The common wisdom is that to be a better investor one needs a edge. This edge is usually regarded as an informational advantage obtained through superior research, or insider information. Investors continually inch closer to the line of what could be considered legal in an attempt to reduce the risk of a trade and earn a more guaranteed return. Informational edges are the "war stories" of investing. Gather more than 2-3 investors and they'll start sharing stories of famous investors who camped out in a van counting delivery vans in the middle of the night, the crucial piece of information that supposedly netted them millions.
An informational advantage is fleeting. Nothing lasts forever, and an edge in the investing world has a half-life that rivals francium (which is 22 minutes). There are simply too many people and too many dollars looking for more dollars. This is not unlike the washout that happened in the poker world.
In the early 2000s my youngest brother started to ride the poker wave. Whatever wiring it takes to be good at poker my brother had. He used to play local games and come away with fat pockets full of his competitor's money. When poker was all the rage there were a lot of players who had full pockets full of cash in search of a better home. My brother had some sort of edge that he used to his advantage. Unfortunately for poker players there were structural issue with the game that led to its demise.
In poker you are playing against everyone else at your table. And for those without much skill, or the inability to find easy tables once their pockets have been cleaned out it's unlikely they will continue to play. What naturally happens is the easy money leaves the game the quickest and the pool of suckers shrinks. As the pool of easy money shrinks only players with some amount of skill continue to play. The same natural selection process continues when previously skilled players become the saps at the table and suffer larger than expected losses. After years of this process the game becomes one limited to players with a very high skill level all still in the hunt for the perfect edge. Eventually the pool of players is distilled down to a group with similar skill sets who are equally suited to compete. Of course there will always be new players entering the game, but if they don't have the skill level held at the top, or extremely deep pockets they will eventually drop out like most other players.
When I asked my brother this summer why he didn't play poker anymore he confirmed my view by saying "it's too hard to make money anymore." The same thing could be said about any previously ripe investing opportunity "large cap value is picked over" or "compounder growth stocks are overpriced." It would seem that every area of opportunity is quickly discovered and edges become worthless.
There are two ways to handle this, the first is to dig deeper and search harder for additional information that can give a better edge. This is the default behavior for most of the market. I think in most cases information is overrated, at times a red herring, and in certain cases even dangerous.
The problem is we delude ourselves into thinking that by exhaustively researching a company we can rest confidently on our knowledge and make superior decisions. I have news for those who believe this, whatever you think you know is nothing, you don't know squat!
Is it ever possible to know a subject exhaustively? Potentially, if you are the person who invented the thing, or are the pre-eminent world leading expert. At that point you probably have a better grasp of the subject than most. In these cases maybe your advanced knowledge gives you an edge, but more likely it probably serves to distract you. You have trouble seeing the forest through the trees because you're so focused on the operational level details of the subject.
I think sometimes we're blinded by how much we think we know that we don't realize how little we know. Sit back for a moment and contemplate how much we don't know. You really have NO idea about what anyone is thinking, or what anyone else's motivations are for anything. This extends beyond acquaintances to even to our spouses and kids. I can 'know' my family by living with them and observing their patterns. It allows me to understand how they think, but I never really know what anyone is thinking. When people tell us what they're thinking we don't have a way to know if that's true or if it's a lie. Maybe it's partially true and partially a lie, we will never know. For anyone with kids you're probably nodding along with me. We think we know our kids, but we really have zero understanding as to what drives some of the wacky decisions they make. We see them daily but we have no idea what's going on in their head.
If a company states they expect to grow at 10% over the next year are they saying this because they believe it's an easy target and management will receive sizable bonuses? Or maybe they believe that investors expect 10% so they say it even if they don't have a plan to hit it. Or it could be a million other reasons. Maybe the CEO's brother-in-law casually mentioned at a BBQ that he heard all companies in the industry should be growing at 10% and the CEO latched on. The point is we really have no idea. And to believe that people will open themselves up and reveal their motivations behind what they say is foolish.
