Boole Microcap Fund

September 1, 2024

Are you a long-term investor? If so, are you interested in maximizing long-term results without taking undue risk?

Warren Buffett, arguably the best investor ever, has repeatedly said that most people should invest in a low-cost broad market index fund. Such an index fund will allow you to do better than 80% to 90% of all investors, net of costs, after several decades.

Buffett has also said that you can do better than an index fund by investing in microcap stocks – as long as you have a sound method. Take a look at this summary of the CRSP Decile-Based Size and Return Data from 1927 to 2020:

Decile	Market Cap-Weighted Returns	Equal Weighted Returns	Number of Firms (year-end 2020)	Mean Firm Size (in millions)
1	9.67%	9.47%	179	145,103
2	10.68%	10.63%	173	25,405
3	11.38%	11.17%	187	12,600
4	11.53%	11.29%	203	6,807
5	12.12%	12.03%	217	4,199
6	11.75%	11.60%	255	2,771
7	12.01%	11.99%	297	1,706
8	12.03%	12.33%	387	888
9	11.55%	12.51%	471	417
10	12.41%	17.27%	1,023	99
9+10	11.71%	15.77%	1,494	199

(CRSP is the Center for Research in Security Prices at the University of Chicago. You can find the data for various deciles here: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html)

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 9^th and 10^th size deciles from 1927 to 2020:

Microcap equal weighted returns = 15.8% per year

Large-cap equal weighted returns = ~10% 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 2020, versus 10% per year for an equal weighted large-cap approach.

Still, if you can do 4% 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.

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

 

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: https://boolefund.com/joseph-piotroski-value-investing/

 

BOTTOM LINE

If you invest in microcap stocks, you can get about 14% a year. If you also use a simple screen for value, that adds at least 2% a year. If, in addition, you screen for improving fundamentals, that adds at least another 2% a year. So that takes you to 18% a year, which compares quite well to the 10% a year you could get from an S&P 500 index fund.

What’s the difference between 18% a year and 10% a year? If you invest $50,000 at 10% a year for 30 years, you end up with $872,000, which is good. If you invest $50,000 at 18% a year for 30 years, you end up with $7.17 million, which is much better.

Please contact me if you would like to learn more.

• • My email: [email protected].
  • My cell: 206.518.2519

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.

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 roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approachesintrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). 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: [email protected]

 

 

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.

 

June 30, 2024

There’s Always Something to Do: The Peter Cundill Investment Approach, by Christopher Risso-Gill (2011), is an excellent book. Cundill was a highly successful deep value investor whose chosen method was to buy stocks below their liquidation value.

Here is an outline for this blog post:

• Peter Cundill
• Getting to First Base
• Launching a Value Fund
• Value Investment in Action
• Going Global
• A Decade of Success
• Investments and Stratagems
• Learning From Mistakes
• Entering the Big League
• There’s Always Something Left to Learn
• Pan Ocean
• Fragile X
• What Makes a Great Investor?
• Glossary of Terms with Cundill’s Comments

 

PETER CUNDILL

It was December in 1973 when Peter Cundill first discovered value investing. He was 35 years old at the time. Up until then, despite a great deal of knowledge and experience, Cundill hadn’t yet discovered an investment strategy. He happened to be reading George Goodman’s Super Money on a plane when he came across chapter 3 on Benjamin Graham and Warren Buffett. Cundill wrote about his epiphany that night in his journal:

…there before me in plain terms was the method, the solid theoretical back-up to selecting investments based on the principle of realizable underlying value. My years of apprenticeship were over: ‘THIS IS WHAT I WANT TO DO FOR THE REST OF MY LIFE!’

What particularly caught Cundill’s attention was Graham’s notion that a stock is cheap if it sells below liquidation value. The farther below liquidation value the stock is, the higher the margin of safety and the higher the potential returns. This idea is at odds with modern finance theory, according to which getting higher returns always requires taking more risk.

Peter Cundill became one of the best value investors in the world. He followed a deep value strategy based entirely on buying companies below their liquidation values.

We do liquidation analysis and liquidation analysis only.

 

GETTING TO FIRST BASE

One of Cundill’s first successful investments was in Bethlehem Copper. Cundill built up a position at $4.50, roughly equal to cash on the balance sheet and far below liquidation value:

Both Bethlehem and mining stocks in general were totally out of favour with the investing public at the time. However in Peter’s developing judgment this was not just an irrelevance but a positive bonus. He had inadvertently stumbled upon a classic net-net: a company whose share price was trading below its working capital, net of all its liabilities. It was the first such discovery of his career and had the additional merit of proving the efficacy of value theory almost immediately, had he been able to recognize it as such. Within four months Bethlehem had doubled and in six months he was able to start selling some of the position at $13.00. The overall impact on portfolio performance had been dramatic.

Riso-Gill describes Cundill as having boundless curiosity. Cundill would not only visit the worst performing stock market in the world near the end of each year in search of bargains. But he also made a point of total immersion with respect to the local culture and politics of any country in which he might someday invest.

 

LAUNCHING A VALUE FUND

Early on, Cundill had not yet developed the deep value approach based strictly on buying below liquidation value. He had, however, concluded that most models used in investment research were useless and that attempting to predict the general stock market was not doable with any sort of reliability. Eventually Cundill immersed himself in Graham and Dodd’s Security Analysis, especially chapter 41, “The Asset-Value Factor in Common-Stock Valuation,” which he re-read and annotated many times.

When Cundill was about to take over an investment fund, he wrote to the shareholders about his proposed deep value investment strategy:

The essential concept is to buy under-valued, unrecognized, neglected, out of fashion, or misunderstood situations where inherent value, a margin of safety, and the possibility of sharply changing conditions created new and favourable investment opportunities. Although a large number of holdings might be held, performance was invariably established by concentrating in a few holdings. In essence, the fund invested in companies that, as a result of detailed fundamental analysis, were trading below their ‘intrinsic value.’ The intrinsic value was defined as the price that a private investor would be prepared to pay for the security if it were not listed on a public stock exchange. The analysis was based as much on the balance sheet as it was on the statement of profit and loss.

Cundill went on to say that he would only buy companies trading below book value, preferably below net working capital less long term debt (Graham’s net-net method). Cundill also required that the company be profitable–ideally having increased its earnings for the past five years–and dividend-paying–ideally with a regularly increasing dividend. The price had to be less than half its former high and preferably near its all time low. And the P/E had to be less than 10.

Cundill also studied past and future profitability, the ability of management, and factors governing sales volume and costs. But Cundill made it clear that the criteria were not always to be followed precisely, leaving room for investment judgment, which he eventually described as an art form.

Cundill told shareholders about his own experience with the value approach thus far. He had started with $600,000, and the portfolio increased 35.2%. During the same period, the All Canadian Venture Fund was down 49%, the TSE industrials down 20%, and the Dow down 26%. Cundill also notes that 50% of the portfolio had been invested in two stocks (Bethlehem Copper and Credit Foncier).

About this time, Irving Kahn became a sort of mentor to Cundill. Kahn had been Graham’s teaching assistant at Columbia University.

 

VALUE INVESTMENT IN ACTION

Having a clearly defined set of criteria helped Cundill to develop a manageable list of investment candidates in the decade of 1974 to 1984 (which tended to be a good time for value investors). The criteria also helped him identify a number of highly successful investments.

For example, the American Investment Company (AIC), one of the largest personal loan companies in the United States, saw its stock fall from over $30.00 to $3.00, despite having a tangible book value per share of $12.00. As often happens with good contrarian value candidates, the fears of the market about AIC were overblown. Eventually the retail loan market recovered, but not before Cundill was able to buy 200,000 shares at $3.00. Two years later, AIC was taken over at $13.00 per share by Leucadia. Cundill wrote:

As I proceed with this specialization into buying cheap securities I have reached two conclusions. Firstly, very few people really do their homework properly, so now I always check for myself. Secondly, if you have confidence in your own work, you have to take the initiative without waiting around for someone else to take the first plunge.

…I think that the financial community devotes far too much time and mental resource to its constant efforts to predict the economic future and consequent stock market beaviour using a disparate, and almost certainly incomplete, set of statistical variables. It makes me wonder what might be accomplished if all this time, energy, and money were to be applied to endeavours with a better chance of proving reliable and practically useful.

Meanwhile, Cundill had served on the board of AIC, which brought some valuable experience and associations.

Cundill found another highly discounted company in Tiffany’s. The company owned extremely valuable real estate in Manhattan that was carried on its books at a cost much lower than the current market value. Effectively, the brand was being valued at zero. Cundill accumulated a block of stock at $8.00 per share. Within a year, Cundill was able to sell it at $19.00. This seemed like an excellent result, except that six months later, Avon Products offered to buy Tiffany’s at $50.00. Cundill would comment:

The ultimate skill in this business is in knowing when to make the judgment call to let profits run.

Sam Belzberg–who asked Cundill to join him as his partner at First City Financial–described Cundill as follows:

He has one of the most important attributes of the master investor because he is supremely capable of running counter to the herd. He seems to possess the ability to consider a situation in isolation, cutting himself off from the mill of general opinion. And he has the emotional confidence to remain calm when events appear to be indicating that he’s wrong.

 

GOING GLOBAL

Partly because of his location in Canada, Cundill early on believed in global value investing. He discovered that just as individual stocks can be neglected and misunderstood, so many overseas markets can be neglected and misunderstood. Cundill enjoyed traveling to these various markets and learning the legal accounting practices. In many cases, the difficulty of mastering the local accounting was, in Cundill’s view, a ‘barrier to entry’ to other potential investors.

Cundill also worked hard to develop networks of locally based professionals who understood value investing principles. Eventually, Cundill developed the policy of exhaustively searching the globe for value, never favoring domestic North American markets.

 

A DECADE OF SUCCESS

Cundill summarized the lessons of the first 10 years, during which the fund grew at an annual compound rate of 26%. He included the following:

• The value method of investing will tend at least to give compound rates of return in the high teens over longer periods of time.
• There will be losing years; but if the art of making money is not to lose it, then there should not be substantial losses.
• The fund will tend to do better in slightly down to indifferent markets and not to do as well as our growth-oriented colleagues in good markets.
• It is ever more challenging to perform well with a larger fund…
• We have developed a network of contacts around the world who are like-minded in value orientation.
• We have gradually modified our approach from a straight valuation basis to one where we try to buy securities selling below liquidation value, taking into consideration off-balance sheet items.
• THE MOST IMPORTANT ATTRIBUTE FOR SUCCESS IN VALUE INVESTING IS PATIENCE, PATIENCE, AND MORE PATIENCE. THE MAJORITY OF INVESTORS DO NOT POSSESS THIS CHARACTERISTIC.

