Category Archives: Investing Process

A Peek into Ted Weschler’s Thought Process

On March 3, 2014 on CNBC’s Squawk Box, Ted Weschler discussed Berkshire’s investment in DaVita Healthcare Partners.

Weschler listed three broad filters he uses for investing in healthcare stocks.

  1. Does the provider deliver better quality of care than someone could get anywhere else?
  2. Does the company deliver a net savings to the healthcare system?
  3. Do you get a high-return on capital, growth and a shareholder friendly management? Presumably, Weschler looks for these same characteristics in other industries.

Weschler began studying the dialysis industry right out of college. Therefore he knows the industry well. The lesson here is to look for insights by studying an industry deeply over a sustained period of time. This echoes lessons from Warren Buffett.

Finally, Weschler is long-term oriented. He has no idea how DaVita will do in the short term (two years out) but he is confident that in five years it will be a more valuable franchise.

The takeaway: a value-oriented rational framework applied consistently over time will deliver (very) satisfactory results.

A quick – and important – thought on P/E ratios

I am in the process of going back and carefully reading everything Buffett has to say about valuing assets.

If you have followed Buffett, you have probably read that he is not a big fan of P/E ratios. P/E ratios are a kind of shorthand. The problem is, that for all they may tell you about a business, there is a lot that they leave out, which brings me to my quick point.

When looking at a P/E ratio, train yourself to carefully look at how much capital was required to produce the “E” (earnings). This can tell you a lot about the quality of the earnings. A business producing $1 million of earnings utilizing $4 million in tangible assets is far different from a business producing $1 million of earnings that requires $9 million in tangible assets.

Both may have the same P/E. The P/E of the second business may even be lower, but that does not necessarily mean that it is cheaper.

Assume these are growth companies that you project to grow at 10% over the next ten years. From a GAAP perspective each business will generate about $17.5 million in “earnings” over the ensuing ten years, but there is a big difference in the economics of the two businesses. Assuming consistent returns on equity, the first business will require an additional $6 million of capital while the second business will require an additional $14 million.

All growth businesses are not created equal.

P/Es are a useful tool to make the first cut. But it is essential to go deeper and look at the amount of capital it took – and will take – to produce those earnings.

10 Ways to Improve Your Investment Process – #10. Continuously Improve

The tenth idea I’ll leave you with is to seek to continuously improve your process.

The best coaches, the best CEOs, the best investors all religiously do this.

One of Nick Saban’s assistant coaches, who was with him at LSU in 2000, re-joined him after ten years apart. The assistant coach was asked how Saban’s process had changed. He responded, “It’s been polished. Coach knows what he wants to do. That’s why he’s been so successful.”

In an interview with ESPN, Paul DePodesta, distanced himself from the notion that his baseball process as described in Moneyball was limited to using statistics to identify and draft undervalued ball players. Rather, he defined his process in much broader terms which could be applied whether you’re running a sports club or a hedge fund.

According to DePodesta, “It’s a constant investigation of stagnant systems, to see if you can find value where it isn’t readily apparent. It can be anything. At the time, it happened to be using statistics to make us better decisions. That’s not always the case. There are new frontiers we need to conquer.”

One final example of continuous improvement is that of value investor Mohnish Pabrai – a disciple of Warren Buffett and Charlie Munger. Pabrai uses a checklist to capture investment mistakes that have been made by great investors. Pabrai scoured their past investment letters and holdings looking for mistakes. In some cases, it was easy because the investors acknowledged the mistake and explained why it happened. In other cases, he had to find the mistakes on his own and deduce why they happened.

Pabrai currently has more than seventy items on his checklist which he credits for improving his performance and avoiding mistakes.

I think this is a powerful way to improve – and to keep improving. Create a checklist of all your investing mistakes and then add to it as you come across mistakes made by other investors.

In the words made famous by Nike, “Just Do It!”

Share via Twitter, Facebook, Email and more.

