There's nothing more frustrating than seeing an asset that you had on your watchlist go up by 50% before you've had time to do work on it, or before you manage to pull the trigger. If you're anything like me, this experience causes profound feelings of regret.
Why do we have these feelings? I see at least four possible reasons:
1) Greed. This seems like an obvious one. But I don't think it's the main driver, at least for myself. It's interesting that I usually think "I can't believe I missed that 50% move", rather than "I could have made $X! And bought so much with it!"
2) The missed opportunity to seem smart to colleagues and other investors. I confess to this one. It's totally understandable - we're social creatures and desire the approval of our peers. But dulling those urges for peer approval is necessary for actually earning outstanding returns. As I argued in a recent post, the exceptional investor will at times appear imprudent, and possibly deviant.
3) Professional pride. I see this one as related to (2), if slightly different. The feelings of regret are magnified if the recently appreciated asset is in the sectors I follow, or a company I used to own. Again, it's a natural emotion, and one which can be a positive spur to performance - in moderation.
4) The fear of missing out. This is the one I really want to focus on. There's a fine line between greed and the fear of missing out (FOMO), but the two often appear identical to outsider observers.
First, a quick digression on over-eating. I hate wasting food, and if someone in my family offers me the last bit of something delicious, my instinct is always to say yes. It's not just simple greed. The more I've become aware of this, the more I think it has deep underpinnings in evolutionary psychology. At some level, I believe, there is part of me that fears that if I don't use the resources at my disposal and consume the food, I will face hunger and possible threats to my survival. That might sound a bit nutty, but there is certainly some evidence for it in psychology. So despite the knowledge that I am (mercifully) unlikely to go without food for long, these pangs occasionally drive me to eat more than I need to.
Back to investing. I think, at some level, we fear missing out on investments because we fear we will never have similar opportunities again, and that we will be forever denied those scarce resources. We seem to be particularly susceptible to FOMO when we know people who have profited from the move (seeing the resources "consumed" just seems to chafe more). Investing FOMO also seems to be heightened in asset classes like real estate, where there appears to be a deep psychological fear of being denied shelter. In fact, there's academic work that backs this up. (The analogy between chasing returns and over-eating isn't perfect. Over-eating delivers an excess of calories. Chasing returns usually results in negative performance. But both of those are unhealthy outcomes!)
I take two things from this realization:
a) Be aware you are subject to investing FOMO. It happens sometimes. But it probably happens less if we restrict our investing to areas where we can build up a deep wealth of experience and information. A former boss used to sagely remind me, "You can't dance with all the pretty girls" if I was frustrated at missing out on something. (I may have taken his words to heart much more than he intended. I got married while working for him.)
Furthermore, markets are cyclical, and hard as it is to believe in the moment, it's quite likely that we'll get other shots. Rather than fixating on the opportunities we've missed, there are other things waiting to be discovered. As Irving Kahn reminded Peter Cundill, "There's always something to do."
(As an aside, when someone offers me delicious food, I try to take it home, rather than eating it on the spot. This seems to convince me that I will in fact enjoy those resources at some point, just at a later time. Psychological tricks seem to work in eating as well as in investing!)
b) Try and recognize when other investors have been swept up in FOMO. Buffett's dictum to be "fearful when others are greedy" is generally wise. But we also need to be fearful when others are fearful (of missing out). My guess is that a great many people who got caught up in the US real estate boom prior to 2007 weren't greedy, but just misguided. Sadly, it seems a cruel truth that it's those who attempt some discipline who usually capitulate right at a market top.
Investing FOMO is a powerful emotion. But being aware of it in ourselves and others is the first step to weakening its hold on us - and our investing decisions.
Saturday, May 28, 2016
Saturday, April 9, 2016
Uncool, Imprudent & Deviant Investors
I've been reading the work of sociologist Howard Becker this past week, in which he makes an argument for reasoning from cases. By this, he means using detailed knowledge of one specific case to uncover more general ideas about how society works. Becker writes, "I want to avoid the fate of researchers who relied too heavily on a relatively few easily observed facts to do their explanatory work... that insistence doesn't fit well with much contemporary thinking about how social facts or events occur and develop, which instead works by measuring the connections between measured things rather than explaining how those connections produce the results we want to understand."
Generally speaking, I'm sympathetic to Becker's viewpoint, particularly in a world where sophisticated quantitative analysis is sometimes used in lieu of clear, intuitive thinking, or where we focus excessively on past outcomes, rather than thinking about the future. More specifically, in the world of investing, I find myself resisting simplistic notions of following what has worked in the past.
A current manifestation of this is the focus on "quality" stocks. As a self-professed admirer of Warren Buffett, I've written recently about his insistence on purchasing high quality businesses. Similarly, the academic work of Robert Novy-Marx finds that quality investing has been profitable. But it's hard to forget another great Buffet-ism: "What the wise man does in the beginning, the fool does in the end."
Rob Arnott, one of the fathers of the "smart beta" movement, recently caused quite a stir by suggesting the strategy could be in for a tough time. He and his colleagues wrote, "We foresee the reasonable probability of a smart beta crash as a consequence of the soaring popularity of factor-tilt strategies." Investors who mindlessly chase performance plow headlong into what has worked, and in so doing push prices higher, providing a further signal the strategy "works" - until it doesn't, and valuations revert to historic norms.