 

INVESTMENTS AND STRATAGEMS

Buying at a discount to liquidation value is simple in concept. But in practice, it is not at all easy to do consistently well over time. Peter Cundill explained:

None of the great investments come easily. There is almost always a major blip for whatever reason and we have learnt to expect it and not to panic.

Although Cundill focused exclusively on discount to liquidation value when analyzing equities, he did develop a few additional areas of expertise, such as distressed debt. Cundill discovered that, contrary to his expectation of fire-sale prices, an investor in distressed securities could often achieve large profits during the actual process of liquidation. Success in distressed debt required detailed analysis.

 

LEARNING FROM MISTAKES

1989 marked the fifteenth year in a row of positive returns for Cundill’s Value Fund. The compound growth rate was 22%. But the fund was only up 10% in 1989, which led Cundill to perform his customary analysis of errors:

…How does one reduce the margin of error while recognizing that investments do, of course, go down as well as up? The answers are not absolutely clear cut but they certainly include refusing to compromise by subtly changing a question so that it shapes the answer one is looking for, and continually reappraising the research approach, constantly revisiting and rechecking the detail.

What were last year’s winners? Why?–I usually had the file myself, I started with a small position and stayed that way until I was completely satisfied with every detail.

For most value investors, the investment thesis depends on a few key variables, which should be written down in a short paragraph. It’s important to recheck each variable periodically. If any part of the thesis has been invalidated, you must reassess. Usually the stock is no longer a bargain.

It’s important not to invent new reasons for owning the stock if one of the original reasons has been falsified. Developing new reasons for holding a stock is usually misguided. However, you need to remain flexible. Occasionally the stock in question is still a bargain.

 

ENTERING THE BIG LEAGUE

In the mid 1990’s, Cundill made a large strategic shift out of Europe and into Japan. Typical for a value investor, he was out of Europe too early and into Japan too early. Cundill commented:

We dined out in Europe, we had the biggest positions in Deutsche Bank and Paribas, which both had big investment portfolios, so you got the bank itself for nothing. You had a huge margin of safety–it was easy money. We had doubles and triples in those markets and we thought we were pretty smart, so in 1996 and 1997 we took our profits and took flight to Japan, which was just so beaten up and full of values. But in doing so we missed out on some five baggers, which is when the initial investment has multiplied five times, and we had to wait at least two years before Japan started to come good for us.

This is a recurring problem for most value investors–that tendency to buy and to sell too early. The virtues of patience are severely tested and you get to thinking it’s never going to work and then finally your ship comes home and you’re so relieved that you sell before it’s time. What we ought to do is go off to Bali or some such place and sit in the sun to avoid the temptation to sell too early.

As for Japan, Cundill had long ago learned the lesson that cheap stocks can stay cheap for “frustratingly long” periods of time. Nonetheless, Cundill kept loading up on cheap Japanese stocks in a wide range of sectors. In 1999, his Value Fund rose 16%, followed by 20% in 2000.

 

THERE’S ALWAYS SOMETHING LEFT TO LEARN

Although Cundill had easily avoided Nortel, his worst investment was nevertheless in telecommunications: Cable & Wireless (C&W). In the late 1990’s, the company had to give up many of its networks in newly independent former British colonies. The shares dropped from 15 pounds per share to 6 pounds.

A new CEO, Graham Wallace, was brought in. He quickly and skillfully negotiated a series of asset sales, which dramatically transformed the balance sheet from net debt of 4 billion pounds to net cash of 2.6 billion pounds. Given the apparently healthy margin of safety, Cundill began buying shares in March 2000 at just over 4 pounds per share. (Net asset value was 4.92 pounds per share.) Moreover:

[Wallace was] generally regarded as a relatively safe pair of hands unlikely to be tempted into the kind of acquisition spree overseen by his predecessor.

Unfortunately, a stream of investment bankers, management consultants, and brokers made a simple but convincing pitch to Wallace:

the market for internet-based services was growing at three times the rate for fixed line telephone communications and the only quick way to dominate that market was by acquisition.

Wallace proceeded to make a series of expensive acquisitions of loss-making companies. This destroyed C&W’s balance sheet and also led to large operating losses. Cundill now realized that the stock could go to zero, and he got out, just barely. As Cundill wrote later:

… So we said, look they’ve got cash, they’ve got a valuable, viable business and let’s assume the fibre optic business is worth zero–it wasn’t, it was worth less than zero, much, much less!

Cundill had invested nearly $100 million in C&W, and they lost nearly $59 million. This loss was largely responsible for the fund being down 11% in 2002. Cundill realized that his investment team needed someone to be a sceptic for each potential investment.

 

PAN OCEAN

In late 2002, oil prices began to rise sharply based on global growth. Cundill couldn’t find any net-net’s among oil companies, so he avoided these stocks. Some members of his investment team argued that there were some oil companies that were very undervalued. Finally, Cundill announced that if anyone could find an oil company trading below net cash, he would buy it.

Cundill’s cousin, Geoffrey Scott, came across a neglected company: Pan Ocean Energy Corporation Ltd. The company was run by David Lyons, whose father, Vern Lyons, had founded Ocelot Energy. Lyons concluded that there was too much competition for a small to medium sized oil company operating in the U.S. and Canada. The risk/reward was not attractive.

What he did was to merge his own small Pan Ocean Energy with Ocelot and then sell off Ocelot’s entire North American and other peripheral parts of the portfolio, clean up the balance sheet, and bank the cash. He then looked overseas and determined that he would concentrate on deals in Sub-Saharan Africa, where licenses could be secured for a fraction of the price tag that would apply in his domestic market.

Lyons was very thorough and extremely focused… He narrowed his field down to Gabon and Tanzania and did a development deal with some current onshore oil production in Gabon and a similar offshore gas deal in Tanzania. Neither was expensive.

Geoffrey Scott examined Pan Ocean, and found that its share price was almost equal to net cash and the company had no debt. He immediately let Cundill know about it. Cundill met with David Lyons and was impressed:

This was a cautious and disciplined entrepreneur, who was dealing with a pool of cash that in large measure was his own.

Lyons invited Cundill to see the Gabon project for himself. Eventually, Cundill saw both the Gabon project and the Tanzania project. He liked what he saw. Cundill’s fund bought 6% of Pan Ocean. They made six times their money in two and a half years.

 

FRAGILE X

As early as 1998, Cundill had noticed a slight tremor in his right arm. The condition worsened and affected his balance. Cundill continued to lead a very active life, still reading and traveling all the time, and still a fitness nut. He was as sharp as ever in 2005. Risso-Gill writes:

Ironically, just as Peter’s health began to decline an increasing number of industry awards for his achievements started to come his way.

For instance, he received the Analyst’s Choice award as “The Greatest Mutual Fund Manager of All Time.”

In 2009, Cundill decided that it was time to step down, as his condition had progressively worsened. He continued to be a voracious reader.

 

WHAT MAKES A GREAT INVESTOR?

Risso-Gill tries to distill from Cundill’s voluminous journal writings what Cundill himself believed it took to be a great value investor.

INSATIABLE CURIOSITY

Curiosity is the engine of civilization. If I were to elaborate it would be to say read, read, read, and don’t forget to talk to people, really talk, listening with attention and having conversations, on whatever topic, that are an exchange of thoughts. Keep the reading broad, beyond just the professional. This helps to develop one’s sense of perspective in all matters.

PATIENCE

Patience, patience, and more patience…

CONCENTRATION

You must have the ability to focus and to block out distractions. I am talking about not getting carried away by events or outside influences–you can take them into account, but you must stick to your framework.

ATTENTION TO DETAIL

Never make the mistake of not reading the small print, no matter how rushed you are. Always read the notes to a set of accounts very carefully–they are your barometer… They will give you the ability to spot patterns without a calculator or spreadsheet. Seeing the patterns will develop your investment insights, your instincts–your sense of smell. Eventually it will give you the agility to stay ahead of the game, making quick, reasoned decisions, especially in a crisis.

CALCULATED RISK

… Either [value or growth investing] could be regarded as gambling, or calculated risk. Which side of that scale they fall on is a function of whether the homework has been good enough and has not neglected the fieldwork.

INDEPENDENCE OF MIND

I think it is very useful to develop a contrarian cast of mind combined with a keen sense of what I would call ‘the natural order of things.’ If you can cultivate these two attributes you are unlikely to become infected by dogma and you will begin to have a predisposition toward lateral thinking–making important connections intuitively.

HUMILITY

I have no doubt that a strong sense of self belief is important–even a sense of mission–and this is fine as long as it is tempered by a sense of humour, especially an ability to laugh at oneself. One of the greatest dangers that confront those who have been through a period of successful investment is hubris–the conviction that one can never be wrong again. An ability to see the funny side of oneself as it is seen by others is a strong antidote to hubris.

ROUTINES

Routines and discipline go hand in hand. They are the roadmap that guides the pursuit of excellence for its own sake. They support proper professional ambition and the commercial integrity that goes with it.

SCEPTICISM

Scepticism is good, but be a sceptic, not an iconoclast. Have rigour and flexibility, which might be considered an oxymoron but is exactly what I meant when I quoted Peter Robertson’s dictum ‘always change a winning game.’ An investment framework ought to include a liberal dose of scepticism both in terms of markets and of company accounts.

PERSONAL RESPONSIBILITY

The ability to shoulder personal responsibility for one’s investment results is pretty fundamental… Coming to terms with this reality sets you free to learn from your mistakes.

 

GLOSSARY OF TERMS WITH CUNDILL’S COMMENTS

Here are some of the terms.

ANALYSIS

There’s almost too much information now. It boggles most shareholders and a lot of analysts. All I really need is a company’s published reports and records, that plus a sharp pencil, a pocket calculator, and patience.

Doing the analysis yourself gives you confidence buying securities when a lot of the external factors are negative. It gives you something to hang your hat on.

ANALYSTS

I’d prefer not to know what the analysts think or to hear any inside information. It clouds one’s judgment–I’d rather be dispassionate.

