Thursday, July 26, 2012

Two Good Articles

Two Good Articles

Case Study: Berkshire Hathaway–Avoiding Value Traps

A contributor, Sid Berger, generously provided us with a concise case study. Thank you Sid.
Berkshire Hathaway, Inc. Case Study – Avoiding Value Traps
“All I want to know is where I’m going to die so I’ll never go there.” – Charlie Munger
This article is the first in a series of case studies highlighting mistakes by famous value investors. This concept was unashamedly stolen from Mohnish Pabrai. See here for the article–his-project-to-learn-from-other-successful-investors-includes-comments-on-dell-and-aig.
In 1962, Warren Buffet came across a struggling textile manufacturer named Berkshire Hathaway. By any measure, the company was cheap. He bought shares from 1962-1965 at an average price of $14.86. This price was 22% below its December 31, 1965 net working capital of $19 per share.
It looked like a classic Grahamian purchase of a company for less than liquidation value. Buffett recognized that the business was unexciting but likely to generate a couple of good quarters which would give the stock price a temporary boost. Yet, Buffett let emotion rule and held on to the business and continued to plow more money into it. He finally pulled the plug in 1985.
What was wrong with Buffet’s investment process that led him to make this mistake? Could it have been avoided?
Buffett himself did a great post-mortem analysis in his 1985 letter to shareholders I will draw upon that letter here but will expand upon some of the concepts and highlight their broader applicability.
First off, the company had absolutely no moat. That is, it had no durable competitive advantages such as brand name. To paraphrase Buffet, they couldn’t charge two cents more than their competitors because consumers had to have a Berkshire lining in their suit.
Second, textiles are an industry with no or low barriers to entry. As a result, any capex was simply wasted as all market participants countered with investments of their own. Standing on its own, Berkshire was presented with investment choices that would produce great returns. But, the investments were neutralized by each of the competitors making investments of their own. As Buffet stated, such a situation is like spectators at a parade all standing on their tiptoes to catch a better view – not much is actually accomplished.
Buffet also seems to have missed or at least minimized the threat of low-cost overseas competition. There were non-US textile mills where employees were willing to work for a fraction of Berkshire’s workers. Could Buffet have seen this coming? It’s difficult for me determine as I am not an expert on the textile industry of the mid-Sixties. He does note in his 1985 letter to Berkshire Shareholders that manufacturers in the Southern part of the US were thought to have an advantage over Berkshire because of their non-unionized workforce. So, he was at least aware that labor costs could be an issue.
More broadly, turnarounds seldom turn. Even the most gifted manager will have difficulty turning around a struggling company in a declining industry. As Buffet stated, “When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” Buffet convinced himself that new management could turn around the Berkshire business, but the secular decline in the US textile industry was too much for anyone to defeat.
Also, if you’re producing a commodity, you better be the lowest cost producer. A low-cost structure is a powerful competitive advantage in that it enables a company to generate higher profits that it can reinvest into its business and distance itself from its competition. A low-cost structure also provides a business flexibility to use price as a weapon to take market share, weakening higher cost competitors who must match price and risk potential losses.
The Berkshire episode also contributed to Buffet’s move away from anchoring valuations on the balance sheet. For one thing, appraisals of liquidation value are typically unreliable. Buffet notes that Berkshire’s assets had been acquired for $13 million, had book value (after accelerated depreciation) of $866,000 and had replacement cost of $30-50 million. At auction, they fetched $163,122 gross or less than 0 net of expenses.
What checklist items does this case study produce? 1. Can the company be killed by low-cost overseas competition? 2. Is it a turnaround situation? Is this a mere blip (Amex) or an industry in secular decline (Berkshire)? Will it take large amounts of capex to turn it around? 3. Does the company have a moat? Does the industry have barriers to entry? Does the company have pricing power? 4. If the company produces a commodity, is it the low-cost producer?
Compare Berkshire with a Buffet success, See’s Candy. See’s Candy was a high quality business with durable competitive advantages that needed little capex and drowned in cash flow. Unfortunately, some companies failed to learn these lessons – even in the same industry.
See the Munsingwear case study, There, management continued to reinvest in the textile industry even though it was losing money on every sale.
How do these lessons apply to a company like Dell, which shows up in the portfolios of a lot of prominent value investors? In 2004, IBM sold off its PC division. At the time, the IBM CEO explained that the PC had become commodity-like and returns were unlikely to exceed IBM’s cost of capital. Is the US PC business the 2011 version of the New England textile industry in 1965?

Mohnish Pabrai - His Project To Learn From Other Successful Investors (Includes Comments On Dell And AIG)

At his annual meeting with investors Mohnish described a project he had undertaken to help him improve as an investor. The project was designed to help him learn from the decision making process of successful fund managers: 

"From the period of 2004 to 2010 we scanned all the 13F filings and all the public filings for Davis Funds, Oakmark, Third Avenue, Longleaf, Fairholme, Baupost, Greenlight, ESL, Pershing, Brave Warrior, Oak Value and Wintergreen. If you track the 13F filings quarter after quarter, you can see changes that are made in the portfolios. We looked at where the company added a brand new position in a quarter which wasn't in the 13F last quarter. We then looked at the next quarter to see if there was a change in the number of shares. If the number of shares went up, then we knew they continued buying. In our analysis, we assumed that they were buying evenly throughout the quarter and came up with an average price. This probably isn't reality, they probably had more sporadic buying, but I don't think those deltas are very large. We focused on the investments where the company had completely exited the investment. They held the investment, then at some point they completely sold the investment, and the investment was no longer on the 13F filing. During the 6 year period, we went through and extracted all the data about the gains and losses over all the positions that these funds held. We could clearly see the ones that they made money on. We could also see the ones that they lost money on, and approximately how much money they made or lost. On that list of mistakes, which is a long list of mistakes, we found 363 mistakes." 

In the annual meeting Monish was asked to elaborate further: 

Question: My question is when you went through the checklist analysis looking at the mistakes of these star investors, what were some of the more like common ones or ones where you saw a lot of managers making the same mistake? And then the other part is, I know it's hard to analyze this, but what about mistakes of omission where a lot of investors say those are the big ones. From your insight and your experience what are maybe one or two things that you can think of to help us as investors. 

Answer: Those are good questions. What I'm doing with the checklist doesn't help me on the omission side because we're not able to see those. And maybe the best lessons are on the omission's side. In terms of some of the lessons, one thing I found very strange is when I look at Longleaf Partners whom I respect a lot. They're a great shop, and do great work. And then I see they make an investment in GM. When I see them invest in GM (GM) I'm saying, "Okay, so do they not see that this is unionized? And do they not see that they have no differentiated products? And do they not see that you've got a very bad, labor management relationship?" 

So I'm scratching my head about why would you go into something like GM when you know there's a whole bunch of items where any benefits from that business are unlikely to come to the shareholders. They're more likely to end up with employees and the unions. I listened to their commentary of why they invested in GM and the commentary was about how GM owns the truck business. Toyota doesn't have a place in the truck business and GM owns the truck business and that's so big and so important. 

One of the things I came out with was that sometimes you can look at the trees and miss the forest. I found that in some of these investments that Longleaf was making they would find some glimmers of a great business inside these huge companies. And of course the truck business went to hell because gas prices went up and people stopped buying SUVs and trucks. 

One of the checklist questions that comes out it is that are you missing the forest from the trees? Are you focusing too much on a few trees and not looking at the forest? Another example is with Dell. You know again Longleaf invested in Dell (DELL) and, in fact, they still have Dell. They have not exited their Dell position and they're still very bullish on Dell. One of the changes that came about with Dell was the change from desktops to laptops. When you change from desktop to laptop, you take away the advantage Dell has in assembly. The traditional Dell model was that you place an order, then they start building the computer and they ship it to you. 

Well, with laptops you really can't do that. It doesn't quite work the same way a computer does, and the whole assembly and parts and all that is somewhat different. Then you go to the next step where you're going from desktops to laptops to smart phones. And you go to iPads and that advantage continues to decline. 

Longleaf will say you have to look at their enterprise business, you have to look at their server business, and you have to look at the storage business. Those are doing well, and okay maybe in the end it works out. But count me as a skeptic. What I found is that sometimes there was an emphasis on the trees. Another example is with Davis Funds. 

