Category Archives: Value Investing – Philosophy

The Psychology of Human Misjudgment by Charlie Munger

This is a great speech given by Charlie Munger. Throughout the speech, Charlie runs through the common causes of human beings to misjudge.

I think it’s important for everyone to understand these concepts, but it’s particularly important for investors. The goal of an investor ought to be to take advantage of human misjudgment. With markets, you’re dealing with the collective judgment of human beings. To make any money, you have to be able to make good decisions and understand why other people are making comparatively bad decisions.

Whenever you find yourself coming to a conclusion about something, I think it’s a good idea to think about this speech and think about whether or not you are succumbing to these common misjudgments.

The common causes that Charlie summarizes in the speech are listed below:

  1. Under-recognition of the power of what psychologists call ‘reinforcement’ and economists call ‘incentives.’ Always think in terms of whether or not someone is gaining from a course of action and whether that lines up with your own goals. “Is my realtor just trying to maximize his commission, or is this house actually a decent value?” Never underestimate the power of incentives.
  2. Psychological denial. The inability of people to accept truths that are too painful to accept.
  3. Incentive-cause bias, or when the interests of two parties aren’t aligned.
  4. Bias from consistency and commitment tendency. This is sticking to your guns over “core beliefs” and refusing to change in the face of evidence to the contrary.
  5. Bias from Pavlovian association, or misconstruing past correlation as a reliable basis for decision-making.
  6. Bias from reciprocation tendency, including the tendency of one on a roll to act as other persons expect.
  7. Lollapalooza: bias from over-influence by social proof. Social proof is your desire to agree with other people for the sake of agreeing. The ultimate examples I can think of are both the real estate bubble and the dot-com bubble of the late ’90s. The prices made no sense, but everyone else was doing it.
  8. “To a man with a hammer every problem looks like a nail”. Economists are cited as an example of loving the efficient market hypothesis because the math was beautiful and that was what they were trained to use even though it was largely useless for the problem that they were tackling.
  9. Bias from contrast-caused distortions of sensation, perception and cognition. In other words, limiting yourself to your own experiences when making decisions instead of looking at the bigger picture.
  10. Over influence by authority. Valuing someone’s opinion more just because they’re an authority figure. Also known as the expert fallacy. You’re more likely to listen to someone in a suit than someone in a t-shirt and jeans.
  11. Bias from deprival super-reaction syndrome, including bias caused by present or threatened scarcity, including threatened removal of something almost possessed, but never possessed. I.e., the reaction of a dog when you try to remove its food or the reaction of the American public when Coca-Cola tried to change the flavor.
  12. Bias from envy or jealousy.  “It’s not greed that drives the world, but envy.” – Warren Buffett
  13. Bias caused by chemical dependency, such as drugs or alcohol.
  14. Bias from a gambling compulsion.
  15. Liking and disliking distortion. This is the tendency to agree with the opinions of someone just because you like them personally. Conversely, there is the same tendency to disagree with the opinions of someone you dislike just because you dislike them. In other words, not analyzing the actual merits of an opinion, but basing your thoughts on your attitude towards the person. You see this a lot in politics. When a President does something that the opposing party dislikes, think of the different reactions that would be caused in the same people if someone from their own party proposed the same course of action.
  16. Bias from the non-mathematical nature of the human brain. Letting yourself be fooled by statistical tricks.
  17. Bias from the over influence of extra vivid evidence. Not looking closely at something because the answer seems obvious. Look closer because the truth isn’t always obvious.
  18. Mental confusion caused by information not arrayed in the mind and theory structures, creating sound generalizations. In other words, you need models to understand the world. Your mind isn’t just randomly collecting scattered facts. They have to exist in some kind of structure to be useful.
  19. Other normal limitations of sensation, memory, cognition and knowledge.
  20. Stress-induced mental changes, small and large, temporary and permanent.
  21. Mental illnesses and declines, temporary and permanent, including the tendency to lose ability through disuse.
  22. Development and organizational confusion from say-something syndrome. In other words, it’s the idea that you feel you have to do or say something for the sake of doing it, not because it will actually achieve anything. Anybody who ever sat in a meeting in corporate America knows this truth. 90% of the people who say something in these meetings have nothing useful to say.
  23. Combinations of these tendencies. Examples cited include Tupperware parties, Alcoholics anonymous and open outcry auctions. All combine several of the psychological biases that Charlie previously described to obtain a result.