BROKERS

I go cold when someone tips me on a company. I like to start with a clean sheet: no one’s word. No givens. I’m more comfortable when there are no brokers looking over my shoulder.

They really can’t afford to be contrarians. A major investment house can’t afford to do research for five customers who won’t generate a lot of commissions.

EXTRA ASSETS

This started for me when Mutual Shares chieftain Mike Price, who used to be a pure net-net investor, began talking about something called the ‘extra asset syndrome’ or at least that is what I call it. It’s taking, you might say, net-net one step farther, to look at all of a company’s assets, figure the true value.

FORECASTING

We don’t do a lot of forecasting per se about where markets are going. I have been burned often enough trying.

INDEPENDENCE

Peter Cundill has never been afraid to make his own decisions and by setting up his own fund management company he has been relatively free from external control and constraint. He doesn’t follow investment trends or listen to the popular press about what is happening on ‘the street.’ He has travelled a lonely but profitable road.

‘Being willing to be the only one in the parade that’s out of step. It’s awfully hard to do, but Peter is disciplined. You have to be willing to wear bellbottoms when everyone else is wearing stovepipes.‘ – Ross Southam

INVESTMENT FORMULA

Mostly Graham, a little Buffett, and a bit of Cundill.

I like to think that if I stick to my formula, my shareholders and I can make a lot of money without much risk.

When I stray out of my comfort zone I usually get my head handed to me on a platter.

I suspect that my thinking is an eclectic mix, not pure net-net because I couldn’t do it anyway so you have to have a new something to hang your hat on. But the framework stays the same.

INVESTMENT STRATEGY

I used to try and pick the best stocks in the fund portfolios, but I always picked the wrong ones. Now I take my own money and invest it with that odd guy Peter Cundill. I can be more detached when I treat myself as a normal client.

If it is cheap enough, we don’t care what it is.

Why will someone sell you a dollar for 50 cents? Because in the short run, people are irrational on both the optimistic and pessimistic side.

MANTRAS

All we try to do is buy a dollar for 40 cents.

In our style of doing things, patience is patience is patience.

One of the dangers about net-net investing is that if you buy a net-net that begins to lose money your net-net goes down and your capacity to be able to make a profit becomes less secure. So the trick is not necessarily to predict what the earnings are going to be but to have a clear conviction that the company isn’t going bust and that your margin of safety will remain intact over time.

MARGIN OF SAFETY

The difference between the price we pay for a stock and its liquidation value gives us a margin of safety. This kind of investing is one of the most effective ways of achieving good long-term results.

MARKETS

If there’s a bad stock market, I’ll inevitably go back in too early. Good times last longer than we think but so do bad times.

Markets can be overvalued and keep getting expensive, or undervalued and keep getting cheap. That’s why investing is an art form, not a science.

I’m agnostic on where the markets will go. I don’t have a view. Our task is to find undervalued global securities that are trading well below their intrinsic value. In other words, we follow the strict Benjamin Graham approach to investing.

NEW LOWS

Search out the new lows, not the new highs. Read the Outstanding Investor Digest to find out what Mason Hawkins or Mike Price is doing. You know good poets borrow and great poets steal. So see what you can find. General reading–keep looking at the news to see what’s troubled. Experience and curiosity is a really winning combination.

What differentiates us from other money managers with a similar style is that we’re comfortable with new lows.

NOBODY LISTENING

Many people consider value investing dull and as boring as watching paint dry. As a consequence value investors are not always listened to, especially in a stock market bubble. Investors are often in too much of a hurry to latch on to growth stocks to stop and listen because they’re afraid of being left out…

OSMOSIS

I don’t just calculate value using net-net. Actually there are many different ways but you have to use what I call osmosis–you have got to feel your way. That is the art form, because you are never going to be right completely; there is no formula that will ever get you there on its own. Osmosis is about intuition and about discipline and about all the other things that are not quantifiable. So can you learn it? Yes, you can learn it, but it’s not a science, it’s an art form. The portfolio is a canvas to be painted and filled in.

PATIENCE

When times aren’t good I’m still there. You find bargains among the unpopular things, the things that everybody hates. The key is that you must have patience.

RISK

We try not to lose. But we don’t want to try too hard. The losses, of course, work against you in establishing decent compound rates of return. And I hope we won’t have them. But I don’t want to be so risk-averse that we are always trying too hard not to lose.

STEADY RETURNS

All I know is that if you can end up with a 20% track record over a longer period of time, the compound rates of return are such that the amounts are staggering. But a lot of investors want excitement, not steady returns. Most people don’t see making money as grinding it out, doing it as efficiently as possible. If we have a strong market over the next six months and the fund begins to drop behind and there isn’t enough to do, people will say Cundill’s lost his touch, he’s boring.

TIMING: “THERE’S ALWAYS SOMETHING TO DO”

…Irving Kahn gave me some advice many years ago when I was bemoaning the fact that according to my criteria there was nothing to do. He said, ‘there is always something to do. You just need to look harder, be creative and a little flexible.’

VALUE INVESTING

I don’t think I want to become too fashionable. In some ways, value investing is boring and most investors don’t want a boring life–they want some action: win, lose, or draw.

I think the best decisions are made on the basis of what your tummy tells you. The Jesuits argue reason before passion. I argue reason and passion. Intellect and intuition. It’s a balance.

We do liquidation analysis and liquidation analysis only.

Ninety to 95% of all my investing meets the Graham tests. The times I strayed from a rigorous application of this philosophy I got myself into trouble.

But what do you do when none of these companies is available? The trick is to wait through the crisis stage and into the boredom stage. Things will have settled down by then and values will be very cheap again.

We customarily do three tests: one of them asset-based–the NAV, using the company’s balance sheet. The second is the sum of the parts, which I think is probably the most important part that goes into the balance sheet I’m creating. And then a future NAV, which is making a stab (which I am always suspicious about) at what you think the business might be doing in three years from now.

WORKING LIFE

I’ve been doing this for thirty years. And I love it. I’m lucky to have the kind of life where the differentiation between work and play is absolutely zilch. I have no idea whether I’m working or whether I’m playing.

My wife says I’m a workaholic, but my colleagues say I haven’t worked for twenty years. My work is my play.

 

BOOLE MICROCAP 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: https://boolefund.com/best-performers-microcap-stocks/

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 roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approachesintrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). 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: [email protected]

 

 

 

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.

June 23, 2024

Nassim Nicholas Taleb’sFooled by Randomness: The Hidden Role of Chance in the Markets and in Life, is an excellent book. Below I summarize the main points.

Here’s the outline:

• • Prologue

Part I: Solon’s Warning–Skewness, Asymmetry, and Induction

• • One: If You’re So Rich, Why Aren’t You So Smart?
  • Two: A Bizarre Accounting Method
  • Three: A Mathematical Meditation on History
  • Four: Randomness, Nonsense, and the Scientific Intellectual
  • Five: Survival of the Least Fit–Can Evolution Be Fooled By Randomness?
  • Six: Skewness and Asymmetry
  • Seven: The Problem of Induction

Part II: Monkeys on Typewriters–Survivorship and Other Biases

• • Eight: Too Many Millionaires Next Door
  • Nine: It Is Easier to Buy and Sell Than Fry an Egg
  • Ten: Loser Takes All–On the Nonlinearities of Life
  • Eleven: Randomness and Our Brain–We Are Probability Blind

Part III: Wax in my Ears–Living With Randomitis

• • Twelve: Gamblers’ Ticks and Pigeons in a Box
  • Thirteen: Carneades Comes to Rome–On Probability and Skepticism
  • Fourteen: Bacchus Abandons Antony

(Albrecht Durer’sWheel of Fortunefrom Sebastien Brant’sShip of Fools(1494) via Wikimedia Commons)

 

PROLOGUE

Taleb presents Table P.1 Table of Confusion, listing the central distinctions used in the book.

GENERAL

Luck	Skills
Randomness	Determinism
Probability	Certainty
Belief, conjecture	Knowledge, certitude
Theory	Reality
Anecdote, coincidence	Causality, law
Forecast	Prophecy

MARKET PERFORMANCE

Lucky idiot	Skilled investor
Survivorship bias	Market outperformance

FINANCE

Volatility	Return (or drift)
Stochastic variable	Deterministic variable

PHYSICS AND ENGINEERING

Noise

Signal

LITERARY CRITICISM

None

Symbol

PHILOSOPHY OF SCIENCE

Epistemic probability	Physical probability
Induction	Deduction
Synthetic proposition	Analytic proposition

 

ONE: IF YOU’RE SO RICH, WHY AREN’T YOU SO SMART?

Taleb introduces an options trader Nero Tulip. He became convinced that being an options trader was even more interesting that being a pirate would be.

Nero is highly educated (like Taleb himself), with an undergraduate degree in ancient literature and mathematics from Cambridge University, a PhD. in philosophy from the University of Chicago, and a PhD. in mathematical statistics. His thesis for the PhD. in philosophy had to do with the methodology of statistical inference in its application to the social sciences. Taleb comments:

In fact, his thesis was indistinguishable from a thesis in mathematical statistics–it was just a bit more thoughtful (and twice as long).

Nero left philosophy because he became bored with academic debates, particularly over minor points. Nero wanted action.

(Photo by Neil Lockhart)

Nero became a proprietary trader. The firm provided the capital. As long as Nero generated good results, he was free to work whenever he wanted. Generally he was allowed to keep between 7% and 12% of his profits.

It is paradise for an intellectual like Nero who dislikes manual work and values unscheduled meditation.

Nero was an extremely conservative options trader. Over his first decade, he had almost no bad years and his after-tax income averaged $500,000. Due to his extreme risk aversion, Nero’s goal is not to maximize profits as much as it is to avoid having such a bad year that his “entertaining money machine called trading” would be taken away from him. In other words, Nero’s goal was to avoidblowing up, or having such a bad year that he would have to leave the business.

Nero likes taking small losses as long as his profits are large. Whereas most traders make money most of the time during a bull market and lose money during market panics or crashes, Nero would lose small amounts most of the time during a bull market and then make large profits during a market panic or crash.

Nero does not do as well as some other traders. One reason is that his extreme risk aversion leads him to invest his own money in treasury bonds. So he missed most of the bull market from 1982 to 2000.