There was a question asked by one of the investors to Mr. Davis after Hank Greenberg left AIG (AIG). "Is this a meaningful event that this person who built this amazing company is no longer here?" And their response was completely relevant. This is a great set of assets and brand set, and of course one of the problems we know very well with levered financial institutions is that you have to be very careful in how they're run. 

In hindsight what we can see with AIG is clearly no one was minding the store too carefully, where one group in London takes the whole thing down. One of the things I focused on with the checklist was to know what data was visible before the investment was made that would stop you from making the investment. 

The important thing about the checklist is that it's not data that comes out later. It's data that's with you today. So what was visible about AIG is that Hank had left. You can handicap that in whatever way you want to. The second thing that was absolutely clearly visible about AIG is that it's a levered financial institution in insurance and there are very, very few insurance companies that in the long run are decent businesses. I don't know whether that would have been enough to stop it but those are the data points that come out.

I'm still going through and flushing through these. Sometimes when you see these very large losses being made by very smart investors, I find that sometimes they've fixated on the wrong variables. They really should have fixated on some different ones and that would have created maybe a different outcome.

Monday, July 9, 2012

A Very Nice Charlie Munger Compilation

Disclaimer: This is not my personal post. All the work here is attributable to the author of the blog "learn to earn"

Poor Charlie’s Almanack Summary

  1. Buffett: “Investing is all about laying cash out now to get cash back in the future.  The timing, certainty and amount of this are what you need to evaluate… If you need a spreadsheet or a calculator to get to an answer, you should probably pass.  The number should scream at youfrom the paper”.
    [My note: It is vitally important to invest in a business that keeps throwing off free cash flow. With dividend-paying stock, you get some assurance that some of that FCF will come back to you as cash. However if you buy stocks for capital gains, you are relying on the mood of Mr Market to prove you right. That's why for capital gains, you need to buy companies with sustainable competitive advantage that will grow and grow and become a leader of its industry/sector. That will force Mr Market to recognise its worth. If you buy a fair business at a great price, Mr Market may never ever recognise that mis-pricing (you need activist market participants to correct that, which may not happen for a long long time, and during that time, lots of negative things can happen to a fair business compared to a great business).]
  2. Holding Cash
    1. Li Lu: “In making investments, I have always believed that you must act with discipline whenever you see something you truly like…. Once in a while, you will find a ‘fat pitch’ that is slow, straight, and right in the middle of your sweet spot. Then you swing hard. This way, no matter what natural ability you start with, you will substantially increase your hitting average. One common problem for investors is that they tend to swing too often…. However, the opposite problem is equally harmful to long-term results: You discover a ‘fat pitch’ but are unable to swing with the full weight of your capital.
    2. “There are worse situations than drowning in cash and sitting, sitting, sitting. I remember when I wasn’t awash in cash — and I don’t want to go back.”
    3. Buffett: “The one thing I will tell you is the worst investment you can have is cash… Cash is going to become worth less over time. But good businesses are going to become worth more over time… We always keep enough cash around so I feel very comfortable and don’t worry about sleeping at night. But it’s not because I like cash as an investment. You always want to have enough so that nobody else can determine your future essentially” [My note: market plunging and you can't act, margin calls, etc.]
  3. Charlie’s investment process
    1. Business
      1. Analyses a ton of things including the current and prospective regulatory climate; state of labour, supplier, and customer relations; potential impact of changes in technology; competitive strengths and vulnerabilities; pricing power; scalability; environmental issues; and the presence of hidden exposures.
      2. Assess competitive advantage – products, markets, trademarks, employees, distribution channels, societal trends, etc. – and the durability of that advantage.
      3. Consider “competitive destruction” forces that over the long term lay siege to most companies. Identify and buy only those businesses with a good chance of beating these tough odds. [My note: this is an interesting point. Might be good to start putting together a table of companies and the reasons why they failed.]
      4. Goes through all risks of the investment failing. “There is no such thing as a riskless investment, look for those with few risks that are easily understandable.”
    2. Valuation
      1. Recast financial statement figures to fit his own view of reality, including actual free or “owners” cash being produced, inventory and other working capital assets, fixed assets, and frequently overstated intangible assets.
      2. Calculate the intrinsic value of the whole business, with allowance for potential dilution, etc., to determine an approximate value per share.
    3. Liability
      1. Completes an assessment of the true impact, current and future, of the cost of stock options, pension plans, and retiree medical benefits.
      2. Scrutinizes the liability side of the balance sheet (e.g. insurance float can be more properly viewed as an asset)
    4. Management
      1. Assesses a company’s management, are they able, trustworthy, owner-oriented (e.g. how do they deploy cash? overcompensate themselves? pursue ego-oriented growth for growth’s sake?)
    5. Ignore insignificant detail in the analysis.
    6. Proper timing is important. Apply a “prior to pulling the trigger” checklist, especially useful in evaluating “close calls”
      1. What are the current price, volume, and trading considerations?
      2. What disclosure timing or other sensitivities exist?
      3. Do contingent exit strategies exist?
      4. Are better uses of capital currently or potentially available?
      5. Is sufficient liquid capital currently on hand or must it be borrowed?
      6. What is the opportunity cost of that capital?
    7. When all circumstances are just right, make a large, decisive bet. Do not take “initial positions”.
  4. “A great business at a fair price is superior to a fair business at a great price.”. My notes:
    1. A great business grows and grows and forces Mr Market to recognize its value. A fair business can be subject to Mr Market’s moods for a long time.
    2. Great businesses seldom trade at fair prices or below, hence you need to grab such opportunities when they present themselves.
    3. “If you buy something because it’s undervalued, then you have to think about selling it when it approaches your calculation of its intrinsic value. That’s hard. But if you buy a few great companies, then you can sit on your ass. That’s a good thing.”
    4. “We’re partial to putting out large amounts of money where we won’t have to make another decision.”
  5. Diversification
    1. “If you took our top fifteen decisions out, we’d have a pretty average record. It wasn’t hyperactivity, but a hell of a lot of patience.”
    2. “Our game is to recognize a big idea when it comes along, when one doesn’t come along very often. Opportunity comes to the prepared mind.”
  6. “Really good investment opportunities aren’t going to come along too often and won’t last too long, so you’ve got to be ready to act. Have a prepared mind.”
  7. Short Selling
    1. “Being short and seeing a promoter take the stock up is very irritating. It’s not worth it to have that much irritation in your life.”
  8. Cost of Capital
    1. Buffett: “Charlie and I don’t know our cost of capital… We measure everything against our alternatives.”
    2. “… people make decisions based on opportunity costs – in other words, its your alternatives that matter. That’s how we make all of our decisions.”
On Thinking:
  1. “Personally, I’ve gotten so that I now use a kind of two-track analysis. First, what are the factors that really govern the interests involved, rationally considered? And second, what are the subconscious influences where the brain at a subconscious level is automatically conclusions in various ways — which, by and large, are useful — but which often malfunction? One approach is rationality… And the other is to evaluate the psychological factors that cause subconscious conclusions — many of which are wrong.”
  2. Mental Models
    1. “You must know the big ideas in the big disciplines and use them routinely….. What you need is a latticework of mental models in your head. And, with that system, things gradually get to fit together in a way that enhances cognition.”. Instead of making stand-alone assessment of a company’s financial information, Charlie also conducts a comprehensive analysis of the larger, integrated “ecosystem” in which it operates.
    2. Einstein: “A scientific theory should be as simple as possible, but no simpler.”
  3. How to Think
    1. “I’m afraid that’s the way it is. If there are twenty factors and they interact some, you’ll just have to learn to handle it — because that’s the way the world is. But you won’t find it that hard if you go at it Darwin-like, step by step with curious persistence. You’ll be amazed at how good you can get.”
    2. “The most important thing to keep in mind is the idea that especially big forces often come out of these one hundred models. When several models combine, you get lollapalooza effects; this is when two, three, or four forces are all operating in the same direction. And, frequently, you don’t get simple addition.”
    3. “Most commonly, the forces coming out of these one hundred models are conflicting to some extent. And you get huge, miserable tradeoffs. But if you can’t think in terms of tradeoffs and recognize tradeoffs in what you’re dealing with, you’re a horse’s patoot…. You have to recognize how these things combine… So you must have the models, and you must see the relatedness and the effects from the relatedness.”
On Life
  1. “A lot of successes in life and business comes from knowing what you want to avoid: early death, a bad marriage, etc.”
  2. “Spend each day trying to be a little wiser than you were when you woke up. Discharge your duties faithfully and well. Step by step you get ahead, but not necessarily in fast spurts.”
  3. “What’s the best way to get a good spouse? The best single way is to deserve a good spouse..”
Other Interesting Stuff
  1. Charlie’s first wife was Nancy Huggins whom he married while he is in the military. They subsequently divorced in 1953. This reminded me of how Buffett and his wife separated amicably, and Ben Graham also separated from his wife. This seems to be a price that really successful people for being so engrossed in their interests and work.
  2. “What matters most: passion or competence that was inborn? Berkshire is full of people who have a peculiar passion for their own business. I would argue passion is more important than brain power.”
  3. “In the past, when Berkshire has gotten cheap, we’ve found other even cheaper stocks to buy. I’d always prefer this. It’s no fun to have the company so lacking in repute that we can make money for some shareholders by buying out others.”
Nothing to Adds
  1. Don’t go for open outcry auctions because human psychology of fear of losing causes you to overpay. Don’t go for closed bid auctions because they invite a possibility for big mispricing errors (e.g. winner’s curse of paying double what the 2nd guy bidded).
Funny Stuff
  1. Buffett in the Foreword wrote that Munger improved Ben Franklin’s thinking in many respects, save for some, one of which is below on his “Advice on the Choice of a Mistress” :)
  2. Buffett’s story about Charlie on Pg. 49 is absolutely hilarious!
Other Stuff
  1. Stock Options
    1. “A stock option is both an expense and dilution”
    2. Buffett: “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”
  2. Asbestos
    1. “… lawyers are stealing money from people who are hurt and giving it to people who aren’t entitled.”
  3. Buffett: “Henry Singleton has the best operating and capital deployment record in American business..” (co-founder of Teledyne)
  4. To learn the great concepts, it helps to tie them into the lives and personalities of the people who developed them (e.g. you learn economics better if you make Adam Smith your friend). Make friends with the eminent dead who had the right ideas.