Before making a decision, take a step back and think about whether or not any of these biases are at work. The more we can avoid these biases, the better decisions we can make.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Chasing Perfection

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“Many shall be restored that now are fallen, and many shall fall that are now in honor.”

– Horace.  This is the opening quote in Benjamin Graham and David Dodd’s “Security Analysis”

Buffett & Munger

Warren Buffett started his career buying cheap stocks. These weren’t good companies, they were mediocre and bad companies that were ridiculously cheap. After the 1960s, his style evolved from buying cheap “cigar butt” stocks to finding quality companies at decent prices. “Quality” in the sense that the companies are capable of compounding wealth over long periods of time.

Buffett moved on to the new style of investing primarily as a matter of size. His wealth had advanced to a point where it was difficult to move in and out of companies when they were at 2/3 of their value and then sell when fully valued. He had to be able to park money and let it compound over long stretches of time. Another reason for the style change was via the influence of Charlie Munger. The quality companies that he purchased are now famous investments: The Washington Post, See’s Candies, Coca-Cola, Gillette, etc.

These were companies that had high returns on capital.  They were also businesses with competitive moats. No one will ever be able to make a beverage that can effectively compete with Coca-Cola.  Men will always shave with razors and Gillette is the most well-known brand.  People will always buy candy and See’s candy is a great brand. You’re not necessarily going to play it cheap on Valentine’s Day. No other paper will displace the Washington Post as the premiere newspaper of the Washington, D.C. metroplex.

Many value investors that were small in scale were able to achieve high compounded rates of return dealing with cigar butt stocks. They normally become too wealthy to nimbly move into and out of cheap stocks at the opportune times. A notable exception is Seth Klarman. Very few been able to duplicate Buffett’s returns at his size, or even fractions of his size. Buffett admits that size matters. In fact, he says that if he were running $1 million, he could achieve a 50% rate of return.

It’s Not As Easy As It Looks

Everyone saw what Buffett did and now wants to duplicate it. In retrospect, it seems obvious that the businesses Buffett bought would go on and continue earning their high returns on capital. But was it as obvious as it seems now with the benefit of hindsight? If it is so obvious, why have so few been capable of duplicating Buffett’s results?

The answer is competition. The forces of competition in a capitalist economy are relentless. Consider this: since 1955, 88% of Fortune 500 companies have moved on in one way or another. There were countless companies that had high returns on capital in Buffett’s time that looked invincible. I’m sure most former Fortune 500 companies looked invincible in their heyday, but 88% of them weren’t. Buffett was capable of identifying the companies that would survive and acquiring them at a good price. He made it look easy but it wasn’t.

Competition

Competition is relentless. Any business that achieves high rates of return is going to attract competition. Human nature makes us extrapolate whatever is happening in the present into the future, but this is typically folly.

Let’s say I invent a widget that costs 50 cents to make and generates $1 of revenue, a 100% rate of return. Naturally, other companies are going to try to make widgets.  They will undercut me in price.  The supply of widgets will also continuously increase until it meets the demand. Over time, the introduction of competition will reduce the rates of return. Think of what happened to any major industry and you see the forces of competition in action. This isn’t a flaw of capitalism, it’s a feature. It’s one that benefits the consumer.

The Market

The impact on the stock prices of companies of these competitive forces is even more extreme. The widget company earning 100% returns on capital is going to attract a lot of attention on Wall Street and will likely earn insane valuations. Therefore, not only do these companies have real-world economic pressures that will bring them down, their stocks typically become overvalued as well. The introduction of competition to a company with an overheated price is an explosive combination.

