Presentation at Indian School of Business Annual Investment Conference on  “The Practice of Value Investing”  

held on 16th October 2015 at ITC Maratha Hotel, Mumbai

 

This is what Mr. Munger took from Carl Jacobi, the great 19th century German mathematician, who found that the solutions for many difficult problems could be found if the problems were expressed in the inverse - by working backwards.

I recently came across a lovely column by John Kay in the Financial Times. He talked about the distinction between “Feynman integrity” and “Stigler conviction”. For the physicist Richard Feynman, science involved a “kind of leaning over backwards. For example, if you are doing an experiment, you should report everything that might make it invalid – not only what you think is right about it.” For George Stigler, a founder of the modern Chicago school of economics, “the successful inventor is a one – sided man. He is utterly persuaded by the …correctness of his ideas and he subordinates all other truths because they seem to be less important than the general acceptance of his truth.” This distinction, made by Isaiah Berlin on Tolstoy’s view of history, is between “foxes” who know many little things and “hedgehogs” who know one big thing.

There are a lot of things that Feynman has written that are applicable to investing including leaning over backwards. Having just finished an excellent biography of the Stoic philosopher, Seneca, it was a treat to come across two recent letters by the fund manager and author, Chris Leithner, on how the principles of Stoic philosophy can be applied to value investing. One of the techniques of Stoic philosophy is “negative visualization” or in simple language, picturing the worst-case scenario, the Stoic way of inverted thinking. Negative thinking can paradoxically produce positive results by allowing for proactive risk management. Albert Ellis, a psychotherapist called this “the negative path to contentment.” As Leithner states: “Ellis rediscovered one of the Stoic’s key insights: sometimes the best way to navigate an uncertain future is not to focus on the bright side (“best-case scenario”) but rather the sombre side (“worst-case scenario”)… The ability to manage uncertainty by pondering negative thoughts is not just the key to a more balanced life: it is a sine qua non of successful business, entrepreneurship and investment.”

Charles Ellis wrote a book “Winning the Loser’s Game” – investing is a game where outcomes in the short term tend to be dominated by luck and high transaction costs. By avoiding mistakes there is a better chance of coming out ahead. So invert and ask – how could an investor lose money buying cigar butts and how could an investor lose money by buying into a wonderful business?

From a Grahamian perspective, the “margin of safety” comes from a study of the historical record of the company. The unstated assumption was that value is static or if the company had a superior current earnings power, grew at a rate that should not be assumed to be greater than the historical growth rate of profitability. The Buffett/Munger worldview, I think, has a far greater appreciation of the value of superior earnings power combined with growth rates that could be significantly different from those achieved in the past. The emphasis, I believe, was on future intrinsic value rather than on current conservatively calculated intrinsic value. Buffett/Munger relied primarily on the sustainability of the superior business model for value creation. That sustainability obviously depended on a long competitive advantage period. Graham focused primarily on the current price for value creation. Both have their pitfalls and both have their advantages.

What is it about spiderwebs that help them achieve their strength? The silk that spiders use to build their webs, trap their prey and dangle from the ceiling is one of the strongest materials used. But it is not simply the material’s exceptional strength that makes spiderwebs so resilient; it is the material’s unusual combination of strength and stretchiness – silk’s characteristic way of first softening and then strengthening when pulled. Damage also tends to be localized, affecting just a few threads, making it a very flaw-tolerant system. I think the Grahamian system can be thought to be like a spider-web. There are so many screens that can be run using the Grahamian framework and many ideas that come out from that quantitative perspective. Some turn out to be gems and some value-traps. Ex ante, I have found it difficult to distinguish between the two. And Graham stressed on adequate diversification, again something that I have not found psychologically easy. Sometimes I have erred by having too many stocks in certain portfolios that I used to manage.

“Dragonflies have two eyes, like humans, but they are very different from ours. They are enormous with the surface covered with tiny lens, aggregating in some species upto thirty thousand. Each adjacent lens covers a different physical space and thus gives a unique perspective. The vision thus is a synthesis of these unique perspectives”. Aggregating perspectives is the key to understanding ideas in the Buffett/Munger system. But it is not easy.