To be clear, Arnott et al are not suggesting this is true of low beta investing (which I take to be similar to "quality" investing). Despite observing large inflows into low beta products, they think "normal" valuations for low beta assets may have changed. But they caution that strategies like low beta "may still be an attractive investment, but for their risk-reducing characteristics, not for the alpha they have historically provided, net of their rising popularity and relative valuation."
A slavish adherence to "quality investing", therefore, is unlikely to produce satisfactory results. We have a tendency to label companies as "good" or "bad", but the reality is that "quality" is ill-defined and is a spectrum, not binary. At the right price, investors are being compensated to own businesses that are somewhat economically sensitive and which have good, but not great business moats.
There are two strategies for dealing with this reality. John Huber, who writes the excellent Base Hit Investing blog, has taken the first route, which is to identify a watchlist of 50-100 good companies, and assume that among those, "there are almost always a few opportunities at any given time for one reason or another." The second is to pursue a flexible investment philosophy that seeks value in unloved places. While we often associate this with global macro investors, it was also the hallmark of John Templeton, who people often mistake as a traditional stock-picker. Templeton said, "If you want to produce the best results in twenty or thirty years, you have to be flexible. A flexible viewpoint is a matter of avoiding a peculiar trait of human nature, which is to buy the things that you wish you had bought in the past, or to continue to buy the things that did well for you in the past."
Ultimately, it seems unlikely that one can generate exceptional investment returns without being an intelligent contrarian. As David Swensen has written, "Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom." With customary pithiness, Jason Zweig said, "To be a great investor, you have to want to be uncool."
Being influenced by sociology, I phrased it a bit differently in 2014. I wrote then, "To succeed spectacularly, one must be unconventional, and therefore deviant." A curious coincidence, then: one of the towering figures in the sociology of deviance, and the person whose work I was channeling in that earlier post, was the same Howard Becker.
Generally speaking, I'm sympathetic to Becker's viewpoint, particularly in a world where sophisticated quantitative analysis is sometimes used in lieu of clear, intuitive thinking, or where we focus excessively on past outcomes, rather than thinking about the future. More specifically, in the world of investing, I find myself resisting simplistic notions of following what has worked in the past.
A current manifestation of this is the focus on "quality" stocks. As a self-professed admirer of Warren Buffett, I've written recently about his insistence on purchasing high quality businesses. Similarly, the academic work of Robert Novy-Marx finds that quality investing has been profitable. But it's hard to forget another great Buffet-ism: "What the wise man does in the beginning, the fool does in the end."
Rob Arnott, one of the fathers of the "smart beta" movement, recently caused quite a stir by suggesting the strategy could be in for a tough time. He and his colleagues wrote, "We foresee the reasonable probability of a smart beta crash as a consequence of the soaring popularity of factor-tilt strategies." Investors who mindlessly chase performance plow headlong into what has worked, and in so doing push prices higher, providing a further signal the strategy "works" - until it doesn't, and valuations revert to historic norms.
To be clear, Arnott et al are not suggesting this is true of low beta investing (which I take to be similar to "quality" investing). Despite observing large inflows into low beta products, they think "normal" valuations for low beta assets may have changed. But they caution that strategies like low beta "may still be an attractive investment, but for their risk-reducing characteristics, not for the alpha they have historically provided, net of their rising popularity and relative valuation."
A slavish adherence to "quality investing", therefore, is unlikely to produce satisfactory results. We have a tendency to label companies as "good" or "bad", but the reality is that "quality" is ill-defined and is a spectrum, not binary. At the right price, investors are being compensated to own businesses that are somewhat economically sensitive and which have good, but not great business moats.
There are two strategies for dealing with this reality. John Huber, who writes the excellent Base Hit Investing blog, has taken the first route, which is to identify a watchlist of 50-100 good companies, and assume that among those, "there are almost always a few opportunities at any given time for one reason or another." The second is to pursue a flexible investment philosophy that seeks value in unloved places. While we often associate this with global macro investors, it was also the hallmark of John Templeton, who people often mistake as a traditional stock-picker. Templeton said, "If you want to produce the best results in twenty or thirty years, you have to be flexible. A flexible viewpoint is a matter of avoiding a peculiar trait of human nature, which is to buy the things that you wish you had bought in the past, or to continue to buy the things that did well for you in the past."
Ultimately, it seems unlikely that one can generate exceptional investment returns without being an intelligent contrarian. As David Swensen has written, "Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom." With customary pithiness, Jason Zweig said, "To be a great investor, you have to want to be uncool."
Being influenced by sociology, I phrased it a bit differently in 2014. I wrote then, "To succeed spectacularly, one must be unconventional, and therefore deviant." A curious coincidence, then: one of the towering figures in the sociology of deviance, and the person whose work I was channeling in that earlier post, was the same Howard Becker.
