Category Archives: Avoid Stupid Mistakes

The David Sokol Scandal and Recency Bias

The recent discussions about how the David Sokol matter reflects on Warren Buffett and Berkshire Hathaway have been largely impacted by the recency effect. Wikipedia defines this as, “The tendency to weigh initial events more than earlier events.”

Because of the scandal, Berkshire has been the subject of a lot of criticism that it is operated too loosely and that it lacks the corporate governance structure of other large corporations.

Does running Berkshire Hathaway in a fashion that is light on rules and regulations provide cover for those who wish to get away with something? Probably. Does running a company with tons of rules and regulations stop people of mal-intent from carrying out their malfeasance? Sometimes, but not always. And although the desired outcome of extra rules and regulations is less than guaranteed, that it will have unintended consequences and impact productivity is virtually assured.

People quickly forget the enormous benefits that Berkshire has enjoyed by Buffett running it in a decentralized, lean fashion. This unleashes human potential in the same way that it has driven unprecedented productivity and wealth in the United States. If you have smart, talented people, the best thing you can do is to get out of their way.

This lack of structure has provided a platform to fuel the entrepreneurial drive of Berkshire’s scores of talented, proven managers and has provided Buffett with the time to do what he does best: allocate capital. Shareholders are far richer for it.

Is Berkshire perfect? No. But, its many virtues should not be obscured by this most recent incident. Lessons will be learned from it and necessary corrections made. This isn’t Buffett or Munger’s first rodeo.

One lesson for us is to once again observe how the media is driven by recency bias. The good news is we don’t have to go there. We are free to ask better questions and seek a broader perspective. It is wise to be on guard against the many cognitive biases that can negatively impact our judgments and actions.

On the critical task of risk management

We live in a very uncertain world. The unfolding of events in the Arab world was unforeseen. Moreover, the future course of events is difficult, if not impossible, to predict.

Add to this the uncertainty that surrounds our economy. Few would argue that the U.S. economy and the global economy are benefitting from an unprecedented level of fiscal and monetary stimulus. Given its vast scope, the effects of this stimulus will be far reaching and many of its consequences will only be known and understood in hindsight. Smart and reasonable people disagree on whether these policies – along with the serious economic problems they are meant to address – will lead to inflation or deflation. Add to that the reality that the duration and shape of these policies will largely be determined by future political outcomes and it’s no wonder investors sometime feel like they are playing three-dimensional chess.

Yet, this is the world we live in. As investors it is critical that we consider the downside first. You are the risk manager of your portfolio. Just as CEO’s of many of our leading financial institutions badly miscalculated by delegating this task to others, it would be a mistake to stick your head in the sand and not understand the risks you are taking with your precious capital.

Paying lip service to risk management is easy. Everyone does it just like every businessman is fond of saying that his people are his most precious asset. Words and deeds are two entirely different things. Buffett is fond of the book When Genius Failed because it shows that even very smart people can do very risky and dumb things with their capital.

Here are a few ideas that may help you with managing risk.

  1. Set aside a regular period of time to carefully go through your holdings and consider the risks involved in each position? Create a checklist to use in doing this assessment.
  2. Are you exposed to life changing economic risk, meaning can you envision a scenario that has any likelihood of happening where you could be wiped out?
  3. Are you exposed to ignorance risk in that you don’t understand a given position and why you are holding it? Consider that it appears likely that Buffett liquidated Lou Simpson’s stocks picks (Buffett’s motive is speculation on my part) when Simpson left Geico because Buffett does not back into positions and hold things that he does not understand (in the Buffett predictive sense of the word), even if they are otherwise good companies. Remember that you are much more likely to succumb to fear and dump a position in a downturn if you lack conviction born of your own work.
  4. Are you holding overvalued securities that subject you to permanent loss of capital in a downturn?
  5. Is your concentration in long-equities too high or are you overly concentrated in one stock or one industry?
  6. Have you considered how the businesses in which you are invested would do if high inflation ensues? How about if deflation and low-GDP growth develop?
  7. Do you have positions that are overly leveraged and overly dependent on the capital markets?
  8. If a company’s valuation is predicated on growth, how certain are you that the growth will materialize?

