Monthly Archives: August 2011

100 Ways to Beat the Market #9: Cash is King!

One of the realities that makes value investing possible and profitable is that market prices vary more – sometimes much more – than underlying business values. Joel Greenblatt is fond of illustrating this point by getting out the newspaper and showing his students the huge variances in prices between 52 week highs and lows. This, of course, is also the lesson of Graham’s famous Mr. Market parable.

To take advantage of these opportunities requires cash.

You not only need to have cash on hand to provide reasonable buying power when the market goes into a funk, but also you need to have enough cash on hand to never be in a position of needing to raise cash in a down market by selling your undervalued holdings. If you don’t have any cash, you won’t be able to profit from Mr. Market’s gifts. If you need to sell your holdings in a severe market decline, you turn your primary advantage as a value investor on its head and make it work against you.

There is no precise formula on how to do this but a few common sense principles should go a long way.

1. Have sufficient liquidity from income and savings that you can go three to five years without needing to tap into your equity holdings.

2. If one of your holdings becomes materially overvalued – thereby discounting years of the most optimistic expectations for progress in the underlying business – sell it to restock your cash position.

3. Maintain a meaningful portion of your portfolio in liquid form so you have buying power when opportunity presents itself. This is not to say that you should never be fully invested, but the bar should be set pretty high for you to part with that last 20% of your portfolio held in cash. The prospective investment should be screaming at you, and you should be fully cognizant of the opportunity costs of committing these funds.

4. As a compliment to point 2, consider a meaningful investment in companies such as Berkshire Hathaway that have the ability to buy opportunistically on your behalf. For example, Berkshire has a huge cash stock pile of around $40 billion, annual earnings power of approximately $12 billion, ready access to funding, and – most importantly – the skills and attitude to put it to work when opportunity presents itself.

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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.

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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.

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100 Ways to Beat the Market #8: Have the Right Psychological Framework Regarding Losses

It is common in market downturns to hear and read about mounting investor losses. Pundits talk about the hundreds of billions or even trillions of dollars of wealth that have been wiped out. Of course, some real wealth is wiped out in market downturns as overvalued stocks come back to earth and when investors lock in losses by selling as a result of fear or a liquidity crunch.

Ben Graham taught us a better way in The Intelligent Investor. “The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price speculation.”

To be a true investor has some requirements:

1) That you can reasonably value a prospective business before making an investment.

2) That you don’t overpay.

3) That you consider yourself a part owner in that business.

4) That you have enough cash from income or savings to not be forced to sell.

5) That you avoid leverage.

Perhaps most importantly, you need the right emotional framework to not panic when everyone around you is losing their head. There is no shame in feeling the pangs of fear when facing stiff quotational losses. We can’t undo the way we are wired. We can, however, choose our response to a given emotional reaction. As Steven Covey teaches, “Between stimulus and response there is a space. In that space lies our freedom and power to choose our response. In those choices lie our growth and our happiness.”

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Links of Interest – August 19, 2011

A Different View of Investing – – Insight from Murray Stahl, the chief investment officer of New York-based Horizon Kinetics. I am a fan of Stahl. He is an original thinker. Check out his firm’s commentary.

Warren Buffett on Charlie Rose

Buffett: U.S. May Pick Up Sooner Than Fed Thinks – Real Time Economics – WSJ – Noteworthy given the amount of data that Buffett sees from Berkshire’s far-flung businesses.

Investing for Higher After-Tax Returns – Tweedy Browne

Microeconomics and Psychology – “a nice summary of the principles of behavioral economics” – Jason Zweig

Cash Doesn’t Lie –

Cisco’s Disruptive (And Cooler) Rival – – It’s tough to judge the strength of Cisco’s moat going forward.

Lessons From The Great –

Audio of Wesco Morning with Charlie

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100 Ways to Beat the Market #7: Avoid Hot Industries with No Barriers to Entry

A Lex column in yesterday’s Financial Times, “Solar: the sun also sets”, is yet another stark reminder that a growing industry does not necessarily make a good investment.

The solar panel industry is expanding rapidly as measured by worldwide megawatts of solar panel shipments. By that measure, business is up approximately sixteen fold in the past five years.

In stark contrast, solar energy stocks, as measured by the Mac Solar Energy Index, are badly trailing the S&P 500. The problem is overcapacity and cheap products coming out of China. One casualty, Evergreen Solar, just filed for bankruptcy protection.

Investors are easily enamored with hot industries with seemingly unlimited growth opportunities. However, in many cases, the businesses in these industries do not have any durable competitive advantages. Competitors pile in and drive margins into the ground.

Society may be the ultimate beneficiary if competition drives down prices far enough for solar power to compete with fossil fuels, particularly if it can be done without subsidies. Investors in this sector may not be so lucky.

Steer clear of hot industries with no barriers to entry. Don’t invest in a business without a moat. Pay attention to whether managers gets this and what steps they are taking to strengthen their hand. This may be the single most important factor if you are a long-term investor.

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100 Ways to Beat the Market #6: Focus on What is Knowable and Important

It is useful to think about the world in terms of a four-quadrant matrix where the horizontal dimension comprises what is knowable and unknowable and the vertical dimension comprises what is important and unimportant.


Knowable       Unknowable





It should be obvious that you should not spend any time on what is unknowable and unimportant.

The trick is steering clear of the Unknowable/Important box and the Knowable/Unimportant box.

The Unknowable/Important box is very tempting. Lots of people pretend to have something worthwhile to say about things that fall into this quadrant. This is where most macro forecasts live and discussions about timing and short-term price movements. Promoters like to set-up shop here. This is the domain of unfounded opinions where the prognosticator’s incentives almost never align with your interests.

The Knowable/Unimportant box is also tempting. An example is useful here. Buffett pointed out that it was knowable quite early on that automobiles and airplanes were destined to rise and become a central part of modern life. These insights were not particularly useful to investors because a) it was impossible to handicap the eventual winners in those emerging industries and b) even if you could, they were unattractive investments given their reliance on massive low-return capital investments.

The trick is to focus on what is important and knowable. For example, it is very important to try to understand where a prospective business investment will be in ten years, even if it cannot be done with precision. It’s equally important to limit the time you invest thinking about investments to those businesses where this is actually possible. You can’t do this very often, but this is what you should be looking for.

Focus on spending your day in this quadrant. This is where meaningful decisions are made. This is where you can gain an edge over those who are unwittingly wasting time on the unknowable and the unimportant.

The temptation to be drawn to these time wasters is real and strong. It is deeply grounded in human nature. The Internet only exacerbates this tendency.

Challenge yourself. Examine your day and resolve to improve where you’re spending your time and what questions you are asking.

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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.