A Dozen Things I’ve Learned about Value Investing from Jean Marie Eveillard

Jean-Marie Eveillard “started his career in 1962 with Societe Generale until relocating to the United States in 1968. Two years later, Mr. Eveillard began as an analyst with the SoGen International Fund. In 1979, he was appointed as the portfolio manager of the Fund, later named the First Eagle Global Fund. He then went on to manage the First Eagle Overseas and First Eagle Gold Funds at their inception in 1993 as well as the First Eagle U.S. Value Fund in September 2001. After managing the Funds for over 30 years, Mr. Eveillard now serves as Senior Adviser and Board Trustee to First Eagle Funds and as a Senior Vice President of Arnhold and S. Bleichroeder Advisers, LLC.”

1. “Benjamin Graham’s book The Intelligent Investor has three lessons. The first is humility, that the future is uncertain. There are people on Wall Street who will predict the Dow will be at a certain level, but that is nonsense. The second thing is that because the future is uncertain, there’s a need for caution. The third thing was especially important. Graham values the idea that securities can be more than just paper. You should try to figure out the intrinsic value of a business. In the short term, the market is a voting machine where people vote with their dollars, but in the long term, it’s a weighing machine that measures the realities of business.” 

“You need humility because you know you can be wrong, and when you admit that you stress caution by assigning a margin of safety to your investments so that you don’t overpay for them.” 

“I focused mainly on stocks that were trading at 30 to 40 percent below my intrinsic value calculations.”

This passage is a distillation of many key points about value investing. The Great Depression made Ben Graham humble as an investor. As a result of that experience he developed his value investing system. This system is only appropriate for people who can take a long term viewpoint and sometimes underperform a benchmark in the short term. Many people can’t do these things for psychological or emotional reasons, or won’t do the work required to actually understand the business underlying each security.

Value investing is not the right investing system for everyone, but it is unique in that can potentially be successfully implemented by an ordinary investor with slightly above average intelligence and a sound work ethic. The limitation of the system is that very few people actually have the full set of skills and personal attributes required to be successful in implementing the system. Value investing is simple but not easy.

As for the 30-40% discount to intrinsic value which creates the margin of safety, Matthew McLennan (one of Jean-Marie Eveillard’s colleagues at First Eagle) notes:

“We’ve typically looked to buy 70 cent dollars. I think the mental model of paying 70 cents for a business makes great sense; if the normal equity is priced for 7% returns, and you’re going for 70 cents on the dollar, you’re starting with a 10% ROI. Closing that valuation gap over five to ten years may generate a low-teens return. If it’s a great business, there’s an argument to be made, not necessarily for paying 100 cents on the dollar, but for paying 80 to 85 cents on that dollar. As Charlie Munger would say, it’s a fair price for a great business. Your time horizon’s long enough that you’re capturing less spread day one, but if the business has a drift to intrinsic value of 4-5% a year, held for a decade, you may potentially reclaim that and then some. The more patient you are, the more you’re potentially rewarded for holding good businesses.”

2. “By being a value investor you are a long-term investor. When you are a long-term investor, you accept the fact that your investment performance will lag behind that of your peers or the benchmark in the short term. And to lag is to accept in advance that you will suffer psychologically and financially. I am not saying that value investors are masochists, but you do accept in advance that your reward, if any, will come in time and that there is no immediate gratification.”

“I think one of the reasons I didn’t enjoy growth investing was because it assumes the world to be perfect and certain, which it is not! Becoming a value investor allowed me to acknowledge the fact that I am uncertain about the future.”

What Jean Marie Eveillard is talking about here is something that you either understand and embrace or you don’t.  It is also something that you are comfortable with or not. People who are not humble about their ability to predict the future or who need immediate gratification are not good candidates to be successful value investors. These people should put value investing in the “too hard” pile and move on.

3. “We don’t buy markets. We buy specific securities.”

“An investor who buys a building or an entire corporation gives a great deal of attention to the price to be paid for the asset. So does the buyer of a car or even a bathing suit. They all seek value. What’s so different with equities? Are they just pieces of paper to be traded in and out of on the basis of psychology, sentiment, herd instinct?”

“The search for undervalued stocks beings with the idea that stocks are not just pieces of paper that are traded in the market. Every stock represents a business, which has its own intrinsic value. To determine that value, you have to estimate what a knowledgeable buyer would be willing to pay for the business in cash. It is important to understand that intrinsic value is not an exact figure, but a range that is based on your assumptions. Because you have to revise your assumptions from time to time to reflect business and market conditions, intrinsic value fluctuates over time, and it can go up or down.”

The best value investors are people who have significant experience in business. This allows the investor to successfully answer a key question: What would a private market buyer pay in cash for the business in question? The point made by Jean Marie Eveillard about intrinsic value not being precise is important. The future is always uncertain and a future business result is not an annuity.

One other important thing about determining intrinsic value is knowing that it is not always possible to determine intrinsic value in a given case. If you can’t reliably determine intrinsic value for a specific business, just move on (put it in the “too hard” pile). In other words, the value investor will try to find another security to buy which allows them to easily determine intrinsic value. Jean Marie Eveillard is also pointing out that a fuzzy intrinsic valuation result can be OK for a value investor since the investor is protected to a significant degree by a margin of safety. First Eagle’s approach as described by Matthew McLennan is as follows:

“There’s a willingness to pay higher multiples for franchise businesses. By going in at 10x – 12x EBIT, you could get a 6%normalized free cash flow yield that can potentially grow 4-5%sustainably over time, and thus you may achieve the prospect of a double digit return. If it’s a businesses that is more Graham in nature, with no intrinsic value growth, we may be inclined to go in at 6x – 7x EBIT, where we get our potential return through a low double digit normalized earnings yield.”

4. “We invest, if in the end we think we understand the business, we think we like the business and we think the investors are mispricing the business.” 

“We try to determine what a knowledgeable buyer expecting a reasonable return would be willing to pay today, in cash, for the entire business. Our approach requires us to understand the business – its strengths and weaknesses – rather than just the numbers. As investors have learned, the numbers can’t always be trusted.”

“Buffett says that value investors are not hostile to growth. Buffett says that value and growth are joined at the hip – value investors just want profitable growth and they don’t want to pay outrageous prices for future growth because, as Graham said, the future is uncertain.” 

As Howard Marks points out, investing is “the search for mistakes by other investors.” Sometimes a security is offered for sale at a bargain price that represents a 30% discount to the intrinsic value of the business. This will happen rarely, but when it does there will often be several opportunities available at the same time. In other words, the arrival of opportunities for value investors will tend to be lumpy.

5. “If one is wrong in judging a company to have a sustainable competitive advantage, the investment results can be disastrous.” 

A “sustainable competitive advantage” is another name for a “moat.”  Sometimes even the best value investors fail to see that the business has no moat or that the moat is about to disappear. For example, Warren Buffett found in buying Dexter Shoes that “What I had assessed as durable competitive advantage vanished within a few years.”  Warren Buffett also thought the UK retailer Tesco had a moat at one point. Other investors thought at an inopportune time that Kodak had a moat, or Blackberry or Nortel. Without a moat a business has no pricing power. 0Matthew McLennan of First Eagle puts it this way:

“Unfortunately, asset-intensive businesses often lack pricing power. What sometimes occurs is a need to reinvest during a time of weak pricing power, and this results in balance sheet deterioration and reduced earnings power. Also, asset-intensive businesses tend to have longer tail assets. With those come management teams that promote their desire to reinvest and grow the business. As a result, there’s less return of capital.”

6. “Value investing is a big tent that accommodates many different people. At one end of the tent there is Ben Graham, and at the other end of the tent there is Warren Buffett, who worked with Graham and then went out on his own and made adjustments to the teachings of Ben Graham.” 

“Over the past almost 30 years, we have sort of floated between Ben Graham and Buffett. We began with the Graham approach which is somewhat static and less potentially rewarding than the Buffett approach, but less time consuming. So as we staffed up, we moved more to the Buffett approach, although not without trepidation because the Buffett approach – yes, you can get the numbers right, but there is also a major qualitative side to the Buffett approach.”

“Having more people allowed us to spend a lot of time trying to find out the major characteristics of businesses and their sustainable competitive advantage – what Buffett calls a ‘business moat.’”

There are many ways to be a value investor as long as the four bedrock principles of value investing are adhered to – 1. a security is partial stake in a business, 2. margin of safety, 3. Mr. Market is your master and not your servant, 4. be rational. Value investing styles can vary when it comes to issues like the level of diversification, whether quality of the business is taken into consideration, and the amount of the margin of safety. Some value investors diversify their investments more than Warren Buffett. Other value investors are numbers-driven cigar-butt investors who do not consider the quality of the business. Other value investors are “focus investors” (they concentrate holdings rather than diversify) and do consider quality of the company in question.

7. “I have a great belief that everything is cyclical in life, particularly in the investment world. Value investors are bottom-up investors. But when we establish intrinsic values and update them, we do not assume eternal prosperity but accept that there is a business cycle.”

Other people I have written about in this series like Howard Marks , Fred Wilson, and Bill Gurley also believe that cycles are inevitable in all types of businesses.  That cycles are inevitable does not mean that their timing is predictable with certainty.

8. “I think the secret of success of most value investors is that when times became difficult they stuck to their guns and did not capitulate.”

It is easy to talk about being “greedy when others are fearful and fearful when others are greedy,” but actually doing so is harder than people imagine. It is warm and comforting for many people to sit inside a herd. Being genuinely contrarian is a lonely thing to do at times. Especially when fear of missing out is strong, people can do nutty things.

9. “Both closet indexing and shooting for the stars are exposing financial planners’ clients to undue risk. Both are a result of benchmark tyranny.”

“The knock on diversified funds is that they’re index-huggers, which given the geographic breadth of where we invest, is not at all the case for us. I know the argument that you should only own your best 30 or 40 ideas, but I’ve never proven over time that I actually know in advance what those are.”

“I think a concentrated portfolio is more of a bull market phenomenon. In a bear market, if you are too concentrated, you never know what can happen to your stocks. Some people have asked me whether I just invest in my best ideas, but the truth is that I don’t know in advance what my best ideas will be, so I’d rather diversify. Besides, the beauty of our global fund was that we could invest internationally, which helped to minimize country-specific risks. With that in mind, I am not saying that you should diversify the portfolio to the extent of creating a quasi-market index.”

“How come we don’t have more concentrated portfolio? Number one, because I’m not as smart as Warren Buffett. And number two, because truly, people say, “Well, why don’t you just invest in your best ideas?” But I don’t know in advance what will turn out to be my best ideas. So, that’s why we’re diversified.” 

Some value investors own only six stocks, some 30 and some hundreds. The degree of diversification an investor uses is a choice that fits within value investing as long as it does not rise to the level of closet indexing (“index huggers”). Charlie Munger points out that “[With] closet indexing, you’re paying a manager a fortune and he has 85% of his assets invested parallel to the indexes.  If you have such a system, you’re being played for a sucker.”

10. “By definition there are two characteristics to borrowing. Number one: borrowing works both ways. So you are compromising the idea of margin of safety if you borrow. Number two: borrowing reduces your staying power. As I said, if you are a value investor, you are a long term investor, so you want to have staying power.”

You can’t stay invested and participate in rising markets caused by a growing economy if you are out of the process since leverage has wiped out your equity stake. Howard Marks says: “Leverage magnifies outcomes, but doesn’t add value.”  Charlie Munger has said: “I’ve seen more people fail because of liquor and leverage – leverage being borrowed money.” Montier adds: “Leverage can’t ever turn a bad investment good, but it can turn a good investment bad.  When you are leveraged you can run into volatility that impairs your ability to stay in an investment or investing in general which can result in “a permanent loss of capital.”

11. “Sometimes in life, it’s not just about what we buy, but what we don’t buy.”

“A value investor doesn’t need to be constantly in touch with every security in every market in the world.”

This is consistent with Charlie Munger’s idea that instead of focusing all your energy on trying to be smart, a person should also focus on not being dumb.  It is important to have a “too hard pile” and to limit decisions to areas in which we are competent. By focusing your research on a smaller number of businesses that fall within your circle of competence you can do a better job on your research. Risk goes down when you know what you are doing.

12. “Contrary to many mutual fund managers, we do not believe we have to be fully invested 100% of the time.”

“Our cash balance is purely a residual of whether or not we’re finding enough to invest in.”

Some people think that because value investors tend to have cash to invest when markets are near bottom, value investor are “timing” markets. Value investors tend to have cash near market bottoms since they stop buying securities when markets are near the top of the cycle due to individual company valuations that do not provide a margin of safety.  If a value investor focuses on the micro aspect of individual businesses on a bottoms up basis, the macro tends to take care of itself. Matthew McLennan of First Eagle said recently: “We had our greatest cash levels in early 2009, not because we correctly timed the market bottom.”  Value, not price determines how much cash a genuine value investor has in the portfolio at any given time since that cash is a residual of a disciplined buying process.

Notes:

Staying Power: Jean-Marie Eveillard – Graham And Doddsville  http://www.grahamanddoddsville.net/…/an_interview_with_jeanmarie_eveillar

Eveillard: A value maestro’s encore   http://archive.fortune.com/2007/06/19/pf/funds/eveillard.fortune/index.htm

Morningstar http://corporate.morningstar.com/us/asp/subject.aspx?xmlfile=174.xml&filter=PR4061

Ivey Lecture: http://www.bengrahaminvesting.ca/Resources/Video_Presentations/Guest_Speakers/2014/Eveillard_2014.htm

Consuelo Mack: https://www.youtube.com/watch?v=Nd9MIJasr8I   http://www.gurufocus.com/news/147599/full-transcript-and-video-of-jeanmarie-eveillards-interview-with-consuelo-mack

Interview:  https://www.youtube.com/watch?v=i46Gt7ZT6yQ

Columbia Directory: https://www8.gsb.columbia.edu/cbs-directory/detail/je2402

A Dozen Things I’ve learned from Julian Robertson about Investing

1. “Smart idea, grounded on exhaustive research, followed by a big bet.”

“Hear a story, analyze and buy aggressively if it feels right.”

A colleague of Robertson once said: “When he is convinced that he is right, Julian bets the farm” George Soros and Stanley Druckenmiller are similar.  Big mispriced bets don’t appear very often and when they do people like Julian Robertson bet big. This is not what he has called a “gun slinging” approach, but rather a patient approach which seeks bets with odds that are substantially in his favor. Research and critical analysis are critical for Julian Robertson. Being patient, disciplined and yet aggressive is a rare combination and Robertson has proven he has each of these qualities.

2. “Hedge funds are the antithesis of baseball.  In baseball you can hit 40 home runs on a single-A-league team and never get paid a thing. But in a hedge fund you get paid on your batting average. So you go to the worst league you can find, where there’s the least competition. You can bat 400 playing for the Durham Bulls, but you will not make any real money. If you play in the big leagues, even if your batting average isn’t terribly high, you still make a lot of money.”

“It is easier to create the batting average in a lower league rather than the major league because the pitching is not as good down there. That is consistently true; it is easier for a hedge fund to go to areas where there is less competition. For instance, we originally went into Korea well before most people had invested in Korea. We invested a lot in Japan a long time before it was really chic to get in there. One of the best ways to do well in this business is to go to areas that have been unexploited by research capability and work them for all you can.”

“I suppose if I were younger, I would be investing in Africa.” 

What Julian Robertson is saying is that there is profit for an investor in going to where the competition is weak. Competing in markets that are less well researched give an investor who does their research an advantage. Charlie Munger was once asked who he was most thankful for in all his life. He answered that he was as most thankful for his wife Nancy’s previous husband.  When asked why this was true he said:  “Because he was a drunk. You need to make sure the competition is weak.”