Recommended Books
  1. Deep Simplicity: Bringing Order to Chaos and Complexity
  2. James Bowell’s biography of Samuel Johnson on transcending envy.
Talk One: Harvard School Commencement Speech (Jun e 13, 1986)
  1. Don’t take drugs or alcohol to change your mood/perception.
  2. Don’t be envious.
  3. Don’t be resentful.
  4. Be reliable.
  5. Learn everything that you can from your own experience, maximizing what you learn from the good and bad experience of others, living and dead.
  6. Learn from the best work done before yours.
  7. Never stay down when defeated.
  8. Invert. Understand why people and things fail, and avoid them.
  9. Maximize objectivity, criticize your own ideas, be vurious, and have perseverance.
  10. Aim high.
Talk Two: A Lesson on Elementary Worldly Wisdom as It Relates to investment Management and Business (The University of Southern California Marshall School of Business, April 14, 1994)
  1. You have to array your experience – both vicarious and direct – on a latticework of models.
  2. Models
    1. Mathematics
      • Basic arithmetic
      • Compound interest
      • Math of permutations and combinations
      • Decision trees
    2. Accounting
      • Accounting and its limitations
    3. Psychology
      • If you tell people why, they will understand it better, and will consider it more important, and will be more likely to comply. Carl Braun had a rule that all communications in his company has to have 5 Ws (who, what, where, when, why). If you don’t do it, you would get fired after two times.
    4. Engineering quality control
      • Tradeoff exist between the cost and the likelihood of things breaking
    5. Statistics
      • Able to do rough calculation using the Gaussian distribution because events and huge aspects of reality end up distributed that way.
    6. Engineering
      • Backup system
      • Breakpoints
    7. Physics
      • Critical mass
    8. Biology/physiology
      • People are programmed by our genetic makeup to be much the same.
    9. Psychology
      • Psychology of misjudgment
    10. Microeconomics
      • A free market economy is equivalent to an ecosystem, people who narrowly specialize can get terribly good at occupying some little niche.
      • Patents, trademarks, exclusive franchises
      • Discriminate between when technology is going to help you and when it’s going to kill you. Determine how much of the cost savings is going to the bottom line and how much is going to flow through to the customer (e.g. are you producing a commodity product? or are you the sole producer?)
      • Competitive destruction due to new technology. The ‘early birds’ get to surf for a long, long time, after which they need to get into a different business or they’re dead.
    11. Microeconomics: Advantages of scale
      1. Human nature: Cost reductions along the experience curve. Greater volume causes people to improve their ability and efficiency because human beings try to improve and are motivated by incentives.
      2. Geometry: If you build a circular tank, as you build it bigger, the amount of steel you use in the surface goes up with the square and the cubic volume goes up with the cube.
      3. Resources: Big companies selling huge volume (e.g. P&G) can afford expensive network TV advertising that small companies cannot.
      4. Informational: Large companies have an informational advantage (e.g. Wrigley can be known in a remote place compared to an unknown brand) that allows it to command a premium.
      5. Psychology: People are influenced by what others do. If everyone is drinking Coca-Cola all around the world because of Coca-Cola’s worldwide distribution setup, people will just follow suit. The wide distribution setup is a huge advantage that is very hard to get.
      6. Snowball effect: In some business the very nature of things is to cascade toward the overwhelming dominance of one firm, e.g. daily newspapers. This is because the scale builds upon itself; when a newspaper gets most of the circulation, it gets most of the advertising, and once it has most of the advertising and circulation, nobody will want the smaller papers with less information. [my note: like social networking, its a network effect.]
      7. Specialization: Advantages of scale allow greater specialization within the firm, so each person can be better at what he does. E.g. specialists at Wal-Mart HQ that know a lot about refrigerators, etc. to perform the buying compared to some proprietor of a little store.
      8. Business: Huge purchasing power. Also a large chain store can have ‘little laboratories’ of stores to conduct experiments.
      9. Process: Established systems that forces everyone to do what works.
    12. Microeconomics: Disadvantages of scale
      1. Ecosystem: Susceptible to being dislodged by competitors that go for a narrower specialization. E.g. Berkshire had a travel magazine for business travel, this was killed by a competitor that created a magazine targeted solely at corporate travel departments. They gave very targeted information, became more efficient, and didn’t need to waste resources in giving general information. E.g. Saturday Evening Post vs. Motocross.
      2. Human nature: Bureaucracy with layers of management and associated costs, work pushing, slow decision-making, no shareholder focus (e.g. Sears vs. Wal-Mart).
      3. Tendency for dysfunctional behavior: E.g. Westinghouse loaned billions of dollars to real estate developers building hotels and lost them.
      4. Pavlovian association: Ex-CBS CEO Bill Paley had an automatic reaction of antipathy towards people that tell him unpleasant things that he didn’t want to hear, so he lived in a cocoon where people only told him what he liked to hear.
  3. Puzzle on Dynamics of Market Competition
    1. Many markets get down to 2-6 big competitors. In some of those markets, nobody makes any money, but in others, everybody does very well. Why is the competition in some markets rational so that shareholders do well, while in other markets there’s destructive competition that destroys shareholder wealth?
    2. E.g. net amount of money made by shareholders of airlines since Kitty Hawk is a substantial negative figure. Intense competition ravaged shareholder wealth.
    3. E.g. in cereals, big players make ~40% on your capital, medium-grade cereal maker can make ~15%.
    4. A main factor can be because there is a brand identity factor in cereals that doesn’t exist in airlines.
    5. [My thought: It depends on how obviously a good is the same across all competitors, i.e. how obvious is it a commodity. Airline seats are obvious, all the seats are the same, the planes are pretty much the same from competitor to competitor, and all of them take you from one place to another. Whereas for cereals, they may not all be the same. When it comes to food, you might think that Kellogg's cereals might have used better raw materials, or the process is cleaner, or you are willing to pay a little more for a brand that has been around for a long time (which makes you trust it). Same for petrol, you are not sure whether the petrol sold by the different companies are the same so you tend to stick to one brand because you might be afraid of 'spoiling' your car if you change. Petrol companies on their part will try to create and maintain that doubt in your mind by their advertising. When there is product differentiation, companies can occupy their own strata in the market (e.g. premium, low-cost), or be occupy their own individual sphere in the market. This allows for an equilibrium where all players can make money.]
