Saturday, December 01, 2007

Probability and its relevance to life

Why do we lose money in our ventures, be it business, lottery, gambling, stocks? Marcus Tullius Cicero cited “Probability is the very guide of life.”

Between winning and losing, it is a 50/50 chance of each events happening. Some quarter of the population thinks it is difficult or even impossible to overcome the odds for the market or outcome of an event is always efficient. Warren Buffett said “if the market is always efficient, I’d be a bum with a tin can lying on the street.”

Probabilities of an event happening are like guesses. Whoever that has the most accurate information that goes through a thoughtful process will have a higher likelihood of getting a higher probability of guessing the event rightly. The question in a successful life of getting what you want is “How likely do we believe that some sort of event will occur?” There are again two sides to the guesses, the good guesses and the bad guesses. The theory of probability is a system for making better guesses.

Probability can either be estimated based on its relative frequency (the proportion of times an event happened in the past) or by making an educated guess based on past experiences or whatever important and relevant information or evidence is available.

How likely is it a hurricane strikes Texas?

According to the National Hurricane Center, there’ve been 36 hurricane strikes in Texas from 1900 to 1996. Based on based experience and barring no change in conditions, we can estimate there is about a 37% chance that a hurricane will strike Texas in any given year. This figure is also called the base rate of frequency of outcomes.

In order for relative frequency to be accurate and use it for our future guide, we must ensure that the conditions that produced the past frequency of events remain relatively unchanged.

Besides ensuring conditions remaining pretty much the same as before, we must also look at the variations of outcome and severity – the level of damage caused by an event. Take Tornadoes for example, according to the National Climate Data Center, between 1950 to 1999, there has been an average of 810 tornadoes yearly in the United States. But in 1950, there were 201 tornadoes causing 70 deaths, in 1975 there were 919 causing 60 deaths, and in 1999, there were 1342 tornadoes causing 94 deaths.

At times, a doctor says, “This is the first time I’ve seen this disease. I estimate there’s a 50-50 chance that the patient will come through.” This statement has only two possible outcomes. Either the patient dies or not. Probing further, does then saying 50-50 chance of surviving makes any sense if there is no past date or other evidence to base the probability on? Does it really tell us something? If there is no historical comparable or representative date to base an estimate on, the probability figure only measures the doctor’s belief in the outcome of the event. And to say 50-50 chance of an unprecedented event is a statement any one can intelligently make.

Another doctor says, “According to medical records of similar cases, under the same conditions, 50% of the patients survived five years or longer.” The more representative the background data we have the better our estimate of the probability.

Events may happen with great frequency or rarely. Some events are not repeatable and some events have never happened before. For certain events, past experience may not be representative. Others are characterized by low past frequency and high severity. Unforeseen events occur where our actual exposure is unknown. The more uncertainty there is, the harder it is to find a meaningful probability. Instead our estimate must be constrained to a range of possible outcomes and their probabilities.

Uncertainty increases the difficulty for insurers to appropriately price catastrophes, such as hurricanes or earthquakes. Warren Buffett says:

Catastrophe insurers can’t simply extrapolate past experience. If there is truly “global warming,” for example, the odds would shift, since tiny changes in atmospheric conditions can produce momentous changes in weather patterns. Furthermore, in recent years there has been a mushrooming of population and insured values in U.S. coastal areas that are particularly vulnerable to hurricanes, the number one creator of super-cats. A hurricane that caused X dollars of damage 20 years ago could easily cost 10X now.

But Warren went on to say it is possible to price sensibly.

Even if perfection in assessing risks is unattainable, insurers can underwrite sensibly. After all, you need not know a man’s precise age to know that he is old enough to vote no know his exact weight to recognize his need to diet.

How reliable is past experience for predicting the future then? Peter Bernstein in his book, In Against the Gods, refers to a 1703 letter written by German mathematician Gottfried Wilhelm von Leibniz to the Swiss scientist and mathematician Jacob Bernoulli referring to mortality rates: “New illnesses flood the human race, so that no matter how many experiments you have done on corpes, you have not thereby imposed a limit on the nature of events so that in the future they could not vary.” Even with the best empirical evidence, nobody knows precisely what will happen in the future.

After 9/11, Warren Buffett wrote the importance on focusing on actual exposure and how using past experience sometimes can be dangerous.

In setting prices and also in evaluating aggregation risk, we had either overlooked or dismissed the possibility of large-scale terrorism losses. In pricing property coverages, for example, we had looked to the past and taken into account only costs we might expect to incur from windstorm, fire, explosion and earthquake. But what will be the largest insured property loss in history originated from none of these forces. In short, all of us in the industry made a fundamental underwriting mistake by focusing on experience, rather than exposure, thereby assuming a huge terrorism risk for which we received no premium.

Experience, of course, is a highly useful starting point in underwriting most coverages. For example, it’s important for insurers writing California earthquake policies to know how many quakes in the state during the past century have registered 6.0 or greater on the Richter scale. This information will not tell you the exact probability of a big quake next year, or where in the state it might happen. But the statistic has utility, particularly if you are writing a huge statewide policy.

At certain times, however, using experience as a guide to pricing is not only useless, but actually dangerous. Late in the bull market, for example, large losses from directors and officers liability insurance (D&O) are likely to be relatively rare. When stocks are rising, there’re a scarcity of targets to sue, and both questionable accounting and management chicanery often go undetected. At that juncture, experience on high-limit D&O may look great.

But that’s just when exposure is likely to be exploding, by way of ridiculous public offerings, earnings manipulation, chain-letter-like stock promotions and a potpourri of other unsavory activities. When stocks fall, these sins surface, hammering investors with losses that can run into the hundreds of billions.

Even if we can’t estimate the probability for some events, there may be some evidence telling us if their probabilities are increasing or decreasing. Ask: Do I understand the forces that can cause an event? What are the key factors? Are there more opportunities for the event to happen?

Warren Buffett says on terriorism:

No one knows the probability of a nuclear detonation in a major metropolis area this year….Nor can anyone, with assurance, assess the probability in this year, or another, of deadly biological or chemical agents being introduced simultaneously…into multiple office buildings and manufacturing plant.

Here’s what we do know: a. The probability of such mind-boggling disasters, though likely very low at present, is not zero. b. The probabilities are increasing, in an irregular and immeasurable manner, as knowledge and materials become available to those who wish us ill.

Low frequency events

Adam Smith, a Scottish philosopher, said: The chance of gain is by every man more or less overvalued, and the chance of loss is by most men undervalued.

Supreme Court Justice Oliver Wendell Holmes, Jr. said: “Most people think dramatically, not quantitatively.” We overestimate the frequency of deaths from publicized events like tornadoes, floods, homicides, and underestimate the frequency of deaths from less publicized ones like diabetes, stroke, and stomach cancer. Why? We tend to overestimate how often rare but recent, vivid or highly publicized events happen. The media has an interest in translating the improbable to the believable. There’s a difference between the real risk and the risk that sells papers. A catastrophe like a plane crash makes a compelling news story. Highly emotional events make headlines but are not an indicator of frequency. Consider instead all the times that nothing happens. Most flights are accident-free. Ask: How likely is the event? How serious are the consequences?

John is board a plane tomorrow and wonders, “How likely am I to die on this trip?”

What is the risk of a disaster? First, we need to know the available record of previous flights that can be compared to John’s flight. Assume, we find that in 1 out of 10,000 flights there was an accident. The record also shows that when an accident happens, on average 8 out of 10 are killed, 1 injured, and 1 safe. This means that the chance that a passenger will be involved in an accident is 1 in 10,000; being killed, 1 in 12,500 (10,000/0.8); being injured, 1 in 100,000 (10,000/0.1).

According to the National Transportation Safety Board, the number of passengers killed in air accidents in the U.S. during 1992 to 2001 was 433. For reference, in 2001, the annual number of lives lost in road traffic accidents in the U.S. was 42,119.

That people feel safer driving than flying makes sense since we are orientated towards survival. As Antonio Damasio says in Descartes’ Error, “Planes do crash now and then, and fewer people survive plane crashes than survive car crashes.” Studies also show that we fear harm from what’s unfamiliar much more than mundane hazards and by things we feel we control. We don’t feel in control when we fly.

Why do we lose money gambling? Why do we invest in exotic long shot ventures?

We often overestimate the chance of low probability but high-payoff bets. For example, how likely is it that anyone guesses a number between 1 and 8 million? What is John’s chance of winning “Toto (6 winning numbers out of 45)” if there are 8 million outcomes? What must happen? He must pick 6 numbers out of 45 and if they all match the winning numbers, he wins. What can happen? How many permutations can he chose from? The possible number of ways he can chose 6 numbers out of 49 is 8,145,060. The probability that someone chooses the winning combination is thus one in about 8 million. An odd merely slightly better than throwing heads on 20 successive tosses of a coin.