This list is not exhaustive, nor is it intended to be. The point is that you are your own risk manager and that is something that in my view should be taken very seriously. Develop your own process and then have the discipline to follow it. Many great investors are great because they managed the downside and let the upside take care of itself. You can’t win if you don’t finish. Moreover, serious permanent loss of capital disrupts compounding and makes it much more difficult psychologically to step up to the plate when future fat pitches appear.

Financial Porn

I recently watched a video of a lecture that Tim McElvaine gave at The Ben Graham Centre for Value Investing at the Richard Ivey School of Business in Ontario. Tim now runs his own investment management company and worked for many years with the celebrated value investor Peter Cundill.

There are many lessons in Tim’s talk and it is worth watching. One simple but important point Tim made was the importance of filtering out financial porn. Buffett understood this many years ago when he located back to his home in Omaha in order to get away from people whispering stock ideas in his ear. Now, with the Internet, it takes more than going to a different location to get away from the financial porn that Wall Street spews worth.

Don’t get me wrong. The Internet is a transformational tool for an investor. The problem is the sheer quantity and quality of the information. Blogs, financial forums, RSS feeds, stock recommendations: the information flows like a mighty river. The problem with most of it is that it is an inch deep and a mile wide. No nutritional value.

As I have written before, good ideas cannot be produced according to the dictates of a publishing schedule. Pay close attention to the incentives of those publishing stock ideas. Only rarely do they remotely align with your own.

Big money is made the old fashioned way: by doing deep fundamental analysis that requires time and solitude to read and think. There are no short-cuts. We all need to find ways to filter out financial porn. There is some great stuff out there, but a lot of it – if not most of it – will not help you make money and become a better investor. Make it a point to plan your business/investing day around the things that really matter and then practice the discipline of sticking to your plan.

A few good lessons from Buffett

I am in the process of improving my use of investment checklists. As such, I am always on the lookout for new items that I should include in my list. I have tried to make it a habit that anytime I read or hear about a good idea, I jot it down for consideration in my checklist.

One list I maintain, which was inspired by Monish Pabrai, contains investing mistakes which I have learned from others (although the list also contains my own mistakes). The list continues to grow, but it does not take much time to run down the list in thinking about an investment idea and the potential upside is huge.

Over the last couple days, I listened to Warren Buffett’s testimony for the U.S. Government’s Financial Crisis Inquiry Commission. The Financial Crisis Inquiry Commission was created to “examine the causes, domestic and global, of the current financial and economic crisis in the United States.”

Here is an account by The Motley Fool.

My purpose today is to share a few valuable lessons from Buffett (which he has stated before) that I think should be included in an investment checklist.

Have I drawn the wrong conclusion from a sound premise? Buffett quotes Ben Graham who said, “You can get in more trouble with a sound premise than an unsound premise because you’ll just throw out the unsound premise.” In the financial crisis, people took a sound premise – that real estate prices generally go up – and acted on it as if it would happen with a kind of metaphysical certitude. This led to taking risks based on this assumption that led to massive exposure to a “black-swan” event.

Buffett reminds us that people did the same thing in the twenties when they took a sound premise – that stocks generally outperform bonds, at least over long periods of time, because of stock’s higher earnings yield and reinvestment of earnings – and distorted it to conclude that they would always do so. Finally, the Internet bubble was based on a sound premise that the Internet would change our lives. It did not follow from that premise that one could invest in Internet stocks regardless of earnings or competitive forces.

A second lesson Buffett states is that a warning should go up if a company begins making investments that are totally unrelated to its core mission. It reminded me of how Buffett began to zero in on Coca-Cola as an investment just after the time when Roberto Goizuetta divested the company of non-core businesses such a shrimp farming. It is worth looking for businesses that are jettisoning lower margin businesses to focus on their core mission. Think American Express spinning off Ameriprise Financial or Citigroup’s ongoing divestiture of its Citi Holdings assets.

The third takeaway from Buffett’s testimony is that you should probably sell a stock if it goes up too much in price and becomes overvalued. Buffett said he probably should have sold Moody’s in 2006. This reminds me of similar remarks he made about not selling Berkshire’s Coca-Cola stock when it became grossly overvalued.