Saturday, April 2, 2016
The Point Of A Bear Market
In his classic book Supermoney, the writer Jerry Goodman (aka “Adam Smith”) tells a story of an investment group therapy session gone wrong. After a vicious bear market in 1969, he convened a group of investment professionals to discuss mistakes they had made in the "Go-Go Years". For a while it appears to be going well, with participants sharing the pain collectively. The meeting, however, takes an unexpected turn when Goodman asks David Babson to speak. Babson, described as “a crusty, amiable New Englander who heads the sixth biggest investment-counseling firm in the country”, proceeds to criticize professionals who got sucked into speculation. Looking out at the crowd, Babson tells them, “Some of you should leave this business.” He then pulls out a list of former speculative high-fliers that had declined dramatically or gone bankrupt. Goodman attempts to intervene several times:
“David,” I said gently into the microphone. The audience was beginning to rustle. You can tell something has happened to the good feelings when the water pitchers start to clink nervously against the water glasses in a rising cacophony.
Babson continues reading the names of former stock market darlings.
Goodman tries to interject again:
“Don’t read the list,” I said. The audience was beginning to scrape its chairs. My massive group therapy session had taken a sour turn. Nobody was going to confess if they were being accused.
Unrelenting, Babson continues to read names. Finally, Goodman cuts in:
“David,” I said, “you have passed the pain threshold of the audience.”
Phew. I attended a much milder version of a group therapy session gone awry in 2009. At a well-attended investment conference in New York, one panelist repeated a Wall Street aphorism I had never heard before. “The point of a bear market”, he said smugly, “is to return capital to its rightful owners.” There was an uncomfortable silence, as a noticeable tension filled the air. While the speaker had obviously avoided the worst of 2008, there were many in the room to whom financial markets had been less forgiving.
That adage has stayed with me all these years. But I don’t think our self-satisfied friend was quite right. The point of a bear market, I think, is to return risky assets to their rightful owners.
Put simply, assets exist on a continuum of safety. US Treasury notes are one extreme, while equities are another. As anyone familiar with the risk/reward trade-off knows, equities usually offer the possibility of high returns, but these returns face great variability. High returns compensate the investor for bearing risk.
In finance, we use the prosaic phrase "equity risk premium" to represent this truth. The equity risk premium, combined with a company-specific risk premium, is an important input to discount future cash flows. Together, these are the whole basis of valuation. The investor's task is to understand when the market is wrong about future cash flows or about risk. But behind the jargon lies a simple fact: risky assets aren't for everyone. Some people crave stable returns to meet near-term liquidity needs. Others are just temperamentally incapable of facing volatility. That's why people are wrong to criticize financial markets as zero-sum games. When a bear market occurs, risk premiums increase, and risky assets return to those who are willing to bear the discomfort of an uncertain outcome. The sellers discover to their horror they were accepting lower risk premiums than they should have. Some of these sellers will almost certainly be so-called professional investors, realizing they woefully underestimated the riskiness of previously beloved assets.
David Babson, I am sure, would never have made that mistake.
In finance, we use the prosaic phrase "equity risk premium" to represent this truth. The equity risk premium, combined with a company-specific risk premium, is an important input to discount future cash flows. Together, these are the whole basis of valuation. The investor's task is to understand when the market is wrong about future cash flows or about risk. But behind the jargon lies a simple fact: risky assets aren't for everyone. Some people crave stable returns to meet near-term liquidity needs. Others are just temperamentally incapable of facing volatility. That's why people are wrong to criticize financial markets as zero-sum games. When a bear market occurs, risk premiums increase, and risky assets return to those who are willing to bear the discomfort of an uncertain outcome. The sellers discover to their horror they were accepting lower risk premiums than they should have. Some of these sellers will almost certainly be so-called professional investors, realizing they woefully underestimated the riskiness of previously beloved assets.
David Babson, I am sure, would never have made that mistake.
Saturday, March 19, 2016
If You Want Profit, Prepare For Loss
It's that time of year in the US Northeast where the weather is changing from bitter cold to more bearable temperatures. Unfortunately, something about the shift in weather seems to make people more susceptible to coughs and colds. I readily confess to being a bit of a germaphobe, so it's hard for me not to cringe when people are coughing or sneezing around me. It certainly seems like I use even more hand sanitizer than normal this time of year. But sometimes I meet people who are even more militant about hygiene:
Me: *Cough*
Them: "ARE YOU SICK?"
Me: "No, I'm choking on something."
Them: "Oh, that's fine then."
Charming, to say the least! Lack of empathy aside, it struck me that you can really take the whole hygiene thing too far. No-one wants to get sick, but there's a point when it become unhealthy to obsess over every sniffle around you, and when hyper-vigilance probably detracts from your overall health and well-being. This is especially true since common coughs and colds, while unpleasant, are usually short-lived.
Much of this applies to investing. No-one wants to lose money, but it's bound to happen at some point all the same. Despite the analyst's best efforts, markets occasionally sell off, taking good companies with them. Maybe a company's fundamentals change. Or sometimes - again, despite one's best efforts - the original analysis is proven flawed. There is an optimal level of insecurity analysis that should occur when investments go sour: too little, and you risk missing important feedback; too much, and you turn yourself into the very bag of nerves that characterizes Mr. Market.
The second part of this is ensuring that you can bounce back from losses, whether temporary or permanent. At a recent investor presentation, ExxonMobil CEO Rex Tillerson said that in his 41 years in the oil business, he hadn't learned any more about his ability to foresee the price of oil. Instead, he has learned more about how to deal with the market's gyrations. Similarly, a robust investing philosophy ensures that no one event can knock you out of the game, as unpredictable as that event may be. Reasonable diversification is one solution. Avoiding leverage is another. I'm a huge fan of the Buffett admonition: "If you're smart, you don't need it, and if you're dumb, you have no business using it."