Imagine the time it takes to put together 8 million combinations. If we assume each combination on average takes a minute to put down on paper, and John spend 24 hours a day writing the numbers, it will take him 15.5 years to write them all down.

Even if John invests $8 million to buy 8 million tickets in the hopes of winning a $15 million jackpot, he may have to share the jackpot with others that picked the winning number. If just one other person picked the winning combination, he would lose $0.5 million.

Why do people play a game when the likelihood of losing is so high? Even if we exclude the amusement factor and the reinforcement from an occasional payoff, it is understandable since they perceive the benefit of being right as huge and the cost of being wrong as low – merely the cost of the ticket or a dollar. It brings us back to Benjamin Franklin’s teaching: “He that waits upon fortune, is never sure of a dinner.”

Chance has no memory

How many times have we heard “My luck is about to change. The trend will reverse.” Sir John Templeton cited: “The four most expensive words in the English language are, ‘This time it is different.’”

We tend to believe that the probability of an independent event is lowered when it has happened recently or that the probability is increased when it hasn’t happened recently. For example, after a run of bad outcomes in independent events that appear randomly, we sometimes believe a good outcome is due. But previous outcomes neither influence nor have any predictive value of future outcomes. There is neither memory nor a sense of justice.

John flipped a coin and got 5 heads in a row. Is a tail due next? It must be, since in the long run heads and tails balance out.

When we say that the probability of tossing tails is 50%, we mean that over a long run of tosses, tails come up half the time. The probability that John flips a head on his next toss is still 50%. The coin has no sense of fairness. As the 19th century French mathematician Joseph Bertrand said: “The coin has neither memory or consciousness.” John committed the gambler’s fallacy. This happens when we believe that when something has continued for a certain period of time, it goes back to its long-term average. This is the same as the roulette player when he bets on red merely because black has come up four times in a row. But black has the same chance as red to come up on the next spin. Each spin, each outcome is independent of the one before. Only in the long run will the ratio of red to black be about equal.

Every single time John tosses, the probability it lands on heads is 50% and tails 50%. Even if we know that the probability is 50%, we can’t predict if a given flip results in a head or tail. We may flip heads ten times in a row or none. The laws of probability don’t count our luck.

John thought, “I got a speeding ticket yesterday, so now I can cross the speed limit again.” Even criminals suffer the gambler’s fallacy. Studies show that repeat criminals expect their chance of getting caught to be reduced after being caught and punished unless they are extremely unlucky.

John finds it comforting knowing it will take another 99 years until the next giant storm happen.

What is a 100-year storm? To predict storms we look at past statistics. We also assume that the same magnitude of storm will occur with the same frequency in the future. A 100-year storm doesn’t mean it happens only once every 100 years. It could happen any year. If we get a once in 100-year storm this year, another big one could happen next year. A 100-year storm only means that there’s a 1% chance that the event will happen in any given year. So even if large storms are rare, they occur at random. The same reasoning is true for floods, tsunamis, or plane crashes. In all independent events that have random components in them, there is no memory of the past.

Controlling chance events

We believe in lucky numbers and we believe we can control the outcome of chance events. But skill or effort doesn’t change the probability of chance events.

Someone offered John to exchange his lottery tickets. John said: “Change tickets. Are you crazy? I would feel awful if my number comes up and I’d traded it away.”

In one experiment a social psychologist found that people were more reluctant to give up a lottery ticket they had chosen themselves, than one selected at random for them. They wanted four times as much money for selling the chosen ones compared to what they wanted for the randomly selected ticket. But in random drawings, it doesn’t make any difference if we choose a ticket or are assigned one. The probability of winning is the same. The lesson is, if you want to sell lottery tickets, let people choose their own numbers instead of randomly drawing them.

The consequences of being wrong

“Pascal’s Wager” is the application by Blaise Pascal of the decision theory for believing in God. Pascal reasoned that it is a better “bet” to believe that God exists than not to believe because the expected value of believing is always greater than the expected value of not believing. He thought: If we believe in God, and God exists, we would gain in afterlife. If we don’t believe in God, and God exists, we will lose in afterlife. Independent of the probabilities of a God, the consequences of not believing are so awful, we should hedge our bet and believe.

Pascal suggests that we are playing a game with 2 choices, believe and not believe: If God exists, and we believe God exists, we are saved. This is good. If we don’t believe, and God is unforgiving, we are damned. If we believe but God doesn’t exist, we miss out on some worldly pleasures. If God doesn’t exist and we don’t believe that God exists, we live a normal life.

Pascal said: “If I lost, I would have lost little. If I won I would have gained eternal life.” Our choice depends on the probabilities, but Pascal assumed that the consequences of being damned as infinite, meaning the expected value of believing is least negative and therefore he reasoned that believing in God is best no matter how low we set the probability of God exists.

John wants to make some extra money and is offered to play Russian roulette. If John wins he gets $10 million. Should he play? There are 6 equally likely possible outcomes when he pulls the trigger – empty, empty, empty, empty, empty, bullet. This makes a probability of 5/6 or 83%.

Should he play this game once? The probability is 83% that he gets $10 million. The probability is only 17% that he loses.

Let’s look at the consequences. If John doesn’t play and there’s a bullet he is glad he didn’t play. If he plays and there is a bullet, he dies. If he doesn’t play and there is no bullet, he loses the pleasure the extra money could have brought him. If he plays and there is not bullet he gains $10 million which would buy him extra pleasure. To play is to risk death in exchange for extra pleasure. There’s an 83% probability that John is right but the consequence of being wrong is fatal. Even if the probabilities favor him, the downside is unbearable. Why should John risk his life? The value of survival is infinite, so the strategy of not playing is best no matter what probability we assign for the existence of “no bullet” or what money is being offered. But there may be exceptions. Someone that is poor, in need of supporting a family who knows he will die of a lethal disease within 3 months might pull the trigger. He could lose 3 months of life, but if he wins, his family will be taken care of after his death.

We should never risk something that we have and need for something that we don’t have and don’t need. But some people pull the trigger anyway. This is what Warren Buffett said about the Long Term Capital Management affair:

Here are 16 extremely bright – and I do mean extremely bright – people at the top of LTCM. The average IQ among their top 16 people would probably be as high or higher than at any other organization you could find. And individually, they had decades of experience – collectively, centuries of experience – in the sort of securities in which LTCM was invested.

Moreover, they had a huge amount of their own money up – and probably a very high percentage of their net worth in almost every case. So here were super-bright, extremely experienced people, operating with their own money. And yet, in effect, on that day in September, they were broke. To me, that’s absolutely fascinating.

In fact, there’s a book with a great title – You only have to get rich once. It’s a great title, but not a very good book. (Walter Guttman wrote it many years ago.) But the title is right: You only have to get rich once.

Why do very bright people risk losing something that’s very important to them to gain something that’s totally unimportant? The added money has no utility whatsoever – and the money that was lost had enormous utility. And on top of that, their reputation gets tarnished and all of that sort of thing. So the gain/loss ration in any real sense is just incredible. Whenever a really bright person who has lost a lot of money goes broke, it’s because of leverage. It’s almost impossible to go broke without borrowed money in the equation.

Wednesday, October 10, 2007

The Kelly Formula make easy

Some 50 years ago, John Larry Kelly came up with a formula to determine how much you should bet on a gamble or investment to optimize your bankroll. Now known as the Kelly Formula, the equation determines the optimal percentage of your cash to bet on a favorable bet.
Let’s talk about this a little as I find it an interesting concept and it echoes somewhat on my perspective of life and principle towards investing – bet (read invest) when the odds are with you or otherwise do nothing. So I guess again I should try to be a copycat. But heck, it pays to be one.

What is Kelly Formula?

I first came across Kelly Formula in the book, Fortune’s Formula. The history of it is detailed in the book that also happens to be a favorite book of Charlie Munger. Despite all the odds, a minority of gamblers – unsure if I should really classify this group of minority as gamblers because of how they carry out their bets that in high likelihood they shouldn’t be for they know what they are doing - still able to make a lot of money. For example, in Hong Kong, people are wild over horse racing, yet somebody was actually making a lot of money despite the croupier’s take because that person was able to develop some form of an algorithms that taught him how much to bet each time given the odds. One of such algorithms is the Kelly Formula that seems quite plausible. The gist of it makes sense in terms of sizing your bet according to the odds.