Warren Buffett makes the point that the way to beat Bobbie Fisher is to play him at something other than chess. Buffett adds: The important thing is to keep playing, to play against weak opponents and to play for big stakes.” And “If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”  Some investors try to find a market or a part of a market where you aren’t the patsy if you want to outperform an index.

3. “I believe that the best way to manage money is to go long and short stocks. My theory is that if the 50 best stocks you can come up with don’t outperform the 50 worst stocks you can come up with, you should be in another business.”

The investing strategy being referred to here is a so-called “long-short” approach in which long and short positions are taken in various stocks to try to hedge exposure to the broader market which makes gains more associated with solid stocking picking. This approach is actually involves an attempt to hedge exposure to the market, unlike some hedge fund strategies that involve no real hedging at all. When Julian Robertson started using this this long-short approach it was less used and short bets especially were more likely to be mispriced than they are today. Many of Julian Robertson’s so-called “Tiger Cubs” continue to do long-short investing. A recent report claims that $687 billion is currently invested in long-short equity hedge funds.

4. “Avoid big losses. That’s the way to really make money over the years.”

Julian Robertson believes that hedge fund should make it a priority to “outperform the market in bad times.” That means adopting a strategy where the hedge fund actually hedges. As previously noted, the long-short strategy helps achieve that objective.  Another way to avoid big losses is to buy an asset at a substantial discount to its private market value. When the right entry point is found in terms of price, an investor can make a mistake and still come out OK financially. This, of course, is a margin of safety approach.

5. “For my shorts, I look for a bad management team, and a wildly overvalued company in an industry that is declining or misunderstood.”

When an investor shorts a company with a bad management team it is a safer bet since a business with a good management team is far more likely to fix problems. In other words, if a shorted business has a bad management team it is insurance that the real business problem problem underlying the short will continue. Julian Robertson is also saying that the overvaluation must be “wild” rather than mild for him to be interested in a short, and that he likes shorts in an industry in secular decline so the wind is at his back.

6. “There are not a whole lot of people equipped to pull the trigger.”

“I’m normally the trigger-puller here.”

The system used by Julian Robertson may decentralize the research and analysis function but it concentrates the trigger pulling with him. The newsletter Hedge Fund Letters writes:Managers oversaw different industries and made recommendations but Robertson had final say. The firm made large bets where they had conviction and each manager commonly covered less than ten long and shorts. Positions were continuously revisited and if things changed there were no holds – positions were either added to or removed.”  Someone can be a great analyst and yet a lousy trigger puller. Successful trigger pulling requires psychological control since most investing mistakes are emotional rather than analytical.

7. “I’ve never been particularly comfortable with gold as an investment. Once it’s discovered none of it is used up, to the point where they take it out of cadavers’ mouths. It’s less a supply/demand situation and more a psychological one – better a psychiatrist to invest in gold than me.”

“Gold bugs, generally speaking, are some of the craziest people on the face of the globe.”

On gold, Julian Robertson agrees with Warren Buffett, who has said:

“The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else — who also knows that the assets will be forever unproductive — will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century. This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce — it will remain lifeless forever — but rather by the belief that others will desire it even more avidly in the future. The major asset in this category is gold, [favored by investors] who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end. What motivates most gold purchasers is their belief that the ranks of the fearful will grow.”

To buy gold is to speculate based on your predictions about human psychology. That is not investing, but rather speculation. A gold speculator is engaged in a Keynesian Beauty contest: “It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.” (Keynes, General Theory of Employment, Interest and Money, 1936).

8. “When you manage money, it takes over your whole life. It’s a 24-hour-a-day thing.”

This is a quote from the book Hedge Fund Masters on the Rewards, the Risk, and the Reckoning by Katherine Burton. Julian Robertson is not alone in this way since many financial and tech billionaires only turn to things like philanthropy after a career change. This is also a statement about how competitive and constantly changing the investing world is. Only an academic like Bob Gordon who is not involved in the real world can make a claim that the pace of innovation is slowing. The pace of innovation is increasing and its impact is brutal. With regard to innovation and the level of competition in hedge funds, Roberto Mignone, head of Bridger Management said once: “You’ve got a better chance surviving as a crack dealer in Chicago than lasting four years in the hedge fund business.”

9. “The hedge fund business is about success breeding success.”

One of my favorite essays was written by Duncan Watts and is entitled: Is Justin Timberlake a Product of Cumulative Advantage? The concept of cumulative advantage is so important in understanding outcomes in life and yet it is so poorly understood. The basic idea is that once a person or business gains a small advantage over others, that advantage will compound over time into an increasingly larger advantage. This is sometimes called  “the rich get richer and the poor get poorer” or the Matthew effect based on a biblical reference. Merton used this cumulative advantage concept to explain advancement in scientific careers, but it is far broader in it application. Cumulative advantage operates as a general mechanism which increases inequality and explains why wealth and incomes follow the power law described by Pareto. Part of what Robertson is saying is that the more money you raise, the more money you can raise [repeat] the more talent you can attract, the more talent you can attract [repeat].

10. ” I remember one time I got on the cover of Business Week as “The World’s Greatest Money Manager.” Everybody saw it and I was kind of impressed with it, too. Then three years later the same author wrote the most scathing lies. It’s a rough racket. But I think it’s a good thing in human narcissism to realize you go from highs and lows based on your views from the press – really, it shouldn’t matter.”

Letting the views of the press on you impact your view of yourself or what you do is folly. Criticism is hard to take for most anyone, but considering the source is helpful in getting past that. The only thing that everyone likes is pizza. My uncle who recently passed away liked to say ‘Illegitimi non carborundum’ which is a mock-Latin aphorism meaning: “Don’t let the bastards grind you down.” This saying was popularized by US General Vinegar Joe Stillwell during World War II, who is said to have borrowed it from the British army.

11. “[In March 2000] This approach isn’t working and I don’t understand why. I’m 67 years old, who needs this? [In March 2000] There is no point in subjecting our investors to risk in a market which I frankly do not understand. After thorough consideration, I have decided to return all capital to our investors. I didn’t want my obituary to be ‘he died getting a quote on the yen’.”

Sometimes the world changes so much that it is time to either take a break or hang up your cleats – especially if you are already very rich. Some people do this successfully. Others ride old methods to their financial doom. Druckenmiller and others decided to mostly retire when they saw that their methods were no longer working. In 1969, Warren Buffett wrote a letter to his partners saying that he was “unable to find any bargains in the current market,” and he began liquidating his portfolio. That situation of course changed and Warren Buffett emerged with a new competitive weapon in the form of the permanent capital of a corporation rather than the panicky capital of a partnership.

12. “[At the age of six.] I still remember the first time I ever heard of stocks. My parents went away on a trip, and a great-aunt stayed with me. She showed me in the paper a company called United Corp., which was traded on the Big Board and selling for about $1.25. And I realized that I could even save up enough money to buy the shares. I watched it. Sort of gradually stimulated my interest.”

If you want a child to be interested in investing it is wise to introduce key ideas to them early in life in real form. No matter how small the stake, the impact of real money at work in a market means the experience is meaningful and memorable. Mary Buffett writes in her book that Warren Buffet believes that whether a person will be successful in business is determined more by whether a person had “a lemonade stand as a child than by where they went to college. An early love of being in business equates later in life to being successful in business.”

Notes:

Bloomberg Interview: http://www.marketfolly.com/2009/10/julian-robertson-interview-bloomberg.html

CNBC Interview: http://www.cnbc.com/id/101092813

Business Week:  http://www.bloomberg.com/bw/stories/1996-03-31/fall-of-the-wizard

Graham and Doddsville Newsletter: http://www8.gsb.columbia.edu/rtfiles/Heilbrunn/Graham%20%26%20Doddsville%20-%20Issue%2015%20-%20Spring%202012.pdf

Forbes Article: http://www.forbes.com/sites/schifrin/2013/06/05/julian-robertson-hedge-funds-are-the-antithesis-of-baseball/

UNC Blog: http://blogs.kenan-flagler.unc.edu/2010/09/27/hedge-fund-pioneer-julian-roberston-on-his-investment-philosophy/

The New Investment Superstars http://www.amazon.com/gp/search?index=books&linkCode=qs&keywords=9780471403135

Hedge Hunters: http://www.nytimes.com/2007/12/19/your-money/19iht-MCOLUMN22.html?_r=0

A Dozen Things I’ve Learned from Irving Kahn about Value Investing and Business

Irving Kahn was the chairman of the investment firm Kahn Brothers Group. He was born in 1905 and prior to his recent death was one of the oldest active professional investors.  The New York Times in its obituary of Irving Kahn wrote: “A disciple and later partner of Benjamin Graham, the contrarian advocate of value investing, Mr. Kahn would go on to work at Abraham & Company and Lehman Brothers, which he left in 1978 to open Kahn Brothers Group with two of his sons, Alan and Thomas.” Jason Zweig wrote in his tribute to Kahn: “He [was] Mr. Graham’s teaching assistant in the classes on security analysis that the great investor taught at Columbia Business School. Mr. Kahn also assisted Mr. Graham and Columbia professor David Dodd in researching their classic book, ‘Security Analysis,’ published in 1934.”

1. “In the Thirties, Ben Graham and others developed security analysis and the concept of value investing, which has been the focus of my life ever since. Value investing was the blueprint for analytical investing, as opposed to speculation.” 

“Very few people have Ben Graham’s ability to take a subject very complex and boil it down to something simple.” 

“Value investing is an art, not a science.”

“Between the ultra-depression-conservatism of Ben Graham and the brilliance of monopoly investor Warren Buffett, there are ample levels [of value investing] that should fit your own pattern of risk to reward, suitable for your capital needs and lifestyle.”

In these few sentences Irving Kahn identified many important points about value investing. First, value investing is a system. Second, the system is simple, but not easy to implement since certain aspects of value investing are an art. Third, by following the value investing system’s analytical approach you can invest rather than speculate. Fourth, the value investing system created by Ben Graham in the Thirties has evolved since times have changed. Fifth, there are variants of the value investing system that can be created on top of certain bedrock principles which will be discussed below. You can always find an approach that meets your unique needs.  For example, after you retire, certain aspects of your approach to value investing can change.

2. “[Always] know much more about the stock I’m buying than the man who’s selling does.”

“The gambling nature of Wall Street has little or no interest in the serious, underlying nature of businesses.”

A value investor treating an investment security as a partial interest in an actual business is the first bedrock principle of value investing. If a share of stock does not represent an actual interest in a real business, what the hell is it? To understand that business requires research about the business not investor psychology. Irving Kahn is also pointing out in this set of quotations a truism that for every seller there is a buyer and vice versa. Daniel Kahneman writes: “There is always someone on the other side of a transaction; in general, it’s a financial institution or professional investor, ready to take advantage of the mistakes that individual traders make.” You must work hard to understand the underlying business and its markets better than other investors to generate an investing edge.

 
3.  “Prices are continuously molded by fears, hopes, and unreliable estimates, capital is always at risk unless you buy better than average values.”

“There are always good companies that are overpriced. A disciplined investor avoids them. As Warren Buffett has correctly said, a good investor has the opposite temperament to that prevailing in the market. Throughout all the crashes, sticking to value investing helped me to preserve and grow my capital.” 

That an asset should be purchased at a sufficient discount to intrinsic value (which provides the investor with a margin of safety) is the second bedrock principle of value investing. Irving Kahn is saying that price is a very different concept than value since prices are determined in the short term by the emotional state of investors and speculators. There is always a risk that price will be less than value just like there is always the opportunity that price will exceed value. Irving Kahn is also saying that you can pay too much even for a quality company and that avoiding conventional wisdom is wise. Seth Klarman points out that “value investing is a marriage between a contrarian and a calculator.”

4. “Security prices are as volatile as ocean waves – they range from calm to stormy.”

“No one knows when the tide will turn. Those who are leveraged, trade short-term and have bought at a high prices will be exposed to permanent loss of capital. I prefer to be slow and steady. I study companies and think about what they might return over, say, four or five years. If a stock goes down, I have time to weather the storm, maybe buy more at the lower price. If my arguments for the investment haven’t changed, then I should like the stock even more when it goes down.”

That Mr. Market should be treated as a servant rather than a master is the third bedrock principle of value investing. When J. P. Morgan was asked for a market prediction he said: “It will fluctuate.” Business cycles are inevitable due to wildly gyrating emotions of the people who make up a market. As large numbers of people follow each other due to their herding instinct they will inevitably sometimes underestimate and sometimes overestimate the actual intrinsic value of a business. Markets cycling back and forth between fear and greed present a rational investor with an opportunity to benefit, if the investor purchases assets based on intrinsic value and doesn’t try to time market prices .  This is a hard concept for many people to grasp. Buying at a discount to intrinsic value seems like timing to some people, but it isn’t because you are not predicting the future price of the asset in the short term. You wait for an attractive price rather than predict its timing. The bet is that you know something will happen in the future, but you do not know when.  If you are having trouble with this idea, I suggest you read Seth Klarman’s book Margin of Safety.  They key word for me is “wait.” When you are waiting you are not predicting when something will happen, just that it will very likely happen sometime. Irving Kahn is essentially saying that good things come to he or she who patiently waits for a bargain purchase to become more valuable.

5. “You must have the discipline and temperament to resist your impulses. Human beings have precisely the wrong instincts when it comes to the markets.”

“The Depression taught me what frugality means and the importance of not losing money.”

That an investor must make rational decisions is the fourth bedrock principle of value investing. This fourth principle is by far the hardest part of value investing. The battle humans constantly fight to make rational decisions is never ending.  You will never stop making some boneheaded mistakes, but you can, with work and attention, reduce both their frequency and magnitude. learning from mistakes, especially the mistakes of others which is less personally painful, is wise. Many value investors like to read biographies since it is a great source of stories about mistakes and successes of all kinds. The way to acquire good judgment is often through bad judgment.

6.  “We basically look for value where others have missed it. Our ideas have to be different from the prevailing views of the market. When investors flee, we look for reasonable purchases that will be fruitful over many years.”

“Lemmings always lose.”

Irving Kahn thought like a contrarian in order to identify mispriced assets. Howard Marks says investing is a search for the mistakes of other people. Market inefficiency is a fancy academic term for mistakes. That people often acting like lemmings is an opportunity for the rational investor. It is mathematically impossible to follow the crowd and outperform the crowd. Charlie Munger noted at the 2015 Berkshire Annual Meeting that “If people weren’t often so wrong, we wouldn’t be so rich.”  You must “think differently” and be right about what you are thinking differently about to outperform a market. In seeking to be contrarian, one must avoid what some people call “the hipster paradox” (attempts to be different often end up with people making the same decisions).

7. “Our goal has always been to seek reasonable returns over a very long period of time. I don’t know why anyone would look at a short time horizon. In my life, I invested over decades. Looking for short-term gains doesn’t aid this process.”

Because most people are impatient, a smart, rational and patient investor is able to arbitrage time and generate outperformance. Value investing is a process in which you get rich not only slowly but in a lumpy fashion. If you can’t handle a slow process, irregular returns and occasional periods of underperformance, you are not a candidate to be a successful value investor.

8. “Remember the power of compounding. You don’t need to stretch for returns to grow your capital over the course of your life.”

Vanguard has an example which illustrates the power and value of compounding. How reinvesting can pay off over time:

“Let’s say you begin with two separate $10,000 investments that each earn 6% a year (keep in mind this is a hypothetical example, and actual returns would likely be different and a lot less predictable). In one $10,000 investment, you withdraw your investment earnings in cash each year, and the value of your account stays steady, as you see with the flat line in the chart below. In the other investment, you don’t cash out your earnings—they get reinvested. The curved line below shows the power of compounding and time. If you keep reinvesting the earnings (and again, we’re assuming a steady hypothetical return of 6% each year) after 20 years your investment will have grown by more than $20,500. And if you’ve got an even longer time frame—for example, if you’re in your 20s and saving for retirement—after 40 years, your investment will have grown by more than $92,000.”

