RANDOM MUSSINGS (i)

“Sell your losers and ride your winners” – that’s what James Montier was proposing in 2002 and probably now would recommend, too. (This is, by the way, a great place of his highly recommended writings – Link).

This dilemma tortured me for a long time and I wanted to share my thoughts.  Losers are not always bad investments. Actually, they are one of the best. Nobody likes them, i.e. there are clear willing sellers and for all kind of reasons, psychological and economic.

As it’s written, it has a very absolute meaning, very undemocratic.

Averaging down is a good thing and I am doing it routinely. As per his most recent annual review, Prem Watsa also likes it and calls it “long term value investing approach”. (Link, btw, his liking of RIM still puzzles me – I admit that I do not understand the odds in this particular case). You just have to practice it deliberately. Know the misjudgment and make conscious decision.

New facts (not emotion, not mood, not liking/disliking) and intrinsic value should guide you and not your brain’s asymmetric treatment of pains of loss and pleasures of gain. Each stock has a price and value. When discrepancy is big enough, you can strike.

TRADING UPDATE (i)

I initiated a small 2.5% position @ $0.31 in a bankrupt airline on the last day (April 10) of its trading on Nasdaq, so it was reasonable to assume that there will be some forced sellers. In a funny hindsight, I could have made it a 10% position and a quick double in 2 weeks. In any case, it was my fastest double so far, if only for a brief moment yesterday, and I wanted to feel a little genius for a minute.

Date Open High Low Close Volume Adj Close* Apr 23, 2012 0.51 0.67 0.48 0.53 506,200 0.53 Apr 20, 2012 0.41 0.49 0.41 0.47 195,800 0.47 Apr 19, 2012 0.44 0.44 0.41 0.42 182,100 0.42 Apr 18, 2012 0.40 0.44 0.40 0.44 99,400 0.44 Apr 17, 2012 0.38 0.41 0.38 0.40 118,800 0.40 Apr 16, 2012 0.40 0.40 0.39 0.40 205,600 0.40 Apr 13, 2012 0.41 0.42 0.39 0.40 172,200 0.40 Apr 12, 2012 0.42 0.44 0.30 0.43 1,063,700 0.43 Apr 11, 2012 0.33 0.45 0.32 0.44 764,300 0.44 Apr 10, 2012 0.32 0.34 0.28 0.30 1,487,200 0.30

Growing volume is a concern but most likely it is normal for normal people to run away after such a quick double.

Obviously to some, it is Pinnacle Airlines, a long time holding of Mohnish Pabrai. It is bankruptcy #2, if I remember correctly, from his recent portfolio names and #2 with the name Delta attached to it (Delta Financial was #1). Delta is the only client of Pinnacle. Delta is its death and life at the same time, future and past, profit and loss. Whatever… I like that it is doing not bad at the moment (EBITDA $3.7b and net debt of $10b) and PNCLQ is only a few percentage points of its operations.

In summary, my full of naivete investment thesis is:

== book tangible equity is +$200m (deferred revenue of ~$150m is accounting fiction)

== there are activists involved (Meson, Nantahala)

== Delta damages unsecured claim size is unclear but should be below $100m

== management is in the pocket of Delta and does not have any skin in the game

== bankruptcy fees will not exceed $50m

== as a result of confluence of all observations, Delta will have to maintain some face and will not cancel the entire equity (now valued at $10m) – my wild guess is $40m or 4x from today but in 18 months

And @$0.6 odds reflect the following: 30% probability of $2.0 ($40m) and 70% of $0. Or 15% - $4 (80m) and 85% - $0. Only with money I can afford to lose.

What's next: Pursuant to section 341 of the Bankruptcy Code, the United States Trustee for the Southern District of New York (the “United States Trustee”) has scheduled a meeting of creditors to be held on Thursday, May 3, 2012 at 3:30 


Some Links

This is not recommendation to buy or sell this stock. Please perform your own due diligence. I may sell or buy at any time in the future without any notice.

FOR BEGINNERS (PART VI)

II. c) Psychological Misjudgments

Human brain was designed to work in a wild world. Not that the present world is not wild but what was useful then may ruin you in the present day. You cannot rewire the brain, which seeks to help itself and regularly make shortcuts or automatic decisions without thinking (judgmental heuristics). That is what really useful for savvy sellers and very important to be aware of for investors.

Charlie Munger recommends knowing them by heart because the list is not long and this way the study would become applicable in practice (help to avoid problems).

I prepared a list of the most common and recurring misjudgments. The list really works for me - I memorized it and reread regularly. I know that I have similar points but with different framing – I thought that certain situations are easier to memorize as compared to dry theory.

In order to facilitate memorizing, I divided the list into 4 manageable sub-lists and I recommend devoting 15 minutes per day for each and in a week you will see the difference.

Before we go into the details, I would highly recommend the following links and books on the subject.

