FOR BEGINNERS (PART I)
Today I will start a series of articles providing good foundation for anyone willing to study and practice investing.
If anyone had introduced me to value investing 10 years ago, I would have been able to engage into things I love (or "retire") much earlier. Yes, early independence is of the significant importance to me. Who would not love to have the best boss in the world – yourself? If you are not interested in becoming independent early, you should stop reading this immediately.
I did not have such a mentor and had to find book-mentors on my own instead. Accidentally, I was able to compound at ~20% from my graduation (bought a flat in 1996) but I could have done better than that. At 23% compound rate, 50c turns into $1m in 70 years. We need to remember that we will be living longer. Think about the cost of trading-up to a more expensive brand instead of getting "good enough", especially at a young age. Consequences are huge. Compounding is great.
Thus, if you know anyone who is tireless in reading, did not start smoking when the entire class did, is not afraid of numbers, and is open-minded, please make him a favor and introduce value investing. You either get the value thing in 10 minutes or you do not get it ever. There is always a chance to propel someone's life.
What is value? It is a philosophy of life. Live within means, study life, and leave everything to civilization (except of a few millions for your off-springs). In simple terms, value is buying $1 worth things for 50c. It is really possible but not easy.
There are very few essential things which you should understand (you must study life continuously, though). In W. E. Buffett’s opinion, there should be only 2 classes in a business school: I) how to understand and value business, and II) psychology and how stock markets work. I will post a collection of articles and list books potentially leading to your personal nirvana.
One man said that without value thing in life you are like a one-legged-man in an ass kicking contest. He also said that if you mix raisins with turds, you still get the same thing. This value thing is lots of fun, also. You will find about harems, naked swimming, badminton, and ...what a heck, search for yourself.
FOR BEGINNERS (PART II)
I. 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)
FOR BEGINNERS (PART III)
Book value / Liquidation value
Going concern / Multiple based valuation
Sum of parts
Explanations of mispricing
FOR BEGINNERS (PART IV)
III. Markets & Psychology
I would break down Markets & Psychology discussion in 3 sub-sections: a) market model parables; b) market valuation and long term trend; c) psychological misjudgments.
I would break down Markets & Psychology discussion in 3 sub-sections: a) market model parables; b) market valuation and long term trend; c) psychological misjudgments.
III. a) Market Model Parables.
W. E. Buffett referred to 3 chapters essential for investing. Those are:
1. Chapter 12. The State of Long-termExpectations from “The General Theory of Employment, Interest and Money” by John Maynard Keynes:
“Or, to change the metaphor slightly, professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which 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 practise the fourth, fifth and higher degrees.”
2. Chapter 8. The Investor and Market Fluctuations from “The Intelligent Investor” by Benjamin Graham:
“Let us close this section with something in the nature of a parable. Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.
If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.”
3. Chapter 20. Margin of Safety as the Central Concept of Investment from “The Intelligent Investor” by Benjamin Graham.
“The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, nonexistent at some still higher price.”
A dollar is worth a dollar. When you cannot say how much a thing is worth exactly, it makes sense to be careful and pay less. The concept of margin of safety was first introduced in investing in this chapter. It was routinely used in engineering though. Bridges are designed with backup systems and extra capacity to prevent failures.
4. I would add George Soros lectures to the list. It is an interesting read, can satisfy your philosophical needs and suppress a bias to act.
“Let me state the two cardinal principles of my conceptual framework as it applies to the financial markets. First, market prices always distort the underlying fundamentals. The degree of distortion may range from the negligible to the significant. This is in direct contradiction to the efficient market hypothesis, which maintains that market prices accurately reflect all the available information.”
“Second, instead of playing a purely passive role in reflecting an underlying reality, financial markets also have an active role: they can affect the so-called fundamentals they are supposed to reflect. That is the point that behavioral economics is missing. It focuses only on one half of a reflexive process: the mispricing of financial assets; it does not concern itself with the impact of the mispricing on the so-called fundamentals.”
FOR BEGINNERS (PART V)
II. b) Market Valuation and Long-term Trend
Understanding of the current market level is essential for successful investing. It should provide guidance for your investment stance: is it advisable to be active or passive, hedged or fully long.
Alice Schroeder started her brilliant The Snowball, the best book about life of Warren Buffett, with a memorable lecture the value investing grandmaster gave to the wealthiest and successful businessmen back in 1999, a few months before an important market top.