Speaking to a company's management can be helpful to understanding how their business works, or understanding how they view the industry, but beyond that take any talk with a large grain of salt. As we saw with Valeant the company's management was willing to tell their largest shareholder anything to keep him appeased. The job of a manager is to make sure operations move forward, and a large part of that is building consensus for decisions. An executive is quick to find a common ground with an investor, and in doing so builds trust. But don't be blinded by that trust because sometimes causes us to see only what we want to see.
Now extrapolate the idea that we don't know what one person is thinking to the number of employees at a company. Is it really possible to know what's going on? We see the results, but what created those results? Did a company earn more money because of the quarterly rewards program, or was it a new motivational manager, or did the company start catering lunch and workers simply put in more time at their desks? Who knows!
Measuring business results isn't a science, there are too many uncontrolled variables. How many managers divide up departments into equal working groups and then test different work styles with those groups and measure results? But that's not enough, the groups would need to be mixed up and methods tested again to make sure results were reproducible. This doesn't happen, and if it does it's rare. Every business I've interacted with has a sort of dual mandate. The first mandate is to do things the "correct" and proper way, when there's time. But when deadlines are approaching the second "git-r-done" mandate comes into play. The bigger the deadline the more "we'll fix that later" compromises are taken.
So how do you as an outsider know what's happening? If a company is rushing to a deadline can you understand the magnitude and impact of the decisions that were made? It's impossible, absolutely impossible. If each decision has two potential outcomes the possibilities grow exponentially very quickly. And most decisions don't have two outcomes, they have multiple outcomes meaning the graph of the decision tree grows even quicker. Then multiply these decisions across the number of employees. It's overwhelming.
When thinking about companies like this it's almost unbelievable that anything ever gets done. I have worked on the ground level of some large caps and it certainly feels like this. It appears that every person is spinning their wheels and collectively the company is spinning their wheels. But even with that spinning each person is usually making a little progress, and a little progress multiplied by a lot of employees means forward movement.
If at this point in this post business analysis seems like futility it's because at times it is. The information that's important to an investment is probably the information that an outsider might never obtain. It might be information that decision makers never share because it furthers their own agendas, or makes them look bad. I firmly believe that finding out those hidden agendas is something we'll never do. If we don't even know what's motivating our spouse or kids to make decisions, and likewise they don't know what we're thinking then why could we can discern the reasons for a manager's decisions, maybe a manager we've spoken to for 20m at most on the phone?
Through all of this there is an actual litmus test for results, it's the company's financial statements. A company either earned money or it didn't. It grew or it didn't.
Benjamin Graham pronounced in Security Analysis that the financial results of a company tell us about the quality of a company's management. Great management produces great results, poor management produces poor results. Somewhere along the way Phil Fisher came along and told us that there might be secrets we can discover beyond financial results if we dig hard enough. Fisher played into our common psychology leading us to believe that there is always something more. When I first started investing I understood the logic of Graham's writings, but I thought I could do better by layering a bit of Fisher on top. I would understand the numbers first then dig a little deeper to find these secrets that would allow me to out earn peers.
What I'm writing today is that there are no secrets, and if there are good luck finding them. The secrets are probably located in Florida next to Ponce de Leon's Fountain of Youth.
You cannot out-research others. The more time you put into research doesn't lead to better results. Most investments hinge on one or two factors and discovering those factors and the likelihood of their outcome will generate the same results as someone who exhaustively reads the annals of a given industry. This is what Graham was trying to tell us decades ago, and it took me years of investing for it to sink in.
Instead of trying to understand a company's management or understand the future with complicated decision trees there is a better method. That method is using the statement of record, a company's financial statements and making one or two probability guesses or bets regarding the future. As outside investors with very limited information we are relegated to making educated guesses about the future. If a company is trading for 50% of book value it's up to us to decide whether they will go out of business in the next year as the market has priced, or if they'll last. If the company is profitable and even has a little growth then the probability of them lasting another year is greater than the probability of them failing. And in that case they should be worth more than their current valuation. That's the simple investment case for most value investments.
