Cheap, Solid Microcaps Far Outperform the S&P 500

(Image: Zen Buddha Silence, by Marilyn Barbone)

November 12, 2017

The wisest long-term investment for most investors is an S&P 500 index fund.  Warren Buffett has maintained this position for some time:

But you can do significantly better — roughly 7% per year (on average) — by systematically investing in cheap, solid microcap stocks.  The mission of the Boole Microcap Fund is to help you do just that.

Most professional investors never consider microcaps because their assets under management are too large.  Microcaps aren’t as profitable for them.  That’s why there continues to be a compelling opportunity for savvy investors.  Because microcaps are largely ignored, many get quite cheap on occasion.

Warren Buffett earned the highest returns of his career when he could invest in microcap stocks.  Buffett has maintained that he’d do the same today if he were managing small sums:

Look at this summary of the CRSP Decile-Based Size and Return Data from 1927 to 2015:

Decile Market Cap-Weighted Returns Equal Weighted Returns Number of Firms (year-end 2015) Mean Firm Size (in millions)
1 9.29% 9.20% 173 84,864
2 10.46% 10.42% 178 16,806
3 11.08% 10.87% 180 8,661
4 11.32% 11.10% 221 4,969
5 12.00% 11.92% 205 3,151
6 11.58% 11.40% 224 2,176
7 11.92% 11.87% 300 1,427
8 12.00% 12.27% 367 868
9 11.40% 12.39% 464 429
10 12.50% 17.48% 1,298 107
9+10 11.85% 16.14% 1,762 192

(CRSP is the Center for Research in Security Prices at the University of Chicago.  You can find the data for various deciles here:

The smallest two deciles – 9+10 – comprise microcap stocks, which typically are stocks with market caps below $500 million.  What stands out is the equal weighted returns of the 9th and 10th size deciles from 1927 to 2015:

Microcap equal weighted returns = 16.14% per year

Large-cap equal weighted returns = ~11% per year

In practice, the annual returns from microcap stocks will be 1-2% lower because of the difficulty (due to illiquidity) of entering and exiting positions.  So we should say that an equal weighted microcap approach has returned 14% per year from 1927 to 2015, versus 11% per year for an equal weighted large-cap approach.

Still, if you can do 3% better per year than the S&P 500 index (on average) — even with only a part of your total portfolio — that really adds up after a couple of decades.



By systematically implementing a value screen — e.g., low EV/EBIT or low P/E — to a microcap strategy, you can add 2-3% per year.



You can further boost performance by screening for improving fundamentals.  One excellent way to do this is using the Piotroski F_Score, which works best for cheap micro caps.  See:



In sum, over the course of several decades, a quantitative value strategy — applied to cheap microcap stocks with improving fundamentals — has high odds of returning at least 7% (+/- 3%) more per year than an S&P 500 index fund.



An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are 15-25 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 10-15% (at cost), while the average position is 5-7% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees.  The Boole Fund has low fees. 


If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail:




Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

Lifelong Learning

(Image: Zen Buddha Silence, by Marilyn Barbone)

October 29, 2017

Lifelong learning—especially if pursued in a multidisciplinary fashion—can continuously improve your productivity and ability to think.  Lifelong learning boosts your capacity to serve others.

Robert Hagstrom’s wonderful book, Investing: The Last Liberal Art (Columbia University Press, 2013), is based on the notion of lifelong, multidisciplinary learning.

Ben Franklin was a strong advocate for this broad-based approach to education.  Charlie Munger—Warren Buffett’s business partner—wholeheartedly agrees with Franklin.  Hagstrom quotes Munger:

Worldly wisdom is mostly very, very simple.  There are a relatively small number of disciplines and a relatively small number of truly big ideas.  And it’s a lot of fun to figure out.  Even better, the fun never stops…

What I am urging on you is not that hard to do.  And the rewards are awesome… It’ll help you in business.  It’ll help you in law.  It’ll help you in life.  And it’ll help you in love… It makes you better able to serve others, it makes you better able to serve yourself, and it makes life more fun.

Hagstrom’s book is necessarily abbreviated.  This blog post even more so.  Nonetheless, I’ve tried to capture many of the chief lessons put forth by Hagstrom.

Here’s the outline:

  • A Latticework of Mental Models
  • Physics
  • Biology
  • Sociology
  • Psychology
  • Philosophy
  • Literature
  • Mathematics
  • Decision Making

(Image: Unfolding of the Mind, by Agsandrew)



Charlie Munger has long maintained that in order to be able to solve a broad array of problems in life, you must have a latticework of mental models.  This means you have to master the central models from various areas—physics, biology, social studies, psychology, philosophy, literature, and mathematics.

As you assimilate the chief mental models, those models will strengthen and support one another, notes Hagstrom.  So when you make a decision—whether in investing or in any other area—that decision is more likely to be correct if multiple mental models have led you to the same conclusion.

Ultimately, a dedication to lifelong, multidiscipinary learning will make us better people—better leaders, citizens, parents, spouses, and friends.

In the summer of 1749, Ben Franklin put forward a proposal for the education of youth.  The Philadelphia Academy—later called the University of Pennsylvania—would stress both classical (“ornamental”) and practical education.  Hagstrom quotes Franklin:

As to their studies, it would be well if they could be taught everything that is useful and everything that is ornamental.  But art is long and their time is short.  It is therefore proposed that they learn those things that are likely to be most useful and most ornamental, regard being had to the several professions for which they are intended.

Franklin held that gaining the ability to think well required the study of philosophy, logic, mathematics, religion, government, law, chemistry, biology, health, agriculture, physics, and foreign languages.  Moreover, says Hagstrom, Franklin viewed the opportunity to study so many subjects as a wonderful gift rather than a burden.

(Painting by Mason Chamberlin (1762) – Philadelphia Museum of Art, via Wikimedia Commons)

Franklin himself was devoted to lifelong, multidisciplinary learning.  He remained open-minded and intellectually curious throughout his life.

Hagstrom also observes that innovation often depends on multidisciplinary thinking:

Innovative thinking, which is our goal, most often occurs when two or more mental models act in combination.



Hagstrom remarks that the law of supply and demand in economics is based on the notion of equilibrium, a fundamental concept in physics.

(Research scientist writing physics diagrams and formulas, by Shawn Hempel)

Many historians consider Sir Isaac Newton to be the greatest scientific mind of all time, points out Hagstrom.  When he arrived at Trinity College at Cambridge, Newton had no mathematical training.  But the scientific revolution had already begun.  Newton was influenced by the ideas of Johannes Kepler, Galileo Galilei, and René Descartes.  Hagstrom:

The lesson Newton took from Kepler is one that has been repeated many times throughout history:  Our ability to answer even the most fundamental aspects of human existence depends largely on measuring instruments available at the time and the ability of scientists to apply rigorous mathematical reasoning to the data.

Galileo invented the telescope, which then proved that the heliocentric model proposed by Nicolaus Copernicus was correct, rather than the geocentric model—first proposed by Aristotle and later developed by Ptolemy.  Moreover, Galileo developed the mathematical laws that describe and predict falling objects.

Hagstrom then explains the influence of Descartes:

Descartes promoted a mechanical view of the world.  He argued that the only way to understand how something works is to build a mechanical model of it, even if that model is constructed only in our imagination.  According to Descartes, the human body, a falling rock, a growing tree, or a stormy night all suggested that mechanical laws were at work.  This mechanical view provided a powerful research program for seventeenth century scientists.  It suggested that no matter how complex or difficult the observation, it was possible to discover the underlying mechanical laws to explain the phenomenon.

In 1665, due to the Plague, Cambridge was shut down.  Newton was forced to retreat to the family farm.  Hagstrom writes that, in quiet and solitude, Newton’s genius emerged:

His first major discovery was the invention of fluxions or what we now call calculus.  Next he developed the theory of optics.  Previously it was believed that color was a mixture of light and darkness.  But in a series of experiments using a prism in a darkened room, Newton discovered that light was made up of a combination of the colors of the spectrum.  The highlight of that year, however, was Newton’s discovery of the universal law of gravitation.

(Copy of painting by Sir Godfrey Kneller (1689), via Wikimedia Commons)

Newton’s three laws of motion unified Kepler’s planetary laws with Galileo’s laws of falling bodies.  It took time for Newton to state his laws with mathematical precision.  He waited twenty years before finally publishing Principia Mathematica.

Newton’s three laws were central to a shift in worldview on the part of scientists.  The evolving scientific view held that the future could be predicted based on present data if scientists could discover the mathematical, mechanical laws underlying the data.

Prior to the scientific worldview, a mystery was often described as an unknowable characteristic of an “ultimate entity,” whether an “unmoved mover” or a deity.  Under the scientific worldview, a mystery is a chance to discover fundamental scientific laws.  The incredible progress of physics—which now includes quantum mechanics, relativity, and the Big Bang—has depended in part on the belief by scientists that reality is comprehensible.  Albert Einstein:

The most incomprehensible thing about the universe is that it is comprehensible.

Physics was—and is—so successful in explaining and predicting a wide range of phenomena that, not surprisingly, scientists from other fields have often wondered whether precise mathematical laws or ideas can be discovered to predict other types of phenomena.  Hagstrom:

In the nineteenth century, for instance, certain scholars wondered whether it was possible to apply the Newtonian vision to the affairs of men.  Adolphe Quetelet, a Belgian mathematician known for applying probability theory to social phenomena, introduced the idea of “social physics.”  Auguste Comte developed a science for explaining social organizations and for guiding social planning, a science he called sociology.  Economists, too, have turned their attention to the Newtonian paradigm and the laws of physics.

After Newton, scholars from many fields focused their attention on systems that demonstrate equilibrium (whether static or dynamic), believing that it is nature’s ultimate goal.  If any deviations in the forces occurred, it was assumed that the deviations were small and temporary—and the system would always revert back to equilibrium.

Hagstrom explains how the British economist Alfred Marshall adopted the concept of equilibrium in order to explain the law of supply and demand.  Hagstrom quotes Marshall:

When demand and supply are in stable equilibrium, if any accident should move the scale of production from its equilibrium position, there will instantly be brought into play forces tending to push it back to that position; just as a stone hanging from a string is displaced from its equilibrium position, the force of gravity will at once tend to bring it back to its equilibrium position.  The movements of the scale of production about its position of equilibrium will be of a somewhat similar kind.

(Alfred Marshall, via Wikimedia Commons)

Marshall’s Principles of Economics was the standard textbook until Paul Samuelson published Economics in 1948, says Hagstrom.  But the concept of equilibrium remained.  Firms seeking to maximize profits translate the preferences of households into products.  The logical structure of the exchange is a general equilibrium system, according to Samuelson.

Samuelson’s view of the stock market was influenced by the works of Louis Bachelier, Maurice Kendall, and Alfred Cowles, notes Hagstrom.

In 1932, Cowles founded the Cowles Commission for Research and Economics.  Later on, Cowles studied 6,904 predictions of the stock market from 1929 to 1944.  Cowles learned that no one had demonstrated any ability to predict the stock market.

Kendall, a professor of statistics at the London School of Economics, studied the histories of various individual stock prices going back fifty years.  Kendall was unable to find any patterns that would allow accurate predictions of future stock prices.

Samuelson thought that stock prices jump around because of uncertainty about how the businesses in question will perform in the future.  The intrinsic value of a given stock is determined by the future cash flow the business will produce.  But that future cash flow is unknown.

Bachelier’s work showed that the mathematical expectation of a speculator is zero, meaning that the current stock price is in equilibrium based on an equal number of buyers and sellers.

Samuelson, building on Bachelier’s work, invented the rational expectations hypothesis.  From the assumption that market participants are rational, it followed that the current stock price is the best collective guess of the intrinsic value of the business—based on estimated future cash flows.

Eugene Fama later extended Samuelson’s view into what came to be called the Efficient Markets Hypothesis (EMH).  Stock prices fully reflect all available information, therefore it’s not possible—except by luck—for any individual investor to beat the market over the long term.

Many scientists have questioned the EMH.  The stock market sometimes does not seem rational.  People often behave irrationally.

In science, however, it’s not enough to show that the existing theory has obvious flaws.  In order to supplant existing scientific theory, scientists must come up with a better theory—one that better predicts the phenomena in question.  Rationalist economics, including EMH, is still the best approximation for a wide range of phenomena.

Some scientists are working with the idea of a complex adaptive system as a possible replacement for more traditional ideas of the stock market. Hagstrom:

Every complex adaptive system is actually a network of many individual agents all acting in parallel and interacting with one another.  The critical variable that makes a system both complex and adaptive is the idea that agents (neurons, ants, or investors) in the system accumulate experience by interacting with other agents and then change themselves to adapt to a changing environment.  No thoughtful person, looking at the present stock market, can fail to conclude that it shows all the traits of a complex adaptive system.  And this takes us to the crux of the matter.  If a complex adaptive system is, by definition, continuously adapting, it is impossible for any such system, including the stock market, ever to reach a state of perfect equilibrium.

It’s much more widely accepted today that people often do behave irrationally.  But Fama argues that an efficient market does not require perfect rationality or information.

Hagstrom concludes that, while the market is mostly efficient, rationalist economics is not the full answer.  There’s much more to the story, although it will take time to work out the details.



(Photo by Ben Schonewille)

Robert Darwin, a respected physician, enrolled his son Charles at the University of Edinburgh.  Robert wanted his son to study medicine.  But Charles had no interest.  Instead, he spent his time studying geology and collecting insects and specimens.

Robert realized his son wouldn’t become a doctor, so he sent Charles to Cambridge to study divinity.  Although Charles got a bachelor’s degree in theology, he formed some important connections with scientists, says Hagstrom:

The Reverend John Stevens Henslow, professor of botany, permitted the enthusiastic amateur to sit in on his lectures and to accompany him on his daily walks to study plant life.  Darwin spent so many hours in the professor’s company that he was known around the university as “the man who walks with Henslow.”

Later, Professor Henslow recommended Darwin for the position of naturalist on a naval expedition.  Darwin’s father objected, but Darwin’s uncle, Josiah Wedgewood II, intervened.  When the HMS Beagle set sail on December 27, 1831, from Plymouth, England, Charles Darwin was aboard.

Darwin’s most important observations happened at the Galapagos Islands, near the equator, six hundred miles west of Ecuador.  Hagstrom:

Darwin, the amateur geologist, knew that the Galapagos were classified as oceanic islands, meaning they had arisen from the sea by volcanic action with no life forms aboard.  Nature creates these islands and then waits to see what shows up.  An oceanic island eventually becomes inhabited but only by forms that can reach it by wings (birds) or wind (spores and seeds)…

Darwin was particularly fascinated by the presence of thirteen types of finches.  He first assumed these Galapagos finches, today called Darwin’s finches, were a subspecies of the South American finches he had studied earlier and had most likely been blown to sea in a storm.  But as he studied distribution patterns, Darwin observed that most islands in the archipelago carried only two or three types of finches; only the larger central islands showed greater diversification.  What intrigued him even more was that all the Galapagos finches differed in size and behavior.  Some were heavy-billed seedeaters; others were slender billed and favored insects.  Sailing through the archipelago, Darwin discovered that the finches on Hood Island were different from those on Tower Island and that both were different from those on Indefatigable Island.  He began to wonder what would happen if a few finches on Hood Island were blown by high winds to another island.  Darwin concluded that if the newcomers were pre-adapted to the new habitat, they would survive and multiply alongside the resident finches; if not, their number would ultimately diminish.  It was one thread of what would ultimately become his famous thesis.

(Galapagos Islands, Photo by Hugoht)

Hagstrom continues:

Reviewing his notes from the voyage, Darwin was deeply perplexed.  Why did the birds and tortoises on some islands of the Galapagos resemble the species found in South America while those on other islands did not?  This observation was even more disturbing when Darwin learned that the finches he brought back from the Galapagos belonged to different species and were not simply different varieties of the same species, as he had previously believed.  Darwin also discovered that the mockingbirds he had collected were three distinct species and the tortoises represented two species.  He began referring to these troubling questions as “the species problem,” and outlined his observations in a notebook he later entitled “Notebook on the Transmutation of the Species.”

Darwin now began an intense investigation into the species variation.  He devoured all the written work on the subject and exchanged voluminous correspondence with botanists, naturalists, and zookeepers—anyone who had information or opinions about species mutation.  What he learned convinced him that he was on the right track with his working hypothesis that species do in fact change, whether from place to place or from time period to time period.  The idea was not only radical at the time, it was blasphemous.  Darwin struggled to keep his work secret.

(Photo by Maull and Polyblank (1855), via Wikimedia Commons)

It took several years—until 1838—for Darwin to put together his hypothesis.  Darwin wrote in his notebook:

Being well-prepared to appreciate the struggle for existence which everywhere goes on from long-continued observation of the habits of animals and plants, it at once struck me that under these circumstances, favorable variations would tend to be preserved and unfavorable ones to be destroyed.  The result of this would be the formation of new species.  Here, then, I had at last got a theory—a process by which to work.

The struggle for survival was occurring not only between species, but also between individuals of the same species, Hagstrom points out.  Favorable variations are preserved.  After many generations, small gradual changes begin to add up to larger changes.  Evolution.

Darwin delayed publishing his ideas, perhaps because he knew they would be highly controversial, notes Hagstrom.  Finally, in 1859, Darwin published On the Origin of Species by Means of Natural Selection, or the Preservation of Favoured Races in the Struggle for Life.  The book sold out on its first day.  By 1872, The Origin of Species was in its sixth edition.

Hagstrom writes that in the first edition of Alfred Marshall’s famous textbook, Principles of Economics, the economist put the following on the title page:

Natura non facit saltum

Darwin himself used the same phrase—which means “nature does not make leaps”—in his book, The Origin of Species.  Although Marshall never explained his thinking explicitly, it seems Marshall meant to align his work with Darwinian thinking.

Less than two decades later, Austrian-born economist Joseph Schumpeter put forth his central idea of creative destruction.  Hagstrom quotes British economist Christopher Freeman, who—after studying Schumpeter’s life—remarked:

The central point of his whole life work is that capitalism can only be understood as an evolutionary process of continuous innovation and creative destruction.

Hagstrom explains:

Innovation, said Schumpeter, is the profitable application of new ideas, including products, production processes, supply sources, new markets, or new ways in which a company could be organized.  Whereas standard economic theory believed progress was a series of small incremental steps, Schumpeter’s theory stressed innovative leaps, which in turn caused massive disruption and discontinuity—an idea captured in Schumpeter’s famous phrase “the perennial gale of creative destruction.”

But all these innovative possibilities meant nothing without the entrepreneur who becomes the visionary leader of innovation.  It takes someone exceptional, said Schumpeter, to overcome the natural obstacles and resistance to innovation.  Without the entrepreneur’s desire and willingness to press forward, many great ideas could never be launched.

(Image from the Department of Economics, University of Freiburg, via Wikimedia Commons)

Moreover, Schumpeter held that entrepreneurs can thrive only in certain environments.  Property rights, a stable currency, and free trade are important.  And credit is even more important.

In the fall of 1987, a group of physicists, biologists, and economists held a conference at the Santa Fe Institute.  The economist Brian Arthur gave a presentation on “New Economics.”  A central idea was to apply the concept of complex adaptive systems to the science of economics.  Hagstrom records that the Santa Fe group isolated four features of the economy:

Dispersed interaction:  What happens in the economy is determined by the interactions of a great number of individual agents all acting in parallel.  The action of any one individual agent depends on the anticipated actions of a limited number of agents as well as on the system they cocreate.

No global controller:  Although there are laws and institutions, there is no one global entity that controls the economy.  Rather, the system is controlled by the competition and coordination between agents of the system.

Continual adaptation:  The behavior, actions, and strategies of agents, as well as their products and services, are revised continually on the basis of accumulated experience.  In other words, the system adapts.  It creates new products, new markets, new institutions, and new behavior.  It is an ongoing system.

Out-of-equilibrium dynamics:  Unlike the equilibrium models that dominate the thinking in classical economics, the Santa Fe group believed the economy, because of constant change, operates far from equilibrium.

Hagstrom argues that different investment or trading strategies throughout history have competed against one another.  Those that have most accurately predicted the future for various businesses and their associated stock prices have survived, while less profitable strategies have disappeared.

But in any given time period, once a specific strategy becomes profitable, then more money flows into it, which eventually makes it less profitable.  New strategies are then invented and compete against one another.  As a result, a new strategy becomes dominant and then the process repeats.

Thus, economies and markets evolve over time.  There is no stable equilibrium in a market except in the short term.  To go from the language of biology to the language of business, Hagstrom refers to three important books:

  • Creative Destruction: Why Companies That Are Built to Last Underperform the Market—and How to Successfully Transform Them, by Richard Foster and Sarah Kaplan of McKinsey & Company
  • The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail, by Clayton Christensen
  • The Innovator’s Solution: Creating and Sustaining Successful Growth, by Clayton Christensen and Michael Raynor

Hagstrom sums up the lessons from biology as compared to the previous ideas from physics:

Indeed, the movement from the mechanical view of the world to the biological view of the world has been called the “second scientific revolution.”  After three hundred years, the Newtonian world, the mechanized world operating in perfect equilibrium, is now the old science.  The old science is about a universe of individual parts, rigid laws, and simple forces.  The systems are linear:  Change is proportional to the inputs.  Small changes end in small results, and large changes make for large results.  In the old science, the systems are predictable.

The new science is connected and entangled.  In the new science, the system is nonlinear and unpredictable, with sudden and abrupt changes.  Small changes can have large effects while large events may result in small changes.  In nonlinear systems, the individual parts interact and exhibit feedback effects that may alter behavior.  Complex adaptive systems must be studied as a whole, not in individual parts, because the behavior of the system is greater than the sum of the parts.

The old science was concerned with understanding the laws of being.  The new science is concerned with the laws of becoming.

(Photo by Isabellebonaire)

Hagstrom then quotes the last passage from Darwin’s The Origin of Species:

It is interesting to contemplate an entangled bank, clothed with many plants of many kinds, with birds singing on the bushes, with various insects flitting about, and with worms crawling through the damp earth, and to reflect that these elaborately constructed forms, so different from each other, and dependent on each other in so complex a manner, have all been produced by laws acting around us.  These laws, taken in the largest sense, being Growth with Reproduction; Inheritance which is almost implied by reproduction; Variability from the indirect and direct action of the external conditions of life, and from use and disuse; a Ratio of Increase so high as to lead to a Struggle for Life, and as a consequence to Natural Selection, entailing divergence of Character and Extinction of less improved forms.  Thus, from the war of nature, from famine and death, the most exalted object which we are capable of conceiving, namely, the production of higher animals, directly follows.  There is grandeur in this view of life, with its several powers, having been originally breathed into a few forms or into one; and that, whilst this planet has gone cycling on according to the fixed law of gravity, from so simple a beginning endless forms most beautiful and most wonderful have been, and are being, evolved.



Because significant increases in computer power are now making vast amounts of data about human behavior available, the social sciences may at some point get enough data to figure out more precisely and more generally the laws of human behavior.  But we’re not there yet.

(Auguste Comte, via Wikimedia Commons)

The nineteenth century—despite the French philosopher Auguste Comte’s efforts to establish one unified social science—ended with several distinct specialties, says Hagstrom, including economics, political science, and anthropology.

Scottish economist Adam Smith published his Wealth of Nations in 1776.  Smith argued for what is now called laissez-faire capitalism, or a system free from government interference, including industry regulation and protective tariffs.  Smith also held that a division of labor, with individuals specializing in various tasks, led to increased productivity.  This meant more goods at lower prices for consumers, but it also meant more wealth for the owners of capital.  And it implied that the owners of capital would try to limit the wages of labor.  Furthermore, working conditions would likely be bad without government regulation.

Predictably, political scientists appeared on the scene to study how the government should protect the rights of workers in a democracy.  Also, the property rights of owners of capital had to be protected.

Social psychologists studied how culture affects psychology, and how the collective mind affects culture.  Social biologists, meanwhile, sought to apply biology to the study of society, notes Hagstrom.  Recently scientists, including Edward O. Wilson, have introduced sociobiology, which involves the attempt to apply the scientific principles of biology to social development.

Hagstrom writes:

Although the idea of a unified theory of social science faded in the late nineteenth century, here at the beginning of the twenty-first century, there has been a growing interest in what we might think of as a new unified approach.  Scientists have now begun to study the behavior of whole systems—not only the behavior of individuals and groups but the interactions between them and the ways in which this interaction may in turn influence subsequent behavior.  Because of this reciprocal influence, our social system is constantly engaged in a socialization process the consequence of which not only alters our individual behavior but often leads to unexpected group behavior.

To explain the formation of a social group, the theory of self-organization has been developed.  Ilya Prigogine, the Russian chemist, was awarded the Nobel Prize in 1977 for his thermodynamic concept of self-organization.

Paul Krugman, winner of the 2008 Nobel Prize for Economics, studied self-organization as applied to the economy.  Hagstrom:

Setting aside for the moment the occasional recessions and recoveries caused by exogenous events such as oil shocks or military conflicts, Krugman believes that economic cycles are in large part caused by self-reinforcing effects.  During a prosperous period, a self-reinforcing process leads to greater construction and manufacturing until the return on investment begins to decline, at which point an economic slump begins.  The slump in itself becomes a self-reinforcing effect, leading to lower production; lower production, in turn, will eventually cause return on investment to increase, which starts the process all over again.

Hagstrom notes that equity and debt markets are good examples of self-organizing, self-reinforcing systems.

If self-organization is the first characteristic of complex adaptive systems, then emergence is the second characteristic.  Hagstrom says that emergence refers to the way individual units—whether cells, neurons, or consumers—combine to create something greater than the sum of the parts.

(Collective Dynamics of Complex Systems, by Dr. Hiroki Sayama, via Wikimedia Commons)

One fascinating aspect of human collectives is that, in many circumstances—like finding the shortest way through a maze—the collective solution is better when there are both smart and not-so-smart individuals in the collective.  This more diverse collective outperforms a group that is composed only of smart individuals.

This implies that the stock market may more accurately aggregate information when the participants include many different types of people, such as smart and not-so-smart, long-term and short-term, and so forth, observes Hagstrom.

There are many areas where a group of people is actually smarter than the smartest individual in the group.  Hagstrom mentions that Francis Galton, the English Victorian-era polymath, wrote about a contest in which 787 people guessed at the weight of a large ox.  Most participants in the contest were not experts by any means, but ordinary people.  The ox actually weighed 1,198 pounds.  The average guess of the 787 guessers was 1,197 pounds, which was more accurate than the guesses made by the smartest and the most expert guessers.

This type of experiment can easily be repeated.  For example, take a jar filled with pennies, where only you know how many pennies are in the jar.  Pass the jar around in a group of people and ask each person—independently (with no discussion)—to write down their guess of how many pennies are in the jar.  In a group that is large enough, you will nearly always discover that the average guess is better than any individual guess.  (That’s been the result when I’ve performed this experiment in classes I’ve taught.)

In order for the collective to be that smart, the members must be diverse and the members’ guesses must be independent from one another.  So the stock market is efficient when these two conditions are satisfied.  But if there is a breakdown in diversity, or if individuals start copying one another too much—what Michael Mauboussin calls an information cascade—then you could have a boom, fad, fashion, or crash.

There are some situations where an individual can be impacted by the group.  Solomon Asch did a famous experiment in which the subject is supposed to match lines that have the same length.  It’s an easy question that every subject—if left alone—gets right.  But then Asch has seven out of eight participants deliberately choose the wrong answer, unbeknownst to the subject of the experiment, who is the eighth participant in the same room.  When this experiment was repeated many times, roughly one-third of the subjects gave the same answer as the group, even though this answer is obviously wrong.  Such can be the power of a group opinion.

Hagstrom asks about how crashes can happen.  Danish theoretical physicist Per Bak developed the notion of self-organized criticality.

According to Bak, large complex systems composed of millions of interacting parts can break down not only because of a single catastrophic event but also because of a chain reaction of smaller events.  To illustrate the concept of self-criticality, Bak often used the metaphor of a sand pile… Each grain of sand is interlocked in countless combinations.  When the pile has reached its highest level, we can say the sand is in a state of criticality.  It is just on the verge of becoming unstable.

(Computer Simulation of Bak-Tang-Weisenfeld sandpile, with 28 million grains, by Claudio Rocchini, via Wikimedia Commons)

Adding one more grain starts an avalanche.  Bak and two colleagues applied this concept to the stock market.  They assumed that there are two types of agents, rational agents and noise traders.  Most of the time, the market is well-balanced.

But as stock prices climb, rational agents sell and leave the market, while more noise traders following the trend join.  When noise traders—trend followers—far outnumber rational agents, a bubble can form in the stock market.



The psychologists Daniel Kahneman and Amos Tversky did research together for over two decades.  Kahneman was awarded the Nobel Prize in Economics in 2002.  Tversky would also have been named had he not passed away.

(Daniel Kahneman, via Wikimedia Commons)

Much of their groundbreaking research is contained in Judgment Under Uncertainty: Heuristics and Biases (1982).

Here you will find all the customary behavioral finance terms we have come to know and understand:  anchoring, framing, mental accounting, overconfidence, and overreaction bias.  But perhaps the most significant insight into individual behavior was loss aversion.

Kahneman and Tversky discovered that how choices are framed—combined with loss aversion—can materially impact how people make decisions.  For instance, in one of their well-known experiments, they asked people to choose between the following two options:

  • (a) Save 200 lives for sure.
  • (b) Have a one-third chance of saving 600 lives and a two-thirds chance of saving no one.

In this scenario, people overwhelmingly chose (a)—to save 200 lives for sure.  Kahneman and Tversky next asked the same people to choose between the following two options:

  • (a) Have 400 people die for sure.
  • (b) Have a two-thirds chance of 600 people dying and a one-third chance of no one dying.

In this scenario, people preferred (b)—a two-thirds chance of 600 people dying, and a one-third chance of no one dying.

But the two versions of the problem are identical.  The number of people saved in the first version equals the number of people who won’t die in the second version.

What Kahneman and Tversky had demonstrated is that people are risk averse when considering potential gains, but risk seeking when facing the possibility of a certain loss.  This is the essence of prospect theory, which is captured in the following graph:

(Value function in Prospect Theory, drawing by Marc Rieger, via Wikimedia Commons)

Loss aversion refers to the fact that people weigh a potential loss about 2.5 times more than an equivalent gain.  That’s why the value function in the graph is steeper for losses.

Richard Thaler and Shlomo Benartzi researched loss aversion by hypothesizing that the less frequently an investor checks the price of a stock he or she owns, the less likely the investor will be to sell the stock because of temporary downward volatility.  Thaler and Benartzi invented the term myopic loss aversion.

Hagstrom writes:

In my opinion, the single greatest psychological obstacle that prevents investors from doing well in the stock market is myopic loss aversion.  In my twenty-eight years in the investment business, I have observed firsthand the difficulty investors, portfolio managers, consultants, and committee members of large institutional funds have with internalizing losses (loss aversion), made all the more painful by tabulating losses on a frequent basis (myopic loss aversion).  Overcoming this emotional burden penalizes all but a very few select individuals.

Perhaps it is not surprising that the one individual who has mastered myopic loss aversion is also the world’s greatest investor—Warren Buffett…

Buffett understands that as long as the earnings of the businesses you own move higher over time, there’s no reason to worry about shorter term stock price volatility.  Because Berkshire Hathaway, Buffett’s investment vehicle, holds both public stocks and wholly owned private businesses, Buffett’s long-term outlook has been reinforced.  Hagstrom quotes Buffett:

I don’t need a stock price to tell me what I already know about value.

Hagstrom mentions Berkshire’s investment in The Coca-Cola Company (KO), in 1988.  Berkshire invested $1 billion, which was at that time the single largest investment Berkshire had ever made.  Over the ensuing decade, KO stock went up ten times, while the S&P 500 Index only went up three times.  But four out of those ten years, KO stock underperformed the market.  Trailing the market 40 percent of the time didn’t bother Buffett a bit.

As Hagstrom observes, Benjamin Graham—the father of value investing, and Buffett’s teacher and mentor—made a distinction between the investor focused on long-term business value and the speculator who tries to predict stock prices in the shorter term.  The true investor should never be concerned with shorter term stock price volatility.

(Ben Graham, Photo by Equim43, via Wikimedia Commons)

Hagstrom quotes Graham’s The Intelligent Investor:

The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage.  That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by another person’s mistakes of judgment.

Terence Odean, a behavioral economist, has done extensive research on the investment decisions of individuals and households.  Odean discovered that:

  • Many investors trade often—Odean found a 78 percent portfolio turnover ratio in his first study, which tracked 97,483 trades from ten thousand randomly selected accounts.
  • Over the subsequent 4 months, one year, and two years, the stocks that investors bought consistently trailed the market, while the stocks that investors sold beat the market.

Hagstrom mentions that people use mental models as a basis for understanding reality and making decisions.  But we tend to assume that each mental model we have is equally probable, rather than working to assign different probabilities to different models.

Moreover, people typically can make models for what something is—or what is true—instead of what something is not—or what is false.  Also, our mental models are usually quite incomplete.  And we tend to forget details of our models, especially after time passes.  Finally, writes Hagstrom, people tend to construct mental models based on superstition or unwarranted belief.

Hagstrom asks the question: Why do people tend to be so gullible in general?  For instance, while there’s no evidence that market forecasts have any value, many otherwise intelligent people pay attention to them and even make decisions based on them.

The answer, states Hagstrom, is that we are wired to seek and to find patterns.  We have two basic mental systems, System 1 (intuition) and System 2 (reason).  System 1 operates automatically.  It takes mental shortcuts which often work fine, but not always.  System 1 is designed to find patterns.  And System 1 seeks confirming evidence for its hypotheses (patterns).

But even System 2—which humans can use to do math, logic, and statistics—uses a positive test strategy, meaning that it seeks confirming evidence for its hypotheses (patterns), rather than disconfirming evidence.



Hagstrom introduces the chapter:

A true philosopher is filled with a passion to understand, a process that never ends.

(Socrates, J. Aars Platon (1882), via Wikimedia Commons)

Metaphysics is one area of philosophy.  Aesthetics, ethics, and politics are other areas.  But Hagstrom focuses his discussion of philosophy on epistemology, the study of knowledge.

Having spent a few years studying the history and philosophy of science, I would say that epistemology includes the following questions:

  • What different kinds of knowledge can we have?
  • What constitutes scientific knowledge?
  • Is any part of our knowledge certain, or can all knowledge be improved indefinitely?
  • How does scientific progress happen?

In a sense, epistemology is thinking about thinking.  Epistemology is also studying the history of science in great detail, because humans have made enormous progress in generating scientific knowledge.

Studying epistemology can help us to become better, more rigorous, and more coherent thinkers, which can make us better investors.

