to state ‘There is no free lunch.’ Rather the more meaningful comment is ‘Somebody has to pay for lunch.’” See my post on John Bogle regarding the inevitable math of fees and expenses:  http://25iq.com/2013/09/28/a-dozen-things-ive-learned-from-john-bogle-about-investing/

A Dozen Things I’ve Learned from Jason Zweig about Investing

1. “The future value of every investment is a function of its present price. The higher the price you pay, the lower your return will be.” Value investors *price* assets based on their value *now* (based on data from the present) rather than make predictions about markets in the *future.*  Value investors put predictions about the future in the “too hard” pile.

2. “A stock is not just a ticker symbol or an electronic blip; it is an ownership interest in an actual business, with an underlying value that does not depend on its share price.” The best way to determine the intrinsic value a business is based on the price a *private* investor would pay for the entire business.

3. “You should do business with [Mr. Market]—but only to the extent that it serves your interests. Mr. Market’s job is to provide you with prices; your job is to decide whether it is to your advantage to act on them. You do not have to trade with him just because he constantly begs you to. By refusing to let Mr. Market be your master, you transform him into your servant…. “It’s harder than ever for long-term investors to ignore the trading madness of Mr. Market. But ignoring it remains the very essence of what it means to be an investor.” Markets are bi-polar and will *always* move up and down. These movements are not (1) rationally based, (2) based on market efficiency or (3) predictable with certainty. The best advice is simple: “be greedy when others are fearful and be fearful when others are greedy.” This is easy to say, but hard to do since it requires courage at the hardest possible time.  To outperform the market you must occasionally be a contrarian and be right on those occasions.

4. “Regression to the mean is the most powerful law in financial physics: Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.” That prices of investment assets will wiggle above and below intrinsic value is Mr. Market’s gift to you. Don’t try to predict when the wiggles will happen but rather be patiently waiting for when it happens. The “being patient” part of being a value investor is hard. If you expect the market to give you enough profit to buy a car or a speedboat next week, you will fall down. ” Value investors price stocks” rather than “time markets.”

5. “Investors have never liked uncertainty–and yet it is the most fundamental and enduring condition of the investing world.” An investor faces these situations: 1) possible future state known, probability known (risk), (2) Possible future state known, probability unknown (uncertainty) and (3) future state unknown, probability not computable (ignorance). How an investor deals with risk, uncertainty and ignorance will determine their level of success.

6. “The intelligent investor realizes that stocks become more risky, not less, as their prices rise, and less risky, not more, as their prices fall.” Risk is *not* equal to volatility as some people claim. There are many money managers who want you to believe/convince you that volatility is equal to risk because volatility is a major risk for them since if stocks drop in price investors will flee the money manager. These managers also love equating risk with volatility since it gives investors the impression that risk can be precisely quantified which justifies their fees. Since some probabilities are unknown and some future states are unknown, “risk” is not computable number.  It is “volatility” after all which enables an investor to benefit from Mr. Market’s bi-polar behavior (i.e., volatility is actually the source of a value investor’s opportunity). For the best essay on the proper definition of risk read Warren Buffett’s 1993 Berkshire Shareholder’s letter.

7. “Approximately 99% of the time, the single most important thing investors should do is absolutely nothing.” As an investor you should bet seldom and only when the odds of success are substantially in your favor. The temptation of investors is too often toward action when inaction is their friend.  Keeping fees and expenses very low is important and avoiding hyperactivity helps with that objective.

8. “Investing isn’t about beating others at their game. It’s about controlling yourself at your own game.” Overcoming dysfunctional psychological heuristics is a trained response. That trained response requires work and discipline - if you want to avoid that, buy an index fund.

9. “Keep better records of your decisions.” By writing down your decisions and measuring their outcomes you are confronted with the fact that you are often a muppet. Hindsight bias, denial, overconfidence and other psychological biases are powerful. The easiest person to fool is yourself. I have a friend who thought he was a great investor until he wrote down his investing results for three years.  Now he is an index fund zealot.

10. “The way I like to think of day trading is that it’s probably the most effective weapon ever to commit financial suicide, … It’s an absolutely lethal way for the typical person to invest because it’s not even really a form of investing, it’s gambling pure and simple.” People love to gamble as anyone driving by a casino can see. In far too many cases this gambling finds its way into a person’s investing behavior. The difference between making a bet when the odds are substantially in your favor and when “the house” has an advantage is night and day.

11. “Most people will buy more when something goes up and either sell it or freeze when it goes down. The brain is really built as a pattern-recognition machine and a performance-chasing mechanism, and when you combine automatically perceiving patterns where they don’t actually exist with pursuing performance right before it disappears, you have a recipe for disaster.” Training yourself not to “chase performance” is essential.