    6. There are many markets where bottlers of Pepsi and Coke both make a lot of money and many others where they destroy most of the profitability of the two franchises.
  4. Nature of the Stock Market
    1. The stock market is like a pari-mutuel system at the race track. Everybody goes there and bets, and the odds change based on what’s bet. A clear good horse pays very little, and a bad horse pays high odds. Because of this, it is not clear which is the best bet.
    2. Charlie knew someone who made a substantial living doing nothing but bet harness races, and he would think about harness races and bet only occasionally when he saw some mispriced bet available.
    3. Work hard to look for a mispriced bet, bet big when the world gives you that opportunity. And the rest of the time, you don’t.
  5. Investment Style
    1. Sector rotation (e.g. oil, retail, etc.) may work, but he knows of no really rich sector rotator.
    2. Ben Graham’s bargains are hard to find now. Accounting nowadays is also not realistic – when the business starts to fail, significant assets will not be there (e.g. money owed to employees, health plans, pension plans, etc.)
    3. Most of Berkshire’s money has come from the great businesses (momentums implicit in their position, unusual managerial skill, etc.). Most of the people who have made a lot of money have done so in high-quality businesses.
      • Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return — even if you originally buy it at a huge discount. Conversely, if a business earns 18% return on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with one hell of a result. So the trick is getting into great companies.
      • Get into great companies by finding them when they are small.
      • In addition, sit-on-your-ass investing means you are paying less to brokers, and paying less taxes. The tax savings itself is equivalent to an extra 1-3% annually compounded. E.g. if you buy something that compounds at 15% per annum, hold for 30 years then pay 35% tax at the end, your returns after tax is 13.3% per annum. If you pay tax every year, you get only 9.75% per annum.
  6. The Right Structure for Investment Management
    1. Buffett and Munger do not have any clients who could fire them at Berkshire.
    2. That is why they can do their approach of finding a mispriced bet and loading up when they are very confident of being right, even though that could cause huge volatility and bad short-term results.
  7. Averaged out, betting on the quality of a business is better than betting on the quality of management.
  8. On-going
Talk Four: Practical Thought About Practical Thought (An Informal Talk, July 20, 1996)
  1. Five notions helpful in solving problems
    1. Decide big “no-brainer” questions first.
    2. Use math to sort out the messy, practical life.
    3. It is not enough to think problems through forward. Think also in reverse (i.e. invert the problem, think of what not to do, think of how things could fail).
    4. Think in a multidisciplinary manner using elementary academic wisdom.
    5. Really big effects (lollapalooza effects) will often come only from large combination of factors.
  2. On-going
Benjamin Franklin, Advice to a Young Man on the Choice of a Mistress (1745)
My dear Friend,
I know of no Medicine fit to diminish the violent natural Inclinations you mention; and if I did, I think I should not communicate it to you. Marriage is the proper Remedy. It is the most natural State of Man, and therefore the State in which you are most likely to find solid Happiness. Your Reasons against entering into it at present, appear to me not well-founded. The circumstantial Advantages you have in View by postponing it, are not only uncertain, but they are small in comparison with that of the Thing itself, the being married and settled. It is the Man and Woman united that make the compleat human Being. Separate, she wants his Force of Body and Strength of Reason; he, her Softness, Sensibility and acute Discernment. Together they are more likely to succeed in the World. A single Man has not nearly the Value he would have in that State of Union. He is an incomplete Animal. He resembles the odd Half of a Pair of Scissars. If you get a prudent healthy Wife, your Industry in your Profession, with her good Economy, will be a Fortune sufficient.
But if you will not take this Counsel, and persist in thinking a Commerce with the Sex inevitable, then I repeat my former Advice, that in all your Amours you should prefer old Women to young ones. You call this a Paradox, and demand my Reasons. They are these:
1. Because as they have more Knowledge of the World and their Minds are better stor’d with Observations, their Conversation is more improving and more lastingly agreable.
2. Because when Women cease to be handsome, they study to be good. To maintain their Influence over Men, they supply the Diminution of Beauty by an Augmentation of Utility. They learn to do a 1000 Services small and great, and are the most tender and useful of all Friends when you are sick. Thus they continue amiable. And hence there is hardly such a thing to be found as an old Woman who is not a good Woman.
3. Because there is no hazard of Children, which irregularly produc’d may be attended with much Inconvenience.
4. Because thro’ more Experience, they are more prudent and discreet in conducting an Intrigue to prevent Suspicion. The Commerce with them is therefore safer with regard to your Reputation. And with regard to theirs, if the Affair should happen to be known, considerate People might be rather inclin’d to excuse an old Woman who would kindly take care of a young Man, form his Manners by her good Counsels, and prevent his ruining his Health and Fortune among mercenary Prostitutes.
5. Because in every Animal that walks upright, the Deficiency of the Fluids that fill the Muscles appears first in the highest Part: The Face first grows lank and wrinkled; then the Neck; then the Breast and Arms; the lower Parts continuing to the last as plump as ever: So that covering all above with a Basket, and regarding2 only what is below the Girdle, it is impossible of two Women to know an old from a young one. And as in the dark all Cats are grey, the Pleasure of corporal Enjoyment with an old Woman is at least equal, and frequently superior, every Knack being by Practice capable of Improvement.
6. Because the Sin is less. The debauching a Virgin may be her Ruin, and make her for Life unhappy.
7. Because the Compunction is less. The having made a young Girl miserable may give you frequent bitter Reflections; none of which can attend the making an old Woman happy.