Hagstrom makes it clear in the Preface that his book is necessarily abbreviated, otherwise it would have been a thousand pages long.  That said, had he been aware of Willard Van Orman Quine’s epistemology, Hagstrom likely would have mentioned it.

Here is a passage from Quine’s From A Logical Point of View:

The totality of our so-called knowledge or beliefs, from the most casual matters of geography and history to the profoundest laws of atomic physics or even of pure mathematics and logic, is a man-made fabric which impinges on experience only along the edges.  Or, to change the figure, total science is like a field of force whose boundary conditions are experience.  A conflict with experience at the periphery occasions readjustments in the interior of the field.  Truth values have to be redistributed over some of our statements.  Re-evaluation of some statements entails re-evaluation of others, because of their logical interconnections—the logical laws being in turn simply certain further statements of the system, certain further elements of the field.  Having re-evaluated one statement we must re-evaluate some others, which may be statements logically connected with the first or may be the statements of logical connections themselves.  But the total field is so underdetermined by its boundary conditions, experience, that there is much latitude of choice as to what statements to re-evaluate in the light of any single contrary experience.  No particular experiences are linked with any particular statements in the interior of the field, except indirectly through considerations of equilibrium affecting the field as a whole.

If this view is right, it is misleading to speak of the empirical content of an individual statement—especially if it is a statement at all remote from the experiential periphery of the field.  Furthermore it becomes folly to seek a boundary between synthetic statements, which hold contingently on experience, and analytic statements, which hold come what may.  Any statement can be held true come what may, if we make drastic enough adjustments elsewhere in the system.  Even a statement very close to the periphery can be held true in the face of recalcitrant experience by pleading hallucination or by amending certain statements of the kind called logical laws.  Conversely, by the same token, no statement is immune to revision.  Revision even of the logical law of the excluded middle has been proposed as a means of simplifying quantum mechanics…

(Image by Dmytro Tolokonov)

Quine continues:

For vividness I have been speaking in terms of varying distances from a sensory periphery.  Let me now try to clarify this notion without metaphor.  Certain statements, though about physical objects and not sense experience, seem peculiarly germane to sense experience—and in a selective way: some statements to some experiences, others to others.  Such statements, especially germane to particular experiences, I picture as near the periphery.  But in this relation of “germaneness” I envisage nothing more than a loose association reflecting the relative likelihood, in practice, of our choosing one statement rather than another for revision in the event of recalcitrant experience.  For example, we can imagine recalcitrant experiences to which we would surely be inclined to accomodate our system by re-evaluating just the statement that there are brick houses on Elm Street, together with related statements on the same topic.  We can imagine other recalcitrant experiences to which we would be inclined to accomodate our system by re-evaluating just the statement that there are no centaurs, along with kindred statements.  A recalcitrant experience can, I have urged, be accomodated by any of various alternative re-evaluations in various alternative quarters of the total system; but, in the cases which we are now imagining, our natural tendency to disturb the total system as little as possible would lead us to focus our revisions upon these specific statements concerning brick houses or centaurs.  These statements are felt, therefore, to have a sharper empirical reference than highly theoretical statements of physics or logic or ontology.  The latter statements may be thought of as relatively centrally located within the total network, meaning merely that little preferential connection with any particular sense data obtrudes itself.

As an empiricist, I continue to think of the conceptual scheme of science as a tool, ultimately, for predicting future experience in the light of past experience.  Physical objects are conceptually imported into the situation as convenient intermediaries—not by definition in terms of experience, but simply as irreducible posits comparable, epistemologically, to the gods of Homer.  For my part I do, qua lay physicist, believe in physical objects and not in Homer’s gods; and I consider it a scientific error to believe otherwise.  But in point of epistemological footing the physical objects and the gods differ only in degree and not in kind.  Both sorts of entities enter our conception only as cultural posits.  The myth of physical objects is epistemologically superior to most in that it has proved more efficacious than other myths as a device for working a manageable structure into the flux of experience.

Physical objects, small and large, are not the only posits.  Forces are another example; and indeed we are told nowadays that the boundary between energy and matter is obsolete.  Moreover, the abstract entities which are the substance of mathematics—ultimately classes and classes of classes and so on up—are another posit in the same spirit.  Epistemologically these are posits on the same footing with physical objects and gods, neither better nor worse except for differences in the degree to which they expedite our dealings with sense experiences.

Historically, philosophers distinguished between “analytic” statements, which were thought to be true by definition, and “synthetic” statements, which were thought to be true on the basis of certain empirical data or experiences.  One of Quine’s chief points is that this distinction doesn’t hold.

Mathematics, logic, scientific theories, scientific laws, working hypotheses, ordinary language, and much else including simple observations, are all a part of science.  The goal of science—which extends common sense—is to predict various future experiences—including experiments—on the basis of past experiences.

When predictions—including experiments—don’t turn out as expected, then any part of the totality of science is revisable.  Often it makes sense to revise specific hypotheses, or specific statements that are close to experience.  But sometimes highly theoretical statements or ideas—including the laws of mathematics, the laws of logic, and the most well-established scientific laws—are revised in order to make the overall system of science work better, i.e., predict phenomena (future experiences) better, with more generality or with more exactitude.

The chief way scientists have made—and continue to make—progress is by testing predictions that are implied by existing scientific theory or law, or that are implied by new hypotheses under consideration.

(Top quark and anti top quark pair decaying into jets, Collider Detector at Fermilab, via Wikimedia Commons)

Because of recent advances in computing power and because of the explosion of shared knowledge, ideas, and experiments on the internet, scientific progress is probably happening much faster than ever before.  It’s a truly exciting time for all curious people and scientists.  And once artificial intelligence passes the singularity threshold, scientific progress is likely to skyrocket, even beyond what we can imagine.



Critical reading is a crucial part of becoming a better thinker.

(Photo by VijayGES2, via Wikimedia Commons)

One excellent book about how to read analytically is How to Read a Book, by Mortimer J. Adler.  The goal of analytical reading is to improve your understanding—as opposed to only gaining information.  To this end, Adler suggests active readers keep the following four questions in mind:

  • What is the book about as a whole?
  • What is being said in detail?
  • Is the book true, in whole or part?
  • What of it?

Before deciding to read a book in detail, it can be helpful to read the preface, table of contents, index, and bibliography.  Also, read a few paragraphs at random.  These steps will help you to get a sense of what the book is about as a whole.  Next, you can skim the book to learn more about what is being said in detail, and whether it’s worth reading the entire book carefully.

Then, if you decide to read the entire book carefully, you should approach it like you would approach assigned reading for a university class.  Figure out the main points and arguments.  Take notes if that helps you learn.  The goal is to understand the author’s chief arguments, and whether—or to what extent—those arguments are true.

The final step is comparative reading, says Hagstrom.  Adler considers this the hardest step.  Here the goal is to learn about a specific subject.  You want to determine which books on the subject are worth reading, and then compare and contrast these books.

Hagstrom points out that the three greatest detectives in fiction are Auguste Dupin, Sherlock Holmes, and Father Brown.  We can learn much from studying the stories involving these sleuths.

Auguste Dupin was created by Edgar Allan Poe.  Hagstrom remarks that we can learn the following from Dupin’s methods:

  • Develop a skeptic’s mindset; don’t automatically accept conventional wisdom.
  • Conduct a thorough investigation.

Sherlock Holmes was created by Sir Arthur Conan Doyle.

(Illustration by Sidney Paget (1891), via Wikimedia Commons)

From Holmes, we can learn the following, says Hagstrom:

  • Begin an investigation with an objective and unemotional viewpoint.
  • Pay attention to the tiniest details.
  • Remain open-minded to new, even contrary, information.
  • Apply a process of logical reasoning to all you learn.

Father Brown was created by G. K. Chesterton.  From Father Brown, we can learn:

  • Become a student of psychology.
  • Have faith in your intuition.
  • Seek alternative explanations and redescriptions.

Hagstrom ends the chapter by quoting Charlie Munger:

I believe in… mastering the best that other people have figured out [rather than] sitting down and trying to dream it up yourself… You won’t find it that hard if you go at it Darwinlike, step by step with curious persistence.  You’ll be amazed at how good you can get… It’s a huge mistake not to absorb elementary worldly wisdom… Your life will be enriched—not only financially but in a host of other ways—if you do.



Hagstrom quotes Warren Buffett:

…the formula for valuing ALL assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C.E.  The oracle was Aesop and his enduring, though somewhat incomplete, insight was “a bird in the hand is worth two in the bush.”  To flesh out this principle, you must answer only three questions.  How certain are you that there are indeed birds in the bush?  When will they emerge and how many will there be?  What is the risk-free interest rate?  If you can answer these three questions, you will know the maximum value of the bush—and the maximum number of birds you now possess that should be offered for it.  And, of course, don’t literally think birds.  Think dollars.

Hagstrom explains that it’s the same formula whether you’re evaluating stocks, bonds, manufacturing plants, farms, oil royalties, or lottery tickets.  As long as you have the numbers needed for the calculation, the attractiveness of all investment opportunities can be evaluated and compared.

So to value any business, you have to estimate the future cash flows of the business, and then discount those cash flows back to the present.  This is the DCF—discounted cash flows—method for determining the value of a business.

Although Aesop gave the general idea, John Burr Williams, in The Theory of Investment Value (1938), was the first to explain the DCF approach explicitly.  Williams had studied mathematics and chemistry as an undergraduate at Harvard University.  After working as a securities analyst, Williams returned to Harvard to get a PhD in economics.  The Theory of Investment Value was Williams’ dissertation.

Hagstrom writes that in 1654, the Chevalier de Méré, a French nobleman who liked to gamble, asked the mathematician Blaise Pascal the following question: “How do you divide the stakes of an unfinished game of chance when one of the players is ahead?”

(Photo by Rossapicci, via Wikimedia Commons)

Pascal was a child prodigy and a brilliant mathematician.  To help answer de Méré’s question, Pascal turned to Pierre de Fermat, a lawyer who was also a brilliant mathematician.  Hagstrom reports that Pascal and Fermat exchanged a series of letters which are the foundation of what is now called probability theory.

There are two broad categories of probabilities:

  • frequency probability
  • subjective probability

A frequency probability typically refers to a system that can generate a great deal of statistical data over time.  Examples include coin flips, roulette wheels, cards, and dice, notes Hagstrom.  For instance, if you flip a coin 1,000 times, you expect to get heads about 50 percent of the time.  If you roll one 6-sided dice 1,000 times, you expect to get each number about 16.67 percent of the time.

If you don’t have a sufficient frequency of events, plus a long time period to analyze results, then you must rely on a subjective probability.  A subjective probability, says Hagstrom, is often a reasonable assessment made by a knowledgeable person.  It’s a best guess based a logical analysis of the given data.

When using a subjective probability, obviously you want to make sure you have all the available data that could be relevant.  And clearly you have to use logic correctly.

But the key to using a subjective probability is to update your beliefs as you gain new data.  The proper way to update your beliefs is by using Bayes’ Rule.

(Thomas Bayes, via Wikimedia Commons)

Bayes’ Rule

Eliezer Yudkowsky of the Machine Intelligence Research Institute provides an excellent intuitive explanation of Bayes’ Rule:

Yudkowsky begins by discussing a situation that doctors often encounter:

1% of women at age forty who participate in routine screening have breast cancer.  80% of women with breast cancer will get positive mammographies.  9.6% of women without breast cancer will also get positive mammographies.  A woman in this age group had a positive mammography in a routine screening.  What is the probability that she actually has breast cancer?

Most doctors estimate the probability between 70% and 80%, which is wildly incorrect.

In order to arrive at the correct answer, Yudkowsky asks us to think of the question as follows.  We know that 1% of women at age forty who participate in routine screening have breast cancer.  So consider 10,000 women who participate in routine screening:

  • Group 1: 100 women with breast cancer.
  • Group 2: 9,900 women without breast cancer.

After the mammography, the women can be divided into four groups:

  • Group A:  80 women with breast cancer, and a positive mammography.
  • Group B:  20 women with breast cancer, and a negative mammography.
  • Group C:  950 women without breast cancer, and a positive mammography.
  • Group D:  8,950 women without breast cancer, and a negative mammography.

So the question again:  If a woman out of this group of 10,000 women has a positive mammography, what is the probability that she actually has breast cancer?

The total number of women who had positive mammographies is 80 + 950 = 1,030.  Of that total, 80 women had positive mammographies AND have breast cancer.  In looking at the total number of positive mammographies (1,030), we know that 80 of them actually have breast cancer.

So if a woman out of the 10,000 has a positive mammography, the chances that she actually has breast cancer = 80/1030  or 0.07767 or 7.8%.

That’s the intuitive explanation.  Now let’s look at Bayes’ Rule:

P(A|B) = [P(B|A) P(A)] / P(B)

Let’s apply Bayes’ Rule to the same question above:

1% of women at age forty who participate in routine screening have breast cancer.  80% of women with breast cancer will get positive mammographies.  9.6% of women without breast cancer will also get positive mammographies.  A woman in this age group had a positive mammography in a routine screening.  What is the probability that she actually has breast cancer?

P(A|B) = the probability that the woman has breast cancer (A), given a positive mammography (B)

Here is what we know:

P(B|A) = 80% – the probability of a positive mammography (B), given that the woman has breast cancer (A)

P(A) = 1% – the probability that a woman out of the 10,000 screened actually has breast cancer

P(B) = (80+950) / 10,000 = 10.3% – the probability that a woman out of the 10,000 screened has a positive mammography

Bayes’ Rule again:

P(A|B) = [P(B|A) P(A)] / P(B)

P(A|B) = [0.80*0.01] / 0.103 = 0.008 / 0.103 = 0.07767 or 7.8%

Derivation of Bayes’ Rule:

Bayesians consider conditional probabilities as more basic than joint probabilities.  You can define P(A|B) without reference to the joint probability P(A,B).  To see this, first start with the conditional probability formula:

P(A|B) P(B) = P(A,B)

but by symmetry you get:

P(B|A) P(A) = P(A,B)

It follows that:

P(A|B) = [P(B|A) P(A)] / P(B)

which is Bayes’ Rule.

In conclusion, Hagstrom makes the important observation that there is much we still don’t know about nature and about ourselves.  (The question mark below is by Khaydock, via Wikimedia Commons.)

Nothing is absolutely certain.

One clear lesson from history—whether the history of investing, the history of science, or some other area—is that very often people who are “absolutely certain” about something turn out to be wrong.

Economist and Nobel laureate Kenneth Arrow:
  • Our knowledge of the way things work, in society or in nature, comes trailing clouds of vagueness.  Vast ills have followed a belief in certainty.

Investor and author Peter Bernstein:

The recognition of risk management as a practical art rests on a simple cliché with the most profound consequences:  when our world was created, nobody remembered to include certainty.  We are never certain;  we are always ignorant to some degree.  Much of the information we have is either incorrect or incomplete.



Take a few minutes and try answering these three problems:

  • A bat and a ball cost $1.10.  The bat costs one dollar more than the ball.  How much does the ball cost?
  • If it takes 5 machines 5 minutes to make 5 widgets, how long would it take 100 machines to make 100 widgets?
  • In a lake, there is a patch of lily pads.  Every day the patch doubles in size.  If it takes 48 days for the patch to cover the entire lake, how long will it take for the patch to cover half the lake?

Roughly 75 percent of the Princeton and Harvard students got at least one problem wrong.  These questions form the Cognitive Reflection Test, invented by Shane Frederick, an assistant professor of management science at MIT.

Recall that System 1 (intuition) is quick, associative, and operates automatically all the time.  System 2 (reason) is slow and effortful—it requires conscious activation and sustained focus—and it can learn to solve problems involving math, statistics, or logic.

To understand the mental mistake that many people—including smart people—make, let’s consider the first of the three questions:

  • A bat and a ball cost $1.10.  The bat costs one dollar more than the ball.  How much does the ball cost?

After we read the question, our System 1 (intuition) immediately suggests to us that the bat costs $1.00 and the ball costs 10 cents.  But if we slow down just a moment and engage System 2, we realize that if the bat costs $1.00 and the ball costs 10 cents, then the bat costs only 90 cents more than the ball.  This violates the condition stated in the problem that the bat costs one dollar more than the ball.  If we think a bit more, we see that the bat must cost $1.05 and the ball must cost 5 cents.

System 1 takes mental shortcuts, which often work fine.  But when we encounter a problem that requires math, statistics, or logic, we have to train ourselves to slow down and to think through the problem.  If we don’t slow down in these situations, we’ll often jump to the wrong conclusion.

(Cognitive Bias Codex, by John Manoogian III, via Wikimedia Commons.  For a closer look, try this link:

It’s possible to train your intuition under certain conditions, according to Daniel Kahneman.  Hagstrom:

Kahneman believes there are indeed cases where intuitive skill reveals the answer, but that such cases are dependent on two conditions.  First, “the environment must be sufficiently regular to be predictable” second, there must be an “opportunity to learn these regularities through prolonged practice.”  For familiar examples, think about the games of chess, bridge, and poker.  They all occur in regular environments, and prolonged practice at them helps people develop intuitive skill.  Kahneman also accepts the idea that army officers, firefighters, physicians, and nurses can develop skilled intuition largely because they all have had extensive experience in situations that, while obviously dramatic, have been repeated many times over.

Kahneman concludes that intuitive skill exists mostly in people who operate in simple, predictable environments and that people in more complex environments are much less likely to develop this skill.  Kahneman, who has spent much of his career studying clinicians, stock pickers, and economists, notes that evidence of intuitive skill is largely absent in this group.  Put differently, intuition appears to work well in linear systems where cause and effect is easy to identify.  But in nonlinear systems, including stock markets and economies, System 1 thinking, the intuitive side of our brain, is much less effectual.

Experts in fields such as investing, economics, and politics have, in general, not demonstrated the ability to make accurate forecasts or predictions with any reliable consistency.

Philip Tetlock, professor of psychology at the University of Pennsylvania, tracked 284 experts over fifteen years (1988-2003) as they made 27,450 forecasts.  The results are no better than “dart-throwing chimpanzees,” as Tetlock describes in Expert Political Judgment: How Good Is It? How Can We Know? (Princeton University Press, 2005).

Hagstrom explains:

It appears experts are penalized, like the rest of us, by thinking deficiencies.  Specifically, experts suffer from overconfidence, hindsight bias, belief system defenses, and lack of Bayesian process.

Hagstrom then refers to an essay by Sir Isaiah Berlin, “The Hedgehog and the Fox: An Essay on Tolstoy’s View of History.”  Hedgehogs view the world using one large idea, while Foxes are skeptical of grand theories and instead consider a variety of information and experiences before making decisions.

(Photo of Hedgehog, by Nevit Dilmen, via Wikimedia Commons)

Tetlock found that Foxes, on the whole, were much more accurate than Hedgehogs.  Hagstrom:

Why are hedgehogs penalized?  First, because they have a tendency to fall in love with pet theories, which gives them too much confidence in forecasting events.  More troubling, hedgehogs were too slow to change their viewpoint in response to discomfirming evidence.  In his study, Tetlock said Foxes moved 59 percent of the prescribed amount toward alternate hypotheses, while Hedgehogs moved only 19 percent.  In other words, Foxes were much better at updating their Bayesian inferences than Hedgehogs.

Unlike Hedgehogs, Foxes appreciate the limits of their knowledge.  They have better calibration and discrimination scores than Hedgehogs.  (Calibration, which can be thought of as intellectual humility, measures how much your subjective probabilities correspond to objective probabilities.  Discrimination, sometimes called justified decisiveness, measures whether you assign higher probabilities to things that occur than to things that do not.)

(Photo of Fox, by Alan D. Wilson, via Wikimedia Commons)

Hagstrom comments that Foxes have three distinct cognitive advantages, according to Tetlock:

  • They begin with “reasonable starter” probability estimates.  They have better “inertial-guidance” systems that keep their initial guesses closer to short-term base rates.
  • They are willing to acknowledge their mistakes and update their views in response to new information.  They have a healthy Bayesian process.
  • They can see the pull of contradictory forces, and, most importantly, they can appreciate relevant analogies.

Hagstrom concludes that the Fox “is the perfect mascot for The College of Liberal Arts Investing.”

Many people with high IQ have difficulty making rational decisions.  Keith Stanovich, professor of applied psychology at the University of Toronto, invented the term dysrationalia to refer to the inability to think and behave rationally despite high intelligence, remarks Hagstrom.  There are two principal causes of dysrationalia:

  • a processing problem
  • a content problem

Stanovich explains that people are lazy thinkers in general, preferring to think in ways that require less effort, even if those methods are less accurate.  As we’ve seen, System 1 operates automatically, with little or no effort.  Its conclusions are often correct.  But when the situation calls for careful reasoning, the shortcuts of System 1 don’t work.

Lack of adequate content is a mindware gap, says Hagstrom.  Mindware refers to rules, strategies, procedures, and knowledge that people possess to help solve problems.  Harvard cognitive scientist David Perkins coined the term mindware.  Hagstrom quotes Perkins:

What is missing is the metacurriculum—the ‘higher order’ curriculum that deals with good patterns of thinking in general and across subject matters.

Perkins’ proposed solution is a mindware booster shot, which means teaching new concepts and ideas in “a deep and far-reaching way,” connected with several disciplines.

Of course, Hagstrom’s book, Investing: The Last Liberal Art, is a great example of a mindware booster shot.


Hagstrom concludes by stressing the vital importance of lifelong, continuous learning.  Buffett and Munger have always highlighted this as a key to their success.

(Statue of Ben Franklin in front of College Hall, Philadelphia, Pennsylvania, Photo by Matthew Marcucci, via Wikimedia Commons)


Although the greatest number of ants in a colony will follow the most intense pheromone trail to a food source, there are always some ants that are randomly seeking the next food source.  When Native Americans were sent out to hunt, most of those in the party would return to the proven hunting grounds.  However, a few hunters, directed by a medicine man rolling spirit bones, were sent in different directions to find new herds.  The same was true of Norwegian fishermen.  Each day most of the ships in the fleet returned to the same spot where the previous day’s catch had yielded the greatest bounty, but a few vessels were also sent in random directions to locate the next school of fish.  As investors, we too must strike a balance between exploiting what is most obvious while allocating some mental energy to exploring new possibilities.

Hagstrom adds:

The process is similar to genetic crossover that occurs in biological evolution.  Indeed, biologists agree that genetic crossover is chiefly responsible for evolution.  Similarly, the constant recombination of our existing mental building blocks will, over time, be responsible for the greatest amount of investment progress.  However, there are occasions when a new and rare discovery opens up new opportunities for investors.  In much the same way that mutation can accelerate the evolutionary process, so too can new ideas speed us along in our understanding of how markets work.  If you are able to discover a new building block, you have the potential to add another level to your model of understanding.



An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are 15-25 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 10-15% (at cost), while the average position is 5-7% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees.  The Boole Fund has low fees. 


If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail:




Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

Common Stocks and Common Sense

(Image:  Zen Buddha Silence by Marilyn Barbone)

October 15, 2017

It’s crucial in investing to have the proper balance of confidence and humility.  Overconfidence is very deep-seated in human nature.  Nearly all of us tend to believe that we’re above average across a variety of dimensions, such as looks, smarts, academic ability, business aptitude, driving skill, and even luck (!).

Overconfidence is often harmless and it even helps in some areas.  But when it comes to investing, if we’re overconfident about what we know and can do, eventually our results will suffer.

(Image by Wilma64)

The simple truth is that the vast majority of us should invest in broad market low-cost index funds.  Buffett has maintained this argument for a long time:

The great thing about investing in index funds is that you can outperform most investors, net of costs, over the course of several decades.  This is purely a function of costs.  A Vanguard S&P 500 index fund costs 2-3% less per year than the average actively managed fund.  This means that, after a few decades, you’ll be ahead of roughly 90% (or more) of all active investors.

You can do better than a broad market index fund if you invest in a solid quantitative value fund.  Such a fund can do at least 1-2% better per year, on average and net of costs, than a broad market index fund.

But you can do even better—at least 5% better per year than the S&P 500 index—by investing in a quantitative value fund focused on microcap stocks.

  • At the Boole Microcap Fund, our mission is to help you do at least 5% better per year, on average, than an S&P 500 index fund.  We achieve this by implementing a quantitative deep value approach focused on cheap micro caps with improving fundamentals.  See:


I recently re-read Common Stocks and Common Sense (Wiley, 2016), by Edgar Wachenheim III.  It’s a wonderful book.  Wachenheim is one of the best value investors.  He and his team at Greenhaven Associates have produced 19% annual returns for over 25 years.

Wachenheim emphasizes that, due to certain behavioral attributes, he has outperformed many other investors who are as smart or smarter.  As Warren Buffett has said:

Success in investing doesn’t correlate with IQ once you’re above the level of 125.  Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.

That’s not to say IQ isn’t important.  Most of the finest investors are extremely smart.  Wachenheim was a Baker Scholar at Harvard Business School, meaning that he was in the top 5% of his class.

The point is that—due to behavioral factors such as patience, discipline, and rationality—top investors outperform many other investors who are as smart or smarter.  Buffett again:

We don’t have to be smarter than the rest; we have to be more disciplined than the rest.

Buffett himself has always been extraordinarily patient and disciplined.  There have been several times in Buffett’s career when he went for years on end without making a single investment.

Wachenheim highlights three behavioral factors that have helped him outperform others of equal or greater talent.

The bulk of Wachenheim’s book—chapters 3 through 13—is case studies of specific investments.  Wachenheim includes a good amount of fascinating business history, some of which is mentioned here.

Outline for this blog post:

  • Approach to Investing
  • Being a Contrarian
  • Probable Scenarios
  • Controlling Emotions
  • IBM
  • Interstate Bakeries
  • U.S. Home Corporation
  • Centex
  • Union Pacific
  • American International Group
  • Lowe’s
  • Whirlpool
  • Boeing
  • Southwest Airlines
  • Goldman Sachs

(Photo by Lsaloni)



From 1960 through 2009 in the United States, common stocks have returned about 9 to 10 percent annually (on average).

The U.S. economy grew at roughly a 6 percent annual rate—3 percent from real growth (unit growth) and 3 percent from inflation (price increases).  Corporate revenues—and earnings—have increased at approximately the same 6 percent annual rate.  Share repurchases and acquisitions have added 1 percent a year, while dividends have averaged 2.5 percent a year.  That’s how, on the whole, U.S. stocks have returned 9 to 10 percent annually, notes Wachenheim.

Even if the economy grows more slowly in the future, Wachenheim argues that U.S. investors should still expect 9 to 10 percent per year.  In the case of slower growth, corporations will not need to reinvest as much of their cash flows.  That extra cash can be used for dividends, acquisitions, and share repurchases.

Following Warren Buffett and Charlie Munger, Wachenheim defines risk as the potential for permanent loss.  Risk is not volatility.

Stocks do fluctuate up and down.  But every time the market has declined, it has ultimately recovered and gone on to new highs.  The financial crisis in 2008-2009 is an excellent example of large—but temporary—downward volatility:

The financial crisis during the fall of 2008 and the winter of 2009 is an extreme (and outlier) example of volatility.  During the six months between the end of August 2008 and end of February 2009, the [S&P] 500 Index fell by 42 percent from 1,282.83 to 735.09.  Yet by early 2011 the S&P 500 had recovered to the 1,280 level, and by August 2014 it had appreciated to the 2000 level.  An investor who purchased the S&P 500 Index on August 31, 2008, and then sold the Index six years later, lived through the worst financial crisis and recession since the Great Depression, but still earned a 56 percent profit on his investment before including dividends—and 69 percent including the dividends that he would have received during the six-year period.  Earlier, I mentioned that over a 50-year period, the stock market provided an average annual return of 9 to 10 percent.  During the six-year period August 2008 through August 2014, the stock market provided an average annual return of 11.1 percent—above the range of normalcy in spite of the abnormal horrors and consequences of the financial crisis and resulting deep recession.

(Photo by Terry Mason)

Wachenheim notes that volatility is the friend of the long-term investor.  The more volatility there is, the more opportunity to buy at low prices and sell at high prices.

Because the stock market increases on average 9 to 10 percent per year and always recovers from declines, hedging is a waste of money over the long term:

While many investors believe that they should continually reduce their risks to a possible decline in the stock market, I disagree.  Every time the stock market has declined, it eventually has more than fully recovered.  Hedging the stock market by shorting stocks, or by buying puts on the S&P 500 Index, or any other method usually is expensive, and, in the long run, is a waste of money.

Wachenheim describes his investment strategy as buying deeply undervalued stocks of strong and growing companies that are likely to appreciate significantly due to positive developments not yet discounted by stock prices.

Positive developments can include:

  • a cyclical upturn in an industry
  • an exciting new product or service
  • the sale of a company to another company
  • the replacement of a poor management with a good one
  • a major cost reduction program
  • a substantial share repurchase program

If the positive developments do not occur, Wachenheim still expects the investment to earn a reasonable return, perhaps close to the average market return of 9 to 10 percent annually.  Also, Wachenheim and his associates view undervaluation, growth, and strength as providing a margin of safety—protection against permanent loss.

Wachenheim emphasizes that at Greenhaven, they are value investors not growth investors.  A growth stock investor focuses on the growth rate of a company.  If a company is growing at 15 percent a year and can maintain that rate for many years, then most of the returns for a growth stock investor will come from future growth.  Thus, a growth stock investor can pay a high P/E ratio today if growth persists long enough.

Wachenheim disagrees with growth investing as a strategy:

…I have a problem with growth-stock investing.  Companies tend not to grow at high rates forever.  Businesses change with time.  Markets mature.  Competition can increase.  Good managements can retire and be replaced with poor ones.  Indeed, the market is littered with once highly profitable growth stocks that have become less profitable cyclic stocks as a result of losing their competitive edge.  Kodak is one example.  Xerox is another.  IBM is a third.  And there are hundreds of others.  When growth stocks permanently falter, the price of their shares can fall sharply as their P/E ratios contract and, sometimes, as their earnings fall—and investors in the shares can suffer serious permanent loss.

Many investors claim that they will be able to sell before a growth stock seriously declines.  But very often it’s difficult to determine whether a company is suffering from a temporary or permanent decline.

Wachenheim observes that he’s known many highly intelligent investors—who have similar experiences to him and sensible strategies—but who, nonetheless, haven’t been able to generate results much in excess of the S&P 500 Index.  Wachenheim says that a key point of his book is that there are three behavioral attributes that a successful investor needs:

In particular, I believe that a successful investor must be adept at making contrarian decisions that are counter to the conventional wisdom, must be confident enough to reach conclusions based on probabilistic future developments as opposed to extrapolations of recent trends, and must be able to control his emotions during periods of stress and difficulties.  These three behavioral attributes are so important that they merit further analysis.



(Photo by Marijus Auruskevicius)

Most investors are not contrarians because they nearly always follow the crowd:

Because at any one time the price of a stock is determined by the opinion of the majority of investors, a stock that appears undervalued to us appears appropriately valued to most other investors.  Therefore, by taking the position that the stock is undervalued, we are taking a contrarian position—a position that is unpopular and often is very lonely.  Our experience is that while many investors claim they are contrarians, in practice most find it difficult to buck the conventional wisdom and invest counter to the prevailing opinions and sentiments of other investors, Wall Street analysts, and the media.  Most individuals and most investors simply end up being followers, not leaders.

In fact, I believe that the inability of most individuals to invest counter to prevailing sentiments is habitual and, most likely, a genetic trait.  I cannot prove this scientifically, but I have witnessed many intelligent and experienced investors who shunned undervalued stocks that were under clouds, favored fully valued stocks that were in vogue, and repeated this pattern year after year even though it must have become apparent to them that the pattern led to mediocre results at best.

Wachenheim mentions a fellow investor he knows—Danny.  He notes that Danny has a high IQ, attended an Ivy League university, and has 40 years of experience in the investment business.  Wachenheim often describes to Danny a particular stock that is depressed for reasons that are likely temporary.  Danny will express his agreement, but he never ends up buying before the problem is fixed.

In follow-up conversations, Danny frequently states that he’s waiting for the uncertainty to be resolved.  Value investor Seth Klarman explains why it’s usually better to invest before the uncertainty is resolved:

Most investors strive fruitlessly for certainty and precision, avoiding situations in which information is difficult to obtain.  Yet high uncertainty is frequently accompanied by low prices.  By the time the uncertainty is resolved, prices are likely to have risen.  Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty.  The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.



(Image by Alain Lacroix)

Many (if not most) investors tend to extrapolate recent trends into the future.  This usually leads to underperforming the market.  See:

The successful investor, by contrast, is a contrarian who can reasonably estimate future scenarios and their probabilities of occurrence:

Investment decisions seldom are clear.  The information an investor receives about the fundamentals of a company usually is incomplete and often is conflicting.  Every company has present or potential problems as well as present or future strengths.  One cannot be sure about the future demand for a company’s products or services, about the success of any new products or services introduced by competitors, about future inflationary cost increases, or about dozens of other relevant variables.  So investment outcomes are uncertain.  However, when making decisions, an investor often can assess the probabilities of certain outcomes occurring and then make his decisions based on the probabilities.  Investing is probabilistic.

Because investing is probabilitistic, mistakes are unavoidable.  A good value investor typically will have at least 33% of his or her ideas not work, whether due to an error, bad luck, or an unforeseeable event.  You have to maintain equanimity despite inevitable mistakes:

If I carefully analyze a security and if my analysis is based on sufficiently large quantities of accurate information, I always will be making a correct decision.  Granted, the outcome of the decision might not be as I had wanted, but I know that decisions always are probabilistic and that subsequent unpredictable changes or events can alter outcomes.  Thus, I do my best to make decisions that make sense given everything I know, and I do not worry about the outcomes.  An analogy might be my putting game in golf.  Before putting, I carefully try to assess the contours and speed of the green.  I take a few practice strokes.  I aim the putter to the desired line.  I then putt and hope for the best.  Sometimes the ball goes in the hole…



(Photo by Jacek Dudzinski)


I have observed that when the stock market or an individual stock is weak, there is a tendency for many investors to have an emotional response to the poor performance and to lose perspective and patience.  The loss of perspective and patience often is reinforced by negative reports from Wall Street and from the media, who tend to overemphasize the significance of the cause of the weakness.  We have an expression that aiplanes take off and land every day by the tens of thousands, but the only ones you read about in the newspapers are the ones that crash.  Bad news sells.  To the extent that negative news triggers further selling pressures on stocks and further emotional responses, the negativism tends to feed on itself.  Surrounded by negative news, investors tend to make irrational and expensive decisions that are based more on emotions than on fundamentals. This leads to the frequent sale of stocks when the news is bad and vice versa.  Of course, the investor usually sells stocks after they already have materially decreased in price.  Thus, trading the market based on emotional reactions to short-term news usually is expensive—and sometimes very expensive.

Wachenheim agrees with Seth Klarman that, to a large extent, many investors simply cannot help making emotional investment decisions.  It’s part of human nature.  People overreact to recent news.