This thinking can be extended to compounders or growth stocks. If a company is growing at 25% a year is it more or less probable that they'll continue to grow at that rate? And if the result is a "more probable" then the next question is "what's that worth?" These are simple questions, and the answers are simple. For myself if the question isn't simple, or if determining the answer isn't simple then the investment goes into the "too hard" pile.
When Graham talked about net-nets it was a short-hand way of saying "this company appears too cheap given circumstances and the probability of a gain is higher than the probability of a loss." He wasn't making a judgement call as to the quality of the business, it wasn't necessary.
A common retort to this is by mentioning that Buffett is an expert business analyst and with all those years of reading 10-K's he can somehow figure all these variables out in his head and make superior decisions. I don't think that's true. Buffett was a horse handicapper when he was younger, and he just moved onto business handicapping. When he made the investments in Goldman Sachs and Bank of America do you think he spent his nights building Excel spreadsheets modeling out derivative exposure and interest rate risk? No! I think he looked at the companies and said "with my investment they have a much better chance of being in business in five years verses not being in business." And with that he invested. He knew the odds were what mattered, not what the Actuarial Support Department deep in the bowels of Goldman Sachs was doing.
But you might say "But Buffett is constantly on the phone! He's getting better information that we don't have!" And while that might be true I believe he's really just getting information that better informs his probability judgements.
My guess is most readers will disregard this post as simplistic, or foolish, or think they're smarter than me (which you probably are) and go on with whatever they've always been doing. And if the results from doing what you've always been doing are good then why stop? But if your results aren't what you expect them to be then read on.
There are two ways to apply this. The first is to stop wasting your time trying to gain a vanishing edge. This means focusing on a company's financial statements, finding fulcrum points and making a probability judgement about the future. To me this is the essence of value investing. I find companies at depressed valuations, make a probability judgement that they're worth more and invest.
The second way to apply this is through a buy and hold strategy. It is heretical to most investors to promote this strategy, but I think it works. Find stable companies that are likely to be stable in the future with predictable growth, buy and hold on. The only way to get burned with this strategy is to pay too much on the initial purchase, or to buy into nonexistent growth. The best way to apply a buy and hold strategy is to buy companies with lower growth. Growth that is roughly equal to inflation + GDP growth and don't overpay.
Being an outside investor shouldn't be hard work, if it is you're working too hard or looking for an edge in little nooks and crannies. The key is to take in all relevant measurable information, the company's financial statements and then make a judgement call on the company's valuation. Points aren't rewarded to those who read 15 years of annual reports. Rather points are rewarded to those who can make accurate probability judgements. All that's required for that is a bit of common sense and some patience.
If you're interested in learning more about my investment system, check out my investing mini-course here.
An informational advantage is fleeting. Nothing lasts forever, and an edge in the investing world has a half-life that rivals francium (which is 22 minutes). There are simply too many people and too many dollars looking for more dollars. This is not unlike the washout that happened in the poker world.
In the early 2000s my youngest brother started to ride the poker wave. Whatever wiring it takes to be good at poker my brother had. He used to play local games and come away with fat pockets full of his competitor's money. When poker was all the rage there were a lot of players who had full pockets full of cash in search of a better home. My brother had some sort of edge that he used to his advantage. Unfortunately for poker players there were structural issue with the game that led to its demise.
In poker you are playing against everyone else at your table. And for those without much skill, or the inability to find easy tables once their pockets have been cleaned out it's unlikely they will continue to play. What naturally happens is the easy money leaves the game the quickest and the pool of suckers shrinks. As the pool of easy money shrinks only players with some amount of skill continue to play. The same natural selection process continues when previously skilled players become the saps at the table and suffer larger than expected losses. After years of this process the game becomes one limited to players with a very high skill level all still in the hunt for the perfect edge. Eventually the pool of players is distilled down to a group with similar skill sets who are equally suited to compete. Of course there will always be new players entering the game, but if they don't have the skill level held at the top, or extremely deep pockets they will eventually drop out like most other players.