In essence, the Kelly Formula is a mathematical formula that is used to maximize the long-term growth rate of a series of repeated bets that have a positive expected value. Huh?

The Kelly Formula simply figures out how much to bet if the odds are in your favor – in Vegas, in card games, in the stock market, in a coin flip, whatever. The equation of the Kelly Formula can be simplified to:

That is the simplified formula. The actual formula (for purists) is:

A Kelly Example

Let’s say you have $1,000 in cash and someone offers you 2 to 1 on a coin flip. That is, they’ll pay you $2 if it comes up heads or you’ll lose $1 if it comes up tails. The Kelly Formula will tell you how much you should bet on the coin flip to earn the maximum amount of money.

By inserting the numbers in the formula, it shows:

In this coin flip gamble, the Kelly Formula tells you that the maximum you should bet on any flip is 25% of your bankroll – $250 in this case. Doing so will give you the maximum long-term growth with minimum downside.

The Kelly Formula Guarantees and its Weaknesses

Don’t fool yourself. There’s no perfect system to avoid all losses. All we can do is minimize losses, maximize gains, and optimize bankrolls. The Kelly Formula insures that you’ll never loss everything; still, it doesn’t guarantee that you won’t lose at times.

You never want to overbet the Kelly Formula. That is, you never want to put more of your bankroll than the formula prescribes.

At any rate, investing is somewhat like a coin flip offering favorable odds. On any given flip of the coin, you can lose money. Still, over the long term, if the odds are in your favor (as they are when you buy more of the dollar-for-fifty-cent cases rather than its contrast), you’ll make good money. In short, the Kelly Formula helps maximize your return though it does nothing for volatility that is something to understand about on how to think about stock prices.

Kelly Formula Applied to Investing

There’s one thing to note with the Kelly Formula when applying it to investing in businesses when they are on hot-fire sale: It would prescribe you to put a large portion of your bankroll into one business. That may not be a bad event actually. As said earlier, bet big when odds are highly favorable.

When you wait patiently for dollars to sell for half of it, the odds of winning is so large that it overwhelms the odds of losing, and you will end up putting 85% or more of your available bankroll into one position.

Now, if you try to run the Kelly Formula on most value stocks, what the model will tell you is likely to be you ought to put a high percentage of your bankroll in such position.

Does this make sense? Hell, it does to me at least. Why? Because the odds of a loss are so low and the odds of winning are so high.

So, why should we care about the Kelly Formula?

For one, it helps us understand that it is alright to own just a few holdings when the odds are good – be it five or fifteen.

Don’t focus on calculating the Kelly Formula for your investments and then diversifying based on your mathematical models. Rather, spend the time and energy finding “no-brainers” – investments that would be in that 85%-of-bankroll or more range. Then, buy the heck out of them.

Wednesday, September 26, 2007

Tips from Warren Buffett

Widely regarded as the most successful investor of all time, Warren Buffett is a luminous example of the school of value, or rather intelligent, investing. With an initial war chest of $105,000 in 1956 garnered from his close friends and family, Warren grew it to over $45 billion over the next 50 years, making him the second richest man in the world. How did a single simple man from the quietest of all cities, Omaha, manage to bulldoze his way to such position, and in the process, became a major owner in some of the most important businesses in the world? Though he is widely recognized as being an investor, the bulk of Buffett’s wealth was built through intelligent use of leverage offered by his insurance companies. Since most individual investors do not have access to the type of capital that Buffett does, it is tough to replicate his type of astounding wealth-building feat. Nevertheless, not being able to be like Buffett doesn’t mean unable to be at least like Graham. So, by understanding and applying the basic principles of Buffett’s investment approach to their own investing decisions, most long term investors can comfortably beat the returns of all but the best mutual fund managers.

“There’re only two courses investment students need to learn – How to value a business & How to think about market prices. This of course is not the prevailing view at most business schools [but it doesn’t dampen its importance].” – Warren E. Buffett

Thus, in an attempt to answer the two questions as raised. The following will shed some light to unraveling the answers.

Invest in Businesses, not in stocks

“Whenever we buy common stocks for Berkshire’s insurance companies (leaving aside arbitrage purchases), we approach the transaction as if we were buying into a private business. We look at the economic prospects of the business, the people in charge of running it, and the price we must pay.” – Warren Buffett

This is one of the cornerstones of Buffett’s investment style. Whenever he evaluates an opportunity in investment, he thinks of it as a business, and not as pieces of papers of stocks. He even noted that investment is best approached in the most business-like manner. This makes him look closely at the business’s fundamentals, earnings prospects, financial health, and management. On the converse, this style of evaluating a business bars him from buying a stock just because it is going up even though it has dubious prospects. A lot of investors tend to buy stocks based on tips from friends, rumors, or brokers. By adopting Buffett’s approach, you can save yourself a lot of grief later on, although in the short term, it would seems that you forego a lot of easy and quick profits.

Stick to businesses you understand

“Did we foresee thirty years ago what would transpire in the television manufacturing or computer industries? Of course not. Why, then, should Charlie and I now think we can predict the future of other rapidly evolving business? We’ll stick instead with the easy cases. Why search for a needle buried in a haystack when one is sitting in plain sight?” – Warren Buffett

Buffett has a record of compounding over 20 percent of annual returns over a 50-year investment time span, a feat hardly matched, or rather unmatched, by very few investment managers. Though some technology companies delivered some of the best returns during this period, Buffett has never owned one for the simple reason that he could not understand the long term economic prospects of these companies. So the next time you get a tip to buy a “hot” company that you do not understand, you should ask yourself: “If the greatest investor in the world will not invest in something he doesn’t understand, should I?”

Buy companies with defensible “franchises” or “moats”

“As Peter Lynch says, stocks of companies selling commodity-like products should come with a warning label: ‘Competition may prove hazardous to human wealth’.” – Warren Buffett

Bulk of Berkshire Hathaway’s holdings in marketable securities are concentrated in no more than ten businesses – such as Coca Cola, P&G, Johnson & Johnson, Moodys, and American Express. These are examples of businesses that have a significant hold over their market that they are in. This can be attributed to the inherent competitive advantages, whether it be a highly recognizable brand, or near-monopoly status in a geographical area. This in turn leads to fantastic earnings growth (that far exceeds inflation rate) and, consequently, great investment performance. What counts in the best kind of business to own is the question if such a business can raise price as it wants to without losing market share.

A couple of test on how to evaluate how good a business is to ask two questions: 1) How long does the management takes to think before they decide to raise prices; 2) Will the core business strength be the same as it is five or ten years from now? You have to decide whether the business will still be around, and if there’s any other way people can get the same service from different sources. In determining the ability to raise prices, you’re only looking at a marvelous business when you look in the mirror and say “mirror, mirror on the wall, how much should I charge for Coke this fall?” and the mirror says “more.” On the other hand, when you say, for example in a commodity-like business, when you get down on your knees, summon all the priests, rabbis, monks, and just about every holy ones, and pray to rise for “just half a cent.” Then you get up and they say “We won’t pay it.” It’s just a lousy business. An example is if you walk into a convenience store and you say “I’d like a Hershey bar” and the man says “I don’t have any Hershey bars but I’ve this unmarked chocolate bar, and it’s 20cents cheaper than a Hershey bar.” And if you just walk out of the store and cross the road and look for a Hershey bar, that’s a great business.

Over time, you will find only a few companies that meet these stringent standards. So when you see one that qualifies, you should buy a meaningful amount of stock.

Hold for the long term

“We are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate……we do not sell our holdings just because they have appreciated or because we have held them for a long time.” – Warren Buffett

“You must also resist the temptations to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upwards over the years, and so also will the portfolio’s market value.” – Warren Buffett

Berkshire Hathaway’s investment of $10 million in 1973 in the Washington Post Company had grown to more than a billion by 2003. While a lot of us may be able to do this occasionally, Buffett has been able to do so with startling regularity. One of the reasons he is able to achieve so is because he holds for the long term and is not quick to dance in or out or the business as would the market suggests so. In fact, he stuck with WPC for two years even though its price fell below his purchase price significantly because he understood the fundamentals of the business and believed it was undervalued. Even once it became profitable, he was not quick to exit because it is firstly not easy to find a great business at a fair price that can be purchased in a meaningful amount and also, good management cannot be purchased at any price. He held it through several bull and bear markets and no greater proof is needed than the return he achieved to show that he was right in holding it for the long run.