The final piece of this is committing to learning from losses, whether temporary or permanent. Nassim Taleb coined the term "antifragility" to describe things that gain from disorder. This is an even higher bar than merely being robust to disorder. Few securities, other than US Treasury bonds, seem to meet this criterion. Nevertheless, the investor who learns from mistakes over time is in fact benefiting from that disorder, and is thus long-term antifragile.
There's a saying: "If you want peace, prepare for war." I happen to think that rings true, even if it's often misused by people who have no desire for peace. I would paraphrase it this way: if you want profit, prepare for loss. Recognize that losses will happen at some point, and (1) prepare to approach them with equanimity and clear thinking, (2) prepare so that losses will be manageable, and (3) prepare to learn from the episode. This is the foundation for dealing with, and ultimately benefiting from, adversity in the investing arena.
Me: *Cough*
Them: "ARE YOU SICK?"
Me: "No, I'm choking on something."
Them: "Oh, that's fine then."
Charming, to say the least! Lack of empathy aside, it struck me that you can really take the whole hygiene thing too far. No-one wants to get sick, but there's a point when it become unhealthy to obsess over every sniffle around you, and when hyper-vigilance probably detracts from your overall health and well-being. This is especially true since common coughs and colds, while unpleasant, are usually short-lived.
Much of this applies to investing. No-one wants to lose money, but it's bound to happen at some point all the same. Despite the analyst's best efforts, markets occasionally sell off, taking good companies with them. Maybe a company's fundamentals change. Or sometimes - again, despite one's best efforts - the original analysis is proven flawed. There is an optimal level of insecurity analysis that should occur when investments go sour: too little, and you risk missing important feedback; too much, and you turn yourself into the very bag of nerves that characterizes Mr. Market.
The second part of this is ensuring that you can bounce back from losses, whether temporary or permanent. At a recent investor presentation, ExxonMobil CEO Rex Tillerson said that in his 41 years in the oil business, he hadn't learned any more about his ability to foresee the price of oil. Instead, he has learned more about how to deal with the market's gyrations. Similarly, a robust investing philosophy ensures that no one event can knock you out of the game, as unpredictable as that event may be. Reasonable diversification is one solution. Avoiding leverage is another. I'm a huge fan of the Buffett admonition: "If you're smart, you don't need it, and if you're dumb, you have no business using it."
The final piece of this is committing to learning from losses, whether temporary or permanent. Nassim Taleb coined the term "antifragility" to describe things that gain from disorder. This is an even higher bar than merely being robust to disorder. Few securities, other than US Treasury bonds, seem to meet this criterion. Nevertheless, the investor who learns from mistakes over time is in fact benefiting from that disorder, and is thus long-term antifragile.
There's a saying: "If you want peace, prepare for war." I happen to think that rings true, even if it's often misused by people who have no desire for peace. I would paraphrase it this way: if you want profit, prepare for loss. Recognize that losses will happen at some point, and (1) prepare to approach them with equanimity and clear thinking, (2) prepare so that losses will be manageable, and (3) prepare to learn from the episode. This is the foundation for dealing with, and ultimately benefiting from, adversity in the investing arena.
Saturday, March 5, 2016
Berkshire Hathaway: Come For The Returns, Stay For The Philosophy
The release of Berkshire Hathaway's annual letter to shareholders is always a wonderful opportunity to learn from Warren Buffett. As usual, the letter has already been picked over by the media and blogosphere, but I wanted to record some of my own thoughts. This post can be read in tandem with an older piece I did on Buffett's shareholder essays.
1) Simplicity. Buffett's letters are remarkable for their clarity. This is extremely unusual in a world where investment managers often aim to wow their clients with technical sophistication and jargon. Instead, with Buffett, we are left with the impression of someone who is able to take the complexities of investing and cut right to the core of the problem. Here's one example: Buffett notes that he and Munger expect Berkshire's normalized earning power to increase every year. This is a simple statement, but powerful in conveying that every investor can dramatically simplify his life and improve his returns by focusing on his portfolio's normalized earning power, rather than explicitly trying to generate high returns.
2) Dealing from strength. Buffett highlights Berkshire portfolio companies that pressed their advantage over competitors by making investments in new equipment. He notes, "Dealing from strength is one of Berkshire's enduring advantages." The source of strength is having dry powder when others don't, which requires patience and discipline. Buffett famously said, "Lethargy bordering on sloth is the cornerstone of our investment style." Similarly, there's a Munger quote that I love: "We don't mind long periods in which nothing happens...You look at [Buffett's] schedule sometimes and there's a haircut. Tuesday, haircut day." Instead of fretting about his portfolio, Buffett reveals that he spends ten hours a week playing bridge online - one way to combat boredom, which I've referred to in the past as the third emotion of investing. But of course the flipside of this is being aggressive when opportunities arise, and when competitors are unable or unwilling to act.
Obviously, no-one sets out hoping to operate from a position of weakness, but prioritizing it as a strategic goal helps. As I've noted before, one of the mortal sins of investing is compounding earlier errors, and this typically happens when one is operating from a position of weakness and reacting to events in a haphazard fashion.