9. I don’t watch [the stock market every day], because I’m not a trader.” 

“The public is spellbound by daily price moves. Less noticed are long-term economic changes that ultimately set future prices.”

“Investors must remember that their first job is to preserve their capital. After they’ve dealt with that, they can approach the second job, seeking a return on that capital.” 

“If the art of investing were actually easy, or quickly achieved, no one would be in the lower or middle classes.”

If investing was easy everyone would be rich. For some people one of the hardest things to do as an investor is to not be overly focused on daily price variations. Watching prices wiggle back and forth can be mesmerizing. But watching prices move all the time can make people do nutty things. Unfortunately, many investors seem to think there is some sort of a financial prize for hyperactivity when it is in fact a penalty because of fees, costs and the potential for more mistakes. The best way to prevent mistakes from ruining performance is to have something that is a cushion against mistakes.  One analogy I like is the safety driving distance between your car and the car ahead of it on the freeway. Even if the car ahead of you stops unexpectedly, you have build in a margin of safety. If you are building a bridge as the engineer you want to make sure that it is significantly stronger than necessary to deal with more than the very worst case.  Preserving capital as an investor is best achieved by buying at a margin of safety since even if you make a mistake things can still work out well due to the cushion against error. And if the investment goes well you can earn an even bigger return obviously if you buy the asset at a bargain price.

10. “I stick to the 20 odd stocks that I hold.”

Irving Kahn was a focus investor who liked to hold only a relatively small number of stocks. Whether one concentrates stock holdings as a value investor like Irving Kahn or diversifies their investments is a personal choice. Both approaches can be successful in their own way.  As was mentioned above, an investor’s choice regarding diversification is a variable in the value investing system.

For example, the value investor Joel Greenblatt has chosen diversification for his most recent fund. He has done so because he does not believe the  people who invested in his fund have the courage to stay in the fund if they underperform for a significant period of time. Ben Graham was also relatively diversified as an investor but for different reasons. Famous value investor Walter Schloss was also someone who diversified his portfolio. In comparison, Charlie Munger and others believe in concentrating their investments. For example, in the fall of 2014 Bill Ackman’s Pershing Square International fund owned only six stocks.

11. “You don’t have to be fully invested all the time. Have patience, keep your standards.”

“You gain much more by slow investing and concentrating on what you know, than on fast investing, which is nothing more than gambling.”

Patience is an essential attribute of a Ben Graham-style value investor. And sometimes being patient means holding significant amounts of cash and not being fully invested.  This cash position for a value investor is usually just a natural product of not finding businesses selling at prices that allow for a  margin of safety. “Concentrating on what you know” is what is called staying with a circle of competence in value investing circles. The way to lower risk is to know what you are doing and the way to know what you are doing is to stay focused on areas where you have genuine knowledge and skills. “Getting rich slow” is too hard for most people to do.

12. “From some of the financial history books I read that discussed the market cycle, I learned that stocks in certain industries were especially volatile, and copper was one. I looked at the stock index list, and decided to short a copper company called Magma Copper. Because I had little money, I had to ask my brother-in-law, who was a lawyer, to open a brokerage account for me. With $50, I shorted the stock in the summer, and my brother-in-law said it wouldn’t be long before I lost all my money because the market was going up, and I was telling it to go down. In October 1929, when the stock market crashed, my $50 became nearly $100. That was the first trade of my life.”

“I’m a passionate reader. That’s why being an investor is the perfect job for me.”

“To be a successful investor learning is essential.” 

“Net-net stocks were easy to find in the early days. All I had to do was to look over annual reports and study balance sheets. I tried to find companies that had dependable assets such as cash, land, and real properties. Then I made sure they didn’t have too much debt and had decent prospects. If these stocks traded at below their net working capital, then I would be interested in buying them.

I understand that net-net stocks are not too common anymore, but today’s investors should not complain too much because there were only a handful of industries in which to look for stocks in the old days. Now there are so many different types of businesses in so many different countries that investors can easily find something. Besides, the Internet has made more information available. If you complain that you cannot find opportunities, then that means you either haven’t looked hard enough or you haven’t read broadly enough.” 

The best investors read a lot. It’s that simple. They also take time to think about what they have read. It is amazing how many people who don’t read. Particularly amazing to me are people who think buying books without reading them creates any value. They must imagine that the ideas in the unread books travel magically into their brains as they sleep or watch television. What Irving Kahn is also talking about here is the fact that value investing has evolved over the years. As time passed after the Great Depression, it became harder and harder to find publicly traded stocks trading at less than liquidation value. Some value investors started looking outside the major markets, others went looking in private markets and others started considering quality in the analysis of value. Charlie Munger points out that despite this evolution the value investing system continues to work well.

Notes:

Telegraph – 108-year-old investor, “I’m Still Winning”
WSJ – Jason Zweig on Irving Kahn

NPR – The 100 Year Old on Wall Street

A Dozen Things I’ve Learned from Roelof Botha about Venture Capital and Business

Roelof Botha is a partner at the venture capital firm Sequoia Capital. He has been involved in many businesses. He also writes: “Some democratize technology access (Square, Eventbrite, Unity); some create global user communities (YouTube, Tumblr, Instagram, Whisper, QuizUp); and others disrupt markets through innovative business models (Evernote, Weebly, Xoom).” In 2000, prior to his graduation from Stanford Graduate School of Business, he was a director of corporate development for PayPal. He was named CFO in September 2001 and after the PayPal IPO joined Sequoia in 2003.

1. “The key characteristic [of a founder] is the desire to solve a problem for the customer. That is the driving passion, not ‘I think this is going to be a billion-dollar company and I want to hop in because I can get rich.’”  

“I look for the personal passion of the entrepreneur, their ability to describe the problem articulately, and the clarity with which they can explain why they have a unique and compelling solution to the problem.”  

“The most successful entrepreneurs tend to start with a desire to solve an interesting problem—one that’s often driven by personal frustration.”

If a business is not solving a genuinely valuable problem for customers nothing else matters and failure is inevitable. Founders who are thinking about revenue models, term sheets and lots of peripheral issues when the business is not yet solving an important and valuable customer problem are missing the boat. In making these statements Roelof Botha is expressing a desire for missionary founders over mercenary founders. Botha’s partner Doug Leone also favors missionary founders. John Doerr of KPCB also feels the same way about missionaries being preferable to mercenaries. For the same reason, Brian Chesky of AirBnB once said: “in a war, missionaries outlast and endure mercenaries.”

On a related point, Roelof Botha has said that he thinks many great companies sell out too early. He has said that Sequoia “loves being in business with entrepreneurs that want to build something enduring.”

2.  “There is a 50% mortality rate for venture-funded businesses. Think about that curve. Half of it goes to zero. There are some growth investments—later stage investments—which makes things less drastic. Some people try for 3-5x returns with a very low mortality rate. But even that VC model is still subject to power law. The curve is just not as steep.” 

Venture capital requires outsized tape measure home runs to be successful because of the failure rate. A few giant winners must make up for many failures. Basic mathematics dictates this requirement. You can’t have failure rates that reflect a power law without huge returns from so-called “unicorns.”  The need for unicorns drives the selection process of venture capitalists. This fact of life in the venture business means focusing on big markets and businesses that have the potential to grow revenues and profits at nonlinear rates. Most businesses that are formed are not candidates for venture capital. That’s OK.  The best way forward for a business which will never have revenue above $100 million may be bootstrapping with internally generated cash, business loans or investments from friends and family.

3. “Entrepreneurship is much more than what VCs participate in.” 

Many businesses described by founders as needing venture capital are really just small businesses looking for what amounts to small business finance. The people who start these businesses are genuine entrepreneurs. Often they are better off with bootstrap financing or borrowing money in the form of a loan. The businesses created by these entrepreneurs are very important businesses, and a key part of building an economy and creating jobs. But they are not the sort of businesses that are suitable for venture investing. Again, that’s OK.  the total amount of venture financing is overall a relatively small part of an economy. Because of its impact on innovation and productivity venture capital punches far above its weight in terms of impact, but the absolute dollar amount invested per year is relatively small.

4. “Think of yourself as the central point of a network.”

The best way to scale a business is to create flywheels, which is another name for a self-reinforcing phenomena. And in the center of any flywheels benefitting any startup are the founders and their team. To make a flywheel happen they must create a network that is mutually reinforcing. The tricky part of any flywheel is overcoming the chicken and egg problem. How does the business generate initial momentum before all the pieces are in place. Usually the jump start takes the form of a free chicken or a free egg.

5. “The answer [to creating a flywheel] lies in two essential variables: the size of the market and the strength of the value proposition. Any growth goes through an exponential curve, then flatters with saturation. If the ceiling of the market opportunity is $200 million, even if you get a flywheel, it will take you from twenty to sixty or seventy, then peter out because you saturated the available space.

The bigger the market the more runway you have—so if you hit that knee of the curve, you can grow exponentially and keep going for a long time. Doubling a business of material size for three to four years leads to a really large, important company. That’s a key element in the flywheel idea.”

To achieve the sort of growth needed by venture capital it is best to be surfing on a phenomenon that is nonlinear. Moore’s law is one such phenomenon especially when the business also benefits from network effects. Sometimes a flywheel is created in a really small markets and that is not so interesting to a venture capitalist given the need for unicorn style returns.

6. “Companies can end up with too much cash. They might have a 15-month runway. They get complacent and there’s not enough critical thinking. Things go bump at 9 months and it turns into a crisis. And then no one wants to invest more.”

Josh Kopelman of First Round Capital has a great post about raising cash in which he said: “You should target 18 to 24 months of runway post Series Seed.” He also makes important notes about how much harder it is to raise an A round than seed stage capital. The amount of Series A capital available is not much bigger and the number of seed funded startups competing for the money is larger than has been the case in the past. One suggested rule is that a startup that has 12 months of cash should be thinking about raising more cash, and should definitely have started raising by the time they have only 9 months of cash, and should be nervous if they only have six months of cash on hand.

7. To achieve a big success, many things must come together. In some cases, what looked like smooth sailing from the outside was more like a near death experience; a few small changes and the outcome would have been dramatically different. There is always a mixture of skill and luck involved.”

“You have to put yourself in a position to be lucky.”

When considering the difference between luck and skill is it always best to refer to the work of Michael Mauboussin: “There’s a quick and easy way to test whether an activity involves skill; ask whether you can lose on purpose. In games of skill, it’s clear that you can lose intentionally but when playing roulette or the lottery you can’t lose on purpose.” My friend Craig McCaw said to me more than once that a ship as viewed from the dock may look pretty with the captain smiling from the upper deck in a resplendent uniform — but under the decks there is inevitably some ugliness associated with the travails of actually running something.

8. “Problem companies can actually take up more of your time than the successful ones.”

Time is the scarcest resource of a founder or venture capitalist. And the biggest time sink is a business that has lots of problems. When problems arise, that is when the value of a great board, advisers and mentors kicks in and the reason why when given a choice a startup always wants to raise more than money. Investors who bring expertise and helpful relationships to the business are always preferable to purely financial investors.

9. “It’s important to choose initial investors who are not twitchy and rushing for an exit.” 

“Who are you getting in business with? You really have to get to know the [VCs] you might be working with. You’re essentially entering a long-term relationship.”

“Consider a simple 2 x 2 matrix: on one axis you have easy to get along with founder, and not.  On the other, you have exceptional founder, and not. It’s easy to figure out which quadrant VCs make money backing.”

When you are potentially entering into a relationship with people who will be in your life for many years, why would you make a choice to involve people in your business who are hard to get along with? Not only do poor relationships with key people substantially lower your chance of success, the process will make you miserable. Why be miserable? Life is short.

10. “Think about private investing. It’s very different from hedge-fund investing or public investing; you can take advantage of market psychology and short term mismatches because you can exit. We don’t have that luxury in venture capital. We can’t bet this trend will be fashionable for the next three years. By definition we need to have a long term stance. Maybe the company goes public or is acquired in three years, five years, ten years— who knows …We like long runways.”

The length of time it takes for a venture capital investment to pay off drives many aspects of the venture capital industry. Sequoia is rather famous for saying to its portfolio companies: “if you don’t have cash for a long runway, you better have a revenue model that gets you to cash-flow positive quickly.” The better option is to have enough cash and cash flow to last a long time. Warren Buffett treats cash as a call option with no expiration date, an option on every asset class, with no strike price. As an analogy, venture capital funds lock up capital from the limited partners during the life of the fund for that reason.  Buffett again says “Cash combined with courage in a crisis is priceless.” It is during a downturn that the hiring gets easier and cheaper, so building a company then can ironically be very attractive.

11.  “Since the distribution of startup investment outcomes follows a power law, you cannot simply expect to make money by simply cutting checks. That is, you cannot simply offer a commodity. You have to be able to help portfolio companies in a differentiated way, such as leveraging your network on their behalf or advising them well.”

Every startup and its founders, employees, business and markets are unique. Startups need hands-on help with finding product market fit, recruiting, finance, team building and other aspects of building a business. If the venture capitalists involved in a startup are not assisting with things like recruiting early engineers and closing big sales, the startup has the wrong venture capitalists. Venture capital is a service business, not just a way to make money via finance.

12. “There is a subtle benefit of actuarial science which I didn’t appreciate when I joined the profession. Professor Robert Dorrington at UCT once quipped, ‘Actuaries are trained to think 30 years into the future and accountants are trained to think a year in arrears.’ Part of what actuarial science enforces in you is long-term thinking and that frame of mind influences the work that I do today. We invest in companies that employ three people and we have to imagine what the company might turn out to be in 10 or 15 years.”

Roelof Botha was actually trained as an actuary. He points out that a successful venture capitalist must able to imagine what something might be a 10-15 years later. Of course, since it is magnitude of success and not frequency of success that will determine outcomes, a venture capitalist only needs to be really right about what they imagine in a few cases.

Imagining the future is not a science but an art. This description from Botha about what he is looking for is qualitative: “The key to start-up success is purity of motivationIf they can weave a believable story with a compelling value proposition, they’ll have us hooked.”

 

 

Notes:

Nothing Risked Nothing Special Gained (video)

What does Roelof Botha look for in a founder? (video)

This Week in Startups (video)

Roelof Botha: Entrepreneurship is Not Synonymous With Founder (video)

Peter Thiel’s Startup Class 7 Notes (Blake Masters)

AllThingsD – Kara Visits Sequoia’s Roelof Botha

Roelof Botha on startups: Ditch the polish, it’s about ‘raw authenticity’

TechCrunch Disrupt 2012 – Sequoia’s Botha on Entrepreneurship

Reuters: IPO? No thanks, say Silicon Valley CEOs

The Actuary Interview: Roelof Botha

A Dozen Things I’ve Learned from Ben Carlson about Investing

Ben Carlson is one of my favorite finance writers. He is a CFA and has been managing institutional investment portfolios since 2005. He is both a writer and a teacher. His book on investing entitled A Wealth of Common Sense is out soon (you should pre-order it).

What I like best about Ben Carlson is that he is young and very savvy about not only investing but the tools of social and other forms of modern media like Twitter and Tumblr.  Too many of the people I write about who are able to teach others about investing are, well, either old or very old. People like  Ben Carlson, Patrick O’Shaughnessy, Morgan Housel, James Osborne and Josh Brown (the Magnificent Five) represent the next generation in financial writing. They are fearless in confronting financial advice poseurs of all kinds. That they all are moving swiftly into media formats like video makes me hopeful they can successfully combat more of the hucksters pushing “easy wealth in seven steps” style schemes. I am rooting for them, especially when they go after people like constantly self-promoting old coots flogging their financial flim-flams that hurt ordinary investors. The way they attack promoters of high sales loads and hidden fees with these new tools inspires me. When these Magnificent Five go after the “bad guys” I am always cheering  them on.