Fianally, Buffett reminds us to never invest in things we don’t understand. Virtually no one understood that complex derivatives that took down so many businesses in the crisis, yet people continued to invest in companies with massive exposure to these instruments.

In typical Buffett style, these are fairly simple lessons grounded in common sense and the core principles of value investing. The trick – as is often the case – is putting into place a rational framework that harnesses their wisdom and having the emotional temperament and discipline to put them into practice.

Know Your Limitations

At the 1989 Berkshire Hathaway shareholders meeting, Buffett said that he had recently received a letter from the daughter of David Dodd. Dodd’s daughter wrote that her father thought it was important to know your limitations. Buffett added that this was one of Dodd’s favorite themes.

“Knowing your limitations” has been studied by behavioral finance, which has labeled the lack of this virtue overconfidence bias. Numerous studies have shown our strong inclination towards this bias, even when we are made aware of its presence. It seems to be a kind of useful short-cut mechanism from a utilitarian perspective that is used in everyday life when there is nothing really riding on expressing a particular point of view, for example, predicting the outcome of a football game.

This bias is practiced so frequently, and it is so psychologically ingrained, that it can be a real challenge to check it when you are dealing with something that requires absolute accuracy grounded in facts. Its stubborn presence has been a material factor in everything from airplane crashes to botched medical procedures. Check lists have been recognized as a surprisingly simple and effective way to counter this bias.

Investing is an art that has no place for overconfidence bias and many fortunes have been lost as a result of it.

Investing presents a particular problem because it inherently involves making predictions about the future based on imperfect information. Moreover, greed acts as a kind of magnet drawing us towards an imagined positive outcome, even if our conclusion about the probability of that outcome is not grounded in facts.

The trick in fighting this bias is to be brutally honest about what you know and what you don’t know. This is where knowing your limitations comes in. You must first isolate what you really know and then determine if it is enough to make a prediction. If not, you should take a pass. If it is, then, according to Buffett, your task essentially comes down to determining the chance that you are correct times the amount of possible gain minus the chance that you are wrong times the amount of possible loss.

One useful thought experiment is to imagine giving a presentation on your investment thesis to a group of knowledgeable industry executives. Could you do it? Write down your thesis. Share it with another savvy investor.

One other word of caution. Big money is made by taking meaningful positions when you are certain the odds are in your favor. This requires a high degree of certainty. You can delude yourself into thinking that you know what you’re doing by only investing a trivial amount in a stock relative to your net worth. This is why Buffett says that diversification is a hedge against ignorance. The more you invest this way the more likely it is that your returns will equal that of a stock index. Put another way, taking only small positions is a way of perpetuating overconfidence bias because you can pretend you know what you’re doing when in fact you’re really speculating.

Outstanding Investor Digest, June 23, 1989, pages 5, 6.

A Blueprint for Being a Lousy Investor

In 1986, Charlie Munger gave the commencement speech at the Harvard School, a prep school that five of his sons attended. Munger took his inspiration from a prior commencement speech given by Johnny Carson in which Carson, using inversion, told the students how they could guarantee a miserable life. Here’s Carson’s prescription:

  1. “Ingesting chemicals in an effort to alter mood or perception;
  2. Envy; and
  3. Resentment”

Munger offered his own reflections on Carson’s prescription, and added four more of his own:

  1. Be unreliable;
  2. Ignore the experience of others, both living and dead;
  3. If you get knocked down in life, stay down; and
  4. Ignore the advice of the rustic who said, “I wish I knew where I was going to die, and I’d never go there.”

Inversion allows you to see a problem or situation from a different perspective in order to gain fresh insights that you did not previously notice or that you took for granted. It is in that spirit that I offer the following advice for how to be a poor investor.

1. First, don’t spend much time looking for new investment ideas. Don’t look for ideas off the beaten path, but rather stick with ideas and themes that enjoy a strong consensus. Also, be inconsistent in searching for investment ideas and lose interest when the market is going down and everyone is negative and afraid.

2. Second, be content with superficial analysis of your investment ideas and count on being able to quickly dump your stocks if things go wrong. Don’t do your homework like you would if you were investing substantially all of your net worth in a local business or farm.  Save yourself a lot of time by making your purchase decision based on a write-up in a business magazine, analyst report or blog post.