3) Business quality. For someone who is known as the doyen of value investing, Buffett makes surprisingly little mention of the prices paid for the businesses he purchased. Rather, he focuses on their quality. I'm not suggesting that Buffett ignores price; his discussion of insurance underwriting reveals, as always, a keen grasp of risk and reward, as does a note of caution on prices paid for bolt-on acquisitions. Nevertheless, his emphasis on quality, rather than cheapness, is telling. Despite his ability to be patient, Buffett is clearly not just waiting for cyclical lows. Unlike most investors who agonize endlessly over whether equities are cheap, Buffett continues to pour money into investments that he believes will pay off over the long run (Precision Castparts, Wells Fargo, Coca-Cola).
4) Optimism. We're bombarded by soundbites from pundits (and truth be told, investors) who usually appear smarter for being negative. Buffett, on the other hand, comes across as unusually optimistic (a view shared by his friend, Bill Gates). Having a long-term horizon helps, but Buffett's success is supported by Dimson, Marsh and Staunton, who lauded the "Triumph of the Optimists".
5) Come for the returns, stay for the philosophy. I'm guessing that most people start following Buffett and Munger because of the prospect of mimicking their investment success. I'm also willing to guess that most of those who stick around do so because they're attracted by the duo's integrity and life philosophy. In this year's letter, Buffett wrote, "There is no one more important to us than the shareholder of limited means who trusts us with a substantial portion of his savings." In a world of relentless asset-gathering masquerading as investing, Buffett's easy manner is why I, like many others, look forward to his letter year after year.
1) Simplicity. Buffett's letters are remarkable for their clarity. This is extremely unusual in a world where investment managers often aim to wow their clients with technical sophistication and jargon. Instead, with Buffett, we are left with the impression of someone who is able to take the complexities of investing and cut right to the core of the problem. Here's one example: Buffett notes that he and Munger expect Berkshire's normalized earning power to increase every year. This is a simple statement, but powerful in conveying that every investor can dramatically simplify his life and improve his returns by focusing on his portfolio's normalized earning power, rather than explicitly trying to generate high returns.
2) Dealing from strength. Buffett highlights Berkshire portfolio companies that pressed their advantage over competitors by making investments in new equipment. He notes, "Dealing from strength is one of Berkshire's enduring advantages." The source of strength is having dry powder when others don't, which requires patience and discipline. Buffett famously said, "Lethargy bordering on sloth is the cornerstone of our investment style." Similarly, there's a Munger quote that I love: "We don't mind long periods in which nothing happens...You look at [Buffett's] schedule sometimes and there's a haircut. Tuesday, haircut day." Instead of fretting about his portfolio, Buffett reveals that he spends ten hours a week playing bridge online - one way to combat boredom, which I've referred to in the past as the third emotion of investing. But of course the flipside of this is being aggressive when opportunities arise, and when competitors are unable or unwilling to act.
Obviously, no-one sets out hoping to operate from a position of weakness, but prioritizing it as a strategic goal helps. As I've noted before, one of the mortal sins of investing is compounding earlier errors, and this typically happens when one is operating from a position of weakness and reacting to events in a haphazard fashion.
3) Business quality. For someone who is known as the doyen of value investing, Buffett makes surprisingly little mention of the prices paid for the businesses he purchased. Rather, he focuses on their quality. I'm not suggesting that Buffett ignores price; his discussion of insurance underwriting reveals, as always, a keen grasp of risk and reward, as does a note of caution on prices paid for bolt-on acquisitions. Nevertheless, his emphasis on quality, rather than cheapness, is telling. Despite his ability to be patient, Buffett is clearly not just waiting for cyclical lows. Unlike most investors who agonize endlessly over whether equities are cheap, Buffett continues to pour money into investments that he believes will pay off over the long run (Precision Castparts, Wells Fargo, Coca-Cola).
4) Optimism. We're bombarded by soundbites from pundits (and truth be told, investors) who usually appear smarter for being negative. Buffett, on the other hand, comes across as unusually optimistic (a view shared by his friend, Bill Gates). Having a long-term horizon helps, but Buffett's success is supported by Dimson, Marsh and Staunton, who lauded the "Triumph of the Optimists".
5) Come for the returns, stay for the philosophy. I'm guessing that most people start following Buffett and Munger because of the prospect of mimicking their investment success. I'm also willing to guess that most of those who stick around do so because they're attracted by the duo's integrity and life philosophy. In this year's letter, Buffett wrote, "There is no one more important to us than the shareholder of limited means who trusts us with a substantial portion of his savings." In a world of relentless asset-gathering masquerading as investing, Buffett's easy manner is why I, like many others, look forward to his letter year after year.
Saturday, February 27, 2016
Adventures In The Bargain Bin
I was at my local grocery store last week, and noticed that salmon fillets were 50% off. I stood in front of the display for a good two minutes, racked with indecision. I like salmon. It's usually more expensive than other meat, and it's rare to see it on sale. I vaguely recalled a Buffett quote about being happy to buy merchandise when it went on sale. And yet, I just couldn't bring myself to buy it. The fact that salmon is rarely on sale suggested to me it might not have been the freshest fish. Also, that store doesn't have the best reputation for selling the freshest meat & produce. And so I walked away.
