Thursday, November 23, 2006

Basic to being a good stock picker (Part 5)

To continue on the earlier 4 parts on how to be a good stock picker, in general, many investors are sort of too influenced by their investment managers or their friends who are indirectly also too influenced by all the reports issued by the investment managers. It is thus important to understand what makes sense for the investor is different from what makes sense for the manager. For instance, at Berkshire Hathaway, it would be hard to get paid as an investment manager as well as what they’re currently paid because you’d be holding a block of Wal-Mart, a block of Coca Cola, a block of Nike, a block of American Express, a block of P&G, Johnson & Johnson and so on. You’d just sit there. And the client would be getting rich. And after a while, the client would think, “Why am I paying this guy half a percent a year on my wonderful passive holdings?” So what determines the behavior in human affairs? As usual, incentives are the determinant for the decision maker.

A classic case on incentives is Federal Express. The heart and soul of their system which creates the integrity of the product is having their airplanes come to one place in the middle of the night and shift all the packages from plane to plane. If there are delays, the whole operation can’t deliver a product of full integrity to FedEx customers.

And it was always screwed up at one time. They could never get it done on time. They tried everything you named it and nothing worked.

Finally, someone came along with the idea to pay all these people not so much an hour, but so much a shift and “bam”, it’s all solved. And when it’s done, they can all go home. Well, problems cleared up overnight.

So, getting the incentives right is a very, very important lesson. It was not obvious to FedEx what the solution was. But maybe now, it will hereafter more often be obvious to you.

As we’ve recognized that the market is efficient as a pari-mutuel system is efficient for the favorite to be more likely than the long shot to do well in racing, but not necessarily giving any betting advantage to those who bet on the favorite.

In the stock market, some railroad that’s beset by better competitors may be available at one-third of its book value. In contrast, IBM in its heyday might be selling at 6 times book value. So, it’s just like a pari-mutuel system. Any fool could plainly see that IBM had better business prospects than the railroad. But once you put the price into the formula, it wasn’t so clear anymore what was going to work best for a buyer choosing between the two stocks. So it’s a lot like the pari-mutuel system and, thus, it gets very hard to beat.

So, what style should the investor use as a picker of common stocks in order to beat the market, in other words, to get an above average long-term result? A standard technique that appeals to a lot of people is called “sector rotation.” You simply figure out when oils are going to outperform retailers, when car manufacturer are going to outperform oils and so on. You just kind of dart around being in the hot sector of the market by making better choices than other people. And presumably, over a long period of time, you get ahead. However, there’s no truly known investor who got successful or really rich in this fashion. Maybe some people can do it and no one is saying they can’t. All that is known is so far no one can give an example of someone who got really rich and successful by practicing it consistently in the long run. And conversely, there’re many successful investors who did not do it this way.

The second basic approach is the one that Benjamin Graham used – much admired by Warren Buffet and Charlie Munger and many other successful value investors. He had this concept of value to a private investor – whereby what the whole enterprise would sell for if it were available. And that was calculable in many cases.

Then, if you could take the stock price and multiply by the number of shares and get something that was one third or less of sellout value, he would say that you’ve got a lot of edge going for you. Even with an elderly alcoholic running a stodgy business. This significant excess of real value per share that is working for you means that all kinds of good things can happen to you. You had a margin of safety as he puts it by having this big excess value going for you.

But he was, by and large, operating when the world was in shell shock from the 1930s which was the worst contraction in the world in about 600 years. Wheat in Liverpool got down to something like a 600-year low, adjusted for inflation. People were so shell-shocked for a long time thereafter that Benjamin could run his Geiger counter over this detritus from the collapse of the 1930s and find things selling below their working capital per share and so on. And in those days, working capital actually belonged to the shareholders. If the employees were no longer useful, you just sacked them all, took the working capital and stuck it in the owner’s pockets. That was the way capitalism worked then.

In modern times, the accounting is not realistic because the minute the business starts contracting, significant assets are not there. Under social norms and the new legal rules of civilization, so much is owed to the employees that the minute the enterprise goes into reverse, some of the assets on the balance sheet are not there anymore.

However, that may not be true all the time. If you run a little auto dealership yourself and run it without any health plan, unions and so on, you can still take your working capital home and close your business. But in businesses like IBM, General Motors, they can’t or at least they didn’t. Just look at what disappeared from its balance sheet when it decided to change size both because the world had changed technologically and because its market position had deteriorated.

And in terms of blowing it, IBM is some example. Those were brilliant, disciplined people. But there was enough turmoil in technological change that IBM got bounced off the wave after “surfing” successfully for 60 years.

At any rate, the trouble with what is called the classic Ben Graham’s concept is that gradually the world wised up and those real obvious bargains disappeared. You could run your Geiger counter over the rubble and nothing clicked. But such is the nature of people who have a hammer – everything seems like a nail. So, Ben Graham followers responded by changing the calibration on their Geiger counters. In effect, they started defining a bargain in a different way. And they kept changing the definition so that they could keep doing what they’d always done. And it still worked pretty well. So the Ben Graham intellectual system was a very good one.

Of course, the best part of it all was his concept of “Mr. Market.” Instead of thinking the market was efficient, he treated it as a manic-depressive who comes by every day. In some days, Mr. Market comes by and says, “I’ll buy your interest at a price that’s way higher than you think it’s worth.” And you get the option of deciding whether you want to sell your interest to him, buy his interest or do nothing at all.

To Benjamin, it was a blessing to be in business with a manic-depressive who gave you this series of options all the time. That was a very significant mental construct. And it’s been very useful to many value investors over their lifetime.

However, his concept was not totally unflawed. If Warren Buffett had stayed totally with the classic Benjamin way, Berkshire would surely not be where they are now – not even close to it. And that’s because Graham was not trying to do what Berkshire did. For example, Benjamin didn’t want to ever talk to management. And his reason was that, like the best sort of professor aiming his teaching at a mass audience, he was trying to invent a system that anybody could use. And he didn’t feel that the man on the street could run around and talk to management and learn things. He also had a concept that the management would often couch the information very shrewdly to mislead. Thus, it was very difficult.

And with the way Warren Buffett started out as a pure Grahamites which was actually a fine way, he gradually got what is better insights to value investment. He realized that some company that was selling at 2 or 3 times book value could still be hell of a bargain because of momentums implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual or other, or some system or other.

And once he gotten over the hurdle of recognizing that a business could be a bargain based on quantitative measures that would have otherwise horrified Benjamin, he started looking out for better businesses. For example, he got American Express and Disney when they got pounded down.

Monday, November 20, 2006

Basic to being a good stock picker (Part 4)

In the earlier three parts of this subject, it’s a mix of microeconomics, a little bit of psychology, a little bit of mathematics which help to create a general structure of worldly wisdom. Now, we shall move on from the carrot part of the subject to the dessert part of the subject, which shall bring us closer to the subject of stock picking. While we move on, we shall also draw on this general worldly wisdom which was earlier touched on.

Common stock picking shall be touched on, we’ll not be going into emerging markets, bond arbitrage, or any other “sophisticated” financial instruments.

The first question to ask is, “What’s the nature of the stock market?” And that gets you directly to this efficient market theory that got to be the rage taught at all business schools. It states that at any point, at any time, the market is always efficient, that is to say the price always adjust very quickly to reflect all the news of a business. Simply, it means that no one can beat or perform better than the average of the market. Those who do are plain lucky.

So the next question is to ask, “Is the stock market so efficient that people can’t beat it?” Well, the efficient market theory is only roughly right – meaning that markets are quite efficient and it’s quite hard for anybody to beat the market by significant margins as a stock picker by just being intelligent and working in a disciplined way.