12. “Most financial journalism, like most of Wall Street itself, is dedicated to a basic principle of marketing: When the ducks quack, feed ‘em…. Every columnist knows that if you ever write something that didn’t make anybody angry, you blew it.”

A dozen things said by Jesse Livermore that apply to investing even though he was a speculator

1. “An investor looks for safety… The speculator looks for a quick profit.” Livermore is saying that what differentiated him and other speculators from investors was: (1) a willingness to make bets with short duration and (2) not seeking safety.  Anyone reading about Livermore must remember that he was not a person who often/always followed his own advice. He eventually shot himself leaving a suicide note which included the sentence: “I am a failure.”

2. “A professional gambler is not looking for long shots, but for sure money…Since suckers always lose money when they gamble in stocks – they never really speculate…”  Livermore believed he was not a gambler since he only speculated when the odds were substantially in his favor (“sure money”).   Livermore’s statement reminds me of a quotation from Peter Lynch: “An investment is simply a [bet] in which you’ve managed to tilt the odds in your favor.” Livermore’s statement also reminds me of the poker player Puggy Pearson who famously talked about need to know “the 60/40 end of a proposition.”  When the odds are substantially in your favor you are not a gambler; when the odds are not substantially in your favor, you are a sucker.

3. “I trade in accordance to my means and always leave myself an ample margin of safety. …After I paid off my debts in full I put a pretty fair amount into annuities. I made up my mind I wasn’t going to be strapped and uncomfortable and minus a stake ever again.”  Livermore is not referring here to seeking a Benjamin Graham style “margin of safety” on each bet but rather to this: once you establish a big financial stake as a speculator, setting aside enough money so you don’t need to “return to go” financially is wise.  Livermore wanted a margin of safety in terms of safe assets so that he would always have a grubstake to start over in his chosen profession of speculation. On this point and others, he failed to follow his own advice.

4. “Keep the number of stocks you own to a controllable number. It’s hard to herd cats, and it’s hard to track a lot of securities.” There is only so much information a single person can track in terms of stocks whether you are in investor or a speculator. By focusing on a smaller number of stocks you are more likely to (1) know what you are doing (which lowers risk) and (2) find an informational advantage you can arbitrage.

5. “Only make a big move, a real big plunge, when a majority of factors are in your favor.” Only bet when the odds are substantially in your favor. And when that happens, bet in a big way.  The rest of the time, don’t do anything.

6.  ” It never was my thinking that made big money for me. It was always my sitting. Got that? My sitting tight! There is the plain fool who does the wrong thing at all times anywhere, but there is the Wall Street fool who thinks he must trade all the time.” Neither investors nor speculators get any benefits from activity and instead generate fees and mistakes.

7. “The professional concerns himself with doing the right thing rather than with making money, knowing that the profit takes care of itself if the other things are attended to.” Michael Mauboussin: “the best long-term performers in any probabilistic field — such as investing, sports-team management, and pari-mutuel betting — all emphasize process over outcome.”

8. “When you know what not to do in order not to lose money, you begin to learn what to do in order to win.” The finest art is not to lose money. Making money in the stock market can be done by anybody.”  This is another way of saying what Warren Buffett has said many times:  “The first rule of investing is: don’t lose money; the second rule is don’t forget Rule No. 1.” It is amazing how much benefit once can get from consistently not being stupid.

9. “If I buy stocks on Smith’s tip I must sell those same stocks on Smith’s tip. I am depending on him. Suppose Smith is away on a holiday when the selling time comes around? No sir, nobody can make big money on what someone else tells him.” Livermore claimed that he was never someone to rely on others. He did his own work and made his own decisions as a speculator (with a few well known exceptions that hurt him badly).

10. “The speculator’s deadly enemies are: ignorance, greed, fear and hope. All the statute books in the world and all the rule books on all the Exchanges of the earth cannot eliminate these from the human animal….” Jesse Livermore was a student of behavioral economics when the idea had not yet been given a name.  Being greedy when other are fearful and vice versa is a simple rule that is hard to execute in practice. For example, buying assets at the lows of 2009 required courage few people had at the time.  Livermore was clearly a brave fellow. But being brave when the odds are not substantially in your favor is unwise.

11. “Whenever I have lost money in the stock market I have always considered that I have learned something; that if I have lost money I have gained experience, so that the money really went for a tuition fee.”  The source of good judgment is often bad judgment.  Unfortunately for him, Livermore did not always make new mistakes and repeated some old ones too.

12. “Whatever happens in the stock market today has happened before and will happen again.” When people are saying: “this time it is different” grab your wallet and walk carefully toward the door. History never precisely repeats, but it does rhyme. Markets move is cycles because Mr. Market is bi=polar (fluctuating between free and greed). That markets will fluctuate in cycles is inevitable; predicting the timing and extent of the cycles is impossible.  Value investing is about putting yourself in position to benefit when the inevitable happens.  Price, don’t predict!