I've written before that it's one thing to be a value investor, and another thing to be a cheapskate. But the salmon episode got me thinking: why couldn't I pull the trigger on what appeared to be something on sale? Two issues seemed key:
1) I couldn't be sure of the fish's quality. I looked up the Buffett quote when I got home: "Whether we're talking about socks or stocks, I like buying quality merchandise when it's marked down." The word "quality" is very important in that quote. The salmon price mark-down was in fact signalling something about the quality of the merchandise, and I didn't like the signal I was getting.
2) The consequences of being wrong could be deeply unpleasant. If you buy a cheap pair of socks and discover the elastic is already worn, the worst that happens is that you've wasted a few dollars and have to toss the socks in the trash. Not true of food, though: if the salmon had been less than fresh, it probably wouldn't have been life-threatening, but could easily have made me miserable for a day or two!
My adventures in the bargain bin have some clear implications for investing. Value-oriented investors are often drawn to stocks that have been beaten up, but it requires some genuine judgment to assess if price declines are warranted. Similarly, they may shy away from companies trading at lofty multiples, believing that valuations are excessive, even if the underlying company has excellent fundamentals. As with fish, this judgment depends on accurately evaluating the quality of the stocks and the consequences of being wrong.
Assessing quality is aided by the following:
a) Deep fundamental research. This should be a prerequisite, of course, but without this kind of work, it becomes far too tempting to use price as a signal of quality.
b) Stress testing/scenario analysis to understand if quality is genuine. I'm reminded of a great Ben Graham quote: "The risk of paying too high a price for good-quality stocks - while a real one - is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions. The purchasers view the current good earnings as equivalent to "earning power" and assume that prosperity is synonymous with safety." I suspect there are many investors in the natural resources complex who have become painfully aware of the truth of Graham's words over the past 12-18 months.
c) Long ownership or familiarity with a company/industry. Most people value a long-term investment horizon because when done right, it is easier to implement and more profitable than a trading strategy. As Phil Fisher wrote, "Finding the really outstanding companies and staying with them through all the fluctuations of a gyrating market proved far more profitable to far more people than did the more colorful practice of trying to buy them cheap and sell them dear." This long-term ownership, however, serves another important purpose. Over time, the analyst has the opportunity to observe the company through different economic conditions, and develops an understanding of its economic sensitivity. Following a business for a long time reduces the risk that one will mistake cyclical earnings for true earnings power.
Finally, it's worth noting that one's willingness to take a risk should depend on the severity of a negative outcome. Socks with loose elastic are harmless, rotten fish less so. As Sanjay Bakshi points out in a wonderful speech, the eventual consequences of risk-seeking or risk-blind behaviour can be dire in many aspects of life. This is certainly true for one's long-term financial well-being. Sometimes, when something smells fishy, it's best to just walk away.
I've written before that it's one thing to be a value investor, and another thing to be a cheapskate. But the salmon episode got me thinking: why couldn't I pull the trigger on what appeared to be something on sale? Two issues seemed key:
1) I couldn't be sure of the fish's quality. I looked up the Buffett quote when I got home: "Whether we're talking about socks or stocks, I like buying quality merchandise when it's marked down." The word "quality" is very important in that quote. The salmon price mark-down was in fact signalling something about the quality of the merchandise, and I didn't like the signal I was getting.
2) The consequences of being wrong could be deeply unpleasant. If you buy a cheap pair of socks and discover the elastic is already worn, the worst that happens is that you've wasted a few dollars and have to toss the socks in the trash. Not true of food, though: if the salmon had been less than fresh, it probably wouldn't have been life-threatening, but could easily have made me miserable for a day or two!
My adventures in the bargain bin have some clear implications for investing. Value-oriented investors are often drawn to stocks that have been beaten up, but it requires some genuine judgment to assess if price declines are warranted. Similarly, they may shy away from companies trading at lofty multiples, believing that valuations are excessive, even if the underlying company has excellent fundamentals. As with fish, this judgment depends on accurately evaluating the quality of the stocks and the consequences of being wrong.
Assessing quality is aided by the following:
a) Deep fundamental research. This should be a prerequisite, of course, but without this kind of work, it becomes far too tempting to use price as a signal of quality.
b) Stress testing/scenario analysis to understand if quality is genuine. I'm reminded of a great Ben Graham quote: "The risk of paying too high a price for good-quality stocks - while a real one - is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions. The purchasers view the current good earnings as equivalent to "earning power" and assume that prosperity is synonymous with safety." I suspect there are many investors in the natural resources complex who have become painfully aware of the truth of Graham's words over the past 12-18 months.
c) Long ownership or familiarity with a company/industry. Most people value a long-term investment horizon because when done right, it is easier to implement and more profitable than a trading strategy. As Phil Fisher wrote, "Finding the really outstanding companies and staying with them through all the fluctuations of a gyrating market proved far more profitable to far more people than did the more colorful practice of trying to buy them cheap and sell them dear." This long-term ownership, however, serves another important purpose. Over time, the analyst has the opportunity to observe the company through different economic conditions, and develops an understanding of its economic sensitivity. Following a business for a long time reduces the risk that one will mistake cyclical earnings for true earnings power.