You can see this in the backtesting for mechanically buying “quality” stocks with high growth and returns . The returns aren’t linear like you would expect. The “best” decile doesn’t perform the best. Unlike the backtesting for value metrics — which typically show a linear relationship where the cheapest decile has the highest stock gains and then they decline from there — quality metrics typically show lumpy returns. Typically the best returns are somewhere in the middle. The companies in the highest decile “quality” metrics don’t deliver the higher rates of return. You can see this in backtesting for return on equity, return on invested capital, return on assets, growth in earnings per share, etc. The notable exception to this is gross profits to assets, as discovered by Robert Novy-Marx. Although now that it has been discovered, it is possible that this advantage may be arbitraged away in the upcoming years.

In an attempt to duplicate Buffett and try to elevate value investing above the dirty business of buying cigar butts, value investors are constantly trying to marry “quality” with “cheap”. They’re looking for companies with amazing managers, a competitive moat, high returns on capital . . . that also sell for a good price.

This might sound easy but it’s not. As I mentioned, 88% of the Fortune 500 from 1955 is now gone. I’ll bet they all thought they had a “moat”.

General Motors used to have a moat in the 1950s and 1960s (well, it was an entrenched oligopoly, but a form of moat nonetheless). Other companies that appeared at one time or another to have a moat were Bethlehem Steel, Kodak, Standard Oil, Western Union, The American Tobacco Company, Fairchild Semiconductor, RCA.  All of these companies eventually succumbed to the relentless forces of competition and were taken off their perch.

Buffett and Munger have an underappreciated genius in identifying these rare firms with strong moats and high returns on capital and then buying them at discounted prices. I don’t think this is something that can be replicated in any quantitative fashion. Joel Greenblatt attempted to do this in The Little Book That Beats the Market, with outstanding results. However, Tobias Carlisle discovered that the quality component of Greenblatt’s formula (return on invested capital) actually reduces the returns. You can read about this in Deep Value.  Simply using the “cheap” component of the magic formula actually achieves better results.

My thinking is that attempts to duplicate Warren Buffett and Charlie Munger actually leads to the under performance of value managers. It’s the reason that most value managers outperform the S&P 500, but can’t beat the lowest deciles of price-to-book and price-to-earnings.

The Good News

The obsession with quality creates many of the value investing bargains that I seek. The flip side of the relentless impact of competition on high return business is that low return businesses attract little attention. Low return, bad businesses aren’t necessarily dead. They may be at the end of a waning period in their industry in which many of their competitors are dying. The decline of competition will ultimately drive returns higher. A struggling business with a low ROE is trying to turn things around, likely by reducing their costs. If their strategy doesn’t drive returns higher, at the very least there will be very little competition and the existing competition may leave the market behind.

A good example of something like this is a stock like Archer Daniels Midland. It operates in a mediocre return business (ADM has a ROE of 7.77%, compared to a Buffett stock like Coke with an ROE of 15.92%), but attracts little competition due to the mediocre returns of the business and large investments necessary to penetrate the market. No one is going to make the massive investments in scale to duplicate ADM’s results for a relatively low ROE. Simultaneously, low ROE stocks will typically be ridiculously cheap at the end of a competitive cycle because they generate an “ick” reaction in most investors. “Ick” creates bargains.

The “Ick” Factor

I’m not opposed to quality investing. I just think it is far more difficult to implement than is typically appreciated.

If one is going to go down the “quality” road, I think it’s important that the stock have some level of an “ick” factor to the investing public. If a consistently high ROE stock with a competitive moat has what appears to be an attractive price, it’s important to ask why everyone else doesn’t see the value (particularly if your insight into the attractive price is achieved with DCF analysis).

A great quality investment needs to generate an “ick” to ensure you’re getting a good price. Some of the best Buffett buys had a massive temporary “ick” factor — like the salad oil scandal, New Coke, or GEICO’s massive losses in the mid-1970s. If the stock isn’t reaching out to you with an “ick” factor, it’s probably not really a bargain. If you find one of these stocks, my suggestion would be to only go after it if there is an “ick” factor and you’ve done sufficient research to know that the “ick” is temporary.