 

1. “The all-time great investors –Buffett, Marks, Dalio, Klarman, Munger and even Gundlach – have the ability to translate their ideas into simple terminology. Not only are they brilliant, but they all simplify their message when explaining their process.”

Teaching other people helps you think through your own ideas. If you can’t reduce your ideas and investing process to something you can describe simply to others, it is less likely that you have a sound investing process or at least your investing process is not as good as it might be. Teaching about investing has another benefit in that limited partners who understand your investing process are much more likely to stay with you when you are under-performing the market. Simply put, having investors who understand your investing process is a competitive advantage. Seth Klarman puts it this way: “At the worst possible moment, when your fund is down because cheap things have gotten cheaper, you need to have capital, to have clients who will actually love the phone call and – most of the time, if not all the time – add, rather than subtract, capital.” And finally, teaching others about investing is good for the teacher’s brand. A strong personal brand buffed to a shine via teaching makes raising money from limited partners easier.

2. “If you study Buffett, Marks, Soros, Lynch, Dalio, etc. you will find that even though their strategies differ, they all share the ability to control their emotions and make clear, probability-weighted investment decisions based on past experiences.”

The psychological aspects of investing are by far the biggest challenge for any investor. Getting control of yourself is a key part of getting control of your finances and investments. Humans will never stop making emotional mistakes. Focusing a significant portion of your time and energy on reducing those mistakes pays big dividends. On Ben Carlson’s second point Michael Mauboussin describes how to make wise, probability-weighted decisions: “Expected value is the weighted-average value for a distribution of possible outcomes. You calculate it by multiplying the payoff (i.e., stock price ) for a given outcome by the probability that the outcome materializes.”

If you can think probabilistically while controlling your emotions, investing gets far easier. Studying great investors helps with that learning process. Famous value investor Irving Kahn said once: “millions of people die every year of something they could cure themselves: lack of wisdom and lack of ability to control their impulses.”

3. “Everyone is conflicted in some way. It’s impossible to avoid conflicts of interest in the financial services industry. It is a business after all. The trick is to understand how incentives drive people’s actions and look for those firms and individuals that are up front and honest about any potential conflicts.”

The phrase “everyone is talking their book, all the time” has been seared in my brain ever since I heard it first from my friend Bill Gurley. It’s such a simple way to capture an important idea. An old German proverb says: “whose bread I eat, his song I sing.” And a lot of the time you are eating your own bread. Daniel Kahneman puts it this way: “Facts that threaten people’s livelihood and self-esteem — are simply not absorbed. The mind does not digest them.”  Warren Buffett advises people to beware of asking your barber if you need a haircut for that reason.

Buffett’s partner Charlie Munger said recently: “If the incentives are wrong, the behavior will be wrong. I guarantee it.”  That adds to what he said many years earlier: “I think I’ve been in the top five percent of my age cohort almost all my adult life in understanding the power of incentives, and yet I’ve always underestimated that power. Never a year passes but I get some surprise that pushes a little further my appreciation of incentive superpower.”
4. “It’s easy to be a long-term investor during a bull market. Everyone’s making money and it feels like you can do no wrong.  It’s when things don’t go as planned that this group loses control.”

People panic. Not only do they panic, but they follow other people who have panicked, who are following other people who have panicked [repeat]. Being in a “thundering herd” is most often not a good thing.  And to outperform the market you must leave the confines of the herd and be right about your reason for leaving. No one is ever contrarian as an investor “just in time” on a consistent basis. Contrarians must inevitably endure periods of underperformance and sometimes even ridicule from the herd.  Of course, being too early is often indistinguishable from being wrong.
5. “It’s not enough to say you will buy when fear is high and stock prices are low. You also have to have the necessary funds available to make purchases during times of maximum pessimism.”

Jason Zweig did a wonderful interview of Charlie Munger in which he wrote: “Successful investing, Mr. Munger told me, requires ‘this crazy combination of gumption and patience, and then being ready to pounce when the opportunity presents itself, because in this world opportunities just don’t last very long.” Sitting on the sidelines in a rising market with cash earning just about nothing is a very hard thing to do. Lots of people may see a bargain during a downturn but may not have any dry powder at that time which allows them to act on that insight. Timing markets is folly, but having a long term attitude and only buying stock at prices that offer a margins of safety can help someone have cash available at a time like 2009.

6. “Understanding yourself and your own tendencies can be much more helpful to the investment process than knowing exactly what’s going on in the markets. You have no control over what’s going to happen in the markets, but you have complete control over your reactions to them.”

Most mistakes are psychological or emotional. Even Daniel Kahneman has said that after a lifetime of study of dysfunctional heuristics he still makes bonehead errors. Staying rational when making investment decisions is a life long struggle. You can never learn enough so that dysfunctional heuristics won’t potentially lead you to folly and error.

Everyone makes mistakes. The job of an investor is to make fewer new mistakes and to try to avoid being an idiot. Simply avoiding idiocy is highly underrated. My sister, a psychologist, said to me recently “what I think about in my practice is often not too different from what you write about on your blog.” This is of course true. Knowing yourself pays big dividends if you are an investor.

7. “Increased activity does not necessarily lead to better results.”

Investing by nature requires some activity. But not much. In other words, investing can never be completely passive. For example, you must allocate assets and chose an index fund/ETF if you are a passive investor. But there are aspects of investing where doing less through diversification improves performance since it decreases fees and lowers the adverse effects of performance chasing. As another example, an active investor who invests seldom but in a very aggressive way when the odds are substantially in their favor often experiences the best results. The market does not award prizes to investors who are hyperactive. Investors who are too concerned with always “doing something” are like horses wearing extra weight at a racetrack.

8. “All else equal, a talented sales staff will trump a talented investment staff when attracting capital from investors. There are organizations that can have both, but typically the firms with the best sales teams or tactics will end up bringing in the most money from investors. A well-thought-out narrative by an intelligent, experienced marketing department with the right pitch book can do wonders at persuading investors to hand over their hard-earned money. It’s difficult to admit we can be so easily persuaded but it’s true.”

Most investments are sold rather than purchased. Nothing else explains people still paying sales loads when purchasing an investment, when they are often easily avoided. There are people who can sell ice to Eskimos and many of them are selling investments. Howard Marks in a masterful recently published essay on liquidity skewers a few marketing strategies that are being foisted on people as an ‘investment free lunch’.

9. “Most investors will be immediately drawn to the marketing firms because people typically gravitate towards certainty, confidence and the latest fads.”

People love people who are confident. Daniel Kahneman writes: “Overconfident professionals sincerely believe they have expertise, act as experts and look like experts. You will have to struggle to remind yourself that they may be in the grip of an illusion.” You’ve seen these supremely confident motivational speakers make their pitch to investors saying things like “Just follow these seven steps and you will be rich.” It’s bullshit, but as long as it is presented confidently large numbers of sheep, err people, will follow.

10. “Financial models are fairly useless if you take them at face value. I dealt with extremely complex Excel spreadsheet models on a daily basis. They were a thing of beauty for spreadsheet geeks. Complex formulas and macros, linked data, pro-forma financial statements — all with the analysis spit out in a neat summary page. Every tiny piece of company and industry data was meticulously estimated or tracked down to the nearest decimal point. 

Many of the analysts I worked with told me it was their modelling skills that really set them apart from their peers.  But what I found from navigating these models is that there was always one or two levers you could pull that would completely change your output (price target or earnings estimate). A minor change to a discount rate or future growth rate assumption could drastically change the end result by a wide margin.”

When someone delivers you a spreadsheet and makes an argument based on that spreadsheet, I suggest to travel right to the assumptions.  This approach saves great amounts of time and wasted energy. Contrary to that old proverb, the devil is actually making trouble in the assumptions rather than in the details. There are also angels lurking in the assumptions too since a lot of innovation has its source changing a commonly believed assumption. Scott Adams could have just as easily been talking about spreadsheets rather than slides when he said: “If you just look at a page and drag things around and play with fonts, you think you’re a genius and you’re in full control of your world.” People who believe their projections that run six years into the future are accurate are as common as leaves in New England.

11.”Sometimes negative knowledge by learning what not to do is just as important as figuring out the right way to do something.”

Getting ahead by avoiding stupidity, particularly if the activity can potentially result in a big mistake, is such a simple idea. No one personifies this idea more than Charlie Munger. “I think part of the popularity of Berkshire Hathaway is that we look like people who have found a trick. It’s not brilliance. It’s just avoiding stupidity.” In learning what not to do, it is best if you learn through other people’s mistakes rather than your own. Avoiding stupidity is best done vicariously. There is no better way to see a lot of stupid behavior over a short time than reading.

You can learn so much just by watching people make mistakes in life, especially if you are genuinely paying attention. Charlie Munger’s ideas again come to mind: “Just avoid things like racing trains to the crossing, doing cocaine, etc.  Develop good mental habits…. A lot of success in life and business comes from knowing what you want to avoid: early death, a bad marriage, etc.” As I’ve said many times, it is best to avoid situations where you have a big downside and a small upside (negative optionality) and to seek the inverse (big upside small downside).

12. “The reason so many people don’t have their financial house in order is because they (a) become overwhelmed or (b) don’t care about finance because they find it boring.”

If you don’t find business interesting you should not be trying to outperform the markets. If actively investing in stocks is not about understanding individual businesses and business in general then exactly what is it about?  Most everyone should buy a diversified portfolio of low fee index funds/ETFs.  One trick that may help is to understand that business gets more interesting the more you learn about it. Once you get to critical mass in understanding basic principles, it all gets more interesting. Especially if you enjoy understanding how systems fit together and mutually reinforce each other, business can be very interesting. Andy Warhol said once: “Being good in business is the most fascinating kind of art. Making money is art and working is art and good business is the best art.”

But even then to be really good at understanding business and investing you must understand many disciplines. You must adopt what Charlie Munger calls a lattice of mental models approach. The best book on this is by Robert Hagstrom entitled: Investing: The Last Liberal Art.

Notes:

http://awealthofcommonsense.com/

A Dozen Things I’ve learned from Stanley Druckenmiller About Investing

“Stan may be the greatest moneymaking machine in history. He has Jim Roger’s analytical ability, George Soros’s trading ability, and the stomach of a riverboat gambler when it comes to placing his bets. His lack of volatility is unbelievable. I think he’s had something like five down quarters in 25 years and never a down year. The Quantum record from 1989 to 2000 is really his. The assets grew from $1 billion to $20 billion over that time and the performance never suffered. Soros’s record was made on a smaller amount of money at a time when there were fewer hedge funds to compete against.”  – Inside the House of Money

 

1. “I think David Tepper is awesome and if he’d take my money, I’d give him some but I think his fund is closed.”

I included this quote to make the point that even though a very small number of great investors do beat the market, it is very unlikely that they are going to be willing to invest your money. Even Stanley Druckenmiller does not believe he can get into David Tepper’s fund. In other words, you won’t be a limited partner in David Tepper’s fund anytime soon. It is also unlikely that you will be able to replicate the market outperformance of these great investors on your own. It would be much easier for me to write on this blog and elsewhere that no one ever beats the market even though I know it is not true. Some people might find the fib justifiable by the fact that it will encourage people to invest in a diversified portfolio of low fee index funds/ETFs. But that would not be truthful, so I just can’t do it.

But this truth has a cost since overconfidence will cause a significant number of people to think that they can do what David Tepper and Stanley Druckenmiller have achieved as investors.  And these overconfident investors will go out and inevitably underperform the market. For me, honesty trumps paternalism. Dishonesty, even if only a fib in one area with arguably benevolent intent, is a slippery slope and has other costs. As George Washington said: ‘I cannot tell a lie.” But I will say that it is *highly* unlikely that you can be as successful as David Tepper and Stanley Druckenmiller. The sooner you realize that, the better off you will be.  Having said that, everyone can benefit from learning to make better decisions in life including decisions about how to allocate assets.

2. “George Soros has a philosophy that I have also adopted: The way to build long-term returns is through preservation of capital..

If you look at other posts I have written in this series on my blog you will see a consistent view expressed: not losing money is a critical part of the investing process. The great investors say it in different ways, but the point is always the same. For example, Warren Buffett says: “Rule No. 1: never lose money; rule No. 2: don’t forget rule No. 1.″ Paul Tudor Jones puts it this way: “I think I am the single most conservative investor on earth in the sense that I absolutely hate losing money.”  Seth Klarman provides the fuller explanation his book Margin of Safety:

“Avoiding loss should be the primary goal of every investor. This does not mean that investors should never incur the risk of any loss at all. Rather “don’t lose money” means that over several years an investment portfolio should not be exposed to appreciable loss of capital. While no one wishes to incur losses, you couldn’t prove it from an examination of the behavior of most investors and speculators. The speculative urge that lies within most of us is strong; the prospect of free lunch can be compelling, especially when others have already seemingly partaken. It can be hard to concentrate on losses when others are greedily reaching for gains and your broker is on the phone offering shares in the latest “hot” initial public offering. Yet the avoidance of loss is the surest way to ensure a profitable outcome.”

3. “Soros has taught me that when you have tremendous conviction on a trade, you have to go for the jugular.”

“I’ve learned many things from [George Soros]  but perhaps the most significant is that it’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”

As I noted in my blog post on Nassim Taleb, investing home runs come from finding mispriced optionality. “Optionality is the property of asymmetric upside (preferably unlimited) with correspondingly limited downside (preferably tiny).” Occasionally you can find a situation with a big upside and a small downside if you are patient and work hard to find it. When that happens if you can be brave and aggressive in your bet, you can hit a home run. Charlie Munger argues that hitting a few financial home runs in a lifetime is all you need for financial success. Unfortunately, being patient, brave and aggressive is not a typical combination of character traits for most people.

4. “My job for 30 years was to anticipate changes in the economic trends that were not expected by others, and, therefore not yet reflected in security prices.”

Fundamentally, the job of an investor is to find assets which are available for purchase that are mispriced by the markets. If a given trend is expected by others they will be reflected in security prices and there is not opportunity for the investor. In my post about George Soros I note that he once said: “Money is made by discounting the obvious and betting on the unexpected.” Like all great investors, Stanley Druckenmiller trained himself to be an intelligent contrarian when making a bet and only to do that when there was a big upside and a small downside. Phil Fisher put it this way: “Doing what everyone else is doing at the moment, and therefore what you have an almost irresistible urge to do, is often the wrong thing to do at all.”

Richard Thaler and Cass Sunstein do a fine job of relaying a Warren Buffett story here:  “Warren Buffett retells the story of the dead oil prospector who gets stopped at the pearly gates and is told by St Peter that Heaven’s allocation of miners is full up. The speculator leans through the gates and yells ‘Hey, boys! Oil discovered in Hell.’ A stampede of men with picks and shovels duly streams out of Heaven and an impressed St Peter waves the speculator through. ‘No thanks,’ says the sage. ‘I’m going to check out that Hell rumor. Maybe there is some truth in it after all.’”

5.  “I have always made big concentrated investments. I don’t believe in diversification. I don’t believe that’s the way to make money.”

“You are not going to make money talking about risk adjusted returns and diversification. You’ve got identify the big opportunities and go for them.”

“As far as Soros is concerned, when you’re right on something, you can’t own enough.”  

As Warren Buffett has pointed out many times: “diversification is protection against ignorance. It makes little sense if you know what you are doing.” Of course is that most people have no idea what they are doing when it comes to investing.  Most people don’t even understand the difference between speculating and investing. For this reason and others almost everyone should buy a diversified portfolio of low fee index funds/ETFs. Warren Buffett points out that by acknowledging that you are not smart money by putting a strategy in place that harnesses diversification you become the smart money.