Surely, the average result has to be the average result. By definition, everybody can’t beat the market as it is an average. But the iron rule in life is that only 20% of the people can be in the top fifth. That’s just the way it is. So the answer is that it’s partly efficient and partly inefficient.

Then there are people who went to the extreme efficient market theory by doing extreme research. It was just an intellectually consistent theory that enabled them to do pretty mathematics. So obviously when things get complicated, it gets a little more seductive to people with large mathematical gifts. The problem is they have a difficulty in that the fundamental assumption does not tie properly to reality. Again, to the man with a hammer, everything seems like a nail. If you’re good at manipulating higher mathematics in a consistent way, why not make an assumption which enables you to use your tool?

If you think about the pari-mutuel system of the racetrack, pari-mutuel system is essentially a market. Everybody goes there and bets and the odds change based on what’s bet. That’s what happens in a stock market.

Any fool can see that a horse carrying a light weight with a wonderful win rate and a good post position and etc. is way more likely to win than a horse with a terrible record and extra weight and so on. But if you look at the odds, the bad horse pays 100 to 1 while the good horse pays 3 to 2. Then it’s not clear which is statistically the best bet using mathematic. The prices have changed in such a way that it’s very hard to beat the system.

And then the track is taking 17% off the top. So not only do you have to outwit the rest of the betters, but you have to outwit them by such a huge margin that on average you can afford to pay the 17% of your gross bets off the top to the house before the rest of the money can be put to work.

Given those constraints, is it possible to beat the horses only using one’s intelligence? Intelligence should give some edge because a lot of people who don’t know anything go out and bet lucky numbers and so forth. Therefore, somebody who really thinks about nothing but horse performance and is shrewd and mathematical incline could have a very considerable edge, in the absence of the frictional cost caused by the house take.

Unfortunately, what a shrewd horseplayer’s edge does in most cases is to reduce is average loss over a season of betting from the 17% that he would lose if he got the average result to maybe 10%. However, there are actually a few people who can beat the game after paying the 17% house take. Then perhaps these people would bet only occasionally when he saw some mispriced bet available. And by doing so, after paying the full take by the house, he made a substantial living.

You have to say that’s rare. But the market was not perfectly efficient. And if it weren’t for that big 17% take, lots of people would regularly be beating lots of other people at the horse races. It’s efficient but not perfectly. And with enough shrewdness and dedication, some people will get better results than the others.

The stock market works about the same way except that the house take is a lot much lesser though I would say it is still very substantial. If take transaction costs – the spread between the bid and the ask plus the commissions – and if you do not trade too actively, you are talking about fairly low transaction costs. So that together with enough dedication and enough discipline, some of the shrewd people are going to get way better results than average in the nature of things. Of course, like the nature of things, 50% will end up in the bottom half and 70% will end up in the bottom 70%, you can’t change the nature. But some people will have an advantage and they ends up in the upper tier of the class. And in a fairly low transaction cost operation, they will get better than average results in stock picking.

How do you get to be one of those who is a winner – in a relative sense – instead of a loser?

Again, look at the pari-mutuel system. In the whole history of people who’ve beaten the pari-mutuel system is quite simple – they bet very seldom.

It’s not given to mankind to have such talents that they can know just everything about everything all the time. But it is given to humans who work hard at it – who took and sift the world for a mispriced bet – that they can occasionally find one. And the wise ones bet heavily when the world offers them the opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.

It’s such a simple concept but yet, in investment management, practically no one operates that way. A large majority of the investment community have some crazy ideas in their heads. And instead of waiting for a near cinch and loading up, they apparently ascribe to the theory that if they work a little harder or hire more business school students, they’ll come to know everything about everything all the time. That’s insane. The way to win is to work, work, work, work and hope to have a few insights.

So how many insights do you need? Well, you don’t need many in a lifetime. If you look at Berkshire Hathaway and all of its accumulated millions, the top ten insights account for most of it. That doesn’t means the man operating Berkshire has got only ten insights. It is just that most of the money came from ten insights.

So you can get very remarkable investment results if you think more like a winning pari-mutuel player. Just think of it as a heavy odds against game full of craziness with an occasional mispriced bet or something. And you’re probably not going to be smart enough to find thousands in a lifetime. And when you get a few, you really load up. It’s just that simple.

Warren Buffett preaches that “I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches – each representing all the investments that you got to make in a lifetime. And once you’ve punched through the card, you couldn’t make any more investments at all.”

He says, “Under those rules, you’d really think carefully about what you did and you’d be forced to load up on what you’d really thought about. So you’d do so much better.”

This is a concept which is pretty straightforward and obvious but yet, this one of the few idea which very few business schools will teach – simply because it isn’t a conventional wisdom. It is obvious because the winner has to bet very selectively.

Why then it isn’t obvious to the rest? The reason could be like in this story about what someone told a guy who sold fishing tackle. Someone ask the seller, “My god, they’re in purple and green. Do fish really take these lures?” and the sell said, “Mister, I don’t sell fish.” Investment managers are in the position of that fishing tackle salesman. They’re like the guy who was selling salt to the guy who already has too much salt. And as long as the guy will buy salt, they’ll sell salt. But that isn’t what ordinarily works for the buyer of investment advice. On Wall Street, they will sell anything that you will buy – quality control is never prized.

Saturday, November 18, 2006

Basic to being a good stock picker (Part 3)

In continuation of the subject of advantages of scale in part two of the same subject, the concept of chain stores is extremely interesting. It was a fascinating and refreshing invention. You get this huge purchasing power which translates to lower merchandising cost.

If one little guy is trying to buy across 30 different merchandise categories influenced by traveling salesmen in a decentralized way, he’s going to make a lot of poor decisions. But if the buying is done in headquarters for a huge bunch of stores, you can get very bright people that know a lot about televisions and so on to do the buying. So there are huge purchasing advantages. And then you get the slick systems of forcing everyone else to do what works

A classic example is Wal-Mart. It is interesting to think about how Wal-Mart starting from a single store in Bentonville, Arkansas rolled over the Sears, Roebuck with its name, reputation and all of its billions. How did a guy in Bentonville with no money blow right by Sears? And he does it during his lifetime. He played the chain store game harder and better than anyone. Sam invented practically nothing. But he copied everything anybody else ever did that was smart – and he did it with more fanaticism and better employee manipulation. So he just blew right by them all.

He also had a very interesting competitive strategy in the early days. He was like a prizefighter who wanted a great record so that he could be in the finals and make a big TV hit. But what did he do? He went out and fought 42 fighters. And the result was knockout, knockout and knockout for 42 times.

Being shrewd as he was, he broke other small town merchants in the early days. With his more efficient system, he might not be able to tackle some titan head-on as yet. But with his better system, he could destroy those smaller players. And he went around doing it time and again and then, as he got better, he got stronger and he started destroying the bigger boys.

Well, that is a simple and very shrewd strategy. But you may think if it is a nice way to behave. And, capitalism is a pretty brutal place where the idea of Darwin is in place. But personally, the world is a better place with Wal-Mart around than to have lots of small merchants around to service the customers. Wal-Mart created lots of jobs, brought down prices with a more efficient system. In any case, there is no qualm for a superior culture to replace an inferior culture.

Then when you think of the other side where the big boys were destroyed where with all the great advantages they seem to have, it is very interesting to see what causes it. The disadvantages of bureaucracy did such terrible damage to Sears. Sears had layers and layers of people it didn’t need. It was slowed to react and by the time they decide on something, they were behind the line. And in such a system, if you poked your head up with a new thought, the system kind of turned against you.