Charlie Munger’s Article on Psychology of Human Misjudgment - Link

Online Behavioral Finance Resource (very technical) - Link

Influence by Robert Cialdini - Link

Why Smart People Make Big Money Mistakes by Gary Belsky and Thomas Gilovich - Link

The Little Book of Behavioral Investing by James Montier - Link

List I

1. Mental Accounting. The key principle to remember: all money is equal. People tend to spent some money differently, e.g. inheritance, credit card or lottery winnings. If you play roulette and start with $1, then reach $100,000 and then lose it all. How much did you lose – most people will say that they lost a dollar.

2. Integrate Losses. Would you drive 4 blocks to get a lamp for $75 while at a store you are in it goes for $100? What if prices are $1,500 and $1,525? When you have a loss you prefer to hide it from yourself inside a bigger loss.

3. Asymmetry in Loss & Gain Treatment. A lost dollar is twice as painful as a gained dollar. That is how you avoid to get rid of your portfolio losers because until you sold it, it feels less painful. You start gambling with losers but are ultra conservative with winners. Scientifically, it is a part of a prospect theory and is called loss aversion and sunk cost fallacy.

4. Status Quo Bias. A variation of loss aversion. It may paralyze you, especially in the most important perceptively moment (decision paralysis).  You are simply avoiding a feeling of regret. This also explains why loss aversion can lead us to avoid or delay action. Addition of second good deal makes people less likely to take advantage of either opportunity. Remember March of 2009, when all had to invest while terrified and opportunities were plentiful (Link). How many dared to catch a falling knife?

5. Endowment Effect. People tend to overvalue what belongs to them - another manifestation of loss aversion and that is how trial periods and money back guarantees work. This explains why most people would demand at least twice as much to sell than they would to buy it.

6. Weber’s Law. The impact of change in the intensity of a stimulus is proportional to the absolute level of the original stimulus. When dealing about gain, difference between 0 and 500 is greater than between 500 and 1,000. When dealing about loss, difference between losing 500 and nothing is greater psychologically than that between losing 500 and losing 1,000.

FOR BEGINNERS (PART II)

I. Business

I. a) Understanding of Business

The key in stock picking is not to lose your principal amount. This can be achieved investing only in sound businesses at sensible prices. The first part of the dilemma is distinguishing good business from mediocre and the second one is valuation. When you get a grasp on business quality, you can delve into “average” businesses having full knowledge of the situation and what you are doing.

Micro economy or bottom-up approach is what leads to the overall macro picture because macro is a sum of micro units. Some industries are doing better and some units are doing better than others inside an industry. This is common sense. How to distinguish a good from bad?

A quick way to filter is looking at the return on invested capital (profit / capital needed to run the business) (10-year numbers). High profit margins (profit / sales) could be another hint [NB: a very distant break-even point can also very a powerful competitive advantage; e.g. think of Coca Cola making 1c from every serving…]. High values in both parameters should lead you to good businesses. It sounds simple but really common sense – if you can charge high margins, you must be doing something great for you customer (they still buy from you) and are better than competitor (they cannot offer anything better), and if you can pay back invested capital quickly and reinvest generated money at high return rates, this means that you have a lot of invisible / unquantifiable capital and value. Now you just have to make sense of those invisible things. [NB this does not mean that high capital requiring industries are bad investments – they are of a different kind, like financial companies, and could be very profitable investments]

The trick is to find out what is invisible and determine if it is sustainable (i.e. cannot be destructed by capital and creativeness). In other words, profits are protected by moats (Buffett’s vocabulary) or competitive advantages (Michael Porter), which are continuously under assault of creative destruction.

Moats or Competitive Advantage 

“[What counts is] competition from the new commodity, the new technology, the new source of supply, the new type of organization... competition which... strikes not at the margins of the profits and the outputs of the existing firms, but at their foundations and their very lives.”  Capitalism, Socialism and Democracy by Joseph Schumpeter

The topic of business moats / competitive advantages is one of the most interesting in business studies. The basic concept is easy to grasp (I will try to make some sense of it below), however, life is a dynamic process and new moats are emerging while old, supposedly sustainable ones, are becoming must-haves and ubiquitous elements of businesses. And really, the key concept here is sustainability.

It is important to remember that if the best possible management meets the worst industry / business, the latter will prevail. Think about textiles – does it make a difference if you can buy a 2-times more efficient machine, which can be bought by anybody? Such a “first mover” (or machine buyer) advantage can last for a few months, which does not bode well for sustainability.

So, what can make a firm unique and having capacity to take money profitably from its customers for long time? There are 2 aspects: a) industry structure; and b) business specific features.

If we still remember that industry is stronger than management, industry structure becomes crucial for determining predictability of profits. It is common sense that if you have fewer competitors, profits can be larger. When there are 2 or 3 remaining, nice things can happen to profits, especially if those remaining in action can demonstrate pricing discipline or, in other words, agree on pricing without discussing the subject, which is illegal.

Without going into great detail, I will give you reference where you can dig further. First of all, Michael Porter developed a useful chart of 5 forces (all charts are borrowed from M. Mauboussine & K. Bartholdson paper “Measuring the Moat”).

After practicing this chart on a few businesses, you should develop a useful habit of running any industry fundamentals through such lenses. One of the key concepts to discuss is barriers of entry. Obviously, if they are high, there will be less competition.