I’ll Stick With Cigar Butts

I’m not Warren Buffett. I’m not Charlie Munger. I’m not going to achieve their rates of return over long stretches of time.  The good news is that I don’t need to identify Buffett stocks to do well in the market, mainly because I’m operating with small sums of money and can behaviorally deal with temporary losses in the realm of cigar butts.

15% rates of return in the lowest value deciles of the market may not sound as sexy as the Buffett’s 19.2% returns on billions and billions of dollars in capital, but it is an excellent return to strive for and it’s one that can be obtained by operating in the lower valuation deciles with small sums of capital.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.  Full disclosure: my current holdings.

Long Term Capital Management and the Dangers of Debt

This is a good documentary about the ’90s hedge fund Long Term Capital Management (LTCM). If you want to learn more you should read Roger Lowenstein’s excellent bookWhen Genius Failed.

The story is a cautionary tale about leverage (leverage: what rich people call debt). LTCM was leveraged 25-1, meaning a 4% reduction in assets would kill the firm. That’s precisely what happened.

LTCM would make ‘safe’ bets and leverage up on those safe bets to amplify returns.  It worked great for years, until 1998 when the world defied the model with Russia’s default.

Leverage boosts returns but it blows up in your face when you are wrong, no matter how brilliant you are. Everyone gets things wrong.  That’s a part of life.  That’s a part of investing.  In the face of an error, the proper course of action is to pick up the pieces and move on.  Excessive leverage destroys the ability to do that, because one mistake will wipe you out.  LTCM had two Nobel Prize winners and one of the greatest bond traders of all time, John Meriwether.  If they can get things wrong, then anyone can.

Whenever I hear of the returns of Renaissance Technologies, I think of LTCM. Genius minds, complex mathematical models, massive returns and leverage. They may not be leveraged 25-1, but they are reportedly leveraged 17-1.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures. Full disclosure: my current holdings.

Seth Klarman Interview

This is a great interview between Charlie Rose and Seth Klarman.

Seth Klarman is a value investing legend.  What fascinates me about Seth Klarman is that he never moved beyond the “cigar butt” deep value style of investing, while many value investors eventually adopt the Buffett-Munger style of finding quality companies at attractive prices.  His out of print book, Margin of Safety, sells used on Amazon for $765.  Since the early 1980s, his fund (Baupost Group) has been able to achieve a 19% rate of return.  There are many great insights in this interview and it is well worth your time.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.  Full disclosure: my current holdings.

The Benjamin Graham Approach

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Grahamian Value Investing

My investment approach is inspired by Benjamin Graham, so I think it is only appropriate that my first post describe Benjamin Graham’s philosophy and how I plan to apply it in my own portfolio.

Benjamin Graham is the father of value investing.  He was one of the first to advocate for fundamental analysis (trying to figure out what a company is worth based on financial statements), as opposed to technical analysis (analyzing chart patterns the way a fortune teller reads your palm).  The Benjamin Graham approach is to look at stocks as ownership shares in a company, rather than pieces of paper or dots on a stock chart.  His approach is simple to grasp: figure out what a company is worth and purchase shares in that company for less than they are worth.  On the particulars, value investors differ greatly in approach, but this basic outlook remains consistent throughout the value community.

Graham’s 1949 book, The Intelligent Investor, espoused his principles to a mass audience.  The key concept in the book was that investors should purchase stocks with a margin of safety.  The margin of safety is the extent to which you are buying the stock below its true intrinsic value.  He also described the market not as an all knowing master of the universe, but as a manic depressive called Mr. Market.  When Mr. Market is in a good mood (think 1999 at the height of the “New Economy” financial euphoria), he offers absurdly high prices for companies.  When Mr. Market is in a depressive mood (think the aftermath of the 2008-2009 financial meltdown), he pushes the prices of companies to absurdly low levels.  The goal of the intelligent investor is not to allow his investment decisions to be dictated by the moods of Mr. Market, but to instead seek to gain from Mr. Market’s erratic behavior.  In other words, buy from Mr. Market when he is depressed and sell when he is elated.