The great lesson in microeconomics is to discriminate between when technology is going to help you and when it is going to destroy you. And many people do not get this straight. For example, in the early days when Buffett acquired Berkshire when it was still in the textile business, one day, the people came to Warren and said, “A new loom was invented that we think will do twice as much work as our old ones.” And Warren said, “I hope this doesn’t work because if it does, I’m going to close the mill.”

What was he thinking? He was thinking, “It’s a lousy business. We’re earning substandard returns and keeping it open just to be nice to the elderly workers. But he’s not going to put huge amounts of new capital into a lousy business.”
Although huge productivity increases would come from a better machine introduced into the production of a product, but all the benefits will go to the buyers of the product. Nothing was going to stick to the ribs of the owners. This is a simple and obvious concept – that there are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that’s still going to be lousy. The money still won’t come to you. All of the advantages from great improvements are going to flow to the customers.

By and large in all cases, the people who sell the invention show you projections with the amount you will save at current prices with the new technology. However, they don’t do the second step of the analysis which is to determine how much is going to stay home and how much is going to flow to the customers. Rather, they always read, “This capital outlay will save “you” so much money that it will pay for itself in 3 years.”

So if you keep buying things that will pay for itself in 3 years. And after 20 years of doing it, somehow you’ve still earned a return of only about 4% per annum. And that’s the way how some businesses are.

It just isn’t that the machine is not better. It is just that the savings don’t go to you. The cost reductions came through all right as projected. But the benefit of the cost reductions didn’t go to the guy who bought the equipment. It’s such a simple idea and basic but yet, so forgotten as in many other things.

There’s another model from microeconomics which is very interesting. When technology moves as fast as it does in a civilization like ours, you get a phenomenon which is termed competitive destruction. You may have the finest buggy whip factory and all of a sudden in comes this little horseless carriage. And before too many years go by, your buggy whip business is dead. You either get into a different business or you’re dead. It just happens again and again.

And when these new businesses come in, the early birds have the most advantages. And when you’re an early bird, there’s a model called “surfing.” In surfing, a surfer gets up and catches the wave and just stays there, he can go a long time. But if he gets off the wave, he becomes mired in shallows. Think of Intel, Dell, or in the early days, National Cash Register.

The cash register was a wonderful story. Patterson, founder of NCR, didn’t make much money when he was a small retail merchant. Then, someone sold him a crude cash register which he used for his retail operation. And instantly, it instantly changed from losing money to making because it was harder for an employee to steal. Then he thought “Oh, good for my retail business, if I can sell it to the others retailer, why not go into the cash register business?” And then NCR was created and he surfed. He got the best distribution system, the biggest collection of patents and the best of everything. He was a fanatic as well. And a well educated orangutan can see that buying into the business in those early days of surfing is a 100% sure bet. And that’s exactly what an investor should look out for. In a lifetime, you can expect to profit heavily from at least a few of these opportunities if you develop the wisdom and will to seize them. In any case, “surfing” is a very powerful tool.

However, this method of investment should be not popularized or practiced because it is not easy for one to develop the correct wisdom to pick out the right surfer from the millions. Unless you’ve the right competence in selecting the winner in the technology field, then it is easy. And again, this is yet another powerful tool to recognize at what you are good at.

Every person should have a circle of competency and know its boundaries. So you have to figure out what your own aptitudes are. If you are going to play games where other people have the aptitudes but you don’t, you are going to lose. And that’s as close to certain as any prediction that you can make. You have to figure out where you’ve got the advantage and you’ve to play within your own circle of competence.

If you want to be the best tennis player in the world, you may start out trying and soon realize that it’s hopeless because other people blow right by you. However, if you want to become the best plumbing contractor in your hometown, that is probably achievable by most of us. It takes a will and the intelligence. And after a while, you’d gradually know all about the plumbing business and master the art. That is an attainable objective, given enough discipline. And for people who could never win a chess tournament or stand in center court in a respectable tennis tournament, they can still rise quite high in life by slowly developing a circle of competence which results partly from what they were born with and partly from what they slowly develop through work and experience.

So, some edges can be acquired. And the game of life to some extent for most of us is trying to be something like a good plumbing contractor. Very few of us are chosen to win the world’s tennis tournaments.

Basic to being a good stock picker (Part 2)

In the history of thoughts, there’s one very accurate observation that comes from Pascal, “The mind of man at one and the same time is both the glory and the shame of the universe.”

It pays to take heed to this statement because it describes exactly what had taken place and will takes place. This statement has enormous power. However, it also has some standard malfunctions that often cause it to reach the wrong conclusions. It also makes man extraordinarily susceptible to manipulation by others. For instance, roughly half of the army of Adolf Hitler comprised of Catholics (this has nothing to do with religion). Given enough clever psychological manipulation, what human beings will do is quite interesting.

There are two questions to ask. First, what are the factors that really govern the interest involved taken with rational consideration? Second, what are the subconscious influences where the brain at a subconscious level is automatically doing these things – which by and large are useful but often malfunction.

One approach is rationality – the way you work out any problem – by evaluating the real interest, the real probabilities and so on. And the other is to evaluate the psychological factors that cause subconscious conclusions which are often wrong.

Then we come to another somewhat less reliable form of human wisdom – microeconomics. Here, it is useful to think of a free market economy as kind of equivalent to an ecosystem. Though it is an outdated way of thinking because in the early days after Darwin came along, people like the robbers barons assumed that the doctrine of the survivor of the fittest authenticated them as deserving power – “I’m the richest. Thus, I’m the best.” And that thinking of the robber barons surely does not goes well to the others and it makes it unfashionable to think of an economy as an ecosystem. But in truth, a free market economy is a lot like an ecosystem.

Just like an ecosystem, people who narrowly specialize can get terribly good at occupying some little niche. It is the same as how animals flourish in niches. Similarly, people who specialize in the business world frequently find good economics that they wouldn’t get in any other way.

Here, we get into the concept of advantages of scale which brings us much closer to actual investment analysis because in terms of which businesses succeed and which fail, much is dependent on advantages of scale.

An example of advantages of scale taught in all business schools is cost reductions along the so-called experience curve. Well, as human do something more and more in volume, it enables them to do it more efficiently as they try to improve while being motivated by the incentives of capitalism.

If you think of it in simple geometric in building a spherical tank, obviously as you build it bigger, the amount of steel you use for the surface goes up with the square and the cubic volume goes up with the cube. So as you increase the dimensions, you can hold a lot more volume per unit area of steel. Like that, simple geometric exercise like this shows simple reality of life which gives one an advantage of scale.

A much more relevant example that shows how advantage of scale is towards business is from TV advertising. When TV advertising first arrived, it was an unbelievably powerful tool. If you were P&G, you could afford to use this new method of advertising. You could afford the very expensive cost of network television because you were selling so many cans and bottles. Some little guy couldn’t. And there was no way you can buy it in part. Thus, the small guy can’t use it. In effect, if you didn’t have a big volume, you couldn’t use network TV advertising which was the most effective technique. So when TV came along, the big companies were given a huge tail wind pushing them forward. Indeed, they prospered and prospered until some of them got really fat and sluggish – which happens with prosperity inevitably most times.

And this sort of advantage of scale through TV advertising gives an informational advantage too. For instance, if I’m to buy chewing gum, between Wrigley Gum and China Gum, Wrigley costs 40 cents and China costs 30 cents, which do I choose? I know Wrigley and how it taste. Am I going to take something else I don’t know and put it in my mouth which is a pretty personal place after all just for a difference of a lousy dime? Surely not! So what can you gain from here? When you have advantage of scale, it goes in many ways that is advantageous to the business. Most important, as in the Wrigley case, they have an advantage in dictating price even if it is 33% more than their competitors.