Note: From a value investing point of view, Nero should at least have invested in undervalued stocks, since such a strategy will almost certainly do well after 10+ years. But Nero wasn’t trained in value investing, and he was acutely aware of what can happen during market panics or crashes.

Also Note: For a value investor, a market panic or crash is an opportunity to buy more stock at very cheap prices. Thus bear markets benefit the value investor who can add to his or her positions.

Nero and his wife live across the street from John the High-Yield Trader and his wife. John was doing much better than Nero. John’s strategy was to maximize profits for as long as the bull market lasted. Nero’s wife and even Nero himself would occasionally feel jealous when looking at the much larger house in which John and his wife lived. However, one day there was a market panic and Johnblew up, losing virtually everything including his house.

Taleb writes:

…Nero’s merriment did not come from the fact that John went back to his place in life, so much as it was from the fact that Nero’s methods, beliefs, and track record had suddenly gained in credibility. Nero would be able to raise public money on his track record precisely because such a thing could not possibly happen to him. A repetition of such an event would pay off massively for him. Part of Nero’s elation also came from the fact that he felt proud of his sticking to his strategy for so long, in spite of the pressure to be the alpha male. It was also because he would no longer question his trading style when others were getting rich because they misunderstood the structure of randomness and market cycles.

Taleb then comments that lucky fools never have the slightest suspicion that they are lucky fools. As long as they’re winning, they get puffed up from the release of the neurotransmitter serotonin into their systems. Taleb notes that our hormonal system can’t distinguish between winning based on luck and winning based on skill.

(A lucky seven. Photo by Eagleflying)

Furthermore, when serotonin is released into our system based on some success, we act like we deserve the success, regardless of whether it was based on luck or skill. Our new behavior will often lead to a virtuous cycle during which, if we continue to win, we will rise in the pecking order. Similarly, when we lose, whether that loss is due to bad luck or poor skill, our resulting behavior will often lead to a vicious cycle during which, if we continue to lose, we will fall in the pecking order. Taleb points out that these virtuous and vicious cycles are exactly what happens with monkeys who have been injected with serotonin.

Taleb adds that you can always tell whether some trader has had a winning day or a losing day. You just have to observe his or her gesture or gait. It’s easy to tell whether the trader is full of serotonin or not.

 

TWO: A BIZARRE ACCOUNTING METHOD

Taleb introduces the concept ofalternative histories. This concept applies to many areas of human life, including many different professions (war, politics, medicine, investments). The main idea is that you cannot judge the quality of a decision based only on its outcome. Rather, the quality of a decision can only be judged by considering all possible scenarios (outcomes) and their associated probabilities.

Once again, our brains deceive us unless we develop the habit of thinking probabilistically, in terms of alternative histories. Without this habit, if a decision is successful, we get puffed up with serotonin and believe that the successful outcome is based on our skill. By nature, we cannot account for luck or randomness.

Taleb offers Russian roulette as an analogy. If you are offered $10 million to play Russian roulette, and if you play and you survive, then you were lucky even though you will get puffed up with serotonin.

Taleb argues that many (if not most) business successes have a large component of luck or randomness. Again, though, successful businesspeople in general will be puffed up with serotonin and they will attribute their success primarily to skill. Taleb:

…the public observes the external signs of wealth without even having a glimpse at the source (we call such source thegenerator).

Now, if the lucky Russian roulette player continues to play the game, eventually the bad histories will catch up with him or her. Here’s an important point: If you start out with thousands of people playing Russian roulette, then after the first round roughly 83.3% will be successful. After the second round, roughly 83.3% of the survivors of round one will be successful. After the third round, roughly 83.3% of the survivors of round two will be successful. And on it goes… After twenty rounds, there will be a small handful of extremely successful and wealthy Russian roulette players. However, these cases of extreme success are due entirely to luck.

In the business world, of course, there are many cases where skill plays a large role. The point is that our brains by nature are unable to see when luck has played a role in some successful outcome. And luck almost always plays an important role in most areas of life.

Taleb points out that there are some areas where success is due mostly to skill and not luck. Taleb likes to give the example of dentistry. The success of a dentist will typically be due mostly to skill.

Taleb attributes some of his attitude towards risk to the fact that at one point he had a boss who forced him to consider every possible scenario, no matter how remote.

Interestingly, Taleb understands Homer’sThe Iliad as presenting the following idea: heroes are heroes based on heroic behavior and not based on whether they won or lost. Homer seems to have understood the role of chance (luck).

 

THREE: A MATHEMATICAL MEDITATION ON HISTORY

A Monte Carlo generator creates manyalternative random sample paths. Note that a sample path can be deterministic, but our concern here is with random sample paths. Also note that some random sample paths can have higher probabilities than other random sample paths. Each sample path represents just one sequence of events out of many possible sequences, ergo the word “sample”.

Taleb offers a few examples of random sample paths. Consider the price of your favorite technology stock, he says. It may start at $100, hit $220 along the way, and end up at $20. Or it may start at $100 and reach $145, but only after touching $10. Another example might be your wealth during at a night at the casino. Say you begin with $1,000 in your pocket. One possibility is that you end up with $2,200, while another possibility is that you end up with only $20.

Taleb says:

My Monte Carlo engine took me on a few interesting adventures. While my colleagues were immersed in news stories, central bank announcements, earnings reports, economic forecasts, sports results and, not least, office politics, I started toying with it in fields bordering my home base of financial probability. A natural field of expansion for the amateur is evolutionary biology… I started simulating populations of fast mutating animals called Zorglubs under climactic changes and witnessing the most unexpected of conclusions… My aim, as a pure amateur fleeing the boredom of business life, was merely to develop intuitions for these events… I also toyed with molecular biology, generating randomly occurring cancer cells and witnessing some surprising aspects to their evolution.

Taleb continues:

Naturally the analogue to fabricating populations of Zorglubs was to simulate a population of “idiotic bull”, “impetuous bear”, and “cautious” traders under different market regimes, say booms and busts, and to examine their short-term and long-term survival… My models showed almost nobody to really ultimately make money; bears dropped out like flies in the rally and bulls got ultimately slaughtered, as paper profits vanished when the music stopped. But there was one exception; some of those who traded options (I called them option buyers) had remarkable staying power and I wanted to be one of those. How? Because they could buy insurance against the blowup; they could get anxiety-free sleep at night, thanks to the knowledge that if their careers were threatened, it would not be owing to the outcome of a single day.

Note from a value investing point of view

A value investor seeks to pay low prices for stock in individual businesses. Stock prices can jump around in the short term. But over time, if the business you invest in succeeds, then the stock will follow, assuming you bought the stock at relatively low prices. Again, if there’s a bear market or a market crash, and if the stock prices of the businesses in which you’ve invested decline, then that presents a wonderful opportunity to buy more stock at attractively low prices. Over time, the U.S. and global economy will grow, regardless of the occasional market panic or crash. Because of this growth, one of the lowest risk ways to build wealth is to invest in businesses, either on an individual basis if you’re a value investor or via index funds.

Taleb’s methods of trying to make money during a market panic or crash will almost certainly doless well over the long term than simple index funds.

Taleb makes a further point: The vast majority of people learn only from their own mistakes, and rarely from the mistakes of others. Children only learn that the stove is hot by getting burned. Adults are largely the same way: We only learn from our own mistakes. Rarely do we learn from the mistakes of others. And rarely do we heed the warnings of others. Taleb:

All of my colleagues whom I have known to denigrate history blew up spectacularly–and I have yet to encounter some such person who has not blown up.

Keep in mind that Taleb is talking about traders here. For a regular investor who dollar cost averages into index funds and/or who uses value investing, Taleb’s warning does not apply. As a long-term investor in index funds and/or in value investing techniques, you do have to be ready for a 50% decline at some point. But if you buy more after such a decline, your long-term results will actually be helped, not hurt, by a 50% decline.

Taleb points out that aged traders and investors are likely better to use as role models precisely because they have been exposed to markets longer. Taleb:

I toyed with Monte Carlo simulations of heterogeneous populations of traders under a variety of regimes (closely resembling historical ones), and found a significant advantage in selecting aged traders, using, as a selection criterion their cumulative years of experience rather than their absolute success (conditional on their having survived without blowing up).

Taleb also observes that there is a similar phenomenon in mate selection. All else equal, women prefer to mate with healthy older men over healthy younger ones. Healthy older men, by having survived longer, show some evidence of better genes.

 

FOUR: RANDOMNESS, NONSENSE, AND THE SCIENTIFIC INTELLECTUAL

Using a random generator of words, it’s possible to create rhetoric, but it’s not possible to generate genuine scientific knowledge.

 

FIVE: SURVIVAL OF THE LEAST FIT–CAN EVOLUTION BE FOOLED BY RANDOMNESS?

Taleb writes about Carlos “the emerging markets wizard.” After excelling as an undergraduate, Carlos went for a PhD. in economics from Harvard. Unable to find a decent thesis topic for his dissertation, he settled for a master’s degree and a career on Wall Street.

Carlos did well investing in emerging markets bonds. One important reason for his success, beyond the fact that he bought emerging markets bonds that later went up in value, was that he bought the dips. Whenever there was a momentary panic and emerging markets bonds dropped in value, Carlos bought more. This dip buying improved his performance. Taleb:

It was the summer of 1998 that undid Carlos–that last dip did not translate into a rally. His track record today includes just one bad quarter–but bad it was. He had earned close to $80 million cumulatively in his previous years. He lost $300 million in just one summer.

When the market first started dipping, Carlos learned that a New Jersey hedge fund was liquidating, including its position in Russian bonds. So when Russian bonds dropped to $52, Carlos was buying. To those who questioned his buying, he yelled: “Read my lips: it’s li-qui-da-tion!”

Taleb continues:

By the end of June, his trading revenues for 1998 had dropped from up $60 million to up $20 million. That made him angry. But he calculated that should the market rise back to the pre-New Jersey selloff, then he would be up $100 million. That was unavoidable, he asserted. These bonds, he said, would never, ever trade below $48. He was risking so little, to possibly make so much.

Then came July. The market dropped a bit more. The benchmark Russian bond was now $43. His positions were under water, but he increased his stakes. By now he was down $30 million for the year. His bosses were starting to become nervous, but he kept telling them that, after all, Russia would not go under. He repeated the cliche that it was too big to fail. He estimated that bailing them out would cost so little and would benefit the world economy so much that it did not make sense to liquidate his inventory now.