10 Ways to Improve Your Investment Process – #9. Be Patient

The ninth idea to improve your investment process is to be (more) patient.

The great investor Peter Cundill, who died earlier this year and whose fund achieved 15% returns for over thirty years, stated that the most important attribute for success as an investor is being patient and that most investors don’t have it. The importance of patience is frequently cited by other great investors.

No investment process – even the best – outperforms in every period. This is asking too much given the amount of external factors that affect performance.

Patience is not only required of long-term investors. Even frequent traders must have conviction in their investment process and have the patience to trade through the inevitable draw-downs.

In short, investors cannot escape the requirement of patience or they condemn themselves to mediocrity or failure. Without patience, you’ll abandon your current approach only to chase the next investment fad, only to see it take an inevitable downturn.

Can patience be learned? I think it is one of the fruits of a good investment process. The better your process, the greater your conviction to stay with it long enough to bear fruit. This is the only sensible approach to building a consistent record of good performance.

10 Ways to Improve Your Investment Process – #8. Pay Attention to the Details

The eighth idea to improve your investment process is to pay attention to the details.

The book The Extra 2% tells the story of how former Goldman Sachs colleagues Staurt Sternberg and Matthew Silverman took over operations of the Tampa Bay Rays baseball team in 2005. Prior to that, the team had been a disaster and a perennial bottom feeder.

The turnaround was dramatic. In 2008, the Rays became the first team in modern Major League history to hold the best record through Memorial Day after having the worst record the year before. They went on that year to play in the World Series where they lost to the Phillies.

How did they do it?

They relentlessly sought to improve all aspects of their baseball process, no matter how small – from parking, to concessions, to how they looked for new players. To identify undervalued ball players, they carefully analyzed statistical data – a method known as sabermetrics – to rebuild the team around lesser-known young stars.

The lesson here is fairly obvious, yet nonetheless powerful: to be successful, you need to look at all aspects of your process and look for small incremental ways to make them better. If you plug away at it, these little things – the Extra 2% – can make a huge difference.

In an earlier post on improving your investment process, I mentioned how casinos achieve a good outcome by focusing on their process, namely only playing games where the mathematical expectancy is in their favor. But they don’t stop there. They maniacally focus on little things to keep folks playing, knowing the longer people play, the more the house earns: free drinks, comps, table limits, shoes vs. single decks, “help” from the dealer, minimum bet sizes, classes on how to play, an exciting ambiance, comfortable seats, attractive servers, cameras to prevent cheating, and chips instead of cash to foster mental accounting. Nothing is overlooked.

Share via Twitter, Facebook, Email and more.

10 Ways to Improve Your Investment Process – #7. Manage Yourself

The seventh idea to improve your investment process is to manage yourself.  I want to focus on three components of self-management: management of cognitive biases, management of your time and management of your work ethic.

We all have certain quirks in our mental wiring that impair our judgment. Behavioral scientists calls these cognitive biases.

They include being overly confident in our abilities, giving too much importance to recent events, and discounting information that runs counter to our beliefs. They influence us on a subconscious level and geniuses are not excluded.

The problem is that they lead to irrational and costly decisions.

If you want to avoid these errors, you need to understand these quirks and take precautions. Following Munger, I recommend making a checklist of the these misjudgments and studying it. You can then run it down when you’re making an important decision.

You could also collect the best books and articles on the subject and make their study a serious part of your professional development.

The second element of self-management is time management.

Time is arguably an investor’s scarcest resource. There is always something to do, along with unlimited distractions and interruptions.

A successful investor must become a master of his or her time. Having a well defined process is half the battle because it gives you a tool to say NO to things that don’t serve your objectives.

Fortunately, there are a number of good tools available to help you manage your time. Two I like are Getting Things Done by David Allen and The Pomodoro Technique by Francesco Cirillo.

Getting Things Done gives you a robust process for managing your tasks and projects. It uses checklists to manage everything from what to do now to thinking about your career over the next five years.