Influence on Warren Buffett

One of the readers of the 1949 edition of The Intelligent Investor was a 19 year old named Warren Buffett.  Buffett sought a coherent investment framework throughout his teens but was unable to find one that was intellectually convincing until he came across Graham’s book.  In fact, Warren Buffett later went on to say about the book: “It changed my life. If I hadn’t read that book in late 1949, I’d have had a different future.”

Buffett went on to enroll in Columbia primarily because Benjamin Graham taught an investing course at Columbia.  He later went on to work for Ben Graham in his investment partnership.  Below is an excellent interview where Buffett describes his experience with Graham:

As everyone knows, Warren Buffett used Graham’s concepts to become the greatest investor of all time.  Graham recommended buying stocks when they were deeply depressed.  Buffett employed this method extensively in the 1950’s and 1960’s.  Eventually, however, he outgrew this approach.  Instead of buying stocks when they were deeply depressed and selling after a run up in price, Buffett sought to buy quality companies for the long term, still following Graham’s basic approach of waiting until the price was right but increasing his standards for quality and lowering his standards for price discounts.

This change in approach was due to two factors.  The first reason was the influence of Charlie Munger, who was more interested in buying excellent businesses for the long term than looking for the kind of ugly bargain stocks that Graham advocated.  The other reason was scale.  Buffett simply became too big to operate exclusively in the world of depressed stocks.

Nevertheless, Buffett experienced his greatest returns in the 1950’s and 1960’s when he was small enough to focus on Graham style bargains.

Simple Quantitative Approaches

Graham advocated two quantitative methods of stock selection that make a lot of sense to me.

Method #1: Net-Nets.  The first, and most famous, is the “net net” approach.  He advocated buying stocks when they were selling at 66% or below of the company’s liquidation value.  Why 66%?  If the company were completely liquidated, the owner of the stock would experience a 50% gain.  Graham suggested that investors buy 20-30 net-net stocks selling at 66% of their liquidation value, then selling after two years or when the stock price appreciated by 50%.

Famed investor Joel Greenblatt investigated the performance of net-net stocks when he was enrolled in Wharton in the 1970s.  The underlying results were quite impressive.  One of Joel’s portfolios experienced an annual compound return of 42.2%.

Other academic studies also verify that the returns of net-net stocks frequently deliver impressive results.  Unfortunately, net-net stocks are difficult to come by, particularly during bull markets such as the one that we have experienced since 2009.  During recessions, such as in 2002 or 2009, large numbers of them are frequently available.  In my own portfolio, I plan on purchasing net-net stocks when they are available in sufficient quantities.  Fortunately for small investors, the net-net stocks that are typically available are small companies that large investors can typically not exploit.

Method #2: Low P/E, safe balance sheet.  The second, lesser known, approach that Graham advocated was explained in a 1976 interview that Graham gave shortly before his death.  It was published in the September 1976 issue of Medical Economics.  In the article, he suggested buying stocks when they delivered an earnings yield that was double that of a typical AAA corporate bond.  As a measure of safety, he also suggested that they have a debt to equity ratio less than 50%.  In other words, the stock should be cheap relative to its earnings and it should have double the amount of assets than it has in debt as a measure of the company’s solvency.  Graham tested the method from 1926 to 1976 and found that a diversified portfolio of these of these safe bargain stocks would deliver 15% returns over the long term.  Quite impressive for such a simple method with only two variables.

15% is an outstanding rate of return over a long period of time and it is what I would like to strive for over the next ten years.  If I could achieve this rate of return, I will be able to turn my $50,000 value-oriented IRA into $200,000 over the next ten years.

Over at Alpha Architect, they backtested the simple P/E oriented Graham method and found it still works. The portfolios they tested produced long term compounded annual growth rates ranging between 15.07% and 16.42%, exactly as Graham predicted!

I plan on using this method extensively with my own portfolio.  I also plan on pursuing net-net stocks and other quantitative bargains when they are available.  A key thing to keep in mind is that while these methods succeed over the long haul, there are periods of time when they do not work.  I hope this blog will help me remain disciplined and focused on my own value investment journey.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional.  I am an amateur and the purpose of this site is to simply monitor my successes and failures.