Friday, July 10, 2009

Basics for a decent investor/money manager

What traits do Warren Buffett, Charlie Munger, John Niff, Bill Ruane, Philip Fisher, John Templeton, Jean-Marie Evaillard and other successful money managers possess in common? It is worth to examine the approaches and traits they have. My goal is to learn from their successes and equally as important, their failures. This involves two main ingredients: 1) The correct principle and 2) The correct person.

At the outset, I must point out that all that are written here do not guarantee you to be truly successful but it certainly can make you an over average, or at least, a decent investor.

The correct principle
Certainly, there are many ways to make money but this doesn't mean every way is the same. For long-term investment success, I strongly believe chances are enhanced when it embodies the following principles:
  1. Think of investing as how you would purchase a business, rather than the trading of stocks. Investing today at a particular price is all about laying out cash today in exchange for all the cash flow a business will produce, discounted at an appropriate interest rate, in the future. The key is to pay less than what the business will produce in terms of the total present value over the business life time. Trading price will varies everyday, at times very wildly, but business value or rather, the intrinsic value of a business, hardly varies by much from time to time. Intrinsic value follows the fundamentals of the business while stock prices may or may not follow the business fundamentals. Many times, stock prices are priced to emotions rather than fundamentals. Well, that provides an opportunity for us to take advantage of.
  2. Keep your eyes on the playing field, not on the scoreboard. If you invest in a business, it is what the business do, or equally as important, what it does not do, that really matters. If you focus on the stock price and not study the business, it is where most investors are done in. An example is the existing financial crisis, it is what the disciplined banks, like Wells Fargo and JPMorgan, did not do that set them apart from the rest. They did not pursue seemingly good and easy profits by abandoning an approach they understand and is effective for another approach which they did not understand and seemingly profitable business for the short-run, in exchange for long-term risk to the business. Now, we know these "good and easy profits" are nothing but a mirage.
  3. Think independently. Do not rely on "expert" advice. Ignore the market, other than to take advantage of its occasional foolishness. We must be able to jot down our reasons for buying. If we buy Johnson & Johnson at $50 per share, we must be able to answer: "JNJ at $50 is undervalued because . . . . ." Ben Graham's dictum told us "the fact that other people agree or disagree with you makes you neither right nor wrong. You will be right if your facts and reasoning are correct."
  4. Be flexible to the types of businesses you buy, but never pay more than the business is worth. To cater for errors, always purchase with a comfortable margin of safety unless you are very certain with your analysis. If the intrinsic value of JNJ is $70, do not purchase at $70, if it is selling at $50, buy it for you have a safety margin of 28.5%. As Warren Buffett says, "If you're driving a truck across a bridge that says it holds 10,000 pounds and you've got a 9,800 pound vehicle, [and] if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it's over the Grand Canyon, you may feel you want a little larger margin of safety."
  5. Bull market creates a lot of temptations but it is also a test on the investor's discipline. Stock prices run up during a bull market and we know that as stock prices surge, the risk becomes higher and the margin of safety gets narrower. However, part of us, says, "Geez, we don't want to miss the train. There's easy profit to be made as price will goes yet higher." We know it is risky but yet we don't want to miss the train. It is thus imperative to be absolutely discipline in not abandoning an approach that works and is safe for another approach that tempts us with seemingly easy profits but highly destructive and risky. Controlling greed is important - not that we should not be greedy. But the right time to be greedy is actually counter-cyclical as Buffett says, "Be greedy when others are fearful and be fearful when others are greedy." Better be long-term greedy than short-term greedy.