Carlos asserted that the Russian bonds were trading near default value. If Russia were to default, then Russian bonds would stay at the same prices they were at currently. Carlos took the further step of investing half of his net worth, then $5,000,000, into Russian bonds.

Russian bond prices then dropped into the 30s, and then into the 20s. Since Carlos thought the bonds could not be less than the default values he had calculated, and were probably worth much more, he was not alarmed. He maintained that anyone who invested in Russian bonds at these levels would realize wonderful returns. He claimed that stop losses “are for schmucks! I am not going to buy high and sell low!” He pointed out that in October 1997 they were way down, but that buying the dip ended up yielding excellent profits for 1997. Furthermore, Carlos pointed out that other banks were showing even larger losses on their Russian bond positions. Taleb:

Towards the end of August, the bellwether Russian Principal Bonds were trading below $10. Carlos’s net worth was reduced by almost half. He was dismissed. So was his boss, the head of trading. The president of the bank was demoted to a “newly created position”. Board members could not understand why the bank had so much exposure to a government that was not paying its own employees–which, disturbingly, included armed soldiers. This was one of the small points that emerging market economists around the globe, from talking to each other so much, forgot to take into account.

Taleb adds:

Louie, a veteran trader on the neighboring desk who suffered much humiliation by these rich emerging market traders, was there, vindicated. Louie was then a 52-year-old Brooklyn-born-and-raised trader who over three decades survived every single conceivable market cycle.

Taleb concludes that Carlos is a gentleman, but a bad trader:

He has all of the traits of a thoughtful gentleman, and would be an ideal son-in-law. But he has most of the attributes of the bad trader. And, at any point in time, the richest traders are often the worst traders. This, I will call thecross-sectional problem: at a given time in the market, the most profitable traders are likely to be those that are best fit to the latest cycle.

Taleb discusses John the high-yield trader, who was mentioned near the beginning of the book, as another bad trader. What traits do bad traders, who may be lucky idiots for awhile, share? Taleb:

• • An overestimation of the accuracy of their beliefs in some measure, either economic (Carlos) or statistical (John). They don’t consider that what they view as economic or statistical truth may have been fit to past events and may no longer be true.
  • A tendency to get married to positions.
  • The tendency to change their story.
  • No precise game plan ahead of time as to what to do in the event of losses.
  • Absence of critical thinking expressed in absence of revision of their stance with “stop losses”.
  • Denial.

 

SIX: SKEWNESS AND ASYMMETRY

Taleb presents the following Table:

Event	Probability	Outcome	Expectation
A	999/1000	$1	$.999
B	1/1000	-$10,000	-$10.00
		Total	-$9.001

The point is that thefrequency of losing cannot be considered apart from themagnitude of the outcome. If you play the game, you’re extremely likely to make $1. But it’s not a good idea to play. If you play this game millions of times, you’re virtually guaranteed to lose money.

Taleb comments that even professional investors misunderstand this bet:

How could people miss such a point? Why do they confuse probability and expectation, that is, probability and probability times the payoff? Mainly because much of people’s schooling comes from examples in symmetric environments, like a coin-toss, where such a difference does not matter. In fact the so-called “Bell Curve” that seems to have found universal use in society is entirely symmetric.

(Coin toss. Photo by Christian Delbert)

Taleb gives an example where he is shorting the S&P 500 Index. He thought the market had a 70% chance of going up and a 30% chance of going down. But he thought that if the market went down, it could go down a lot. Therefore, it was profitable over time (by repeating the bet) to be short the S&P 500.

Note: From a value investing point of view, no one can predict what the market will do. But you can predict what some individual businesses are likely to do. The key is to invest in businesses when the price (stock) is low.

Rare Events

Taleb explains his trading strategy:

The best description of my lifelong business in the market is “skewed bets”, that is, I try to benefit from rare events, events that do not tend to repeat themselves frequently, but, accordingly, present a large payoff when they occur. I try to make money infrequently, as infrequently as possible, simply because I believe that rare events are not fairly valued, and that the rarer the event, the more undervalued it will be in price.

Taleb gives an example where his strategy paid off:

One such rare event is the stock market crash of 1987, which made me as a trader and allowed me the luxury of becoming involved in all manner of scholarship.

Taleb notes that in most areas of science, it is common practice to discardoutliers when computing the average. For instance, a professor calculating the average grade in his or her class might discard the highest and the lowest values. In finance, however, it is often wrong to discard the extreme outcomes because, as Taleb has shown, the magnitude of an extreme outcome can matter.

Taleb advises studying market history. But then again, you have to be careful, as Taleb explains:

Sometimes market data becomes a simple trap; it shows you the opposite of its nature, simply to get you to invest in the security or mismanage your risks. Currencies that exhibit the largest historical stability, for example, are the most prone to crashes…

Taleb notes the following:

In other words history teaches us that things that never happened before do happen.

History does not always repeat. Sometimes things change. For instance, today the U.S. stock market seems high. The S&P 500 Index is over 3,000. Based on history, one might expect a bear market and/or a recession. There hasn’t been a recession in the U.S. since 2009.

However, with interest rates low, and with the profit margins on many technology companies high, it’s possible that stocks will not decline much, even if there’s a recession. It’s also possible that any recession could be delayed, partly because the Fed and other central banks remain very accommodative. It’s possible that the business cycle itself may be less volatile because the fiscal and monetary authorities have gotten better at delaying recessions or at making recessions shallower than before.

Ironically, to the extent that Taleb seeks to profit from a market panic or crash, for the reasons just mentioned, Taleb’s strategy may not work as well going forward.

Taleb introducesthe problem of stationarity. To illustrate the problem, think of an urn with red balls and black balls in it. Taleb:

Think of an urn that is hollow at the bottom. As I am sampling from it, and without my being aware of it, some mischievous child is adding balls of one color or another. My inference thus becomes insignificant. I may infer that the red balls represent 50% of the urn while the mischievous child, hearing me, would swiftly replace all the red balls with black ones. This makes much of our knowledge derived through statistics quite shaky.

The very same effect takes place in the market. We take past history as a single homogeneous sample and believe that we have considerably increased our knowledge of the future from the observation of the sample of the past. What if vicious children were changing the composition of the urn? In other words, what if things have changed?

Taleb notes that there are many techniques that use past history in order to measure risks going forward. But to the extent that past data are not stationary, depending upon these risk measurement techniques can be a serious mistake. All of this leads to a more fundamental issue: the problem of induction.

 

SEVEN: THE PROBLEM OF INDUCTION

Taleb quotes the Scottish philosopher David Hume:

No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion.

(Black swan. Photo by Damithri)

Taleb came to believe that Sir Karl Popper had an important answer to the problem of induction. According to Popper, there are only two types of scientific theories:

• • Theories that are known to be wrong, as they were tested and adequately rejected (i.e., falsified).
  • Theories that have not yet been known to be wrong, not falsified yet, but are exposed to be proved wrong.

It also follows that we should not always rely on statistics. Taleb:

More practically to me, Popper had many problems with statistics and statisticians. He refused to blindly accept the notion that knowledge can always increase with incremental information–which is the foundation for statistical inference. It may in some instances, but we do not know which ones. Many insightful people, such as John Maynard Keynes, independently reached the same conclusions. Sir Karl’s detractors believe that favorably repeating the same experiment again and again should lead to an increased comfort with the notion that “it works”.

Taleb explains the concept of anopen society:

Popper’s falsificationism is intimately connected to the notion of an open society. An open society is one in which no permanent truth is held to exist; this would allow counterideas to emerge.

For Taleb, a successful trader or investor must have anopen mind in which no permanent truth is held to exist.

Taleb concludes the chapter by applying the logic of Pascal’s wager to trading and investing:

…I will use statistics and inductive methods to make aggressive bets, but I will not use them to manage my risks and exposure. Surprisingly, all the surviving traders I know seem to have done the same. They trade on ideas based on some observation (that includes past history) but, like the Popperian scientists, they make sure that the costs of being wrong are limited (and their probability is not derived from past data). Unlike Carlos and John, they know before getting involved in the trading strategy which events would prove their conjecture wrong and allow for it (recall the Carlos and John used past history both to make their bets and measure their risk).

 

PART II: MONKEYS ON TYPEWRITERS–SURVIVORSHIP AND OTHER BIASES

If you put an infinite number of monkeys in front of typewriters, it is certain that one of them will type an exact version of Homer’s The Iliad. Taleb asks:

Now that we have found that hero among monkeys, would any reader invest his life’s savings on a bet that the monkey would writeThe Odyssey next?

 

EIGHT: TOO MANY MILLIONAIRES NEXT DOOR

Taleb begins the chapter by describing a lawyer named Marc. Marc makes $500,000 a year. He attended Harvard as an undergraduate and then Yale Law School. The problem is that some of Marc’s neighbors are much wealthier. Taleb discusses Marc’s wife, Janet:

Every month or so, Janet has a crisis… Why isn’t her husband so successful? Isn’t he smart and hard working? Didn’t he get close to 1600 on the SAT? Why is Ronald Something whose wife never even nods to Janet worth hundred of millions when her husband went to Harvard and Yale and has such a high I.Q., and has hardly any substantial savings?

Note: Warren Buffett and Charlie Munger have long made the point that envy is a massively stupid sin because, unlike other sins (e.g., gluttony), you can’t have any fun with it. Granted, envy is a very human emotion. But we can and must train ourselves not to fall into it.

Daniel Kahneman and others have demonstrated that the average person would rather make $70,000 as long as his neighbor makes $60,000 than make $80,000 if his neighbor makes $90,000. How stupid to compare ourselves to people who happen to be doing better! There will always be someone doing better.

Taleb mentions the book,The Millionaire Next Door. One idea from the book is that the wealthy often do not look wealthy because they’re focused on saving and investing, rather than on spending. However, Taleb finds two problems with the book. First, the book does not adjust for survivorship bias. In other words, for at least some of the wealthy, there is some luck involved. Second, there’s the problem of induction. If you measure someone’s wealth in the year 2000 (Taleb was writing in 2001), at the end of one of the biggest bull markets in modern history (from 1982 to 2000), then in many cases a large degree of that wealth came as a result of the prolonged bull market. By contrast, if you measure people’s wealth in 1982, there would be fewer people who are millionaires, even after adjusting for inflation.