In the long run economy grows because of fundamentals: population size and productivity change. Stock prices depend on profit size (% of GDP gives a good perspective, too) and multiple of earnings, which is dictated by prevailing interest rates and inflation expectations – gravity force of the market. Share price can go up via growing profits and expanding multiple. Dividend payback is also a very important part of the total investment return. That is a brief summary of how the markets work in the long term.
In 1999, W. Buffett made his first prediction in 30 years that market would grow by 6% annually for the next 17 years (he highlighted a period between 1964 and 1981 when Dow Jones Industrial moved from 874 to 875 while economy grew fivefold).
Dow Jones in July 30, 1999 - 10,655
Dow Jones in July 31, 2011 – 12,143
17.27% up in 12 years or 1.1% annual cumulative returns. Presently, it seems that W. Buffett was an optimist and based on his frequent and recent media appearances he still is. We have 5 years to go, so who knows… And you have to remember that he speaks his book.
From 1900 to 2011 S&P 500 generated 5% cumulative return (dividends provided another 4%+). Coincidentally, 4.8% is a historical S&P 500 profit growth rate and 6.2% is historical nominal GDP growth rate (Ed Esterling’sCrestmont Research website). Long term simple average inflation is 2.9%, population growth rate is 1.3%, therefore, the rest (or 2.0%) is productivity driven growth. Noteworthy, GDP growth is slowing down during the last 30 years because accumulated leveraged started to weight economy down.
Multiples awarded by Mr. Market or a fellow with fast swinging mood are probably the most unpredictable. Jeremy Grantham of GMO nicely put it in Risk Management and Investing Part II (Q1 2006):
“Exhibit 1, the “Exhibit of the Quarter,” shows the incredibly low volatility of the U.S. GDP, which two-thirds of the time has a volatility that is a mere ±1% around its long-term trend of about +3.5% a year real. This trend is stable because the economy is mean reverting, and bad times (like the 1930s) that produce spare capacity in both labor and capital are followed by strong times as the economy works to use up its excess resources. This ultra stable GDP engine can be thought of as the engine driving corporate profits and dividends. They in turn, although far less stable at a yearly level, follow the GDP in its mean reverting tendency towards a ‘normal’ level. Because of this, if you were clairvoyant in 1882 about the entire actual stream of corporate earnings and dividends until today, and used your clairvoyance to calculate a fair value, and then did the same for 1883 and so on for every year, it would produce a very stable trend of stock market fair value, as first revealed by Robert Shiller 18 or so years ago. Perhaps, not surprisingly, the volatility of this fair market value also stays within ±1% of its long-term trend two-thirds of the time. But what a contrast these two series are to the actual stock market, which manages to spend two-thirds of its time within only ±19% of fair value. This means that the market is 19 times as volatile as the underlying fundamentals would seem to justify! Understanding this 19 to 1 discrepancy would put us a long way along the road to understanding risk.”
A few highly respectable investors estimate that now fair market value of S&P is 900-1,000 (2012), which probably means that it is better to be cautious.
Media pays most of attention to short term forecasts, which are mainly based on estimated next year’s operating earnings. It may really look reasonable to apply 10-15 earnings multiple to a basket of equities, however, one has to remember that currently profits command unprecedentedly high share of the economy, which - history tells - should mean revert. Problem is that nobody knows when.
Stock market as % of GDP - Link
Inflation adjusted S&P 500 compared to the trend - Link
4 different methods (Tobin's Q Ratio including) compared to the trend - Link
Dollar value against stock returns - Link
Make your own conclusions but I am fully hedged.
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.
List II
1. Direction of Comparison. When people view a decision as one of preference, they tend to focus on positive qualities. In contrast, when asked to sell stocks, people tend to focus more on the negative qualities of each option. It is a good idea to go through your stock portfolio routinely and compare holdings to each other and to potential new ones via buying / selling lenses.
2. Extremeness Aversion. Scientifically, this refers to context of choice (and is complemented with tradeoff contrast). In practice, when you have 2 phones to choose from with price tags of $200 and $300, the distribution is approximately 50/50. However, when you add the third option with a price of $500, $300 radio wins by a wide margin (2 to 1 against the cheapest one).
3. Preferential Bias. Once people develop preferences, even small ones, they tend to view information in such a way that it supports those preferences. Everybody heard of the first impression and brand loyalty. It can become very costly. Saying is, that people hear what they want to hear.