  6. Buy stocks as how you buy clothes - only when on sale.
  7. There are only three options when we decide whether to buy a stock - in, out, or too hard, as Buffett told us. Accept it when you don't know something. We all have our limited circle of competency. As Thomas Watson, founder of IBM told us, "I'm smart in spots and I stay in those spots." It doesn't matter how large or small the spot or circle is, the important thing is to recognize the limitation of the circle and stay within it. We do not need to know everything. As long as we understand something better than others, we have an edge.
  8. The pain of losing a dollar is double the joy of gaining a dollar. Focus on avoiding losses, especially permanent loss of capital, and then think about potential gains.
  9. Find one-feet hurdle to step over rather than ten-footer to jump over. Businesses that require the least changes and are simple are superior over businesses that involve lots of changes, innovation and are sexy. Sexy business as in sexy ladies, get us in trouble. Buffett said, "We look for businesses that in general aren't going to be susceptible to very much change."
  10. Invest only when the odds are highly favorable, and if you find it, you must be able to bet heavily. Investors at times have been overly sold on the idea of diversification or dollar-averaging, for fear of having too many eggs in one basket if the bet turns sour. The key here is how well you understand what you invest in. If you understand it perfectly, you need not diversify as it makes no sense to give up something that has a higher chance for a higher return for something that has a lower chance for a higher return. The depth of understanding also affects the degree of margin of safety you need. The more you understand, the less you need in terms of margin of safety and degree of diversification.
  11. Do not focus on predicting macroeconomic factors.
  12. Always be flexible. Be able to recognize mistakes immediately. There's no shame with being wrong. The only shame is being unable to recognize mistakes. Ability to question and discard your best loved ideas if it is proven wrong is not very common but it is certainly important.
  13. Beware of technical analysis, momentum trading, or any geeks who focus much on mathematical modeling. The "quant" or "technician" tries to predict stock movement through the shapes on a stock's chart, without reference to value. When you come across someone who advises a stock at $50, "seems to be poised for a breakthrough to the $54-56 area, although a stop-loss order should be placed at $47," that is an antithesis to the principle of investing.
The correct person
We have identified the principles - by no means, exhaustive - necessary but yet insufficient for long-term success. The other ingredient is the correct person. The following provides some clues on the characteristics successful investors should have:
  1. Patience is a vital virtue. Buffett constantly reminds that you should never buy a stock unless you would be happy with it if the stock exchange was to close for the next five years.
  2. Having the right emotion is important because we are easily affected by the movement of everyday trading price.
  3. High intelligence is not a necessity for successful investing. Buffett noted: "Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ." What you need is just a reasonable IQ and the right mentality and emotions.
  4. A flair for numbers is important but do not be obsessive in it to the decimal. High advanced maths model is irrelevant.
  5. Be humble and check your ego while staying confident with what you believe in. Almost all money managers have confidence in abundance but few are blessed with humidity. The moment arrogance creeps which is fairly easy when your portfolio is on the rise, you become overconfident. The worst kind of overconfidence is to assume success is due to skill rather than because of "when the tide raises, all boat raises." Always ask if your success is due to skills or market conditions. Overconfidence is the start of most disasters because it creates a potential to blind and hinder a person objectivity. They forget to question themselves and assume what was successful in the past will be successful in the future, which often isn't.
  6. Be able to sit on your butt. "The game of investing is one of making better predictions about the future than other people. How are you going to do that," Charlie Munger said, "One way is to limit your tries to areas of competence. If you try to predict the future of everything, you attempt too much."