 

NINE: IT IS EASIER TO BUY AND SELL THAN FRY AN EGG

Taleb writes about going to the dentist and being confident that his dentist knows something about teeth. Later, Taleb goes to Carnegie Hall. Before the pianist begins her performance, Taleb has zero doubt that she knows how to play the piano and is not about to produce cacophony. Later still, Taleb is in London and ends up looking at some of his favorite marble statues. Once again, he knows they weren’t produced by luck.

However, in many areas of business and even more so when it comes to investing, luck does tend to play a large role. Taleb is supposed to meet with a fund manager who has a good track record and who is looking for investors. Taleb comments that buying and selling, which is what the fund manager does, is easier than frying an egg. The problem is that luck plays such a large role in almost any good investment track record.

In order to study the role luck plays for investors, Taleb suggests a hypothetical game. There are 10,000 investors at the beginning. In the first round, a fair coin is tossed for each investor. Heads, and the investor makes $10,000, tails, and the investor loses $10,000. (Any investor who has a losing year is not allowed to continue to play the game.) After the first round, there will be about 5,000 successful investors. In the second round, a fair coin is again tossed. After the second round, there will be 2,500 successful investors. Another round, and 1,250 will remain. A fourth round, and 625 successful investors will remain. A fifth round, and 313 successful investors will remain. Based on luck alone, after five years there will be approximately 313 investors with winning track records. No doubt these 313 winners will be puffed up with serotonin.

Taleb then observes that you can play the same hypothetical game with bad investors. You assume each year that there’s a 45% chance of winning and a 55% chance of losing. After one year, 4,500 successful (but bad) investors will remain. After two years, 2,025. After three years, 911. After four years, 410. After five years, there will be 184 bad investors who have successful track records.

Taleb makes two counterintuitive points:

• • First, even starting with only bad investors, you will end up with a small number of great track records.
  • Second, how many great track records you end up with depends more on the size of the initial sample–how many investors you started with–than it does on the individual odds per investor. Applied to the real world, this means that if there are more investors who start in 1997 than in 1993, then you will see a greater number of successful track records in 2002 than you will see in 1998.

Taleb concludes:

Recall that the survivorship bias depends on the size of the initial population. The information that a person made money in the past, just by itself, is neither meaningful nor relevant. We need to know that size of the population from which he came. In other words, without knowing how many managers out there have tried and failed, we will not be able to assess the validity of the track record. If the initial population includes ten managers, then I would give the performer half my savings without a blink. If the initial population is composed of 10,000 managers, I would ignore the results.

The mysterious letter

Taleb tells a story. You get a letter on Jan. 2 informing you that the market will go up during the month. It does. Then you get a letter on Feb. 1 saying the market will go down during the month. It does. You get another letter on Mar. 1. Same story. Again for April and for May. You’ve now gotten five letters in a row predicting what the market would do during the ensuing month, and all five letters were correct. Next you are asked to invest in a special fund. The fund blows up. What happened?

The trick is as follows. The con operator gets 10,000 random names. On Jan. 2, he mails 5,000 letters predicting that the market will go up and 5,000 letters predicting that the market will go down. The next month, he focuses only on the 5,000 names who were just mailed a correct prediction. He sends 2,500 letters predicting that the market will go up and 2,500 letters predicting that the market will go down. Of course, next he focuses on the 2,500 letters which gave correct predictions. He mails 1,250 letters predicting a market rise and 1,250 predicting a market fall. After five months of this, there will be approximately 200 people who received five straight correct predictions.

Taleb suggests the birthday paradox as an intuitive way to explain the data mining problem. If you encounter a random person, there is a one in 365.25 chance that you have the same birthday. But if you have 23 random people in a room, the odds are close to 50 percent that you can find two people who share a birthday.

Similarly, what are the odds that you’ll run into someone you know in a totally random place? The odds are quite high because you are testing for any encounter, with any person you know, in any place you will visit.

Taleb continues:

What is your probability of winning the New Jersey lottery twice? One in 17 trillion. Yet it happened to Evelyn Adams, whom the reader might guess should feel particularly chosen by destiny. Using the method we developed above, Harvard’s Percy Diaconis and Frederick Mosteller estimated at 30 to 1 the probability the someone, somewhere, in a totally unspecified way, gets so lucky!

What isdata snooping? It’s looking at historical data to determine the hypothetical performance of a large number of trading rules. The more trading rules you examine, the more likely you are to find trading rules that would have worked in the past and that one might expect to work in the future. However, many such trading rules would have worked in the past based on luck alone.

Taleb next writes about companies that increase their earnings. The same logic can be applied. If you start out with 10,000 companies, then by luck 5,000 will increase their profits after the first year. After three years, there will be 1,250 “stars” that increased their profits for three years in a row. Analysts will rate these companies a “strong buy”. The point is not that profit increases are entirely due to luck. The point, rather, is that luck often plays a significant role in business results, usually far more than is commonly supposed.

 

TEN: LOSER TAKES ALL–ONE THE NONLINEARITIES OF LIFE

Taleb writes:

This chapter is about how a small advantage in life can translate into a highly disproportionate payoff, or, more viciously, how no advantage at all, but a very, very small help from randomness, can lead to a bonanza.

Nonlinearity is when a small input can lead to a disproportionate response. Consider a sandpile. You can add many grains of sand with nothing happening. Then suddenly one grain of sand causes an avalanche.

(Photo by Maocheng)

Taleb mentions actors auditioning for parts. A handful of actors get certain parts, and a few of them become famous. The most famous actors are not always the best actors (although they often are). Rather, there could have been random (lucky) reasons why a handful of actors got certain parts and why a few of them became famous.

The QWERTY keyboard is not optimal. But so many people were trained on it, and so many QWERTY keyboards were manufactured, that it has come to dominate. This is called a path dependent outcome. Taleb comments:

Such ideas go against classical economic models, in which results either come from a precise reason (there is no account for uncertainty) or the good guy wins (the good guy is the one who is more skilled and has some technical superiority)… Brian Arthur, an economist concerned with nonlinearities at the Santa Fe Institute, wrote that chance events coupled with positive feedback rather than technological superiority will determine economic superiority–not some abstrusely defined edge in a given area of expertise. While early economic models excluded randomness, Arthur explained how “unexpected orders, chance meetings with lawyers, managerial whims… would help determine which ones achieved early sales and, over time, which firms dominated”.

Taleb continues by noting that Arthur suggests a mathematical model called the Polya process:

The Polya process can be presented as follows: assume an urn initially containing equal quantities of black and red balls. You are to guess each time which color you will pull out before you make the draw. Here the game is rigged. Unlike a conventional urn, the probability of guessing correctly depends on past success, as you get better or worse at guessing depending on past performance. Thus the probability of winning increases after past wins, that of losing increases after past losses. Simulating such a process, one can see a huge variance of outcomes, with astonishing successes and a large number of failures (what we called skewness).

 

ELEVEN: RANDOMNESS AND OUR BRAIN–WE ARE PROBABILITY BLIND

Our genes have not yet evolved to the point where our brains can naturally compute probabilities. Computing probabilities is not something we even needed to do until very recently.

Here’s a diagram of how to compute the probability of A, conditional on B having happened:

(Diagram by Oleg Alexandrov, via Wikimedia Commons)

Taleb:

We are capable of sending a spacecraft to Mars, but we are incapable of having criminal trials managed by the basic laws of probability–yet evidence is clearly a probabilistic notion…

People who are as close to being criminal as probability laws can allow us to infer (that is with a confidence that exceeds theshadow of a doubt) are walking free because of our misunderstanding of basic concepts of the odds… I was in a dealing room with a TV set turned on when I saw one of the lawyers arguing that there were at least four people in Los Angeles capable of carrying O.J. Simpson’s DNA characteristics (thus ignoring the joint set of events…). I then switched off the television set in disgust, causing an uproar among the traders. I was under the impression until then that sophistry had been eliminated from legal cases thanks to the high standards of republican Rome. Worse, one Harvard lawyer used the specious argument that only 10% of men who brutalize their wives go on to murder them, which is a probability unconditional on the murder… Isn’t the law devoted to the truth? The correct way to look at it is to determine the percentage of murder cases where women were killed by their husbandand had previously been battered by him (that is, 50%)–for we are dealing with what is called conditional probabilities; the probability that O.J. killed his wifeconditional on the information of her having been killed, rather than theunconditional probability of O.J. killing his wife. How can we expect the untrained person to understand randomness when a Harvard professor who deals and teaches the concept of probabilistic evidence can make such an incorrect statement?

Speaking of people misunderstanding probabilities, Daniel Kahneman and Amos Tversky have asked groups to answer the following question:

Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations.

Which is more probable?

1. 1. Linda is a bank teller.
   2. Linda is a bank teller and is active in the feminist movement.

The majority of people believe that 2. is more probable the 1. But that’s an obvious fallacy. Bank tellers who are also feminists is a subset of all bank tellers, therefore 1. is more probable than 2. To see why, consider the following diagram:

(By svjo, via Wikimedia Commons)

B represents ALL bank tellers. Out of ALL bank tellers, some are feminists and some are not. Those bank tellers that are also feminists is represented by A.

Here’s a probability question that was presented to doctors:

A test of a disease presents a rate of 5% false positives. The disease strikes 1/1,000 of the population. People are tested at random, regardless of whether they are suspected of having the disease. A patient’s test is positive. What is the probability of the patient being stricken with the disease?

Many doctors answer 95%, which is wildly incorrect. The answer is close to 2%. Less than one in five doctors get the question right.

To see the right answer, assume that there are no false negatives. Out of 1,000 patients, one will have the disease. Consider the remaining 999. 50 of them will test positive. The probability of being afflicted with the disease for someone selected at random who tested positive is the following ratio:

Number of afflicted persons / Number of true and false positives

So the answer is 1/51, about 2%.

Another example where people misunderstand probabilities is when it comes to valuing options. (Recall that Taleb is an options trader.) Taleb gives an example. Say that the stock price is $100 today. You can buy a call option for $1 that gives you the right to buy the stock at $110 any time during the next month. Note that the option is out-of-the-money because you would not gain if you exercised your right to buy now, given that the stock is $100, below the exercise price of $110.