Ignore short-term fluctuations in price

“Charlie and I let our marketable equities tell us by their operating results – not by their daily, or even yearly, price quotations – whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it.” - Warren Buffett

One of the most famous quotes of Benjamin Graham that is imprinted and cast in stone in Buffett’s mind is “In the short run, the stock market is a voting machine, in the long run, it is a weighing machine.” The stock market has an incurable tendency to overreact on both the upside and downside. Often the market ignores the fundamentals of a business and reacts sharply to news flow. Sometimes entire sectors become either overly depressed or overdriven by euphoria. Ben Graham, having one of the best brains in understanding the behavior of the market participants, told the story of an imaginative character – Mr. Market. If Mr. Market is happy, he will offer you an extraordinary high price to buy out your stake for he fears you will make more than him. If he is depressed, he will sell you his stake at a low price for he fears you will unload your interest on him. One of the pillars to Buffett’s strategy is to ignore short-term fluctuations in price. If he does, it is to take advantage of it, not to let it guides him. He does not sell a stock because the market suddenly drops. Neither, does he buy because it goes up. He will only buy the stock once he thinks that the business fundamentals are correct and at a good price. If the business is great but the price is not, he will wait. He waited for over 50 years before he buys his first share in Coca Cola. Even if the stock dips after he purchases it, he does not worry so long as its fundamentals are good. He said: “The less they sell for, the better I like it. Any time any thing gets cheaper, I like it better than I did the day before.” Had he got jittery due to short-term price fluctuations, he would have been a lot less richer than he is currently.

Buy good businesses when prices are down or at rational prices

“If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get his one wrong. Even though they are going to be net buyers of stocks for many years to come, they feel elated when stock prices rise and depressed when they fall. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective buyers should much prefer sinking prices.” – Warren Buffett

“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.” – Warren Buffett.

On 19th October 1987, all global stock markets crashed. The Dow Jones Industrial Average suffered its greatest single-day drop in its history by 22%. Every stock on the market fell. Most people sold their holdings in panic that day. Buffett, however, was scooping them up. He made the single largest stock purchase of his life that day. While all others hit the panic button, Buffett scooped up ten percent of Coca Cola for $1 billion. Not only was it his largest single stock purchase, he also became the single largest shareholder in the company. In his analysis, Coca Cola had a great business franchise, great long-term prospects both in price and product, and the ability to expand because of globalization. If the market was willing to sell it at an unreasonable cheap price, he was willing to scoop it up with both hands. Coca Cola became one of his most famous and successful investments in Berkshire’s portfolio. By 2006, Berkshire’s gain on it was over $11 billion.

Besides purchasing businesses when prices drop, it is also important to purchase at a rational price. Investors must realize that it takes time for the stock to play catch up to the high price that they pay depending on how high they value each dollar of earnings in multiples. Investors who bought Coke in late 1990s at an earning multiple of 50 are still suffering about 20% deficit. Investors who bought Coke in the same period at an earning multiple of 30 is making at an average compounded return of 3%.

Be a passive investor, not an active trader

“Indeed, we believe that according to the name ‘investors’ to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a romantic.” – Warren Buffett

Buffett is an unusual investor not only because he is highly successful but also because he does not even look at stock tickers. He believes that trading too much is a tax-inefficient and costly approach to investing. As a result, he has a very low turnover portfolio, very low brokerage fees and has not paid very much in the nature of capital gain taxes (of course, capital gain tax in stocks is not applicable in Singapore).

Do not over-diversify

“If you are a know-something investor, able to understand business economics and to find five to ten sensibly priced companies that possess important long-term competitive advantage, conventional diversification makes no sense for you.” – Warren Buffett

A striking aspect of Berkshire’s portfolio is the small number of stocks in it. This number has rarely exceeded 10 stocks (for the long term holdings). Buffett believes that there’re very few outstanding investment opportunities at any given point of time and that one should invest enough in each of those to make a substantial difference. In contrast, most people (of course not retail investors because most do not have the kind of money, this is referring to fund houses, pension funds and such) fill up their portfolios with more than fifty stocks. As a result, even if a stock appreciates 100 percent, the impact on their net worth will only be 2 percent. Investors who want to generate truly outstanding returns should identify a small number of great businesses at the right prices and invest a significant amount of their money in each of them in order to make a big difference to the net-worth positively.

Invest only when there is a Margin of Safety

Buffett believes that the concept of margin of safety by Benjamin Graham is the most important cornerstone to the field of investment. Though it is slightly difficult to understand at times, it does not diminish its importance. It can be loosely defined as the difference between price and value. Price is easy to see but value is not, thus arising in the difficulty in understanding this concept. If the value of what you buy is higher than the price you pay for it, you have a margin of safety. When the margin of safety is high, the investor need not worry about short-term fluctuations in price and can buy more if he or she has the resources to do so. If you are putting your money in a business bought with a significant margin of safety, you are likely to make a higher return because you are buying at a relatively low price.

However, how does one quantify this margin of safety? It is admittedly a grey area. There’re seemingly scientific approaches such as discounted cash flow which are taught in most corporate finance textbooks. In practice, it is both highly subjective and very difficult for an individual investor to apply with accuracy. However, there’re some simplified ways that are more easily understood but has its own pitfalls. One way is to purchase stocks at a price below its net working capital.

Ignore macroeconomic events

“Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage & price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%. But, surprise – none of these blockbuster events made the slightest dent in Ben Graham’s investment principles. Nor did they render unsound the negotiated prices of fine businesses at sensible prices. Imagine the cost to us, then, if we had let the fear of the unknowns cause us to defer or alter the deployment of capital. Indeed, we’ve usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist. A different sort of major shock is sure to occur in the next 30 years. We will neither try to predict those nor profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results.” – Warren Buffett

Market participants generally have the habit to try to guess what the Fed is doing, what price oil will be in the next few months, or raise or fall in inflation. Buffett does not think it makes any difference whatsoever to an investor in stocks what they do today. Although his view is apparently not in line with the general public, I’m inclined to agree with him. Not because it came from him but more important, it’s better to be approximately correct than to be precisely wrong. He went on to explain that he wouldn’t care if the Fed raise their rates in terms of what he’d do in stock, even if he knew exactly what the Fed did do. The important thing in investing is to buy stocks in good businesses, at a reasonable price. Anybody that is buying or selling stocks based on what the Fed is doing, or what they think they’d do at their next meeting is destined not to have a great financial future. People who think they can dance in and out based on some tips or signals are only going to make their brokers rich, but they are not going to make themselves rich.

Intelligent investing = one that has both growth and value

“In our opinion, the two opinions are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous, and whose impact can be negative as well as positive.” – Warren Buffett

Most analysts think that value investing and growth are strategies of opposite poles. They think these two approaches are mutually exclusive where the fundamental investing are based on stocks with low price to earnings ratio, or price to book ratio, and growth strategies with the exact opposite characteristics. However, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments.

In Buffett’s initial investment career, he was famous for not paying two or three times book value of any company. In fact, he nearly forego buying See’s Candies because the owner wanted $30 million but Buffett was only willing to pay $25 million but fortunately, the owner then lower his price. This original strategy of paying low price to book ratio was effective for a while, but thanks to Charlie Munger, Buffett discovered it is far better to pay a fair price for a great business rather than a great price for a fair business.

Thus, opposite characteristics as advocated by Graham are in no way inconsistent with a “value” purchase. Indeed, value is what happens when a business can deploy a dollar to finance growth that creates more than a dollar in long-term market value. The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.

The problem with the traditional Graham method lies in that it may take an extended period in order for 50 cent to appreciate to a dollar. You don’t want a dollar bill that’s sitting for 50 cents and it’s only going to be a dollar bill ten years from now. What you should want is a dollar bill that’s going to compound at 12% for a long run.

With all that have been said, Buffett’s investment approach is easy to understand, but calls for significant effort on your part to understand businesses, evaluate them and invest successfully, but then, no one said that becoming a billionaire is easy.

Thursday, September 20, 2007

Comments on Case 1 (Fundamental and speculative return)

Last week, I posted an article on a case scenario to estimate the price a business is worth. Unfortunately and disappointedly, there was only one reply. In my view, I think it is important for an investor to think about the price that he is willing to pay so that it matches the rate of return that he expects in the future. There’re a few ways to put a price to a marketable security. One is to determine the intrinsic value by estimating the present value of all future cash and one other is what I will describe here and it has nothing much (or nothing at all) to do with the intrinsic value of the business. Neither does this method examine the future viability and strength of the business. As an investor, determining the future existence of the business is the most important factor over any other factors because if it doesn’t exist or its business is not viable, it makes no sense to any value that you calculate. So essentially, this method is purely about numbers and nothing more, proper investing must constitute more than numbers, it must be a latticework of many mental models.