When I asked my brother this summer why he didn't play poker anymore he confirmed my view by saying "it's too hard to make money anymore." The same thing could be said about any previously ripe investing opportunity "large cap value is picked over" or "compounder growth stocks are overpriced." It would seem that every area of opportunity is quickly discovered and edges become worthless.
There are two ways to handle this, the first is to dig deeper and search harder for additional information that can give a better edge. This is the default behavior for most of the market. I think in most cases information is overrated, at times a red herring, and in certain cases even dangerous.
The problem is we delude ourselves into thinking that by exhaustively researching a company we can rest confidently on our knowledge and make superior decisions. I have news for those who believe this, whatever you think you know is nothing, you don't know squat!
Is it ever possible to know a subject exhaustively? Potentially, if you are the person who invented the thing, or are the pre-eminent world leading expert. At that point you probably have a better grasp of the subject than most. In these cases maybe your advanced knowledge gives you an edge, but more likely it probably serves to distract you. You have trouble seeing the forest through the trees because you're so focused on the operational level details of the subject.
I think sometimes we're blinded by how much we think we know that we don't realize how little we know. Sit back for a moment and contemplate how much we don't know. You really have NO idea about what anyone is thinking, or what anyone else's motivations are for anything. This extends beyond acquaintances to even to our spouses and kids. I can 'know' my family by living with them and observing their patterns. It allows me to understand how they think, but I never really know what anyone is thinking. When people tell us what they're thinking we don't have a way to know if that's true or if it's a lie. Maybe it's partially true and partially a lie, we will never know. For anyone with kids you're probably nodding along with me. We think we know our kids, but we really have zero understanding as to what drives some of the wacky decisions they make. We see them daily but we have no idea what's going on in their head.
If a company states they expect to grow at 10% over the next year are they saying this because they believe it's an easy target and management will receive sizable bonuses? Or maybe they believe that investors expect 10% so they say it even if they don't have a plan to hit it. Or it could be a million other reasons. Maybe the CEO's brother-in-law casually mentioned at a BBQ that he heard all companies in the industry should be growing at 10% and the CEO latched on. The point is we really have no idea. And to believe that people will open themselves up and reveal their motivations behind what they say is foolish.
Speaking to a company's management can be helpful to understanding how their business works, or understanding how they view the industry, but beyond that take any talk with a large grain of salt. As we saw with Valeant the company's management was willing to tell their largest shareholder anything to keep him appeased. The job of a manager is to make sure operations move forward, and a large part of that is building consensus for decisions. An executive is quick to find a common ground with an investor, and in doing so builds trust. But don't be blinded by that trust because sometimes causes us to see only what we want to see.
Now extrapolate the idea that we don't know what one person is thinking to the number of employees at a company. Is it really possible to know what's going on? We see the results, but what created those results? Did a company earn more money because of the quarterly rewards program, or was it a new motivational manager, or did the company start catering lunch and workers simply put in more time at their desks? Who knows!
Measuring business results isn't a science, there are too many uncontrolled variables. How many managers divide up departments into equal working groups and then test different work styles with those groups and measure results? But that's not enough, the groups would need to be mixed up and methods tested again to make sure results were reproducible. This doesn't happen, and if it does it's rare. Every business I've interacted with has a sort of dual mandate. The first mandate is to do things the "correct" and proper way, when there's time. But when deadlines are approaching the second "git-r-done" mandate comes into play. The bigger the deadline the more "we'll fix that later" compromises are taken.
So how do you as an outsider know what's happening? If a company is rushing to a deadline can you understand the magnitude and impact of the decisions that were made? It's impossible, absolutely impossible. If each decision has two potential outcomes the possibilities grow exponentially very quickly. And most decisions don't have two outcomes, they have multiple outcomes meaning the graph of the decision tree grows even quicker. Then multiply these decisions across the number of employees. It's overwhelming.