I have continually seen intelligent and experienced investors repeatedly lose control of their emotions and repeatedly make ill-advised decisions during periods of stress.

That said, it’s possible (for some, at least) to learn to control your emotions.  Whenever there is news, you can learn to step back and look at your investment thesis.  Usually the investment thesis remains intact.



(IBM Watson by Clockready, Wikimedia Commons)

When Greenhaven purchases a stock, it focuses on what the company will be worth in two or three years.  The market is more inefficient over that time frame due to the shorter term focus of many investors.

In 1993, Wachenheim estimated that IBM would earn $1.65 in 1995.  Any estimate of earnings two or three years out is just a best guess based on incomplete information:

…having projections to work with was better than not having any projections at all, and my experience is that a surprisingly large percentage of our earnings and valuation projections eventually are achieved, although often we are far off on the timing.

The positive development Wachenheim expected was that IBM would announce a concrete plan to significantly reduce its costs.  On July 28, 1993, the CEO Lou Gerstner announced such a plan.  When IBM’s shares moved up from $11½ to $16, Wachenheim sold his firm’s shares since he thought the market price was now incorporating the expected positive development.

Selling IBM at $16 was a big mistake based on subsequent developments.  The company generated large amounts of cash, part of which it used to buy back shares.  By 1996, IBM was on track to earn $2.50 per share.  So Wachenheim decided to repurchase shares in IBM at $24½.  Although he was wrong to sell at $16, he was right to see his error and rebuy at $24½.  When IBM ended up doing better than expected, the shares moved to $48 in late 1997, at which point Wachenheim sold.

Over the years, I have learned that we can do well in the stock market if we do enough things right and if we avoid large permanent losses, but that it is impossible to do nearly everything right.  To err is human—and I make plenty of errors.  My judgment to sell IBM’s shares in 1993 at $16 was an expensive mistake.  I try not to fret over mistakes.  If I did fret, the investment process would be less enjoyable and more stressful.  In my opinion, investors do best when they are relaxed and are having fun.

Finding good ideas takes time.  Greenhaven rejects the vast majority of its potential ideas.  Good ideas are rare.



(Photo of a bakery by Mohylek, Wikimedia Commons)

Wachenheim discovered that Howard Berkowitz bought 12 percent of the outstanding shares of Interstate Bakeries, became chairman of the board, and named a new CEO.  Wachenheim believed that Howard Berkowitz was an experienced and astute investor.  In 1967, Berkowitz was a founding partner of Steinhardt, Fine, Berkowitz & Co., one of the earliest and most successful hedge funds.  Wachenheim started analyzing Interstate in 1985 when the stock was at about $15:

Because of my keen desire to survive by minimizing risks of permanent loss, the balance sheet then becomes a good place to start efforts to understand a company.  When studying a balance sheet, I look for signs of financial and accounting strengths.  Debt-to-equity ratios, liquidity, depreciation rates, accounting practices, pension and health care liabilities, and ‘hidden’ assets and liabilities all are among common considerations, with their relative importance depending on the situation.  If I find fault with a company’s balance sheet, especially with the level of debt relative to the assets or cash flows, I will abort our analysis, unless there is a compelling reason to do otherwise.  

Wachenheim looks at management after he is done analyzing the balance sheet.  He admits that he is humble about his ability to assess management.  Also, good or bad results are sometimes due in part to chance.

Next Wachenheim examines the business fundamentals:

We try to understand the key forces at work, including (but not limited to) quality of products and services, reputation, competition and protection from future competition, technological and other possible changes, cost structure, growth opportunities, pricing power, dependence on the economy, degree of governmental regulation, capital intensity, and return on capital.  Because we believe that information reduces uncertainty, we try to gather as much information as possible.  We read and think—and we sometimes speak to customers, competitors, and suppliers.  While we do interview the managements of the companies we analyze, we are wary that their opinions and projections will be biased.

Wachenheim reveals that the actual process of analyzing a company is far messier than you might think based on the above descriptions:

We constantly are faced with incomplete information, conflicting information, negatives that have to be weighed against positives, and important variables (such as technological change or economic growth) that are difficult to assess and predict.  While some of our analysis is quantitative (such as a company’s debt-to-equity ratio or a product’s share of market), much of it is judgmental.  And we need to decide when to cease our analysis and make decisions.  In addition, we constantly need to be open to new information that may cause us to alter previous opinions or decisions.

Wachenheim indicates a couple of lessons learned.  First, it can often pay off when you follow a capable and highly incentivized business person into a situation.  Wachenheim made his bet on Interstate based on his confidence in Howard Berkowitz.  Interstate’s shares were not particularly cheap.

Years later, Interstate went bankrupt because they took on too much debt.  This is a very important lesson.  For any business, there will be problems.  Working through difficulties often takes much longer than expected.  Thus, having low or no debt is essential.



(Photo by Dwight Burdette, Wikimedia Commons)

Wachenheim describes his use of screens:

I frequently use Bloomberg’s data banks to run screens.  I screen for companies that are selling for low price-to-earnings (PE) ratios, low prices to revenues, low price-to-book values, or low prices relative to other relevant metrics.  Usually the screens produce a number of stocks that merit additional analyses, but almost always the additional analyses conclude that there are valid reasons for the apparent undervaluations. 

Wachenheim came across U.S. Home in mid-1994 based on a discount to book value screen.  The shares appeared cheap at 0.63 times book and 6.8 times earnings:

Very low multiples of book and earnings are adrenaline flows for value investors.  I eagerly decided to investigate further.

Later, although U.S. Home was cheap and produced good earnings, the stock price remained depressed.  But there was a bright side because U.S. Home led to another homebuilder idea…



(Photo by Steven Pavlov, Wikimedia Commons)

After doing research and constructing a financial model of Centex Corporation, Wachenheim had a startling realization:  the shares would be worth about $63 a few years in the future, and the current price was $12.  Finally, a good investment idea:

…my research efforts usually are tedious and frustrating.  I have hundreds of thoughts and I study hundreds of companies, but good investment ideas are few and far between.  Maybe only 1 percent or so of the companies we study ends up being part of our portfolios—making it much harder for a stock to enter our portfolio than for a student to enter Harvard.  However, when I do find an exciting idea, excitement fills the air—a blaze of light that more than compensates for the hours and hours of tedium and frustration.

Greenhaven typically aims for 30 percent annual returns on each investment:

Because we make mistakes, to achieve 15 to 20 percent average returns, we usually do not purchase a security unless we believe that it has the potential to provide a 30 percent or so annual return.  Thus, we have very high expectations for each investment.

In late 2005, Wachenheim grew concerned that home prices had gotten very high and might decline.  Many experts, including Ben Bernanke, argued that because home prices had never declined in U.S. history, they were unlikely to decline.  Wachenheim disagreed:

It is dangerous to project past trends into the future.  It is akin to steering a car by looking through the rearview mirror…



(Photo by Slambo, Wikimedia Commons)

After World War II, the construction of the interstate highway system gave trucks a competitive advantage over railroads for many types of cargo.  Furthermore, fewer passengers took trains, partly due to the interstate highway system and partly due to the commercialization of the jet airplane.  Excessive regulation of the railroadsin an effort to help farmersalso caused problems.  In the 1960s and 1970s, many railroads went bankrupt.  Finally, the government realized something had to be done and it passed the Staggers Act in 1980, deregulating the railroads:

The Staggers Act was a breath of fresh air.  Railroads immediately started adjusting their rates to make economic sense.  Unprofitable routes were dropped.  With increased profits and with confidence in their future, railroads started spending more to modernize.  New locomotives, freight cars, tracks, automated control systems, and computers reduced costs and increased reliability.  The efficiencies allowed the railroads to reduce their rates and become more competitive with trucks and barges….

In the 1980s and 1990s, the railroad industry also enjoyed increased efficiencies through consolidating mergers.  In the west, the Burlington Northern merged with the Santa Fe, and the Union Pacific merged with the Southern Pacific.  

Union Pacific reduced costs during the 2001-2002 recession, but later this led to congestion on many of its routes and to the need to hire and train new employees once the economy had picked up again.  Union Pacific experienced an earnings shortfall, leading the shares to decline to $14.86.

Wachenheim thought that Union Pacific’s problems were temporary, and that the company would earn about $1.55 in 2006.  With a conservative multiple of 14 times earnings, the shares would be worth over $22 in 2006.  Also, the company was paying a $0.30 annual dividend.  So the total return over a two-year period from buying the shares at $14½ would be 55 percent.

Wachenheim also thought Union Pacific stock had good downside protection because the book value was $12 a share.

Furthermore, even if Union Pacific stock just matched the expected return from the S&P 500 Index of 9½ percent a year, that would still be much better than cash.

The fact that the S&P 500 Index increases about 9½ percent a year is an important reason why shorting stocks is generally a bad business.  To do better than the market, the short seller has to find stocks that underperform the market by 19 percent a year.  Also, short sellers have limited potential gains and unlimited potential losses.  On the whole, shorting stocks is a terrible business and often even the smartest short sellers struggle.

Greenhaven sold its shares in Union Pacific at $31 in mid-2007, since other investors had recognized the stock’s value.  Including dividends, Greenhaven earned close to a 24 percent annualized return.

Wachenheim asks why most stock analysts are not good investors.  For one, most analysts specialize in one industry or in a few industries.  Moreover, analysts tend to extrapolate known information, rather than define future scenarios and their probabilities of occurrence:

…in my opinion, most individuals, including securities analysts, feel more comfortable projecting current fundamentals into the future than projecting changes that will occur in the future.  Current fundamentals are based on known information.  Future fundamentals are based on unknowns.  Predicting the future from unknowns requires the efforts of thinking, assigning probabilities, and sticking one’s neck out—all efforts that human beings too often prefer to avoid.

Also, I believe it is difficult for securities analysts to embrace companies and industries that currently are suffering from poor results and impaired reputations.  Often, securities analysts want to see tangible proof of better results before recommending a stock.  My philosophy is that life is not about waiting for the storm to pass.  It is about dancing in the rain.  One usually can read a weather map and reasonably project when a storm will pass.  If one waits for the moment when the sun breaks out, there is a high probability others already will have reacted to the improved prospects and already will have driven up the price of the stock—and thus the opportunity to earn large profits will have been missed.

Wachenheim then quotes from a New York Times op-ed piece written on October 17, 2008, by Warren Buffett:

A simple rule dictates my buying:  Be fearful when others are greedy, and be greedy when others are fearful.  And most certainly, fear is now widespread, gripping even seasoned investors.  To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions.  But fears regarding the long-term prosperity of the nation’s many sound companies make no sense.  These businesses will indeed suffer earnings hiccups, as they always have.  But most major companies will be setting new profit records 5, 10, and 20 years from now.  Let me be clear on one point:  I can’t predict the short-term movements of the stock market.  I haven’t the faintest idea as to whether stocks will be higher or lower a month—or a year—from now.  What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up.  So if you wait for the robins, spring will be over.



(AIG Corporate, Photo by AIG, Wikimedia Commons)

Wachenheim is forthright in discussing Greenhaven’s investment in AIG, which turned out to be a huge mistake.  In late 2005, Wachenheim estimated that the intrinsic value of AIG would be about $105 per share in 2008, nearly twice the current price of $55.  Wachenheim also liked the first-class reputation of the company, so he bought shares.

In late April 2007, AIG’s shares had fallen materially below Greenhaven’s cost basis:

When shares of one of our holdings are weak, we usually revisit the company’s longer-term fundamentals.  If the longer-term fundamentals have not changed, we normally will continue to hold the shares, if not purchase more.  In the case of AIG, it appeared to us that the longer-term fundamentals remained intact.

When Lehman filed for Chapter 11 bankruptcy protection on September 15, 2008, all hell broke loose:

The decline in asset values caused financial institutions to mark down the carrying value of their assets, which, in turn, caused sharp reductions in their credit ratings.  Sharp reductions in credit ratings required financial institutions to raise capital and, in the case of AIG, to post collateral on its derivative contracts.  But the near freezing of the financial markets prevented the requisite raising of capital and cash and thus caused a further deterioration in creditworthiness, which further increased the need for new capital and cash, and so on… On Tuesday night, September 16, the U.S. government agreed to provide the requisite cash in return for a lion’s share of the ownership of AIG.  As soon as I read the agreement, it was clear to me that we had a large permanent loss in our holdings of AIG.

Wachenheim defends the U.S. government bailouts.  Much of the problem was liquidity, not solvency.  Also, the bailouts helped restore confidence in the financial system.

Wachenheim asked himself if he would make the same decision today to invest in AIG:

My answer was ‘yes’—and my conclusion was that, in the investment business, relatively unpredictable outlier developments sometimes can quickly derail otherwise attractive investments.  It comes with the territory.  So while we work hard to reduce the risks of large permanent loss, we cannot completely eliminate large risks.  However, we can draw a line on how much risk we are willing to accept—a line that provides sufficient apparent protection and yet prevents us from being so risk averse that we turn down too many attractive opportunities.  One should not invest with the precept that the next 100-year storm is around the corner.

Wachenheim also points out that when Greenhaven learns of a flaw in its investment thesis, usually the firm is able to exit the position with only a modest loss.  If you’re right 2/3 of the time and if you limit losses as much as possible, the results should be good over time.



(Photo by Miosotis Jade, Wikimedia Commons)

In 2011, Wachenheim carefully analyzed the housing market and reached an interesting conclusion:

I was excited that we had a concept about a probable strong upturn in the housing market that was not shared by most others.  I believed that the existing negativism about housing was due to the proclivity of human beings to uncritically project recent trends into the future and to overly dwell on existing problems.  When analyzing companies and industries, I tend to be an optimist by nature and a pragmatist through effort.  In terms of the proverbial glass of water, it is never half empty, but always half full—and, as a pragmatist, it is twice as large as it needs to be.

Next Wachenheim built a model to estimate normalized earnings for Lowe’s three years in the future (in 2014).  He came up with normal earnings of $3 per share.  He thought the appropriate price-to-earnings ratio was 16.  So the stock would be worth $48 in 2014 versus its current price (in 2011) of $24.  It looked like a bargain.

After gathering more information, Wachenheim revised his earnings model:

…I revise models frequently because my initial models rarely are close to being accurate.  Usually, they are no better than directional.  But they usually do lead me in the right direction, and, importantly, the process of constructing a model forces me to consider and weigh the central fundamentals of a company that will determine the company’s future value.

Wachenheim now thought that Lowe’s could earn close to $4.10 in 2015, which would make the shares worth even more than $48.  In August 2013, the shares hit $45.

In late September 2013, after playing tennis, another money manager asked Wachenheim if he was worried that the stock market might decline sharply if the budget impasse in Congress led to a government shutdown:

I answered that I had no idea what the stock market would do in the near term.  I virtually never do.  I strongly believe in Warren Buffett’s dictum that he never has an opinion on the stock market because, if he did, it would not be any good, and it might interfere with opinions that are good.  I have monitored the short-term market predictions of many intelligent and knowledgeable investors and have found that they were correct about half the time.  Thus, one would do just as well by flipping a coin.

I feel the same way about predicting the short-term direction of the economy, interest rates, commodities, or currencies.  There are too many variables that need to be identified and weighed.

As for Lowe’s, the stock hit $67.50 at the end of 2014, up 160 percent from what Greenhaven paid.



(Photo by Steven Pavlov, Wikimedia Commons)

Wachenheim does not believe in the Efficient Market Hypothesis:

It seems to me that the boom-bust of growth stocks in 1968-1974 and the subsequent boom-bust of Internet technology stocks in 1998-2002 serve to disprove the efficient market hypothesis, which states that it is impossible for an investor to beat the stock market because stocks always are efficiently priced based on all the relevant and known information on the fundamentals of the stocks.  I believe that the efficient market hypothesis fails because it ignores human nature, particularly the nature of most individuals to be followers, not leaders.  As followers, humans are prone to embrace that which already has been faring well and to shun that which recently has been faring poorly.  Of course, the act of buying into what already is doing well and shunning what is doing poorly serves to perpetuate a trend.  Other trend followers then uncritically join the trend, causing the trend to feed on itself and causing excesses.

Many investors focus on the shorter term, which generally harms their long-term performance:

…so many investors are too focused on short-term fundamentals and investment returns at the expense of longer-term fundamentals and returns.  Hunter-gatherers needed to be greatly concerned about their immediate survival—about a pride of lions that might be lurking behind the next rock… They did not have the luxury of thinking about longer-term planning… Then and today, humans often flinch when they come upon a sudden apparent danger—and, by definition, a flinch is instinctive as opposed to cognitive.  Thus, over years, the selection process resulted in a subconscious proclivity for humans to be more concerned about the short term than the longer term.

By far the best thing for long-term investors is to do is absolutely nothing.  The investors who end up performing the best over the course of several decades are nearly always those investors who did virtually nothing.  They almost never checked prices.  They never reacted to bad news.

Regarding Whirlpool:

In the spring of 2011, Greenhaven studied Whirlpool’s fundamentals.  We immediately were impressed by management’s ability and willingness to slash costs.  In spite of a materially subnormal demand for appliances in 2010, the company was able to earn operating margins of 5.9 percent.  Often, when a company is suffering from particularly adverse industry conditions, it is unable to earn any profit at all.  But Whirlpool remained moderately profitable.  If the company could earn 5.9 percent margins under adverse circumstances, what could the company earn once the U.S. housing market and the appliance market returned to normal?

Not surprisingly, Wall Street analysts were focused on the short term:

…A report by J. P. Morgan dated April 27, 2011, stated that Whirlpool’s current share price properly reflected the company’s increased costs for raw materials, the company’s inability to increase its prices, and the current soft demand for appliances…

The J. P. Morgan report might have been correct about the near-term outlook for Whirlpool and its shares.  But Greenhaven invests with a two- to four-year time horizon and cares little about the near-term outlook for its holdings.

The bulk of Greenhaven’s returns has been generated by relatively few of its holdings:

If one in five of our holdings triples in value over a three-year period, then the other four holdings only have to achieve 12 percent average annual returns in order for our entire portfolio to achieve its stretch goal of 20 percent.  For this reason, Greenhaven works extra hard trying to identify potential multibaggers.  Whirlpool had the potential to be a multibagger because it was selling at a particularly low multiple of its potential earnings power.  Of course, most of our potential multibaggers do not turn out to be multibaggers.  But one cannot hit a multibagger unless one tries, and sometimes our holdings that initially appear to be less exciting eventually benefit from positive unforeseen events (handsome black swans) and unexpectedly turn out to be a complete winner.  For this reason, we like to remain fully invested as long as our holdings remain reasonably priced and free from large risks of permanent loss.



(Photo by José A. Montes, Wikimedia Commons)

Wachenheim likes to read about the history of each company that he studies.

On July 4, 1914, a flight took place in Seattle, Washington, that had a major effect on the history of aviation.  On that day, a barnstormer named Terah Maroney was hired to perform a flying demonstration as part of Seattle’s Independence Day celebrations.  After displaying aerobatics in his Curtis floatplane, Maroney landed and offered to give free rides to spectators.  One spectator, William Edward Boeing, a wealthy owner of a lumber company, quickly accepted Maroney’s offer.  Boeing was so exhilarated by the flight that he completely caught the aviation bug—a bug that was to be with him for the rest of his life.

Boeing launched Pacific Aero Products (renamed the Boeing Airplane Company in 1917).  In late 1916, Boeing designed an improved floatplane, the Model C.  The Model C was ready by April 1917, the same month the United States entered the war.  Boeing thought the Navy might need training aircraft.  The Navy bought two.  They performed well, so the Navy ordered 50 more.

Boeing’s business naturally slowed down after the war.  Boeing sold a couple of small floatplanes (B-1’s), then 13 more after Charles Lindberg’s 1927 transatlantic flight.  Still, sales of commercial planes were virtually nonexistent until 1933, when the company started marketing its model 247.

The twin-engine 247 was revolutionary and generally is recognized as the world’s first modern airplane.  It had a capacity to carry 10 passengers and a crew of 3.  It had a cruising speed of 189 mph and could fly about 745 miles before needing to be refueled.

Boeing sold seventy-five 247’s before making the much larger 307 Stratoliner, which would have sold well were it not for the start of World War II.

Boeing helped the Allies defeat Germany.  The Boeing B-17 Flying Fortress bomber and the B-29 Superfortress bomber became legendary.  More than 12,500 B-17s and more than 3,500 B-29s were built (some by Boeing itself and some by other companies that had spare capacity).

Boeing prospered during the war, but business slowed down again after the war.  In mid-1949, the de Havilland Aircraft Company started testing its Comet jetliner, the first use of a jet engine.  The Comet started carrying passengers in 1952.  In response, Boeing started developing its 707 jet.  Commercial flights for the 707 began in 1958.

The 707 was a hit and soon became the leading commercial plane in the world.

Over the next 30 years, Boeing grew into a large and highly successful company.  It introduced many models of popular commercial planes that covered a wide range of capacities, and it became a leader in the production of high-technology military aircraft and systems.  Moreover, in 1996 and 1997, the company materially increased its size and capabilities by acquiring North American Aviation and McDonnell Douglas.

In late 2012, after several years of delays on its new, more fuel-efficient plane—the 787—Wall Street and the media were highly critical of Boeing.  Wachenheim thought that the company could earn at least $7 per share in 2015.  The stock in late 2012 was at $75, or 11 times the $7.  Wachenheim believed that this was way too low for such a strong company.

Wachenheim estimated that two-thirds of Boeing’s business in 2015 would come from commercial aviation.  He figured that this was an excellent business worth 20 times earnings (he used 19 times to be conservative).  He reckoned that defense, one-third of Boeing’s business, was worth 15 times earnings.  Therefore, Wachenheim used 17.7 as the multiple for the whole company, which meant that Boeing would be worth $145 by 2015.

Greenhaven established a position in Boeing at about $75 a share in late 2012 and early 2013.  By the end of 2013, Boeing was at $136.  Because Wall Street now had confidence that the 787 would be a commercial success and that Boeing’s earnings would rise, Wachenheim and his associates concluded that most of the company’s intermediate-term potential was now reflected in the stock price.  So Greenhaven started selling its position.



(Photo by Eddie Maloney, Wikimedia Commons)

The airline industry has had terrible fundamentals for a long time.  But Wachenheim was able to be open-minded when, in August 2012, one of his fellow analysts suggested Southwest Airlines as a possible investment.  Over the years, Southwest had developed a low-cost strategy that gave the company a clear competitive advantage.

Greenhaven determined that the stock of Southwest was undervalued, so they took a position.

The price of Southwest’s shares started appreciating sharply soon after we started establishing our position.  Sometimes it takes years before one of our holdings starts to appreciate sharply—and sometimes we are lucky with our timing.

After the shares tripled, Greenhaven sold half its holdings since the expected return from that point forward was not great.  Also, other investors now recognized the positive fundamentals Greenhaven had expected.  Greenhaven sold the rest of its position as the shares continued to increase.



(Photo of Marcus Goldman, Wikimedia Commons)

Wachenheim echoes Warren Buffett when it comes to recognizing how much progress the United States has made:

My experience is that analysts and historians often dwell too much on a company’s recent problems and underplay its strengths, progress, and promise.  An analogy might be the progress of the United States during the twentieth century.  At the end of the century, U.S. citizens generally were far wealthier, healthier, safer, and better educated than at the start of the century.  In fact, the century was one of extraordinary progress.  Yet most history books tend to focus on the two tragic world wars, the highly unpopular Vietnam War, the Great Depression, the civil unrest during the Civil Rights movement, and the often poor leadership in Washington.  The century was littered with severe problems and mistakes.  If you only had read the newspapers and the history books, you likely would have concluded that the United States had suffered a century of relative and absolute decline.  But the United States actually exited the century strong and prosperous.  So did Goldman exit 2013 strong and prosperous.

In 2013, Wachenheim learned that Goldman had an opportunity to gain market share in investment banking because some competitors were scaling back in light of new regulations and higher capital requirements.  Moreover, Goldman had recently completed a $1.9 billion cost reduction program.  Compensation as a percentage of sales had declined significantly in the past few years.

Wachenheim discovered that Goldman is a technology company to a large extent, with a quarter of employees working in the technology division.  Furthermore, the company had strong competitive positions in its businesses, and had sold or shut down sub-par business lines.  Wachenheim checked his investment thesis with competitors and former employees.  They confirmed that Goldman is a powerhouse.

Wachenheim points out that it’s crucial for investors to avoid confirmation bias:

I believe that it is important for investors to avoid seeking out information that reinforces their original analyses.  Instead, investors must be prepared and willing to change their analyses and minds when presented with new developments that adversely alter the fundamentals of an industry or company.  Good investors should have open minds and be flexible.

Wachenheim also writes that it’s very important not to invent a new thesis when the original thesis has been invalidated:

We have a straightforward approach.  When we are wrong or when fundamentals turn against us, we readily admit we are wrong and we reverse our course.  We do not seek new theories that will justify our original decision.  We do not let errors fester and consume our attention.  We sell and move on.

Wachenheim loves his job:

I am almost always happy when working as an investment manager.  What a perfect job, spending my days studying the world, economies, industries, and companies;  thinking creatively;  interviewing CEOs of companies… How lucky I am.  How very, very lucky.



An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are 15-25 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 10-15% (at cost), while the average position is 5-7% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees.  The Boole Fund has low fees. 


If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail:




Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

Buffett’s Best: Microcap Cigar Butts

(Image:  Zen Buddha Silence by Marilyn Barbone)

October 8, 2017

Warren Buffett, the world’s greatest investor, earned the highest returns of his career from microcap cigar butts.  Buffett wrote in the 2014 Berkshire Letter:

My cigar-butt strategy worked very well while I was managing small sums.  Indeed, the many dozens of free puffs I obtained in the 1950’s made the decade by far the best of my life for both relative and absolute performance.

Even then, however, I made a few exceptions to cigar butts, the most important being GEICO.  Thanks to a 1951 conversation I had with Lorimer Davidson, a wonderful man who later became CEO of the company, I learned that GEICO was a terrific business and promptly put 65% of my $9,800 net worth into its shares.  Most of my gains in those early years, though, came from investments in mediocre companies that traded at bargain prices.  Ben Graham had taught me that technique, and it worked.

But a major weakness in this approach gradually became apparent:  Cigar-butt investing was scalable only to a point.  With large sums, it would never work well…

Before Buffett led Berkshire Hathaway, he managed an investment partnership from 1957 to 1970 called Buffett Partnership Ltd. (BPL).  While running BPL, Buffett wrote letters to limited partners filled with insights (and humor) about investing and business.  Jeremy C. Miller has written a great book— Warren Buffett’s Ground Rules (Harper, 2016)—summarizing the lessons from Buffett’s partnership letters.

This blog post considers a few topics related to microcap cigar butts:

  • Net Nets
  • Dempster: The Asset Conversion Play
  • Liquidation Value or Earnings Power?
  • Mean Reversion for Cigar Butts
  • Focused vs. Statistical
  • The Rewards of Psychological Discomfort
  • Conclusion



Here Miller quotes the November 1966 letter, in which Buffett writes about valuing the partnership’s controlling ownership position in a cigar-butt stock:

…Wide changes in the market valuations accorded stocks at some point obviously find reflection in the valuation of businesses, although this factor is of much less importance when asset factors (particularly when current assets are significant) overshadow earnings power considerations in the valuation process…

Ben Graham’s primary cigar-butt method was net nets.  Take net current asset value minus ALL liabilities, and then only buy the stock at 2/3 (or less) of that level.  If you buy a basket (at least 20-30) of such stocks, then given enough time (at least a few years), you’re virtually certain to get good investment results, predominantly far in excess of the broad market.

A typical net-net stock might have $30 million in cash, with no debt, but have a market capitalization of $20 million.  Assume there are 10 million shares outstanding.  That means the company has $3/share in net cash, with no debt.  But you can buy part ownership of this business by paying only $2/share.  That’s ridiculously cheap.  If the price remained near those levels, you could in theory buy $1 million in cash for $667,000—and repeat the exercise many times.

Of course, a company that cheap almost certainly has problems and may be losing money.  But every business on the planet, at any given time, is in either one of two states:  it is having problems, or it will be having problems.  When problems come—whether company-specific, industry-driven, or macro-related—that often causes a stock to get very cheap.

The key question is whether the problems are temporary or permanent.  Statistically speaking, many of the problems are temporary when viewed over the subsequent 3 to 5 years.  The typical net-net stock is so extremely cheap relative to net tangible assets that usually something changes for the better—whether it’s a change by management, or a change from the outside (or both).  Most net nets are not liquidated, and even those that are still bring a profit in many cases.

The net-net approach is one of the highest-returning investment strategies ever devised.  That’s not a surprise because net nets, by definition, are absurdly cheap on the whole, often trading below net cash—cash in the bank minus ALL liabilities.

Buffett called Graham’s net-net method the cigar butt approach:

…I call it the cigar butt approach to investing.  You walk down the street and you look around for a cigar butt someplace.  Finally you see one and it is soggy and kind of repulsive, but there is one puff left in it.  So you pick it up and the puff is free – it is a cigar butt stock.  You get one free puff on it and then you throw it away and try another one.  It is not elegant.  But it works.  Those are low return businesses.


(Photo by Sky Sirasitwattana)

When running BPL, Buffett would go through thousands of pages of Moody’s Manuals (and other such sources) to locate just one or a handful of microcap stocks trading at less than liquidation value.  Other leading value investors have also used this technique.  This includes Charlie Munger (early in his career), Walter Schloss, John Neff, Peter Cundill, and Marty Whitman, to name a few.

The cigar butt approach is also called deep value investing.  This normally means finding a stock that is available below liquidation value, or at least below net tangible book value.

When applying the cigar butt method, you can either do it as a statistical group approach, or you can do it in a focused manner.  Walter Schloss achieved one of the best long-term track records of all time—near 21% annually (gross) for 47 years—using a statistical group approach to cigar butts.  Schloss typically had a hundred stocks in his portfolio, most of which were trading below tangible book value.

At the other extreme, Warren Buffett—when running BPL—used a focused approach to cigar butts.  Dempster is a good example, which Miller explores in detail in his book.



Dempster was a tiny micro cap, a family-owned company in Beatrice, Nebraska, that manufactured windmills and farm equipment.  Buffett slowly bought shares in the company over the course of five years.

(Photo by Digikhmer)

Dempster had a market cap of $1.6 million, about $13.3 million in today’s dollars, says Miller.

  • Note:  A market cap of $13.3 million is in the $10 to $25 million range—among the tiniest micro caps—which is avoided by nearly all investors, including professional microcap investors.

Buffett’s average price paid for Dempster was $28/share.  Buffett’s estimate of liquidation value early on was near $35/share, which is intentionally conservative.  Miller quotes one of Buffett’s letters:

The estimated value should not be what we hope it would be worth, or what it might be worth to an eager buyer, etc., but what I would estimate our interest would bring if sold under current conditions in a reasonably short period of time.

To estimate liquidation value, Buffett followed Graham’s method, as Miller explains:

  • cash, being liquid, doesn’t need a haircut
  • accounts receivable are valued at 85 cents on the dollar
  • inventory, carried on the books at cost, is marked down to 65 cents on the dollar
  • prepaid expenses and “other” are valued at 25 cents on the dollar
  • long-term assets, generally less liquid, are valued using estimated auction values

Buffett’s conservative estimate of liquidation value for Dempster was $35/share, or $2.2 million for the whole company.  Recall that Buffett paid an average price of $28/share—quite a cheap price.

Even though the assets were clearly there, Dempster had problems.  Stocks generally don’t get that cheap unless there are major problems.  In Dempster’s case, inventories were far too high and rising fast.  Buffett tried to get existing management to make needed improvements.  But eventually Buffett had to throw them out.  Then the company’s bank was threatening to seize the collateral on the loan.  Fortunately, Charlie Munger—who later became Buffett’s business partner—recommended a turnaround specialist, Harry Bottle.  Miller:

Harry did such an outstanding job whipping the company into shape that Buffett, in the next year’s letter, named him “man of the year.”  Not only did he reduce inventories from $4 million to $1 million, alleviating the concerns of the bank (whose loan was quickly repaid), he also cut administrative and selling expenses in half and closed five unprofitable branches.  With the help of Buffett and Munger, Dempster also raised prices on their used equipment up to 500% with little impact to sales volume or resistance from customers, all of which worked in combination to restore a healthy economic return in the business.

Miller explains that Buffett rationally focused on maximizing the return on capital:

Buffett was wired differently, and he achieves better results in part because he invests using an absolute scale.  With Dempster he wasn’t at all bogged down with all the emotional baggage of being a veteran of the windmill business.  He was in it to produce the highest rate of return on the capital he had tied up in the assets of the business.  This absolute scale allowed him to see that the fix for Dempster would come by not reinvesting back into windmills.  He immediately stopped the company from putting more capital in and started taking the capital out.

With profits and proceeds raised from converting inventory and other assets to cash, Buffett started buying stocks he liked.  In essence, he was converting capital that was previously utilized in a bad (low-return) business, windmills, to capital that could be utilized in a good (high-return) business, securities.

Bottle, Buffett, and Munger maximized the value of Dempster’s assets.  Buffett took the further step of not reinvesting cash in a low-return business, but instead investing in high-return stocks.  In the end, on its investment of $28/share, BPL realized a net gain of $45 per share.  This is a gain of a bit more than 160% on what was a very large position for BPL—one-fifth of the portfolio.  Had the company been shut down by the bank, or simply burned through its assets, the return after paying $28/share could have been nothing or even negative.

Miller nicely summarizes the lessons of Buffett’s asset conversion play:

Buffett teaches investors to think of stocks as a conduit through which they can own their share of the assets that make up a business.  The value of that business will be determined by one of two methods: (1) what the assets are worth if sold, or (2) the level of profits in relation to the value of assets required in producing them.  This is true for each and every business and they are interrelated…

Operationally, a business can be improved in only three ways: (1) increase the level of sales; (2) reduce costs as a percent of sales; (3) reduce assets as a percentage of sales.  The other factors, (4) increase leverage or (5) lower the tax rate, are the financial drivers of business value.  These are the only ways a business can make itself more valuable.

Buffett “pulled all the levers” at Dempster…



For most of the cigar butts that Buffett bought for BPL, he used Graham’s net-net method of buying at a discount to liquidation value, conservatively estimated.  However, you can find deep value stocks—cigar butts—on the basis of other low “price-to-a-fundamental” ratio’s, such as low P/E or low EV/EBITDA.  Even Buffett, when he was managing BPL, used a low P/E in some cases to identify cigar butts.  (See an example below: Western Insurance Securities.)

Tobias Carlisle and Wes Gray tested various measures of cheapness from 1964 to 2011.  Quantitative Value (Wiley, 2012)—an excellent book—summarizes their results.  James P. O’Shaugnessy has conducted one of the broadest arrays of statistical backtests.  See his results in What Works on Wall Street (McGraw-Hill, 4th edition, 2012), a terrific book.