Unfortunately any investor must still choose how to diversify, so they still must learn to make sound investing decisions (portfolio asset allocation requires that an investor actively make certain choices even if it is to buy low fee index funds/ETfs).

6. “Soros is the best loss taker I’ve ever seen. He doesn’t care whether he wins or loses on a trade. If a trade doesn’t work, he’s confident enough about his ability to win on other trades that he can easily walk away from the position. There are a lot of shoes on the shelf; wear only the ones that fit. If you’re extremely confident, taking a loss doesn’t bother you.”  

Michael Mauboussin has no peer in explaining why great investors focus on creating sound investing processes rather than outcomes. Because investing is a probabilistic process, results in the short term do not always distinguish between good and lousy processes. David Sklansky wrote in The Theory of Poker: ‘Any time you make a bet with the best of it, where the odds are in your favor, you have earned something on that bet, whether you actually win or lose the bet. By the same token, when you make a bet with the worst of it, where the odds are not in your favor, you have lost something, whether you actually win or lose the bet.” If your process is sound taking a loss in the short term shouldn’t bother you, as Druckermiller learned from George Soros.

7. “I particularly remember the time I gave (the research director) my paper on the banking industry. I felt very proud of my work. However, he read through it and said, ‘This is useless. What makes the stock go up and down?’ That comment acted as a spur. Thereafter, I focused my analysis on seeking to identify the factors that were strongly correlated to a stock’s price movement as opposed to looking at all the fundamentals. Frankly, even today, many analysts still don’t know what makes their particular stocks go up and down.”

“Valuation only tells me how far the market can go once a catalyst enters the picture to change the market direction.”

Stanley Druckermiller is referring here to the importance of identifying what Mario Gabelli calls a catalyst. Gabelli writes: “A catalyst may take many forms and can be an industry or company specific event. Catalysts can be a regulatory change, industry consolidation, a repurchase of shares, a sale or spin-off of a division, or a change in management.” Valuation is most, ahem, valuable when it can be combined with a catalyst. Buying at an attractive valuation gives you a margin of safety against mistakes and the catalyst can provide you will a turbocharged result on that basic foundation.

8. “I learned you could be right on a market and still end up losing if you use excessive leverage.”

“It takes courage to ride a profit with huge leverage.”

Leverage magnifies mistakes as much as any successes. But because wrong decisions when leveraged can take the investor or speculator completely out of the investing process, leverage is particularly destructive of financial returns. Howard Marks point out that “Leverage magnifies outcomes, but doesn’t add value.” Having said this it is clear that George Soros uses leverage and so has Stanley Druckenmiller. So the key word for Stanley Druckenmiller must be “excessive” when it comes to leverage. How much exactly is “excessive”? The answer it seems, from what I have read, is that it depends on the strength of your confidence in the bet. Druckenmiller did says once in The Wall Street Journal that “leverage at Soros’s Quantum rarely exceeds 3-to-1 or 4-to-1.” Needless to say I don’t think anyone playing along at home should think that investing in this way is applicable or appropriate for them.

9. “I only focus on what is black or white and kind of sift out the gray area in my investing style.”

Why invest in anything which you are unsure about when there are other options that you are more sure about? This is simple “opportunity cost” thinking. Michael Mauboussin puts it this way:  “We don’t have odds on the tote board [like in a horse race], but we have something called the stock price. So we reverse engineer the expectations built into that price. We say, ‘What has to happen for that to make sense?’ And then we look at how the fundamentals are likely to unfold.  It’s a probabilistic exercise. That would be the first piece. The second piece, analytically, is bet size, which is once you have an edge, how much do you bet in your portfolio? That’s a second key component which is often overlooked.”

Charlie Munger finishes the thought: “And then all that is required is a willingness to bet heavily when the odds are extremely favorable, using resources available as a result of prudence and patience in the past. We look for a horse with one chance in two of winning and which pays you three to one. And the one thing that all those winning betters in the whole history of people who’ve beaten the pari-mutuel system have is quite simple. They bet very seldom. It’s not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it—who look and sift the world for a mispriced bet—that they can occasionally find one. And 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’s just that simple.”

10. “Many managers, once they’re up 30 or 40 percent, will book their year [i.e., trade very cautiously for the remainder of the year so as not to jeopardize the very good return that has already been realized]. The way to attain truly superior long-term returns is to grind it out until you’re up 30 or 40 percent, and then if you have the convictions, go for a 100 percent year. If you can put together a few near-100 percent years and avoid down years, then you can achieve really outstanding long-term returns.”

Stanley Druckenmiller is talking about loss aversion here. Most people get conservative when they are winning. The best analogy for this bias happens in golf: “even the best golfers systematically miss the opportunity to score a “birdie” — when a player sinks a ball in one stroke less than the number of expected strokes for a given hole — out of fear of having a “bogey” — or taking one stroke more than what is expected. According to the researchers, for many, the agony of a bogey seems to outweigh the thrill of a birdie.”

Loss aversion can be found everywhere if you look. Venture capitalists investing “good money after bad” in the hope of saving a loss is just one example. Similarly, too much energy can be put into saving a business instead of devoting that energy to building one with greater potential. Daniel Kahneman describes loss aversion with a helpful example:  “In my classes, I say: ‘I’m going to toss a coin, and if it’s tails, you lose $10. How much would you have to gain on winning in order for this gamble to be acceptable to you?…People want more than $20 before it is acceptable. And now I’ve been doing the same thing with executives or very rich people, asking about tossing a coin and losing $10,000 if it’s tails. And they want $20,000 before they’ll take the gamble.”

11. “I certainly made my share of mistakes over the years, but I was fortunate enough to make outside gains a number of times when we had different views and various central banks. Since most investors like betting with the central bank, these occasions provided our most outside returns and the subsequent price adjustments were quite extreme. I don’t know whether we’re going to end with a malinvestment bust, due to misallocation of resources. Whether its inflation, or whether the outcome will actually be benign. I really don’t. But neither does the Fed.”

Many people believe that the Fed has extraordinary ability to predict the economy. Stanley Druckenmiller is saying that the people at the Fed put their underwear on one leg at a time like everyone else. They are reacting to events like everyone else. I think Janet Yellen is a great choice as a Federal Reserve Chairperson.  But it makes me nervous when I see people write about how she predicted this or that. I remember when people thought Alan Greenspan was great too. I believe that Janet Yellen is smart enough to know what she can’t predict.

As for how Druckenmiller made his bets against central banks, my hat is off to him. I don’t know how he did it. He has talked about the importance of understanding how central banks impact liquidityThe story he tells about the decision to short the British Pound is incredible. My hat is particularly off to him when he admitted that in today’s environment the tools he developed probably wouldn’t work. Humility is essential in a money manager he says, as is a focus on mistakes. In my view, we are in a new abnormal.” Charlie Munger commented about this recently: “I think it’s highly likely that the people who confidently think they know the consequences – none of whom predicted this – now they know what’s going to happen next? Again, the witch doctors. You ask me what’s going to happen? Hell, I don’t know what’s going to happen. I regard it all as very weird. Anybody who is intelligent who is not confused doesn’t understand the situation very well. If you find it puzzling, your brain is working correctly.”

12. “This is insane. I’ve never owned a stock that goes from $40 to $250 in a few months.”

The Internet bubble was literally insane. I’ve never been involved in anything in my life that was more surreal. Fear of missing out (FOMO) caused the bubble to reach unprecedented levels. FOMO is driven by an innate human desire to avoid regret. Daniel Kahneman has counseled financial advisors to “try to prevent people from acting out of regret.” Investors and speculators who are prone to regret are more prone to change their mind at precisely the wrong time. Primarily you want to protect them from regret, you want to protect them from the emotions associated with very big losses.

They key takeaway from the Internet bubble, for me, is that when it happens is not predictable. If it is a bubble and it does bust, the day before is like any other day. One key “tell” that can give you a sense that something is up is looking around and seeing lots of companies that are unprofitable paying far too much to acquire customers. What is too much? If the customer over their lifetime is producing a return that is significantly net present value negative the business is paying too much. How much is too much? It depends. If this pattern of acquiring net present value negative customers is persistent and widespread hairs should be standing up on the back of your neck. The bigger the net present value deficit the bigger the risk. Can you predict when it will end? No. “You can’t predict, but you can prepare says Howard Marks, and I agree. And for the hundredth time: risk is not the same thing as valuation.

 

Notes:

Inside the House of Money (Amazon)

The New Market Wizards: Conversations with America’s Top Traders (Amazon)

Soros: The Life and Times of a Messianic Billionaire (Amazon)

Bloomberg Interview on Strategy, Shorting IBM

Finance Trends – Stan Druckenmiller Talks Trading

Speech Transcript at Alpha

 

The Wall Street Journal – May 22, 2000

CNBC – Delivering Alpha Speech

Bloomberg – Druckenmiller calls it quits after 30 years

ZeroHedge – Druckenmiller on China’s Future & Investing’s New Normal

CNBC Interview (video) & article 

A Dozen Things I’ve Learned from Lou Simpson About Investing and Business

“Warren Buffett, in Berkshire’s annual letter to shareholders for 2004, devoted a section to [Lou] Simpson titled “Portrait of a Disciplined Investor,” saying Lou’s picks had produced an annual average return of 20 percent since 1980, compared with 14 percent for the Standard & Poor’s 500 Index.” – Bloomberg

“I pondered for eight years what makes Lou knock the cover off the ball,” Byrne said. “Lou is very bright, with an economics background from Princeton. But the woods are filled with bright guys. It has more to do with his personality. He is very, very sure of his own judgments. He ignores everybody else. He gets one or two really strong ideas a year and then likes to swing very hard.” -Jack Byrne

Lou Simpson is a man of few words in the press, so I have added thoughts from other value investors below a bit more than usual.

 

1. “When you ask whether someone is a value or growth investor – they’re really joined at the hip. A value investor can be a growth investor because you’re buying something that has above-average growth prospects and you’re buying it at a discount to the economic value of the business.”

I picked this quotation to start this blog post to illustrate how Lou Simpson and Warren Buffett “think alike.” Here’s Warren Buffett on the same point: “Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive…. Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.”

The idea that an investor might buy a stock regardless of whether it is available at a bargain price simply because the business is growing is foreign to both Buffett and Simpson. Charlie Munger agrees: “The whole concept of dividing it up into ‘value’ and ‘growth’ strikes me as twaddle.” What you want to find is a bargain, which takes a lot more work that just finding a business that is growing revenue a lot. There are some very high quality growing business that you would be nuts to buy at a high enough price and equally nuts not to buy at a low price. A high growth asset can be very risky if you overpay for it. Howard Marks points out: “When someone says, ‘I wouldn’t buy that at any price,” it’s as illogical as, “I’ll take it regardless of price.’” 

 

2. “Investors are going to make out a whole lot better if their whole emphasis is on owning businesses.”

“Invest in high return businesses run for the shareholders.”

“Return on capital. That really tells you a lot. One of the basic problems is that there is so much noise around earnings that you really have to rip apart the financials to understand what the real numbers are. It’s really the basic returns on equity capital [that are] important, but sometimes they’re not obvious. Even so, I think you have to look at a lot of things. You have to figure out what the earnings growth rate of the company will be over an extended period of time, and then apply a discount rate to it so you can come up with the best valuation. It’s easy in principle but it’s extremely difficult in practice.”

One of the four bedrock principles of Ben Grahamstyle value investing is that a security represents partial ownership of an actual business and should not be treated as a piece of paper to be traded based on investor psychology. This means that understanding the business itself is essential to understand the value of a security. To be a value investor you must dig deep and do research on how the business operates, its markets and its competitors. Charlie Munger argues: “All intelligent investing is value investing — acquiring more than you are paying for.  You must value the business in order to value the stock.” If you find this process boring or can’t find the time to do it, it is very unlikely that you will be a successful investor.

Ben Graham once said: “Investment is most intelligent when it is most businesslike.” What he means is that to understand a stock or bond you must understand not only the business but business generally. Seth Klarman in a Charlie Rose interview once said: “I think Buffett is a better investor than me because he has a better eye towards what makes a great business. When I find a great business, I am happy to buy it and hold it. [But] most businesses don’t look so great to me.” Daniel Kahneman has a nice take on this point arguing that people like Lou Simpson or Warren Buffett are not in the business of stock picking; they pick businesses and managers. Lou Simpson again: “One of the things I have learned over the years is how important management is in building or subtracting from value. We will try to see a senior person and prefer to visit a company at their office, almost like kicking the tires. You can have all the written information in the world, but I think it is important to figure out how senior people in a company think.”

 

3. “Even the world’s greatest business is not a good investment, if the price is too high.”

“We try to be disciplined in the price we pay for ownership even in a demonstrably superior business.”

“Pay only a reasonable price, even for an excellent business.”

The second bedrock principle of Ben Graham-style value investing is that a security must be purchased at a sufficient bargain to intrinsic value that it provides the investor with a margin of safety. Buying securities at a significant discount to intrinsic value (e.g., 25%) creates a margin of safety which can protect against mistakes. In an ideal situation a value investor feels like they are “buying a dollar for 50 cents.” This opportunity does not happen often, but when it does, the value investor should load up the truck (buy a lot of the asset; bet big).  If you have a margin of safety when buying assets you don’t need to precisely predict intrinsic value. Roughly right is enough and far better than precisely wrong. Securities that represent a partial interest in some businesses are selling at a price that is significantly less than their intrinsic value and some are not.  Paraphrasing Seth Klarman, at one price a partial interest in a business “is a buy, at another it’s a hold, and at another it’s a sell.” When you buy a partial stake in a business at a price that represents a margin of safety you can make an idiotic decision and sometimes still do OK. And when you are right you can do even better financially.

 

4. “Over time, the market is ultimately rational, or at least somewhat rational.”

“Attempting to short-term swings in individual stocks, the stock market, or the economy, is not likely to produce consistently good results.”

The third bedrock principle of Ben Graham-style value investing is that is that you must make Mr. Market your servant rather than your master. To a value investor Mr. Market is not wise, but rather highly unpredictable and irrational. Warren Buffett minces no words here: “This imaginary person out there — Mr. Market — he’s kind of a drunken psycho. Some days he gets very enthused, some days he gets very depressed. And when he gets really enthused, you sell to him and if he gets depressed you buy from him. There’s no moral taint attached to that.”

A cornerstone to this ‘make Mr. Market your servant” viewpoint is: the price of an asset is rarely the same as the value of an asset. Price is what you pay and value is what you get. Asset prices will always fluctuate. The objective of a value investor is to profit from volatility by waiting for something to happen that is inevitable rather than trying to predict its timing.  Once you reach this rather simple realization, life gets far better for an investor.

 

 

5. “A lot of people don’t have the patience or temperament to really be investors.”

“The stock market is like the weather in that if you don’t like the current conditions all you have to do is wait awhile.”

The fourth bedrock principle of Ben Graham-style value investing is that the investor must be rational to avoid mistakes which are usually caused by emotional or psychological errors. If you cannot be patient is it impossible to be a successful value investor. While being patient is a key attribute you must also be capable of being aggressive and pouncing on an opportunity when the time is right. Patience and aggressiveness as desirable qualities for an investor may seem a bit at odd to some people, but they are essential.

March of 2009 would be an example of such a time. Seth Klarman said to Charlie Rose: “I think that the analysis is actually the easy part. When I speak to business school students, I tell them investing is the intersection between economics and psychology. Economics, the valuation of a business, is not that hard. The psychology – how much do you buy? Do you buy it at this price? Do you wait for a lower price? What do you do when it looks like the world might end? Those things are harder and knowing whether you stand there and buy more or something legitimately has gone wrong and you need to sell, those are harder things and that you learn with experience and you learn by having the right psychological make-up in the first place.”