When thinking about companies like this it's almost unbelievable that anything ever gets done. I have worked on the ground level of some large caps and it certainly feels like this. It appears that every person is spinning their wheels and collectively the company is spinning their wheels. But even with that spinning each person is usually making a little progress, and a little progress multiplied by a lot of employees means forward movement.
If at this point in this post business analysis seems like futility it's because at times it is. The information that's important to an investment is probably the information that an outsider might never obtain. It might be information that decision makers never share because it furthers their own agendas, or makes them look bad. I firmly believe that finding out those hidden agendas is something we'll never do. If we don't even know what's motivating our spouse or kids to make decisions, and likewise they don't know what we're thinking then why could we can discern the reasons for a manager's decisions, maybe a manager we've spoken to for 20m at most on the phone?
Through all of this there is an actual litmus test for results, it's the company's financial statements. A company either earned money or it didn't. It grew or it didn't.
Benjamin Graham pronounced in Security Analysis that the financial results of a company tell us about the quality of a company's management. Great management produces great results, poor management produces poor results. Somewhere along the way Phil Fisher came along and told us that there might be secrets we can discover beyond financial results if we dig hard enough. Fisher played into our common psychology leading us to believe that there is always something more. When I first started investing I understood the logic of Graham's writings, but I thought I could do better by layering a bit of Fisher on top. I would understand the numbers first then dig a little deeper to find these secrets that would allow me to out earn peers.
What I'm writing today is that there are no secrets, and if there are good luck finding them. The secrets are probably located in Florida next to Ponce de Leon's Fountain of Youth.
You cannot out-research others. The more time you put into research doesn't lead to better results. Most investments hinge on one or two factors and discovering those factors and the likelihood of their outcome will generate the same results as someone who exhaustively reads the annals of a given industry. This is what Graham was trying to tell us decades ago, and it took me years of investing for it to sink in.
Instead of trying to understand a company's management or understand the future with complicated decision trees there is a better method. That method is using the statement of record, a company's financial statements and making one or two probability guesses or bets regarding the future. As outside investors with very limited information we are relegated to making educated guesses about the future. If a company is trading for 50% of book value it's up to us to decide whether they will go out of business in the next year as the market has priced, or if they'll last. If the company is profitable and even has a little growth then the probability of them lasting another year is greater than the probability of them failing. And in that case they should be worth more than their current valuation. That's the simple investment case for most value investments.
This thinking can be extended to compounders or growth stocks. If a company is growing at 25% a year is it more or less probable that they'll continue to grow at that rate? And if the result is a "more probable" then the next question is "what's that worth?" These are simple questions, and the answers are simple. For myself if the question isn't simple, or if determining the answer isn't simple then the investment goes into the "too hard" pile.
When Graham talked about net-nets it was a short-hand way of saying "this company appears too cheap given circumstances and the probability of a gain is higher than the probability of a loss." He wasn't making a judgement call as to the quality of the business, it wasn't necessary.
A common retort to this is by mentioning that Buffett is an expert business analyst and with all those years of reading 10-K's he can somehow figure all these variables out in his head and make superior decisions. I don't think that's true. Buffett was a horse handicapper when he was younger, and he just moved onto business handicapping. When he made the investments in Goldman Sachs and Bank of America do you think he spent his nights building Excel spreadsheets modeling out derivative exposure and interest rate risk? No! I think he looked at the companies and said "with my investment they have a much better chance of being in business in five years verses not being in business." And with that he invested. He knew the odds were what mattered, not what the Actuarial Support Department deep in the bowels of Goldman Sachs was doing.
But you might say "But Buffett is constantly on the phone! He's getting better information that we don't have!" And while that might be true I believe he's really just getting information that better informs his probability judgements.