Another advantage of scale comes from psychology or rather what psychologists term as “social proof.” We are all influenced – subconsciously and to some extent consciously – by what we see others do and approve. Therefore, if everyone’s buying something, we think and assume it must be better. We don’t like to be the odd one out.

Then again, some of this is at a subconscious level and some of it isn’t. Sometimes, we consciously and rationally think, “Hey, I don’t know much about this. They know more than I do. So, why shouldn’t I follow them?”

So why does social proof give huge advantages of scale? So for any business that holds an advantage of scale of such kind, for example, coca cola, they have a very wide distribution where it’s available almost everywhere on earth. So when you have an advantage of such kind, it can become very hard for anybody to dislodge you.

Then, there is another form of advantages of scale. In some businesses, the nature of things is kind of cascade toward the overwhelming dominance of one firm – monopoly. One great example is newspapers business. And, that is a scale thing. Once one secures most of the business, one gets most of the advertising. And once one gets most of the advertising and circulation, why would anyone want the thinner paper with less information in it? So it tends to cascade to a winner-takes-all situation. Similarly, all these huge advantages of scale allow greater specialization within the firm. So, each person can be better at what he does.

And really, these advantages of scale are a great thing although it kills out the smaller players. But well, that is how the way the world works – the Darwin way. When Jack Welch first came into control at General Electric, he said, “To hell with it. We’re either going to be number 1 or 3 in every field we’re in or we’re going out of it. I don’t care how many people I have to fire and what I have to sell. We’re going to be number 1 or 2 or out.” Wow, that was a very tough worded statement and thing to make and do. But there was nothing wrong in the idea. In fact, it was a great guiding principle and a correct decision if you’re thinking about maximizing shareholder’s wealth. And it is not a bad thing to do either, even if competition was killed because better products were delivered and GE was stronger with Jack there.

Thus far, only advantages of scale are mentioned. But in truth, there are also disadvantages of scale. An example is in some newspaper of publication business. As you know, when we talk about a business which does newspaper or publishing or both, it is really a specialization of doing something. At Capital Cities/ABC (a USA media company), they had trade publications that got killed and also a few who got ahead of them. And the way those who got ahead of them was by going to a narrower specialization. They have a travel magazine. Then someone would create one which addressed corporate travel. Like an ecosystem, you are getting a narrower and narrower specialization. Well, the one who got narrower got more efficient in what they do. They could tell the guy who ran corporate travel department more. Plus, they didn’t have to waste ink and paper mailing out stuff that corporate travel staff wouldn’t be interested in reading. It was a more efficient system. There are some papers that did not further specialize who got killed, and some who survive were those who further specialize. For example, there’s Motorcross – a magazine which is read by a bunch of nuts who like to participate in tournaments where they turn somersaults on their motorcycles. These people they don’t care much about the price of the magazine, it is their purpose of life. A magazine of such kind is really a total necessity to these people. And its profit margin would make anyone salivate.

So if you think about it, occasionally scaling down gives you the big advantage. Bigger is not always better.

Then one of the greatest defects of scale is that as you get big, you get the bureaucracy. And with the bureaucracy comes the territoriality which is again sort grounded in the nature of human. This defect really makes the game much more interesting because when you get bigger, it creates some problems and it shows that the big people don’t always win.
For example, let’s say that you work in a very big company with a great deal of bureaucracy, who the hell will really think about the shareholder or anything else? And in a bureaucracy, you think the work is done when it goes out of your in-tray into someone else’s in-tray. But of course, it isn’t. The work is not done until the business delivers what it’s supposed to deliver. So you get the big, fat, dumb and unmotivated bureaucracies. They also tend to be somewhat “corrupt.” In other words, if I’ve got a department and you’ve got a department, and we kind of share power running this thing, there’s a sort of unwritten rule: “If you won’t bother me, I won’t bother you and we’re both happy.” So you get layers of management and associated costs which no one needs. Then, while people are justifying these layers, it takes forever to get any real jobs that count done. They’re too slow to make decisions and nimbler people run circles around them.

The constant curse of scale is that it tends to lead to big and dumb bureaucracy which gets to the highest and worst form in governments where the incentives are really perverse. That doesn’t mean we don’t need government which of course is needed. But it is a terrible problem to solve by getting big bureaucracy to behave. So, people use ploys. They create little decentralized units and fancy motivation and training programs. One of the big companies that fought off bureaucracy with amazing skill was GE. But that’s because they have a genius and a fanatic running it and that’s was Jack. And they put him in young enough to have a long run in it to get things work out.

Then, there is another interesting aspect of psychology which CBS provides an interesting example – namely Pavlovian association. If people tell you what you really don’t want to hear and unpleasant, there’s an almost automatic reaction of antipathy. You’ve to train yourself out of it. It isn’t destined that you have to be in this way. But you will tend to be this way if you don’t think about it.

In the early days, CBS was the dominance TV network. And their founder, Paley was a god. But he didn’t like to hear what he didn’t like to hear. And people soon learned that. So they only told him what he liked to hear. Therefore, he was soon living in a little cocoon of unreality and everything else was corrupt although it was a great business.

So the stupidity that crept into the system was followed by a huge tide. You can get severe malfunction in the high ranks of business. And if you are investing, it can make a lot of difference. If you take all the acquisitions made under him, his advisors – the investment bankers, management consultants and so forth – were all paid handsomely which was absolutely terrible. You get a lot of dysfunction in a big fat, powerful place where no one will bring unwelcome reality to the boss. It’s really hard to tell the emperor that he is naked.

So in a business and life is an everlasting battle between those two forces – to get these advantages of scale on one side and a tendency to get very bureaucratic where they just sit around doing nothing much useful.

Wealth as a convenience only

In finding a great management, it is important ask the question if the person does it for money or for passion. Money must never guide the principle of return. This can be an extremely controversial, contrary notion. If someone has a passion to do well in something, they will be rewarded justly. For instance, a great management should never be too focused on the performance of the share price. Instead, they should be totally passionate and be focused on operating the business, when the business does well, the share price will takes care of itself.
In investing, to do really extraordinary, one should be challenged by the the growth of capital rather than to be emotionally controlled by the possession of money. The satisfaction lies in achieving knowledge, goals being met, and ideas being vindicated. In fact, money is only a convenience in settling the basic needs of one's life. It will not make any difference between anyone. We'll be the same, the only difference is in wealth. No one needs more things than the other. No one can eat more than the other. To be obsessed with money is the road to disaster.
Success does not equates only in terms of money. Success comes from turning your plan and ideas into reality in a sustainable manner, not through luck. Luck perhaps constitute 10% of most things, 90% of what happens come from what you can control. Luck is perhaps just the starting point in discovering an idea, and after you discover an idea, the rest is how you control the idea to make it works out to your goals.