There are different layers and twists, some concepts are dependent on each other or complimentary but I think that the list provided below is a useful checklist:

== cost advantage (think about: economies of scale, location, process, access to unique resource, proprietary process, quick learning curve, etc.)

== proprietary product / service and / or technology / process (think about: patents, brands, regulatory licenses, contracts; the key test for brand strength is if it can charge a higher price; in other words – captivity induced by habit; yes, business can create habits)

== switching cost (key word here again is captivity; changing vendor is always a hassle – psychological, monetary, time, training, very important component and low % of total cost, etc.)

== network effects (value of products and services increases with the number of users – build a critical mass and let the snowball grow by itself)

== capital requirements (apart of obvious, think also about advertising spending)

== access to distribution / selling channel (best is if the channel is created in-house – think of multi layer marketing, Coca Cola sign is usually max 50m from you on the street, etc.)

== government regulation (government is famous and very capable of creating monopoly monsters but the best thing is to have many small concessions than one big and easy removable)

== expected retaliation (balance sheet strength is very important here)

Please let me know if you know how to improve the list.

Note that efficiency and differentiation are absolutely essential in any business.

Finally, company specific moats (in addition to industry situation) and the strongest moats are usually combinations of many smaller moats and factors. In value investing slang it is called lollapalooza effect. You will definitely be a better person if you read these 2 pieces:

Elementary Wordly Wisdom or Artof Stock Picking by Charlie Munger (there are only about 100 models worth studying which cover almost all life tricks)

Practical Thought AboutPractical Thought by Charlie Munger (Coca Cola case study) (email me for a photocopy from Of Permanent Value)

INVESTMENT PHILOSOPHY

In 10 words: Margin of safety. Circle of competence. Preparation. Discipline. Judgement. Patience.

I read a lot for the last couple of years (approaching 10,000 hours) and mainly value investing literature and various investor market commentaries. Below is the list of tenets which stayed on in my mind and keep on coming back.

Not ranked, numbered for future reference: 

1. Model – Mr. Market metaphor is simple and powerful. You are dealing with an ever evolving crowd system. (HT Ben Graham)

2.  Circle of competence - lean towards simple, expand and know it. (HT Buffett)

3. 50c dollars - you need margin of safety because you do not really know much. Value and price are different things and opportunity arises when they diverge. (HT Buffett, Klarman)

4. Activity bias - you must be a gentleman of leisure as you do not have to do anything on any given day and feel great about that. (HT Buffett, Pabrai)

5. Duration (long term) - synchronize expectations with pace of life - business does not change in a day or even in a month. Three years is enough but not universal. Patience is a great, unappreciated and unrecognized edge. (HT Pabrai)

6. Duration (short term) - nobody went bankrupt by taking quick 30% gains, especially when you have offsetting short term losses. This depends on your conviction, though, and is a good test.

7. Volatility is your friend because provides opportunity to enter and exit. (HT Buffett)

8. Beta is nonsense because 50% down stock is twice cheaper, i.e. less risky also twice. (HT Buffett)

9. 52 week highs and buy & hold are for Buffett because he has too much money and lack of time. He was much much more active 60 years ago and he admitted publicly that he would behave differently with only $1m in capital. 

10. Macro - follow the macro situation and FMV of the market, which consists of a set of micro. 

11. Discounting - think what market knows (discounts) (HT Ken Fisher)

12. Big is VERY rarely mispriced. (HT Buffett)

13. Mispricing - it always depends on supply and demand - forced sellers is a good sign but how to know that. Why security is cheap? What is a bear story? (HT Klarman)

14. Risks - try to kill the business and first discuss bad things rather than merits. (HT Berkowitz)

15. Shorting - yes, it is an asymmetrical bet but index short is safer. You can profit on both ways: up and down, which is the essence of absolute returns but always remember that Mr. Market can remain irrational a lot longer than you can stay solvent. 
16. News - beware the writer's bias to attract audience. (HT Mark Sellers)

17. Get a sense of proportions and context in any numbers - billion is not always huge, a 5% miss may not justify EV drop of 25%. (HT Ken Fisher)

18. Diversification - size of bets is proportional to your edge, conviction and expertise. Normal position is 10% of investable assets and do not expect to initiate more than 1 or 2 in a normal year (vs. market crash year).

19. Cash - I always feel better with 20-30% of investable assets in cash. Index shorts are also future cash for cheap stocks when markets are reasonably priced (as if that would be so easy – this topic probably deserves a separate post).

20. Sustainable competitive advantage - study moats and look for lollapaloozas, identify headwinds and tailwinds, invert. (HT Munger)

21. Know yourself well (misjudgments and mental capacity). Psychological awareness and stability can be your edge. Maintain stock lists and document your process - it is guaranteed that you will forget important things. (HT Munger)

22. Reading  –  it is an easy test to determine if you can invest on your own. In this business you can earn more money reading and thinking rather than meeting and talking. (HT Buffett)

23. Numbers – you have to love numbers, which is another easy test.

24. Gold – silver is better because it has more practical uses. If India (1/4 of annual gold demand vs. closer to 1/8 for silver’s global jewelry demand) suddenly changes its preference, gold will tank. This article provides a very good perspective on the subject.