The Charlie Munger Checklists

“Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things.”
“It is not given to human beings to have such talent that they can just know everything about everything all the time but it is given to human beings who work hard at it, who look and sift the world for a mispriced bet, that they can occasionally find one. The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.”
The Charlie Munger Checklist…for Psychology…
“Grand General Principle of Social Psychology: Cognition is ordinarily situation-dependent so that different situations often cause different conclusions, even when the same person is thinking in the same general subject area.”
- reward/punishment
- liking/loving
- disliking/hating
- doubt avoidance
- inconsistency avoidance
- curiosity
- Kantian fairness
- envy/jealousy
- reciprocation
- influence from mere association
- simple pain avoiding psychological denial
- excessive self regard
- overoptimism
- deprival
- social proof
- contrast misreaction
- stress influence
- availability misweighing
- authority misinfluence
- reason respecting
- drug misinfluence
- use it or lose it
- senescence misinfluence
- twaddle
- LOLLAPALOOZA of the above forces
“The 25 standard causes of human misjudgment…Reward/Punishement, Liking/Loving, Disliking/Hating, Doubt-Avoidance, Inconsistency-Avoidance, Curiosity, Kantian Fairness, Envy/Jealousy, Reciprocation, Influence From Mere Association/Association, Simple Pain Avoiding Psychological Denial, Excessive Self Regard, Overoptimism, Deprival Reaction (loss experience of possessed or almost possessed reward), Social Proof, Contrast Misreaction, Stress Influence, Availability Misweighting, Use It Or Lose It, Drug Misinfluence, Senescence Misinfluence, Authority Misinfluence, Reason Respecting, Twaddle, Lollapalooza (in getting extreme consequences from streams flowing together/confluences of psychological tendencies acting in favor of a particular outcome)”
The Charlie Munger Checklist…of Ultra Simple General Problem Solving Notions…
Decide the big ‘no brainer’ questions first, Apply numerical fluency, Invert (think the problem through in reverse), Apply elementary multidisciplinary wisdom never relying entirely upon others, Watch for combinations of factors the Lollapalooza effect
1. Decide big no brainer questions first
2. Apply numerical fluency
3. Invert – think problems through in reverse
4. Apply elementary multidisciplinary wisdom never relying entirely upon others
5. Watch for combination of factors – Lollapalooza effect
The Charlie Munger Checklist…for Investing and Decision Making…
…Preparation. Discipline. Patience. Decisiveness…
Risk – All investment evaluations should begin by measuring risk, especially reputational
* Incorporate an appropriate margin of safety
* Avoid dealing with people of questionable character
* Insist upon proper compensation for risk assumed
* Always beware of inflation and interest rate exposures
* Avoid big mistakes; shun permanent capital loss
Independence – “Only in fairy tales are emperors told they are naked”
* Objectivity and rationality require independence of thought
* Remember that just because other people agree or disagree with you doesn’t make you right or wrong – the only thing that matters is the correctness of your analysis and judgment
* Mimicking the herd invites regression to the mean (merely average performance)
Preparation – “The only way to win is to work, work, work, work, and hope to have a few insights”
* Develop into a lifelong self-learner through voracious reading; cultivate curiosity and strive to become a little wiser every day
* More important than the will to win is the will to prepare
* Develop fluency in mental models from the major academic disciplines
* If you want to get smart, the question you have to keep asking is “why, why, why?”
Intellectual humility – Acknowledging what you don’t know is the dawning of wisdom
* Stay within a well-defined circle of competence
* Identify and reconcile disconfirming evidence
* Resist the craving for false precision, false certainties, etc.
* Above all, never fool yourself, and remember that you are the easiest person to fool
Analytic rigor - Use of the scientific method and effective checklists minimizes errors and omissions
* Determine value apart from price; progress apart from activity; wealth apart from size
* It is better to remember the obvious than to grasp the esoteric
* Be a business analyst, not a market, macroeconomic, or security analyst
* Consider totality of risk and effect; look always at potential second order and higher level impacts
* Think forwards and backwards – Invert, always invert
Allocation – Proper allocation of capital is an investor’s number one job
* Remember that highest and best use is always measured by the next best use (opportunity cost)
* Good ideas are rare – when the odds are greatly in your favor, bet (allocate) heavily
* Don’t “fall in love” with an investment – be situation-dependent and opportunity-driven
Patience - Resist the natural human bias to act
* “Compound interest is the eighth wonder of the world” (Einstein); never interrupt it unnecessarily
* Avoid unnecessary transactional taxes and frictional costs; never take action for its own sake
* Be alert for the arrival of luck
* Enjoy the process along with the proceeds, because the process is where you live
Decisiveness – When proper circumstances present themselves, act with decisiveness and conviction
* Be fearful when others are greedy, and greedy when others are fearful
* Opportunity doesn’t come often, so seize it when it comes
* Opportunity meeting the prepared mind; that’s the game
Change – Live with change and accept unremovable complexity
* Recognize and adapt to the true nature of the world around you; don’t expect it to adapt to you
* Continually challenge and willingly amend your “best-loved ideas”
* Recognize reality even when you don’t like it – especially when you don’t like it
Focus – Keep things simple and remember what you set out to do
* Remember that reputation and integrity are your most valuable assets – and can be lost in a heartbeat
* Guard against the effects of hubris (arrogance) and boredom
* Don’t overlook the obvious by drowning in minutiae (the small details)
* Be careful to exclude unneeded information or slop: “A small leak can sink a great ship”
* Face your big troubles; don’t sweep them under the rug
…Preparation. Discipline. Patience. Decisiveness…
The Charlie Munger Checklist…for 2-track analysis…
“what are the factors that really govern the interests involved rationally considered (i.e. macro and micro level economic factors) and what are the subconscious influences where the brain at a subconscious level is automatically”
“2 track analysis: what are the factors that really govern the interests involved here rationally considered (i.e. macro and micro level economic factors) and what are the subconscious influences where the brain at a subconscious level is automatically forming conclusions (i.e. influences from instincts, emotions, cravings, and so on)”
The Charlie Munger Investment Criteria Logic – The High Quality Business
“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result. So the trick is getting into better businesses.”
“I’d say that Berkshire Hathaway’s system is adapting to the nature of the investment problem as it really is. We’ve really made the money out of high quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money’s been made in the high quality businesses. And most of the other people who’ve made a lot of money have done so in high quality businesses.”
a. Find them small b. Find them big c. And ideally – and we’ve done a lot of this – you get into a great business which also has a great manager because management matters.
“So you do get an occasional opportunity to get into a wonderful business that’s being run by a wonderful manager. And, of course, that’s hog heaven day. If you don’t load up when you get those opportunities, it’s a big mistake…Occasionally, you’ll find a human being who’s so talented that he can do things that ordinary skilled mortals can’t. I would argue that Simon Marks – who was second generation in Marks & Spencer of England – was such a man. Patterson was such a man at National Cash Register. And Sam Walton was such a man. These people do come along – and in many cases, they’re not all that hard to identify. If they’ve got a reasonable hand – with the fanaticism and intelligence and so on that these people generally bring to the party – then management can matter much…However, averaged out, betting on the quality of a business is better than betting on the quality of management. In other words, if you have to choose one, bet on the business momentum, not the brilliance of the manager. But, very rarely. you find a manager who’s so good that you’re wise to follow him into what looks like a mediocre business…”
“If you’re going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that works out is that after taxes, you keep 13.3% per annum. In contrast, if you bought the same investment, but had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15% – or only 9.75% per year compounded. So the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening.”
“There are huge advantages for an individual to get into a position where you make a few great investments and just sit back and wait: You’re paying less to brokers. You’re listening to less nonsense. And if it works, the governmental tax system gives you an extra 1, 2 or 3 percentage points per annum compounded”
Risks: paying 50 or 70 times earnings like in the Nifty Fifties. But if you can find some fairly priced great company and buy it and sit, that tend to work out very, very well indeed.
Some of Charlie’s Models
* Growth Sub-position Untapped Pricing Power
* Graham Style+Great Management+Winner Take All
* Low Priced+Marketing Advantage(+Surfing New Technology)
* Cancer Surgery Formula (Perfectly magnificent business submerged in a mess but still working where you find something sound and cut away everything and if doesn’t work liquidate, sick-business-fix-up, bunch of foolishness that could easily be cut out and cut out all the folly and go back to the perfectly wonderful business that was lying there and people come in temperamentally and intellectually designed so they are going to cut it out)
COLLECT INANITIES … become a collector of inanities. You’ll never run out or get bored.
“The number one idea is to view a stock as an ownership of the business and to judge the staying quality of the business in terms of its competitive advantage. Look for more value in terms of discounted future cash-flow than you’re paying for. Move only when you have an advantage. It’s very basic. You have to understand the odds and have the discipline to bet only when the odds are in your favor. We just keep our heads down and handle the headwinds and tailwinds as best we can, and take the result after a periods of years.”
“We’re trying to buy businesses with sustainable competitive advantages at a low, or even fair, price.”
…betting on sure things…
“Keep learning and get better over time gradually. Warren has learned alot which allowed him to expand his circle of competence so he could invest in something like PetroChina. Get a little better over time so you’re virtually certain to make investments that are virtually certain to be good over time. Discipline, hard work and patience are the keys. Other people pass you by when you don’t learn. You have to work on it.”