In order to put a purchase price based on one’s expectation future rate of return, we shall look at how the past business performance and market valuation contributed to the price of today of $44.


1) Inversion – Road to the current price of $44. (Refer to previous article for full picture)

Let’s examine how did the stock price came to $44 from the year of 1980. The idea in this first step is to invert. Inversion is a great idea. It scrutinizes and examines all the contributing factors of an outcome. It is much like an investigative report into most things, like an accident report or something. We find out the source of the cause to predict into what will likely to happen in the future.

The stock price in 1980 was $0.12 and as of today, it is $44. The PE of the stock at $0.12 in 1982 is 11 and in 2007, at the price of $44, the PE is 16.3. The earning per share was 1.05cents in 1980 and in 2007, it was $2.71.

To understand how it spiraled from 12cents to 44 times on the dollar, there’re two major components that contributed to this phenomenal rise – 1) Fundamental return; 2) Speculative return, i.e. changes to the PE valuation.

In fundamental return, there’re two portions to be determined – 1) the compounded average EPS growth rate from 1980 to 2007; 2) the initial dividend’s yield based.

In this case, the EPS that moved from 1.05cents to $2.71 compounded at a rate of 22.85% for the past 27 years. The initial yield in dividend is 1.49%. Thus, giving a total fundamental return of 22.85% plus 1.49% that makes it 24.34%.

Now that we have determined the fundamental return, we shall determine the speculative return. As you can see for the past 27 years, investors in this business gradually value more of each dollar of the business earnings over time. It went from an earning multiple of 11 in 1980 to 16.3 in 2007. That means the PE translated to a compounded growth that averaged 1.45%.

Now let’s find out the average compounded growth of the stock price that went from 12cents to $44. It simply compounded at a rate of 24.6%.

Now if you add up both the fundamental return of 24.34% and the speculative return of 1.45%, it gives you a total real growth of 25.79%. Oh la la, now you may think that the return in stock price of 24.6% is pretty close to 25.79%, right? Well close, but not close enough. So, let’s make it even closer, since dividend is cash that is taken out from the business, it should be logically then deducted from the real growth of 25.79%, it will then gives you 24.3% after taking the dividend’s yield of 1.49%. Is it then a coincidence that 24.3% - the total of 1) average compounded return in EPS and 2) the return on the speculative component due to the changes in earnings valuation by the market – is so close to the actual average compounded stock price of 24.6%? That is something you have to think about based on what has been given so far – i.e. if what has been said thus far sounds logical to you.

A word of caution before going further: It is important to understand the logic of how the price of $44 is derived from the past performance. It is only upon understanding it would you then able to figure out the manner or thought process I would go about in trying to determine the example that I have given in Case 1 in the article I posted last week. For the benefit of those who do not know, here is the case presented.

A big retailer who has a past record of a far-above industry returns on invested capital and equity of over 20%. As such, its past performance in share price also compounded at a rate of over 20%. At its high two years ago in 2005, the stock price went to almost $60 and at this price the valuation then was 25 times earnings. However, in the past two years, the rate of growth on invested capital and equity slowed to a pace of slightly below 20% - a few percentage points drop. Similarly, the share price tracks the slight drop in return on capital and it is traded at $44 today at a valuation of about 16 times earnings. On the outlook, this would seems like a steal to most intelligent investors provided if the variables – return on capital, and valuation level – remain the same (into the foreseeable future).

However, every investor has a different take on a business. The question is if an should pay $44 today if he wants an average of 12% return on stock price for the next 20 years.

If Investor A thinks that the business economics will slow over time to 12% return on capital over the next 20 years on average, should he then pay $44 today if he expects an average of 12% return on stock price over the next 20 years?

If Investor B thinks that the business economics will maintain at about 18% to 20% return on capital over the next 20 years on average, is $44 today a steal and thus be able to gain him at least 12% return on stock price over the next 20 years?

Under both circumstances, if you stand in these investors’ position (what would you do?):

Under circumstance 1 (Investor A), a) what price would you pay if you want an average of 12% return on stock price for the next 20 years, and b) if you pay $44 today, do you think you would be able to achieve 12% return over the next 20 years, and if not, what return would you think you can gain if you pay $44 today?

Under circumstance 2 (Investor B), what price would you think the stock price will be in 20 years time?

2) Is $44 a correct price for a 12% return on stock price over the next 20 years (assuming return on capital falls to 12%)
Just to jot your memory, in the past, the historical return on capital is over 20% and with this performance, its earnings valuation is 16.3 times. So if return on capital is to drop to 12%, then logically, the valuation for each dollar of earning would also fall commensurately. So we shall assume, the final PE valuation would be 10 times at the end of the 20 years.

Since in the past return on capital of over 20% produces an almost similar return on EPS (22.85%), we shall then assume it to be the same in the future. That means we shall take the average compounded rate of EPS in the next 20 years to be 12%. With 12% compounded growth on EPS, the EPS of $2.71 in 2007 will be $26.14 in 2027. Since we have fixed the final value of PE at 10 at the end of 20 years, it means that the eventual stock price in 2027 will be $26.14 x 10 = $264.14.

So does $264.14 in 2007 gives you an average of 12% return on stock price? If you pay $44 today and you expect 12% return for the next 20 years, it means you want the stock to be worth $424 in 2007. So obviously, $264.14 falls way short of 12% that you have expected – 38% short.

So if you pay $44 today, and the eventual stock price is $264 in 2027, that translates to an average compounded growth on stock price of 9.3%. It falls short by 2.7% of your expectation.

So now you may again ask how is it possible that it falls shorter than the growth in EPS of 12%? Well, again, the stock price is determined by two factors – the fundamental return (only take in account EPS growth, ignore dividend here) and the speculative component.

We know the fundamental return is 12% for EPS. And now we have earlier assumed that the PE of 16.3 in 2007 will fall almost commensurately because of the deterioration of the return on capital. So the PE falls from 16.3 to 10 in 2027 eventually. And this fall in PE over the next 20 years resulted in a negative compounded return of –2.4%. So 12% minus 2.4% equals to 9.6% and this is very close to the 9.3% as calculated.

So by paying $44 today and if you expect the business’s return on capital to falls to 12%, the likelihood is that you’d be disappointed if you are looking for a 12% return on stock price.

So the next question, you may be asking is “Then how much should I pay for if I want a 12% return?” Simple, if you think the eventual PE is 10 because the average return on EPS or capital falls to 12%, then you should only pay $27 today (divide $264 by a factor of 1.12 back by 20 times).

Anyway, I’ll not do the example on the second circumstance because it is quite obvious that the investor would easily fulfill the hurdle rate he sets for himself. This is because if the return on capital in the future is about the same as it is now, the return on EPS will be close to 18% and the drop in eventual PE will be minimal. So it will be quite easy.

In case you miss out, you think that 12% and 9.3% do not give much difference, or you think “so what if I get 9.3% or 12%, it is small difference.” Then this example will show you that the eventual net worth is large in magnitude and wide in disappointment. Because if a stock is to compound at 12% return, it’d be worth $424 in 20 years, and if it did at a rate of 9.3%, then it is about $264 – a difference of $160 (almost 4 times your original principal). Imagine that this investment is a house that you buy, it means you have 4 less houses in 20 years than you could have had – now it probably sounds very huge to you for this difference in 2.7% in performance.

Maybe you are thinking that one single calculation may not be true for all the rest. In fact, I have did quite a few others and all shows similar result. In addition, I pick a random stock on SGX now just for this article – Singtel – to show what causes the price if an investor had bought in 2001 at $1.75 results in if he is still holding it as at today which trades at $3.78.

In 2001, the EPS was 13cents and the EPS in 2007 is 23.25cents which translates to a fundamental compounded growth of 10.2% on EPS. At the price of $1.75 which an investor had gotten in 2001, he was paying at a multiple of 13.46 for each dollar of earnings. As at today, the earning multiple is 16.26. This increase in PE from 13.46 to 16.26 represents a compounded growth of 3.2%.

So when you add the EPS fundamental growth and the speculative growth, you have a total growth of 13.4%. So how did the stock perform? Singtel went from $1.75 in 2001 to $3.78 as of today which represents a compounded growth of 13.7%.

Hopefully, the article makes some sense to you or it do helps you to think a little bit more. Maybe the thought process or idea may not be perfect but this is the first time I’m thinking it through in this manner – if you have some ideas to improve on, do drop a note.

All in all, I think fundamental growth is much easier to predict for the future, but not speculative. So it is always better to based an investor calculation more on fundamental growth rather than to bank on the market to value each dollar of earning of a business more.