(Illustration by Maxim Popov)

  • Carlisle and Gray found that low EV/EBIT was the best-performing measure of cheapness from 1964 to 2011. It even outperformed composite measures.
  • O’Shaugnessy learned that low EV/EBITDA was the best-performing individual measure of cheapness from 1964 to 2009.
  • But O’Shaugnessy also discovered that a composite measure—combining low P/B, P/E, P/S, P/CF, and EV/EBITDA—outperformed low EV/EBITDA.

Assuming relatively similar levels of performance, a composite measure is arguably better because it tends to be more consistent over time.  There are periods when a given individual metric might not work well.  The composite measure will tend to smooth over such periods.  Besides, O’Shaugnessy found that a composite measure led to the best performance from 1964 to 2009.

Carlisle and Gray, as well as O’Shaugnessy, didn’t include Graham’s net-net method in their reported results.  Carlisle wrote another book, Deep Value (Wiley, 2014)—which is fascinating—in which he summarizes several tests of net nets:

  • Henry Oppenheimer found that net nets returned 29.4% per year versus 11.5% per year for the market from 1970 to 1983.
  • Carlisle—with Jeffrey Oxman and Sunil Mohanty—tested net nets from 1983 to 2008. They discovered that the annual returns for net nets averaged 35.3% versus 12.9% for the market and 18.4% for a Small Firm Index.
  • A study of the Japanese market from 1975 to 1988 uncovered that net nets outperformed the market by about 13% per year.
  • An examination of the London Stock Exchange from 1981 to 2005 established that net nets outperformed the market by 19.7% per year.
  • Finally, James Montier analyzed all developed markets globally from 1985 to 2007. He learned that net nets averaged 35% per year versus 17% for the developed markets on the whole.

Given these outstanding returns, why didn’t Carlisle and Gray, as well as O’Shaugnessy, consider net nets?  Primarily because many net nets are especially tiny microcap stocks.  For example, in his study, Montier found that the median market capitalization for net nets was $21 million.  Even the majority of professionally managed microcap funds do not consider stocks this tiny.

  • Recall that Dempster had a market cap of $1.6 million, or about $13.3 million in today’s dollars.
  • Unlike the majority of microcap funds, the Boole Microcap Fund does consider microcap stocks in the $10 to $25 million market cap range.

In 1999, Buffett commented that he could get 50% per year by investing in microcap cigar butts.  He was later asked about this comment in 2005, and he replied:

Yes, I would still say the same thing today.  In fact, we are still earning those types of returns on some of our smaller investments.  The best decade was the 1950s;  I was earning 50% plus returns with small amounts of capital.  I would do the same thing today with smaller amounts.  It would perhaps even be easier to make that much money in today’s environment because information is easier to access.  You have to turn over a lot of rocks to find those little anomalies.  You have to find the companies that are off the map—way off the map.  You may find local companies that have nothing wrong with them at all.  A company that I found, Western Insurance Securities, was trading for $3/share when it was earning $20/share!!  I tried to buy up as much of it as possible.  No one will tell you about these businesses.  You have to find them.

Although the majority of microcap cigar butts Buffett invested in were cheap relative to liquidation value—cheap on the basis of net tangible assets—Buffett clearly found some cigar butts on the basis of a low P/E.  Western Insurance Securities is a good example.



Warren Buffett commented on high quality companies versus statistically cheap companies in his October 1967 letter to partners:

The evaluation of securities and businesses for investment purposes has always involved a mixture of qualitative and quantitative factors.  At the one extreme, the analyst exclusively oriented to qualitative factors would say, “Buy the right company (with the right prospects, inherent industry conditions, management, etc.) and the price will take care of itself.”  On the other hand, the quantitative spokesman would say, “Buy at the right price and the company (and stock) will take care of itself.”  As is so often the pleasant result in the securities world, money can be made with either approach.  And, of course, any analyst combines the two to some extent—his classification in either school would depend on the relative weight he assigns to the various factors and not to his consideration of one group of factors to the exclusion of the other group.

Interestingly enough, although I consider myself to be primarily in the quantitative school… the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a “high-probability insight”.  This is what causes the cash register to really sing.  However, it is an infrequent occurrence, as insights usually are, and, of course, no insight is required on the quantitative side—the figures should hit you over the head with a baseball bat.  So the really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.

Buffett and Munger acquired See’s Candies for Berkshire Hathaway in 1972.  See’s Candies is the quintessential high quality company because of its sustainably high ROIC (return on invested capital) of over 100%.

Truly high quality companies—like See’s—are very rare and difficult to find.  Cigar butts—including net nets—are much easier to find by comparison.

Furthermore, it’s important to understand that Buffett got around 50% annual returns from cigar butts because he took a focused approach, like BPL’s 20% position in Dempster.

The vast majority of investors, if using a cigar butt approach like net nets, should implement a group—or statistical—approach, and regularly buy and hold a basket of cigar butts (at least 20-30).  This typically won’t produce 50% annual returns.  But net nets, as a group, clearly have produced very high returns, often 30%+ annually.  To do this today, you’d have to look globally.

As an alternative to net nets, you could implement a group approach using one of O’Shaugnessy’s composite measures—such as low P/B, P/E, P/S, P/CF, EV/EBITDA.  Applying this to micro caps can produce 15-20% annual returns.  Generally not as good as net nets, but much easier to apply consistently.

You may think that you can find some high quality companies.  But that’s not enough.  You have to find a high quality company that can maintain its competitive position and high ROIC.  And it has to be available at a reasonable price.

Most high quality companies are trading at very high prices, to the extent that you can’t do better than the market by investing in them.  In fact, often the prices are so high that you’ll probably do worse than the market.

Consider this comment by Charlie Munger:

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.

(Illustration by Nadoelopisat)

A horse with a great record (etc.) is much more likely to win than a horse with a terrible record.  But—whether betting on horses or betting on stocks—you don’t get paid for identifying winners.  You get paid for identifying mispricings.

The statistical evidence is overwhelming that if you systematically buy stocks at low multiples—P/B, P/E, P/S, P/CF, EV/EBITDA, etc.—you’ll almost certainly do better than the market over the long haul.

A deep value—or cigar butt—approach has always worked, given enough time.  Betting on “the losers” has always worked eventually, whereas betting on “the winners” hardly ever works.

Classic academic studies showing “the losers” doing far better than “the winners” over subsequent 3- to 5-year periods:

That’s not to say deep value investing is easy.  When you put together a basket of statistically cheap companies, you’re buying stocks that are widely hated or neglected.  You have to endure loneliness and looking foolish.  Some people can do it, but it’s important to know yourself before using a deep value strategy.

In general, we extrapolate the poor performance of cheap stocks and the good performance of expensive stocks too far into the future.  This is the mistake of ignoring mean reversion.

When you find a group of companies that have been doing poorly for at least several years, those conditions typically do not persist.  Instead, there tends to be mean reversion, or a return to “more normal” levels of revenues, earnings, or cash flows.

Similarly for a group of companies that have been doing exceedingly well.  Those conditions also do not continue in general.  There tends to be mean reversion, but in this case the mean—the average or “normal” conditions—is below recent activity levels.

Here’s Ben Graham explaining mean reversion:

It is natural to assume that industries which have fared worse than the average are “unfavorably situated” and therefore to be avoided.  The converse would be assumed, of course, for those with superior records.  But this conclusion may often prove quite erroneous.  Abnormally good or abnormally bad conditions do not last forever.  This is true of general business but of particular industries as well.  Corrective forces are usually set in motion which tend to restore profits where they have disappeared or to reduce them where they are excessive in relation to capital.

With his taste for literature, Graham put the following quote from Horace’s Ars Poetica at the beginning of Security Analysis—the bible for value investors:

Many shall be restored that now are fallen and many shall fall than now are in honor.

Tobias Carlisle, while discussing mean reversion in Deep Value, smartly (and humorously) included this image of Albrecht Durer’s Wheel of Fortune:

(Albrecht Durer’s Wheel of Fortune from Sebastien Brant’s Ship of Fools (1494) via Wikimedia Commons)



We’ve already seen that there are two basic ways to do cigar-butt investing: focused vs. statistical (group).

Ben Graham usually preferred the statistical—or group—approach.  Near the beginning of the Great Depression, Graham’s managed accounts lost more than 80 percent.  Furthermore, the economy and the stock market took a long time to recover.  As a result, Graham had a strong tendency towards conservatism in investing.  This is likely part of why he preferred the statistical approach to net nets.  By buying a basket of net nets (at least 20-30), the investor is virtually certain to get the statistical results of the group over time, which are broadly excellent.

Graham also was a polymath of sorts.  He had wide-ranging intellectual interests.  Because he knew net nets as a group would do quite well over the long term, he wasn’t inclined to spend much time analyzing individual net nets.  Instead, he spent time on his other interests.

Warren Buffett was Graham’s best student.  Buffett was the only student ever to be awarded an A+ in Graham’s class at Columbia University.  Unlike Graham, Buffett has always had an extraordinary focus on business and investing.  After spending many years learning everything about virtually every public company, Buffett took a focused approach to net nets.  He found the ones that were the cheapest and that seemed the surest.

Buffett has asserted that returns can be improved—and risk lowered—if you focus your investments only on those companies that are within your circle of competence—those companies that you can truly understand.  Buffett also maintains, however, that the vast majority of investors should simply invest in index funds:

Regarding individual net nets, Graham admitted a danger:

Corporate gold dollars are now available in quantity at 50 cents and less—but they do have strings attached.  Although they belong to the stockholder, he doesn’t control them.  He may have to sit back and watch them dwindle and disappear as operating losses take their toll.  For that reason the public refuses to accept even the cash holdings of corporations at their face value.

Graham explained that net nets are cheap because they “almost always have an unsatisfactory trend in earnings.”  Graham:

If the profits had been increasing steadily it is obvious that the shares would not sell at so low a price.  The objection to buying these issues lies in the probability, or at least the possibility, that earnings will decline or losses continue, and that the resources will be dissipated and the intrinsic value ultimately become less than the price paid.

(Image by Preecha Israphiwat)

Value investor Seth Klarman warns:

As long as working capital is not overstated and operations are not rapidly consuming cash, a company could liquidate its assets, extinguish all liabilities, and still distribute proceeds in excess of the market price to investors.  Ongoing business losses can, however, quickly erode net-net working capital.  Investors must therefore always consider the state of a company’s current operations before buying.

Even Buffett—nearly two decades after closing BPL—wrote the following in his 1989 letter to Berkshire shareholders:

If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible.  I call this the “cigar butt” approach to investing.  A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit.

Unless you are a liquidator, that kind of approach to buying businesses is foolish.  First, the original “bargain” price probably will not turn out to be such a steal after all.  In a difficult business, no sooner is one problem solved than another surfaces—never is there just one cockroach in the kitchen.  Second, any initial advantage you secure will be quickly eroded by the low return that the business earns.  For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return.  But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost…

Based on these objections, you might think that Buffett’s focused approach is better than the statistical (group) method.  That way, the investor can figure out which net nets are more likely to recover rather than burn through their assets and leave the investor with a low or negative return.

However, Graham’s response was that the statistical or group approach to net nets is highly profitable over time.  There is a wide range of potential outcomes for net nets, and many of those scenarios are good for the investor.  Therefore, while there are always some individual net nets that don’t work out, a group or basket of net nets is nearly certain to work well eventually.

Indeed, Graham’s application of a statistical net-net approach produced 20% annual returns over many decades.  Most backtests of net nets have tended to show annual returns of close to 30%.  In practice, while around 5 percent of net nets may suffer a terminal decline in stock price, a statistical group of net nets has done far better than the market and has experienced fewer down years.  Moreover, as Carlisle notes in Deep Value, very few net nets are actually liquidated or merged.  In the vast majority of cases, there is a change by management, a change from the outside, or both, in order to restore earnings to a level more in line with net asset value.  Mean reversion.



We noted earlier that it’s far more difficult to find a company like See’s Candies, at a reasonable price, than it is to find statistically cheap stocks.  Moreover, if you buy a basket of statistically cheap stocks, you don’t have to possess an ability to analyze individual businesses in great depth.

That said, in order to use a deep value strategy, you do have to be able to handle the psychological discomfort of being lonely and looking foolish.

(Illustration by Sangoiri)

John Mihaljevic, author of The Manual of Ideas (Wiley, 2013), writes:

Comfort can be expensive in investing.  Put differently, acceptance of discomfort can be rewarding, as equities that cause their owners discomfort frequently trade at exceptionally low valuations….

…Misery loves company, so it makes sense that rewards may await those willing to be miserable in solitude…

Mihaljevic explains:

If we owned nothing but a portfolio of Ben Graham-style bargain equities, we may become quite uncomfortable at times, especially if the market value of the portfolio declined precipitously.  We might look at the portfolio and conclude that every investment could be worth zero.  After all, we could have a mediocre business run by mediocre management, with assets that could be squandered.  Investing in deep value equities therefore requires faith in the law of large numbers—that historical experience of market-beating returns in deep value stocks and the fact that we own a diversified portfolio will combine to yield a satisfactory result over time.  This conceptually sound view becomes seriously challenged in times of distress…

Playing into the psychological discomfort of Graham-style equities is the tendency of such investments to exhibit strong asset value but inferior earnings or cash flows.  In a stressed situation, investors may doubt their investment theses to such an extent that they disregard the objectively appraised asset values.  After all—the reasoning of a scared investor might go—what is an asset really worth if it produces no cash flow?

Deep value investors often find some of the best investments in cyclical areas.  A company at a cyclical low may have multi-bagger potential—the prospect of returning 300-500% (or more) to the investor.

A good current example is Ensco plc (NYSE: ESV), an offshore oil driller.  Having just completed its acquisition of Atwood Oceanics (NYSE: ATW), Ensco is now a leading offshore driller with a high-specification, globally diverse fleet.  The company also has one of the lowest cost structures, and relatively low debt levels (with the majority of debt due in 2024 or later).  Ensco—like Atwood—has a long history of operational excellence and safety.  Ensco has been rated #1 for seven consecutive years in the leading independent customer satisfaction survey.

  • At $5.60 recently, Ensco is trading near 20% of tangible book value.  (It purchased Atwood at about the same discount to tangible book.)  If oil prices revert to a mean of $60-70 per barrel (or more), Ensco will probably be worth at least tangible book value.
  • That implies a 400% return (or more)—over the next 3 to 5 years—for an investor who owns shares today.

However, it’s possible oil will never return to $60-70.  It’s possible the seemingly cyclical decline for offshore oil drillers is actually more permanent in nature.  Mihaljevic observes:

The question of whether a company has entered permanent decline is anything but easy to answer, as virtually all companies appear to be in permanent decline when they hit a rock-bottom market quotation.  Even if a business has been cyclical in the past, analysts generally adopt a “this time is different” attitude.  As a pessimistic stock price inevitably influences the appraisal objectivity of most investors, it becomes exceedingly difficult to form a view strongly opposed to the prevailing consensus.

Consider the following industries that have been pronounced permanently impaired in the past, only to rebound strongly in subsequent years:  Following the financial crisis of 2008-2009, many analysts argued that the banking industry would be permanently negatively affected, as higher capital requirements and regulatory oversight would compress returns on equity.  The credit rating agencies were seen as impaired because the regulators would surely alter the business model of the industry for the worse following the failings of the rating agencies during the subprime mortgage bubble.  The homebuilding industry would fail to rebound as strongly as in the past, as overcapacity became chronic and home prices remained tethered to building costs.  The refining industry would suffer permanently lower margins, as those businesses were capital-intensive and driven by volatile commodity prices.

Are offshore oil drillers in a cyclical or a secular decline?  It’s likely that oil will return to $60-70, at least in the next 5-10 years.  But no one knows for sure.

Ongoing improvements in technology allow oil producers to get more oil—more cheaply—out of existing fields.  Also, growth in transport demand for oil will slow significantly at some point, due to ongoing improvements in fuel efficiency.  See:

Transport demand is responsible for over 50% of daily oil consumption, and it’s inelastic—typically people have to get where they’re going, so they’re not very sensitive to fuel price increases.

But even if oil never returns to $60+, oil will be needed for many decades.  At least some offshore drilling will still be needed, and Ensco will be a survivor.

Full Disclosure:

  • The Boole Fund had an investment in Atwood Oceanics. With the acquisition of Atwood by Ensco now completed, the Boole Fund currently owns shares in Ensco plc.
  • The Boole Fund holds positions for 3 to 5 years. The fund doesn’t sell an investment that is still cheap, even if the stock in question is no longer a micro cap.



Buffett has made it clear, including in his 2014 letter to shareholders, that the best returns of his career came from investing in microcap cigar butts.  Most of these were mediocre businesses (or worse).  But they were ridiculously cheap.  And, in some cases like Dempster, Buffett was able to bring about needed improvements when required.

When Buffett wrote about buying wonderful businesses in his 1989 letter, that’s chiefly because investable assets at Berkshire Hathaway had grown far too large for microcap cigar butts.

Even in recent years, Buffett invested part of his personal portfolio in a group of cigar butts he found in South Korea.  So he’s never changed his view that an investor can get the highest returns from microcap cigar butts, either by using a statistical group approach or by using a more focused method.



An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are 15-25 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 10-15% (at cost), while the average position is 5-7% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees.  The Boole Fund has low fees. 


If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail:




Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

The Art of Value Investing

(Image:  Zen Buddha Silence by Marilyn Barbone.)

September 17, 2017

The Art of Value Investing (Wiley, 2013) is an excellent book by John Heins and Whitney Tilson.  Heins and Tilson have been running the monthly newsletter, Value Investor Insight, for a decade now.  Over that time, they have interviewed many of the best value investors in the world.  The Art of Value Investing is a collection of quotations carefully culled from those interviews.

I’ve selected and discussed the best quotes from the following areas:

  • Margin of Safety
  • Humility, Flexibility, and Patience
  • Courage
  • Cigar-Butt’s
  • Opportunities in Micro Caps
  • Predictable Human Irrationality
  • Long-Term Time Horizon
  • Screening and Quantitative Models



(Ben Graham, by Equim43)

Ben Graham, the father of value investing, stressed having a margin of safety by buying well below the probable intrinsic value of a stock.  This is essential because the future is uncertain.  Also, mistakes are inevitable.  (Good value investors tend to be right 60 percent of the time and wrong 40 percent of the time.)  Jean-Marie Eveillard:

Whenever Ben Graham was asked what he thought would happen to the economy or to company X’s or Y’s profits, he always used to deadpan, ‘The future is uncertain.’  That’s precisely why there’s a need for a margin of safety in investing, which is more relevant today than ever.

Value investing legend Seth Klarman:

People should be highly skeptical of anyone’s, including their own, ability to predict the future, and instead pursue strategies that can survive whatever may occur.  

The central idea in value investing is to figure out what a business is worth (approximately), and then pay a lot less to acquire part ownership of that business via stock.  Howard Marks:

If I had to identify a single key to consistently successful investing, I’d say it’s ‘cheapness.’  Buying at low prices relative to intrinsic value (rigorously and conservatively derived) holds the key to earning dependably high returns, limiting risk and minimizing losses.  It’s not the only thing that matters—obviously—but it’s something for which there is no substitute.



(Image by Wilma64)

Successful value investing, to a large extent, is about having the right mindset.  Matthew McLennan identifies humility, flexibility, and patience as key traits:

Starting with the first recorded and reliable history that we can find—a history of the Peloponnesian war by a Greek author named Thucydides—and following through a broad array of key historical global crises, you see recurring aspects of human nature that have gotten people into trouble:  hubris, dogma, and haste.  The keys to our investing approach are the symmetrical opposite of that:  humility, flexibility, and patience.

On the humility side, one of the things that Jean-Marie Eveillard firmly ingrained in the culture here is that the future is uncertain.  That results in investing with not only a price margin of safety, but in companies with conservative balance sheets and prudent and proven management teams….

In terms of flexibility, we’ve been willing to be out of the biggest sectors of the market…

The third thing in terms of temperament we think we value more than most other investors is patience.  We have a five-year average holding period….We like to plant seeds and then watch the trees grow, and our portfolio is often kind of a portrait of inactivity.

It’s hard to overstate the importance of humility in investing.  Many of the biggest investing mistakes have occurred when intelligent investors who have succeeded in the past have developed high conviction in an idea that happens to be wrong.  Kyle Bass explains this point clearly:

You obviously need to develop strong opinions and to have the conviction to stick with them when you believe you’re right, even when everybody else may think you’re an idiot.  But where I’ve seen ego get in the way is by not always being open to questions and to input that could change your mind.  If you can’t ever admit you’re wrong, you’re more likely to hang on to your losers and sell your winners, which is not a recipe for success.

It often happens in investing that ideas that seem obvious or even irrefutable turn out to be wrong.  The very best investors—such as Warren Buffett, Charlie Munger, Seth Klarman, Howard Marks, Jeremy Grantham, George Soros, and Ray Dalio—have developed enough humility to admit when they’re wrong, even when all the evidence seems to indicate that they’re right.

Here are two great examples of how seemingly irrefutable ideas can turn out to be wrong:

  • shorting the U.S. stock market;
  • shorting the Japanese yen.

(Illustration by Eti Swinford)

Professor Russell Napier is the author of Anatomy of the Bear (Harriman House, 4th edition, 2016).  Napier was a top-rated analyst for many years and has been studying and writing about global macro strategy for institutional investors since 1995.

Napier has maintained (at least since 2012) that the U.S. stock market is significantly overvalued based on the Q-ratio and also the CAPE (cyclically adjusted P/E).  Moreover, Napier points out that every major U.S. secular bear market bottom in the last 100 years or so has seen the CAPE approach single digits.  The catalyst for the major drop has always been either inflation or deflation, states Napier.

Napier continues to argue (mid-2017) that U.S. stocks are overvalued and that deflation will cause the U.S. stock market to drop significantly, similar to previous secular bear markets.

Many highly intelligent value investors—at least since 2012 or 2013—have maintained high cash balances and/or short positions because they essentially agree with Napier’s argument.

However, Napier is probably wrong.  Here’s why:  U.S. interest rates are quite low, while profit margins are high compared to history.  And these conditions are likely to continue.

Low interest rates cause stocks to be much higher than otherwise.  At the extreme, as Buffett has noted, if rates stayed low enough for long enough, the stock market could have a P/E of 50 or more.

Also, U.S. profit margins are considerably higher than they have been in the last 100 years.  This situation will probably persist because software and related technology keep becoming more important in the U.S. and global economy.  The five largest U.S. companies are Google, Apple, Microsoft, Facebook, and Amazon, all technology companies.

One of the most astute value investors who tracks fair value of the S&P 500 Index is Jeremy Grantham of GMO.  Grantham used to think, back in 2012-2013, that the U.S. secular bear market was not over.  Then he partially revised his view and predicted that the S&P 500 Index was likely to exceed 2250-2300.  This level would have made the S&P 500’s value two standard deviations above the historical mean, indicating that it was back in bubble territory according to GMO’s definition.

Recently, in the GMO Quarterly Letter (Q2 2017), Grantham has revised his view again.  See:

Grantham now says that without a crash in profit margins, or without a dramatic sustained rise in inflation, there’s no reason to expect a market crash.  Furthermore, Grantham believes it’s unlikely for either of those things to happen, especially in the near term.  The fact that Grantham has been able to take in new information and noticeably revise his strongest convictions illustrates why he is a top value investor.

(Image by joshandandreaphotography)

As John Maynard Keynes is (probably incorrectly) reported to have said:

When the information changes, I alter my conclusions.  What do you do, sir?

There are some very smart value investors—such as Frank Martin and John Hussman—who still basically agree with Russell Napier’s views.  They may eventually be right.

But no one has ever been able to predict the stock market.  Ben Graham—with a 200 IQ—was as smart or smarter than any value investor who’s ever lived.  And here’s what Graham said near the end of his career:

If I have noticed anything over these sixty years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.

In 1963, Graham gave a lecture, “Securities in an Insecure World.”  Link:

In the lecture, Graham admits that the Graham P/E—based on ten-year average earnings of the Dow components—was much too conservative.  Graham:

The action of the stock market since then would appear to demonstrate that these methods of valuations are ultra-conservative and much too low, although they did work out extremely well through the stock market fluctuations from 1871 to about 1954, which is an exceptionally long period of time for a test.  Unfortunately in this kind of work, where you are trying to determine relationships based upon past behavior, the almost invariable experience is that by the time you have had a long enough period to give you sufficient confidence in your form of measurement just then new conditions supersede and the measurement is no longer dependable for the future.

Jeremy Grantham, in the GMO Q2 2017 Letter mentioned earlier, actually quotes these two sentences (among others).  But I first discovered Graham’s 1963 lecture several years ago.

Graham goes on to note that, in the 1962 edition of Security Analysis, Graham and Dodd addressed this issue.  Because of the U.S. government’s more aggressive policy with respect to preventing a depression, Graham and Dodd concluded that the U.S. stock market should have a fair value 50 percent higher.

Similar logic can be applied to the S&P 500 Index today—which exceeds 2500.  If interest rates remain relatively low for many years—in part based on a more aggressive Fed policy (designed to avoid deflation and create inflation)—and if profit margins are at a permanently higher level, then fair value for the S&P 500 has arguably increased significantly.  Whereas the CAPE (cyclically adjusted P/E)—the modern form of the original Graham P/E—put fair value of the S&P 500 Index at around 1100-1200 back in 2011-2013, that’s way too low if interest rates remain low and if profit margins are permanently higher.

In brief, previous methods—very well-established based on nearly a century—put fair value for the S&P 500 Index around 1100-1200.  But actual fair value could easily be closer to 1800 or more.  And fair value grows each year as the economy grows.  The U.S. economy is still growing steadily.  So 2500 for the S&P 500 may be quite far from “bubble” territory.  In fact, the market may be fairly valued—if not now, then in 5-10 years.

Furthermore, always bear in mind that no one can predict the stock market.  This has not only been observed by Graham.  But it’s also been pointed out by Peter Lynch, Seth Klarman, Henry Singleton, and Warren Buffett.  Peter Lynch is one of the best investors.  Klarman is even better.  Buffett is arguably the best.  And Singleton was even smarter than Buffett.

In a word, history strongly demonstrates that no one has ever been able to predict the stock market with any sort of reliability.

(Illustration by Maxim Popov)

Peter Lynch:

Nobody can predict interest rates, the future direction of the economy, or the stock market.  Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you’ve invested.

Seth Klarman:

In reality, no one knows what the market will do; trying to predict it is a waste of time, and investing based upon that prediction is a speculative undertaking.

Now, every year there are “pundits” who make predictions about the stock market.  Therefore, as a matter of pure chance, there will always be people in any given year who are “right.”  But there’s zero evidence that any of those who were “right” at some point in the past have been correct with any sort of reliability.

Howard Marks has asked: of those who correctly predicted the bear market in 2008, how many of them predicted the recovery in 2009 and since then?  The answer: very few.  Marks points out that most of those who got 2008 right were already disposed to bearish views in general.  So when a bear market finally came, they were “right,” but the vast majority missed the recovery starting in 2009.

There are always naysayers making bearish predictions.  But anyone who owned an S&P 500 index fund from 2007 to present (Sept. 2017) would have done dramatically better than most of those who listened to naysayers.  Buffett:

Ever-present naysayers may prosper by marketing their gloomy forecasts.  But heaven help them if they act on the nonsense they peddle.

Buffett himself made a 10-year wager against a group of talented hedge fund (and fund of hedge fund) managers.  With only a few months left until the conclusion of the bet, Buffett’s investment in a Vanguard S&P 500 index fund has roughly quadrupled the performance of the hedge funds:

Some very able investors have stayed largely in cash since 2011-2012.  The S&P 500 Index has more than doubled since then.  Moreover, many have tried to short the U.S. stock market since 2011-2012.  Some are down 50 percent, while the S&P 500 Index has more than doubled.  The net result of that combination is to be at only 20-25% of the S&P 500’s current value.

Henry Singleton, a business genius (100 points from being a chess grandmaster) who was easily one of the best capital allocators in American business history, never relied on financial forecasts—despite operating in a secular bear market from 1968 to 1982:

I don’t believe all this nonsense about market timing. Just buy very good value and when the market is ready that value will be recognized.

Warren Buffett puts it best:

  • Charlie and I never have an opinion on the market because it wouldn’t be any good and it might interfere with the opinions we have that are good.
  • We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen.
  • Market forecasters will fill your ear but never fill your wallet.
  • Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.
  • Stop trying to predict the direction of the stock market, the economy, interest rates, or elections.
  • [On economic forecasts:] Why spend time talking about something you don’t know anything about?  People do it all the time, but why do it?
  • I don’t invest a dime based on macro forecasts.

Another good example of a “can’t lose” investment idea that has turned out not to be right:  shorting the Japanese yen.  Many macro experts have been quite certain that the Japanese yen versus the U.S. dollar would eventually exceed 200.  They thought this would have happened years ago.  Some called it the “trade of the decade.”  But the yen versus U.S. dollar is still around 110.  A simple S&P 500 index fund appears to be doing far better than the “trade of the decade.”

(Illustration by Shalom3)

Some have tried to short Japanese government bonds (JGB’s), rather than shorting the yen currency.  But that hasn’t worked for decades.  In fact, shorting JGB’s has become known as the widowmaker trade.

Seth Klarman on humility:

In investing, certainty can be a serious problem, because it causes one not to reassess flawed conclusions.  Nobody can know all the facts.  Instead, one must rely on shreds of evidence, kernels of truth, and what one suspects to be true but cannot prove.

Klarman on the vital importance of doubt:

It is much harder psychologically to be unsure than to be sure;  certainty builds confidence, and confidence reinforces certainty.  Yet being overly certain in an uncertain, protean, and ultimately unknowable world is hazardous for investors.  To be sure, uncertainty breeds doubt, which can be paralyzing.  But uncertainty also motivates diligence, as one pursues the unattainable goal of eliminating all doubt.  Unlike premature or false certainty, which induces flawed analysis and failed judgments, a healthy uncertainty drives the quest for justifiable conviction.

My own painful experiences:  shorting the U.S. stock market and shorting the Japanese yen.  In each case, I believed that the evidence was overwhelming.  By far the biggest mistake I’ve ever made was shorting the U.S. stock market in 2011-2013.  At the time, I agreed with Russell Napier’s arguments.  I was completely wrong.

After that, I shorted the Japanese yen because I was convinced the argument was virtually irrefutable.  Wrong.  Perhaps the yen will collapse some day, but if it’s 10-20 years in the future—or even later—then an index fund or a quantitative value fund would be a far better and safer investment.

Spencer Davidson:

Over a long career you learn a certain humility and are quicker to attribute success to luck rather than your own brilliance.  I think that makes you a better investor, because you’re less apt to make the big mistake and you’re probably quicker to capitalize on good fortune when it shines upon you.

Jeffrey Bronchick:

It’s important not to get carried away with yourself when times are good, and to be able to admit your mistakes and move on when they’re not so good.  If you are intellectually honest—and not afraid to be visibly and sometimes painfully judged by your peers—investing is not work, it’s fun.

Patiently waiting for pessimism or temporary bad news to create low stock prices (some place), and then buying stocks well below probable intrinsic value, does not require genius in general.  But it does require the humility to focus only on areas where you can do well.  As Warren Buffett has remarked:

What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know.



(Courage concept by Travelling-light)

Humility is essential for success in investing.  But you also need the courage to think and act independently.  You have to be able to develop an investment thesis based on the facts and good reasoning without worrying if many others disagree.  Most of the best value investments are contrarian, meaning that your view differs from the consensus.  Ben Graham:

In the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand.

Graham again:

You’re neither right nor wrong because the crowd disagrees with you.  You’re right because your data and reasoning are right.

Or as Carlo Cannell says:

Going against the grain is clearly not for everyone—and it doesn’t tend to help you in your social life—but to make the really large money in investing, you have to have the guts to make the bets that everyone else is afraid to make.

Joel Greenblatt identifies two chief reasons why contrarian value investing is hard:

Value investing strategies have worked for years and everyone’s known about them.  They continue to work because it’s hard for people to do, for two main reasons.  First, the companies that show up on the screens can be scary and not doing so well, so people find them difficult to buy.  Second, there can be one-, two- or three-year periods when a strategy like this doesn’t work.  Most people aren’t capable of sticking it out through that.

Contrarian value investing requires buying what is out-of-favor, neglected, or hated.  It also requires the ability to endure multi-year periods of trailing the market, which most investors just can’t do.  Furthermore, while you’re buying what everyone hates and while you’re trailing the market, you also have to put up with people calling you an idiot.  In a word, you must have the ability to suffer.  Eveillard:

If you are a value investor, you’re a long-term investor.  If you are a long-term investor, you’re not trying to keep up with a benchmark on a short-term basis.  To do that, you accept in advance that every now and then you will lag behind, which is another way of saying you will suffer.  That’s very hard to accept in advance because, the truth is, human nature shrinks from pain.  That’s why not so many people invest this way.  But if you believe as strongly as I do that value investing not only makes sense, but that it works, there’s really no credible alternative.



(Photo by Leung Cho Pan)

Warren Buffett has remarked that buying baskets of statistically cheap cigar-butt’s—50-cent dollars—is a more dependable way to generate good returns than buying high-quality businesses.  Rich Pzena perhaps expressed it best:

When I talk about the companies I invest in, you’ll be able to rattle off hundreds of bad things about them—but that’s why they’re cheap!  The most common comment I get is ‘Don’t you read the paper?’  Because if you read the paper, there’s no way you’d buy these stocks.

They’re priced where they are for good reason, but I invest when I believe the conditions that are causing them to be priced that way are probably not permanent.  By nature, you can’t be short-term oriented with this investment philosophy.  If you’re going to worry about short-term volatility, you’re just not going to be able to buy the cheapest stocks.  With the cheapest stocks, the outlooks are uncertain.

Many investors incorrectly assume that high growth in the past will continue into the future, or that a high-quality company is automatically a good investment.  Behavioral finance expert and value investor James Montier:

There’s a great chapter [in Dan Ariely’s Predictably Irrational] about the ways in which we tend to misjudge price and use it as an indicator of something or other.  That links back to my whole thesis that the most common error we as investors make is overpaying for the hope of growth.  Dan did an experiment involving wine, in which he told people, ‘Here’s a $10 bottle of wine and here’s a $90 bottle of wine.  Please rate them and tell me which tastes better.’  Not surprisingly, nearly everyone thought the $90 wine tasted much better than the $10 wine.  The only snag was that the $90 wine and the $10 wine were actually the same $10 wine.