  7. Successful investors neither take any comfort in standing with the crowd nor derive pride from standing alone. Bargains are rarely - not never - found with the crowd. When most people head for something, it drives up the desirability of that something, which means also its price and thus, lower its margin for profit. This is simple economics of supply and demand. The more people want it, the higher the price. The less people want it, the cheaper it is. But beware of the value trap: the key is to identify which are truly cheap and good, not cheap and no good.
  8. Always recognize it is hard, if not impossible, to find a bottom. If you find shares that are low in prices, they don't go up suddenly. Most likely, it will fall much further, at times, even 60% lower. But it doesn't matter. If you buy at $50, and it drops to $20, but in 5 years, it is worth $150, $150 is what matters, not $20.
  9. Be as discipline as you are when you buy as well as when you sell. If you purchase any investment, say a house, at $100,000, for which you know for sure it is worth $600,000, and if someone comes by and offer you $200,000, you should not sell. And if you reject the first offer, and the next day, another buyer comes by and offer $150,000, you should not feel discourage and sell due to desperation, thinking that if you reject the second offer, the next offer may be lower. The key is to come to peace with your own valuation and reasoning. If you know perfectly well what you are purchasing and $600,000 is the intrinsic value, why sell at $200k, $150k, or even $400k? The only time to sell below the intrinsic value is: 1) if you do not know perfectly well what you purchasing, then you should sell at $400k or even lower; or 2) if you can find a better investment that is more undervalue than what you hold. Consider the opportunity cost of all alternatives.
  10. Have passion and love what you do. In Buffett words, one must be able to "tap dance" to work.
  11. Investing is a life-long education. He or she must be an avid learner. The moment we stop learning, we are one feet in the grave. Evolution is the only constant so learning is a must, not a choice. If you find yourself a little bit knowledgeable or smarter when you sleep as opposed to when you wake up earlier, you are partly successful.
  12. Emotions are not part of decision making. Analysis of hard facts are.
  13. For any money manager, three traits are must-have, they are: 1) Integrity, 2) Intelligence, and 3) Passion (as mentioned above). What is most important is integrity for which if it is missing, having the other two create more harm than good to investors who commit money with them. As Buffett says: "It is far easier to rob with the point of a pen than with the point of a gun." Unethical money managers will outwit unknowing investors - think of Bernie Madoff. He probably has both intelligence and passion but no doubt a lack of integrity. "Honesty is the best policy," as Ben Franklin told us.
  14. Never allow greed to take possession of you so that you become in a hurry or afraid to miss the boat. Neither should you be too interested in money, you will kill yourself. However, if you are not interested enough, you won't go to the office. Instead, you must be animated by controlled greed, and fascinated by the investment process, i.e. to enjoy the game.
  15. Possess the security and self-confidence that are backed by knowledge, without being rash or headstrong. If you lack confidence due to a lack of knowledge, fear will drive you out at the bottom. Nervous investors who aren't armed with the right facts have the habit of selling out when they go down.
  16. Must be logical and think objectively.
  17. Last but not least, ssk who is the idol of this person. Most successful investors have some common idols. Warren Buffett admires Benjamin Graham and Benjamin Franklin. Charlie Munger admires Benjamin Franklin. Bill Ruane admires Benjamin Graham. John Niff, Mario Gabelli, Michael Price and John Bogle are all influenced by Graham as well. If you draw a chart, you probably would be able to link a lot of these successful money managers back to the village of Graham and Doddsville.
The two main ingredients for a decent investing career are actually joint at the hip - not mutually exclusive. Some characteristics of the principles are also the characteristics the investor should possess.