This concept of waiting vs predicting baffles many people. If you let go of the idea of predicting “when” and focus on “what” intrinsic value is and “how” to buy a partial stake in a real business, that you understand, with a margin of safety, there is some hope for you as a Graham value investor.

 

6.  “Think independently. We try to be skeptical of conventional wisdom and try to avoid the waves of irrational behavior and emotion that periodically engulf Wall Street. We don’t ignore unpopular companies. On the contrary, such situations often present the greatest opportunities.”

“You live by the sword, you die by the sword. If you are right, you are going to add value. If you are going to add value, you are going to have to look different than the market. That means either being concentrated, or, if you are not concentrated in a number of issues, you are concentrated in types of businesses or industries.”

You can’t beat the market if you are the market. That a contrarian viewpoint and being correct about that viewpoint is necessary to outperform a market is provable mathematically. Seth Klarman has famously said: “Value investing is at its core the marriage of a contrarian streak and a calculator.” It is easy to say you are a contrarian but hard to actually be one. There are many poseurs who think they are contrarian. Getting an unusual haircut or tattoo does not by itself make you a contrarian. The warmth of the herd is comforting. In some circles not it is the tattoo owners that is the herd dweller. People who are wrong while acting conventionally are rarely shunned. To be successfully contrarian requires honesty, self-awareness, aggressiveness and bravery since it is not a natural human state.

Seth Klarman believes: “You need to balance arrogance and humility…when you buy anything, it’s an arrogant act. You are saying the markets are gyrating and somebody wants to sell this to me and I know more than everybody else so I am going to stand here and buy it. I am going to pay an 1/8th more than the next guy wants to pay and buy it. That’s arrogant. And you need the humility to say ‘but I might be wrong.’ And you have to do that on everything.”

 

7. “Most investors should own no more than 10 to 20 stocks.

“Good investment ideas… are difficult to find. When we think we have found one, we make a large commitment.”

“Do not diversify excessively.”

Some Ben Graham Style investors have a diversified portfolio and some do not.  Lou Simpson is a focus investor (he doesn’t diversify widely). Charlie Munger is also a focus investor. Other value investors, like Joel Greenblatt in his current fund, are diversified. Whether an investor is diversified is not a bedrock part of the Graham value investing system. In the case of Lou Simpson, he feels that the number of stocks that an investor can genuinely understand is limited. He would rather put fewer eggs in a basket and spend a lot of time understanding those eggs.

The idea that a dentist working full time in his or her profession is going to pick technology stocks better than the market after fees and expenses is unlikely. A UPS driver is hoping to beat the market by buying a health care stock or an automaker?  I have said many times in this series on my blog: most people should buy a diversified portfolio of low fee index funds/ETFs.  You are not Lou Simpson. You are unlikely to be like Lou Simpson.  It is possible, but unlikely that you can invest like him. The fact that there is a tiny chance you might be like Lou Simpson is what gets so many people into trouble with their investing. People think: “these other people are muppets, but I am a super genius.”

 

8. “Dealing in a circle of competence, dealing with companies that you have the ability to understand, being able to come up with a good analysis of a company’s value and earning power, is fundamental.”

“Invest in what others don’t know.”

“I get excited when we get some insights on a business that’s not really well understood.” 

The goal of a value investor is not just to buy a share in a quality business, but to find assets to purchase that represent a mispriced bet. To find a mispriced bet, someone must have made a mistake. Howard Marks points out that “active management has to be seen as the search for mistakes.” To find a mispriced bet you must know what you are doing. To raise the probability that you will know what you are doing, it is wise to stay within your circle of competence. Charlie Munger makes this point succinctly: “For a security to be mispriced, someone else must be a damn fool. It may be bad for the world, but not bad for Berkshire.”

There is this interesting idea that as more people (~38% in the US less globally) move to index investing that there will be less alpha for experts. On the margin this conclusion seems logical, but the supply of “damn fool” investors is still massive. in any event, at some point as the number of index investors increases the ability to outperform will increase, since markets will be less efficient.

 

9. “One lesson I have learned is to make fewer decisions. Sometimes the best thing to do is nothing. The hardest thing to do is sit with cash. It is very boring.”

People have a tendency to think that there is a benefit to hyperactivity in investing. Some activity is essential since with no activity of any kind it’s a good sign you are dead. But as a rule, making fewer decisions as an investor results in better decisions and lower fees and expenses as well.  As is usual, Jason Zweig describes these issues perfectly: “Mr. Munger favors what he calls ‘sitting on your a—,’ regardless of what the investing crowd is doing, until a good investment finally materializes….Many money managers spend their days in meetings, riffling through emails, staring at stock-quote machines with financial television flickering in the background, while they obsess about beating the market. Mr. Munger and Mr. Buffett, on the other hand, ‘sit in a quiet room and read and think and talk to people on the phone,’ says Shane Parrish, a money manager who edits Farnam Street, a compelling blog about decision making. ‘By organizing their lives to tune out distractions and make fewer decisions,’ he adds, Mr. Munger and Mr. Buffett ‘have tilted their odds toward making better decisions.’”

 

10. “We do not have hard and fast rules on selling. We do not sell that well.”

Life is far easier for a Graham value investor if you set your holding period at forever. This is, of course, not always possible. In an upcoming blog post on Mason Hawkins I included this quote about selling: “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.” That selling shares is harder than buying shares is not a technical issue. Instead, it is easier to make emotional and psychological mistakes when selling shares.  Resisting the urge to try to “time” the market when putting in sell orders can be excruciating. Mistakes from tendencies like loss aversion are so easy to makeIt’s a good idea to follow Charlie Munger’s advice when selling shares: “Other people are trying to act smarter. I’m just trying to be non-idiotic.”

 

11. “It is very important to look at your mistakes and determine why you made them.”

“When we make mistakes, we always try to do postmortems.” 

The best way to learn is through feedback. Ray Dalio, the founder of the Bridgewater investment fund, has expressed this idea in a formula: “You learn so much more from the bad experiences in your life than the good ones. Make sure to take the time to reflect on them. If you don’t, a precious opportunity will have gone to waste. Remember that pain plus reflection equals progress.” And there is no better feedback than the negative results from personal mistakes and folly.  Charlie Munger believes in “rubbing his nose” in his mistakes. If you do this post-mortem work, you can increase the percentage of mistakes that are new as opposed to repeated mistakes. Investment performance can be remarkably improved simply by making fewer mistakes. Sometimes what looks like a special technique or system generating success is simply the people involved being dedicated to being less stupid.

 

12. “I try to read at least five to eight hours a day.”

I don’t know any successful investors who don’t read a lot. As just one example, in Michael Eisner’s book Working Together: Why Great Partnerships Succeed Warren Buffett is quoted as saying: “Look, my job is essentially just corralling more and more and more facts and information, and occasionally seeing whether that leads to some action. And Charlie — his children call him a book with legs.”

Of course, reading alone is not enough. Charlie Munger puts it this way: Neither Warren nor I are smart enough to make the decisions with no time to think. We make actual decisions very rapidly, but that’s because we’ve spent so much time preparing ourselves by quietly sitting and reading and thinking.”

Read and think. Read and think. Read and think. And don’t forget the thinking part.

 

Notes:

NYTimes – A Maestro of Investments in the Style of Buffett

NYTimes – Lou Simpson’s Five Basic Investing Principles

 

Bloomberg – Buffett Stock Picker Simpson Opens Own Firm After Leaving Geico

Chicago Tribune –  Lou Simpson retiring from Geico

Washington Post – Profile on Lou Simpson

A Dozen Things I’ve Learned from Startup L. Jackson About Venture Capital Investing and Startups

There has been a lot of speculation about the identity of Startup L. Jackson. One theory is that “he” is actually composed of machine learning algorithms and a database of the insight of a few well-known venture capitalists. Evidence will be presented below that Startup L. Jackson’s views suspiciously track the consistently expressed views of specific highly successful venture capitalists. This evidence points toward a vast conspiracy, probably orchestrated by Elon Musk. In short, Startup L. Jackson may be an example of the type of super-advanced artificial intelligence that will eventually spell doom for humanity. Or not. The only other alternative to this conspiracy thesis would be that there are fundamental principles and best practices involved in venture capital and that learning from the most successful venture capitalists is wise. In other words, Startup L Jackson is either a cutting edge example of artificial intelligence that will ultimately doom humanity or a world class venture capitalist who speaks the unvarnished truth about the venture capital industry.

While the best venture capitalists are all unique, they inevitably share certain bedrock methods of approaching their business. Startup L. Jackson has chosen to convey his ideas in a humorous and entertaining way. I find his approach refreshing and helpful. He is trying to educate and help others. As Charlie Munger said once: “The best thing a human being can do is to help another human being know more.”

 

1. “Raise enough that your business is “real” by the time you have six months or less of cash. What that means will depend on your business, but you will never again be able to raise on a dream.”

“Raise enough that if things go well you can get to the A.”

When a startup is raising a seed round they are often able to get away with selling a dream because if they are audacious enough in attacking a massive market what they plan to do can’t be captured in a spreadsheet. Chris Dixon makes that point in #8 here when he points out: “If you are arguing market size with a VC using a spreadsheet, you’ve already lost the debate.” That is why at the seed stage the best pitch is a great narrative. The story/dream must be audacious and compelling and take place in a massive market with just the right team. Don Valentine also lays it out in #1 here: “The art of storytelling is incredibly important. Learning to tell a story is critically important because that’s how the money works. The money flows as a function of the story.”

How much money should you raise? Startup L. Jackson uses an “enough to get to real” standard because he is very focused on the need for delivering metrics at an A round. Josh Kopelman recently argued: “You should target 18 to 24 months of runway post Series Seed. The best time to raise follow-on capital is when you don’t need it, and 2 years of runway gives you the best chance to land in that situation.” Mark Suster has given advice on this, and Fred Wilson has a view you can see in a video here that argues in part that ‘less can be more’. Fred Wilson seems more focused on the amount raised by the startup when he said  “I just think if you’re forced to figure out how to get from here to here on a million bucks, if you’re good, you’ll figure out how to do it.”

Startup Jackson points out that Founders should keep in mind that venture capital is a cyclical industry, as pointed out many times by Bill Gurley. Doug Leone has also discussed dilution here when he says: “Be incredibly, ruthlessly selfish with your equity.”

The hard part about raising money as a founder is raising enough capital so that you can focus on the business, have a margin of safety and enjoy significant optionality but still have the discipline to focus on aspects of the business that are genuinely important instead of four different things that are insanely distracting. Bill Gurley makes that clear when he says: “We like to say that ‘more startups die of indigestion than starvation.” If you raise too much money you can end up solving things with money instead of with innovation and great company culture. Keith Rabois also makes that point: “Many entrepreneurs are raising more money than they need and it can cause derivative consequences down the road that are not healthy.”

 

2. “Power laws rule everything around me.”

“Most startup outcomes are binary. Optimizing for the size of your slice is almost never a good idea if the pie is big. Raise enough to bake a big pie.”

The data undeniably shows that financial success in venture capital reflects a power law. John Doerr makes it in #1 here: “The key insight is that actual [VC] returns are incredibly skewed. The more a VC understands this skew pattern, the better the VC. Bad VCs tend to think the dashed line is flat, i.e. that all companies are created equal, and some just fail, spin wheels, or grow. In reality you get a power law distribution” Peter Thiel basically says that if you end up with a Unicorn result (a big pie), everyone gets rich. A venture capitalist or a founder getting a very high share of a 0% return is neither helpful or wise.

 

3. “The worst possible thing you can do to your business is raise just enough money to throw up mediocre metrics right around the next round, especially with a high valuation you can’t back off of.”

Broken cap tables are a huge problem as Fred Wilson has notedJim Breyer discussed (#6), and Sam Altman states simply: “don’t forget the prime directive of fundraising strategy: set things up so that you never do a down round. The badness of a down round is difficult to overstate; in fact, the threat of that is the best reason not to take a super high price when you’re offered one.  If you raise at such a price, everything has to go perfectly in order for your next round to be an up one.” Metrics referred to by Startup L Jackson above will be discussed more below, including the Five Horsemen (CAC, WACC, ARPU, COGs and churn) and their friend customer lifetime value.

 

4. “The existential threat to early-stage startups is almost always lack of demand. There’ll be infinite VC to fix tech if you clear that hurdle.”

Ann Winblad agrees with Startup L Jackson when she says: “Warren Buffet’s quote: ‘The market bats last’ means ‘Have you figured out: are there customers out there?’ ‘Do the dogs have their head in the dish? Are the customers buying?'”

Getting to product/market fit and proving that “dogs are actually eating the dog food” is essential. If you want to know even more about how product/market fit fits into building a business Paul Graham lays it out here: “You need three things to create a successful startup: to start with good people, to make something customers actually want, and to spend as little money as possible.” Too many people forget that you need to solve a real customer problem. Without that, the business is toast (not even the artisanal variety). Reid Hoffman describes the other key element here: “If your technology is a little better or you execute a little better, you’re screwed. Marginal improvements are rarely decisive.”

 

5. “Most successful startups are overnight success. That night is usually somewhere between day 1000 and day 3500.”

“You can recognize a company that isn’t executing by the arrows in its back.”

“If you’re talented, don’t let the tech press do your thinking. You’d be better off relying on Dr. Seuss books.”

“If you’re competing on price, it better be the case that the incumbent’s cost structure doesn’t allow them to do the same.”

“BigCo may be late to market, but if there’s not a winner by the time they show up, it’ll probably be them. Go faster.”

As Rich Barton points out: “Ideas are cheap. Execution is dear.” Jeff Bezos is always thinking: “Your margin is my opportunity.”  Relentless perseverance is a requirement for any founder. Reid Hoffman asks: “Where’s the contrarian thinking that, if they turn out to be right, could be really, really big? Consensus indicates it’s probably not a total break-out project. If your thinking isn’t truly contrarian, there’s a dog pile of competitors thinking the same thing, and that will limit your total success.”

Ann Winblad has said (#3): “We invest in markets. If the opportunity is not large, then the business, independent of the people or the technology, will fail. Because of this issue of intense competition and capital efficiency, opportunities always get smaller as soon as you fund the company.”  If you can’t get to $100 million in revenue the math does not work for the venture capitalist since the failure rate is so high, says Bill Gurley. Fred Wilson has also made that point (#1).

 

6. “Can we start referring to the obligatory five year revenue forecast slide as uniporn?”

“Figure out how long you think it’ll take you to get there. It’s hard to go fast for extended periods of time. Be realistic about that ski-slope graph you made in YC. It might not last for the next 24 months.”

Michael Mortiz could not make this point more simply: “Five-year plans aren’t worth the ink cartridge they’re printed with.” Good venture capitalists mentally giggle when see hockey stick shaped distribution curves based on unrealistic assumptions that don’t map to reality. Chris Dixon has talked about this (#8): “If you can’t make the case that you’re addressing a possible billion dollar market, you’ll have difficulty getting VCs to invest.” Bill Gurley makes the point as well: “If your idea is not something that can generate $100 million in revenue, you may not want to take venture capital.”

 

7.  “Take your budget and pad it by 50%. Shit happens, particularly in startups.”

“You can iterate your way out of stupid ideas, but you can’t iterate your way out of stupid.”

Heidi Roizen has said: “Things outside of your control will happen. You need to lean into this fact.” One great way to deal with uncertainty is to have optionality. Warren Buffett treats cash as a call option with no expiration date or strike price. Warren Buffett also says that “cash combined with courage in a crisis is priceless.” Vinod Khosla describes the situations faced by most founders: “Bad times come for every startup – I haven’t seen a single startup that hasn’t gone through a bad time. Entrepreneurship can be very depressing. If you really believe in your product, you stick with it.”