3. Third, don’t limit yourself to simple, boring investments that are easy to understand. Look for ideas in more exotic, “fast-moving” sectors – biotech, commodities, options, alternative energy, and emerging markets – where you have little experience or competence. Ignore the examples of others – including sophisticated institutions – who have lost their capital by speculating in areas they did not understand.

4. Fourth, invest in businesses with mediocre or poor returns on invested capital that do not enjoy any durable competitive advantages. Reach for more speculative returns by betting on the turnarounds of poorly performing businesses. Count on the fact that, even though you have no expertise in a given industry, you’ll be able to predict if a struggling company will be able to turn around. Ignore the advice of investors like Buffett and Greenblatt who have found that good businesses have a much better chance of delivering satisfactory investment results.

5. Fifth, don’t take the time to investigate the track record of a company’s management. That way you won’t be troubled if management has a poor record of allocating capital, if they will be highly compensated regardless of how the business performs, or if there is evidence that they have been dishonest or unethical in their prior dealings.

6. Sixth, don’t worry about the price you pay for an investment as long as the company’s story is sufficiently exciting, loved by the media or a consensus winner. If you do decide to look at how much you’re paying, don’t spend a lot of time thinking about valuation, normalizing earnings power, and future growth prospects. Instead, rely on simple (simplistic) metrics like price-earnings ratios or price-to-book ratios where you don’t have to think too much or that don’t require as much research. Be content with a superficial valuation and assume that the factors that led to the business’ past success will be firmly in place for the next five to ten years.

7. Seventh, buy a lot of small positions. That way, you’ll never miss out on the excitement of betting on your latest hunch, and you’ll never need to worry too much about a position because it won’t overly matter if the investment works out or not. You’ll always have plenty of action and you can hedge against not really knowing much about any of your investments.

8. Eighth, embrace the newer short-term oriented approach to investing and don’t fall for an out-of-fashion strategy like patiently buying and holding an investment. Who wants to wait three to five years for an investment to work? Focus on investments that will be up big in the next six to twelve months – or sooner. Ignore the fact that there is no rational basis for consistently making short term predictions of prices.

9. Ninth, ignore the lessons of your past mistakes. It’s psychologically painful to go back over your failed investments and it takes time. Ignore developments in behavioral finance and assume that you’re above all that anyway – that you already know what you’re doing. Assume that you’ll get better results in the future without changing any of the methods and behaviors that led to your past results.

10. Finally, take pride in the fact that you already know what you need to know and that learning the lessons of financial history are a waste of time. Also, don’t take the time to study all the great investors who have generously shared their investing methods. Ignore the fact that business is an evolving, complex reality and that investing is a highly competitive endeavor where you go up against the best and the brightest. Ignore the examples of investors like Munger and Buffett – and most successful investors – who are life-long learners.

Charlie Munger: What Would he Make of Stock Recommendations and Incentives?

Charlie Munger has wisely drawn attention to the power of incentives to drive human behavior. For example, he cites the case of FedEx’s challenge of having the night shift finish processing packages on schedule. FedEx tried all kinds of things to accomplish this objective without success. Finally, they stopped paying the night shift workers by the hour and started paying them a fixed amount for the entire shift. Workers were free to go home when all the packages were processed. Problem solved.

If you are using any type of service that produces stock recommendations on a regular basis – monthly, weekly, or even daily – it makes sense to examine the recommendations in light of Munger’s thoughts on incentives. For this post, I’m not talking about the obvious incentive bias involved when someone is touting a stock. Here I’m talking about legitimate services that produce a steady stream of recommendations.

Is it possible to find such a stream of stock picks that are available at a compelling bargain price according to some fixed cycle or publishing schedule? Would subscribers keep coming back to a stock recommendation service that announced week after week that no compelling bargains were available?

In spite of Munger’s staunch disdain for efficient market theory as traditionally taught in academia, Munger teaches that the market is actually quite efficient most of the time. He likens the market to a pari-mutual race track where the odds generally reflect the capabilities of the various horses.

Here’s Munger in a talk at the USC Business School in 1994.