In any case, there’re a lot of numbers involved here and it may confuse you. And if need be, you may request for the excel file which I did to arrive at the conclusion.

Monday, September 17, 2007

Is Diversification an "illusion"?

Most gurus are usually focused investors, from Warren Buffett to Charlie Munger to Mohnish Pabrai. These three gurus, at least two of them qualify to be named the “deans” of value investing and my personal heroes, all believe in making large bets when the odds are in their favor. Buffett’s purchase of American Express during the “salad oil” scandal of 1963 had him put 40% of Buffett’s Partnership assets into one single asset. Buffett in his speeches to college students is famous for mentioning the card with ONLY 20 punches for their entire investment career. He said that each student or investor should imagine they each are holding a punch card where there’re only 20 opportunities for you to enter into an investment. This will makes one think deeply and seriously to minimize their number of tries although it doesn’t seems to most people that the more they limit their swings, they more they would be able to find themselves holding back their swings in order to wait for the fat pitch. Personally, I think most investors have the misconstrued idea that the more tries they have and the more they try to switch from one boat to another, the higher their chance of beating the market or the general performance – I may be wrong but I think no one has been able to do so consistently or more important, sustainably. If you can ignore the noise when others tell you “swing, you bum!” and think by yourself, you’ll be much better off financially and emotionally.

So every time you make an investment, you punch your card once. It’s difficult to really get 20 wonderful decision in an investment lifetime. But it is possible to get a couple, or even a few. And these few wonderful ideas would make you a very wealthy person.

Buffett did not get rich by jumping ship whenever Wall Street paints a different picture. He got rich mainly because he is 1) objective; 2) focused (both in thoughts and betting when the odds is right); 3) waiting for the fat pitch and betting big when it comes. He is smart for sure but that has probably less to do with his investment success than being objective and logical. There’re many people who are as smart as him in terms of I.Q. But in investing, the most important quality, according to Buffett, is not how much IQ you’ve got, but rather temperament. You can have an IQ of 150 but you can be pauper if you lack the emotion needed in investing (Long Term Capital Management is one prime example). A reasonable amount of intelligence is required but temperament is 90% of it.

So when you restrict yourself to 20 opportunities in investing, it is essentially telling yourself you must not diversify. In Buffett’s words, DIVERSIFICATION is only for people who do not know what they are doing. Well, although I have to admit diversification is on the whole good for people who do not have the prerequisites to proper sustainable investing, then putting money in a diversified mutual funds or ETF is the best investing method. One thing to note for investors who invest in funds that track the market, they cannot and must not expect their returns to be better than what the index or market can perform on the average, or even on a yearly basis for any of the year that they have their money in the fund. Why? Any funds that track the market will always tag along to the market performance, and in any case, investors have to pay haircuts or commissions to the intermediaries. So the return must logically be less than the market performance. But what an investor can do to ensure that his long term result is better than most other investors who similarly have invested in a fund that tracks the market is to find the fund that has the least cost and low turnover rate because cost is the component that caused the fund performance to be below that of the market index.

If you chose to be one who wants to have the fun and experience to be a true investor, then the idea of restricting oneself to 20 opportunities is a big idea. But the important thing here is to be able to recognize those 20 ideas when you see them, and that you do something about them. There’re only few questions an investor should ask themself in order to identify such Twenties. First question is “how long does it takes the management to have to think before they decide to raise prices?” The ability to raise prices coupled with the ability to differentiate yourself in a real way means you can charge a different price and that makes it one-half towards being a great business. Then the next question to ask is “will the business still be around five or 10 years from now?” And if they do, “will their customers be able to get their fixes, services or products from some other different sources?” Essentially, these are questions an investor must ask before investing and the key is to identify firstly, great businesses and then secondly, to purchase a meaningful amount at a fair price, or even better unvalued price. These questions are simple enough but it is actually more in depth which I shall write a little more in my next article.

Charlie Munger, in his speech at USC in 1994 on a Lesson on Elementary, Worldly Wisdom as it relates to Investment Management and Business, said that you wait until you find a mispriced opportunity. The wise ones bet – read invest – only when they get that great opportunity – read fat pitch in Buffett’s words. They bet big when they have that opportunity. The rest of the time they don’t, it’s that simple. Ironically, most people, they find themselves smarter when they try to do more and to have more tries. Later in the same speech he says that “most of Berkshire Hathaway and all of its accumulated billions, the top ten insights account for most of it. And that’s a very brilliant man. Warren’s a lot more able than I am and very disciplined…devoting his lifetime to it. I don’t mean to say that he’s only had ten insights. I’m just saying that most of the money came from ten insights.” Right now Berkshire’s top 6 marketable stocks account for 70% of their stock’s portfolio.

Mohnish Pabrai manages Pabrai Investment Funds and, since 1999, has delivered annualized returns of over 28% (net to investors). With a track record like that, he’s worth listening to (at least somewhat because it takes a much longer time in order to be recognized as a great investor). As of March 31, 2007, Pabrai registered 13 holdings in his portfolio. A steel producer, IPSCO, comprises over 18% of his portfolio. In his book, “Few bets, big bets, and infrequent bets,” is the title to Chapter 10.

Now really do we need further analysis to prove all the above? I understand there’ll always be many investors who are “impatient” and want to own “many stocks” or even “jumping from flower to flower.” It is good to have more such, in fact, I hope so because it reduces the pool of serious investors who are of a better grade. But the question to ask is which side do you like to be on. Each person needs to do what suits their personality best. I cannot guarantee you that the stock you buy at 45 times earnings have no chance of going to 70 or 80 but I can tell you the likelihood is against you. The stock that you buy at 45 times earnings that doubles in 6 months might be profitable but you are not practicing value investing. (DISCIPLINE we are talking about here.) The true value investor bets infrequently and on stocks that are “priced” appropriately. Buffett has not, never before, and apparently never will buy any stocks that are priced at 35 times earnings. Walmart, Coke, Gillette, Geico, Johnson and Johnson, Wells Fargo or any of his other holdings that got him the bulk of his wealth were not bought at PE that were 35 or even 25 for the matter. They were purchased when they were “teenagers” (PE in their teens). Pabrai in an interview in early 2007 says that the number one trait a successful investor needs is patience. He even admitted that he is a shameless cloner of Buffett.

One thing to add besides what have been communicated by my heroes, or even Pabrai is the fact that in life, not everyone will feel they’re as much rewarded financially than they’re intellectually. But personally, I think intellectual reward is much gratifying than financial rewards. In most cases, intellectual rewards will lead to financial rewards but not necessarily on the same scale that you feel or expect it to be. Having said that, a person only can have about 3 meals and 24 hours a day, so why the heck does one really need to be rewarded financially way beyond what they really need? Having 2X financially may initially make you jump for joy but not necessarily when you have 3X against 2X. Personally, I think it will be more rewarding and satisfying if the multiple of X, in terms of intellect, increases.

Want to make 28% compounded annually? Well, just be a shameless cloner. We don’t need to be an original thinker or inventor like Einstein or Mozart to be successful. Even Mozart led a miserable life because he overspent his income that is a nuttiness that sometimes accompanies even a smart guy like Mozart. And we can definitely see there’re many smart talented people in the investment community with a streak of nuttiness. After all that have been said, it seems investing is a simple game, although not easy by any means, but by no means is investing a difficult task. Essentially, if you can answer the few answers that are important – most are not – and applying those by finding the few ideas that cause extraordinary results and finally, have the wisdom and discipline to sit on your bum, you’re well on the way to a decent result, although it seems to be a boring one.

Thursday, September 13, 2007

Charlie Munger's Opening Note at Wesco 2007 Annual Meeting

The following is the opening remark from Charlie Munger, Vice Chairman of Berkshire Hathaway and Chairman of Wesco, during the 2007 shareholder’s annual meeting of Wesco Financial. The notes are done by Whitney Tilson. Maybe our local media should feature more of such informative investing guidance and news rather than some other market participants who may seems successful because of the post they are holding or because they seems rich but then, personally, the principles fall extremely way short of the decent manner to sustainable and reasonable method of investing. Especially some of those participating market members who acts like salesman, peddling any issues or ideas as long as it could be sold, some corners of the media may feature and publish such members market forecast and they earn big bucks and thus qualify as so-called investors that maybe others should look upon for advice. Well, it's like a quote I shall borrow that I came across in the media: "It's like dropping an object and then claiming credit for gravity."

Note: Words in brackets are Whitney’s comments, edits or, when Whitney missed something, his best guess of what was said.