(Illustration by Mopic)

Micro-cap stocks are the most inefficiently priced.  That’s because, for most professional investors, assets under management are too large.  These investors cannot even consider micro caps.  The Boole Microcap Fund is designed to take advantage of this inefficiency:

James Vanasek on the opportunity in micro caps:

We’ll invest in companies with up to $1 billion or so in market cap, but have been most successful in ideas that start out in the $50 million to $300 million range.  Fewer people are looking at them and the industries the companies are in can be quite stable.  Given that, if you find a company doing well, it’s more likely it can sustain that advantage over time.

Because very few professional investors can even contemplate investing in micro caps, there’s far less competition.  Carlo Cannell:

My basic premise is that the efficient markets hypothesis breaks down when there is inconsistent, imperfect dissemination of information.  Therefore it makes sense to direct our attention to the 14,000 or so publicly traded companies in the U.S. for which there is little or no investment sponsorship by Wall Street, meaning three or fewer sell-side analysts who publish research…

You’d be amazed how little competition we have in this neglected universe.  It is just not in the best interest of the vast majority of the investing ecosphere to spend 10 minutes on the companies we spend our lives looking at.

Robert Robotti adds:

We focus on smaller-cap companies that are largely ignored by Wall Street and face some sort of distress, of their own making or due to an industry cycle.  These companies are more likely to be inefficiently priced and if you have conviction and a long-term view they can produce not 20 to 30 percent returns, but multiples of that.



Value investors recognize that the stock market is not always efficient, largely because humans are often less than fully rational.  As Seth Klarman explains:

Markets are inefficient because of human nature—innate, deep-rooted, permanent.  People don’t consciously choose to invest with emotion—they simply can’t help it.

Quantitative value investor James O’Shaugnessy:

Because of all the foibles of human nature that are well documented by behavioral research—people are always going to overshoot and undershoot when pricing securities.  A review of financial markets all the way back to the South Sea Company nearly 300 years ago proves this out.

Bryan Jacoboski:

The very reason price and value diverge in predictable and exploitable ways is because people are emotional beings.  That’s why the distinguishing attribute among successful investors is temperament rather than brainpower, experience, or classroom training.  They have the ability to be rational when others are not.

Overconfidence is extremely deep-rooted in human psychology.  When asked, the vast majority of us rate ourselves as above average across a wide variety of dimensions such as looks, smarts, driving skill, academic ability, future well-being, and even luck (!).

In a field such as investing, it’s vital to become aware of our natural overconfidence.  Charlie Munger likes this quote from Demosthenes:

Nothing is easier than self-deceit.  For what each man wishes, that also he believes to be true.

But becoming aware of our overconfidence is usually not enough.  We also have to develop systems—such as checklists – that can automatically reduce both the frequency and the severity of mistakes.

(Image by Aleksey Vanin)

Charlie Munger reminds value investors not only to develop and use a checklist, but also to follow the advice of mathematician Carl Jacobi:

Invert, always invert.

In other words, instead of thinking about how to succeed, Munger advises value investors to figure out all the ways you can fail.  This is a powerful concept in a field like investing, where overconfidence frequently causes failure.  Munger:

It is occasionally possible for a tortoise, content to assimilate proven insights of his best predecessors, to outrun hares which seek originality or don’t wish to be left out of some crowd folly which ignores the best work of the past.  This happens as the tortoise stumbles on some particularly effective way to apply the best previous work, or simply avoids the standard calamities.  We try more to profit by always remembering the obvious than from grasping the esoteric.  It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.

When it comes to checklists, it’s helpful to have a list of cognitive biases.  Here’s my list:

Munger’s list is more comprehensive:

Recency bias is one of the most important biases to be aware of as an investor.  Jed Nussdorf:

It is very hard to avoid recency bias, when what just happened inordinately informs your expectation of what will happen next.  One of the best things I’ve read on that is The Icarus Syndrome, by Peter Beinart.  It’s not about investing, but describes American hubris in foreign policy, in many cases resulting from doing what seemed to work in the previous 10 years even if the setting was materially different or conditions had changed.  One big problem is that all the people who succeed in the recent past become the ones in charge going forward, and they think they have it all figured out based on what they did before.  It’s all quite natural, but can result in some really bad decisions if you don’t constantly challenge your core beliefs.

Availability bias is closely related to recency bias and vividness bias.  You’re at least 15-20 times more likely to be hit by lightning in the United States than to be bitten by shark.  But often people don’t realize this because shark attacks tend to be much more vivid in people’s minds.  Similarly, your odds of dying in a car accident are 1 in 5,000, while your odds of dying in a plane crash are 1 in 11 million.  Nonetheless, many people view flying as more dangerous.

John Dorfman on investors overreacting to recent news:

Investors overreact to the latest news, which has always been the case, but I think it’s especially true today with the Internet.  Information spreads so quickly that decisions get made without particularly deep knowledge about the companies involved.  People also overemphasize dramatic events, often without checking the facts.



(Illustration by Marek)

Because so many investors worry and think about the shorter term, value investors continue to gain a large advantage by focusing on the longer term (especially three to five years).  In a year or less, a given stock can do almost anything.  But over a five-year period, a stock tracks intrinsic business value to a large extent.  Jeffrey Ubben:

It’s still true that the biggest players in the public markets—particularly mutual funds and hedge funds—are not good at taking short-term pain for long-term gain.  The money’s very quick to move if performance falls off over short periods of time.  We don’t worry about headline risk—once we believe in an asset, we’re buying more on any dips because we’re focused on the end game three or four years out.

Mario Cibelli:

One of the last great arbitrages left is to be long-term-oriented when there is a large class of shareholders who have no tolerance for short-term setbacks.  So it’s interesting when stocks get beaten-up because a company misses earnings or the market reacts to a short-term business development.  It’s crazy to me when someone says something is cheap but doesn’t buy it because they think it won’t go anywhere for the next 6 to 12 months.  We have a pretty high tolerance for taking that pain if we see glory longer term.

Whitney Tilson wrote about a great story that value investor Bill Miller told.  Miller recalled that, early in his career, he was visiting an institutional money manager, to whom he was pitching R.J. Reynolds, then trading at four times earnings.  Miller:

“When I finished, the chief investment officer said: ‘That’s a really compelling case but we can’t own that.  You didn’t tell me why it’s going to outperform the market in the next nine months.’  I said I didn’t know if it was going to do that or not but that there was a very high probability it would do well over the next three to five years.

“He said: ‘How long have you been in this business?  There’s a lot of performance pressure, and performing three to five years down the road doesn’t cut it.  You won’t be in business then.  Clients expect you to perform right now.’

“So I said: ‘Let me ask you, how’s your performance?’

“He said: ‘It’s terrible, that’s why we’re under a lot of performance pressure.’

“I said: ‘If you bought stocks like this three years ago, your performance would be good right now and you’d be buying RJR to help your performance over the next three years.’”


Many investors are so focused on shorter periods of time (a year or less).  They forget that the value of any business is ALL of its (discounted) future free cash flow, which often means 10-20 years or more.  David Herro:

I would assert the biggest reason quality companies sell at discounts to intrinsic value is time horizon.  Without short-term visibility, most investors don’t have the conviction or courage to hold a stock that’s facing some sort of challenge, either internally or externally generated.  It seems kind of ridiculous, but what most people in the market miss is that intrinsic value is the sum of ALL future cash flows discounted back to the present.  It’s not just the next six months’ earnings or the next year’s earnings.  To truly invest for the long term, you have to be able to withstand underperformance in the short term, and the fact of the matter is that most people can’t.

As Mason Hawkins observes, a company may be lagging now precisely because it’s making longer-term investments that will probably increase business value in the future:

Classic opportunities for us get back to time horizon.  A company reports a bad quarter, which disappoints Wall Street with its 90-day focus, but that might be for explainable temporary reasons or even because the company is making very positive long-term investments in the business.  Many times that investment increases the likely value of the company five years from now, but disappoints people who want the stock up tomorrow.

Whitney George:

We evaluate businesses over a full business cycle and probably our biggest advantage is an ability to buy things when most people can’t because the short-term outlook is lousy or very hard to judge.  It’s a good deal easier to know what’s likely to happen than to know precisely when it’s going to happen.

In general, humans are impatient and often discount multi-year investment gains far too much.  John Maynard Keynes: 

Human nature desires quick results, there is a particular zest in making money quickly, and remoter gains are discounted by the average man at a very high rate.



(Word cloud by Arloofs)

Automating of the investment process, including screening, is often more straightforward now than it has been, thanks to enormous advances in computing in the past two decades.

Will Browne:

We often start with screens on all aspects of valuation.  There are characteristics that have been proven over long periods to be associated with above-average rates of return:  low P/Es, discounts to book value, low debt/equity ratios, stocks with recent significant price declines, companies with patterns of insider buying and—something we’re paying a lot more attention to—stocks with high dividend yields.

Stephen Goddard:

Our basic screening process weights three factors equally:  return on tangible capital, the multiple of EBIT to enterprise value, and free cash flow yield.  We rank the universe we’ve defined on each factor individually from most attractive to least, and then combine the rankings and focus on the top 10%.

Carlo Cannell:

[We] basically spend our time trying to uncover the assorted investment misfits in the market’s underbrush that are largely neglected by the investment community.  One of the key metrics we assign to our companies is an analyst ratio, which is simply the number of analysts who follow the company.  The lower the better—as of the end of last year, about 65 percent of the companies in our portfolio had virtually no analyst coverage.

For some time now, it has been clear that simple quant models outperform experts in a wide variety of areas:

Quantitative value investor James O’Shaugnessy:

Models beat human forecasters because they reliably and consistently apply the same criteria time after time.  Models never vary.  They are never moody, never fight with their spouse, are never hung over from a night on the town, and never get bored.  They don’t favor vivid, interesting stories over reams of statistical data.  They never take anything personally.  They don’t have egos.  They’re not out to prove anything.  If they were people, they’d be the death of any party.

People on the other hand, are far more interesting.  It’s far more natural to react emotionally or to personalize a problem than it is to dispassionately review broad statistical occurrences—and so much more fun!  It’s much more natural for us to look at the limited set of our personal experiences and then generalize from this small sample to create a rule-of-thumb heuristic.  We are a bundle of inconsistencies, and although this tends to make us interesting, it plays havoc with our ability to successfully invest.

Buffett maintains (correctly) that the vast majority of investors, large or small, should invest in low-cost broad market index funds:

If you invest in a quantitative value fund focused on cheap micro caps with improving fundamentals, then you can reasonably expect to do about 7% (+/- 3%) better than the S&P 500 Index over time:

Will Browne:

When you have a model you believe in, that you’ve used for a long time and which is more empirical than intuitive, sticking with it takes the emotion away when markets are good or bad.  That’s been a central element of our success.  It’s the emotional dimension that drives people to make lousy, irrational decisions.



An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are 15-25 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 10-15% (at cost), while the average position is 5-7% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees.  The Boole Fund has low fees. 


If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail:




Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

Quantitative Microcap Value

(Image:  Zen Buddha Silence by Marilyn Barbone.)

September 10, 2017

Warren Buffett:

Investing is simple but not easy.

(Photo by USA International Trade Administration)

There are four simple but important facts that virtually every investor should bear in mind when choosing an investment strategy:

  • A low-cost S&P 500 index fund is likely to outperform at least 90-95% of all investors, net of costs, over 4-5 decades.  For the vast majority of investors, an index fund is the best option.  That’s why Warren Buffett consistently suggests index funds not only to small investors, but also to mega-rich individuals, institutions, and pension funds.
  • You can do a bit better than an index fund over time if you adopt a quantitative value approach.  Properly implemented, this is like a value index and should do at least 1-2% better per year, net of costs, than an S&P 500 index fund.  However, quantitative value sometimes trails the market for years in a row.  If you can’t stick with it during such a period, then it’s better to invest in an S&P 500 index fund.
  • If you’re pondering quantitative value investing, you should also consider quantitative microcap value.  That’s what the Boole Microcap Fund does.  By screening for cheap micro caps with improving fundamentals, you can reasonably expect to outperform the S&P 500 by roughly 7% (+/- 3%) per year on average.  (Compared to the S&P 500, this microcap strategy could do 4% better per year, 10% better, or anything in-between.  There’s a high degree of randomness in investing.  The important thing is to stick with it for at least 5-10 years.)
  • Determining which strategy, or mix of strategies, is best for you requires humility.  The trouble is that, generally, we’re overconfident.  If asked, most of us believe we’re above average across a variety of dimensions such as looks, smarts, driving skill, academic ability, future well-being, and even luck.  (Men suffer from overconfidence more than women, perhaps in part because overconfidence was useful for hunting.)  We also suffer from other cognitive biases, all of which are the result of evolution.

On the topic of overconfidence, Buffett’s partner Charlie Munger likes this quote from Demosthenes:

Nothing is easier than self-deceit.  For what each man wishes, that also he believes to be true.

(Charlie Munger at the 2010 Berkshire Hathaway shareholders meeting.  Photo by Nick Webb)

Let’s consider each point in a bit more detail.



Would you like to do better than approximately 90-95% of all investors, net of costs, over the next 4-5 decades?  It is surprisingly simple to achieve this result:  invest in a low-cost broad market index fund.  That’s why Warren Buffett, arguably the best investor ever, consistently recommends such an index fund to small investors and also to mega-rich individuals, institutions, and pension funds.

If your investment time horizon is measured in decades, a low-cost index fund is the obvious choice.  Passive investors on the whole will match the market.  Therefore, active investors will also match the market, before costs.  After costs, active investors (on the whole) will trail the market by 2-3% per year.  (John Bogle has done a terrific job telling this simple truth for a long time.)

  • 2-3% per year really adds up over the course of decades.  For example, if the average active approach returns 6.5% per year (net of costs) over the next 30 years, then $1 million will become $6.61 million.  If an S&P 500 index fund returns 9% per year (net) over the next 30 years, the same $1 million will become $13.27 million, twice as much.  (Moreover, the index fund is well-diversified across 500 American businesses.)

Even over the course of one decade, a low-cost broad market index fund can produce excellent results.  Warren Buffett’s 10-year bet against Protégé Partners demonstrates clearly that a simple index fund can beat the vast majority of all investors:

After nine years, a group of a few hundred hedge funds – managed by intelligent, honest people who are highly incentivized to maximize their performance – is up a bit over 22%, net of costs.  Buffett’s investment in a Vanguard S&P 500 index fund is up 85.4%, net of costs.  That’s 7.1% per year for the index fund versus 2.2% per year for highly intelligent hedge fund (and fund of hedge fund) managers.

This illustrates how investing is simple but not easy.  Even if you restrict your examination to the most intelligent 10% of all investors, the long-term results are the same:  the vast majority of these investors will trail an S&P 500 index fund, net of costs, over time.

In the 2016 Berkshire Hathaway Letter to Shareholders, Buffett writes that, in his own lifetime, he identified – early on – ten investors he thought would beat the market over the long term.  Buffett was right about these ten.  But that’s only ten out of hundreds, or even thousands, of similarly intelligent investors.  Buffett:

There are no doubt many hundreds of people – perhaps thousands – whom I have never met and whose abilities would equal those of the people I’ve identified.  The job, after all, is not impossible.  The problem simply is that the great majority of managers who attempt to over-perform will fail. 


In a nutshell, you can do better than about 90-95% of all investors over 4-5 decades by investing in an S&P 500 index fund.  This is purely a function of costs, which average 2-3% per year for active approaches.  Therefore, for the vast majority of investors, whether large or small, you should follow Warren Buffett’s advice:  simply invest in American business by investing in a low-cost broad market index fund.

(BNSF, owned by Berkshire Hathaway.  Photo by Winnie Chao.)



A seminal paper on quantitative deep value investing is by Josef Lakonishok, Andrei Shleifer, and Robert Vishny (1994), “Contrarian Investment, Extrapolation, and Risk.”  Link:

LSV (Lakonishok, Schleifer, and Vishny) were so convinced by their research that they launched LSV Asset Management, which currently manages $105 billion.  LSV’s quantitative deep value strategies have beaten their respective benchmark indices by at least 1-2% per year over time.



(Illustration by Madmaxer.)

Check out this summary of the CRSP Decile-Based Size and Return Data from 1927 to 2015:

Decile Market Cap-Weighted Returns Equal Weighted Returns Number of Firms (year-end 2015) Mean Firm Size (in millions)
1 9.29% 9.20% 173 84,864
2 10.46% 10.42% 178 16,806
3 11.08% 10.87% 180 8,661
4 11.32% 11.10% 221 4,969
5 12.00% 11.92% 205 3,151
6 11.58% 11.40% 224 2,176
7 11.92% 11.87% 300 1,427
8 12.00% 12.27% 367 868
9 11.40% 12.39% 464 429
10 12.50% 17.48% 1,298 107
9+10 11.85% 16.14% 1,762 192

(You can find the data for various deciles here:

The smallest two deciles – 9+10 – comprise microcap stocks, which typically are stocks with market caps below $500 million.  What stands out is the equal weighted returns of the 9th and 10th size deciles from 1927 to 2015:

Microcap equal weighted returns = 16.14% per year

Large-cap equal weighted returns = ~11% per year

In practice, microcap annual returns will be 1-2% lower because of the difficulty (due to illiquidity) of entering and exiting positions.  So we should say that an equal weighted microcap approach has returned 14% per year from 1927 to 2015.  Still, 3% more per year than large caps really adds up over the course of decades.

  • Most professional investors ignore micro caps as too small for their portfolios.  This causes many micro caps to get very cheap.  And that’s why an equal weighted strategy – applied to micro caps – tends to work well.

Value Screen: +2-3%

By adding a value screen – e.g., low EV/EBIT or low P/E – to a microcap strategy, it is possible to add 2-3% per year.  To maximize the odds of achieving this additional margin of outperformance, you should adopt a quantitative approach.

Improving Fundamentals: +2-3%

You can further boost performance by screening for improving fundamentals.  One excellent way to do this is using the Piotroski F_Score, which works best for cheap micro caps.  See:

Bottom Line

In sum, over the course of several decades, a quantitative value strategy – applied to cheap microcap stocks with improving fundamentals – has high odds of returning at least 7% (+/- 3%) more per year than a low-cost S&P 500 index fund.



(Illustration by Alain Lacroix.)

Human intuition often works remarkably well.  But when a good decision requires careful reasoning – using logic, math, or statistics – our intuition causes systematic errors.  I wrote about cognitive biases here:

Munger’s treatment of misjudgment is more comprehensive:



An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are 15-25 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 10-15% (at cost), while the average position is 5-7% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees.  The Boole Fund has low fees. 


If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail:




Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

Deep Value: Profiting from Mean Reversion

(Image:  Zen Buddha Silence by Marilyn Barbone.)

August 27, 2017

The essence of deep value investing is systematically buying stocks at low multiples in order to profit from future mean reversion.  Sometimes it seems that there are misconceptions about deep value investing.

  • First, deep value stocks have on occasion been called cheap relative to future growth.  But it’s often more accurate to say that deep value stocks are cheap relative to normalized earnings or cash flows.
  • Second, the cheapness of deep value stocks has often been said to be relative to “net tangible assets.”  However, in many cases, even including stocks at a discount to tangible assets, mean reversion relates to the future normalized earnings or cash flows that the assets can produce.
  • Third, typically more than half of deep value stocks underperform the market.  And deep value stocks are more likely to be distressed than average stocks.  Do these facts imply that a deep value investment strategy is riskier than average?  No…

Have you noticed these misconceptions?  I’m curious to hear your take.  Please let me know.

Here are the sections in this blog post:

  • Introduction
  • Mean Reversion as “Return to Normal” instead of “Growth”
  • Revenues, Earnings, Cash Flows, NOT Asset Values
  • Is Deep Value Riskier?
  • A Long Series of Favorable Bets
  • “Cigar Butt’s” vs. See’s Candies
  • Microcap Cigar Butt’s



Deep value stocks tend to fit two criteria:

  • Deep value stocks trade at depressed multiples.
  • Deep value stocks have depressed fundamentals – they have generally been doing terribly in terms of revenues, earnings, or cash flows, and often the entire industry is doing poorly.

The essence of deep value investing is systematically buying stocks at low multiples in order to profit from future mean reversion.

  • Low multiples include low P/E (price-to-earnings), low P/B (price-to-book), low P/CF (price-to-cash flow), and low EV/EBIT (enterprise value-to-earnings before interest and taxes).
  • Mean reversion implies that, in general, deep value stocks are underperforming their economic potential.  On the whole, deep value stocks will experience better future economic performance than is implied by their current stock prices.

If you look at deep value stocks as a group, it’s a statistical fact that many will experience better revenues, earnings, or cash flows in the future than what is implied by their stock prices.  This is due largely to mean reversion.  The future economic performance of these deep value stocks will be closer to normal levels than their current economic performance.

Moreover, the stock price increases of the good future performers will outweigh the languishing stock prices of the poor future performers.  This causes deep value stocks, as a group, to outperform the market over time.

Two important notes:

  1. Generally, for deep value stocks, mean reversion implies a return to more normal levels of revenues, earnings, or cash flows.  It does not often imply growth above and beyond normal levels.
  2. For most deep value stocks, mean reversion relates to future economic performance and not to tangible asset value per se.

(1) Mean Reversion as Return to More Normal Levels

One of the best papers on deep value investing is by Josef Lakonishok, Andrei Shleifer, and Robert Vishny (1994), “Contrarian Investment, Extrapolation, and Risk.”  Link:

LSV (Lakonishok, Schleifer, and Vishny) correctly point out that deep value stocks are better identified by using more than one multiple.  LSV Asset Management currently manages $105 billion using deep value strategies that rely simultaneously on several metrics for cheapness, including low P/E and low P/CF.

  • In Quantitative Value (Wiley, 2012), Tobias Carlisle and Wesley Gray find that low EV/EBIT outperformed every other measure of cheapness, including composite measures.
  • However, James O’Shaughnessy, in What Works on Wall Street (McGraw-Hill, 2011), demonstrates – with great thoroughness – that, since the mid-1920’s, composite approaches (low P/S, P/E, P/B, EV/EBITDA, P/FCF) have been the best performers.
  • Any single metric may be more easily arbitraged away by a powerful computerized approach.  Walter Schloss once commented that low P/B was working less well because many more investors were using it.  (In recent years, low P/B hasn’t worked.)

LSV explain why mean reversion is the essence of deep value investing.  Investors, on average, are overly pessimistic about stocks at low multiples.  Investors understimate the mean reversion in future economic performance for these out-of-favor stocks.

However, in my view, the paper would be clearer if it used (in some but not all places) “return to more normal levels of economic performance” in place of “growth.”  Often it’s a return to more normal levels of economic performance – rather than growth above and beyond normal levels – that defines mean reversion for deep value stocks.

(2) Revenues, Earnings, Cash Flows NOT Net Asset Values

Buying at a low price relative to tangible asset value is one way to implement a deep value investing strategy.  Many value investors have successfully used this approach.  Examples include Ben Graham, Walter Schloss, Peter Cundill, John Neff, and Marty Whitman.

Warren Buffett used this approach in the early part of his career.  Buffett learned this method from his teacher and mentor, Ben Graham.  Graham called this the “net-net” approach.  You take net working capital minus ALL liabilities.  If the stock price is below that level, and if you buy a basket of such “net-net’s,” you can’t help but do well over time.  These are extremely cheap stocks, on average.  (The only catch is that there must be enough net-net’s in existence to form a basket, which is not always the case.)

Buffett on “cigar butts”:

…I call it the cigar butt approach to investing.  You walk down the street and you look around for a cigar butt someplace.  Finally you see one and it is soggy and kind of repulsive, but there is one puff left in it.  So you pick it up and the puff is free – it is a cigar butt stock.  You get one free puff on it and then you throw it away and try another one.  It is not elegant.  But it works.  Those are low return businesses.


But most net-net’s are NOT liquidated.  Rather, there is mean reversion in their future economic performance – whether revenues, earnings, or cash flows.  That’s not to say there aren’t some bad businesses in this group.  For net-net’s, when economic performance returns to more normal levels, typically you sell the stock.  You don’t (usually) buy and hold net-net’s.

Sometimes net-net’s are acquired.  But in many of these cases, the acquirer is focused mainly on the earnings potential of the assets.  (Non-essential assets may be sold, though.)

In sum, the specific deep value method of buying at a discount to net tangible assets has worked well in general ever since Graham started doing it.  And net tangible assets do offer additional safety.  That said, when these particular cheap stocks experience mean reversion, often it’s because revenues, earnings, or cash flows return to “more normal” levels.  Actual liquidation is rare.



According to a study done by Joseph Piotroski from 1976 to 1996 – discussed below – although a basket of deep value stocks clearly beats the market over time, only 43% of deep value stocks outperform the market, while 57% underperform.  By comparison, an average stock has a 50% chance of outperforming the market and a 50% chance of underperforming.

Let’s assume that the average deep value stock has a 57% chance of underperforming the market, while an average stock has only a 50% chance of underperforming.  This is a realistic assumption not only because of Piotroski’s findings, but also because the average deep value stock is more likely to be distressed (or to have problems) than the average stock.

Does it follow that the reason deep value investing does better than the market over time is that deep value stocks are riskier than average stocks?

It is widely accepted that deep value investing does better than the market over time.  But there is still disagreement about how risky deep value investing is.  Strict believers in the EMH (Efficient Markets Hypothesis) – such as Eugene Fama and Kenneth French – argue that value investing must be unambiguously riskier than simply buying an S&P 500 Index fund.  On this view, the only way to do better than the market over time is by taking more risk.

Now, it is generally true that the average deep value stock is more likely to underperform the market than the average stock.  And the average deep value stock is more likely to be distressed than the average stock.

But LSV show that a deep value portfolio does better than an average portfolio, especially during down markets.  This means that a basket of deep value stocks is less risky than a basket of average stocks.

  • A “portfolio” or “basket” of stocks refers to a group of stocks.  Statistically speaking, there must be at least 30 stocks in the group.  In the case of LSV’s study – like most academic studies of value investing – there are hundreds of stocks in the deep value portfolio.  (The results are similar over time whether you have 30 stocks or hundreds.)

Moreover, a deep value portfolio only has slightly more volatility than an average portfolio, not nearly enough to explain the significant outperformance.  In fact, when looked at more closely, deep value stocks as a group have slightly more volatility mainly because of upside volatility – relative to the broad market – rather than because of downside volatility.  This is captured not only by the clear outperformance of deep value stocks as a group over time, but also by the fact that deep value stocks do much better than average stocks in down markets.

Deep value stocks, as a group, not only outperform the market, but are less risky.  Ben Graham, Warren Buffett, and other value investors have been saying this for a long time.  After all, the lower the stock price relative to the value of the business, the less risky the purchase, on average.  Less downside implies more upside.



Let’s continue to assume that the average deep value stock has a 57% chance of underperforming the market.  And the average deep value stock has a greater chance of being distressed than the average stock.  Does that mean that the average individual deep value stock is riskier than the average stock?

No, because the expected return on the average deep value stock is higher than the expected return on the average stock.  In other words, on average, a deep value stock has more upside than downside.

Put very crudely, in terms of expected value:

[(43% x upside) – (57% x downside)] > [avg. return]

43% times the upside, minus 57% times the downside, is greater than the return from the average stock (or from the S&P 500 Index).

The crucial issue relates to making a long series of favorable bets.  Since we’re talking about a long series of bets, let’s again consider a portfolio of stocks.

  • Recall that a “portfolio” or “basket” of stocks refers to a group of at least 30 stocks.

A portfolio of average stocks will simply match the market over time.  That’s an excellent result for most investors, which is why most investors should just invest in index funds:

A portfolio of deep value stocks will, over time, do noticeably better than the market.  Year in and year out, approximately 57% of the deep value stocks will underperform the market, while 43% will outperform.  But the overall outperformance of the 43% will outweigh the underperformance of the 57%, especially over longer periods of time.  (57% and 43% are used for illustrative purposes here.  The actual percentages vary.)

Say that you have an opportunity to make the same bet 1,000 times in a row, and that the bet is as follows:  You bet $1.  You have a 60% chance of losing $1, and a 40% chance of winning $2.  This is a favorable bet because the expected value is positive: 40% x $2 = $0.80, while 60% x $1 = $0.60.  If you made this bet repeatedly over time, you would average $0.20 profit on each bet, since $0.80 – $0.60 = $0.20.

If you make this bet 1,000 times in a row, then roughly speaking, you will lose 60% of them (600 bets) and win 40% of them (400 bets).  But your profit will be about $200.  That’s because 400 x $2 = $800, while 600 x $1 = $600.  $800 – $600 = $200.

Systematically investing in deep value stocks is similar to the bet just described.  You may lose 57% of the bets and win 43% of the bets.  But over time, you will almost certainly profit because the average upside is greater than the average downside.  Your expected return is also higher than the market return over the long term.



In his 1989 Letter to Shareholders, Buffett writes about his “Mistakes of the First Twenty-Five Years,” including a discussion of “cigar butt” (deep value) investing:

My first mistake, of course, was in buying control of Berkshire.  Though I knew its business – textile manufacturing – to be unpromising, I was enticed to buy because the price looked cheap.  Stock purchases of that kind had proved reasonably rewarding in my early years, though by the time Berkshire came along in 1965 I was becoming aware that the strategy was not ideal. 

If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible.  I call this the ‘cigar butt’ approach to investing.  A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the ‘bargain purchase’ will make that puff all profit. 


Buffett has made it clear that cigar butt (deep value) investing does work.  In fact, fairly recently, Buffett bought at basket of cigar butts in South Korea.  The results were excellent.  But he did this in his personal portfolio.

This highlights a major reason why Buffett evolved from investing in cigar butts to investing in higher quality businesses:  size of investable assets.  When Buffett was managing a few hundred million dollars or less, which includes when he managed an investment partnership, Buffett achieved outstanding results in part by investing in cigar butts.  But when investable assets swelled into the billions of dollars at Berkshire Hathaway, Buffett began investing in higher quality companies.

  • Cigar butt investing works best for micro caps.  But micro caps won’t move the needle if you’re investing many billions of dollars.

The idea of investing in higher quality companies is simple:  If you can find a business with a sustainably high ROE – based on a sustainable competitive advantage – and if you can hold that stock for a long time, then your returns as an investor will approximate the ROE (return on equity).  This assumes that the company can continue to reinvest all of its earnings at the same ROE, which is extremely rare when you look at multi-decade periods.

  • The quintessential high-quality business that Buffett and Munger purchased for Berkshire Hathaway is See’s Candies.  They paid $25 million for $8 million in tangible assets in 1972.  Since then, See’s Candies has produced over $2 billion in (pre-tax) earnings, while only requiring a bit over $40 million in reinvestment.
  • See’s turns out more than $80 million in profits each year.  That’s over 100% ROE (return on equity), which is extraordinary.  But that’s based mostly on assets in place.  The company has not been able to reinvest most of its earnings.  Instead, Buffett and Munger have invested the massive excess cash flows in other good opportunities – averaging over 20% annual returns on these other investments (for most of the period from 1972 to present).

Furthermore, buying and holding stock in a high-quality business brings enormous tax advantages over time because you never have to pay taxes until you sell.  Thus, as a high-quality business – with sustainably high ROE – compounds value over many years, a shareholder who never sells receives the maximum benefit of this compounding.

Yet it’s extraordinarily difficult to find a business that can sustain ROE at over 20% – including reinvested earnings – for decades.  Buffett has argued that cigar butt (deep value) investing produces more dependable results than investing exclusively in high-quality businesses.  Very often investors buy what they think is a higher-quality business, only to find out later that they overpaid because the future performance does not match the high expectations that were implicit in the purchase price.  Indeed, this is what LSV show in their famous paper (discussed above) in the case of “glamour” (or “growth”) stocks.



Buffett has said that you can do quite well as an investor, if you’re investing smaller amounts, by focusing on cheap micro caps.  In fact, Buffett has maintained that he could get 50% per year if he could invest only in cheap micro caps.

Investing systematically in cheap micro caps can often lead to higher long-term results than the majority of approaches that invest in high-quality stocks.

First, micro caps, as a group, far outperform every other category.  See the historical performance here:

Second, cheap micro caps do even better.  Systematically buying at low multiples works over the course of time, as clearly shown by LSV and many others.

Finally, if you apply the Piotroski F-Score to screen cheap micro caps for improving fundamentals, performance is further boosted:  The biggest improvements in performance are concentrated in cheap micro caps with no analyst coverage.  See:



An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are 15-25 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 10-15% (at cost), while the average position is 5-7% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees.  The Boole Fund has low fees. 


If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail:




Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

Cognitive Biases

(Image:  Zen Buddha Silence by Marilyn Barbone.)

August 20, 2017

In the great book Thinking, Fast and Slow (2011), Daniel Kahneman explains in detail two different ways of thinking that human beings use.  Kahneman refers to them as System 1 and System 2, which he defines as follows:

System 1:   Operates automatically and quickly, with little or no effort or sense of voluntary control.  Makes instinctual or intuitive decisions – typically based on heuristics.

System 2:   Allocates attention to the effortful mental activities that demand it, including complex computations involving logic, math, or statistics.  The operations of System 2 are often associated with the subjective experience of agency, choice, and concentration.

Heuristics are simple rules we use – via System 1 – to form judgments or make decisions.  Heuristics are mental shortcuts whereby we simplify a complex situation in order to jump to a quick conclusion.

Most of the time, heuristics work well.  We can immediately notice a shadow in the grass, alerting us to the possible presence of a lion.  And we can automatically read people’s faces, drive a car on an empty road, do easy math, or understand simple language.  (For more on System 1, see the last section of this blog post.)

However, if we face a situation that requires the use of logic, math, or statistics to reach a good judgment or decision, heuristics lead to systematic errors.  These errors are cognitive biases.

Let’s examine some of the main cognitive biases:

  • anchoring effect
  • availability bias, vividness bias, recency bias
  • confirmation bias
  • hindsight bias
  • overconfidence
  • narrative fallacy
  • information and overconfidence
  • self-attribution bias



anchoring effect:   people tend to use any random number as a baseline for estimating an unknown quantity, despite the fact that the unknown quantity is totally unrelated to the random number.

Daniel Kahneman and Amos Tversky did one experiment where they spun a wheel of fortune, but they had secretly programmed the wheel so that it would stop on 10 or 65.   After the wheel stopped, participants were asked to estimate the percentage of African countries in the UN.   Participants who saw “10” on the wheel guessed 25% on average, while participants who saw “65” on the wheel guessed 45% on average, a huge difference.

Behavioral finance expert James Montier has run his own experiment on anchoring.   People are asked to write down the last four digits of their phone number.   Then they are asked whether the number of doctors in their capital city is higher or lower than the last four digits of their phone number.   Results:  Those whose last four digits were greater than 7000 on average report 6762 doctors, while those with telephone numbers below 2000 arrived at an average 2270 doctors.  (James Montier, Behavioural Investing, Wiley 2007, page 120)

Those are just two experiments out of many.  The anchoring effect is “one of the most reliable and robust results of experimental psychology” (page 119, Kahneman).  Furthermore, Montier observes that the anchoring effect is one reason why people cling to financial forecasts, despite the fact that most financial forecasts are either wrong, useless, or impossible to time.