The model I like – to sort of simplify the notion of what goes on in a market for common stocks – is the pari-mutuel system at the racetrack.  If you stop to think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds change based on what’s bet.  That’s what happens in the stock market.

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

Munger goes on to say that in spite of this situation, there are a select few people who are able to make good money betting on horses, even after the track taking 17% off the top. They do it by totally focusing on nothing but the performance of the horses and waiting – as long as it takes – until they see an anomaly where the odds are clearly in their favor. Then they bet heavily.

It’s something to think about the next time you turn to a source that cranks out recommendations like clockwork for scores of stocks. Think about whether it would be possible to make a living at the track trying to bet every race because you thought you could accurately handicap them all – or you used a publication that purported to do so – in a way that profitably exploited the available odds net of all transaction costs.

Lessons from Buffett’s Decision not to Sell Coke: “I talked when I should have walked”

In his 2004 letter to the shareholders of Berkshire Hathaway, Warren Buffett admitted that he made a mistake by not selling certain stocks that were “priced ahead of themselves.” The episode contains some powerful lesson that we can use to improve our investment results.

Let’s look at how the businesses of our “Big Four” – American Express, Coca-Cola, Gillette and Wells Fargo – have fared since we bought into these companies. As the table shows, we invested $3.83 billion in the four, by way of multiple transactions between May 1988 and October 2003. On a composite basis, our dollar-weighted purchase date is July 1992. By yearend 2004, therefore, we had held these “business interests,” on a weighted basis, about 12½ years.

In 2004, Berkshire’s share of the group’s earnings amounted to $1.2 billion. These earnings might legitimately be considered “normal.” True, they were swelled because Gillette and Wells Fargo omitted option costs in their presentation of earnings; but on the other hand they were reduced because Coke had a non-recurring write-off.

Our share of the earnings of these four companies has grown almost every year, and now amounts to about 31.3% of our cost. Their cash distributions to us have also grown consistently, totaling $434 million in 2004, or about 11.3% of cost. All in all, the Big Four have delivered us a satisfactory, though far from spectacular, business result.

That’s true as well of our experience in the market with the group. Since our original purchases, valuation gains have somewhat exceeded earnings growth because price/earnings ratios have increased. On a year-to-year basis, however, the business and market performances have often diverged, sometimes to an extraordinary degree. During The Great Bubble, market-value gains far outstripped the performance of the businesses. In the aftermath of the Bubble, the reverse was true.

Clearly, Berkshire’s results would have been far better if I had caught this swing of the pendulum. That may seem easy to do when one looks through an always-clean, rear-view mirror. Unfortunately, however, it’s the windshield through which investors must peer, and that glass is invariably fogged. Our huge positions add to the difficulty of our nimbly dancing in and out of holdings as valuations swing.

Nevertheless, I can properly be criticized for merely clucking about nose-bleed valuations during the Bubble rather than acting on my views. Though I said at the time that certain of the stocks we held were priced ahead of themselves, I underestimated just how severe the overvaluation was. I talked when I should have walked.

As the following charts show, of the big four, Coke and Procter & Gamble reached the most extreme levels of over-valuation. According to Value Line, Coke sold at an average P/E ratio of 47.5 during 1999, its peak being considerably higher.  Procter & Gamble sold at an average P/E of 30.8 during 1999.

(all graphs show quarterly prices and P/E ranges from 1/1/1996 to 7/30/2010)

American Express

Coca-Cola

Procter & Gamble

Wells Fargo

(click images to enlarge)

What lessons can be learned from this?

If you’ve read my investing blueprint you know that I am a strong proponent of patient business-like investing for the long-term. This is a proven way to create wealth. However, at a sufficiently high price, all assets – no matter what their level of quality – should be sold.

What is sufficiently high? When the price clearly exceeds all reasonable estimates of the Net Present Value of the business’s earnings after taking taxes into consideration.

What can make this difficult is that the intrinsic value – the net present value of all future cash flows – of a truly great business may be strikingly high in relation to its current earnings. Consider that a 50-year bond with economics similar to those of Coke (ROE of 30% and a payout ratio of 66.67%) would have a net present value of 46x earnings, assuming a discount rate of 8%. (Here’s the data.)