Thursday, November 16, 2006

Words of wisdom for investors according to Benjamin Graham

Benjamin Graham preached commandments that any investor can use as stars when navigating through the vast and mystifying seas of the investment world. An individual who is not in a hurry or under pressure to shoot comets across the heavens but would instead like to earn a smart, fair, decent and substantially higher return in the long run should take heed from Ben's guidance. In greatly simplified terms, here are some points he constantly delivered in his writing and speaking. Most of these points are not technical but rather in adopting the right attitude and mindset.
  • Be an investor, not a speculator - Speculator is one who seeks to profit from market movements without primary consideration to intrinsic value. A prudent investor is one who buys only at prices amply supported by underlying value and determinedly reduces his stock holdings when the market enters the speculative phase during a sustained advance. Speculation, however he insisted, had its place in the securities market, but only if an investor has done enough research to justify his action and be prepared for losses if they come.
  • Know the asking price - Ask yourself if I bought the whole company would it be worth this much money? Always know what you are paying for. As the old saying goes "value for money."
  • Rake the market for bargains - In his days, he is best known to search for companies that sells below its "net current asset value." By buying stocks that are below this value, essentially, it means an investor is buying a bargain because nothing at all is paid for the fixed assets of the company. As time goes by, stocks like these are getting harder to by. In modern days, disciples of his enlarged the model to look for hidden value in additional ways, but still probe the question, "what is this company worth?"
  • Regard corporate figures with suspicion - It is a company's future earnings that will drive its share price higher but estimates are based on current numbers, of which investors must be wary of. Even with more stringent rules in place, earnings can still be manipulated through creative accounting. There will always be ways around all things. Special attention is urged to be paid to reserves, accounting changes and footnotes when reading company documents.
  • Don't stress out - Always recognize that you are unlikely to hit the precise "intrinsic value" of a stock right on the mark. A margin of safety provides peace of mind.
  • Don't sweat the math - Ben said: "In 44 years of Wall Street experience and study, I have never seen dependable calculations made about common stock values or related investment policies, that went beyond simple arithmetic or the most elementary algebra. Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give speculation the deceptive guise of investment."
  • When in doubt, stick to quality - If you buy good stocks at fair prices, investors do not make mistakes. They make serious mistakes by buying poor stocks, particularly the ones that are pushed for various reasons. And in fact, very frequently, they commit mistakes by buying good stocks in the upper reaches of bull markets.
  • Dividends as a clue - A long record of paying dividends, as long as 20 years, shows that a company has substance and is a limited risk. Growth stocks seldom pay dividends.
  • Be patient - Be prepared both financially and psychologically for the possibility of poor short-term results.
  • Think for yourself - Don't follow the crowd. There are two rules here. One, you have to think correctly. Two, you have to think independently. Always search for better ways to ensure safety and improving your investment mindset. Do not ever STOP thinking.

Sunday, November 12, 2006

My first fund annual report

This is just to share the experience on the journey I have embarked on since last October after having read the biography of Mr. Warren Buffet "The making of an American Capitalist." All thanks to CH who has the grace to share great information like this with me. Without this, I will not find life as meaningful as how it is today.
Well, having said that, it has been a year since I made my first logical investment in the way of an "Intelligent" investor. The first purchase I made on 17 Nov 2005 can also be attributed to CH - SP Ship. This is a stock where CH made a killing, not in terms of just amount but in percentage in return. However, for my case here, it wasn't the same - a pathetic return of slightly above 5%. But, I learnt some really valuable lessons from here - PATIENCE and ignore the noise.
So far, in my fund, the only shareholder beside me is my sister. So rightfully, this report should only be available to her but it does not matter, this is just to cast my journey on record for me to look back and how far the fund have come to many years down the road.
The fund is operated like how a normal business is operated where it is split into a fixed number of shares. I intend not to split the number of shares further though I do not rule out doing it completely, but certainly not at the expense of the owners. I shall explain the logic behind it later in the report.
As at Nov 2005, the net asset value per share was S$1.13. this value has grown to S$1.36, representing a net increase of 19.4%. Compared to the performance of the STI index, the STI was around 2350 then and it is about 2750 now, representing an increase of 17% before accounting for all kind of costs paid to the intermediaries.
While on the subject of cost paid to the intermediaries - brokering houses, custodian fees, SGX charges and so on -, such costs are by no means small. For a normal retail investor, for a trade of S$10,000, it cost about $50 in commission per trade, which means at least $100 is incurred when you buy and you sell a single security. This accounts for about 1% on the principal. If an investor gain is 10% on buy price, this $100 accounts for 10% of gross gain. So it reduces your net gain to 9%. It is an astronomical amount to pay for in my view.
Let's see how much commission is accounted for in my fund for fiscal 2006. Commission paid came up to 2.8% on initial principle. It accounts for 12.4% of gross gain. The fiscal year gain is reduced by 2.8% due to this astronomical commission. To compare like for like, STI gain is 17% while the fund gain is 22.2%.
Certain of my actions have caused my sister money. Sometimes, as a value investor, we must be totally clear and critical on the actions we are taking. I find at times, I practice value investment on the buy side but I become a momentum investor on the sell side, guided by the price shown. This has quite an impart that reduces the overall return. Late in Dec 2006, I acquired quite a substantial amount in Kingboard Copperfoil. At the price I bought at, it was definitely a value which most value investors will readily acknowledge as undervalued. It has a low “Price-to-Earnings” ratio and a substantial discount to “Net Asset Value” while earning a decent return on shareholder's equity. Then sometime in Feb 2006, the trading price increased by almost 50%, a logical value investor will normally have sold off the stake then. As yet so human-like, I was being greedy, hoping for it to go up a little more before I sell off. Then what happens, it went back down slowly. At today price, the gain is about 23% or so.
Another of my action that costs my sister money was the lack of patience, particularly on two occasions. The first was my lack of patience in holding a stock which was earlier highlighted in the case of SP Ship, if I had chosen to hold on, the gain would have been at least 20% compared to 5% - all thanks to my thin patience. The second was the mistake I made in buying a second lot of Kingboard stake. This time, I became a momentum buyer on the buy side. Remember in Feb 06, the share was at its high of S$0.38, it then spiraled downwards sometime in April. This time, I was like the normal investor who looks at the charts to decide on how to invest. The share went to S$0.335, and I thought "Wow, what a great discount from its recent high" and I acquired another batch of Kingboard. Then in May, a slight turbulence in the market happens, the market suffer a drop in investor's confidence, and too driving Kingboard price down further. It went to the price which is almost the same as what I acquire in Dec 2006. "XXXX", if I had been much more patient and logical. But in life, no one really can get over silly mistakes all the time. What can be done is to identify silly mistakes - which are disguised in various forms - as much as possible and avoid going where one do not want to go. But sometimes, some of it just slipped through and that’s when silly mistakes are committed. But even if silly mistakes are committed, it should be acknowledged and addressed so that it will not happen again.
Luckily, thus far, I have not caused any great damage to both myself and my sister. In fact, it is great I committed some mistakes along the way. These mistakes are really a learning point for any investor to have a feel of what an intelligent investor should actually avoids doing. Most importantly, it strengthens my resolve towards the mindset of "never to lose money." To paraphrase Warren Buffett’s advice: “The first rule in investing is never to lose money. The second rule is never forget the first rule.”
Another lesson an intelligent investor ought to learn is never to invest in "cigarette-butt" businesses. Businesses which are dying trade or are generating low returns on equity should be avoided as far as possible. Though, an investor can purchase such business at a much "discounted" price from its book value but really, most of such businesses are really not worth to purchase. I had a personal experience in dealing with a purchase of such kind with my funds from CPF. The stock was Matex – a paint manufacturer. I was pretty lucky to be able to get out of the business at a gain. It is not that one will not gain in the future if you pay at today’s price of about 9 cents per share. The problem is the feeling of holding a business with dying economics or competitiveness is really not a good feeling.
As stated earlier, I do not intend to split any of my stock further even if it grows a lot better. The logic is by splitting stocks, it encourages a different class of investors. There are a few implications for businesses which split their stocks all too often. All of those businesses who split their stocks always state the "all-too-often" used reason "to increase liquidity and shareholder's value". This kind of action has really got nothing to do with increasing a business value or its intrinsic value. Just like a person having a dollar bill or four quarters. What is the difference? This is something where others use their emotions (randomness) than their brains (non-randomness). Were a business to split their stocks, investors and management alike are taking actions that focus on the stock price rather than the business value. It would entice a whole new entering class of buyers who are inferior to the exiting class of sellers. I too like Mr. Buffett encourages long-term investors in the fund.
I thank my brother, CH, in particular for giving me a little light to the path I totally enjoy which is absolutely meaningful and logical to me. Looking backwards, without me borrowing the simple book from him, I would certainly by as aimless as before. And really, this is one of the luckiest events I am sure that will happen in my life when I met CH. Through him, I discover Warren Buffett’s extraordinary logical thoughts on investing, and through Warren, I discover both Benjamin Graham and Charlie Munger. All of these three guys are extraordinary people with an extraordinary logical mind who can educate any normal person who is not resistant to change and open to lifelong learning.
Currently, the fund is invested pretty substantially in businesses in the USA. I find there are a whole lot of great businesses in USA, than in locally. In fact, I foresee that most of my purchase in the near future will be in the States rather than locally unless I can find a great bargain. The only risk in investing in USA is the depreciation of the Dollar, which is nothing but a certainty. If the deficit is not addressed, in the future, you can be certain the Dollar will be worth much lesser than today. When it will happens, no one knows for sure but it will happen if it isn’t address. Just like you throwing a bag of feather when you stand on top of a building. You know for certain the feathers will settle on the ground at somewhere at some time in point, but you cannot tell when it will land on the ground. This is a case how easy it is to predict the long term result than to predict the short term result.
Looking forward to the next fiscal year, I expect the fund to gain in value slowly and fairly while I strengthen on my fundamentals and learn on my mistakes as I move along. Hopefully, there will be many more reporting I can do on an annual basis till such time I am immobile or incapable to do so. That is the fun part of investing. A journey not a destination.