“light on financial yardsticks w/ lots of subjective criteria; can we trust management? can it harm our reputation? what can go wrong? do we understand the business? does it require capital infusions to keep it going? what is the expected cash flow? We don’t expect linear growth; cyclicality is fine with us as long as the price is appropriate.”
“don’t sell anything you wouldn’t buy yourself
don’t work for anyone you don’t respect and admire
work only with people you enjoy”
“There’s no limit to what a man can do or where he can go if he doesn’t mind who gets the credit.”
- seamless web of deserved trust
- false precision, false certainty
- invert everything…just in case
- avoid extremely intense ideology
- “pounding it in” vs flexibility/destroying best loved ideas/adaptive
“The best investing opportunities as mispriced bets on horses
“What we’re really looking for are 50-50 odds which pay three to one”"
“”Regard your good name as the richest jewel you can possibly be possessed of – for credit is like fire; when once you have kindled it you may easily preserve it, but if you once extinguish it, you will find it an arduous task to rekindle it again. The way to gain a good reputation is to endeavor to be what you desire to appear.” – Socrates”
“Taiwan 7.6 magnitude earthquake damage -> “Much of the damage resulted from inadequate steel reinforcement in concrete structures”"
“The antidote to man with a hammer is a tool kit full of tools, not just a hammer. And use the tools checklist style because you’ll miss a lot if you hope the right tool just pops up unaided whenever you need it. But if you’ve got a full list of tools and you go through them in your mind checklist-style, you will find a lot of the answers you won’t find any other way.”
“Economics should emulate physics’ basic ethos, but its search for precision in physics-like formulas is almost always wrong in economics.”
“Well, how did I solve those problems? Obviously, I was using a simple search engine in my mind to go through checklist-style, and I was using some rough algorithms that work pretty well in a great many complex systems, and those algorithms run something like this: Extreme success is likely to be caused by some combination of the following factors:
A) Extreme maximization or minimization of one or two variables. (Examples, costco or our funiture appliance store)
B) Adding success factors so that a bigger combination drives success, often in non-linear fashion, as one is reminded of the concept of breakpoint and the concept of critical mass in physics. Often results are not linear. You get a little bit more mass, and you get a lollapalooza result. And, of course, I’ve been searching for lollapalooza results all my life, so I’m very interested in models that explain their occurence.
C) An extreme of good performance over many factors. (Example, Toyota or Les Schwab)
D) Catching and riding some sort of big wave. (Example, Oracle)”
“Too little attention to second and higher order effects. They chose not to consider effects of effects on effects, and so on…hence why predictions and projections can be so far off. (The movement of any individual piece affects, sometimes dramatically, the overall composition)”
“Avoid creating easily gameable systems and take into account second-order effects and the third-order effects in lying and cheating (i.e. Niederhoffer gaming the economics department system at Harvard to get straight A’s). One must think through consequences of consequences.”
“Economic systems work better when there’s an extreme reliability ethos (i.e. cash register, double entry bookkeeping). And the traditional way to get a reliability ethos, at least in past generations in America, was through religion. The religion instilled guilt. And this guilt, derived from religion, has been a huge driver of a reliability ethos, which has been very helpful to economic outcomes for man.”
“The craving for perfect fairness causes a lot of terrible problems in system function. Some systems should be made deliberately unfair to individuals because they’ll be fairer on average for all of us. Thus, there can be virtue in apparent non-fariness.”
“Paradox: “private vices are public benefits”"
“”It’s not bringing in new ideas that’s so hard. It’s getting rid of the old ones.” Einstein attributing his mental success to “curiosity, concentration, perserverence, and self criticism”. By self critisism, he meant becoming good at destroying your own best loved and hardest won ideas. If you can get really good at destroying your own wrong ideas, that is a great gift.”
“Theme of TRUST: deserved reliance upon the character, values and integrity of those you live and work with. No matter how smart you are, there are smart people out there who can fool you if they really want to. So, be sure you can trust the smart people you work with.”
“I have succeeded mostly by restricting action to jobs and methods in which I was unlikely to fail”
“The Perception system of man – as man is easily fooled, either by cleverly thought out manipulation of man, by circumstances occuring by accident, or by very effective manipulation practices that man has stumbled into during ‘practice evolution’ and kept in place because they work so well. One such outcome is caused by a quantum effect in human perception. If stimulus is kept below a certain level, it does not get through. And even when perception does get through to man’s brain, it is often misweighed, because what is registered in perception is in shockingness of apparent contrast, not the standard scientific units that make possible science and good engineering.”
“Inadequacy of contrast-based perception (i.e. stick one hand in hot, one hand in cold, and now both in luke warm and they are both hot and cold respectively) One thus sees perception so easily fooled by mere contrast, where a simple temperature gauge would make no error, and realizes cognition mimics perception in being misled by mere contrast. Thus, one is one the way to understanding how magicians, and life, fools one.
This can occur, through deliberate human manipulation or otherwise, if one doesn’t take certain precautions against often-wrong effects from generally useful tendencies in his perception and cognition.”
“Super strong ideology left or right should be avoided. Best-form multidisciplinarity requires an objectivity such passionate people have lost, and a difficult synthesis is not likely to be achieved by minds in ideological fetters. Ideology-based folly.”
“The fundamental organizing ethos I am talking about:
1. you must both rank and use disciplines in order of fundamentalness
2. You must master the tested fluency and routinely use the essential parts of all four constitutents of the fundamental four-discipline combination, with particularly intense attention given to disciplines more fundamental than your own
3. You may never practice cross-disciplinary absorption without attribution or departure from a ‘principle of economy’ that forbids explaining in any other way anything readily explainable from more fundamental material in your own or any other discipline
4. But when step 3 doesn’t produce much new and useful insight, you should hypothesize and test to establishment new principles, ordinarily by using methods similar to those that created succcessful old principles. But you may not use any new principles inconsistent with an old one unless you can now prove that the old principle is not true.”
“Like pilot training, the ethos of hard science does not say ‘take what you wish’ but ‘learn it all to fluency, like it or not.’”
“Wrong incentives are a major cause because truth is hard to assimilate in any mind when opposed by interest. And, if institutional incentives cause the problem, then a remedy is feasible – because incentives can be changed.”
“And if duty will not move improvement, advantage is also available.”
“”I read everything: annual reports, 10k’s, 10q’s, biographies, histories, five newspapers a day. On airplanes, I read the instructions on the backs of seats. Reading is key. Reading has made me rich over time” – Buffett”
“Using Forbes, WSJ, Fortune magazines periodicals to perform the function of the aircraft simulator if used to prompt practice in relating events to multidisciplinary causes, often intertwined (i.e. ‘use it or lose it’) And sometimes the periodicals even introduce new models for causes instead of merely refreshing old knowledge. I know no person in business, respected for verified good judgement, whose wisdom-maintenance system does not include use of such periodicals. Why should academia be different?”
“”This business field and this particular business, in its particular location, present crucial problems that are so difficult that unworldly old ladies can not wisely try and solve them through hired help. Given the difficulties and unavoidable agency costs, the old ladies should promptly sell the shoe factory, probably to the competitor who would enjoy the greatest marginal-utility advantage”"
“”We regard the present state of the universe as the effect of its past and the cause of its future. And intellect which at a certain moment would know all forces that set nature in motion, and all positions of all items of which nature is composed, if this intellect were also vast enough to submit these data to analysis, it would embrace in a single formula the movement of the greatest bodies of the universe and those of the tiniest atom; for such an intellect nothing would be uncertain and the future just like the past would be present before its eyes.” – Pierre-Simon Laplace”
“Truly big ideas in each discipline, learned only in essence, carry most of the freight. And they are not so numerous, nor are their interactions so complex, that a large and multidisciplinary understanding is impossible for many, given large amounts of talent and time.”
“Thinking by inversion and through use of ‘checklists’ is easily learned – in broadscale life as in piloting.”
“In my life there are not many questions I can’t properly deal with using my $40 adding machine and dog-eared compound interest table”
“Four causes of Einstein’s achievements being self criticism, curiosity, concentration, and perseverance.”
“If, in many high places, a universal product as successful as Coca-Cola is not properly understood and explained, it can’t bode well for our competency in dealing with much else that is important.”
“People are often massively irrational in ways predicted by psychology that must be taken into account in microeconomics.”
“Think in reverse as you try and disprove your own hardest-won and best-loved ideas.”
“”We build too many walls and not enough bridges” – Isaac Newton”
“Academic psychology, while it is admirable and useful as a list of ingenious and important experiments, lacks intradisciplinary synthesis. In particular, not enough attention is given to lollapalooza effects coming from combinations of psychological tendancies. This is like rounding pi to an even three. It violates the injunction that everything should be made as simple as possible, but not simpler. In general, psychology is laid out and misunderstood as electromagnetism would now be misunderstood if physics had produced many brilliant experiments like Michael Faraday and no grand synthesizer like James Clerk Maxwell.