When faced with the unknown, people will grasp onto almost anything.  So it is little wonder that an investor will cling to forecasts, despite their uselessness.  (Montier, page 120)



availability bias:   people tend to overweight evidence that comes easily to mind.

Related to the availability bias are vividness bias and recency bias.  People typically overweight facts that are vivid (e.g., plane crashes or shark attacks).   People also overweight facts that are recent (partly because they are more vivid).

Note:  It’s also natural for people to assume that hard-won evidence or insight must be worth more.  But often that’s not true, either.



confirmation bias:   people tend to search for, remember, and interpret information in a way that confirms their pre-existing beliefs or hypotheses.

Confirmation bias makes it quite difficult for many people to improve upon or supplant their existing beliefs or hypotheses.   This bias also tends to make people overconfident about existing beliefs or hypotheses, since all they can see are supporting data.

We know that our System 1 (intuition) often errors when it comes to forming and testing hypotheses. First of all, System 1 always forms a coherent story (including causality), irrespective of whether there are truly any logical connections at all among various things in experience.  Furthermore, when System 1 is facing a hypothesis, it automatically looks for confirming evidence.

But even System 2 – the logical and mathematical system that humans possess and can develop – by nature uses a positive test strategy:

A deliberate search for confirming evidence, known as positive test strategy, is also how System 2 tests a hypothesis.  Contrary to the rules of philosophers of science, who advise testing hypotheses by trying to refute them, people (and scientists, quite often) seek data that are likely to be compatible with the beliefs they currently hold.  (page 81, Kahneman)

Thus, the habit of always looking for disconfirming evidence of our hypotheses – especially our “best-loved hypotheses” – is arguably the most important intellectual habit we could develop in the never-ending search for wisdom and knowledge.

Charles Darwin is a wonderful model for people in this regard.  Darwin was far from being a genius in terms of IQ.  Yet Darwin trained himself always to search for facts and evidence that would contradict his hypotheses.  Charlie Munger explains in “The Psychology of Human Misjudgment” (see Poor Charlie’s Alamanack: The Wit and Wisdom of Charles T.  Munger, expanded 3rd edition):

One of the most successful users of an antidote to first conclusion bias was Charles Darwin.  He trained himself, early, to intensively consider any evidence tending to disconfirm any hypothesis of his, more so if he thought his hypothesis was a particularly good one… He provides a great example of psychological insight correctly used to advance some of the finest mental work ever done. 



Hindsight bias:   the tendency, after an event has occurred, to see the event as having been predictable, despite there having been little or no objective basis for predicting the event prior to its occurrence.

Hindsight bias is also called the “knew-it-all-along effect” or “creeping determinism.”  (See:

Kahneman writes about hindsight bias as follows:

Your inability to reconstruct past beliefs will inevitably cause you to underestimate the extent to which you were surprised by past events.   Baruch Fischhoff first demonstrated this ‘I-knew-it-all-along’ effect, or hindsight bias, when he was a student in Jerusalem.  Together with Ruth Beyth (another of our students), Fischhoff conducted a survey before President Richard Nixon visited China and Russia in 1972.   The respondents assigned probabilities to fifteen possible outcomes of Nixon’s diplomatic initiatives.   Would Mao Zedong agree to meet with Nixon?   Might the United States grant diplomatic recognition to China?   After decades of enmity, could the United States and the Soviet Union agree on anything significant?

After Nixon’s return from his travels, Fischhoff and Beyth asked the same people to recall the probability that they had originally assigned to each of the fifteen possible outcomes.  The results were clear.  If an event had actually occurred, people exaggerated the probability that they had assigned to it earlier.  If the possible event had not come to pass, the participants erroneously recalled that they had always considered it unlikely.   Further experiments showed that people were driven to overstate the accuracy not only of their original predictions but also of those made by others.   Similar results have been found for other events that gripped public attention, such as the O.J. Simpson murder trial and the impeachment of President Bill Clinton.   The tendency to revise the history of one’s beliefs in light of what actually happened produces a robust cognitive illusion.  (pages 202-3, my emphasis)

Concludes Kahneman:

The sense-making machinery of System 1 makes us see the world as more tidy, simple, predictable, and coherent that it really is.  The illusion that one has understood the past feeds the further illusion that one can predict and control the future.  These illusions are comforting.   They reduce the anxiety we would experience if we allowed ourselves to fully acknowledge the uncertainties of existence.  (page 204-5, my emphasis)



Overconfidence is such as widespread cognitive bias among people that Kahneman devotes Part 3 of his book entirely to this topic.  Kahneman says in his introduction:

The difficulties of statistical thinking contribute to the main theme of Part 3, which describes a puzzling limitation of our mind:  our excessive confidence in what we believe we know, and our apparent inability to acknowledge the full extent of our ignorance and the uncertainty of the world we live in.   We are prone to overestimate how much we understand about the world and to underestimate the role of chance in events.   Overconfidence is fed by the illusory certainty of hindsight.   My views on this topic have been influenced by Nassim Taleb, the author of The Black Swan.  (pages 14-5)

Several studies have shown that roughly 90% of drivers rate themselves as above average.  For more on overconfidence, see:



In The Black Swan, Nassim Taleb writes the following about the narrative fallacy:

The narrative fallacy addresses our limited ability to look at sequences of facts without weaving an explanation into them, or, equivalently, forcing a logical link, an arrow of relationship, upon them.  Explanations bind facts together.  They make them all the more easily remembered;  they help them make more sense.  Where this propensity can go wrong is when it increases our impression of understanding.  (page 63-4)

The narrative fallacy is central to many of the biases and misjudgments mentioned by Daniel Kahneman and Charlie Munger.  The human brain, whether using System 1 (intuition) or System 2 (logic), always looks for or creates logical coherence among random data.  Often System 1 is right when it assumes causality; thus, System 1 is generally helpful, thanks to evolution.  Furthermore, System 2, by searching for underlying causes or coherence, has, through careful application of the scientific method over centuries, developed a highly useful set of scientific laws by which to explain and predict various phenomena.

The trouble comes when the data or phenomena in question are “highly random” – or inherently unpredictable (at least for the time being).  In these areas, System 1 makes predictions that are often very wrong.  And even System 2 assumes necessary logical connections when there may not be any – at least, none that can be discovered for some time.

Note:  The eighteenth century Scottish philosopher (and psychologist) David Hume was one of the first to clearly recognize the human brain’s insistence on always assuming necessary logical connections in any set of data or phenomena.



In Behavioural Investing, James Montier explains a study done by Paul Slovic (1973).  Eight experienced bookmakers were shown a list of 88 variables found on a typical past performance chart on a horse.  Each bookmaker was asked to rank the piece of information by importance.

Then the bookmakers were given data for 40 past races and asked to rank the top five horses in each race.  Montier:

Each bookmaker was given the past data in increments of the 5, 10, 20, and 40 variables he had selected as most important.  Hence each bookmaker predicted the outcome of each race four times – once for each of the information sets.  For each prediction the bookmakers were asked to give a degree of confidence ranking in their forecast.  (page 136)


Accuracy was virtually unchanged, regardless of the number of pieces of information the bookmaker was given (5, 10, 20, then 40).

But confidence skyrocketed as the number of pieces of information increased (5, 10, 20, then 40).

This same result has been found in a variety of areas.  As people get more information, the accuracy of their judgments or forecasts typically does not change at all, while their confidence in the accuracy of their judgments or forecasts tends to increase dramatically.



self-attribution bias:   people tend to attribute good outcomes to their own skill, while blaming bad outcomes on bad luck.

This ego-protective bias prevents people from recognizing and learning from their mistakes.  This bias also contributes to overconfidence.



When we are thinking of who we are, we use System 2 to define ourselves.  But, writes Kahneman, System 1 effortlessly originates impressions and feelings that are the main source of the explicit beliefs and deliberate choices of System 2.

Kahneman lists, “in rough order of complexity,” examples of the automatic activities of System 1:

  • Detect that one object is more distant than another.
  • Orient to the source of a sudden sound.
  • Complete the phrase “Bread and…”
  • Make a “disgust face” when shown a horrible picture.
  • Detect hostility in a voice.
  • Answer 2 + 2 = ?
  • Read words on large billboards.
  • Drive a car on an empty road.
  • Find a strong move in chess (if you are a chess master).
  • Understand simple sentences.
  • Recognize that “a meek and tidy soul with a passion for detail” resembles an occupational stereotype.

Kahneman writes that System 1 and System 2 work quite well generally:

The division of labor between System 1 and System 2 is highly efficient:  it minimizes effort and optimizes performance.   The arrangement works well most of the time because System 1 is generally very good at what it does:  its models of familiar situations are accurate, its short-term predictions are usually accurate as well, and its initial reactions to challenges are swift and generally appropriate.

“Thinking fast” usually works fine.  System 1 is remarkably good at what it does, thanks to evolution.  Kahneman:

System 1 is designed to jump to conclusions from little evidence.

However, when we face situations that are unavoidably complex, System 1 systematically jumps to the wrong conclusions.  In these situations, we have to train ourselves to “think slow” and reason our way to a good decision.

For the curious, here’s the most comprehensive list of cognitive biases I’ve seen:



An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are 15-25 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 10-15% (at cost), while the average position is 5-7% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees.  The Boole Fund has low fees. 


If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail:




Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

The Psychology of Misjudgment

(Image:  Zen Buddha Silence by Marilyn Barbone.)

August 13, 2017

In order to reach our potential as human beings, we have to study our mistakes, including what causes or leads to those mistakes.

Psychologists have identified cognitive biases we all have (from evolution) that regularly lead to mistakes.  Here’s a short list:

Below is a longer, more comprehensive list of twenty-four psychological tendencies described by Charlie Munger in his talk, “The Psychology of Human Misjudgment.”  See:

Bear in mind this comment by Munger:

Psychological tendencies tend to be both numerous and inseparably intertwined, now and forever, as they interplay in life.

Here are the twenty-four psychological tendencies Munger discusses:

  1.  Reward and Punishment Superresponse Tendency
  2.  Liking/Loving Tendency
  3.  Disliking/Hating Tendency
  4.  Doubt-Avoidance Tendency
  5.  Inconsistency-Avoidance Tendency
  6.  Curiosity Tendency
  7.  Kantian Fairness Tendency
  8.  Envy/Jealousy Tendency
  9.  Reciprocation Tendency
  10.  Influence-from-Mere Association Tendency
  11.  Simple, Pain-Avoiding Psychological Denial
  12.  Excessive Self-Regard Tendency
  13.  Overoptimism Tendency
  14.  Deprival Superreaction Tendency
  15.  Social-Proof Tendency
  16.  Contrast-Misreaction Tendency
  17.  Stress-Influence Tendency
  18.  Availability-Misweighing Tendency
  19.  Use-It-or-Lose-It Tendency
  20.  Drug-Misinfluence Tendency
  21.  Senescence-Misinfluence Tendency
  22.  Authority-Misinfluence Tendency
  23.  Twaddle-Tendency
  24.  Reason-Respecting Tendency

(At the end, Munger gives his answers to a couple of excellent questions, plus a list of good examples to remember.)



Munger introduces his discussion:

Some psychology professors like to demonstrate the inadequacy of contrast-based perception by having students put one hand in a bucket of hot water and one hand in a bucket of cold water.  They are then suddenly asked to remove both hands and place them in a single bucket of room-temperature water.  Now, with both hands in the same water, one hand feels as if it has just been put in cold water and the other hand feels as if it has just been placed in hot water.  When one thus sees perception so easily fooled by mere contrast, where a simple temperature gauge would make no error, and realizes that cognition mimics perception in being misled by mere contrast, he is well on the way toward understanding, not only how magicians fool one, but also how life will fool 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.  (pg. 4)

Our psychological tendencies are generally useful, being the result of evolution.  But in some situations, these tendencies lead to errors.


(1)  Reward and Punishment Superresponse Tendency

Munger observes that hardly a year passes when he does not get some surprise from how powerful incentives are.

Never, ever think about something else when you should be thinking about incentives.


One of the most important consequences of incentive superpower is what I call ‘incentive caused bias.’  A man has an acculturated nature making him a pretty decent fellow, and yet, driven both consciously and subconsciously by incentives, he drifts into immoral behavior in order to get what he wants, a result he facilitates by rationalizing his bad behavior, like the salesmen at Xerox who harmed customers in order to maximize their sales commissions.  (pg. 6)

Munger gives an example of a surgeon who “over the years sent bushel baskets full of normal gall bladders down to the pathology lab in the leading hospital in Lincoln, Nebraska.”  One of the doctors who participated in the removals was a family friend (of the Mungers), so Munger asked him if the surgeon in question thought, ‘Here’s a way for me to exercise my talents and make a high living by doing a few maimings and murders every year in the course of routine fraud.’  Munger’s friend answered: ‘Hell no, Charlie.  He thought that the gall bladder was the source of all medical evil, and, if you really loved your patients, you couldn’t get that organ out rapidly enough.’

Munger comments:

Now that’s an extreme case, but in lesser strength, the cognitive drift of that surgeon is present in every profession and in every human being.  And it causes perfectly terrible behavior.  Consider the presentations of brokers selling commercial real estate and businesses.  I’ve never seen one that I thought was even with hailing distance of objective truth….

On the other hand, you can use the power of incentives – even using as rewards things you already possess! – to manipulate your own behavior for the better.  The business version of ‘Granny’s Rule’ is to force yourself daily to do the unpleasant and necessary tasks first, before rewarding yourself by proceeding to the pleasant tasks.


(2)  Liking/Loving Tendency


One very practical consequence of Liking/Loving Tendency is that it acts as a conditioning device that makes the liker or lover tend (1) to ignore faults of, and comply with wishes of, the object of his affection, (2) to favor people, products, and actions merely associated with the object of his affection (as we shall see when we get to ‘Influence-from-Mere-Association Tendency,’) and (3) to distort other facts to facilitate love.  (pg. 9)

We’re naturally biased, so we have to be careful in some situations.

On the other hand, Munger points out that loving admirable persons and ideas can be very beneficial.

…a man who is so constructed that he loves admirable persons and ideas with a special intensity has a huge advantage in life.  This blessing came to both Buffett and myself in large measure, sometimes from the same persons and ideas.  One common, beneficial example for us both was Warren’s uncle, Fred Buffett, who cheerfully did the endless grocery-store work that Warren and I ended up admiring from a safe distance.  Even now, after I have known so many other people, I doubt if it is possible to be a nicer man than Fred Buffett was, and he changed me for the better.

Warren Buffett:

If you tell me who your heroes are, I’ll tell you how you’re gonna turn out.  It’s really important in life to have the right heroes.  I’ve been very lucky in that I’ve probably had a dozen or so major heroes.  And none of them have ever let me down.  You want to hang around with people that are better than you are.  You will move in the direction of the crowd that you associate with.


(3)  Disliking/Hating Tendency

Munger notes that Switzerland and the United States have clever political arrangements to “channel” the hatreds and dislikings of individuals and groups into nonlethal patterns including elections.

But the dislikings and hatreds never go away completely…  And we also get the extreme popularity of very negative political advertising in the United States.

Munger explains:

Disliking/Hating Tendency also acts as a conditioning device that makes the disliker/hater tend to (1) ignore virtues in the object of dislike, (2) dislike people, products, and actions merely associated with the object of dislike, and (3) distort other facts to facilitate hatred.

Distortion of that kind is often so extreme that miscognition is shockingly large.  When the World Trade center was destroyed, many Muslims concluded that the Hindus did it, while many Arabs concluded that the Jews did it.  Such factual distortions often make mediation between opponents locked in hatred either difficult or impossible.  Mediations between Israelis and Palestinians are difficult because facts in one side’s history overlap very little with facts from the other side’s.


(4)  Doubt-Avoidance Tendency

Munger says:

The brain of man is programmed with a tendency to quickly remove doubt by reaching some decision.  It is easy to see how evolution would make animals, over the course of eons, drift toward such quick elimination of doubt.  After all, the one thing that is surely counterproductive for a prey animal that is threatened by a predator is to take a long time in deciding what to do.  And so man’s Doubt Avoidance Tendency is quite consistent with the history of his ancient, nonhuman ancestors.

Munger then observes:

What triggers Doubt-Avoidance Tendency?  Well, an unthreatened man, thinking of nothing in particular, is not being prompted to remove doubt through rushing to some decision.  As we shall see later when we get to Social-Proof Tendency and Stress-Influence Tendency, what usually triggers Doubt-Avoidance Tendency is some combination of puzzlement and stress.  Both of these factors naturally occur in facing religious issues.  (page 10)


(5)  Inconsistency-Avoidance Tendency

Munger explains:

The brain of man conserves programming space by being reluctant to change, which is a form of inconsistency avoidance.  We see this in all human habits, constructive and destructive.  Few people can list a lot of bad habits that they have eliminated, and some people cannot identify even one of these.  Instead, practically everyone has a great many bad habits he has long maintained despite their being known as bad….  chains of habit that were too light to be felt before they became too heavy to be broken.

If you’re wise, self-improvement is lifelong:

The rare life that is wisely lived has in it many good habits maintained and many bad habits avoided or cured.


It is easy to see that a quickly reached conclusion, triggered by Doubt-Avoidance Tendency, when combined with a tendency to resist any change in that conclusion, will naturally cause a lot of errors in cognition for modern man.  And so it observably works out.  We all deal much with others whom we correctly diagnose as imprisoned in poor conclusions that are maintained by mental habits they formed early and will carry to their graves.

So great is the bad-decision problem caused by Inconsistency-Avoidance Tendency that our courts have adopted important strategies against it.  For instance, before making decisions, judges and juries are required to hear long and skillful presentations of evidence and argument from the side they will not naturally favor, given their ideas in place.  And this helps prevent considerable bad thinking from ‘first conclusion bias.’  Similarly, other modern decision makers will often force groups to consider skillful counterarguments before making decisions. 

And proper education is one long exercise in high cognition so that our wisdom becomes strong enough to destroy wrong thinking, maintained by resistance to change.

Munger points out that, as humans, we collect many attitudes and conclusions that are wrong:

And so, people tend to accumulate large mental holdings of fixed conclusions and attitudes that are not often reexamined or changed, even though there is plenty of good evidence that they are wrong.

But we can develop good mental habits by modeling people who excel at minimizing their biases.  Munger:

One of the most successful users of an antidote to first conclusion bias was Charles Darwin.  He trained himself, early, to intensively consider any evidence tending to disconfirm any hypothesis of his, more so if he thought his hypothesis was a particularly good one.  The opposite of what Darwin did is now called confirmation bias, a term of opprobrium.  Darwin’s practice came from his acute recognition of man’s natural cognitive faults arising from Inconsistency-Avoidance Tendency.  He provides a great example of psychological insight correctly used to advance some of the finest mental work ever done. 


(6)  Curiosity Tendency

There is a lot of innate curiosity in mammals, but its nonhuman version is highest among apes and monkeys.  Man’s curiosity, in turn, is much stronger than that of his simian relatives.  In advanced human civilization, culture greatly increases the effectiveness of curiosity in advancing knowledge…  Curiosity, enhanced by the best of modern education… much helps man to prevent or reduce bad consequences arising from other psychological tendencies.  The curious are also provided with much fun and wisdom long after formal education has ended.

Munger has long maintained that you should be a learning machine:

I constantly see people rise in life who are not the smartest, sometimes not even the most diligent, but they are learning machines.  They go to bed every night a little wiser than they were when they got up and boy does that help, particularly when you have a long run ahead of you.


(7)  Kantian Fairness Tendency

Kant’s ‘categorical imperative’ – a sort of ‘golden rule’ – “that required all humans to follow those behavior patterns that, if followed by all others, would make the surrounding human system work best for everybody.  And it is not too much to say that modern acculturated man displays, and expects from others, a lot of fairness as thus defined by Kant.”  (page 12)

Munger gives an example:

In a small community having a one-way bridge or tunnel for autos, it is the norm in the United States to see a lot of reciprocal courtesy, despite the absence of signs or signals.


(8)  Envy/Jealousy Tendency

Envy/jealousy is extreme in myth, religion, and literature wherein, in account after account, it triggers hatred and injury…

And envy/jealousy is also extreme in modern life… 

Munger has pointed out that envy is particularly stupid because there’s no upside.  Buffett has agreed with Munger on this, adding:

Gluttony is a lot of fun.  Lust has its place, too, but we won’t get into that.


It is not greed that drives the world, but envy.


(9)  Reciprocation Tendency


The automatic tendency of humans to reciprocate both favors and disfavors has long been noticed as it is in apes, monkeys, dogs, and many less cognitively gifted animals.  The tendency facilitates group cooperation for the benefit of members.

Unfortunately, hostility can get extreme.  But we have the ability to train ourselves.  Munger:

The standard antidote to one’s overactive hostility is to train oneself to defer reaction.  As my smart friend Tom Murphy so frequently says, ‘You can always tell the man off tomorrow, if it is such a good idea.’  (page 13)

Munger then notes that the tendency to reciprocate favor for favor is also very intense.  He mentions strange pauses in fighting during wars, caused by some minor courtesy or favor by one side which was then reciprocated by the other side.  Furthermore:

It is obvious that commercial trade, a fundamental cause of modern prosperity, is enormously facilitated by man’s innate tendency to reciprocate favors.  In trade, enlightened self-interest joining with Reciprocation Tendency results in constructive conduct.

Reciprocation Tendency operates largely subconsciously, like the other tendencies.

Munger mentions an experiment conducted by the psychology professor Robert Cialdini:

…Cialdini caused his ‘compliance practitioners’ to wander around his campus and ask strangers to supervise a bunch of juvenile delinquents on a trip to a zoo… one person in six out of a large sample actually agreed to do this… His practitioners next wandered around the campus asking strangers to devote a big chunk of time every week for two years to the supervision of juvenile delinquents.  This ridiculous request got him a one hundred percent rejection rate.  But the practitioner had a follow-up question:  ‘Will you at least spend one afternoon taking juvenile delinquents to a zoo?’  This raised Cialdini’s former acceptance rate of 1/6 to 1/2 – a tripling.

What Cialdini’s ‘compliance practitioners’ had done was make a small concession, which was reciprocated by a small concession from the other side.

Munger gives an important example from the real world:

The importance and power of reciprocate-favor tendency was also demonstrated in Cialdini’s explanation of the foolish decision of the attorney general of the United States to authorize the Watergate burglary.  There, an aggressive subordinate made some extreme proposal for advancing Republican interests… When this ridiculous request was rejected, the subordinate backed off, in gracious concession, to merely asking for consent to a burglary, and the attorney general went along.  Cialdini believes that subconscious Reciprocation Tendency thus became one important cause of the resignation of a United States president in the Watergate debacle, and so do I.  Reciprocation Tendency subtlely causes many extreme and dangerous consequences, not just on rare occasions but pretty much all the time.  (page 14)

But, while the Reciprocation Tendency is often dangerous, on the whole it causes more good than bad, says Munger:

Overall, both inside and outside religions, it seems clear to me that Reciprocation Tendency’s constructive contributions to man far outweigh its destructive effects.  In cases of psychological tendencies being used to counter or prevent bad results from one or more other psychological tendencies – for instance, in the case of interventions to end chemical dependency – you will usually find Reciprocation Tendency performing strongly on the constructive side.

And the very best part of human life probably lies in relationships of affection wherein parties are more interested in pleasing than being pleased – a not uncommon outcome in display of reciprocate-favor tendency.

Guilt is also rooted in evolution.  But Munger views it as a positive, on the whole:

…To the extent the feeling of guilt has an evolutionary base, I believe the most plausible cause is the mental conflict triggered in one direction by reciprocate-favor tendency and in the opposite direction by reward superresponse tendency pushing one to enjoy one hundred percent of some good thing.  Of course, human culture has often greatly boosted the genetic tendency to suffer from feeling of guilt.  Most especially, religious culture has imposed hard-to-follow ethical and devotional demands on people…  And if you, like me… believe that, averaged out, feelings of guilt do more good than harm, you may join in my special gratitude for reciprocate-favor tendency, no matter how unpleasant you find feelings of guilt.


(10)  Influence-from-Mere-Association Tendency

Munger observes that advertisers know the power of mere association.  For instance, Coca-Cola advertisements strive to associate Coke with happiness.

However, our minds can be misled by random association, as Munger explains:

Some of the most important miscalculations come from what is accidentally associated with one’s past success, or one’s liking and loving, or one’s disliking and hating, which includes a natural hatred for bad news.  (page 15)

Munger continues:

To avoid being misled by the mere association of some fact with past success, use this memory clue.  Think of Napoleon and Hitler when they invaded Russia after using their armies with much success elsewhere.  And there are plenty of mundane examples of results like those of Napoleon and Hitler.  For instance, a man foolishly gambles in a casino and yet wins.  This unlikely correlation causes him to try the casino again, or again and again, to his horrid detriment.  Or a man gets lucky in an odds-against venture headed by an untalented friend.  So influenced, he tries again what worked before – with terrible results.

Munger advises:

The proper antidotes to being made such a patsy by past success are (1) to carefully examine each past success, looking for accidental, non-causative factors associated with such success that will tend to mislead as one appraises odds implicit in a proposed new undertaking and (2) to look for dangerous aspects of the new undertaking that were not present when past success occurred.

Hating and disliking also cause miscalculation triggered by mere association.  In business, I commonly see people underappraise both the competency and the morals of competitors they dislike.  This is a dangerous practice, usually disguised because it occurs on a subconscious basis. 

Munger later comments on “Persian Messenger Syndrome”:

…Persian Messenger Syndrome is alive and well in modern life, albeit in less lethal versions.  It is actually dangerous in many careers to be a carrier of unwelcome news.  Union negotiators and employer representatives often know this, and it leads to many tragedies in labor relations.  Sometimes lawyers, knowing their clients will hate them if they recommend an unwelcome but wise settlement, will carry on to disaster…

CBS, in its late heyday, was famous for occurrence of Persian Messenger Syndrome because Chairman Paley was hostile to people who brought him bad news.  The result was that Paley lived in a cocoon of unreality, from which he made one bad deal after another, even exchanging a large share of CBS for a company that had to be liquidated shortly thereafter.


(11)  Simple, Pain-Avoiding Psychological Denial

Munger says:

This phenomenon first hit me hard in World War II when the superathlete, superstudent son of a family friend flew off over the Atlantic Ocean and never came back.  His mother, who was a very sane woman, then refused to believe he was dead.  That’s Simple, Pain-Avoiding Psychological Denial.  The reality is too painful to bear, so one distorts the facts until they become bearable.  We all do that to some extent, often causing terrible problems.  The tendency’s most extreme outcomes are usually mixed up with love, death, and chemical dependency.


(12)  Excessive Self-Regard Tendency

Excessive self-regard is one of the more obvious tendencies.

We all commonly observe the excessive self-regard of man.  He mostly misappraises himself on the high side, like the ninety percent of Swedish drivers that judge themselves to be above average.  Such misappraisals also apply to a person’s major ‘possessions.’  One spouse usually overappraises the other spouse.  And a man’s children are likewise appraised to be higher by him than they are likely to be in a more objective view.  Even man’s minor possessions tend to be overappraised.  Once owned, they suddenly become worth more to him than he would pay if they were offered for sale to him and he didn’t already own them.  There is a name in psychology for this overappraise-your-own-possessions phenomenon: the ‘endowment effect.’  And all man’s decisions are suddenly regarded by him as better than would have been the case just before he made them.

Man’s excess of self-regard typically makes him strongly prefer people like himself…  (page 16)

Munger continues:

Some of the worse consequences in modern life come when dysfunctional groups of cliquish persons, dominated by Excessive Self-Regard Tendency, select as new members of their organizations persons who are very much like themselves…

Well, naturally, all forms of excess of self-regard cause much error.  How could it be otherwise?

Moreover, says Munger:

Intensify man’s love of his own conclusions by adding the possessory wallop from the ‘endowment effect,’ and you will find that a man who has already bought a pork-belly future on a commodity exchange now foolishly believes, even more strongly than before, in the merits of his speculative bet.

And foolish sports betting, by people who love sports and think they know a lot about relative merits of teams, is a lot more addictive than race track betting – partly because of man’s automatic overappraisal of his own complicated conclusions.

Also extremely counterproductive is man’s tendency to be, time after time, in games of skill, like golf or poker, against people who are obviously much better players.  Excessive Self-Regard Tendency diminishes the foolish bettor’s accuracy in appraising his relative degree of talent.

Munger then adds:

More counterproductive yet are man’s appraisals, typically excessive, of the quality of the future service he is to provide to his business.  His overappraisal of these prospective contributions will frequently cause disaster.

There is a famous passage somewhere in Tolstoy that illuminates the power of Excessive Self-Regard Tendency.  According to Tolstoy, the worst criminals don’t appraise themselves as all that bad.  They come to believe either (1) that they didn’t commit their crimes or (2) that, considering the pressures and disadvantages of their lives, it is understandable and forgivable that they behaved as they did and become what they became.  (pg. 17)

Munger comments:

The second half of the ‘Tolstoy effect’, where the man makes excuses for his fixable poor performance, instead of providing the fix, is enormously important.  Because a majority of mankind will try to get along by making way too many unreasonable excuses for fixable poor performance, it is very important to have personal and institutional antidotes limiting the ravages of such folly.  On the personal level a man should try to face the two simple facts:

  • fixable but unfixed bad performance is bad character and tends to create more of itself, causing more damage to the excuse giver with each tolerated instance, and
  • in demanding places, like athletic teams and General Electric, you are almost sure to be discarded in due course if you keep giving excuses instead of behaving as you should.

The best antidote to folly from an excess of self-regard is to force yourself to be more objective when you are thinking about yourself, your family and friends, your property, and the value of your past and future activity.  This isn’t easy to do well and won’t work perfectly, but it will work much better than simply letting psychological nature take its normal course.

Most of the time, excessive self-regard harms our ability to make a good decision.  If you have an important decision, you have to learn to slow yourself down and be humble.  Munger:

You’re less pleasing than you think you are.  You know less than you think you do.

It’s easy for us to see the shortcomings in others, but it’s much harder for us to see our own flaws clearly.  It’s good to be able to laugh at yourself.


(13)  Overoptimism Tendency


Nothing is easier than self-deceit.  For what a man wishes, that also he believes to be true.

Munger suggests:

One standard antidote to foolish optimism is trained, habitual use of the simple probability math of Fermat and Pascal, taught in my youth to high school sophomores.  The mental rules of thumb that evolution gives you are not adequate.  They resemble the dysfunctional golf grip you would have if you relied on a grip driven by evolution instead of golf lessons.  (page 18)


(14)  Deprival-Superreaction Tendency

Munger states:

The quantity of man’s pleasure from a ten dollar gain does not exactly match the quantity of his displeasure from a ten dollar loss.  That is, the loss seems to hurt much more than the gain seems to help.  Moreover, if a man almost gets something he greatly wants and has it jerked away from him at the last moment, he will react much as if he had long owned the reward and had it jerked away.  I include the natural human reactions to both kinds of loss experience – the loss of the possessed reward and the loss of the almost possessed reward – under one description, Deprival Superreaction Tendency.

In displaying Deprival Superreaction Tendency, man frequently incurs disadvantage by misframing his problems.  He will often compare what is near instead of what truly matters.  For instance, a man with $10 million in his brokerage account will often be extremely irritated by the loss of $100 out of the $300 in his wallet.

Munger observes:

…A man ordinarily reacts with irrational intensity to even a small loss, or threatened loss, of property, love, friendship, dominated territory, opportunity, status, or any other valued thing.  As a natural result, bureaucratic infighting over the threatened loss of dominated territory often causes immense damage to an institution as a whole.  This factor among others, accounts for much of the wisdom of Jack Welch’s long fight against bureaucratic ills at General Electric.  Few business leaders have ever conducted wiser campaigns.

Deprival-Superreaction Tendency often protects ideological or religious views by triggering dislike and hatred directed toward vocal nonbelievers.  This happens, in part, because the ideas of the nonbelievers, if they spread, will diminish the influence of views that are now supported by a comfortable environment including a strong belief-maintenance system.  University liberal arts departments, law schools, and business organizations all display plenty of such ideology-based groupthink that rejects almost all conflicting inputs…

It is almost everywhere the case that extremes of ideology are maintained with great intensity and with great antipathy to non-believers, causing extremes of cognitive dysfunction.  This happens, I believe, because two psychological tendencies are usually acting concurrently toward this same sad result: (1) Inconsistency-Avoidance Tendency, plus (2) Deprival-Superreaction Tendency.

One antidote to intense, deliberate maintenance of groupthink is an extreme culture of courtesy, kept in place despite ideological differences, like the behavior of the justices now serving on the U.S. Supreme Court.  Another antidote is to deliberately bring in able and articulate disbelievers of incumbent groupthink….

Even a one-degree loss from a 180-degree view will sometime create enough Deprival-Superreaction Tendency to turn a neighbor into an enemy, as I once observed when I bought a house from one of two neighbors locked into hatred by a tiny tree newly installed by one of them.

Moreoever, says Munger:

Deprival-Superreaction Tendency and Inconsistency-Avoidance Tendency often join to cause one form of business failure.  In this form of ruin, a man gradually uses up all his good assets in a fruitless attempt to rescue a big venture going bad.  One of the best antidotes to this folly is good poker skill learned young.  The teaching value of poker demonstrates that not all effective teaching occurs on a standard academic path.

Deprival-Superreaction Tendency is also a huge contributor to ruin from compulsion to gamble.  First, it causes the gambler to have a passion to get even once he has suffered loss, and the passion grows with each loss.  Second, the most addictive forms of gambling provide a lot of near misses and each one triggers Deprival-Superreaction Tendency.  Some slot machine creators are vicious in exploiting this weakness of man.  Electronic machines enable these creators to produce a lot of meaningless bar-bar-lemon results that greatly increase play by fools who think they have very nearly won large rewards.  (page 19)


(15)  Social-Proof Tendency

Munger notes:

The otherwise complex behavior of man is much simplified when he automatically thinks and does what he observes to be thought and done around him.  And such followership often works fine…

Psychology professors love Social-Proof Tendency because in their experiments it causes ridiculous results.  For instance, if a professor arranges for some stranger to enter an elevator wherein ten ‘compliance practitioners’ are all standing so that they face the rear of the elevator, the stranger will often turn around and do the same.

Of course, like the other tendencies, Social-Proof has an evolutionary basis.  If the crowd was running in one direction, typically your best response was to follow.