However, unlike a bond where the coupon is set and contractually obligated, a holder of equity has no future guarantee other than his judgment about the competitive advantages of the business.  At the peak of the bubble, Coke’s price appeared to more than fully reflect the next 50 years of earnings and then some.

Plus, the proceeds of the sale could have been redeployed in cheaper assets, thereby raising the intrinsic value of Berkshire Hathaway. The challenge is that, unless you have a specific immediate purchase in mind, you never know how long you will need to wait to re-invest the funds of a sale.

If you buy or hold an overvalued security it will materially impact your future performance. Many stocks purchased during the Internet Bubble have shown a large increase in earnings with no progress in the price of the stock.

Consider an example. In 1999, Microsoft earned $.70 a share, sold for an average P/E of 49.8 and traded between $34 and $60 per share. Ten years later during 2009, it earned $1.62 per share, more than doubling its earnings, but sold for an average P/E of 13.4 and traded no higher than 31.5. Lesson: don’t overpay – it’s costly!

Confirmation Bias

Beware of confirmation bias, which Wikipedia defines as, “a tendency for people to favor information that confirms their preconceptions or hypotheses whether or not it is true.” Buffett was long on record as saying that his favorite holding period was forever, going so far in his 1990 shareholder letter as to call Capital Cities/ABC, Coca-Cola, GEICO, and Washington Post his “permanent four”. The risk with confirmation bias is that you are liable to act irrationally even at the expense of your own interests.

How Much Cash Will You Get Back?

If you are a businesslike investor, you should actually expect that a business in which you invest will deliver more cash than you put in. This is how Buffett operates as is evident from the comments about how much of his cost for purchasing shares in the “Big Four” he had already received. This is a lesson in how to think in a businesslike fashion about investing.

“The glass is invariably fogged”

Investing – whether deciding on a new purchase or whether to hold an existing investment – is always a business of judgment fraught with many uncertainties: “the glass is invariably fogged.” Accept this and get on with it by putting a premium on hard work, exceptional research, and following a rational investing process with great discipline.

What are your thoughts? Did Buffett indeed make a mistake by not selling Coke?

Buffett and the Investment Process

Buffett does not believe that successful investing is a function of exceptionally high IQ or inside information.  According to Buffett, investors simply need a rational framework and the discipline to control their emotions.  Buffett has such a framework which he has used to amass his vast fortune.  In contrast, most investors have no such framework and are therefore thrown about by investment fads, faulty theories and emotions.  Often, their methods amount to little more than buying stocks because they going up and selling them because they are going down.  From time to time, these investors obtain a good result and mistakenly attribute it to skill.  These premature declarations of victory are frequently followed by recurring poor outcomes that can permanently destroy capital and erode investor confidence.  These investors not only lack a rational framework, but also they fail to make the fundamental distinction between process and outcome.

To understand this distinction, imagine a gambler playing high-stakes black jack at a crowded table.  After placing a large bet, he draws a hard 17 with his first two cards.  Instead of standing on the hard 17 as the mathematics of optimal blackjack play dictate, he motions the dealer for a hit and draws a 4 for a perfect 21.  In this case, the gambler gets a good outcome but his process is flawed.  He may have won the hand, but in the long run he will produce a poor outcome – he will lose a lot of money – if he continues to use a poor process – ignoring the mathematical rules of optimal blackjack play and playing by gut instinct.  Casinos understand this very well and relentlessly focus on having a good process, which for them means only playing games where the house has a mathematical expectancy of winning.

There is a strong tendency if you get a good outcome to mistakenly attribute it to skill.  This is dangerous because it can lead to costly mistakes and will fail to produce consistently good outcomes.  This is why Buffett says that during a bull market you don’t know who is swimming naked until the tides goes out.  A sports team may win some games with a bad process, but you cannot build a championship organization without a good process.   Moreover, the inherent long-term nature of many endeavors makes focusing on process even more important.  For example, it takes five years to know the outcome of a baseball draft.

If you want to improve your investment results (outcomes), thoroughly review your investment process and make changes wherever necessary.  Reviewing my investment blueprint may help you do this.