Second, there is truly horrible lack of synthesis blending psychology and other academic subjects. But only an interdisciplinary approach will correctly deal with reality – in academia as with the Coca-Cola company.”
“Not understanding elementary psychology well enough to avoid “new coke” – very bright people – is not satisfactory. These bad effects are a lollapalooza.”
“The correct strategies are clear after being related to the elementary academic ideas brought into play by the helpful notions.”
“Yeah. I’m passionate about wisdom. I’m passionate about accuracy and some kinds of curiosity. Perhaps I have some streak of generosity in my nature and a desire to serve values that transcend my brief life. But maybe I’m just here to show off. Who knows?”
“I believe in the discipline of mastering the best that other people have figured out. I don’t believe in just sitting down and trying to dream it all up yourself. Nobody’s that smart…”
“There’s a lot of simple stuff that many of you are quite capable of learning. And your lives will work way better, too, if you do. Plus, learning it is a lot of fun. So I urge you to learn it. “
“”Science cannot solve the ultimate mystery of nature. And that is because, in the last analysis, we ourselves are a part of the mystery that we are trying to solve” – Max Planck”
“”It is not the possession of truth, but the success which attends the seeking after it, that enriches the seeker and brings happiness to him.” – Max Planck”
“But, whatever you decide, I think it’s a huge mistake not to absorb the elementary worldly wisdom if you’re capable of doing it because it makes you better able to serve others, it makes you better able to serve yourself, and it makes life more fun. So if you have an aptitude for doing it, I think you’d be crazy not to. Your life will be enriched – not only financially, but in a host of other ways – if you do.”
“Giving rules like “Judges shouldn’t talk about legal issues that aren’t before them” without giving reasons is crazy.
The human mind is not constructed so that it works well without those reasons.
You’ve got to hang reality on a theoretical structure with reasons. That’s the way it hangs together in a usable form so that you’re an effective thinker.”
“And to teach doctrines – either with no reasons or with poorly explained reasons?! That’s wrong!”
“Many of the legal doctrines are tied to other doctrines. They’re joined at the hip. And, yet, they teach you those legal doctrines without pointing out how they’re tied to other important doctrines?! That’s insanity – absolute insanity.”
“Hard science and engineering tend to be pretty reliably done [in schools]. But the minute you get outside those areas, a certain amount of inanity seems to creep into academia – even [in] academia involving people with very high IQ’s.”
“The whole [law] school experience would be much more fun if the really basic ideas were integrated and pounded in with good examples for a month or so before you got into conventional [law] school material. I think the whole system of education would work better. But nobody has any interest in doing it.”
“If you’re like me, it’s kind of fun for it to be a little complicated. If you want it totally easy and laid out, maybe you should join some cult that claims to provide all the answers.”
“Everything should be made as simple as possible, but no more simple.”
“If there are 20 factors and they interact some, you’ll just have to learn to handle it – because that’s the way the world is. But you won’t find it that hard if you go at it Darwin-like, step by step with curious persistence. You’ll be amazed at how good you can get. “
“To the extent you become a person who thinks correctly, you can add great value.”
“You have to know when to trust experts where you have no wisdom at all and when you override experts who may have incentive caused bias decisions.
In effect, you got to know what you know and what you don’t know. What could possibly be more useful in life than that?
When you don’t know and don’t have any special competence, don’t be afraid to say so.
Don’t screw up the hive and do a bee dance you have no knowledge of. Nobody expects you to know everything about everything. Confidently answering questions about which you don’t have any real knowledge is asinine.”
“What I’m against is being very confident and feeling that you know, for sure, that your particular intervention will do more good than harm, given that you’re dealing with highly complex systems wherein everything is interacting with everything else.”
“Each person has to play the game given his own marginal utility consideration and in a way that takes into account his own psychology.
So you have to adapt your strategy to your own nature and your own talents. I don’t think there’s a one-size-fits-all investment strategy that I can give you.
Mine works for me. But, in part, that’s because I’m good at taking losses. I can take em’ psychologically. And, besides, I have very few. That combination works fine.”
“You will make mistakes, but you can learn to make fewer of them than other people and fix your mistakes faster when you do make them. But there’s no way to live an adequate life without mistakes. The trick is to get so you can handle mistakes. Part of what you must learn is how to handle mistakes and new facts that change the odds. Life, in part, is like a poker game, wherein you have to learn to quit sometimes when holding a much loved hand.
The tendancy is to put in ‘just a little more’ – and people go broke this way by failing to stop, rethink, and say they can afford to write this one off and live to fight again and not pursue things with obsession in a way that will break you.”
“If you try and succeed at what you’re worst at, you’re going to have a very lousy career. Guaranteed. You have to figure out where your talents lie. And you’ll have to use your advantages. Why play a competitive game in a field where you have no advantage – maybe a disadvantage – instead of in a field where you have a clear advantage? The advantage of low tech stuff for us is that we think we understand it fairly well. The other stuff we don’t. And we’d rather deal with what we understand.”
“Have low expectations
Have a sense of humor
Surround yourself with the love of friends and family”
“Above all, live with change and adapt to it.”
“We look for no brainer decisions. We don’t leap over seven foot fences…we look for one foot fences with big rewards on the other side. Succeed by making the world easy for yourself, not by solving hard problems.”
“It doesn’t help us merely for favourable odds to exist. They have to be in a place you can recognize them. So it takes a mispriced opportunity that you’re smart enough to recognize. And that combination doesn’t occur often. BUT IT DOESN’T HAVE TO. If you wait for the big opportunity and have the courage and vigor to grasp it firmly when it arrives, how many do you need? Take the top ten business investments Berkshire’s ever made. We would be very rich if we’d never done anything else – in two lifetimes.
So, again, there isn’t any system for giving you perfect investment judgment on all subjects at all times. You have here, rather, a method you can use to sift reality to obtain an occasional opportunity for rational reaction.
If you take that method into something as competitive as common stock picking, you’re competing with many brilliant people. So, even with our method, we only get a few opportunities. Fortunately, that happens to be enough.”
The Multi Disciplinary Munger Discussion Notes
Math – compound interest, permutations/combination/decision tree theory, cost/benefit analysis
Accounting – limitations
Engineering – quality control, back up systems, breakpoints
Statistics – gaussian/normal distribution/bell shaped curve
Physics – critical mass
Biology/Psychology – why why why for compliance and giving why, perceptual apparatus and function and know it’s limitations, who is going to do what where when and why, rational and subconscious influences, pavlonian ie Paley, munger misjudgement list (reward/punishment incentives, liking/love-disliking/hating, doubt avoidance, inconsistency avoidance, curiosity, kantian fairness, envy/jealousy, reciprocation, influence from mere association, simple pain avoiding psychological denial, excessive self regard, overoptimism, deprival, social proof, contrast misreaction, stress influence, availability misweighing, authority misinfluence, reason respecting, drug misinfluence, use it or lose it, sensescence misinfluence, twaddle)
Microeconomics – ecosystem niche, advantages of scale (cost reductions along experience curve and more volume via incentives and more efficient output, geometry ie more volume per unit area of steel, advertising media usage capability, informational ie glotz gum, psychological social proof subconscious and conscious, overwhelming cascade winner take all dominance ie city newspaper, allowance for greater specialization vs big fat beaucracy, purchasing power thus lower merchandise cost and little labratories ie chainstores, patents/trademarks (ie trademark system well known big operation)/exclusive franchise (ie 1 of 3 stations with limited play or small monopoly of store inside airport), new capital flow through invested into lousy business that will kill or biz that will help and ‘stick to ribs’ idea ie for technology knowing when it helps and hinders, competitive destruction surfing
High quality businesses/Getting into better business for over long term (i.e 6% over 40 year paid cheaply or 18% return over 20 years paid a little more expensively … trick is getting into better businesses, and that involves all these advantages of scale you could consider momentum effects)
Circle of competence
Bet seldom, bet heavy
How find great companies? a. when small b. when big c. great managers (if had to choose bet on the business momentum, not the brilliance of the manager. But rarely you find a manager so good you’re wise to follow him into what looks like a mediocre business)
Frictional costs
Find a few, sit back and wait (large disaster can come from large investment too high priced but if you can find some fairly-priced great company and buy it and sit, that tends to work out very well)
Ultimate no brainer: UNDERPRICING … Untapped Pricing Power (growth stock model sub position [sub position of graham future earning power idea], with brilliant management is perfect …this model is like finding money in the street if you have the courage of your convictions)
Washington Post Dream Model: bought at about 20% of value to a private owner [graham style basis at 1/5th obvious value] and in addition faced ‘winner take all’ situation [you had both the top hand in a game that was clearly going to end up with one winner] and great management [lot of integrity and intelligence/high class people the Katharine Graham family which is why it was a damn dream]
Gillette/Coke Model: Low priced items and tremendous marketing advantage all over the world, and in gillettes case surfing simply technology hard for competitors to do [90% shaving market in whole countries]
GEICO model: Surgery formula – Mess to soundness to Liquidation if doesn’t pan out/Perfectly magnificent business submerged in a mess but still working/Easy to cut out foolishness to go back to perfectly wonderful business lying there