Finally, it's worth noting that one's willingness to take a risk should depend on the severity of a negative outcome. Socks with loose elastic are harmless, rotten fish less so. As Sanjay Bakshi points out in a wonderful speech, the eventual consequences of risk-seeking or risk-blind behaviour can be dire in many aspects of life. This is certainly true for one's long-term financial well-being. Sometimes, when something smells fishy, it's best to just walk away.
Saturday, February 20, 2016
What Manchester United Can Learn from Yahoo
These are dark days for Manchester United fans. Darkness is relative, of course - the club remains an icon of sporting history, with a passionate fan base second to none. But, as the line from James goes, "if I hadn't seen such riches, I could live with being poor." The team's desperately abject performance in a loss to FC Midtjylland underscored the poverty fans have become accustomed to. For United fans, there is perhaps no greater fear than the looming possibility that a cycle of greatness has ended, and the club is on its way to become the new Liverpool - a mighty club rendered irrelevant, forced to watch as its great rivals chip away at its success.
I spend a lot of my professional life trying to understand when sentiment has swung to extremes in financial markets, trying to be even-keeled when panic appears at odds with positive fundamentals. In an age when sports fans take to Twitter with vicious speed, demanding management and personnel changes at every little blip, my attempts to be sanguine are frequently challenged. While Man City's capture of Pep Guardiola is a knife to United's ambitions, I do think some are being too quick to anoint Guardiola's future City side as champions. But sometimes public opinion is spot on. I can't really explain why the Louis van Gaal era has shuddered to a halt so abruptly (to be honest, it never really gathered steam, despite the occasional flicker of promise). But it's safe to say the last few months have been truly hard to watch, both as a Manchester United fan, and a fan of the game. An excellent, if depressing, post by Paul Gunning perfectly captured my sentiments. And as the spectre of "Liverpoolisation" lurks ominously, I thought this week of another fallen giant of yore - Yahoo.
I'm not a tech analyst, so I haven't followed the demise of Yahoo in gruesome detail. All you need to know, however, is that the stock market currently ascribes negative value to Yahoo's core business. If that sounds crazy, here's a little piece by the New York Times explaining what that means. Basically, the stock market is saying that the only thing valuable about Yahoo is its stake in Chinese e-commerce behemoth Alibaba. Even if the market has gotten the valuation wrong, it's a damning indictment of Yahoo.
Where did Yahoo go wrong? Venture capitalist Paul Graham wrote a piece in 2010 taking a stab at the root causes. I highly recommend it - it's both short and fascinating. He identifies two major issues, easy money, and Yahoo's ambivalence about being a technology company.
First, the curse of easy money: "By 1998, Yahoo was the beneficiary of a de facto Ponzi scheme. Investors were excited about the Internet. One reason they were excited was Yahoo's revenue growth. So they invested in new Internet startups. The startups then used the money to buy [banner] ads on Yahoo to get traffic. Which caused yet more revenue growth for Yahoo, and further convinced investors the Internet was investing in." The story ends with Yahoo neglecting its search business because of its booming banner ad business. What it failed to realize was that the search business was far more sustainable, and that Google was eating its lunch there.
This leads to Graham's second point, which was that Yahoo was ambivalent about being a technology company. Yahoo insisted on calling itself a media company, with negative consequences. "What Yahoo really needed to be was a technology company, and by trying to be something else, they ended up being something that was neither here nor there. That's why Yahoo as a company has never had a sharply defined identity...The worst consequence of trying to be a media company was that they didn't take programming seriously enough... In technology, once you have bad programmers, you're doomed."
Which brings us back to United. The club has increasingly positioned itself as a "global brand". Similar to Yahoo's loss of identity, Manchester United seems to have forgotten that it is first and foremost a football club. CEO Ed Woodward has proven himself adept at signing bumper commercial deals for the club. Yet the tail seems to be wagging the dog more and more. Recent reports suggest that Wayne Rooney could be on his way to China, assuming the club can "offset his potential departure with an eminent replacement their global partners would approve of to promote their products." Pause and let that sink in for a second. If that is true, it is diabolically misguided. The decision to replace a senior player should be driven entirely by footballing considerations. Yet Woodward's apparent obsession with "marquee players" seems to be spurred by commercial incentives, and possibly his desire to solidify his reputation as a deal-maker. A bit too much of the investment banker, then, about Woodward.
Perhaps easy money has tainted United the way it tainted Yahoo. The circumstances are different, of course: this isn't the Internet bubble, and I'm sure Woodward works very hard to sign those commercial deals. But the focus on "global superstars" worthy of a "global brand" is unsustainable. Commercial partners appear to be salivating to capitalize on United's global cachet, but that won't last long if the club's leadership neglects the footballing core of the club. Furthermore, rather than hawking the brand at every turn, I believe it makes more sense to think of Manchester United as a luxury brand. The best luxury brands are obsessed with maintaining their aura, which is their greatest asset. Similarly, the fanatical support of a global fan base is a valuable asset that should be treated with the utmost care. I cringe when United players are forced to promote movies on their Twitter feeds. Don't get me wrong; I of all people understand there are commercial considerations. But Manchester United the commercial juggernaut is at serious risk of killing the golden goose that is Manchester United the football club that produced Charlton, Best and Law.