Saturday, November 11, 2006


Mr Market, a manic-depressive frictional character coined by Benjamin Graham long ago to describe the mental attitude toward market fluctuations that is recognized by followers of Ben to be the most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.
Even though the business that the two of you own may have economic characteristics that are stable and strongly rooted, Mr. Market's quotations will be anything but. For the poor fellow has incurable emotional problem. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high price to buy your interest because he fears that you will snap up his interest and rob him of any imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions, he will name a very low price since he is terrified that you will unload your interest on him causing him to sell his stake even lower.
Mr. Market has another endearing characteristic. He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior is, the better it is for you.
But, like "Cinderella at the ball", you must heed one warning or everything will turn into "pumpkin and mice": Mr. Market is there to serve you, not to instruct or guide you. It is his pocketbook, not his wisdom that you will find it useful. If he shows up someday in a particularly foolish mood, you are free to either ignore him or to take advantage of him. However, it will be disastrous if you fall under his influence.
In case if you aren't sure that you understand and can value your business far better than Mr. Market, you don't belong in the game. Like they say "you are only good if you know the game, if not, you are giving a whole lot of advantage to others who are." And just like in the game of Poker, the iron rule is "if you've been in the game for 30 minutes and you don't know who the patsy is, you are the patsy."

Friday, November 10, 2006

Basic to being a good stock picker (Part 1)

Before starting, it is important to attribute what is written are ideas from Charles T. Munger - whom personally I think is a better stock picker and thinker than Warren Buffett. In fact, he was the one who introduced and convinced Warren of the idea to buying businesses at a premium above book value if the moat is durable enough to validate the deal.
The carrot portion of this article is mostly about the general subject of worldly wisdom which forms the framework of this subject. After all, the theory of modern education is that you need a general education before you specialize, and to some extent, before you can be a good stock picker, you need some general education.
So to waltz through the framework of worldly wisdom, there are a few basic notions.
What is elementary worldly wisdom? The first rule is that you cannot really know anything if you just remember isolated facts and try to bang them back to use. If the facts do not hang together on a framework of theory, you do not have it in a useable and understandable form. So you have got to have models in your head through your experience which have to be displayed on this structure of models. If you noticed, students who just try to remember and throw back what is remembered, they failed in school and in life. Thus, you have got to hang experience on a framework of models in your head.
What are models? The first rule is that you have got to have multiple models - because if you have only a few models to use, the nature of human psychology is such that you'll torture reality so that the reality fits your models, or at least you will think your limited models fit reality. It's like the old saying, "To the man with a hammer, everything seems like a nail." So you have got to have a multiple of models.
And these models have to come from multiple disciplines, and thus, reading up a lot is extremely important if one is to gain any wisdom in life. No wise man can be really wise without reading a lot. By the way, being wise has nothing to do with intelligence. Wisdom of the world comes not from one little academic department, it is found in many, as diverse as from engineering to business to psychology and so on. Now you may say "Oh my god! This is getting way too tough." But, fortunately, it isn't that tough because 80 or 90 important models will carry about 90% of the freight in making you a worldly-wise person. And of these 80 to 90, only a handful really carries very heavy freight.
So what are the models that constitute this basic knowledge that everybody has to have before they can become good at stock picking?
Firstly, there's mathematics. Obviously, you have got to be able to handle numbers and quantities which is actually basic arithmetic. The greatest model here is the compound interest or return which is so ungodly important in accelerating growth. Another great useful model, after compound interest, is the elementary math of permutations and combinations. This idea is probably taught in secondary or high schools. These are very simple algebra and not that hard to learn. What is hard is to get a person to use it routinely in life almost every day. These models are consistent with the way that the world works. It is really amazing to find that high school algebra actually works in life. However, by and large, many people can't naturally and automatically use this in their life because they complicate how it can be applied by making the models more complicated than it should be when it can be used simply.
So you have to learn in a very useable way this elementary math and use it routinely in life - just the way if you want to be a golfer, you can't use the natural swing that nature gave you. You have to learn to have a certain grip and swing in a different way to realize your full potential as a golfer. If you don't get this elementary into your blood, then you go through a long life like a one-legged man in an ass kicking contest. You're giving a huge advantage to all others.
One of the advantages like Buffett and Munger hold is that they automatically think in terms of decision trees and the elementary math of permutations and combinations.
The second notion is to know accounting. This is pretty obvious because it is the language of practical business life. It is one of the best gift that has been delivered to civilization. However good accounting may be, there are limitations to it. To understand the most important limitation is accounting is just a crude approximation of things. And it is not hard to understand its limitations. For example, everyone can see that you have to more or less have to guess the useful life of a jet plane, machinery or anything like that. Just because you express the depreciation rate in neat numbers doesn't make it anything you really know.
The third model is to always ask "Why." You may ask why that is so important. Well, that's a rule of psychology. If you think about it a little more deeply, when you align knowledge on a bunch of models that are essentially answers to the question of "why, why, why", you will find people to understand and appreciate it better. If you always tell people why, they'll understand it better, they'll consider it more important, and they'll more likely to comply. Even if they do not fully understand, they'll be more likely to comply. So the iron rule here is for those who want to acquire worldly wisdom, they should start asking "why, why, why" in communicating with other people about everything. Even if it's obvious, it's wise to stick in the "why."
Besides the models aforementioned, which models are the most reliable? Obviously, the models that come from hard facts like hard science or engineering are the most reliable sources on earth because you can calculate and predict many outcomes. Here's a quote from Sir Isaac Newton, "I can calculate the movement of stars but not the madness of man." By the way, these models are very much based on elementary mathematics.
In such models, it gives you a model in a way that "it costs so much and you get so much less likelihood of it breaking if you spend so much." This is basic mathematics. Then also, the backup models of engineering are a very powerful tool. The idea of breaking point is a powerful tool as well.
All these mentioned have great utility in looking at ordinary reality and problems. You can actually apply the basic concept of it to solve some problems which elude others. Then there's all these cost-benefits analysis which is a great model and that's all so elementary. Just that many times it has been dolled up a little bit too much with big lingoes.
Then another great reliable model is from psychology. This is an ungodly important subject if you are going to have any worldly wisdom. It is important to understand that the mental or perceptual function of a man has shortcuts and shortcomings in it. Our brain cannot have unlimited connections in it. So for someone who knows how to take advantage of such shortcuts and cause the brains to miscalculate in certain ways can cause you to see things that aren’t there. So if you are being made to believe these people who know the shortcuts, you buy into ideas that aren’t in existence.
You can demonstrate this point quite easily. You can bet pretty much that there's not a person in a magic show viewing the work of a magician who see a lot of things happening that aren’t happening and do not see a lot of things happening that are happening.
Then when your fellow man starts to act like the magician and manipulates you on purpose by causing your mental function to dysfunction - you will be a victim.
Just as a man working with a tool has to know its limitations, a man working with his mental device has to know its limitations. By the way, this knowledge can be used to control and motivate other people.
Even though psychology is such a useful and practical model, it is very much neglected or ignored. In fact, I think this can be easily taught to any person with ordinary intelligence in a short time. Just that some of us are always too resistant to ideas that seem foreign to them. For me, I learnt it not too long back and it is extremely useful and I am still learning. When I realized how useful it is and how logical and practical it is to everyday life, I felt like a total fool.