The Pomodoro Technique gives you a simple approach to remain focused by doing your work in pre-planned 25-minute chunks, where you work hard at managing interruptions.

The Pomodoro Technique also allows you to track your time so you’ll know how it’s really used. Self delusion is not a useful component of a winning investment process.

The third element of self-management is managing your work ethic.

Woody Hayes said, “I’ve had smarter people around me all my life, but I haven’t run into one yet that can outwork me. And if they can’t outwork you, then smarts aren’t going to do them much good. That’s just way it is.”

Alice Schroder credits much of Warren Buffett’s success to his work ethic. When digging into Buffett’s life, Schroder found no holy grail; rather, she found an intelligent man who worked very hard.

Improve your management of your cognitive biases, your time and your work ethic, and you’ll improve your investment results.

10 Ways to Improve Your Investment Process – #6. Improve Your Risk Management

The sixth idea to improve your investment process is to improve your risk management. The recent financial crisis was another reminder that smart people are capable of doing very foolish things with their money. We all need to re-double our efforts to improve how we manage risk. You are the chief risk officer of your portfolio, and you should never completely delegate that to someone else.

In the book The Warren Buffetts Next Door, investor Bob Krebs tells a story about risk management. Krebs was impacted by an article about fifty career carpenters. It told how ten of the fifty went thirty years with their fingers intact even though they worked daily with saws and cutting tools.

The forty who lost a finger said they knew just before an accident that they were at high risk, but failed to yield to a primal scream inside that was yelling STOP. The other ten, in contrast, always listened to this inner voice. They never operated equipment when tired, rushed or after drinking.

One old-timer, who had gone 70 years without an accident, would carefully inspect his hands for three or four minutes before working. He’d take careful stock of his fingers and imagine how awful it would be to lose them.

I have adapted this simple approach and resolved to regularly review my investments with the use of a risk checklist. I look for flaws in my thinking and risks I’m taking that aren’t worth it.

Here are some of the questions I consider regarding each investment:

(1) What is the competitive risk the business is facing?

(2) Does the investment expose me to life-changing economic risk?

(3) What is my ignorance risk? In other words, am I holding an investment I don’t understand?

(4) Is the stock materially overvalued exposing me to overvaluation risk?

(5) Am I exposed to macro risk? For example, am I continuing to hold a large percentage of my portfolio in equities when the market is clearly overvalued?

(6) What about leverage risk? Is the business overleveraged and vulnerable to a shock if it can’t access the capital markets to roll over its debt?

(7) What other risk to the business am I ignoring because it doesn’t fit in neatly with my thesis? Remember, your brain works hard to ignore information that runs counter to a deeply held belief.

Simply thinking through a series of questions like these will help you avoid costly mistakes and permanent loss of capital, provided like the carpenters who kept their fingers intact, you heed the warning of your inner voice.

Share via Twitter, Facebook, Email and more.

10 Ways to Improve Your Investment Process – #5. Improve Your Search Strategy

The fifth idea to improve your investment process is to improve your search strategy. First, you want to increase the number of ideas you’re looking at. The more rocks you turn over, the greater your chances of finding a great investment.

Second, you don’t want to miss an obvious investment because you weren’t paying attention. That’s Buffett’s famous sin of omission.

I maintain four checklists to help me do this.

First, I have a checklist of great investors whom I track for new ideas. I limit the list to investors whose process and philosophy is similar to my own. I track their 13F disclosures and their investor letters, if available. Caution: any idea you find this way is only a starting point. You still need to do your own work, otherwise you won’t have the necessary conviction to buy a meaningful position and hold the stock through periods of volatility for big gains.

Second, I have a checklist of publications, forums and blogs that I follow for new ideas.

Third, I keep a checklist of my daily routine that includes basic screens I look at – like the 52-week low list – to make sure I don’t miss something.

Finally, I keep a growing watchlist of stocks I follow which includes a valuation estimate and a target price to buy the stock.