But, in today’s world, simply copying others often doesn’t make sense.  Munger:

And in the highest reaches of business, it is not at all uncommon to find leaders who display followership akin to that of teenagers.  If one oil company foolishly buys a mine, other oil companies often quickly join in buying mines.  So also if the purchased company makes fertilizer.  Both of these oil company buying fads actually bloomed, with bad results.

Of course, it is difficult to identify and correctly weigh all the possible ways to deploy the cash flow of an oil company.  So oil company executives, like everyone else, have made many bad decisions that were triggered by discomfort from doubt.  Going along with social proof provided by the action of other oil companies ends this discomfort in a natural way.  (page 20)

Munger remarks:

When will Social-Proof Tendency be most easily triggered?  Here the answer is clear from many experiments:  Triggering most readily occurs in the presence of puzzlement or stress, and particularly when both exist. 

Because stress intensifies Social-Proof Tendency, disreputable sales organizations, engaged, for instance, in such action as selling swampland to schoolteachers, manipulate targets into situations combining isolation and stress.  The isolation strengthens the social proof provided by both the knaves and the people who buy first, and the stress, often increased by fatigue, augments the targets’ susceptibility to the social proof.  And, of course, the techniques of our worst ‘religious’ cults imitate those of the knavish salesmen.  One cult even used rattlesnakes to heighten the stress felt by conversion targets.

Munger points out that Social-Proof can sometimes be constructive:

Because both bad and good behavior are made contagious by Social-Proof Tendency, it is highly important that human societies (1) stop any bad behavior before it spreads and (2) foster and display all good behavior.

Often people find it difficult to resist the social contagion of bad behavior.  Munger:

…And, therefore, we get “Serpico Syndrome,” named to commemorate the state of a near-totally corrupt New York police division joined by Frank Serpico.  He was then nearly murdered by gunfire because of his resistance to going along with the corruption in the division.  Such corruption was being driven by social proof plus incentives, the combination that creates Serpico Syndrome.  The Serpico story should be taught more than it now is because the didactic power of its horror is aimed at a very important evil, driven substantially by a very important force:  social proof.

Munger gives another example:

In social proof, it is not only action by others that misleads but also their inaction.  In the presence of doubt, inaction by others becomes social proof that inaction is the right course.  Thus, the inaction of a great many bystanders led to the death of Kitty Genovese in a famous incident much discussed in introductory psychology courses.

In the ambit of social proof, the outside directors on a corporate board usually display the near ultimate form of inaction.  They fail to object to anything much short of an axe murder until some public embarrassment of the board finally causes their intervention…

Typically there are many psychological tendencies operating at the same time – such as Liking/Loving, Disliking/Hating, Doubt-Avoidance, Inconsistency-Avoidance, and Social-Proof.  Unchecked, a confluence of such tendencies can lead to extreme situations.  Munger gives an example:

…By now the resources spent by Jews, Arabs, and all others over a small amount of disputed land if divided arbitrarily among land claimants, would have made every one better off, even before taking into account any benefit from reduced threat of war, possibly nuclear.  (pg. 21)


(16)  Contrast-Misreaction Tendency

Munger asserts:

Because the nervous system of man does not naturally measure in absolute scientific units, it must rely instead on something simpler.  The eyes have a solution that limits their programming needs: the contrast in what is seen is registered.  And as in sight, so does it go, largely, in the other senses.  Moreover, as perception goes, so goes cognition.  The result is man’s Contrast-Misreaction Tendency.  Few psychological tendencies do more damage to correct thinking.  Small-scale damages involve instances such as man’s buying an overpriced $1,000 leather dashboard merely because the price is so low compared to this concurrent purchase of a $65,000 car.  Large-scale damages often ruin lives, as when a wonderful woman having terrible parents marries a man who would be judged satisfactory only in comparison to her parents.  Or as when a man takes wife number two who would be appraised all right only in comparison to wife number one.

A particularly reprehensible form of sales practice occurs in the offices of some real estate brokers.  A buyer from out of the city, perhaps needing to shift his family there, visits the office with little time available.  The salesman deliberately shows the customer three awful houses at ridiculously high prices.  Then he shows him a merely bad house at a price only moderately too high.  And, boom, the broker often makes an easy sale.

Munger continues:

Contrast-Misreaction Tendency is routinely used to cause disadvantage for customers buying merchandise and services.  To make an ordinary price seem low, the vendor will very frequently create a highly artificial price that is much higher than the price always sought, then advertise his standard price as a big reduction from his phony price.  Even when people know that this sort of customer manipulation is being attempted, it will often work to trigger buying… [It demonstrates that] being aware of psychological ploys is not a perfect defense.  When a man’s steps are consecutively taken toward disaster, with each step being very small, the brain’s Contrast-Misreaction Tendency will often let the man go too far toward disaster to be able to avoid it.  This happens because each step presents so small a contrast from his present position.


(17)  Stress-Influence Tendency

Munger reflects:

Everyone recognizes that sudden stress, for instance from a threat, will cause a rush of adrenaline in the human body, prompting faster and more extreme reaction.  And everyone who has taken Psych 101 knows that stress makes Social-Proof Tendency more powerful.


(18)  Availability-Misweighing Tendency

Munger observes:

Man’s imperfect, limited-capacity brain easily drifts into working with what’s easily available to it.  And the brain can’t use what it can’t remember or what it is blocked from recognizing because it is heavily influenced by one or more psychological tendencies bearing strongly on it, as the fellow is influenced by the nearby girl in the song.  And so the mind overweighs what is easily available and thus displays Availability-Misweighing Tendency.

Munger mentions antidotes:

The main antidote to miscues from Availability-Misweighing Tendency often involve procedures, including use of checklists, which are almost always helpful. 

Another antidote is to behave somewhat like Darwin did when he emphasized disconfirming evidence.  What should be done is to especially emphasize factors that don’t produce reams of easily available numbers, instead of drifting mostly or entirely into considering factors that do produce such numbers.  Still another antidote is to find and hire some skeptical, articulate people with far-reaching minds to act as advocates for notions that are opposite to the incumbent notions.

If some event is vivid or recent, it will generally be more available.  Munger:

One consequence of this tendency is that extra-vivid evidence, being so memorable and thus more available in cognition, should often consciously be underweighed while less vivid evidence should be overweighed.

Munger offers a suggestion:

The great algorithm to remember in dealing with this tendency is simple:  An idea or a fact is not worth more merely because it is easily available to you.


(19)  Use-It-or-Lose-It Tendency

Munger discusses the importance of practice:

All skills attenuate with disuse… The right antidote to such a loss is to make use of the functional equivalent of the aircraft simulator employed in pilot training.  This allows a pilot to continuously practice all of the rarely used skills that he can’t afford to lose.

Throughout his life, a wise man engages in practice of all his useful, rarely used skills, many of them outside his discipline, as a sort of duty to his better self.  If he reduces the number of skills he practices and, therefore, the number of skills he retains, he will naturally drift into error from man with a hammer tendency.  His learning capacity will also shrink as he creates gaps in the latticework of theory he needs as a framework for understanding new experience.  It is also essential for a thinking man to assemble his skills into a checklist that he routinely uses.  Any other mode of operation will cause him to miss much that is important.  (page 23)

If the skill in question is important enough, gaining fluency is wise, says Munger:

The hard rule of Use-It-or-Lose-It Tendency tempers its harshness for the diligent.  If a skill is raised to fluency, rather than merely being crammed in briefly to enable one to pass some test, then the skill (1) will be lost more slowly and (2) will come back faster when refreshed with new learning.  These are not minor advantages, and a wise man engaged in learning some important skill will not stop until he is really fluent in it.


(20)  Drug-Misinfluence Tendency

“This tendency’s destructive power is so widely known to be intense, with frequent tragic consequences for cognition and the outcome of life, that it needs no discussion here to supplement that previously given under ‘Simple, Pain-Avoiding Psychological Denial’.”


(21)  Senescence-Misinfluence Tendency

All of us naturally decay over time.  Munger points out:

But some people remain pretty good in maintaining intensely practiced old skills until late in life, as one can notice in many a bridge tournament. 

Loving to learn can help:

Continuous thinking and learning, done with joy, can somewhat help delay what is inevitable.


(22)  Authority-Misinfluence Tendency

A disturbingly significant portion of copilots will not correct obvious errors made by the pilot during simulation exercises.  There are also real world examples of copilots crashing planes because they followed the pilot mindlessly.  Munger states:

…Such cases are also given attention in the simulator training of copilots who have to learn to ignore certain really foolish orders from boss pilots because boss pilots will sometimes err disastrously.  Even after going through such a training regime, however, copilots in simulator exercises will too often allow the simulated plane to crash because of some extreme and perfectly obvious simulated error of the chief pilot.

Psychologist Stanley Milgram wanted to understand why so many seemingly normal and decent people engaged in horrific, unspeakable acts during World War II.  Munger:

After Corporal Hitler had risen to dominate Germany, leading a bunch of believing Lutherans and Catholics into orgies of genocide and other mass destruction, one clever psychology professor, Stanley Milgram, decided to do an experiment to determine exactly how far authority figures could lead ordinary people into gross misbehavior.  In this experiment, a man posing as an authority figure, namely a professor governing a respectable experiment, was able to trick a great many ordinary people into giving what they had every reason to believe were massive electric shocks that inflicted heavy torture on innocent fellow citizens.  This experiment did demonstrate a terrible result contributed to by Authority-Misinfluence Tendency, but it also demonstrated extreme ignorance in the psychology professoriate right after World War II.

Almost any intelligent person with my checklist of psychological tendencies in his hand would, by simply going down the checklist, have seen that Milgram’s experiment involved about six powerful psychological tendencies acting in confluence to bring about his extreme experimental result.  For instance, the person pushing Milgram’s shock lever was given much social proof from presence of inactive bystanders whose silence communicated that his behavior was okay…


(23)  Twaddle Tendency

Munger mentions:

Man, as a social animal who has the gift of language, is born to prattle and to pour out twaddle that does much damage when serious work is being attempted.  Some people produce copious amounts of twaddle and others very little.  (page 24)


(24)  Reason-Respecting Tendency

People naturally love thinking, reasoning, and learning:

There is in man, particularly one in an advanced culture, a natural love of accurate cognition and a joy in its exercise.  This accounts for the widespread popularity of crossword puzzles, other puzzles, and bridge and chess columns, as well as all games requiring mental skill.

Always trying to understand WHY things happen is a central part of the learning process, says Munger:

In general, learning is most easily assimilated and used when, life long, people consistently hang their experience, actual and vicarious, on a latticework of theory answering the question: Why?  Indeed, the question ‘Why?’ is a sort of Rosetta stone opening up the major potentiality of mental life.

But often we don’t notice when meaningless or incorrect reasons are given:

Unfortunately, Reason-Respecting Tendency is so strong that even a person’s giving of meaningless or incorrect reasons will increase compliance with his orders and requests.  This has been demonstrated in psychology experiments wherein ‘compliance practitioners’ successfully jump to the head of the lines in front of copying machines by explaining their reason: ‘I have to make some copies.’  This sort of unfortunate byproduct of Reason-Respecting Tendency is a conditioned reflex, based on a widespread appreciation of the importance of reasons.  And, naturally, the practice of laying out various claptrap reasons is much used by commercial and cult ‘compliance practitioners’ to help them get what they don’t deserve.


Can you supply a real world model, instead of a Milgram-type controlled psychology experiment, that uses your system to illustrate multiple psychological tendencies interacting in a plausibly diagnosable way?

The answer is yes.  One of my favorite cases involves the McDonnell Douglas airliner evacuation test.  Before a new airliner can be sold, the government requires that it pass an evacuation test, during which a full load of passengers must get out in some short period of time.  The government directs that the test be realistic.  So you can’t pass by evacuating only twenty-year-old athletes.  So McDonnell Douglas scheduled such a test in a darkened hangar using a lot of old people as evacuees.  The passenger cabin was, say, twenty feet above the concrete floor of the hangar and was to be evacuated through moderately flimsy rubber chutes.  The first test was made in the morning.  There were about twenty very serious injuries, and the evacuation took so long it flunked the time test.  So what did McDonnell Douglas next do?  It repeated the test in the afternoon, and this time there was another failure, with about twenty more serious injuries, including one case of permanent paralysis.

What psychological tendencies contributed to this terrible result?  Well, using my tendency list as a checklist, I come up with the following explanation.  Reward-Superresponse Tendency drove McDonnell Douglas to act fast.  It couldn’t sell its airliner until it passed the test.  Also pushing the company was Doubt-Avoidance Tendency with its natural drive to arrive at a decision and run with it.  Then the government’s direction that the test be realistic drove Authority-Misinfluence Tendency into the mischief of causing McDonnell Douglas to overreact by using what was obviously too dangerous a test method.  By now the course of action had been decided, so Inconsistency Avoidance Tendency helped preserve the near idiotic plan.  When all the old people got to the dark hangar, with its high airline cabin and concrete floor, the situation must have made McDonnell Douglas employees very queasy, but they saw other employees and supervisors not objecting.  Social Proof Tendency, therefore, swamped the queasiness.  And this allowed continued action as planned, a continuation that was aided by more Authority-Misinfluence Tendency.  Then came the disaster of the morning test with its failure, plus serious injuries.  McDonnell Douglas ignored the strong disconfirming evidence from the failure of the first test because confirmation bias, aided by the triggering of strong Deprival Superreaction Tendency favored maintaining the original plan.  McDonnell Douglas’ Deprival Superreaction Tendency was now like that which causes a gambler, bent on getting even after a huge loss, to make his final big bet.  After all, McDonnell Douglas was going to lose a lot if it didn’t pass its test as scheduled.  More psychology-based explanation can probably be made, but the foregoing discussion is complete enough to demonstrate the utility of my system when used in checklist mode.  (page 26)


In the practical world, what good is the thought system laid out in this list of tendencies?  Isn’t practical benefit prevented because these psychological tendencies are so thoroughly programmed into the human mind by broad evolution [the combination of genetic and cultural evolution] that we can’t get rid of them?

Well, the answer is that the tendencies are probably more good than bad.  Otherwise, they wouldn’t be there, working pretty well for man, given his condition and his limited brain capacity.  So the tendencies can’t be simply washed out automatically, and they shouldn’t be.  Nevertheless, the psychological thought system described, when properly understood and used, enables the spread of wisdom and good conduct and facilitates the avoidance of disaster.  Tendency is not always destiny, and knowing the tendencies and their antidotes can often help prevent trouble that would otherwise occur.


Here is a short list of examples reminding us of the great utility of elementary psychological knowledge.

  • Carl Braun’s communication practices.
  • The use of simulators in pilot training.
  • The system of Alcoholics Anonymous.
  • Clinical training methods in medical schools.
  • The rules of the U.S. Constitutional Convention:  totally secret meetings, no recorded vote by name until the final vote, votes reversible at any time before the end of the convention, then just one vote on the whole Constitution.  These are very clever psychology-respecting rules.  If the founders had used a different procedure, many people would have been pushed by various psychological tendencies into inconsistent, hardened positions.  The elite founders got our Constitution through by a whisker only because they were psychologically acute.
  • The use of Granny’s incentive-driven rule to manipulate oneself toward better performance of one’s duties.
  • The Harvard Business School’s emphasis on decision trees.  When I was young and foolish I used to laugh at the Harvard Business School.  I said, ‘They’re teaching twenty-eight year-old people that high school algebra works in real life?’  But later, I wised up and realized that it was very important that they do that to counter some bad effects from psychological tendencies.  Better late than never.
  • The use of autopsy equivalents at Johnson & Johnson.  At most corporations, if you make an acquisition and it turns out to be a disaster, all the people, paperwork, and presentations that caused the foolish acquisition are quickly forgotten.  Nobody wants to be associated with the poor outcome by mentioning it.  But at Johnson & Johnson, the rules make everybody revisit old acquisitions, comparing predictions with outcomes.  That is a very smart thing to do.
  • The great example of Charles Darwin as he avoided confirmation bias, which has morphed into the extreme anti-confirmation-bias method of the “double blind” studies wisely required in drug research by the FDA.
  • The Warren Buffett rule for open-outcry auctions:  Don’t go.


Aren’t there factual and reasoning errors in this talk?

The answer is yes, almost surely yes.  The final revision was made from memory over about fifty hours by a man eighty-one years old, who never took a course in psychology and has read none of it, except one book on developmental psychology, for nearly fifteen years.  Even so.  I think the totality of my talk will stand up very well, and I hope all my descendants and friends will carefully consider what I have said.  I even hope that more psychology professors will join me in:

  • making heavy use of inversion;
  • driving for a complete description of the psychological system so that it works better as a checklist;  and
  • especially emphasizing effects from combinations of psychological tendencies.



An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are 15-25 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 10-15% (at cost), while the average position is 5-7% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees.  The Boole Fund has low fees. 


If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail:




Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

The Essays of Warren Buffett

(Image:  Zen Buddha Silence by Marilyn Barbone.)

August 6, 2017

A chief purpose of this blog is to teach others about business and investing.  (My other passion is artificial intelligence.)  For those curious about these and related subjects, I hope this blog is useful.

The other main purpose of this blog is to create awareness for the Boole Microcap Fund, which I manage.

  • Buffett correctly observes that a low-cost index fund is the best long-term investment for most investors:
  • A quantitative value strategy – properly implemented – has high odds of beating an index fund.
  • Buffett, Munger, Lynch, and other top investors started in micro caps because there’s far less competition and far more inefficiency.  An equal weighted microcap approach has outperformed every other size category historically:
  • If you also screen for value and for improving fundamentals, then a microcap value approach is likely to do significantly better (net of all costs) than an S&P 500 index fund over time.


This week’s blog post covers The Essays of Warren Buffett: Lessons for Corporate America (4th edition, 2015), selected and arranged by Lawrence A. Cunningham.  The book is based on 50 years of Buffett’s letters to shareholders, organized according to topic.

Not only is Warren Buffett arguably the greatest investor of all time;  but Buffett wants to be remembered as a “Teacher.”  Buffett and Munger have been outstanding “professors” for decades now, carrying on the value investing community’s tradition of generosity.  Munger:

The best thing a human being can do is to help another human being know more.

Every section (but taxation) from The Essays of Warren Buffett is included here:

  • Prologue: Owner-Related Business Principles
  • Corporate Governance
  • Finance and Investing
  • Investment Alternatives
  • Common Stock
  • Mergers and Acquisitions
  • Valuation and Accounting
  • Accounting Shenanigans
  • Berkshire at Fifty and Beyond



Buffett writes that Berkshire Hathaway shareholders are unusual because nearly all of them focus on long-term compounding of business value.  At the end of a typical year, 98% of those who own shares in Berkshire owned the shares at the beginning of the year.

Buffett remarks that, to a large extent, companies end up with the shareholders they seek and deserve.  Buffett sets forth Berkshire’s fifteen owner-related business principles:

  1. Although our form is corporate, our attitude is partnership.  Charlie Munger and I think of our shareholders as owner-partners, and of ourselves as managing partners… We do not view the company itself as the ultimate owner of our business assets but instead view the company as a conduit through which our shareholders own the assets.
  2. In line with Berkshire’s owner-orientation, most of our directors have a major portion of their net worth invested in the company.  We eat our own cooking.
  3. Our long-term economic goal (subject to some qualifications mentioned later) is to maximize Berkshire’s average annual rate of gain in intrinsic business value on a per-share basis.  We do not measure the economic significance or performance of Berkshire by its size;  we measure by per-share progress…
  4. Our preference would be to reach our goal by directly owning a diversified group of businesses that generate cash and consistently earn above-average returns on capital.  Our second choice is to own parts of similar businesses, attained primarily through purchases of marketable common stocks by our insurance subsidiaries…
  5. Because of our two-pronged approach to business ownership and because of the limitations of conventional accounting, consolidated reported earnings may reveal relatively little about our true economic performance.  Charlie and I, both as owners and managers, virtually ignore such consolidated numbers.  However, we will also report to you the earnings of each major business we control, numbers we consider of great importance.  These figures, along with other information we will supply about the individual businesses, should generally aid you in making judgments about them.
  6. Accounting consequences do not influence our operating or capital-allocation decisions.  When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable.  This is precisely the choice that often faces us since entire businesses (whose earnings will be fully reportable) frequently sell for double the pro-rate price of small portions (whose earnings will be largely unreportable).  In aggregate and over time, we expect the unreported earnings to be fully reflected in our intrinsic business value through capital gains.
  7. We use debt sparingly and, when we do borrow, we attempt to structure our loans on a long-term fixed-rate basis.  We will reject interesting opportunities rather than over-leverage our balance sheet.  This conservatism has penalized our results but it is the only behavior that leaves us comfortable, considering our fiduciary obligations to policyholders, lenders and the many equity holders who have committed unusually large portions of their net worth to our care.  (As one of the Indianapolis ‘500’ winners said:  ‘To finish first, you must first finish.’)
  8. A managerial ‘wish list’ will not be filled at shareholder expense.  We will not diversify by purchasing entire businesses at control prices that ignore long-term economic consequences to our shareholders.  We will only do with your money what we would do with our own, weighing fully the values you can obtain by diversifying your own portfolios through direct purchases in the stock market.
  9. We feel noble intentions should be checked periodically against results.  We test the wisdom of retained earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained.  To date, this test has been met.  We will continue to apply it on a five-year rolling basis…
  10. We will issue common stock only when we receive as much in business value as we give…
  11. You should be fully aware of one attitude Charlie and I share that hurts our financial performance:  Regardless of price, we have no interest at all in selling any good businesses that Berkshire owns.  We are also very reluctant to sell sub-par businesses as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations…
  12. We will be candid in our reporting to you, emphasizing the pluses and minuses important in appraising business value.  Our guideline is to tell you the business facts that we would want to know if our positions were reversed.  We owe you no less… We also believe candor benefits us as managers:  The CEO who misleads others in public may eventually mislead himself in private.
  13. Despite our policy of candor we will discuss our activities in marketable securities only to the extent legally required.  Good investment ideas are rare, valuable and subject to competitive appropriation…
  14. To the extent possible, we would like each Berkshire shareholder to record a gain or loss in market value during his period of ownership that is proportional to the gain or loss in per-share intrinsic value recorded by the company during that holding period…
  15. We regularly compare the gain in Berkshire’s per-share book value to the performance of the S&P 500…



Buffett explains:

At Berkshire, full reporting means giving you the information that we would wish you to give to us if our positions were reversed.  What Charlie and I would want under the circumstance would be all the important facts about current operations as well as the CEO’s frank view of the long-term economic characteristics of the business.  We would expect both a lot of financial details and a discussion of any significant data we would need to interpret what was presented.  (page 37)

Buffett comments that it is deceptive and dangerous – as he and Charlie see it – for CEOs to predict publicly growth rates for their companies.  Though they are pushed to do so by analysts and their own investor relations departments, such predictions too often lead to trouble.  Having internal targets is fine, of course.  Buffett:

The problem arising from lofty predictions is not just that they spread unwarranted optimism.  Even more troublesome is the fact that they corrode CEO behavior.  Over the years, Charlie and I have observed many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings targets they had announced.  Worse still, after exhausting all that operating acrobatics would do, they sometimes played a wide variety of accounting games to ‘make the numbers.’  (page 39)

Buffett offers three suggestions for investors.  He says:

  • First, beware of companies displaying weak accounting… When managements take the low road in aspects that are visible, it is likely they are following a similar path behind the scenes.
  • Second, unintelligible footnotes usually indicate untrustworthy management.  If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to…
  • Finally, be suspicious of companies that trumpet earnings projections and growth expectations.  Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don’t advance smoothly (except, of course, in the offering books of investment bankers).

Buffett writes that when CEOs fall short, it’s quite difficult to remove them.  Part of the problem is that there are no objective standards.

At too many companies, the boss shoots the arrow of managerial performance and then hastily paints the bullseye around the spot where it lands.  (page 41)

A further problem is that the CEO has no immediate superior whose performance is itself being measured.  Buffett describes this and related issues:

But the CEO’s boss is a board of directors that seldom measures itself and is infrequently held to account for substandard corporate performance.  If the Board makes a mistake in hiring, and perpetuates that mistake, so what?  Even if the company is taken over because of the mistake, the deal will probably bestow substantial benefits on the outgoing board members…

Finally, relations between the Board and the CEO are expected to be congenial.  At board meetings, criticisms of the CEO’s performance is often viewed as the social equivalent of belching…

These points should not be interpreted as a blanket condemnation of CEOs or Boards of Directors:  Most are able and hardworking, and a number are truly outstanding.  But the management failings Charlie and I have seen make us thankful that we are linked with the managers of our permanent holdings.  They love their businesses, they think like owners, and they exude integrity and ability.  (pages 41-42)

Buffett wrote more about corporate governance on a different occasion.  He points out that there are three basic manager/owner situations.

The first situation – by far the most common – is that there is no controlling shareholder.  Buffett argues that directors in this case should act as if there is a single absentee owner, whose long-term interest they should try to further.  If a board member sees management going wrong, he should try to convince other board members.  Failing that, he should make his views known to absentee owners, says Buffett.  Also, the board should set standards for CEO performance and regularly meet – without the CEO present – to measure that performance.  Finally, board members should be chosen based on business savvy, interest in the job, and owner-orientation, holds Buffett.

The second situation is that the controlling owner is also the manager.  In this case, if the owner/manager is failing, it’s difficult for board members to improve things.  If the board members agree, they could as a unit convey their concerns.  But this probably won’t achieve much.  On an individual level, a board member who has serious concerns could resign.

The third governance situation is when there is a controlling owner who is not involved in management.  In this case, unhappy directors can go directly to the owner, observes Buffett.

Buffett then remarks:

Logically, the third case should be the most effective in insuring first-class management.  In the second case the owner is not going to fire himself, and in the first case, directors often find it very difficult to deal with mediocrity or mild over-reaching.  Unless the unhappy directors can win over a majority of the board – an awkward social and logistical task, particularly if management’s behavior is merely odious, not egregious – their hands are effectively tied…  (page 44)

Buffett also writes that most directors are decent folks who do a first-class job.  But, nonetheless, being human, some directors will fail to be objective if their director fees are a large part of their annual income.

Buffett says that Berkshire’s policy is only to work with people they like and admire.  Berkshire generally only buys a business when they like and admire the manager and when that manager is willing to stay in place.

…Berkshire’s ownership may make even the best of managers more effective.  First, we eliminate all of the ritualistic and nonproductive activities that normally go with the job of CEO.  Our managers are totally in charge of their personal schedules.  Second, we give each a simple mission:  Just run your business as if:

  • you own 100% of it;
  • it is the only asset in the world that you and your family have or will ever have;  and
  • you can’t sell or merge it for at least a century.

As a corollary, we tell them they should not let any of their decisions be affected even slightly by accounting considerations.  We want our managers to think about what counts, not how it will be counted.  (pages 50-51)

Buffett comments that very few CEOs of public companies can follow such mandates, chiefly because they have owners (shareholders) who focus on short-term prospects and reported earnings.  It’s not that Berkshire ignores current results, says Buffett, but that they should never be achieved at the expense of building ever-greater long-term competitive strengths.

I believe the GEICO story demonstrates the benefits of Berkshire’s approach.  Charlie and I haven’t taught Tony a thing – and never will – but we have created an environment that allows him to apply all of his talents to what’s important.  He does not have to devote his time or energy to board meetings, press interviews, presentations by investment bankers or talks with financial analysts.  Furthermore, he need never spend a minute thinking about financing, credit ratings or ‘Street’ expectations for earnings per share.  Because of our ownership structure, he also knows that this operational framework will endure for decades to come.  In this environment of freedom, both Tony and his company can convert their almost limitless potential into matching achievements.  (page 51)

Buffett discusses the importance of building long-term competitive strengths:

Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger.  If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength.  But if we treat customers with indifference or tolerate bloat, our businesses will wither.  On a daily basis, the effects of our actions are imperceptible;  cumulatively, though, their consequences are enormous.

When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as ‘widening the moat.’  And doing that is essential if we are to have the kind of business we want a decade or two from now.  We always, of course, hope to earn more money in the short-term.  But when short-term and long-term conflict, widening the moat must take precedence.

It’s interesting that Berkshire Hathaway itself, a textile operation, is one of Buffett’s biggest investment mistakes.  Furthermore, Buffett owned the textile business from 1965 to 1985, despite generally bad results.  Buffett explains that he held on to this business because management was straightforward and energetic, labor was cooperative and understanding, the company was a large employer, and the business was still earning modest cash returns.

Buffett was able to build today’s Berkshire Hathaway, one of the largest and most successful companies in the world, because he took cash out of the textile operation and reinvested in a series of highly successful businesses.  Buffett did have to close the textile business in 1985 – twenty years after acquiring it – because, by then, the company was losing money each year, with no prospect for improvement.

Buffett tells the story of Burlington, the largest U.S. textile enterprise.  From 1964 to 1985, Burlington spent about $3 billion on improvement and expansion.  This amounted to more than $200-a-share on a $60 stock.  However, after 20 years, the stock had gone nowhere, while the CPI had more than tripled.  Buffett:

This devastating outcome for the shareholders demonstrates what can happen when much brain power and energy are applied to a faulty premise…

My conclusion from my own experiences and from much observation of other businesses is that a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row (though intelligence and effort help considerably, of course, in any business, good or bad).  Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.  (pages 55-56)

Buffett also covers the topic of executive pay:

When returns on capital are ordinary, an earn-more-by-putting-up-more record is no great managerial achievement.  You can get the same result personally by operating from your rocking chair.  Just quadruple the capital you commit to a savings account and you will quadruple your earnings.  You would hardly expect hosannas for that particular accomplishment.  Yet, retirement announcements regularly sing the praises of CEOs who have, say, quadrupled earnings of their widget company during their reign – with no one examining whether this gain was attributable simply to many years of retained earnings and the workings of compound interest.

If the widget company consistently earned a superior return on capital throughout the period, or if capital employed only doubled during the CEO’s reign, the praise for him may be well deserved.  But if return on capital was lackluster and capital employed increased in pace with earnings, applause should be withheld.  A savings account in which interest was reinvested would achieve the same year-by-year increase in earnings – and, at only 8% interest, would quadruple its annual earnings in 18 years.

The power of this simple math is often ignored by companies to the detriment of their shareholders.  Many corporate compensation plans reward managers handsomely for earnings increases produced solely, or in large part, by retained earnings – i.e., earnings withheld from owners…  (page 67)

Buffett points out that ten-year, fixed-price options ignore the fact that earnings automatically build value, and that carrying capital has a cost.  Managers in this situation profit just as they would if they had an option on the savings account that automatically was building value.

Buffett repeatedly emphasizes that excellent management performance should be rewarded.  Indeed, says Buffett, exceptional managers nearly always get less than they should.  But that means you have to measure return on capital versus cost of capital.  Buffett does admit, however, that some managers he admires enormously disagree with him regarding fixed-price options.

Buffett designs Berkshire’s employment contracts with managers based on returns on capital employed versus the cost of that capital.  If the return on capital is high, the manager is rewarded.  If return on capital is sub-standard, then the manager is penalized.  Fixed-price options, by contrast, besides not usually being adjustable for the cost of capital, also fall short in that they reward managers on the upside without penalizing them on the downside.  (Buffett does adjust manager contracts based on the economic characteristics of the business, however.  A regulated business will have lower but still acceptable returns, for instance.)

Regarding reputation, Buffett has written for over 30 years:

We can’t be perfect but we can try to be…

We can afford to lose money – even a lot of money.  But we can’t afford to lose reputation – even a shred of reputation.  

Most auditors, observes Buffett, see that the CEO and CFO pay their fees.  So the auditors are more worried about offending the CEO than they are about accurate reporting.  Buffett suggests that audit committees ask the following four questions of auditors:

  1. If the auditor were solely responsible for the preparation of the company’s financial statements, would they in any way have been prepared differently from the manner selected by management?  This question should cover both material and nonmaterial differences.  If the auditor would have done something differently, both management’s argument and the auditor’s response should be disclosed.  The audit committee should then evaluate the facts.
  2. If the auditor were an investor, would he have received – in plain English – the information essential to his understanding the company’s financial performance during the reporting period?
  3. Is the company following the same internal audit procedure that would be followed if the auditor himself were CEO?  If not, what are the differences and why?
  4. Is the auditor aware of any actions – either accounting or operational – that have had the purpose and effect of moving revenues or expenses from one reporting period to another?  (page 79)

Buffett remarks that this procedure would save time and expense, in addition to focusing auditors on their duty.



Buffett discusses his purchase of a farm in Nebraska in 1986, a few years after a bubble in Midwest farm prices had popped.  First, he learned from his son how many bushels of corn and of soybeans would be produced, and what the operating expenses would be.  Buffett determined that the normalized return from the farm would be 10%, and that productivity and prices were both likely to increase over time.  Three decades later, the farm had tripled its earnings and Buffett’s investment had grown five times in value.

Buffett also mentions buying some real estate next to NYU shortly after a bubble in commercial real estate had popped.  The unlevered current yield was 10%.  Earnings subsequently tripled and annual distributions soon exceeded 35% of the original equity investment.

Buffett says these two investments illustrate certain fundamentals of investing, which he spells out as follows:

  • You don’t need to be an expert in order to achieve satisfactory investment returns.  But if you aren’t, you must recognize your limitations and follow a course certain to work reasonably well.  Keep things simple and don’t swing for the fences.  When promised quick profits, respond with a quick ‘no.’
  • Focus on the future productivity of the asset you are considering.  If you don’t feel comfortable making a rough estimate of the asset’s future earnings, just forget it and move on.  No one has the ability to evaluate every investment possibility.  But omniscience isn’t necessary;  you only need to understand the actions you undertake.
  • If you instead focus on the prospective price change of a contemplated purchase, you are speculating.  There is nothing improper about that.  I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so… And the fact that a given asset has appreciated in the recent past is never a reason to buy it.
  • With my two small investments, I thought only of what the property would produce and cared not at all about their daily valuations.  Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard.  If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.
  • Forming macro opinions or listening to the macro or market opinions of others is a waste of time.  Indeed, it is dangerous because it may blur your vision of the facts that are truly important…
  • My two purchases were made in 1986 and 1993.  What the economy, interest rates, or the stock market might do in the years immediately following – 1987 and 1994 – was of no importance to me in making those investments.  I can’t remember what the headlines or pundits were saying at the time.  Whatever the chatter, corn would keep growing in Nebraska and students would flock to NYU.