I note that this year we’re in a tent. It’s amazing that a tent can be made to work so well. It’s a tribute to our civilization. If our ancestors had been in a tent, it would not be like this one, with air conditioning and so forth.

It’s amazing that all you people come. You know, I didn’t set out in life to become the assistant leader of a cult. [Laughter] As they say, experience is what happens when you’re looking for something else.

It’s amazing that many of you come to this meeting after the Berkshire meeting for so many years. It’s like the person at the Catholic church who doesn’t want the catechism changed.

People are obviously here to some extent to leave a little wiser than when they came. It’s very hard to do this by merely hearing someone else talk. That’s why most teaching is vivid. For example, when they trained soldiers for World War II, they shot real bullets above them, which really taught them to hug the ground.

That’s why so many learn lessons the hard way, through terrible experience. Mark Twain once said that picking a cat by its tail yielded better learning that was available in any other fashion. But that’s a terrible way to learn things. Another comic thought man ought to learn vicariously: you shouldn’t have to try it to learn not to pee on an electrified fence. [Laughter]

It’s really hard to get ideas from one mind into another. That’s why learning institutions are so selective.

I want to do something I haven’t done before. I feel obligated because many of you came from such great distances, so I’ll talk about a question I’ve chosen, one that ought to interest you: Why were Warren Buffett and his creation, Berkshire Hathaway, so unusually successful? If that success in investment isn’t the best in the history of the investment world, it’s certainly in the top five. It’s a lollapalooza.

Why did one man, starting with nothing, no credit rating, end up with this ridiculous collection of assets: $120 billion of cash and marketable securities, all from $10 million when Warren took over, with about the same number of shares outstanding. It’s a very extreme result.

You’ll get some hints if you read Poor Charlie’s Almanack, which was created by my friend, Peter Kaufman, almost against my will – I let him crawl around my office when I wasn’t there. He said it would make a lot of money, so he put up $750,000 and promised that all profits above this would go to the Huntington Library [one of Munger'’ favorite charities]. Lo and behold, that’s happened. He got his money back, and the donee’s receiving a large profit. Some people are very peculiar, and we tend to collect them.

A confluence of factors in the same direction caused Warren’s success. It’s very unlikely that a lollapalooza effect can come from anything else. So let’s look at the factors that contributed to this result:

The first factor is the mental aptitude. Warren is seriously smart. On the other hand, he can’t beat all corners in chess blindfolded. He’s out-achieved his mental aptitude.

Then there’s the good effect caused by his doing this since he was 10 years old. It’s very hard to succeed until you take the first step in what you’re strongly interested in. There’s no substitute for strong interest and he got a very early start.

This is really crucial: Warren is one of the best learning machines on this earth. The turtles who outrun the hares are learning machines. If you stop learning in this world, the world rushes by you. Warren was lucky that he could still learn effectively and build his skills, even after he reached retirement age. Warren’s investing skills have markedly increased since he turned 65. Having watched the whole process with Warren, I can report that if he had stopped with what he knew at earlier points, the record would be a pale shadow of what it is.

The work has been heavily concentrated in one mind. Sure, others have had input, but Berkshire enormously reflects the contributions of one great single mind. It’s hard to think of great success by committees in the investment world – or in physics. Many people miss this. Look at John Wooden, the greatest basketball coach ever: his record improved later in life when he got a great idea: be less egalitarian. Of 12 players on his team, the bottom five didn’t play – they were just sparring partners. Instead, he concentrated experience in his top players. That happened at Berkshire – there was concentrated experience and playing time.

This is not how we normally live: in a democracy, everyone takes turns. But if you really want a lot of wisdom, it’s better to concentrate decisions and process in one person.

It’s no accident that Singapore has a much better record, given where it started, than the United States. There, power was concentrated in one enormously talented person, Lee Kuan Yew, who was the Warren Buffett of Singapore.

Lots of people are very, very smart in terms of passing tests and making rapid calculations, but they just make one asinine decision after another because they have terrible streaks of nuttiness. Like Nietzsche once said: “The man had a lame leg and he’s proud of it.” If you have a defect you try to increase, you’re on your way to the shallows. Envy, huge self-pity, extreme ideology, intense loyalty to a particular identity – you’ve just taken your brain and started to pound on it with a hammer. You’ll find that Warren is very objective.

All human beings work better when they get what psychologists call reinforcement. If you get constant rewards, even if you’re Warren Buffett, you’ll respond – and few things give more rewards than being a great investor. The money comes in, people look up to you and maybe some even envy you. And if you buy a while lot of operating businesses and they win a lot of admiration, there’s a lot of reinforcement. Learn from this and find out how to prosper by reinforcing the people who are close to you. If you want to be happy in marriage, try to improve yourself as a spouse, not change your spouse. Warren has known this from an early age and it’s helped him a lot.

Alfred North Whitehead pointed out that civilization itself progressed rapidly in terms of GDP per capita when mankind invented the method of invention. This is very insightful. When mankind got good at learning, it progressed in the same way individuals do. The main thing at institutions of learning is to teach students the method of learning, but they don’t do a good job. Instead, they spoon feed students and teach them to do well on tests. In contrast, those who are genuine learners can go into a new field and outperform incumbents, at least on some occasions. I don’t recommend this, however. The ordinary result is failure. Yet, at least three times in my life, I’ve gone into some new field and succeeded.

Mozart is a good example of a life ruined by nuttiness. His achievement wasn’t diminished – he may well have had the best innate musical talent ever – but from that start, he was pretty miserable. He overspent his income his entire life – that will make your miserable. (This room is filled with the opposite [i.e., frugal people].) He was consumed with envy and jealousy of other people who were treated better than he felt they deserved, and he was filled with self-pity. Nothing could be stupider. Even if your child is dying of cancer, it’s not OK to feel self-pity. In general, it’s totally nonproductive to get the idea that the world is unfair. [Roman emperor] Marcus Aurelius had the notion that every tough stretch is an opportunity – to learn, to display manhood, you name it. To him, it was as natural as breathing to have tough stretches. Warren doesn’t spend any time on self-pity, envy, etc.

As for revenge, it’s totally insane. It’s ok to clobber someone to prevent them from hurting you or to set an example, but otherwise – well, look at the Middle East. It reminds me of the joke about Irish Alzheimer’s: when you’ve forgotten everything but the grudges.

So this is the lesson for you to draw on – and I think almost anybody can draw those lessons from Warren’s achievement at Berkshire. The interesting thing is you could go to the top business schools and none are studying and teaching what Warren has done. There’s nothing nutty in the hard sciences, but if you get into the soft sciences and the liberal arts, there’s a lot of nuttiness, even in things like economics. Nutty people pick people like themselves to be fellow professors. It gets back to what Alfred North Whitehead talked about: the fatal unconnectedness of academic disciplines. When people are trying to recruit people to be PhDs in their subjects – the results are often poor.

On the other hand, if you have enough sense to become a mental adult yourself, you can run rings around people smarter than you. Just pick up key ideas from all the disciplines, not just a few, and you’re immensely wiser than they are. This is not a great social advantage, however, as I can tell you from experience of the early Charlie Munger. To meet a great expert in a field and regard him as a malformed child is not a winning social grace. I got a lot of hard knocks when I was young. You could say I was forced into investing. The world will not ordinarily reward you for correcting other people in their area of expertise.

Accounting is a noble profession. It came out of Northern Italy, Venice, spread, and became part of standard accounting textbooks. The people who carry the torch in accounting are in a noble profession, yet these people also gave us Enron. You could have walked into an insane asylum, which was better than Enron, and yet accountants blessed it. So there are defects. I talked to a leading person in the accounting field and said it didn’t make sense to let companies mark weird stuff to their own models – that it would lead to disaster. She looked at me like I was out of my mind and asked, “Aren’t you for the most current data in accounting? My system is more current and therefore should be better.” This mind would score highly on an IQ test, but is scarcely able to throw out the garbage.

There are two factors in interplay a) you need currency and b) you need to set up a system in which it’s not easy for human beings to cheat or delude themselves, despite the presence of incentives to do so. If you can’t perfectly weigh the relative importance of these two things in contrast, you’re a horse’s patoot and not qualified to set accounting standards.

If you go into the liberal arts, you’ll find that education isn’t as good as it should be. I wish I had two or three more lives to live, one of which I could devote to fixing colleges. There is much that is good, but much that is utterly awful and only slightly improved in the 65 years since I left it.

You could say that the dysfunction of others has been an advantage to me. That’s the way it is. That’s really why you’re all here. You all want to get more than you deserve out of life by being rational – who doesn’t?