It sounds simple but it is anything but. One reason is that the quality of the entry barriers and the life-cycle of the entry barriers are subject to enormous change, sometimes over short periods of time emanating from circumstances and industries over which the investor may not have sufficient awareness or knowledge. Let me give you an example. The biggest threat to conventional car makers using gasoline/ diesel engine technology is going to come from companies in the information technology space, companies like Foxconn, Tesla, Xiaomi and Apple because electric vehicles are essentially computer tablets on wheels according to innovation expert Tony Seba. This disruption may happen in the next 3-5 years. The speed of change and the disruption possibilities have never been greater in many industries. Assessing how strong entry barriers are has become the biggest challenge for investors.

Negative space, in art, is the space around and between the subject (s) of an image. Negative space may be most evident when the space around a subject, not the subject itself, forms an interesting or artistically relevant shape, and such space occasionally is used to artistic effect as the “real” subject of an image. In graphic design of printed or displayed materials, where effective communication is the objective, the use of negative space may be crucial. The best story tellers in any form can artfully shape the narrative like designers make use of “negative space”. The Buffett/Munger way of investing is a bit like looking for “negative spaces”. What lies beyond the numbers is more interesting than the numbers themselves. And in this process, when one is dealing in shadows, one can go wrong.

I think, in India, returns have not only been about current or emerging moats, but to a large extent also on the addressable growth and market opportunities that have been present in industries. Competitive advantage comes in a variety of ways – cost advantages, network effects, intangibles like brands, regulatory advantages, switching costs and even things like the culture of a company. But having a competitive advantage is not enough. It must be an increasing competitive advantage. For huge returns, a large market opportunity is also necessary. And I will show you why through this example. Imagine that you have found Aesop’s goose and it is not going to die, not going to mate, not going to eat or fall sick and will keep laying golden eggs every year worth Rs 1 crore. There are no taxes and interest rates are to remain constant at 10 percent. You decide to encash your good fortune and sell the goose for Rs 10 crores to a gold miner. Whilst the goose does have a competitive advantage (zero cost of production and a unique asset) in the gold mining business, the new owner will not become richer with the purchase, unless a way is found to get the goose to lay more than Rs 1cr worth of golden eggs every year. Competitive advantage (or an economic moat) by itself does not lead to wealth creation. Only a growing competitive advantage (deepening and widening the economic moat) does. Of course, if you were fearful and the buyer was greedy, you could have sold the goose for less than its economic worth and value would have been created on purchase.

These, I believe, are important factors, that can bring about large shifts in value migration. They require the use of mental models that fall outside the normal use of “spreadsheet” growth rates. The growth here cannot be easily predicted. I have never felt comfortable going much beyond what I can easily predict with a high degree of conviction, but I want to underscore the importance of these factors in giving huge returns to some investors. The technology and pharma sectors are ones that readily come to mind, but there have been examples of large wealth creation over short periods in other industries. Growing competitive advantage plus, if you may.

Whilst a large part of the Grahamian thinking is on eschewing “speculative” endeavours, which means making assumptions of growth that may be different from what has been achieved historically, “moat” investing is different in as much as it usually has what Graham, I dare say, would have called a large speculative component. The question that a Buffett/Munger investor would ask would be on the likely changes in business design and the business model, what could be the share not of the market, but of the market value a few years down the line, who could be the most important competitors to the company a few years down the road, which business designs could have superior economics and how will value thus migrate away from the company. It means thinking strategically, rather than just quantitatively. And since it focuses on changes that may or may not happen in the future, it is inherently speculative. If got wrong, value destruction for the shareholder can happen in both the paradigms.