 

8. “Effectiveness is knowing 10 things will kill your startup this year and being able to block out all but the one that will kill it this month.”

“Many a startup has failed selling ‘better’ products.”

“Early customers were down and they rolled right with it, We raised our lifetime value by a thousand percentages.”

“10x better = hard to build, easy to sell. Marginally better = easy to build, hard to sell.”

“Being first to market with the right tech but a shitty UX is the same as being late.”

“If you generate a little value for a lot of users in consumer, you’re Facebook. Do the same in B2B, you’re an acquihire.”

These operational points made by Startup L Jackson remind me of a point made by Jim Barksdale: “The main thing is to keep the main thing, the main thing.” Bill Gates said once: “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.”

 

9. “Once you’ve completed this exercise you can go to investors and say ‘We see our Series A happening in X months, when we hit Y metrics. We believe we need Z dollars to hire A-C, grow with D strategy.’ This turns out to be a great way to figure out if investors are smart. Good ones will help you build a better plan and you’ll be better for it. Bad ones will have poor feedback or just ask you where to send the check…”

Chris Sacca points out: “Good investors are in the service business… There are angels who have 75 companies and don’t call any of them ever.” Dan Levitan would agree (#5), and Keith Rabois reiterates (#2): “Early stage, almost every successful entrepreneur I know doesn’t care as much about the economic terms as much as who they are going to work with.” There is a huge difference between an amateur and a professional seed stage investor. Startup L. Jackson say on this point: “Those in the know, go with the pro.”

 

10. “Sufficiently advanced customer acquisition strategies are indistinguishable from magic.”

“Blessed is he who, in the name of profit, shepherds the user through the funnel, for he is truly his user’s keeper.”

“What do you need for marketing? Do you need firm CACs by the A? If so, have you budgeted to figure them out? What is your marketing strategy? MIT super-nerds are often surprised how much Scotch it takes to get a BD deal done even in Silicon Valley.”

“Viral coefficient two point some, I got 99 problems but my pitch ain’t one.”

“Viral is not a product. Beware those selling it.”

Acquiring customers at a low customer acquisition cost (CAC) is great. What is not to like about organic growth where customers are obtained in a cost effective way? Mark Andreessen has made this point (#10): “Many entrepreneurs who build great products simply don’t have a good distribution strategy. Even worse is when they insist that they don’t need one, or call no distribution strategy a ‘viral marketing strategy’ … a16z is a sucker for people who have sales and marketing figured out.”  Reid Hoffman adds: “What a lot of people fail to realize is that without great distribution, the product dies.”

 

11. “The startup that treats their investors like a bank and only calls when they run out of cash is missing opportunities.”

“Investors you have built a relationship with who can see past the metrics and are willing to double down because they believe in you are an under-appreciated asset.”

As Rich Barton points out (#11): “Get the highest octane fuel in the tank [when choosing a venture capitalist].” Keith Rabois again weighs in (#2): “If you have the option, raise money from one lead investor who has the right skill set, background, and temperament to help you.” As far back as when Arthur Rock was more active: “We spent a lot of time with our companies… [sometimes] if you divide up the number of companies they’re invested in by the number of partners, you find that the partners haven’t got ten minutes for any one company.”

The Benchmark Capital partners have talked about how founders can do due diligence on a venture capitalist in this video embedded on Forbes. Founders that don’t work at and devote sufficient time to this due diligence process are, well, bonkers given it is a business relationship that can last more than 10 years.

 

12. “Predicting failure is easy. You can have no clue, a startup can be brilliant, & you’re still probably right. Let’s see you pick winners.”

Most startups fail, as both Marc Andreessen and Fred Wilson have pointed out.  Startup L Jackson is saying that getting actively involved as a venture capitalist in the small number of big winners is hard, which is why the distribution of success among venture capitalists is a power law, not just inside their portfolios. Mike Mortiz says: “[Venture capital] is a business that’s always had the investment returns concentrated in very few hands.”

#5 here from Chris Sacca is a good one to put this post to bed: “As investors, VCs are wrong more often, than we are right… As a VC, I’m wrong most of the time, so whenever any of the VCs tell you about the rules etc. it’s really, because we’re wrong all the time. You should expect me to be wrong most of the time. When I’m right, I’m really really right. That’s what you should expect from a VC.”

 

Notes:

Startup L. Jackson: Website & Twitter

 

Bonus Round (Greatest Hits):  

 

“Is The Jerk the most underrated startup movie ever made? Discuss.” [ Definitely. More on the Jerk in #12 here ]

“Another essential [Bill] Murray principle: Wear your wisdom lightly, so insights arrive as punch lines.” [ See #12 in my Bill Murray post ]

 

“Rapid iteration works for stupid shit, but we’re doing real engineering.” <– if I had a nickel…”

“Code is easy, people are hard. It often takes the best engineers the longest to realize this.”

 

 

“If you have to assess an engineering org based on one question, it should always be “How often do you deploy to production?”

“Complaining about efficient markets &/or constructing artificial barriers (e.g. regulation) are easy, but have never been viable strategies.”

 

 

“Skills of the future: – Creativity – Critical thinking – Communication Code + robots will eat everyone who doesn’t have them.”

“A fool and his money are soon parted, ideally on an uncapped note. —Newish Proverb”

 

 

“Employee equity in tech is like sex ed in the South, most have no idea how it works & are going to be very surprised if they get screwed.” 

“Coincidentally, my Spotify is all Marvin Gaye.” [This just shows excellent taste]

 

 

“Keep your chin up ugly duckling, hot seed rounds are inversely correlated with black swanness.”

“There are only two ways to make money on the internet: intermediating and disintermediating.”

 

 

“Losers blame winners for stealing their ideas. Winners are already 2 steps ahead—riffing off other winners—by the time losers steal theirs.”

“Crowds, like drunk people, are very rarely wise. This is why drunk crowds make such great customers.”

A Dozen Things I’ve Learned from Dan Levitan About Venture Capital, Business and People

“Dan Levitan cofounded consumer-only venture firm Maveron in 1998 with friend Howard Schultz, the famed Starbucks CEO, whom he met as Starbucks’ investment banker for its 1992 IPO. Levitan was a seed and Series A investor for Maveron in e-commerce company Zulily.” “Dan currently serves on the boards of Trupanion, Pinkberry, PayNearMe, Peach, Potbelly and Earnest.”

1. “Get the team right.  Startups to me are about: people, people, people.”

“We’re looking for people first.” “We can find a great sector or business, but we’re investing so early that unless there’s this tenacious grit, determination, resourcefulness, ability to evolve, it won’t work.”

The earlier a venture capitalist invests the greater the level of uncertainty and the more the investment is about buying mispriced optionality. The future of truly disruptive startups is so uncertain that founders and team members who can quickly respond to unanticipated changes have tremendous value. The qualities Dan Levitan describes are essential in a founder and team members since the future is never predictable with certainty. The ability of the startup to adapt to an unpredictably evolving world is essential and is driven by the founders and team members.

Successful venture capitalists also know that the right team chemistry is critical. When you are working with people you know and trust, tremendous efficiencies are created. Charlie Munger refers to the approach that allows Berkshire headquarters to consist of only 25 people as a “seamless web of deserved trust.” The more you know a person, the more likely it is that a seamless web of trust environment can be created. Successful venture capitalists and founders are obsessively focused on finding great people to work with. They spend far more of their time recruiting than most people would imagine for this reason.

When I was writing my post on Maveron co-founder Howard Schultz, Dan Levitan looked at an early draft and said “you need to put the points about people right up front.” Dan emphasized that Howard Schultz is all about people and so it should not be a surprise that Dan is all about people too. Not just any people, but great people. That applies to having the right skills but also to being great people in terms of values (the Yiddish word for this would be mensch: “a person of integrity and honor”) and how the person treats other people.  The best people treat everyone with respect.  Even little things are big clues about character.

2. “We’re looking for extraordinary entrepreneurs who can create very large businesses.  After 15 years and backing almost 100 entrepreneurs, I think it’s that rare person who has a combination of attributes that gets through the challenges of a startup and is able to really create value.”

“The shortage is great entrepreneurs. There’s still too much capital chasing too few great entrepreneurs attacking big ideas.” 

“The world does not need to be a zero sum game with founders. By contrast, there are so few great entrepreneurs and great ideas it is somewhat of a zero-sum game among VCs.”

Fred Wilson wrote a rather famous blog post about factors that limit the scalability of the venture capital model and, by implication, the number of innovative startups that help create growth, productivity and jobs. Dan Levitan and many other people believe that the primary bottleneck shortage in the venture industry is a limited supply of great startup founders. What does it take to be a great founder of a business? Dan Levitan’s firm Maveron has compiled a list:

1) works ridiculously fast;

2) has superior communications skills with team, investors and partners;

3) is self-aware and can evolve;

4) balances being aware with being detail oriented;

5) all-star recruiter that prioritizes team and company building;

6) prioritizes value creation for company investors etc.;

7). can sell both product/vision and knows his/her customers inside out;

8) has category advantage from past experiences and relationships;

9) is a data driven decision maker;

10) has contagious passion and relentless perseverance.

That list is a tall order, but it does sometimes get filled. When venture capitalists see these characteristics there is nearly always a rush to be an investor in the startup.

3. “How is the CEO recruiting? If we are two years in [after seed round] and we think this is a big idea and there’s been no impact players hired, that tells you something about the space or the CEO. The best biggest companies always seem to be able to hire people they shouldn’t be able to hire.”

One characteristic on Maveron’s list of qualities they seek in a CEO is that they be an “all-star recruiter”. Great founders know how to sell and one key “tell” of sales skill is recruiting. If the founder can’t sell employees on the vision and prospects of the business they will probably have trouble selling to potential customers of the product or service. Early hires at a startup are particularly important. On the importance of hiring the right people Dan Levitan has quoted Maveron’s co-founder Howard Schultz: “If you are going to build a 100-story skyscraper, make sure the corners are perfect.”  What Howard Schultz means is that the early hires are particularly important since they set the foundation of what will become the culture of a growing business.

4. “We always talk about how you have to build a brand from the inside out, not the outside in. Brands are not wrappers. Brands are based on the values of the founders, and then they spread to the people who work for the company, and then that psychological contract is spread to the customer.”

“Get the people right and it flows to the customers.”

Even when it comes to building a brand, Dan Levitan believes that the process starts with people. What do founders value? How do the transmit those values to customers? As an example, one of the most interesting things to watch in business right now is McDonald’s current set of challenges and how it is responding with new marketing. McDonald’s does not need new marketing, it needs better food. MCD would benefit from listening to Howard Schultz who points out: “You have to stand for something important. What is your core purpose and reason for being? That should be the guardrails within which you create the enterprises meaning to your customers.” I’ve wrote about Howard Schultz’s approach to branding in this post (see #2 in particular).

5. “Early stage money is not fungible. It comes with an attitude. Makes sure that the people on your bus are the people you want on your bus.” 

“Early stage investing [in particular] is all about the people.”

At this point if you haven’t figured out that Dan Levitan believes people are more important than any other variable in just about everything you are clearly not paying attention. People, People, People. Founders must be great people. The team must be composed of great people. Brands start with great people. Venture capitalists must be great people too. What Dan Levitan is saying is that money received from an investor can come with a big extra price tag attached – choose well. I suggest calling other people who have worked with the venture capitalist who wants to invest in your startup. Doing research on people pays off.

There’s expensive money and value-added money. Knowing the difference is important. And life is lots better when you get to work with great people.

6. “I spent a lot of my thirties and forties creating mentors. As I’ve gotten older, it’s become more fun turning that around and find someone who want to be mentored.”

“One of my mentors is Bill Campbell.  He’s: ‘Product, Product, Product.’” Howard Schultz says the first person you should hire is a human resources person.”

Dan Levitan has said he has four primary mentors: 1) Howard Schultz  2) Coach Bill Campbell  3) Coach K of Duke and 4) Joel Peterson. These mentors are all different and bring different skills and attributes to the relationship.  As Dan Levitan points out, they will disagree on some points. That’s OK and in fact desirable. As you go through life you can say: “I really like how person X does Y.” You don’t need to adopt everything that X does to get this benefit. Having a number of mentors is like being at a supermarket and buying ingredients. Of course, wanting to “be like X when they are doing Y” is a lot easier said than done sometimes, but at least you know what you want. Listening to Dan talk about his mentors is infectious. For example, it was Coach Krzyzewski who taught Dan the central lesson of Maveron’s consumer-focused success: always ask “Do you love your team?”

7. “There are lots of ways to make money in venture capital, and there are even more ways to be mediocre. We believed the world didn’t need another commoditized venture capital firm. Our theory was that the operating characteristics of technology companies would be incorporated into consumer businesses in an unprecedented way.” “Technology-driven consumer-facing brands.”

“We decided to focus on consumer very narrowly and invest only in end-user consumer brands. It’s worked much better, including because we’re presented with more [of these types of startups]; we have a greater pool of companies facing similar problems, which helps our entrepreneurs; and our LPs are getting more consistent returns.”

Dan Levitan is a believer that venture capital firms will increasingly specialize as competition increases. Maveron’s decision to be “consumer only” in its approach to venture capital is “walking the talk” on that viewpoint. When you focus on something you tend to get better at it. When you get better at it, people come to you for that skill, which makes you better yet at that skill. This feedback loop is powerful and financially rewarding if you pick skills that scale well.  It is more lucrative to be a venture capitalists than to be a great maker of chicken rice in a hawker stand in Singapore, but specialization is valuable in both professions.

8. “We dabbled in enterprise and we sucked at it.  This is a humbling business. It’s really hard to be good. We asked ourselves: and every startup should ask yourself: what do you do better than others and how does that concentration work in your favor? What do you do well?”

A value investor would refer to what Dan Levitan is talking about here as implementing a “circle of competence” approach. A good example of someone implementing a circle of competence concerns Tom Watson Sr., the founder of IBM, who once said: “I’m no genius. I’m smart in spots—but I stay around those spots.” By finding what you are truly great at as an investor and focusing on those things you can create in an investing edge. Every investor has strengths and weaknesses and the sooner you recognize what yours are the faster you will travel down the road to success.

Another way of looking at circle of competence is as an opportunity cost analysis.  Charlie Munger puts it simply: “Opportunity cost is a huge filter in life. If you’ve got two suitors who are really eager to have you and one is way the hell better than the other, you do not have to spend much time with the other.” In investing’s case you have two skills, and you are way better at one skill than another. The choice for many people is obvious enough that they chose to specialize.

9. “What we’ve learned over the years is that one of our formulas for success is a smaller fund, where one or two significant wins can really have a positive impact. The challenge for successful venture capitalists is having the discipline to stay small and keep the fundraising within the same parameters as they originally achieved success in. I think there is a lot of temptation [to go big], particularly when the press asks ‘How big is the fund?’ What’s more important is what’s in the fund.”

In investing after a certain scale is reached in terms of “assets under management” or AUM, size can work against performance. Sometimes $500 million is not much more effort to manage than $50 million. But once you reach a certain size it is impossible to put more money into a single business so you must find a new business and have the necessary time to devote to that new business. Since the number of great founders with the right business attacking huge markets is limited, this can cause the some venture capital firms to stretch too far and fund startups that will drag down returns. As was the case with Goldilocks and the Three Bears, what you are looking for is something that is “just right” in terms of fund size.

10. “There’s plenty of money out there for great consumer entrepreneurs with great consumer products attacking really big markets.”

“Grand slam home runs are what defines [success in the venture business.”