Much of what have been written may seem obvious and common sense, but when it comes to putting to practice, majority of money is managed by people who neither have the correct principle nor the correct personal characteristics. After all, common sense aren't that common.

Not all investment managers who have a stellar records are good managers. If you have 10,000 monkeys throwing darts to select stocks, it is certain that a few of them will end up with stellar records due to randomness. This randomness applies to top-performing money managers as well but would they be able to outperform in the future? Of course not for they lack the right ingredients. The luck of these random few will certainly run out as long as they are willing to play the next round continuously till the game ends. Luck, as the dictum says, only "favors the prepared mind." The ingredients mentioned here are part of the preparation.

Thus, these traits are not only useful for evaluating professional money managers but also invaluable in helping you decide how to pick stocks for yourself.

Readers, what do you think? I am as eager to learn from you too if you have any thing good to add.


Daniel M. Ryan said...

I suspect that many of these rules don't really sink in until you try breaking them and get yourself into a spot as a result. Ending up "sadder but wiser" seems to give them the needed meaning.

As far as other ideas are concerned: I've found that ordering up a physical certificate squares our natural tendency to inertia with the value-investing perspective. If I have a certificate in my desk drawer, then I have to take some time out of my day - during business hours - to sell the thing. I have to make a physical trip to the brokerage house's security depository, and then wait some time for it to appear in my account before I could sell it.

If the stock's left in my account, I can easily enter in a sell order through the Internet. Selling a physical certificate, on the other hand, takes time and bother. Thus, I'm far less tempted to trade around.

I heard that the new American system is cumbersome and even more time-consuming, especially for a Canadian like me. Some time ago, I wanted to order a certificate up for an American issue but was dissuaded from doing so by the discount-broker agent I was talking to. He said that it would have taken about six weeks to enter the stock into my account, and that the discount brokerage does not recommend doing so. That disrecommendation made me back off, plus an advisory that I'd have no help with tax matters if I did so.

So, I left it in and traded it away later at a small profit. Had I insisted, though, I would have been sitting on a much larger profit - even if it would have taken me about six weeks to realize the gain.

Had things gone the other way, I might have been sitting on a loss. The delay factor, however, was a point in favour of ordering up. I would have had to wait about six weeks to sell any American stock I'd ordered up, so I would have to make very sure that I'd be going into the issue for solid long-term reasons. I couldn't flip it around.

I don't know how cumbersome the new scrip-registration system is for Americans; it may be as quick as next-day entry. If it's not, though, there's a blessing in disguise: even if you panic, it won't do any good because it may take weeks to get the stock in salable form. For me, anyway, it's like having the stock market closed for six weeks.

The only downside to this approach is seeing the company get wrecked for a previously unknown reason. This drawback, though, would make stop and think hard about going into any stock - which I should be doing anyhow.

Mark Perkins said...

good post. I studied Buffett a good bit to. His framework over of his career is solid I feel. I have been wondering though lately just how rational it is for us small retail investors to try and use his best framework.

His best investments like Washington Post about always happen right at the best time to be a contrarian. When the business itself is horrible. thing is though they always turn around because Buffett

takes some kind of control

over the company. With Washington Post he installed a shareholder friendly CEO etc. If I go and make a contrarian bet today without an activist investor it is likely I can get burned completely. So what I'm getting at is really how much of his success is as an investor vs an activist investor? Don't get me wrong I greatly admire him especially on the macro economics but I wonder about that question.

Mark Perkins said...
This comment has been removed by the author.
Mark Perkins said...

Another thing is intrinsic value. You said in your post that the business doesn't change over time. Atleast that is with durable competitive advantage type businesses that some value investors like.

The thing is stock prices change "but so does the business." Economic externalities and shifts in consumer demand that we can't predict except the greatest like Buffett happen and it blows to crap a discounted cash flow analysis or PE model or whatever you use.

I feel like the only or best time to invest in a big company is when the price is so cheap you don't need a DCF analysis. Like M Pabrai. but as i brought up in last comment all that is is a contrarian bet the fundamentals will turn. I've seen this strategy work a lot just by looking for moat companies distressed.

This worked well when we were in times of fantasy capital and economic growth. These days it is different i feel for most companies tied to the consumer. Though i would buy Amazon or Ebay for a pe of 4 in a heart beat but it isn't going to happen.

I think what im trying to say here is buying Amazon or whatever hypothetically at 60 even 50% of a gamble at intrinsic value is not a big enough margin of safety. I think most value managers and investors that buy stocks around fair valuation or slightly under "even with strong fundys" are juust gambling on what they cannot predict. I guess all of this is why I like Ben Graham stocks . bigger margin of safety bc it is just a contrarin bet pretty much. I wonder if value investors usually just aren't taking advantage of sector rotation.

I feel like the only good value investing is deep, deep contrarian investing bc things often have a way of turning around. I don't get these value people who think they have an edge bc Microsoft is at a tiny discount to their DCF. I think to succeed in this game you have to have huge winners and cut your losers. I don't think value investors do this well at all. That's why I'll only look for net-nets these days that can have huge upside.

Berkshire said...