This is interesting because one actually has to flip thinking about how one perceives a company. You start out focusing on price and the company starts developing strong moats and addressing much larger market opportunities. If you don’t catch on to the change, you sell too early and leave a lot of money on the table. So a Grahamian caterpillar turns into a Buffett/Munger butterfly. I’m not going to name them, but two of the three stocks that have been hundred baggers for me over relatively short periods of time have been in this category. The Buffett/Munger framework has given me the twenty-five year hundred baggers.

“Delta”, in investing, is a term that my friend and an investor whose ideas I respect, Dileep Madgavkar, introduced me to. Don’t look only at the fundamentals, but look at the changes, the deltas, in fundamentals. It’s just not changes in margins or changes in returns on capital employed, but even changes in intangibles such as the size of the moat. Markets rerate and derate on “deltas” and it is important to understand what causes them. “Sigmoid” - I think it is important to be on the sharp upside of the sigmoid curve. It’s about getting in early in a large market opportunity. In my case, I must hasten to add, in most stocks where I have ridden the sigmoid curve up, it has been largely through luck.

Awareness of ignorance, I believe, is a great strength. Only when you know something about a subject can you be aware of what you don’t know. As Warren Buffett has often stated that investors must know when they are operating well within their circle of competence and when they are approaching the perimeter.

What needs to be thought about should be important and knowable by which I mean to some extent predictable within a reasonable narrow band of high probabilities. What needs to be avoided is the “circle of illusory competence” which deals with a whole bunch of things that are not knowable by which I mean predictable within a narrow band of high probabilities. It is easy to migrate from the good circle to the other one because of all the cognitive biases that we are prone to and the tendency to confuse luck and skill. But I believe the trick is not to try to become an expert in too many things, but to be patient for the right price when you know what you truly know.  

What is deconstruction? The late investing legend, Chandrakantbhai Sampat, who I remember and whose presence I miss, used to always talk of the philosopher Jacques Derrida’s “deconstruction”. I’m going to try to explain this in absolutely simple language. If you have ever listened to someone explain a book, a movie, or even a magazine article and you wanted to interrupt and say “But I saw something that contradicts what you are saying”, than you have practiced deconstruction. I’m using the term here as a philosopher and not as a systems engineer, who would define deconstruction as breaking down a larger system into its modules. The philosophical interpretation is that the world is understood in terms of binary oppositions, one element of which is generally suppressed. Deconstruction is central to good investing. What is Steinhardt’s “variant perception” but holding a strong viewpoint that is substantially different from the market or consensus viewpoint or take “second-level thinking” which Howard Marks writes is thinking that is “different and better”. Here is how Howard Marks describes it: “The first-level thinker simply looks for the highest-quality company, the best product, the fastest earnings growth, or the lowest p/e ratio. He's ignorant of the very existence of a second level at which to think, and of the need to pursue it. The second-level thinker goes through a much more complex process when thinking about buying an asset. Is it good? Do others think it’s as good as I think it is? Is it really as good as I think it is? Is it as good as others think it is? Is it as good as others think others think it is? How will it change? How do others think it will change? How is it priced given: its current condition; how do I think its condition will change; how do others think it will change; and how do others think others think it will change? And that’s just the beginning. No, this isn’t easy.” Soros’s fertile fallacies which is basically the separation of thinking and reality. Some knowledge seems to be very true and early experiments confirm its veracity, but eventually the fallacy catches up and you end up in a worse situation. A self-reinforcing cycle followed by a self-defeating cycle.

Natural selection teaches us that the chances of being extinct are higher in some places than in others. The interesting thing in investing is what are the circumstances that cause “portfolio cropping” or “selling”. Logically it is when the odds of earning a decent rate of return go against the investor. The Grahamian system has two broad cropping principles: when the price appreciates by a certain amount or the stock docs not perform over a certain time frame. The Buffett/Munger methodology allows for a much greater focus on the dynamics of the business and deterioration of the moat quality than either price or time. It is inherently more subjective. Of course for the right business the holding period is “forever” which rules out any need to do any cropping. After all, as Peter Lynch remarked, you don’t want to pluck the flowers and water the weeds.