Massive wins require big markets. Fred Wilson’s post that I referred to above lays out the simple arithmetic that leads to this conclusion. The other point Dan Levitan makes is that (especially right now) money is not the input to a business that is in short supply. It is not easy to raise money for a new business, but if you have a great team of people attacking a big market with an innovative solution to a real problem raising money is not your biggest problem. For example, the bottleneck problem at Series A referred to by Josh Koppelman is not happening because venture capitalists are grading on a curve. It is happening because startups are not satisfying the metrics needed for success. Stated simply, the problem at series A is not insufficient dry powder held by venture capitalists.

11. “Some of the best ideas that we’ve invested in have made no sense to conventional sources.”

There have been a few times in the last 16 years when we’ve funded something that was a no-brainer and it worked well for us. But most of the time, it’s not a no-brainer.”

It is mathematically provable that you must be contrarian if you are going to outperform the market. Ray Dalio puts it this way: “You have to be an independent thinker because you can’t make money agreeing with the consensus view, which is already embedded in the price. Yet whenever you’re betting against the consensus, there’s a significant probability you’re going to be wrong, so you have to be humble.”

Dan Levitan and his firm have chosen to specialize and with that comes an opportunity to “think different.” Being a contrarian can be uncomfortable for some people. As Mike Maples points out: “Wildly disruptive startups will be misunderstood for a long time.” Too many people would rather fail conventionally than succeed unconventionally. Great venture capitalists are comfortable standing apart from the crowd.

12.  “We get over 1,000 inquiries a year and will make 4-6 core investments and 15-20 seed investments. If businesses are not referred to us in some way or another, it is hard for us to really focus on it.”

“If we put $100,000 into a seed round, we want to earn the right to do the A round.”

Sorting through more than 1,000 inquiries a year is not simple or easy. This process inevitably means that you must deliver a lot of “no” messages and only a few “yes” messages. By requiring a referral three objectives are achieved:

1) you get a filter operating to make decisions easier,

2) you reduce the number of pitches you need to consider, and

3) you put entrepreneurs to the test (if they can’t somehow get a referral they are not resourceful and may not have good sales skills).

The biggest fear of any venture capitalist’s at this stage are mistakes of omission. There aren’t any venture capitalists who have been in the business that have not passed on a big success. That’s a part of the process. As long as you hit your share of grand-slam tape-measure home-runs, errors of omission will be overshadowed. They know that they will not always be right and that it is magnitude of success and not frequency of success that drives financial returns in their business.

Notes:

Dan Levitan and Michael Grabham at Startup Grind: Full Episode (video)

Seattle Business Journal – Maveron’s Dan Levitan on Elephants Under the Table

King5 Seattle – Maveron’s Levitan: Seattle’s Entrepreneurs “Need More Wins” (video)

Strictly VC – Maveron’s Dan Levitan: This Time Is Not Different

A Dozen Things I’ve Learned from Morgan Housel about Investing and Life

1. “’I don’t know’ are three of the most underused words in investing.”

“What’s really interesting about finance – and I think this is true for a lot of fields whether you’re in physics, math, chemistry, history, or whatever it is – the more you learn, the you more you realize how little you know.”

There is nothing more fundamental to investing than understanding that risk comes from not knowing what you are doing.  And as Morgan Housel is saying here: the more you know, the more you know that there is even more that you do not know. If you are not getting more humble as you: 1) get older, 2) grow as a person, or 3) learn, then you are not paying attention. The best investors keep their circle of competence tightly defined and limited in scope. Skills can atrophy or become outdated. New competencies can be developed with time and effort.

What you are doing when you are investing is buying an ownership interest in an actual business. No matter how hard you may work to know everything about that business, the phenomenon effecting that business, and the markets in which it competes, there always be much that you do not know.  Even if you may chose an index-based approach to investing, you are making choices about what types and amounts of assets to buy. The very best investors have been able to develop systems that deal effectively with the fact that investing is probabilistic process. The best systems are designed to enable the investor to buy and sell assets in a way that is “net present value positive” over time after fees and expenses. Systems that do not produce net present value positive results over time after fees and expenses, are speculation and are not investing.

 

2. “There are no points awarded for difficulty.”

The best investors make frequent use of a “too hard” pile when it comes to investing.  One of the many things that investors like Morgan Housel have learned from great investors like Charlie Munger is how much investing performance can be improved by just avoiding some of the boneheaded mistakes made by other investors. For example, there is no shame in admitting that a given business can’t be valued. There are plenty of other businesses that are understandable which present investment decisions that are not very difficult.  Most of the time what an investor should do is nothing. And there is no better time to do nothing than when something is difficult.

On this point Warren Buffett likes to say “I don’t look to jump over 7-foot bars: I look around for 1-foot bars that I can step over.” These 1-foot bar jumping opportunities with big financial payoffs don’t appear very often, but when they do, it is wise to bet big.

3. “Three of the most important variables to consider are the valuations of stocks when you buy them, the length of time you can stay invested, and the fees you pay to brokers and money managers.”

“The single most important variable for how you’ll do as an investor is how long you can stay invested. I’m always astounded when I think about compound interest and the power that it has for investing.  Time is massively powerful.”  

Each of the points made here by Morgan Housel has a major champion. On the first point, Howard Marks points out:  “It shouldn’t take you too long to figure out that success in investing is not a function of what you buy. It’s a function of what you pay.” On the second point, Charlie Munger puts it simply: “Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things.”  On the third point there is John Bogle: “You get what you don’t pay for.”

An excerpt of a Motley Fool post called I Prefer to Keep Things Simpleby Morgan Housel helps explain compounding:

“What [too often] happens … is that the magic of compounding returns is overwhelmed by the tyranny of compounding costs. It’s a mathematical fact.

You’ve probably heard the story about the guy who invented the game of chess.

It goes like this: An inventor brought his chess board to the emperor of China, who was so impressed he offered to grant the man one wish. The inventor had a simple wish: He requested one grain of rice for the first square on the board, two grains for the second square, four for the third, eight for the fourth, and so on. Sounding like a modest proposal, the emperor agreed. But filling the chess board’s last 10 squares would have required 35 quintillion grains of rice – enough to bury the entire planet. Unamused, the emperor had the inventor beheaded.

While I doubt the story is true, its message is important to understanding the power of compound interest: When things grow exponentially, gains look tiny at first, modest in the middle, and then — very suddenly — they shoot utterly off the charts.” 

4. “[Investing] is just buying and waiting.”

It is hard for some people to understand the difference between 1) waiting and 2) predicting.  Fundamentally, the difference between waiting and predicting is the difference between focusing on what to buy by finding an asset selling at a discount to value right *now* versus trying to guess about *when* in the future the value might rise. Price is not the same thing as value. Price is what you pay for an asset and value is what you get in buying an asset. Only rarely doe price equal value. James Montier adds: “We need to stop pretending that we can divine the future, and instead concentrate on understanding the present, and preparing for the unknown.” We have lots of information about the present and exactly zero information about the future. To work hard to understand the present moment in time is not to think you can predict when something will happen in the future. You may be working from an assumption that sometime over a ten year period Mr. Market will raise price of as asset so it is equal to or greater than value. But it is a fool’s errand to try to predict precisely when it will happen. When it happens, it happens. You will “know it when you see it” if you understand value.

5. “It’s much easier to say ‘I’ll be greedy when others are fearful’ than to actually do it. But those who can truly train themselves to be skeptical of outperformance and attracted to underperformance will likely do better than most. They have an advantage.”

Buying stocks when Mr. Market is fearful is easier to say than do.  You can’t simulate investing. The best way to learn to invest is to invest. The feelings involved in investing are primal and often hard to control. For example, humans are simply not hard wired to be contrarian when others are full of fear. You can read all the books, articles and speeches about being fearless when others are fearful and yet fail to be calm when the time comes. This presents a fundamental problem in that this is the best time to be buyer of assets. The best investors are actually nostalgic for times like March of 2009 when the market was rife with fear and uncertainty. Screaming buys based on valuation like those that existed in March of 2009 may appear only two to three times in an investing lifetime.  By the time you get good at this key skill you may be too old to take advantage of the opportunity.

 

6. “The most important thing to know when you look at long term financial history is that volatility in the stock market is perfectly normal.”  

Anyone who believes in the Mr. Market metaphor understands that volatility is both inevitable and the source of an opportunity for a rational investor. Charlie Munger: “To [Ben] Graham, it was a blessing to be in business with a manic-depressive who gave you this series of options all the time.” It is volatility that creates the mispriced assets which present an opportunity for investors. Volatility is one type of risk. For example, if you’re retiring or have tuition bills to pay at a certain time. While volatility is one type of risk you must face, it’s not the only risk. Why do some investment managers try to equate risk with volatility rather than just considering it as one important type of risk? They want you to believe that volatility is equal to risk because volatility is a major risk for them since, if assets drop in price, investors will flee from their services. They also want you to believe that risk can be expressed a number and controlled by magic formulas with Greek letters in them you do not understand.

 

7. “Saving can be more important than investing.”

“The most powerful way to grow your money is learning to live with less, since you have complete control over it.”

It is reasonable to assume that over long periods of time the return on stocks will be about 6% more than the return on cash. You can quibble with that estimate but not too much. The idea that you can invest your way to retirement is simply not possible without savings. This is especially true since most investors chase performance and earn less that an average return of the market, especially after fees and expenses.  “Boston College’s Center for Retirement Research found that the two most important factors for creating a retirement nest egg are one’s savings rate and the age of retirement. “If people could work until they’re 70, they would have a much higher chance of having a secure retirement. Social Security is higher if you wait until age 70, and it gives your 401(k) assets a longer chance to grow, and it reduces the number of years you have to support yourself,” says Alicia Munnell, the center’s director. Less important was the rate of return earned on investments.”

8. “Most financial problems are caused by debt.” 

“Most people’s biggest expense is interest, which comes from living beyond your means, and buying things you think will impress others, which comes from insecurity. Avoid these two, and you’ll grow richer than most of your peers.”

Debt causes many problems, the worst of which is that the magic of compounding is working against you instead of for you. Leverage can also create situations where underperformance takes you completely out of the investing process.  Since “staying invested” is a key to financial success anything that takes you out of the process is a very bad thing. As Charlie Munger has said: “I’ve seen more people fail because of liquor and leverage – leverage being borrowed money.” James Montier adds: “Leverage can’t ever turn a bad investment good, but it can turn a good investment bad.  When you are leveraged you can run into volatility that impairs your ability to stay in an investment which can result in “a permanent loss of capital.”

 

9. “It can be difficult to tell the difference between luck and skill in investing.”

Investing involves both skill and luck. Sorting out how much of a given result is skill versus luck is neither easy or always possible. The very best books on this topic have been written by Michael Mauboussin, including The Success Equation. Howard Marks also has useful view on the difference between luck and skill and investing: “Success in investing has two aspects. The first is skill, which requires you to be technically proficient. Technical skills include the ability to find mispriced securities (based on capabilities in modeling, financial statement analysis, competitive strategy analysis, and valuation all while sidestepping behavioral biases) and a good framework for portfolio construction. The second aspect is the game inwhich you choose to compete. You want to find games where your skill is better than the other players. Your absolute skill is not what matters; it’s your relative skill.” Warren Buffet describes the object of the process simply: “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.”

10. “Investing is overwhelmingly a game of psychology.”

“Almost invariably the best investors are the people who have control over their emotions.”

Most mistakes in investing are psychological or emotional in nature. Being rational about investing is a task that has no finish line – it is a constant struggle for any human to be rational. It is harder for some people to be rational than others, but everyone is not rational at times. My post on Daniel Kahneman and James Montier examine this in greater depth. Housel elaborates: “Investing is very complicated.  It’s an interaction of psychology and math and history and politics, and it’s all just mushed together and it’s really complicated.  It’s always more complicated than we think it is.  My journey has been one towards growing gradually more humble over the years.  I would say each year that goes by, I realize that I know less and less.”

11. “Daniel Kahneman’s book Thinking Fast and Slow begins, ‘The premise of this book is that it is easier to recognize other people’s mistakes than your own.’ This should be every market commentator’s motto.”

It is an unfortunately aspect of human nature that we do not have perspective on ourselves. Humans have developed a series of heuristics that make it hard for us, especially in a modern world, to see our own mistakes. If you have an interest in exploring this topic, Daniel Kahneman explains why this is true in this excerpt from his book:

“I’m better at detecting other people’s mistakes than my own…. When you are making important decisions and you want to get it right, you should get the help of your friends. And you should get the help of a friend who doesn’t take you too seriously, since they’re not too impressed by your biases.”

Having a posse of people around you who are afraid to tell you that the emperor has no clothes is not helpful in overcoming this bias.  Morgan Housel cites Charlie Munger’s wisdom on this problem: “Only in fairy tales are emperors told they’re naked.Pavlovian association and other heuristics Morgan has written about acting together in the form of a lollapalooza make things worse.

12. “When you think you have a great idea, go out of your way to talk with someone who disagrees with it. At worst, you continue to disagree with them. More often, you’ll gain valuable perspective. Fight confirmation bias like the plague.”

“Starting with an answer and then searching for evidence to back it up.  If you start with the idea that hyperinflation is imminent, you’ll probably read lots of literature by those who share the same view. If you’re convinced an economic recovery is at hand, you’ll probably search for other bullish opinions. Neither helps you separate emotion from reality.”

“Charles Darwin regularly tried to disprove his own theories, and the scientist was especially skeptical of his ideas that seemed most compelling. The same logic should apply to investment ideas.”

I have always loved this Charlie Munger quote on confirmation bias: “Most people early achieve and later intensify a tendency to process new and disconfirming information so that any original conclusion remains intact. The human mind is a lot like the human egg, and the human egg has a shut-off device. When one sperm gets in, it shuts down so the next one can’t get in. … And of course, if you make a public disclosure of your conclusion, you’re pounding it into your own head.” The trick is to really listen to other people who you trust. Ray Dalio’s investing process is very focused on this approach. Set out immediately below are two paragraphs on Dalio’s view:

“There’s an art to this process of seeking out thoughtful disagreement. People who are successful at it realize that there is always some probability they might be wrong and that it’s worth the effort to consider what others are saying — not simply the others’ conclusions, but the reasoning behind them — to be assured that they aren’t making a mistake themselves. They approach disagreement with curiosity, not antagonism, and are what I call ‘open-minded and assertive at the same time.’ This means that they possess the ability to calmly take in what other people are thinking rather than block it out, and to clearly lay out the reasons why they haven’t reached the same conclusion. They are able to listen carefully and objectively to the reasoning behind differing opinions.

When most people hear me describe this approach, they typically say, “No problem, I’m open-minded!” But what they really mean is that they’re open to being wrong. True open-mindedness is an entirely different mind-set. It is a process of being intensely worried about being wrong and asking questions instead of defending a position. It demands that you get over your ego-driven desire to have whatever answer you happen to have in your head be right. Instead, you need to actively question all of your opinions and seek out the reasoning behind alternative points of view.” 

Both Morgan Housel and Charlie Munger cite Darwin as a model for people working hard to avoid confirmation bias. Here’s Munger: “The great example of Charles Darwin is he avoided confirmation bias.  Darwin probably changed my life because I’m a biography nut, and when I found out the way he always paid extra attention to the disconfirming evidence and all these little psychological tricks. I also found out that he wasn’t very smart by the ordinary standards of human acuity, yet there he is buried in Westminster Abbey. That’s not where I’m going, I’ll tell you.”

  

Notes: 

Morgan Housel WSJ Articles

Morgan Housel Motley Fool Articles

Morgan Housel USA today Articles

Morgan Housel on money, psychology, and investing (video)

Everyone Believes It; Most Will Be Wrong: Motley Thoughts on Investing and the Economy (buy on Amazon)

50 Years in the Making: The Great Recession and Its Aftermath (buy on Amazon)