Ultimately, there is only one group who can change the club's direction, and that is the Glazer family, who control its ownership. I've cautioned in the past about blaming the Glazers for all of United's ill fortune, while being critical of the club's ownership structure. But we've reached a crucial juncture for the club. While the Glazers may never understand the importance of the club to fans around the world, I can only hope they have an interest in protecting the long-term value of their investment. If they fail to grasp the seriousness of the situation, it may be a long time yet before United fans can reclaim the riches of the Alex Ferguson era.
I spend a lot of my professional life trying to understand when sentiment has swung to extremes in financial markets, trying to be even-keeled when panic appears at odds with positive fundamentals. In an age when sports fans take to Twitter with vicious speed, demanding management and personnel changes at every little blip, my attempts to be sanguine are frequently challenged. While Man City's capture of Pep Guardiola is a knife to United's ambitions, I do think some are being too quick to anoint Guardiola's future City side as champions. But sometimes public opinion is spot on. I can't really explain why the Louis van Gaal era has shuddered to a halt so abruptly (to be honest, it never really gathered steam, despite the occasional flicker of promise). But it's safe to say the last few months have been truly hard to watch, both as a Manchester United fan, and a fan of the game. An excellent, if depressing, post by Paul Gunning perfectly captured my sentiments. And as the spectre of "Liverpoolisation" lurks ominously, I thought this week of another fallen giant of yore - Yahoo.
I'm not a tech analyst, so I haven't followed the demise of Yahoo in gruesome detail. All you need to know, however, is that the stock market currently ascribes negative value to Yahoo's core business. If that sounds crazy, here's a little piece by the New York Times explaining what that means. Basically, the stock market is saying that the only thing valuable about Yahoo is its stake in Chinese e-commerce behemoth Alibaba. Even if the market has gotten the valuation wrong, it's a damning indictment of Yahoo.
Where did Yahoo go wrong? Venture capitalist Paul Graham wrote a piece in 2010 taking a stab at the root causes. I highly recommend it - it's both short and fascinating. He identifies two major issues, easy money, and Yahoo's ambivalence about being a technology company.
First, the curse of easy money: "By 1998, Yahoo was the beneficiary of a de facto Ponzi scheme. Investors were excited about the Internet. One reason they were excited was Yahoo's revenue growth. So they invested in new Internet startups. The startups then used the money to buy [banner] ads on Yahoo to get traffic. Which caused yet more revenue growth for Yahoo, and further convinced investors the Internet was investing in." The story ends with Yahoo neglecting its search business because of its booming banner ad business. What it failed to realize was that the search business was far more sustainable, and that Google was eating its lunch there.
This leads to Graham's second point, which was that Yahoo was ambivalent about being a technology company. Yahoo insisted on calling itself a media company, with negative consequences. "What Yahoo really needed to be was a technology company, and by trying to be something else, they ended up being something that was neither here nor there. That's why Yahoo as a company has never had a sharply defined identity...The worst consequence of trying to be a media company was that they didn't take programming seriously enough... In technology, once you have bad programmers, you're doomed."
Which brings us back to United. The club has increasingly positioned itself as a "global brand". Similar to Yahoo's loss of identity, Manchester United seems to have forgotten that it is first and foremost a football club. CEO Ed Woodward has proven himself adept at signing bumper commercial deals for the club. Yet the tail seems to be wagging the dog more and more. Recent reports suggest that Wayne Rooney could be on his way to China, assuming the club can "offset his potential departure with an eminent replacement their global partners would approve of to promote their products." Pause and let that sink in for a second. If that is true, it is diabolically misguided. The decision to replace a senior player should be driven entirely by footballing considerations. Yet Woodward's apparent obsession with "marquee players" seems to be spurred by commercial incentives, and possibly his desire to solidify his reputation as a deal-maker. A bit too much of the investment banker, then, about Woodward.
Perhaps easy money has tainted United the way it tainted Yahoo. The circumstances are different, of course: this isn't the Internet bubble, and I'm sure Woodward works very hard to sign those commercial deals. But the focus on "global superstars" worthy of a "global brand" is unsustainable. Commercial partners appear to be salivating to capitalize on United's global cachet, but that won't last long if the club's leadership neglects the footballing core of the club. Furthermore, rather than hawking the brand at every turn, I believe it makes more sense to think of Manchester United as a luxury brand. The best luxury brands are obsessed with maintaining their aura, which is their greatest asset. Similarly, the fanatical support of a global fan base is a valuable asset that should be treated with the utmost care. I cringe when United players are forced to promote movies on their Twitter feeds. Don't get me wrong; I of all people understand there are commercial considerations. But Manchester United the commercial juggernaut is at serious risk of killing the golden goose that is Manchester United the football club that produced Charlton, Best and Law.
Ultimately, there is only one group who can change the club's direction, and that is the Glazer family, who control its ownership. I've cautioned in the past about blaming the Glazers for all of United's ill fortune, while being critical of the club's ownership structure. But we've reached a crucial juncture for the club. While the Glazers may never understand the importance of the club to fans around the world, I can only hope they have an interest in protecting the long-term value of their investment. If they fail to grasp the seriousness of the situation, it may be a long time yet before United fans can reclaim the riches of the Alex Ferguson era.
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