It’s easy to get away from this discipline because most days there’s nothing there. This is a common error with checklists. You get complacent and skip steps even when you remember them. For example, think of an airline pilot who always finds that a given gauge gives the correct reading. He may be tempted to skip the step of checking it. With investments, that might be the day an elephant decides to tiptoe by.

You can also improve if you focus your time on ideas that are obvious. If it’s too close to call, the investment may not be worth it. You’ll get better returns over time if you do this. You’ll also save yourself a lot of time.

Improve your search strategy and you will improve your results.

Share via Twitter, Facebook, Email and more.

10 Ways to Improve Your Investment Process – #4. Use Checklists

The fourth idea to improve your investment process is to use checklists. Charlie Munger has been talking about checklists for years and they recently got a big plug from Atul Gawande’s book The Checklist Manifesto.

Checklists are still massively underutilized, in spite of being one the best performance levers out there.

You should use checklists because they work. Consider the following.

In 1935, Boeing nearly lost a major contract for the B-17 when it crashed during a demo to the Army. Boeing determined that the crash was the result of human error. The B-17 was much more complicated than prior planes. To fix the problem, Boeing came up with a simple checklist. The B-17 went on to fly almost 2 million miles without an accident and the Army bought almost 13,000 planes.

Checklists played a role in the successful landing of US Airways flight 1549 on the Hudson River in 2009. Captain Sully Sullenberger and his co-pilot Jeffrey Skiles followed a series of checklists to try to restart the engines and then ditching procedures to land the plane on the icy river.

They used checklists to stay on task in a moment of massive stress. The checklists didn’t substitute for judgment, but greatly lessened the chance of making a dumb and potentially lethal mistake.

Checklists have also had an unexpected impact in medicine. A simple 4-point checklist was rolled out to Michigan Intensive Care Units to reduce infections from line insertions. Line infections continue to kill thousands of people each year.

The results were dramatic. The typical I.C.U. cut its quarterly infection rate to zero. Fifteen hundred lives were saved and costs were reduced by a hundred and seventy-five million dollars.

Checklists also work in finance. One study looked at the use of checklists by 51 venture capitalists – a group that’s both intelligent and highly motivated to succeed. The VCs said one of their biggest challenges was deciding which entrepreneurs to fund. They found that the jockey was often more important that the idea itself.

The study identified a half-a-dozen different ways that the VCs used to decide who to back. Some went by gut feel. Another relied on extensive interviews. One group used a checklist. This group ended up firing only 10% of entrepreneurs vs. 50% for the other groups. The average return in the checklist group was 80% vs. 35% for the others.

Hedge fund manager Guy Spier talks about how checklists counter what he calls “cocaine brain” which is the feeling of euphoria that can cloud your judgment when you get excited about a stock. A checklist brings you back to earth and prevents stupid mistakes.

Another hedge fund manager in The Checklist Manifesto uses checklists to both drive performance and reduce the time it takes to evaluate a security. This was a surprise because his analysts thought checklists would slow them down.

We can summarize some of the things checklists do.

They are not a substitute for judgment, but they do aid our memory and help us to manage complexity. They help us to manage our emotions and misjudgments. They also help reduce the effects of complacency. Instead of thinking – “Why bother reading the proxy and footnotes? Most of the time there’s not much in them.” – you go through them because it’s on your list and part of your discipline.

In short, checklists help us to prevent mistakes.

So why aren’t they used more often? I think the answer lies in human nature. We all know that diet and exercise are good for us. The problem is often not with knowing what to do, but actually doing it.

I also believe there is some resistance to checklists on the basis of pride. It can be difficult for a highly trained expert to acknowledge that a simple checklist can improve his or her performance.

Checklists are also a useful way to store wisdom and make it accessible. When you come across a good idea to improve your investment process, where do you put it? If you’ve recorded your process in checklists, you can simply add it to the appropriate one. You can even have a “someday” checklist for ideas you want to think about before making them part of your process.

The use of checklists will improve your investing process and in turn improve your results.