Thursday, November 09, 2006

How to make a million just by growing CPF alone and achieve an ability to spend $6000 of today's value monthly till age 80?

This is a follow up on the earlier article I wrote about if saving a thousand every monthly is enough and maybe a bit controversial because ultimately the outcome depends sorely on the mindset of the practitioner. Some of you out there may think this is a frightening fact that a saving a thousand is not enough in my view if grown at a normal interest rate. Moreover, I must admit it is probably a bit too tough for most average people. But as always, there're ways and alternatives around it.
Here's one way. You always still have your CPF to invest, i.e you do not need to come out with cold hard cash. Anyway, this is a case based on a person who is earning 1) $2000 a month for the rest of his working life and 2) having a $10,000 capital in CPF to start with to invest 3) at the age of 29 and 4) at an average compounded return of 15% yearly. These are the 4 impt variables in the calculation. Anyway, I think this probably does not represent the average educated Singaporean income which is sure to be more than this at age 29 on average. So if a worst case scenario can grow his CPF to more than a million at age 55, you can imagine the magic the others can do who earns much more.
If you invest the $10K of initial capital you have at age 29 and every year, you also pump in whatever that is available to you in your CPF to invest (you will have about $2574 every year). You will have an available fund of $1.13 million (present value of about $663,000) at the age of 55. This is excluding the amount which CPF does not allows you to invest (you can only use about 30% of ordinary account to invest in stocks), thus, your CPF funds by then will have more than $1.13 million. Add maybe about 200k more??
With this fund of $1.13 million, you can afford to spend up to $6500 of today's value per month if a person life span is up to 80. But in the last year, you will be in negative equity. By then, the $6500 of present value will equate to $11k when you reach age of 56, and $18K when you reach age 80.
In fact, if you spend $5000 monthly, your fund will always be ever increasing because your yearly returns is more than your yearly spending.
Anyway, to achieve 15% return is not that easy or difficult, even if you think you can't achieve 15%, I think 8 to 12% is reasonable and that will give one a pretty comfortable life by then when one retires till one is gone.
So if you have the discipline, even without investing or saving from your own hard cash, and you do it purely through CPF, you can achieve wonders from a simple way of disciplined investing.

For the benefit of those who think 15% return annually is too much, I shall provide you how much 8% yearly compounded return will be worth in the same scenario. At 8% yearly, your fund at age 55 will be worth about $302,000 (present value of $$177,000). Anyway, I think most educated people earnings will be more than $2000. If you earn $3000 and the yearly return is 8% and calculated based on the same method, the fund by at age 55 will be about $415,000 (present value of $241,000). If your earnings is $4000, it is worth about $525,000 (present value of $307,000).

Wednesday, November 08, 2006

Business and investing quote of wisdom of the week

"The most important quality for an investor is temperament, not intellect."
Warren Buffett once mentioned "any IQ above a reasonable level of intellect is wasted." To start, a conclusion can also be drawn that temperament is necessarily some function of intellect, though not in the conventional way. A person ability to evaluate his individual competence is strongly related to capability. This may not be in the exact same form of the conventional for intellectual capability. But it is an important capability that measures a person ability to react to different emotional situation.
By consciously making an effort to continuously harness temperament, it will lead to fewer investment errors. After all, simple math demonstrates that it takes 100% gain to offset a 50% loss, and the former are lamentably scarcer than the latter. Randomly, three manifestations of temperament are suggested towards reducing erroneous ideas. No doubt there are hundreds more.
TEMPTATION is a pervasive and often hard to rid of human trait. This trait is often the major factor for causing EXCESSIVE TRADING. Many of us just simply cannot resist the temptation to constantly buy and sell due to a lack of patience. The more you trade, the more likely you are pursuing a low return strategy. By trying to sell a stock in the hope of buying it back cheaper, or trying to outwit the impossibly resourceful Wall Street, or hoping to precisely time short term price jumps, there is no one who is known to have done it successfully. It is a struggle to list investors who have accumulated serious wealth through furious trading. But it is easy to come out with a list showcasing wealthy investors who owe their success to holding shares of great businesses for a long time. The most legendary is Warren Buffett. A few of his investments include, Coca Cola, American Express, Gillette (now merged with P&G), Washington Post, See's Candies, Netjets, and so on. Moreover furious trading means high turnover of your holdings, naturally, it incurs a cost - frictional cost like commissions - so why volunteer for more? The next time you find your finger on the trading trigger, stop and ask whether you can prove your action will be more profitable than inaction.
INDEPENDENT CONVICTION was originated popularized by Benjamin Graham, the father of value investing. To paraphrase one of his quotes: "You are neither right nor wrong because others agree with you. You will be right if your facts and reasoning are correct." The challenge in investing is that decisions bear an important financial consequence, and are often made alone. Many famous value investors - especially those who were Graham students like Buffett, Browne, Schloss and many others - they make investment decisions independent from each other, their portfolios are totally different from one and other. But what is similar is they have the same principle in making an investment decision. It can be so easy to submit to a need for emotional reassurance by following the herd with other investors - especially for those who need to justify decisions to clients. Why do investors like to follow most others are doing? Because by being in the herd, it provides a sense of belonging and warmth which you cannot get if you are to stand alone. So when they made a wrong decision, they would not appear as embarrassing. And the best thing is nobody will fault them because the majority is making the same mistake. But if any one of them decide to stand on himself, he stands the chance of being ridiculed if his performance does not appears to be as good as how the other side is doing. But if you decide that by following the herd is a better method, then it is important for you to figure out where among the herd you should stand in relation to the others that will make the difference. The grass is always greener and much more if you are at the edge of the herd. Then by following the herd, it can be frightfully expensive because investors who bought Cisco in Jan 2000, Enron before it went bust, or Xerox in Dec 1972 will be able to illustrate to you.
As with any temperament-honing strategies, basic awareness is a critical step. Here, it is important to subscribe to the mindset of "fact finding." Personally I think if investors are to substitute a reference to "the crowd or herd" with a reliance on verifiable stock-specific facts will definitely inoculate themselves from the market's emotional swings. By developing a fact base for your investments will also help you to avoid getting surprised or spooked by any temporary price declines. It is meaningless to buy stocks with a large margin of safety if a transitory 10% price decrease makes you sell. In fact, with your fact base, and if you refer back to it, it provides a better window of opportunity to accumulate shares of a great business at a better price. In any case, this is much easier said than done, but if it isn’t, then how on earth could moats be worth much more if everyone could have one?
ENVY is uglier than greed though both are the downfall to sustainable success. Charlie Munger lists envy as the worst of all sins because this is the only sin which does not provide any positive outcome. Any other sins like lust, gluttony provides you temporary joy or satisfaction but envy produces absolutely zero satisfaction. In fact, it causes resentment even more and distort any logical ideas that you originally may have thought of. When you weigh its financial ill effects, envy may actually be one of the major factors in causing wrong and emotional decision. It is amazing how many investors furiously scramble into the market's hottest sector or stock, seemingly not wanting to miss out on the "easy" profits others are making. But personally I find this behavior as odd. Why buy when prices are highest and margins of safety and return are lowest? I can never answer the question logically if these people are using facts to make a decision. They rely on emotions and where the arrow is pointing at. Yet the lure of the 1990s dot-com bubble, today's real estate appeal, or any historical famous bubbles amply demonstrate envy's powerful siren sound. Some people they just simply cannot stand anyone beating them at any point in time. They must always be at the head of the line. But some investors, at somewhere, will bound to always have earned a higher return over any recent period or at any time. Even if some investors get richer a little faster than you, so what? I think the demons of envy can be thwarted with a combination of awareness and a disciplined strategy of limiting investments to those that can be purchased with a margin of safety. Sure, there'll always be a "hot" sector, if there isn’t any stories, Wall Street will draw blanks.
Frankly, this can get endless. Temperament is merely just a subset of the broader academic research into behavior finance, and what have been mentioned here, we barely scratched the surface. Serious investors should explore this field in much more depth than my space constraints and limited knowledge would permit. I'd recommend "Poor Charlie's Almanac" for those seeking an experienced practitioner's overview, and John Bogle "Common Sense."