Thursday, July 5, 2012

Notes On Why Smart People Make Big Money Mistakes and How to Correct Them

Lesson 1: Mental Accounting: The tendency to value some dollar less than others and thus to waste them. The inclination to categorize and treat money differently depending on where it comes from, where it is kept, or how it is spent. 

Example: 1. Amateur gamblers view winnings as an entirely different kind of money and was therefore more willing to make extravagant bets with it- playing with House Money.
               2. Spending more with bonus and lottery winning (found money).

Psychological root: It is intellectually difficult, and emotionally taxing, to calculate the cost of every short-term transaction. So to cope with this daunting organizational task, people separate their money into mental accounts, necessarily treating a dollar in one account differently from a dollar in another, since each account has a different significance

Harmful consequence: Too quick to spend, too slow to save, or too conservative when investing.  

Another way mental accounting can cause trouble is the resultant tendency to treat dollars differently depending on the size of the mental account in which they are stashed, the size of the particular transaction in which they are spent, or simple the amount of money in question. For instance, when you are spending $25,000 on a car, a $500 back-up camera seems inconsequential.

We are also subject to the subconscious preference to "integrate losses. " When you incur a loss or expense, you prefer to hide it from yourself by burying it within a bigger loss or expense, so that the pain of spending $500 for a back-up camera is neutralized to a great extent by the larger pain of spending $25,000. That's why electronic stores and car dealers sell extended warranties or service contracts. 

Implication: When making big purchases, do not buy any complementary products without thinking about do you really need it if not for this big purchase. 

Credit cards are dangerous mental accounts because credit card dollars are cheapened because there is seemingly no loss at the moment of purchase, at least on a visceral level. The money we charge on plastic is devalued because it seems as if we are not actually spending anything when we use the cards. 

How to cope with this psychological bias: 

  • Think about how much money you would pay if using cash instead of cards. 
  • When making big purchases, do not buy any complementary products or services without thinking about do you really need it if not for this big purchase. 
  • Train yourself to wait a while before making any spending dicisions. 
  • Treat all money as earned money. 
Lesson 2: Prospect Theory: Decision under Risk. "Loss aversion" and "sunk cost fallacy".

Loss Aversion:Willingness to take more risk if it means avoiding a sure loss and to be more consevative when given the opportunity to lock in a sure gain.

Example: In a game where you know you have can choose between either a guaranteed a gain of $500 or flip a coin and either receive a $1000 or nothing depending on the result, most people choose the guaranteed $500. However, if it's between a guaranteed $500 loss or flipping a coin for either a $1000 loss or no loss, most people will choose to flip a coin.

Weber's law: The impact of a change in the intensity of a stimulus is proportional to the absolute level of the original stimulus. For instance, the difference between nothing and $500 is greater psychologically than the difference between $500 and $1000.The difference between nothing and $500 loss is greater psychologically than the difference between losing $500  and losing $1000. 

Prospect theory says that people generally do not assign values to options based on the option's expected effect on their overall level of wealth: For example, if you have a loss of $500 on your portfolio with MV of $50,000, you don't consider the loss of $500 as 1% of the portfolio, you see it as $500 loss in its absolute value. 

When people view a decision as one of a preference, they tend to focus on the positive qualities of the options. When making a decision regarding cancellation, people tend to focus on the negative qualities of each option. What's important to understand is that people feel more strongly about the pain that comes with loss than they do about the pleasure that comes with an equal gain (about twice as strongly). 

The loss aversion attributes to why people sell the winners too soon and hold on to losers too long. This is creative mental accounting at its worst: the unrealized losses are segregated in a separate account precisely because they are unrealized. 

Sunk Cost Fallacy: Focusing on money already spent and ignoring the future costs and benefits. The more the sunk cost, the more likely you will be focusing on money already spent.

Investment Implications:
Loss Aversion: Between a guaranteed $500 loss and the possibility of "recovering your loss" or "$1000 more loss", do the research and incur the $500 loss and move on. Especially with troubled companies or turnarounds.

Sunk Cost Fallacy: Don't fixate on the cost, focus on current value.

Lesson 3: Dealing with Decision Paralysis. 

1. Decision paralysis is attributable to the fear of regret and a preference for the same old thing.
2. A decision to delay an action, or take no action at all, becomes more likely when there are many attractive options from which to choose.
3. The longer you defer making a decision, the less likely you are to ever get over your hesitation.
4. "Extremeness Aversion": People are more likely to choose an option if it is an intermediate choice within an group, rather than at one extreme end.
5. Regret aversion, decision paralysis, and the status quo bias combined can influence your financial decisions and to cost you money. Examples, leaving money in a bank account rather than investing; staying in a low-paying job rather than making a switch to a better job; failing to sell a stock only to see it drops further; delaying the purchase of a stock only to see it rises later.

To deal with decision paralysis:

  • Write the analysis down. 
  • Change your frame of reference to a more neutral one
  • Reverse the context in which you perceive the choice at hand. Turn a decision of which option to reject into one of which option to select and vice versa. 

Lesson 4: Number Numbness

1. The tendency to ignore inflation.
2. Failing to understand the role of odds and chance in life can lead you to make unwise investment and spending decisions. The tendency to disregard or discount the overall odds in a give situation is what Kahneman and Tversky called "ignoring the base rate."

  • Exceptions to the overall odds are often more easily to called to mind. For eg, people avoided the beach after seeing the movie Jaws. 
  • Overconfidence and ignoring base rate, particularly because of a misguided reliance on memorable events or on inconclusive information, contributes in a variety of ways to poor financial decisions. Examples include amateur investors think they can forecast the future of commodity market, despite 75% o f professional and amateur commodity investors lose money. Or people shell out for life insurances. 
  • If you flip a coin 20 times in a row, there's an 80% chance that you will get three heads in a row at some point during the flipping and 50% chance of getting 4 in a row and 25% chance of a streak of 5. 

3. "Bigness bias,", the way in which indifference to small numbers can cost big bucks, especially over time. This is related to mental accounting.

Lesson 5 Anchoring Aweigh

1. Anchoring is the clinging to a fact or figure that should have no bearing on your judgement or decisions. The difficulty that result from anchoring, furthermore, are often compounded by a second problem known as
confirmation bias or, disconfirmation disinclination. People tend to search for evidence, treat kindly, and be overly impressed by information that confirms their initial impressions or preferences. 
2. Anchoring can be particularly powerful because you often have no idea that such a phenomenon is affecting you. 
3. Two types of anchoring are particularly dangerous. 

  • Most people are particularly vulnerable to the effects of anchoring when they know precious little about the commodity in question. You are particularly prone to anchoring a particular dollar figure when you are swimming in unfamiliar waters. So if you don't know the intrinsic value of a stock, you are more likely to cling to the price you paid. Or you don't even have to buy the stock to anchor on a price. For eg, in the early 1990s, U.S Surgical Corp increased fourfold to $131.50 in just one year. Subsequently, when the share price dropped to $56.50 in 1992, many people rushed in. 
  • The other type of anchoring is when you know enough about a subject but got sucked in anyway. A good example would be you've calculated the intrinsic value of a stock to be $80, so you purchased at $60 and once it reaches $80, you sold it for a profit of $20. Later on the fundamentals of the stock got a little better so you recalculated the intrinsic value to be $90 and you were waiting for a good entry point. Finally the day came: the company missed the quarterly earnings projection by $0.01 even though it posted record earnings and Wall Street dumped the stock. Within two days it went from $82 to $65. You vividly remember that you paid $60 last time and you told yourself it would drop to $60 this time. Unfortunately the day never came and the stock flew from $65 to $92 while you were living in your little fantasy. 
  • Anchoring is so powerful in investing. It doesn't matter if you are selling or buying. How many times do you consider prior year's highs when determining the target price? How many times do you "anchor" to the previous "lows" when you are trying to enter a position. How many times you just want to break even and once a losing position gets back to the cost basis, you sold the stock only to regret it later.
4. To overcome anchoring, knowledge is key.
5. The best way is to find "DIS-CONFIRMING EVIDENCE"!
7. Another way to overcome anchoring is to broaden your board of directors.
6. The most insidious problem with confirmation bias can be summed up with a simple statement: people often hear what they want to hear.

Last But Not Least:: The Ego Trap

  • Planning fallacy: The inability to complete tasks on schedule. 
  • A little knowledge can lead to a lot of overconfidence. 
  • The problem often arise from the fact that people over-confidently confuse familiarity with knowledge. 
  • Especially watch out during a bull market because your ego will also be boosted even though it's more likely than not the overall market's exuberance, rather than you investment skill, that contributed to your portfolio gain.