My guess is most readers will disregard this post as simplistic, or foolish, or think they're smarter than me (which you probably are) and go on with whatever they've always been doing. And if the results from doing what you've always been doing are good then why stop? But if your results aren't what you expect them to be then read on.
There are two ways to apply this. The first is to stop wasting your time trying to gain a vanishing edge. This means focusing on a company's financial statements, finding fulcrum points and making a probability judgement about the future. To me this is the essence of value investing. I find companies at depressed valuations, make a probability judgement that they're worth more and invest.
The second way to apply this is through a buy and hold strategy. It is heretical to most investors to promote this strategy, but I think it works. Find stable companies that are likely to be stable in the future with predictable growth, buy and hold on. The only way to get burned with this strategy is to pay too much on the initial purchase, or to buy into nonexistent growth. The best way to apply a buy and hold strategy is to buy companies with lower growth. Growth that is roughly equal to inflation + GDP growth and don't overpay.
Being an outside investor shouldn't be hard work, if it is you're working too hard or looking for an edge in little nooks and crannies. The key is to take in all relevant measurable information, the company's financial statements and then make a judgement call on the company's valuation. Points aren't rewarded to those who read 15 years of annual reports. Rather points are rewarded to those who can make accurate probability judgements. All that's required for that is a bit of common sense and some patience.
If you're interested in learning more about my investment system, check out my investing mini-course here.
Spot on, Nate.
ReplyDeleteThe other day I was reading one of the smaller investing blogs I follow where he posted an interview he gave. In this interview he "bragged", like many other investors, how he spends "hundreds of hours" researching each company he invests in.
Rather than be impressed, I reeled back in horror. Probably once a quarter I fall for the trap where I spend tens of hours on one company, looking for that "edge", as you put it, some piece of information that would reveal to me their future. Fortunately, more often than not, I catch myself mid-process and realize that if I am spending this much time on arcane technical details of product or the industry dynamics, then this candidate clearly belongs in the "too complicated" category.
When I hear people supposedly spending hundreds of hours, it gives me the impression that they were unable to identify the 1 or 2 key variables that will drive the success or failure of the company.
I tell people that my edge is that in a game of hot potato, I'm willing to take a (hopefully) educated guess at which ones will cool down vs. those that will explode, and I'm willing to hold them in my hands when nobody else will until we see which is which. Sometimes I get burned, but more often than not they turn out to be delicious baked potatoes, sometimes with a little butter and sour cream on the inside. :)
David,
DeleteSpot on. I'm with you on the extensive research as well. In a further comment Ben Jamin distills my point even further by discussing how this is all about odds.
I've found for myself that if I'm lost in the details on an investment situation it doesn't have clear cut odds, and when the odds aren't clear cut is when I make mistakes.
Nate
+1
ReplyDeleteI agree with you, Nate.
ReplyDeleteVery nice post. Thanks.
ReplyDeleteWhat is invisible? Everything that matters. Except every thing and matter. (john loyd)
https://www.youtube.com/watch?v=BxFvxKa-mWo
I recommend watching johns tedx presentation. Highly entertaining and very relevant for investing.
G o-tone
Excellent link, very much in line with this post. I ended up sending that on to a few friends.
DeleteWell. Than my posts on this subject could be of interest of you too.
Deletehttp://undervaluedjapan.blogspot.de/2015/09/value-investing-and-virtue-of-not-being.html
http://undervaluedjapan.blogspot.de/2015/09/on-virtue-of-knowing-about-ones.html
G o-tone
I really enjoyed this thought provoking post. Thank you. It's so true what you say about the impossibility of understanding the motivations and actions of those closest to us, let alone large companies!
ReplyDeleteThank you for the great post.
ReplyDeleteGraham distilled your comments into 3 words in chapter 20, namely "Margin of Safety," which is the thread that runs through his philosophy. Incidentally, this is the same thread which runs through Nassim Taleb's books, which very few people can appreciate (even Taleb doesn't see the commonality between his views and Buffett's for example): Margin over the odds.