Many long-term investors make the mistake of feeling good when stock prices rise.  Buffett says that if you’re going to be a long-term investor and regularly add to your investments, you should prefer stock prices to fall rather than rise.  Eventually, stock prices follow business results.  And it’s safe to assume the U.S. economy will continue to grow over the long term.  But between now and then, if you’re a net buyer of stocks, you’re better off if stock prices fall before they rise.  Buffett:

So smile when you read a headline that says ‘Investors lose as market falls.’  Edit it in your mind to ‘Disinvestors lose as market falls – but investors gain.’  (page 89)

Buffett advises most investors to invest in index funds:

But for a handful of investors who can understand some businesses, it’s better to patiently wait for the fattest pitches.  Buffett gives an analogy:

If my universe of business opportunities was limited, say, to private companies in Omaha, I would, first, try to assess the long-term economic characteristics of each business;  second, assess the quality of the people in charge of running it;  and, third, try to buy into a few of the best operations at a sensible price.  I certainly would not wish to own an equal part of every business in town.  Why, then, should Berkshire take a different tack when dealing with the larger universe of public companies?  And since finding great businesses and outstanding managers is so difficult, why should we discard proven products?  (page 102)

Buffett then quotes the economist and investor John Maynard Keynes:

‘As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes.  It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.  One’s knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence.’ – J. M. Keynes

Here are details on Keynes as an investor:

Buffett explains Berkshire’s equity investment strategy by quoting its 1977 annual report:

We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety.  We want the business to be one (a) that we can understand;  (b) with favorable long-term prospects;  (c) operated by honest and competent people;  and (d) available at a very attractive price.  (page 106)

Buffett then notes that, due to Berkshire’s much larger size as well as market conditions, they would now substitute ‘an attractive price’ for ‘a very attractive price.’  How do you decide what’s ‘attractive’?  Buffett quotes The Theory of Investment Value, by John Burr Williams:

‘The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.’

Buffett comments:

The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase – irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value…

Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.  The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.  Unfortunately, the first type of business is very hard to find…

Though the mathematical calculations required to evaluate equities are not difficult, an analyst – even one who is experienced and intelligent – can easily go wrong in estimating future ‘coupons.’  At Berkshire, we attempt to deal with this problem in two ways.  First, we try to stick to businesses we believe we understand.  That means they must be relatively simple and stable in character.  If a business is complex or subject to constant change, we’re not smart enough to predict future cash flows.  Incidentally, that shortcoming doesn’t bother us.  What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know.  An investor needs to do very few things right as long as he or she avoids big mistakes.

Second, and equally important, we insist on a margin of safety in our purchase price.  If we calculate the value of a common stock to be only slightly higher than its price, we’re not interested in buying.  We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.  (pages 107-108)

At another point, Buffett explains concentrated, buy-and-hold investing:

Inactivity strikes us as intelligent behavior.  Neither we nor most business managers would dream of feverishly trading highly profitable subsidiaries because a small move in the Federal Reserve’s discount rate was predicted or because some Wall Street pundit had reversed his views on the market.  Why, then, should we behave differently with our minority positions in wonderful businesses?  The art of investing in public companies successfully is little different from the art of successfully acquiring subsidiaries.  In each case you simply want to acquire, at a sensible price, a business with excellent economics and able, honest management.  Thereafter, you need only monitor whether these qualities are being preserved.

When carried out capably, an investment strategy of that type will often result in its practitioner owning a few securities that will come to represent a very large portion of his portfolio.  This investor would get a similar result if he followed a policy of purchasing an interest in, say, 20% of the future earnings of a number of outstanding college basketball stars.  A handful of these would go on to achieve NBA stardom, and the investor’s take from them would soon dominate his royalty stream.  To suggest that this investor should sell off portions of his most successful investments simply because they have come to dominate this portfolio is akin to suggesting that the Bulls trade Michael Jordan because he has become so important to the team.  (page 111)

Buffett reiterates that he and Charlie, when buying subsidiaries or common stocks, focus on businesses and industries unlikely to change much over time:

…The reason for that is simple:  Making either type of purchase, we are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now.  A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek.

I should emphasize that, as citizens, Charlie and I welcome change:  Fresh ideas, new products, innovative processes and the like cause our country’s standard of living to rise, and that’s clearly good.  As investors, however, our reaction to a fermenting industry is much like our attitude toward space exploration:  We applaud the endeavor but prefer to skip the ride.

Obviously all businesses change to some extent.  Today, See’s is different in many ways from what it was in 1972 when we bought it:  It offers a different assortment of candy, employs different machinery and sells through different distribution channels.  But the reasons why people today buy boxed chocolates, and why they buy them from us rather than from someone else, are virtually unchanged from what they were in the 1920s when the See family was building the business.  Moreover, these motivations are not likely to change over the next 20 years, or even 50.

Buffett goes on to discuss Coca-Cola and Gillette, labeling companies like Coca-Cola ‘The Inevitables.’  Buffett points out that he’s not downplaying the important work these companies must continue to do in order to maximize their results over time.  He’s merely saying that all sensible observers agree that Coke will dominate worldwide over an investment lifetime.  This degree of brand strength – reflected in sustainably high returns on capital – is very rare.  Buffett:

Obviously many companies in high-tech businesses or embryonic industries will grow much faster in percentage terms than will The Inevitables.  But I would rather be certain of a good result than hopeful of a great one.  (page 112)

The main danger for a great company is getting sidetracked from its wonderful core business while acquiring other businesses that are mediocre or worse.

Unfortunately, that is exactly what transpired years ago at Coke.  (Would you believe that a few decades back they were growing shrimp at Coke?)  Loss of focus is what most worries Charlie and me when we contemplate investing in businesses that in general look outstanding.  All too often, we’ve seen value stagnate in the presence of hubris or of boredom that caused the attention of managers to wander.  (page 113)


Buffett (again) recommends index funds for most investors:

Most investors, both individual and institutional, will find that the best way to own common stocks is through an index fund that charges minimal fees.  Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.

For those investors seeking to pick individual stocks, the notion of circle of competence is crucial.  Buffett and Munger are well aware of which companies they can evaluate and which they can’t.  Buffett:

If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter.  Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter.  If others claim predictive skill in those industries – and seem to have their claims validated by the behavior of the stock market – we neither envy nor emulate them.  Instead, we just stick with what we understand.  (page 115)

Mistakes of the First 25 Years

Buffett first notes that the lessons of experience are not always helpful.  But it’s still good to review past mistakes ‘before committing new ones.’  To that end, Buffett lists mistakes of the twenty-five years up until 1989:

** My first mistake, of course, was in buying control of Berkshire.  Though I knew its business – textile manufacturing – to be unpromising, I was enticed to buy because the price looked cheap.  Stock purchases of that kind had proved reasonably rewarding in my early years, though by the time Berkshire came along in 1965 I was becoming aware that the strategy was not ideal.

If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible.  I call this the ‘cigar butt’ approach to investing.  A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the ‘bargain purchase’ will make that puff all profit.

Unless you are a liquidator, that kind of approach to buying businesses is foolish.  First, the original ‘bargain’ price probably will not turn out to be such a steal after all.  In a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen.  Second, any initial advantage you secure will be quickly eroded by the low return that the business earns…

** That leads right into a related lesson:  Good jockeys will do well on good horses, but not on broken-down nags…

I’ve said many times that when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact…

** A further related lesson:  Easy does it.  After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems.  What we have learned is to avoid them.  To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers.

The finding may seem unfair, but in both business and investments it is usually far more profitable to simply stick with the easy and obvious than it is to resolve the difficult.  On occasion, tough problems must be tackled.  In other instances, a great investment opportunity occurs when a marvelous business encounters a one-time huge, but solvable, problem as was the case many years back at both American Express and GEICO…

** My most surprising discovery:  the overwhelming importance in business of an unseen force that we might call ‘the institutional imperative.’  In business school, I was given no hint of the imperative’s existence and I did not intuitively understand it when I entered the business world.  I thought then that decent, intelligent, and experienced managers would automatically make rational business decisions.  But I learned over time that isn’t so.  Instead, rationality frequently wilts when the institutional imperative comes into play.

For example:  (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction;  (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds;  (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops;  and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.

** After some mistakes, I learned to go into business only with people I like, trust, and admire… We’ve never succeeded in making a good deal with a bad person.

** Some of my worst mistakes were not publicly visible.  These were stock and business purchases whose virtues I understood and yet didn’t make… For Berkshire’s shareholders, myself included, the cost of this thumb-sucking has been huge.

** Our consistently-conservative financial policies may appear to have been a mistake, but in my view were not.  In retrospect, it is clear that significantly higher, though still conventional, leverage ratios at Berkshire would have produced considerably better returns on equity than the 23.8% we have actually averaged.  Even in 1965, perhaps we could have judged there to be a 99% probability that higher leverage would lead to nothing but good.  Correspondingly, we might have seen only a 1% chance that some shock factor, external or internal, would cause a conventional debt ratio to produce a result falling somewhere between temporary anguish and default.

We wouldn’t have liked those 99:1 odds – and never will.  A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns.  If your actions are sensible, you are certain to get good results;  in most such cases, leverage just moves things along faster.  Charlie and I have never been in a big hurry:  We enjoy the process far more than the proceeds – though we have learned to live with those also.  (pages 117-120)



Buffett in 2011:

Investment possibilities are both many and varied.  There are three major categories, however, and it’s important to understand the characteristics of each.  So let’s survey the field.

Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments.  Most of these currency-based investments are thought of as ‘safe.’  In truth they are among the most dangerous of assets.  Their beta may be zero but their risk is huge.

Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal.  This ugly result, moreover, will forever recur.  Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation.  From time to time such policies spin out of control.

Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire.  It takes no less than $7 today to buy what $1 did at that time.  Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power.  Its managers would have been kidding themselves if they thought of any portion of that interest as income.  (pages 123-124)

Buffett then notes that it’s even worse for tax-paying investors, who would have needed 5.7% annually to hold their ground.  In other words, an invisible ‘inflation tax’ has consumed 4.3% per year.  Given that interest rates today (mid-2017) are very low, currency-based investments are not attractive for the long term (decades).

The second major category of investments involves assets that will never produce anything, but that are purchased in the hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future.  Tulips, of all things, briefly became a favorite of such buyers in the 17th century.

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further.  Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.

The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful).  Gold, however, has two significant shortcomings, being neither of much use nor procreative.  True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production.  Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce of gold at its end.

Today, the world’s gold stock is about 170,000 metric tons.  If all of this gold were melded together, it would form a cube of about 68 feet per side.  (Picture it sitting comfortably within a baseball infield.)  At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion.  Call this cube pile A.

Let’s now create a pile B costing an equal amount.  For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus sixteen Exxon Mobiles (the world’s most profitable company, one earning more than $40 billion annually).  After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge).  Can you imagine an investor with $9.6 trillion selecting pile A over pile B?

A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be.  Exxon Mobile will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons).  The 170,000 tons of gold will be unchanged in size and still incapable of producing anything.  You can fondle the cube, but it will not respond.

Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold.  I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.

Our first two categories enjoy maximum popularity at peaks of fear:  Terror over economic collapse drives individuals to currency-based assets, most particularly U.S. obligations, and fear of currency collapse drives investors to sterile assets such as gold.  We heard ‘cash is king’ in late 2008, just when cash should have been deployed rather than held…

My own preference – and you knew this was coming – is our third category:  investment in productive assets, whether businesses, farms, or real estate.  Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment.  Farms, real estate, and many businesses such as Coca-Cola, IBM, and our own See’s Candy meet that double-barreled test.  Certain other companies – think of our regulated utilities for example – fail it because inflation places heavy capital requirements on them.  To earn more, their owners must invest more.  Even so, these investments will remain superior to nonproductive or currency-based assets.

Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See’s peanut brittle.  In the future the U.S. population will move more goods, consume more food, and require more living space than it does now.  People will forever exchange what they produce for what others produce.

Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens… I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined.  More important, it will be by far the safest.  (pages 125-127)


Pessimism creates low prices.  But you cannot be a contrarian blindly:

The most common cause of low prices is pessimism – sometimes pervasive, sometimes specific to a company or industry.  We want to do business in such an environment, not because we like pessimism but because we like the prices it produces.  It’s optimism that is the enemy of the rational buyer.

None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular;  a contrarian approach is just as foolish as a follow-the-crowd strategy.  What’s required is thinking rather than polling.  Unfortunately, Bertrand Russell’s observation about life in general applies with unusual force in the financial world:  ‘Most men would rather die than think.  Many do.’  (page 130)



Transaction costs eat up an astonishing degree of corporate earnings every year.  Buffett writes at length – in the 2005 letter – about how this works:

The explanation of how this is happening begins with a fundamental truth: …the most that owners in aggregate can earn between now and Judgment Day is what their businesses in aggregate earn.  True, by buying and selling that is clever or lucky, investor A may take more than his share of the pie at the expense of investor B.  And, yes, all investors feel richer when stocks soar.  But an owner can exit only by having someone take his place.  If one investor sells high, another must buy high.  For owners as a whole, there is simply no magic – no shower of money from outer space – that will enable them to extract wealth from their companies beyond that created by the companies themselves.

Indeed, owners must earn less than their businesses earn because of ‘frictional’ costs.  And that’s my point:  These costs are now being incurred in amounts that will cause shareholders to earn far less than they historically have.

To understand how this toll has ballooned, imagine for a moment that all American corporations are, and always will be, owned by a single family.  We’ll call them the Gotrocks.  After paying taxes on dividends, this family – generation after generation – becomes richer by the aggregate amount earned by its companies.  Today that amount is about $700 billion annually.  Naturally, the family spends some of these dollars.  But the portion it saves steadily compounds for its benefit.  In the Gotrocks household everyone grows wealthier at the same pace, and all is harmonious.

But let’s now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others.  The Helpers – for a fee, of course – obligingly agree to handle these transactions.  The Gotrocks still own all of corporate America;  the trades just rearrange who owns what.  So the family’s annual gain in wealth dimishes, equalling the earnings of American business minus commissions paid.  The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers.  This fact is not lost upon these broker-Helpers:  Activity is their friend and, in a wide variety of ways, they urge it on.

After a while, most of the family members realize that they are not doing so well at this new ‘beat-my-brother’ game.  Enter another set of Helpers.  These newcomers explain to each member of the Gotrocks clan that by himself he’ll never outsmart the rest of the family.  The suggested cure:  ‘Hire a manager – yes, us – and get the job done professionally.’  These manager-Helpers continue to use the broker-Helpers to execute trades;  the managers may even increase their activity so as to permit the brokers to prosper still more.  Overall, a bigger slice of the pie now goes to the two classes of Helpers.

The family’s disappointment grows.  Each of its members is now employing professionals.  Yet overall, the group’s finances have taken a turn for the worse.  The solution?  More help, of course.

It arrives in the form of financial planners and institutional consultants, who weigh in to advise the Gotrocks on selecting manager-Helpers.  The befuddled family welcomes this assistance.  By now its members know they can pick neither the right stocks nor the right stock-pickers.  Why, one might ask, should they expect success in picking the right consultant?  But this question does not occur to the Gotrocks, and the consultant-Helpers certainly don’t suggest it to them.

The Gotrocks, now supporting three classes of expensive Helpers, find that their results get worse, and they sink into despair.  But just as hope seems lost, a fourth group – we’ll call them the hyper-Helpers –  appears.  These friendly folk explain to the Gotrocks that their unsatisfactory results are occurring because the existing Helpers – brokers, managers, consultants – are not sufficiently motivated and are simply going through the motions…

The new arrivals offer a breathtakingly simple solution:  Pay more money.  Brimming with self-confidence, the hyper-Helpers assert that huge contingent payments – in addition to stiff fixed fees – are what each family member must fork over in order to really outmaneuver his relatives.

The more observant members of the family see that some of the hyper-Helpers are really just manager-Helpers wearing new uniforms, bearing sewn-on sexy names like HEDGE FUND or PRIVATE EQUITY.  The new Helpers, however, assure the Gotrocks that this change of clothing is all-important… Calmed by this explanation, the family decides to pay up.

And that’s where we are today:  A record portion of the earnings that would go in their entirety to owners – if they all just stayed in their rocking chairs – is now going to a swelling army of Helpers.  Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses – and large fixed fees to boot – when the Helpers are dumb or unlucky (or occasionally crooked).

A sufficient number of the arrangements like this – heads, the Helper takes much of the winnings;  tails, the Gotrocks lose and pay dearly for the privilege of doing so – may make it more accurate to call the family the Hadrocks.  Today, in fact, the family’s frictional costs of all sorts may well amount to 20% of the earnings of American business.  In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80% or so of what they would earn if they just sat still and listened to no one.

Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius.  But Sir Isaac’s talents didn’t extend to investing:  He lost a bundle in the South Sea Bubble explaining later, ‘I can calculate the movement of the stars, but not the madness of men.’  If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion:  For investors as a whole, returns decrease as motion increases.  (pages 169-172)

For more details, see:



The Oracle of Omaha says:

Of all our activities at Berkshire, the most exhilarating for Charlie and me is the acquisition of a business with excellent economic characteristics and a management that we like, trust, and admire.  Such acquisitions are not easy to make, but we look for them constantly…

In the past, I’ve observed that many acquisition-hungry managers were apparently mesmerized by their childhood reading of the story about the frog-kissing princess.  Remembering her success, they pay dearly for the right to kiss corporate toads, expecting wondrous transfigurations.  Initially, disappointing results only deepen their desire to round up new toads… Ultimately, even the most optimistic manager must face reality.  Standing knee-deep in unresponsive toads, he then announces an enormous ‘restructuring’ charge.  In this corporate equivalent of a Head Start program, the CEO receives the education but the stockholders pay the tuition.  (page 199)

Not only do most acquisitions fail to create value for the acquirer;  many actually destroy value.  However, a few do create value.  Buffett writes:

…many managerial princesses remain serenely confident about the future potency of their kisses – even after their corporate backyards are knee-deep in unresponsive toads.  In fairness, we should acknowledge that some acquisition records have been dazzling.  Two major categories stand out.

The first involves companies that, through design or accident, have purchased only businesses that are particularly well adapted to an inflationary environment.  Such favored business must have two characteristics:  (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accomodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital.  Managers of ordinary ability, focusing only on acquisition possibilities meeting these tests, have achieved excellent results in recent decades.  However, very few enterprises possess both characteristics, and competition for those that do has now become fierce to the point of being self-defeating.

The second category involves the managerial superstars – who can recognize the rare prince who is disguised as a toad, and who have managerial abilities that enable them to peel away the disguise.  (page 201)

Capital allocation decisions, including value-destroying acquisitions, add up over the long term.  Buffett:

Over time, the skill with which a company’s managers allocate capital has an enormous impact on the enterprise’s value.  Almost by definition, a really good business generates far more money (at least after its early years) than it can use internally.  The company could, of course, distribute the money to shareholders by way of dividends or share repurchases.  But often the CEO asks a strategic planning staff, consultants or investment bankers whether an acquisition or two might make sense.  That’s like asking your interior decorator whether you need a $50,000 rug.

The acquisition problem is often compounded by a biological bias:  Many CEOs obtain their positions in part because they possess an abundance of animal spirits and ego.  If an executive is heavily endowed with these qualities – which, it should be acknowledged, sometimes have their advantages – they won’t disappear when he reaches the top…

At Berkshire, our managers will continue to earn extraordinary returns from what appear to be ordinary businesses.  As a first step, these managers will look for ways to deploy their earnings advantageously in their businesses.  What’s left, they will send to Charlie and me.  We then will try to use those funds in ways that build per-share intrinsic value.  Our goal will be to acquire either part or all of businesses that we believe we understand, that have good, sustainable underlying economics, and that are run by managers whom we like, admire and trust.  (pages 209-210)

Over the years, Berkshire Hathaway has become the buyer of choice for many private business owners.  Buffett remarks:

Our long-avowed goal is to be the ‘buyer of choice’ for businesses – particularly those built and owned by families.  The way to achieve this goal is to deserve it.  That means we must keep our promises;  avoid leveraging up acquired businesses;  grant unusual autonomy to our managers;  and hold the purchased companies through think and thin (though we prefer thick and thicker).

Our record matches our rhetoric.  Most buyers competing against us, however, follow a different path.  For them, acquisitions are ‘merchandise.’  Before the ink dries on their purchase contracts, these operators are contemplating ‘exit strategies.’  We have a decided advantage, therefore, when we encounter sellers who truly care about the future of their businesses.  (pages 221-222)



Buffett writes about Aesop and the Inefficient Bush Theory:

The formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.).

The oracle was Aesop, and his enduring, though somewhat incomplete, investment insight was ‘a bird in the hand is worth two in the bush.’  To flesh out this principle, you must answer only three questions.  How certain are you that there are indeed birds in the bush?  When will they emerge and how many will there be?  What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)?  If you can answer these three questions, you will know the maximum value of the bush – and the maximum number of the birds you now possess that should be offered for it.  And, of course, don’t literally think birds.  Think dollars.

Aesop’s investment axiom, thus expanded and converted into dollars, is immutable.  It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants.  And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota – nor will the Internet.  Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.

Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business.  Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years…

Alas, though Aesop’s proposition and the third variable – that is, interest rates – are simple, plugging in numbers for the other two variables is a difficult task.  Using precise numbers is, in fact, foolish;  working with a range of possibilities is the better approach.

Usually, the range must be so wide that no useful conclusion can be reached.  Occasionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startingly low in relation to value.  (Let’s call this phenomenon the IBT – Inefficient Bush Theory.)  To be sure, an investor needs some general understanding of business economics as well as the ability to think independently to reach a well-founded positive conclusion.  But the investor does not need brilliance nor blinding insights.

At the other extreme, there are many times when the most brilliant of investors can’t muster a conviction about the birds to emerge, not even when a very broad range of estimates is employed.  This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination.  In cases of this sort, any capital commitment must be labeled speculative.

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs.  Nothing sedates rationality like large doses of effortless money.  (pages 223-224)

Here Buffett is talking about the bubble in internet stocks in 1999.  He acknowledges that, overall, much value had been created and there was much more to come.  However, many individual internet companies destroyed value rather than creating it.

As noted earlier, Buffett and Munger love technological progress.  But they generally don’t invest in tech companies because it doesn’t fit their buy-and-hold approach.  It’s just not their game.  Some venture capitalists have excelled at it, but it usually takes a statistical investment approach whereby a few big winners eventually outweigh a large number of losses.

Buffett again:

At Berkshire, we make no attempt to pick the few winners that will emerge from an ocean of unproven enterprises.  We’re not smart enough to do that, and we know it.  Instead, we try to apply Aesop’s 2600-year-old equation to opportunities in which we have reasonable confidence as to how many birds are in the bush and when they will emerge (a formulation that my grandsons would probably update to ‘A girl in the convertible is worth five in the phone book.’)  Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount.  We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners.  Even so, we make many mistakes:  I’m the fellow, remember, who thought he understood the future economics of trading stamps, textiles, shoes and second-tier department stores.  (page 226)

Buffett writes about how to evaluate management:

The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.  In our view, many businesses would be better understood by their shareholder owners, as well as the general public, if managements and financial analysts modified the primary emphasis they place upon earnings per share, and upon yearly changes in that figure.  (page 237)

This leads to a discussion of economic Goodwill:

…businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return.  The capitalized value of this excess return is economic Goodwill.

In 1972 (and now) relatively few businesses could be expected to consistently earn the 25% after tax on net tangible assets that was earned by See’s – doing it, furthermore, with conservative accounting and no financial leverage.  It was not the fair market value of inventories, receivables or fixed assets that produced the premium rates of return.  Rather it was a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.

Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price.  Consumer franchises are a prime source of economic Goodwill.  Other sources include governmental franchises not subject to profit regulation… and an enduring position as the low cost producer in an industry.  (page 239)

Buffett compares economic Goodwill with accounting Goodwill.  As mentioned, economic Goodwill is when the net tangible assets produce earnings in excess of market rates of return.  By contrast, accounting Goodwill is when company A buys company B, and the price paid is above the fair market value of net tangible assets.  The difference between price paid and net tangible asset value is accounting Goodwill.

In the past, companies would amortize accounting Goodwill, typically over a 40-year period.  But the current rule is that companies periodically test the value of the assets acquired.  If it is determined that the acquired assets have less value than when acquired, then the accounting Goodwill is written down based on an impairment charge.  This new way of measuring accounting Goodwill is what Buffett and Munger suggested (see page 247).

Earlier we saw that the net present value of any business is the discounted value of its future cash flows.  However, when we estimate future cash flows, it’s important to distinguish between earnings and free cash flow.  Buffett uses the the term owner earnings instead of free cash flow.  Buffett on owner earnings:

…These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges… less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.

Buffett then observes that item (c), capital expenditures, usually requires a guess.  So owner earnings, or free cash flow, must also be an estimate.  Nonetheless, free cash flow is what matters when estimating the intrinsic value of a business.

If a business requires heavy capital expenditures to maintain its competitive position, that’s worth less to an owner.  By the same logic, if a business requires very little capital investment to maintain its competitive position, that’s clearly worth much more.  The capital-light business will generally earn much higher returns on capital.

So, generally speaking, as Buffett points out, when capital expenditure requirements exceed depreciation, GAAP earnings overstate owner earnings.  When capital expenditure requirements are less than depreciation, GAAP earnings understate owner earnings.

Moreover, Buffett offers a warning.  Often marketers of businesses and securities present ‘cash flow’ as simply (a) plus (b), without subtracting (c).  However, looking at cash flows without subtracting capital expenditures can give you a very misleading notion of what the business is worth.  Every business must make some capital expenditures over time to maintain its competitive position.

Buffett sums up the discussion of owner earnings – or free cash flow – with a note on accounting:

Accounting numbers of course, are the language of business and as such are of enormous help to anyone evaluating the worth of a business and tracking its progress.  Charlie and I would be lost without these numbers:  they invariably are the starting point for us in evaluating our own businesses and those of others.  Managers and owners need to remember, however, that accounting is but an aid to business thinking, never a substitute for it.  (page 254)



Buffett observes that managers should try to report the essential information that investors need:

What needs to be reported is data – whether GAAP, non-GAAP, or extra-GAAP – that helps financially literate readers answer three key questions:  (1) Approximately how much is this company worth?  (2) What is the likelihood that it can meet its future obligations?  and (3) How good a job are its managers doing, given the hand they have been dealt?  (page 259)

In 1998, Buffett observed that it had become common to manipulate accounting statements:

In recent years, probity has eroded.  Many major corporations still play things straight, but a significant and growing number of otherwise high-grade managers – CEOs you would be happy to have as spouses for your children or as trustees under your will – have come to the view that it’s OK to manipulate earnings to satisfy what they believe are Wall Street’s desires.  Indeed, many CEOs think this kind of manipulation is not only okay, but actually their duty.

These managers start with the assumption, all too common, that their job at all times is to encourage the highest stock price possible (a premise with which we adamantly disagree).  To pump the price, they strive, admirably, for operational excellence.  But when operations don’t produce the result hoped for, these CEOs result to unadmirable accounting strategems.  These either manufacture the desired ‘earnings’ or set the stage for them in the future.

Rationalizing this behavior, these managers often say that their shareholders will be hurt if their currency for doing deals – that is, their stock – is not fully-priced, and they also argue that in using accounting shenanigans to get the figures they want, they are only doing what everybody else does.  Once such an everybody’s-doing-it attitude takes hold, ethical misgivings vanish.  Call this behavior Son of Gresham:  Bad accounting drives out good.

The distortion du jour is the ‘restructuring charge,’ an accounting entry that can, of course, be legitimate but that too often is a device for manipulating earnings.  In this bit of legerdemain, a large chunk of costs that should properly be attributed to a number of years is dumped into a single quarter, typically one already fated to disappoint investors.  In some case, the purpose of the charge is to clean up earnings misrepresentations of the past, and in others it is to prepare the ground for future misrepresentations.  In either case, the size and timing of these charges is dictated by the cynical proposition that Wall Street will not mind if earnings fall short by $5 per share in a given quarter, just as long as this deficiency ensures that quarterly earnings in the future will consistently exceed expectations by five cents per share.

This dump-everything-into-one-quarter behavior suggests a corresponding ‘bold, imaginative’ approach to – golf scores.  In his first round of the season, a golfer should ignore his actual performance and simply fill his card with atrocious numbers – double, triple, quadruple bogeys – and then turn in a score of, say, 140.  Having established this ‘reserve,’ he should go to the golf shop and tell his pro that he wishes to ‘restructure’ his imperfect swing.  Next, as he takes his new swing onto the course, he should count his good holes, but not his bad ones.  These remnants from his old swing should be charged instead to the reserve established earlier.  At the end of five rounds, then, his record will be 140, 80, 80, 80, 80 rather than 91, 94, 89, 94, 92.  On Wall Street, they will ignore the 140 – which, after all, came from a ‘discontinued’ swing – and will classify our hero as an 80 shooter (and one who never disappoints).

For those who prefer to cheat up front, there would be a variant of this strategy.  The golfer, playing alone with a cooperative caddy-auditor, should defer the recording of bad holes, take four 80s, accept the plaudits he gets for such athleticism and consistency, and then turn in a fifth card carrying a 140 score.  After rectifying his earlier scorekeeping sins with this ‘big bath,’ he may mumble a few apologies but will refrain from returning the sums he has previously collected from comparing scorecards in the clubhouse.  (The caddy, need we add, will have acquired a loyal patron.)

Unfortunately, CEOs who use variations of these scoring schemes in real life tend to become addicted to the games they’re playing – after all, it’s easier to fiddle with the scorecard than to spend hours on the practice tee – and never muster the will to give them up.  (pages 272-273)


In discussing pension estimates, Buffett explains why index fund investors will do better  – net of all costs – than active investors:

Naturally, everyone expects to be above average.  And those helpers – bless their hearts – will certainly encourage their clients in this belief.  But, as a class, the helper-aided group must be below average.  The reason is simple:  (1)  Investors, overall, will necessarily earn an average return, minus costs they incur;  (2)  Passive and index investors, through their very inactivity, will earn that average minus costs that are very low;  (3)  With that group earning average returns, so must the remaining group – the active investors.  But this group will incur high transaction, management, and advisory costs.  Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren.  That means that the passive group – the ‘know-nothings’ – must win.  (page 276)



Remarks by Buffett (in early 2015) on Berkshire’s fiftieth anniversary:

At Berkshire, we can – without incurring taxes or much in the way of other costs – move huge sums from businesses that have limited opportunities for incremental investment to other sectors with greater promise.  Moreover, we are free of historical biases created by lifelong association with a given industry and are not subject to pressures from colleagues having a vested interest in maintaining the status quo.  That’s important:  If horses had controlled investment decisions, there would have been no auto industry.

Another major advantage we possess is an ability to buy pieces of wonderful business – a.k.a. common stocks.  That’s not a course of action open to most managements.  Over our history, this strategic alternative has proved to be very helpful;  a broad range of options sharpens decision-making.  The businesses we are offered by the stock market every day – in small pieces, to be sure – are often far more attractive than the businesses we are concurrently being offered in their entirety.  Additionally, the gains we’ve realized from marketable securities have helped us make certain large acquisitions that would otherwise have been beyond our financial capabilities.

In effect, the world is Berkshire’s oyster – a world offering us a range of opportunities far beyond those realistically open to most companies.  We are limited, of course, to businesses whose economic prospects we can evaluate.  And that’s a serious limitation:  Charlie and I have no idea what a great many companies will look like ten years from now.  But that limitation is much smaller than that borne by an executive whose experience has been confined to a single industry.  On top of that, we can profitably scale to a far larger size than many businesses that are constrained by the limited potential of the single industry in which they operate.

Berkshire has one further advantage that has become increasingly important over the years:  We are now the home of choice for the owners and managers of many outstanding businesses.  Families that own successful businesses have multiple options when they contemplate sale.  Frequently, the best decision is to do nothing.  There are worse things in life than having a prosperous business that one understands well.  But sitting tight is seldom recommended by Wall Street.  (Don’t ask the barber whether you need a haircut.)

When one part of a family wishes to sell while others wish to continue, a public offering often makes sense.  But, when owners wish to cash out entirely, they usually consider one of two paths.  The first is sale to a competitor who is salivating at the possibility of wringing ‘synergies’ from the combining of the two companies.  The buyer invariably contemplates getting rid of large numbers of the seller’s associates, the very people who have helped the owner build his business.  A caring owner, however – and there are plenty of them – usually does not want to leave his long-time associates sadly singing the old country song:  ‘She got the goldmine, I got the shaft.’

The second choice for sellers is the Wall Street buyer.  For some years, these purchasers accurately called themselves ‘leveraged buyout firms.’  When that term got a bad name in the early 1990s – remember RJR and Barbarians at the Gate? – these buyers hastily relabeled themselves ‘private-equity.’  The name may have changed but that was all:  Equity is dramatically reduced and debt is piled on in virtually all private-equity purchases.  Indeed, the amount that a private-equity purchaser offers to the seller is in part determined by the buyer assessing the maximum amount of debt that can be placed on the acquired company.

Later, if things go well and equity begins to build, leveraged buy-out shops will often seek to re-leverage with new borrowings.  They then typically use part of the proceeds to pay a huge dividend that drives equity sharply downward, sometimes even to a negative figure.  In truth, ‘equity’ is a dirty word for many private-equity buyers;  what they love is debt.  And, these buyers can frequently pay top dollar.  Later the business will be resold, often to another leveraged buyer.  In effect, the business becomes a piece of merchandise.

Berkshire offers a third choice to the business owner who wishes to sell:  a permanent home, in which the company’s people and culture will be retained (though, occasionally, management changes will be needed).  Beyond that, any business we acquire dramatically increases its financial strength and ability to grow.  Its days of dealing with banks and Wall Street analysts are also forever ended.  Some sellers don’t care about these matters.  But, when sellers do, Berkshire does not have a lot of competition.  (pages 289-291)

Buffett also observes that companies are worth more as a part of Berkshire than they would be separately.  Berkshire can move funds between businesses or to new ventures instantly and without tax.  Also, some costs would be duplicated if the businesses were independent entities.  This includes regulatory and administrative expenses.  Moreover, there are tax efficiencies, says Buffett:  Certain tax credits available to Berkshire’s utilities are realizable because Berkshire generates large taxable income in other operations.

Buffett sums it up:

Today Berkshire possesses (1) an unmatched collection of businesses, most of them now enjoying favorable economic prospects;  (2) a cadre of outstanding managers who, with few exceptions, are unusually devoted to both the subsidiary they operate and to Berkshire;  (3) an extraordinary diversity of earnings, premier financial strength and oceans of liquidity that we will maintain under all circumstances;  (4) a first-choice ranking among many owners and managers who are contemplating sale of their businesses;  and (5) in a point related to the preceding item, a culture, distinctive in many ways from that of most large companies, that we have worked 50 years to develop and that is now rock-solid.  These strengths provide us a wonderful foundation on which to build.  (page 292)

For the rest of Buffett’s comments, as well as observations by Charles T. Munger on the history and evolution of Berkshire Hathaway, see pages 34-43 of the 2014 letter:



An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are 15-25 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 10-15% (at cost), while the average position is 5-7% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees.  The Boole Fund has low fees. 


If you are interested in finding out more, please e-mail me or leave a comment.

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Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.