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.

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’s Crestmont 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 IV)

III. Markets & Psychology 


Note that I skipped Parts II (Understanding of Business) and III (Business Valuation) because I want to work on them longer.

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 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.

Intro

"Openmind" stands for being able to do what makes sense without any limits of size, geography, product, share price, liquidity, you name it. This can be one of real advantages of any retail investor.

"Creativity comes from open-mindedness and centeredness--seeing things in a nonemotionally charged way". (Ray Dalio). I called my blog so not because of this quote. I repeatedly read "open-mindedness" mentioned by most of successful investors.

I tagged it "investing without edge" because retail investors never have a real edge and should not fool themselves about that. If price is falling materially without news you never know if it is a forced seller or an inside leak or both. Any investor can have a "soft" edge though. Like an investment horizon and such a vague word like patience, which is completely inappropriate if you want to impress a professional operator.

I do not intend to write frequently, follow up and respond to comments but I promise to change my mind if anybody gives me new facts. It's a journal of thoughts, a trail of records. Why I do this? I cannot write it better than Barry Ritholtz here. It is closer to the end of the post: “Helping to quiet down the voices in my head” and “I write to find out what I think.” (Daniel Boorstin). Sometimes it is just better to write it down.

In the picture on the right side you can observe that open mind is not always a good thing or it is not clear in which place it is open and how (can see it here).