Also, an enormous pleasure in life is to be rightly trusted. One of my kids was a computer nerd and his school gave him access to the entire school computer system. He was exultant by the extreme trust. If your friends are asking you to raise their children if they die, you’re doing something right. It’s wonderful to be trusted. Some think if we just had more compliance checks and process, virtue would be maximized. At Berkshire, we have subnormal process. We try to operate in a web of seamless trust, deserved trust, and try to be careful whom we let in. They act like this at the Mayo Clinic. Imagine if they didn’t. Most patients would die.

Well, I’ve fulfilled as much as I have a stomach for in making some unscripted comments.

Friday, September 07, 2007

Comparison of quality of two different investing forums

Compare the vast difference in both quality of subjects and replies on two different forums online. The links as below.

I think it is very apparent.


It seems all of my past articles are unusually long and with minimal need to squeeze a little bit more of the juice out of the brains that is essentially needed for a true intelligent investor. So this writing will require some thinking that draws upon the ideas from the past writings. The two following examples are constructed for investors to think about how much they should pay with the restrictions as placed.
A big retailer who has a past record of a far-above industry return on invested capital and equity of over 20%. As such, its past performance in share price also compounded at a rate of over 20%. At its high two years ago in 2005, the stock price went to almost $60 and at this price the valuation then was 25 times of earnings. However, in the past two years, the rate of growth on invested capital and equity slowed to a pace of slightly below 20% - a few percentage points drop. Similarly, the share price tracks the slight drop in return on capital and it is traded at $44 today at a valuation of about 16 times earnings. On the outlook, this would seems like a steal to most intelligent investors provided if the variables - return on capital, and valuation level - remain the same.
However, every investors will have a different take on a business. The question is if an investor should pay $44 today if he wants an average of 12% return on stock price for the next 20 years.
Assume in circumstance 1, if Investor A thinks that the business economics will slow over time to 12% return on capital over the next 20 years on average, should he then pay $44 today if he expects an average of 12% return on stock price over the next 20 years?
In circumstance 2, Investor B thinks that the business economics will maintain at about 18 to 20% return on capital over the next 20 years on average, is $44 today a steal and thus be able to gain him at least 12% return on stock price over the next 20 years?
Under both circumstances, if you stand in these investors' position:
Under circumstance 1, a) what price would you pay if you want an average of 12% return on stock price for the next 20 years, and b) if you pay at today $44, do you think you would be able to achieve 12% return over the next 20 years and if not, what return would you think by paying $44 today would likely return in 20 years?
Under circumstance 2, what price would you think the stock price will be in 20 years time?
Consider this example, the odds of throwing a 12 with a pair of dice - a 1 in 36 odds. Now assume that the dice will be thrown once a year, and that an insurer agree to pay $50 million if a 12 appears. And for underwriting this risk, the insurer takes in an annual premium of $1 million. Over 10 years, not a single 12-event appears, and the insurer appears to make $10 million of profit. However, the question is is this $1 million premium sufficient for undertaking the $50 million payout odds? If not, what would seems to be a more reasonable premium to cater for the odds?

Thursday, August 30, 2007

View on long term investing

The major reason why investors lose money is: 1) they view stock market as some sort of magic expecting a dollar invested today to be worth two tomorrow (too short an horizon); 2) by paying the wrong price; 3) at times by paying the wrong price, there’s still a chance for recovery if the business economics will improve with time but then investors do not have the patience and sell themselves out early.

Investors of such practice simply are watching and following the wrong indicator of performance that tells the truth – they are just watching the price ticker. As if in watching a basketball game, the action is on the game floor, not on the scoreboard. It is what the players that are doing on the court that influence what will be shown on the scoreboard.

And then as if one is able to outscore every other player on the board, one tries to outmaneuver the other by trying to catch both the top and the bottom by pressing and squeezing harder than the one next door. These players are just influenced by trying to predict when the next storm is going to come. As a storm approaches, they try to run for cover totally but then a storm does not unroot all tress. Trees which are well deeply rooted are never in the long run destroyed by any storms. Thus, let us look a little in the history of stock which may give a little insight into what may happen in the future and thus improve the chances of investing success.

Firstly, investing is an act of faith. By investing a dollar today, we are entrusting to the steward in a corporation in the faith or at least with the hope that their endeavors will generate a rate of return that more than commensurate our investments. In this commitment of faith, we are committing our investment in the long term success of the corporation or economy at large and that the world’s financial markets will continue to march forward.

Any attempt to try to time, rather than price the market is an act of speculation. This action of timing is more to do with human psychology rather than wisdom. Market participants’ faith in investing has waxed and waned, kindled by bull markets and chilled by bear markets that happened from time to time, but over time the market has always remained intact. The market has survived the Great Depression, two world wars, the rise and fall of communism, two oil shocks, the assassination of a U.S. president, time of high inflation, shocks in commodity prices, among many others. In recent years (since 1982 though), our faith has been enhanced by the bull market in stocks and has accelerated, without much ado – perhaps only in early 2000s – until now.

In the event of both bull, many just can only see all things which are rosy and unfortunately, the reverse applies in the bear market as well where many just cannot see anything rosy except doomsday. Excessive behaviors always lead an investor to either bringing himself to be in a very risky position where he might make a lot but the price to be paid for the risk to be undertaken simply does not commensurate the price with the risk. On the other hand, in a frenzy market downturn, an investor may simply just head for any exit as long as he sees one where again, he will not consider the price he is selling commensurate with the value that he is foregoing.

Might some unforeseeable or unpredictable shock trigger another depression so severe that it would destroy our faith in the promise of investing? Possibility is always there. Excessive confidence in a smooth and rising sea can only blind us to the risk of storms. History is littered with episodes in which the enthusiasm of investors has driven equity prices to and beyond the point at which they are swept into the vortex of speculation, ultimately leading to unexpected losses. There is definitely little certainty in investing, at least for the short run. As long term investors, however, we must be aware of the past and cannot afford to let the ruinous possibilities frighten us away from the markets. For without risk, there is no return.

Here is a story about Chance. Chance is someone who knows about risk in all seasons because he is a gardener. His story contains an inspirational message to long term investors. The seasons of his garden are akin to the cycles of the economy and the financial markets. We can emulate his faith that their patterns of the past is an indication that may define their course in the future.

Chance is a gardener who works for a rich man in his mansion. He lives in a solitary world bereft of contact with the outside world. One day, the rich man dies, Chance wanders out on his first foray into the world. He is hit by the limousine of a powerful advisor to the president. When he is rushed to the advisor’s estate for medical care, he identifies himself only as “Chance the gardener.” In the confusion, his name is wrongly interpreted as “Chauncey Gardiner.”

When the President visits the advisor, the recuperating Chance sits in on the meeting. The economy is slumping; blue chip corporations are under duress and the stock market is collapsing. Unexpectedly, Chance is asked for his advice:

“In a garden,” he said, “growth has its season. There are spring and summer, but there are also fall and winter. And then spring and summer again. As long as the roots are not severed, all is well and all will be well.”

The president seems quietly pleased and delighted with the insightful thoughts of Chance. The president said: “I must admit, Mr. Gardiner, that is one of the most refreshing and optimistic statements I’ve heard in a very, very long time. Many of us forget that nature and society as one. Like nature, our economic system remains, in the long run, stable and rational and that’s why we must not fear to be at its mercy. We welcome the inevitable seasons of nature, yet we are upset by the seasons of our economy. How foolish of us.”

This story may be fictional. But like Chance, I see the history of our economy to be similar. The economy has passed the test of any past disasters and remains as healthy and stable in the long run. No doubt, it is marked by seasons of growth, sluggishness and decline but its roots have remained intact and strong. Despite changing seasons, our economy has persisted in an upward course, rebounding from the blackest of calamities.

Just for some historical figures. The average annual nominal return for three different time periods are: 1) 1802 to 1870 is 7.1%; 2) 1871 to 1925 is 7.2%; 3) 1926 to 1977 is 10.6%. After accounting for inflation, the net real return is 7%, 6.6% and 7.2% for the same periods respectively.

For an eye opener, an initial $10,000 investment in stocks from 1802 on, with all dividends reinvested will result in a terminal value of $5.6 billion in real dollars. Yet more staggering result if the same $10,000 is invested in bonds rather than stocks, it will result in $8 million. Well, that is not the worst, the worst is to invest in lands or properties.

Well, of course, none of us can expect to live near to two centuries, much less one. But having 50 years of investing time period is certainly within the reach of most people and 50 years is certainly a long time period where many different seasons will come and then go and come again. And with the story of Chance, having a strategy like his will certainly be great for most investors, at least for those who don’t know what they are doing.