Insights on value investing

This is a little reply I posted on the forum of Channelnewsasia to a guy who seems to practise value investment as well.
Yes, I agree with you that investors need only a few chances to make it successful in investing in the long run. The problem with most are firstly, the lack of patience, then, the inability to stay still and resist the temptation to keep on moving, then, patience and discipline. Like Charlie Munger once said: "It takes discipline and character to stay there doing nothing."
In life, you don't have to swing at everything -you can wait for your pitch. The problem when you're a money manager is that your fans keep yelling, 'Swing, you bum!'"
Then it is important to understand some of the basic human characteristics. Some people they cannot stand others getting ahead of them even though they are making a profit themselves. These people they want to beat the market at all time at all cost. In life, you cannot outperform all the time at all the points between from now to then. In the short run, you may appears to lag the market, but if things are done in the right fashion, the long run will brings whatever that is out of line into line.
Though the value investing approach may appears to be boring or rather the lack of sex appeal, just like a married man yearning for a young and sexy lady, it keeps you out of trouble.
Then many investors do not recognize that they are being controlled by the market or rather by the price ticker that is shown day to day. The basic for every value investor is to recognize that the market is there to serve you, not to order you. Here is a big difference if you are really by nature a value investor. The best test is during a market downturn. In a market downturn, it shouldn't bother you. In fact, for any long term investor, it is an opportunity to increase your stake in a great business with a great management at a great valuation. Only to short term investors is a market downturn a threat or correction, not an opportunity.
Moreover, it takes a superb genius to figure out hundreds of smart decision during his investing lifetime. One may be able to make hundreds of "ok" decisions but not hundreds of superb decisions that can cause extraordinary returns. So to be extraordinary, making lots of decisions will not enhance your chance of doing good. Be discipline, keep searching and studying great businesses. At the time of studying the great business say for example, Coca Cola, the price may not be a good price to pay but if you study it constantly, and when the time comes where price is so undervalued, your study pays off and you whack as much as you have and sit back and wait for your payoff.
In value investing, we are like "FARMERS." which is coined by another legandary value investor, Christopher Browne (a student of Benjamin Graham and part of the inner circle friends of Warren). When the farmer plants his crops, at times, the crops may pop up of the ground late because of weather conditions. But he does not unearth the seeds that he planted and replant it like what many investors are doing. Many investors does not have the patience because "the crops does not pop up on schedule." They just sell out and jump on to the other lane which they think can bring them forward.
For me, value investing is a mindset. It does not really requires a whole lot of intelligence as long as you have a reasonable level of IQ. Like what Buffett said: "Success in investing doesn't correlate with I.Q. once you're above the reasonable level. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing." I think if you have say an IQ of 110, all the rest above it are wasted. Just like having lunch, you only need to eat so much, and if the table is filled with lots of food, all the rest are wasted. Same logic.
Then for those people who time the market. They really need a magic ball to tell them the future. In bull time, most value investor will not outperform the market and it is important to recognize this and why is it so? Because emotion have taken over logic. When you have emotions driving the price, you'll be amazed how high prices can deviate from what is the correct price. You can't calculate or value emotions but you know it will happen and what it will cause, it causes both the super bull market and the over pessimistic market. You may not know when the bubble will burst or how much it will bottom out. But you know in the future if prices are overdriven or underdriven, logic will prevail sometime in the future. Just like you throwing a bag of feathers, the feathers will float in the air for some time but you don't know when and where it will settle on the ground but it will.
The fact that humans are full of greed, folly and fear are legandary and predictable. The sequence of when each of this emotion will happens is not predictable.
It is only in times of pessimism that value investing returns the most. Pessimism is a huge reason why prices can be so undervalued to the point of being pervasive. Not that value investors like pessimism, but it is the price that it produces which is likeable. Here's something very contratrian, it's optismism that is the enemy of a value investor because it restrict firstly your chances of finding a real bargain and also, the limitation of the upside during a bull market where prices are almost at its roof.
Another thing to recognize is time is the friend of a great business and enemy of a bad business. This is also true towards value investing. It is able to stand the test of time.
I suggest for those who doubt the approach towards value investing to read the article "The superinvestors of Graham and Doddsville", it was printed in 1984 on a speech by Warren Buffett. It is not easy to find the article now but perhaps it could still be found online. Alternatively, I can email anyone of you if you are interested.

Thursday, November 02, 2006

Business and investing quote of wisdom of the week

Someone once mentioned "History is a poor teacher and humans are an atrocious bunch of students." In general, this is every true in many cases. People hardly learn the hard lesson taught by experience or history even though personal experience is encountered. For instance, there will always be people who will spend every cent of their salary on extravagance and then they encounter hardship in their daily expenditures. And when they encounter hardship, they make a resolution to budget properly and do away with unnecessary spending. But then when all is well again, they forgot what they had gone through in the past, they go back to their old habits when they have a little more cash on hand.
Particularly, this phenomenon is no where more prominent than in the field of investment. Many times, investors do not learn from the lessons and facts that were taught in the past. Historically, it has been proven that when asset price is bought when price is being chased up, the chances of losing is much more than winning. But, here, the psychology of human takes control over logic. They get more comfortable to invest when prices are on the high side than to invest when it is on the low end. Another case is investors perpetually likes to invest in the sexiest business in issue that has been so rosily painted by Wall Street even though not a single cent has been earned yet. Hands were burnt before, and these hands withdrew by themselves but yet again, lessons were not inscribed in their memories, they still put their hands in it once again.
Here, if history does not teaches investors a lasting lesson. These sort of investors should in fact behave like how Buffett once described: "A cat who once sat on a hot stove will not sit on another stove again, hot or cold." At least, the behavior akin to the cat will save these investors from losses. But if an investor is able to learn from the past, he or she must never behave like this cat to avoid the market even if it is to his advantage.