Now, what is the expected value of the option? About 90 percent of out-of-the-money options expire worthless, that is, they end up being worth $0. But the expected value is not $0 because there is a 10 percent chance that the option could be worth, say $10, because the stock went to $120. So even though it is 90 percent likely that the option will end up being worth $0, the expected value is not $0. The actual expected value in this example is:

(90% x $0) + (10% x $10) = $0 + $1 = $1

The expected value of the option is $1, which means you would have paid a fair price if you had bought it for $1. Taleb notes:

I discovered very few people who accepted losing $1 for most expirations and making $10 once in a while, even if the game were fair (i.e., they made the $10 more than 10% of the time).

“Fair” is not the right term here. If you make $10 more than 10% of the time, then the game has apositive expected value. That means if you play the game repeatedly, then eventually over time you will make money. Taleb’s point is that even if the game has a positive expected value, very few people would like to play it because on your way to making money, you have to accept small losses most of the time.

Taleb distinguishes betweenpremium sellers, who sell options, andpremium buyers, who buy options. Following the same logic as above, premium sellers make small amounts of money roughly 90% of the time, and then take a big loss roughly 10% of the time. Premium buyers lose small amounts about 90% of the time, and then have a big gain about 10% of the time.

Is it better to be an option seller or an option buyer? It depends on whether you can find favorable odds. It also depends on your temperament. Most people do not like taking small losses most of the time. Taleb:

Alas, most option traders I encountered in my career arepremium sellers–when they blow up it is generally other people’s money.

 

PART III: WAX IN MY EARS–LIVING WITH RANDOMITIS

Taleb writes that when Odysseus and his crew encountered the sirens, Odysseus had his crew put wax in their ears. He also instructed his crew to tie him to the mast. With these steps, Odysseus and crew managed to survive the sirens’ songs. Taleb notes that he would be not Odysseus, but one of the sailors who needed to have wax in his ears.

(Odysseus and crew at the sirens. Illustration by Mr1805)

Taleb admits that he is dominated by his emotions:

The epiphany I had in my career in randomness came when I understood that I was not intelligent enough, nor strong enough, to even try to fight my emotions. Besides, I believe that I need my emotions to formulate my ideas and get the energy to execute them.

I am just intelligent enough to understand that I have a predisposition to be fooled by randomness–and to accept the fact that I am rather emotional. I am dominated by my emotions–but as an aesthete, I am happy about that fact. I am just like every single character whom I ridiculed in this book… The difference between myself and those I ridicule is that I try to be aware of it. No matter how long I study and try to understand probability, my emotions will respond to a different set of calculations, those that my unintelligent genes want me to handle.

Taleb says he has developed tricks in order to handle his emotions. For instance, if he has financial news playing on the television, he keeps the volume off. Without volume, a babbling person looks ridiculous. This trick helps Taleb stay free of news that is not rationally presented.

 

TWELVE: GAMBLERS’ TICKS AND PIGEONS IN A BOX

Early in his career as a trader, Taleb says he had a particularly profitable day. It just so happens that the morning of this day, Taleb’s cab driver dropped him off in the wrong location. Taleb admits that he was superstitious. So the next day, he not only wore the same tie, but he had his cab driver drop him off in the same wrong location.

(Skinner boxes. Photo by Luis Dantas, via Wikimedia Commons)

B.F. Skinner did an experiment with famished pigeons. There was a mechanism that would deliver food to the box in which the hungry pigeon was kept. But Skinner programmed the mechanism to deliver the food randomly. Taleb:

He saw quite astonishing behavior on the part of the birds; they developed an extremely sophisticated rain-dance type of behavior in response to their ingrained statistical machinery. One bird swung its head rhythmically against a specific corner of the box, others spun their heads anti-clockwise; literally all of the birds developed a specific ritual that progressively became hard-wired into their mind as linked to their feeding.

Taleb observes that whenever we experience two events, A and B, our mind automatically looks for a causal link even though there often is none. Note: Even if B always follows A, that doesn’tprovea causal link, as Hume pointed out.

Taleb again admits that after he has calculated the probabilities in some situation, he finds it hard to modify his own conduct accordingly. He gives an example of trading. Taleb says if he is up $100,000, there is a 98% chance that it’s just noise. But if he is up $1,000,000, there is a 1% chance that it’s noise and a 99% chance that his strategy is profitable. Taleb:

A rational person would act accordingly in the selection of strategies, and set his emotions in accordance with his results. Yet I have experienced leaps of joy over results that I knew were mere noise, and bouts of unhappiness over results that did not carry the slightest degree of statistical significance. I cannot help it…

Taleb uses another trick to deal with this. He denies himself access to his performance report unless it hits a predetermined threshold.

 

THIRTEEN: CARNEADES COMES TO ROME–ON PROBABILITY AND SKEPTICISM

Taleb writes:

Carneades was not merely a skeptic; he was a dialectician, someone who never committed himself to any of the premises from which he argued, or to any of the conclusions he drew from them. He stood all his life against arrogant dogma and belief in one sole truth. Few credible thinkers rival Carneades in their rigorous skepticism (a class that would include the medieval Arab philosopher Al Gazali, Hume, and Kant–but only Popper came to elevate his skepticism to an all-encompassing scientific methodology). As the skeptics’ main teaching was that nothing could be accepted with certainty, conclusions of various degrees of probability could be formed, and these supplied a guide to conduct.

Taleb holds that Cicero engaged in probabilistic reasoning:

He preferred to be guided by probability than allege with certainty–very handy, some said, because it allowed him to contradict himself. This may be a reason for us, who have learned from Popper how to remain self critical, to respect him more, as he did not hew stubbornly to an opinion for the mere fact that he had voiced it in the past.

Taleb asserts that the speculator George Soros has a wonderful ability to change his opinions rather quickly. In fact, without this ability, Soros could not have become so successful as a speculator. There are many stories about Soros holding one view strongly, only to abandon it very quickly and take the opposite view, leading to a large profit where there otherwise would have been a large loss.

Most of us tend to become married to our favorite ideas. Most of us are not like George Soros. Especially after we have invested time and energy into developing some idea.

At the extreme, just imagine a scientist who spent years developing some idea. Many scientists in that situation have a hard time abandoning their idea, even after there is good evidence that they’re wrong. That’s why it is said that science evolves from funeral to funeral.

 

FOURTEEN: BACCHUS ABANDONS ANTONY

Taleb refers to C.P. Cavafy’s poem,Apoleipein o Theos Antonion (The God Abandons Antony). The poem addresses Antony after he has been defeated. Taleb comments:

There is nothing wrong and undignified with emotions–we are cut to have them. What is wrong is not following the heroic, or at least, the dignified path. That is what stoicism means. It is the attempt by man to get even with probability.

Taleb concludes with some advice (stoicism):

Dress at your best on your execution day (shave carefully); try to leave a good impression on the death squad by standing erect and proud. Try not to play victim when diagnosed with cancer (hide it from others and only share the information with the doctor–it will avert the platitudes and nobody will treat you like a victim worthy of their pity; in addition the dignified attitude will make both defeat and victory feel equally heroic). Be extremely courteous to your assistant when you lose money (instead of taking it out on him as many of the traders whom I scorn routinely do). Try not to blame others for your fate, even if they deserve blame. Never exhibit any self pity, even if your significant other bolts with the handsome ski instructor or the younger aspiring model. Do not complain… The only article Lady Fortuna has no control over is your behavior.

 

BOOLE MICROCAP 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: https://boolefund.com/best-performers-microcap-stocks/

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 roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approachesintrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). 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: [email protected]

 

 

 

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.

May 26, 2024

I first wrote about Cipher here: https://boolefund.com/case-study-cipher-pharmaceuticals-cphrf/

Since then, the stock price has gone from $2.83 to $6.35, an increase of over 120%. However, the stock still appears quite undervalued, so it’s worth revisiting the investment thesis.

Cipher Pharmaceuticals is an extremely profitable pharmaceutical company based in Canada. Its main product Epirus (the active ingredient is isotretinoin), which cures nodular acne, has been gaining market share steadily in the Canadian market because it is far the best product. The drug does not have a patent, but it would take a competitor at least $30 million to develop a competing product in Canada. Epirus currently has 45% of the Canadian market and is aiming for 65%.

Cipher also earns $6 million in royalty revenue from another isotretinoin product–Absorica–in the United States.

Furthermore, Cipher has the Canadian marketing rights to MOB-015, which cures nail fungus (onychomycosis). The drug is already approved in Europe. It should be approved in North America by January 2025 and available to customers in January 2026. The addressable market for MOB-015 in Canada is CDN $92.4 million. The company expects $15 million in revenue from MOB-015 in 2026 and $30 million in revenue in 2027. The current product in this market is not very good and MOB-015 is expected to be much better.

Cipher expects revenues to triple by 2027 as Epirus keeps winning market share and as MOB-015 is sold in Canada in 2026 and 2027.

The company has $39.8 million in cash and no debt. The company also has over $200 million in NOLs, which means the company won’t pay cash taxes for a long time.

Furthermore, Cipher has been buying back shares very aggressively.

John Mull owns 39% of Cipher’s shares, while his son Craig Mull–who is CEO–owns 2%. They are searching for an acquisition that is a low-risk and profitable dermatological company. If successful, such an acquisition would diversify their revenues and profits. They continue to be very patient in looking for the right company at the right price.

In the meantime, Cipher is generating about $14 million in free cash flow (FCF) per year. The market cap is $163.1 million while enterprise value is $123.6 million. EV/FCF is 8.8. The company is growing at over 25% a year and, as noted, it expects to triple revenues by 2027 and more than triple profits by then. Tripling revenues by 2027 would represent 44% annual growth over the next three years. This growth is based primarily on sales from MOB-015–and, to a much lesser extent, Epuris continuing to gain market share–and does not include any revenue from an acquisition.

Here are the multiples:

• • EV/EBITDA = 3.29
  • P/E = 8.51
  • P/B = 2.04
  • P/CF = 9.02
  • P/S = 8.18

ROE is 29.7%, which is excellent. Insider ownership is 44.5%, which is outstanding. As noted earlier, the company has $39.8 million in cash and no debt. TL/TA is only 7.5%, which is exceptional.