I used to be a currency options trader and one doesn't think about it this way whilst on the trading floor, that is until you step back and reflect (and perchance discover Graham!). But, the essence of Graham's margin of safety is -- on average -- benefiting from positive errors and avoiding ruin (i.e. low downside) in the face of negative errors. It's such a simple and elegant concept. Taleb calls this "barbell" or "antifragile." They're similar, it's just he's a trader and so he doesn't look at stocks as fractions of businesses.
Applying the same thing a different way is Mr Buffett. But, Buffett's edge has nothing to do with digging for that one revealing factor. For example, going back to his "balance sheet days" even, he counted union carbide cars not for an "edge" the way it's thought of today, but for timing purposes: he saw a pattern in the stock's behaviour just as he saw a pattern in Berkshire Hathaway stock when a mill was closed. Coca Cola was not "G.A.R.P" or whatever classification people like to use to describe Buffett's investing since the 80s. It was an extension of margin of safety into "are people more likely to consume this product for a long time to come and why and can we rule it out causing cancer?" (plus other psychological underpinnings in the products favour). If yes and no, odds are time is on his side and he'll benefit more from positive mistakes (population growth, good management, etc) than he'll suffer from negative mistakes (dieting, competition etc). This is also analogous to Taleb's "fragile things despise volatility (time), while antifragile things love volatility." Price then becomes a matter of avoiding overpaying. A biologist studying a species would similarly ask "can this animal run fast and can it reproduce?". So when Buffett advocates reading 10-Ks, I don't think it's to, as you say, find some wrinkle, although that may happen. I think it gets misinterpreted. It's more to "learn about the species." I do wonder if Buffett primarily read 10-Ks or moody's manuals when he was searching for cigar butts.
The problem is that Buffett really has thought about this stuff harder than most and longer than most. So IMO his edge lies in thinking better, and handicapping better (which equates to avoiding biases), and not in what's uncovered in some superficial management meeting. Thus, margin of safety is domain dependent.
Excellent comment. I like the tie-in with Taleb, it's very accurate.
DeleteIt's probably the subject for another post, but people confuse running a business with investing in a business. This is what you hit on. When you run a business you're worried about accounts receivable, inventory, sales. When you invest in a business you're as you put it making a bet that positive mistakes will outweigh negative mistakes.
Very well put.
Nate,
ReplyDeleteI enjoyed this "philosophical" post immensely. I want to add a slightly different angle to the phenomenon you've observed, that being that there is too much to know and the value adding-edge of this information as an investor diminishes markedly over time.
I think the market for ownership of companies is incredibly corrupt in this country and many like it with similar tax and regulatory structures. The double taxation of dividends and the taxation of corporate income breed an environment where the most tax efficient way to maximize shareholder value is to retain earnings in the company to avoid dividend tax, and to spend these retained earnings on "growth" opportunities, usually acquisitions or risky skunk works ventures, to try to grow market value. Investors who ever hope to financially benefit from their holdings must sell their ownership to someone else who knows less than them about the value of what they hold. This means that you can't really benefit from owning companies, and the incentive is to arbitrage information asymmetries which mean less and less-knowledgeable investors come to own companies over time (or more and more passive owners, however you might like to think of it).
The regulatory angle is the way that incumbent managers are treated by the public and the laws as the authorities and anyone who might challenge them must be deranged and looking to steal from the company. The laws allow managements and boards to conspire together to rob and disenfranchise the owners of the company. Again, this makes the incentive clear-- people who want to be actively engaged and apply their knowledge to their investing lose out over time to dopes with excess cash who are willing to sit back and gamble on incumbent management.
These two ideas work together to diminish the value of "intelligence" in investing. If you don't make money from your company by being a long-term holder and earning dividends distributed as personal income, you don't really gain benefits by accumulating more and more knowledge of your company over time. And if the legal system conspires against you influencing the management of your company, you are similarly disincentivized to invest your own time and energy in developing an informational edge (kind of like voting in a democracy...) because you can't do anything with this info.