4. Anchoring. There is a tendency we all have of latching onto an idea or fact and using it as a reference point for future decisions. Those facts can be completely irrelevant as experiments linked personal code last 2 numbers to the price one is willing to pay for a chocolate. People with high numbers overbid 60-120% those with smaller numbers. Anchors could be previous stock price, price estimate or price trend.
5. Confirmation Bias. People are almost 2 times more likely to select information confirming rather than disconfirming their prior beliefs and behaviors. Defensiveness overweight desire for accuracy in driving a preference for confirming over disconfirming information. Such cognitive dissonance leads to rejecting new facts that are contrary to original investment thesis.
6. Rationalizing. Tendency to rationalize leads to explain by an apparently rational story: a) whatever action, even irrelevant; b) whatever event, even of unclear origin; c) whatever possible sources of responsibility (external – negatives, self attribution – positives). Everyday media finds good explanations of why market went down or up. Truth is that nobody knows the truth – we can just guess.
List III
1. Hindsight Bias. This one is about forgetting the original estimates, a memory distortion. New information becomes new reference point. Once an event has passed, we tend to believe we had better knowledge of the outcome before the event than we actually did. Who cannot remember this “I knew it (had to buy/sell)” feeling.
2. Overconfidence Bias. It is not always arrogance and often appears in the form of unrealistically high appraisal of one’s own qualities versus those of others (90% of drivers in Sweden
3 Familiarity (Heuristic). It is about judging events as more frequent or important because they are more familiar in memory. We place too much value on what we know from our own experience simply because it is from our own experience. People overconfidently confuse familiarity with knowledge.
4 Halo Effect. We have to recognize that products / companies / people are often not successful because of their attributes; they are endowed with attributes because they are successful. Think about the long term value of Harry Potter plot line or actors’ acting.
5. Feedback Loops. Even professional analysts get more optimistic / pessimistic after price goes up / down. In extreme positive / negative feedback cases, when the change in belief is long overdue, it results in bubbles / crashes.
6. Narrow Framing (Inside-Outside View). You focus on the problem at hand and do not see the class to which it belongs. Think about forecast for certain project success or duration. If you are raising the fund, you always underestimate the length of the process and usually forget that majority of such efforts are unsuccessful. Call it animal spirits.
List IV
It is definitely worth a further digging in Influence by Robert Cialdini (next 6 items are also covered in great detail with practical examples in his book – highly recommended).
1. Reciprocation. According to social rules we should try to repay, in kind, what another person has provided to us. This is one of the greatest mechanisms of mental shortcut triggering. It is greatly exploited in marketing, especially, in combination with some concession or gift and together with perceptual contrast known as a rejection-then-retreat technique
2. Commitment & Consistency. Once we have made a choice or taken a stand, we will encounter personal and interpersonal pressures to behave consistently with that commitment. From the Influence book: “…all of the foot-in-the-door experts seem to be excited about the same thing: You can use small commitments to manipulate a person’s self-image; you can use them to turn citizens into “public servants,” prospects into “customers,” prisoners into “collaborators.” And once you’ve got a man’s self-image where you want it, he should comply naturally with a whole range of your requests that are consistent with this view of himself.” “Lowball” sales tactic is based on this mechanism. Those carefully reading the list will notice traces of loss aversion and other misjudgments.
3. Social Proof. The more uncertain people are – and the higher the stakes involved – the more vulnerable they are to the sort of cue taking that leads to herd behavior. This explains why teenagers are more likely to succumb to a peer pressure. One of ways how to determine what is correct is to find out what other people think about it. Trends and fads begin when individuals decide to ignore their private information and focus instead on the action of others. Do not allow other people to determine the value of things for you.
4. Liking. Research has shown that we automatically assign to good-looking individuals such favorable traits as talent, kindness, honesty, and intelligence. Liking can come via physical attractiveness, similarity, and compliments.
5 Authority. Beware of uniforms, titles, and trappings (expensive watches, jewelry, and cars) and imagine how strong is in combination with clever reciprocity and compliance (restaurant waiters).
6. Scarcity. Obviously, loss aversion plays here the lead role. As a rule, if something is rare or becoming rare, it is more valuable. From Influence: “Whenever free choice is limited or threatened, the need to retain our freedoms makes us desire them (as well as the goods and services associated with them) significantly more than previously.” That is why we have limited editions, deadlines for purchases, queues in front of restaurants, and … stupid parents.