A ratchet effect is the instance of the restrained ability of human processes to be reversed once a specific thing has happened, analogous with the mechanical ratchet that holds the spring tight as the clock is wound up. Ratchets allow continuous linear or rotary motion in only one direction while preventing motion in the opposite direction. Examples can be found in many fields, in government, environment, cultural anthropology amongst others. But lets keep the discussion to investing. There are lots of psychological reasons which make it hard to admit a mistake: overoptimism, overconfidence, deprival super-reaction, loss aversion, denial, commitment and consistency and we can go on. The pure Grahamian system is fairly automatic, if followed rigorously. A time period for the investment to work out or a specified pre-committed gain and finally a cash level dependent on the overall valuation of the market. It is psychologically easier to keep gains if the system is somewhat mechanical as a pure Grahamian system would be. The Buffett/Munger framework tends to be somewhat more subjective given that holding periods for the “ideal company” are “forever”. But there would be times to sell - they would be dependent more on the delta in moat quality and valuations.

It is easy to explain away facts that contradict our beliefs, rather than changing our beliefs themselves. A word that is used is “knowledge shields” to hold on to inaccurate beliefs. Charlie Munger said that “It is, of course, irritating that extra care in thinking is not all good but also introduces extra error…. The best defense is that of the best physicists, who systematically criticise themselves to an extreme degree…as follows: The first principle is that you must not fool yourself and you’re the easiest person to fool.” And he said somewhere else “part of what you must learn is how to handle mistakes and new facts that change the odds.” This is not psychologically easy. A quasi-mechanical system like the original Grahamian one makes it somewhat easier to deal with denial. The only other way is to develop the habit of not agonizing over errors, but acknowledging and analyzing them.

It is easy to see how investment performance can be improved - reduce errors and increase insights. However they may be in conflict with one another. Steps to reduce investment errors may get in the way of acting on investment insights. Let me give an example. Checklists are important to reducing errors, but overuse of them can increase mindlessness and automaticity which comes in the way of playfulness and curiosity, both of which are necessarily for gaining insights. Furthermore the fear of making errors of commission can lead to an increase in errors of omission. Whilst the focus from the start of the presentation has been on the down arrow, I don’t want to end that way. The up arrow is a call to think in a different manner, independently and against convention, which I believe is a necessity for investment success. Think boats or moats, it does not matter, as long as one thinks independently and knows what one is doing. Whichever school of value investing one follows, it is important to remember that in the end the practice of value investing is about developing a certain sort of character – rational, detached, curious and patient. The last quality, patience, becomes of paramount importance when one is a Buffett/Munger investor. In my personal experience, there have been long periods of severe underperformance in my family portfolio with its concentrated twenty five year old holdings, that have tested my patience and my convictions. I always used to remember a Warren Buffett quote with which I will end: “You cannot get a baby in one month by making nine women pregnant.”

References:

1. “Economists should keep to the facts, not feelings” John Kay, Financial Times, October 7, 2015

2. “Leithner Letter no 192-193 (26 November 2015 – 26 December 2015)” by Chris Leithner

3. “Leithner Letter no 194-195 (26th January 2016 – 26th February 2016)” by Chris Leithner

4. “Seneca – A Life” by Emily Wilson

5. “Charlie Munger – The Complete Investor” by Tren Griffin

6. “Winning the Loser’s Game” by Charles D. Ellis

7. “Benjamin Graham and the Power of Growth Stocks” by Frederick K. Martin

8. “The Luck Factor” by Max Gunther

9. “Superforcasting” by Philip Tetlock and Dan Gardner

10. “Curious” by Ian Leslie

11. “Good Strategy Bad Strategy” by Richard Rumelt

12. “Value Migration” by Adrian Slywotzky

13. “The Real Warren Buffett” by James O'Loughlin

14. "It's not easy" by Howard Marks

15. "Why Big Fierce Animals Are Rare" by Paul Colinvaux.

16. "Seeing What Others Don't" by Gary Klein