What's interesting about all of this, if I am right, is that it actually creates a perverse incentive for criminal activity (ie, insider dealing) because these two circumstances create a kind of "barrier to entry" to otherwise knowledgeable, competent investors and thereby those with the real inside knowledge are protected by this "monopoly" and can reap additional profits that would otherwise be competed away.
That's a frightening assessment, and yet a lot of it sounds close enough to true.
DeleteI always chuckle at the "I have put together a 550 page slide deck on this investment" types. Seems to be the epitome of a low marginal return way of working.
ReplyDeleteHowever, I think it is something else to continually learn about companies you already own. For comfort with a stake that hopefully increases in value at a healthy clip, getting more expert at the business is key to being able to let it grow, and it's easier to let a good current investment grow than to find a new one of equal worth.
A lot of times your blog reads more like a therapy for value investors.
ReplyDeleteThere is a great Einstein quote that goes something like, "clever people solve tough problems, but wise men avoid them." That's how I've always invested. I'm not looking to buy some crazy (to me) biotech company after researching clinical reports I'm looking to buy a company in liquidation that's trading for $18.5m but has $28m in net cash and receivables.
Great post. I AGREE. Information is not the edge. Process ,discipline and patience is.
ReplyDeleteAnother good post Nate.
ReplyDeleteA lot of research has made a quantitative investor out of me - previously a value investor.
I still invest in undervalued companies but quantitatively selected.
This scared me...
In a study bookmakers were given a few bits of information on a horse and had to calculate the odds.
They were then given a lot more information, relevant and irrelevant.
The odds they came up with was the same BUT they were a lot more certain they were correct when they had a lot of information.
Also from Taleb we are fooled by randomness and the other biases built into our brain.
Over confidence is the most dangerous.
-- "When [Buffet] made the investments in Goldman Sachs and Bank of America do you think he spent his nights building Excel spreadsheets modeling out derivative exposure and interest rate risk?"
ReplyDeleteHeck, no! He was on the phone with the Treasury Department, and knew they had his back.
So from a risk perspective, you advocate a 10-20 name portfolio? The perspective in the post doesn't lend itself to the 3-8 name portfolio?
ReplyDeleteGreat post! It took me around 10 years as an amator value inwestor to figure out similar thiking. Patience and risk aversion is the key. You don't need to be extremely smart to make money out of investing - I mean you need to be smart enough to leave all those too complicated investing situations and focus on highly predictable stuff:)
ReplyDeleteThank you for writing this post Nate.
ReplyDeleteLooking back at my successful investments, they have been stable blue chip companies with a long record of annual dividend increases, supported by earnings per share increases, bought below 20 times earnings.
I assumed that a diversified portfolio of 30 - 60 such companies with growing earnings and dividends in the past is more likely to continue growing earnings and dividends in the future.
Of course, I could have been lucky that I just somehow managed to really start investing in 2007 - 2008...
I agree - my edge (if I have one) rarely if ever derives from an informational advantage, but rather from discipline and being able to filter out the 98% of data that is useless and (hopefully) identify the few key factors.
ReplyDeleteSome thoughts on my process:
1) If the justification for my purchase can't be written on the back of a napkin, it's either not cheap enough, or it's just too hard to figure out.
2) I don't estimate 'fair value', I estimate 'expected return'. If the expected return isn't high enough, I don't invest.
3) I don't try to beat the market (I can't predict market behavior), I just try to look for the highest expected return with the lowest risk that I can find.
4) I only invest (and I realize this is a preference) where "time is on my side" - I want a company that is growing in value regardless of what the stock price is doing.
Thanks for writing!
Great post! It took me around 10 years as an amateur value investor to figure out similar thinking. Patience and risk aversion is the key. You don't need to be extremely smart to make money out of investing - I mean you need to be smart enough to leave all those too complicated investing situations and focus on highly predictable stuff:)
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