Hi Daniel,

Thank you for dropping by. Actually, you are right that many rules don't sink in for us till we experience it personally. But on the other hand, we can capitalize by watching the mistakes committed by others so that we try as much as possible to curb our natural instinct which might otherwise lead us to committing mistakes unwittingly -we don't hope to learn a lesson by "peeing on an electric fence."

Hi Mark,

Thank you for your comments.

I think you are spot on on the intrinsic value where IV is doesn't change much only for those businesses with competitive durable advantage - like pg, jnj, kft, kelloggs. A lot of others business where it involves changes, the IV would change quite a bit because of its cyclical nature or unpredictability. Such businesses, it is difficult to derive their IV. Well, that's why my personal circle of competency is relatively small. I like predictable, stable business.

And yes, I totally agree the best time to buy is when you don't even need any DCF calculation because it is so cheap that any sensible investor can recognize. Two months back, personally, I think there was such opportunity. In march, a lot of banks are selling at 3 times or less of their earnings before tax and provision for losses. An example is Wells Fargo, it fell to less than $8. At $8, the company was selling at $34 billion. Its earnings before tax and provision for losses is estimated at about $35 to $40 billion. It was selling at a ridiculous valuation of less than 1 time of its Pretaxpreprovision earnings. The other is JPM, it fell to less than $15, market cap was $55 billion, pretaxpreprovision earnings is about $45 to $50 billion....goodness me, it is selling at 1.3 times pretax and provision earnings. That is madness. Any of the decent banks you value then from USB, PNC, AXP, people are valuing them less than 3 times.

After Buffett purchase of WPO, the price drops - if i remember correctly - by over 20%. After accumulating WPO stake, Berkshire ended up with less than 10% (unsure if correct but should be around there). The controlling interest still lies with the Graham family where Graham shares are A class which gives them more power in voting.

Personally, I think activist investor or not, does not really affects the business fundamentals. Over time, the business fundamentals are what guides the business value or market price. Whether Buffett invested in WPO or not, WPO price will rise to where it deserves to be. On the other hand, let's examine what happen to the original core business of BRK. BRK was in the textile mill business when Buffett purchase it. Buffett, even if he choses to be a Carl Icahn or Henry Kravis, he could never have turned around the textile business, for it has a declining business fundamental - something which WPO is facing today but not in the 1970s.

This year, we look at the car business, GM used to have an activist investor, Kirk Kerkorian. He couldn't turn the business fundamental around. Whether he make any money in his investment is secondary, if he had stayed with GM, his stake would be vanished.

The other is Ceberus investment in Chrysler. The equity are probably wiped out. So much for being an activist investor in any business with weak fundamentals.

Mark Perkins said...

thanks for responding to my comments. This sort of exchange helps me think more constructively about my own opinions.

Good point about the banks. I guess that was written on the wall maybe when the government was giving them money at 0% and all they had to do was do anything. But I'm not that knowledgeable about how they run those businesses.

Daniel M. Ryan said...

I thought of another trait that belongs in the "Right Person" category. It's the ability to thrive, and do your best work, in obscurity.

Some people do work better in spotlight situations: they're the life-of-the-party type. Since spotlight companies are usually overvalued, that kind of person is at a real disadvantage when it comes to buying and holding undervalued stocks - which are usually obscure. The wall-flower, the one-on-one'er, has a better shot if (s)he nails the other habits down.

Berkshire said...

Hi Daniel,

Generally speaking, a good investor should not be affected by the glamour of investing. The good investor will not seek to be in the spotlight, but if that investor turns out to be as good as Buffett, there's no way he could escape being obscure. Being in the spotlight have its disadvantage for it means more people will judge what you do, and then you in turn may get influence by noises. When there are many voices and noises, it is not easy to cut to the bone and get the few things that really counts.

Well just my thoughts.


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Penny Stocks said...

A decent money manager is someone that does not give up easy on their stock picks. Its often darker before is brighter for many stocks especially value stocks.