Intrinsic value scenarios:

• • Low case: Epirus may lose market share, MOB-015 may not be approved in North America, and/or Cipher may make a bad acquisition. Net income could drop 50% and so could the stock.
  • Mid case: Revenue should reach at least $60 million by 2027 and net income should reach at least $50 million by 2027. With a P/E of 10, the market cap would be $500 million. That translates into $20.84 per share, which is over 225% higher than today’s $6.35. This depends on MOB-015 being approved in North America but does not include any revenue from an acquisition.
  • High case: If Epirus gains market share, MOB-015 is approved, and the company makes an accretive acquisition, then net income could reach $80+ million by 2027. With a P/E of 10, the market cap would be $800 million. That translates into $33.35 per share, which is 425% higher than today’s $6.35.

RISKS

The main risks are that the company does a bad acquisition or that MOB-015 is not approved in Canada. (There is also a risk–albeit remote–that Epirus could lose market share.) Craig Mull has stated that they are being very patient with respect to an acquisition because they have a ton of cash ($39.8 million) and are producing high free cash flow ($14 million per year), meaning they can afford to be very patient. Craig Mull said they are laser-focused on not making a stupid move.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.

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 roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approachesintrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). 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: [email protected]

 

 

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.

May 19, 2024

ZTEST (through its wholly-owned subsidiary Permatech) is a tiny, printed circuit board (PCB) manufacturer that is now growing significantly–H1 2024 revenues were 88% higher than H1 2023 revenues.

In December 2022, then President John Perreault retired and was replaced by Suren Jeyanayagam, who has been with the company over 30 years. Whereas Perreault did not have any desire to grow the business, Jeyanayagam has a vision to grow the business and has been aggressive in driving revenue growth. Jeyanayagam is directly involved in the sales process, working with the company’s one other salesperson.

The company currently has a strong backlog of orders, which they expect to continue. Jeyanayagam has stated that the most recent record quarter is repeatable in terms of revenue and net income. More and more customers are looking for domestic manufacturers rather than looking overseas.

Furthermore, the company has recently ordered new equipment, which will be installed this month (May 2024). This equipment will double the number of production lines the company has from two to four. And ultimately this will more than double production capacity, as the new equipment is more efficient because of some automation components.

Also, the company is now expanding into the United States. ZTEST has a significant customer south of the Canadian border. There are opportunities for large repeat orders from this same customer once the current order is complete. Large orders have higher gross margins due to bulk inventory orders and economies of scale.

Finally, the company has a 25.3% ownership stake in Conversance, which is a private AI and Blockchain company developing a secure marketplace platform for the cannabis industry. Conversance is expected to begin producing revenues in the second half of 2024.

Although ZTEST’s most recent quarter–in which they earned $0.011315 per share–is their best so far, the company has a strong backlog as well as new manufacturing capacity coming online. Also, as noted, the President Suren Jeyanayagam is very focused on growth.

Metrics of cheapness (based on annualizing the most recent quarter):

• • EV/EBITDA = 3.58
  • P/E = 5.80
  • P/B = 6.04
  • P/CF = 3.87
  • P/S = 0.89

The market cap is $9.14 million. Cash is $732k while debt is $153k.

Insider ownership is 36.7%, which is excellent. ROE is 74.34%, which is superb and likely sustainable.

Intrinsic value scenarios:

• • Low case: If there’s a bear market or a recession, the stock could decline 50%. This would be a buying opportunity.
  • Mid case: Annualizing the last quarter’s result and applying a 10x EV/Net Income multiple yields a valuation of $0.4526, which is over 70% higher than today’s $0.2628.
  • High case: It’s likely that ZTEST can achieve net income above their last record quarter. Annual earnings may reach $0.10 per share. Applying a 10x EV/Net Income multiple gives a valuation of $1.00, which is over 280% higher than today’s $0.2628. This still does not count any value from the company’s 25.3% ownership of Conversance.

RISKS

• • Joseph Chen owns 17.4% of ZTEST shares, but he is the founder of Conversance–in which ZTEST has a 25.3% take. There is concern that Joseph Chen will try to take control of ZTEST and use its cash flows to fund Conversance. If Chen does this and Conversance is not profitable, it could take down ZTEST.
  • In the past, ZTEST has had supply chain problems that slowed production. However, Suren Jeyanayagam and other top executives have said that there is currently no concern regarding the supply chain.
  • The PCB industry has many competitors and no barriers to entry. But ZTEST stands out with quality products, good customer service, and quick turn-around times.

 

BOOLE MICROCAP 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: https://boolefund.com/best-performers-microcap-stocks/

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 roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approachesintrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). The Boole Fund has low fees.

 

 

 

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.

April 28, 2024

Victoria Gold (VGCX.TO / VITFF) operates in the Yukan, Canada. Despite wild fires, the company had a pretty good 2023, producing 166,700 ounces of gold. It should do much better in 2024 and 2025, given the increasing price of gold.

Here is the most recent investor presentation: https://vgcx.com/investors/corporate-presentation/

The market cap is $358.9 million, while enterprise value (EV) is $514.76 million.

Here are the multiples:

• • EV/EBITDA = 3.74
  • P/E = 10.45
  • P/NAV = 0.49
  • P/CF = 3.15
  • P/S = 1.17

Victoria Gold has a Piotroski F_Score of 7, which is good.

Cash is $26.75 million. Debt is $239.65 million. TL/TA is 42.0%, which is good. ROE is 4.43%. This is low but will likely improve in 2024 and 2025, given increasing gold prices.

Insider ownership is 5.2%, worth $18.7 million. This includes 1.3% for the CEO John McConnell, worth $4.7 million.

Intrinsic value scenarios:

• • Low case: If there is a bear market or recession, the stock could drop 50%. This would be a buying opportunity because long-term intrinsic value would likely stay the same or increase once gold prices moved higher.
  • Mid case: Free cash flow will hit at least $120 million in the next year or so. With an EV/FCF multiple of 7, EV would be $800 million. That works out to a market cap of $644.14 million, or $9.57 per share, which is 80% higher than today’s $5.33.
  • High case: If it’s a secular bull market for gold, then gold could hit $3,000 or more. Free cash flow could hit at least $240 million. With a EV/FCF multiple of 7, EV would be at least $1,600 million. That works out to a market cap of $1,444.14, or $21.45 per share, which is over 300% higher than today’s $5.33.

RISKS

As noted, if there is a bear market or recession, the stock could drop 50% temporarily.

It’s also possible the company’s exploration for new resources won’t be very successful. But, in this case, probable intrinsic value would still be much higher than the current stock prices of $5.33.

 

BOOLE MICROCAP 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: https://boolefund.com/best-performers-microcap-stocks/

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 roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approachesintrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). The Boole Fund has low fees.

 

 

 

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.

April 14, 2024

Investor Lee Freeman-Shor hired 45 of the world’s top investors and gave each between $20 million and $150 million to invest. He instructed each one to invest only in their ten best ideas. Freeman-Shor then examined the 1,866 investments made by this elite group over the course of June 2006 to October 2013. The result is the book,The Art of Execution: How the world’s best investors get it wrong and still make millions (2015).

Freeman-Shor explains that the best ideas of the best investors could reasonably be expected to generate excellent long-term results. Freeman-Shor:

These were ideas that they had significant confidence in, and were often the result of hundreds of hours of research by some of the smartest people on the planet.

Given all this, I was sure that I would make a lot of money.

It might surprise you, then, to be told that most of their investmentslost money.

Out of 1,866 investments, a total of 920–about 49% of the total–made money.

However, almost all of these investors made money. How was this possible? Freeman-Shor studied every single trade in order to analyze what had happened.

Freeman-Shor quotes Leo Melamed, a successful futures trader:

I could be wrong 60% of the time and come out a big winner. The key is money management.

Paul Tudor Jones:

The reason for all the Wall Street success stories he knew was down to: money management, money management, money management.

George Soros:

It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.

Here’s the outline for the book:

PART I. I’M LOSING (WHAT SHOULD I DO?)

• • The Rabbits: Caught in the Capital Impairment
  • The Assassins: The Art of Killing Losses
  • The Hunters: Pursuing Losing Shares

PART II. I’M WINNING (WHAT SHOULD I DO?)

• • The Raiders: Snatching at Treasure
  • The Connoisseurs: Enjoying Every Last Drop

CONCLUSION: THE HABITS OF SUCCESS

THE WINNER’S CHECKLIST

1. 1. Best ideas only
   2. Position size matters
   3. Be greedy when winning
   4. Materially adapt when you are losing
   5. Only invest in liquid stocks

THE LOSER’S CHECKLIST

1. 1. Invest in lots of ideas
   2. Invest a small amount in each idea
   3. Take small profits
   4. Stay in an investment idea and refuse to adapt when losing
   5. Do not consider liquidity

 

PART I. I’M LOSING–WHAT SHOULD I DO?

The Rabbits: Caught in the Capital Impairment

Freeman-Shor remarks that the Rabbits ended up being the least successful investors working for him, despite the fact that these were all prestigious investors.

Freeman-Shor gives a case study: Vyke Communications, a UK-based company that specialized in software that allowed users to make phone calls and send text messages. The investor bought shares on October 31, 2007 at £2.10. When the price fell, the investor bought more. This was the right move if the investor still believed in the idea. However, the stock kept falling and the investor decided to stay invested. Two and a half years later on July 2, 2010, the investor sold the entire position at £0.02, for a 99% loss.

Another case study: Vostok Nafta, an investment company listed on the Swedish stock exchange that invests in assets in the Commonwealth of Independent States, a loose associtaion of some of the countries that used to make up the USSR. This investor bought shares April 11, 2008, at £9.14. Five months later, he sold at £3.95, for a loss of 57%. Freeman-Shor notes that the only reason the investor sold was because Free-Shor was pressuring him to either buy more or sell.

Yet another case study: Raymarine, a company that specializes in marine electronics. An investor bought shares on May 31, 2007, at £4.27. 23 months later the price had collapsed, but the investor still believed in the idea. Eventually, partly due to pressure, the investor sold his entire position on April 15, 2009, at £0.17. This was a loss of 96%.

Where did the Rabbits go wrong? Freeman-Shor states ten reasons for why the Rabbits failed:

(1) The narrative fallacy framing bias

Framing bias, discovered by Amos Tversky and Daniel Kahneman, means that people tend to reach a conclusion based on the way a problem is presented. In the case of the Rabbits, they allowed their favorite types of investment to influence how they viewed the stock in question. The Rabbits still believed in the investment thesis for a stock that had fallen a great deal and so they still believed they would make money going forward. Freeman-Shor:

The Rabbits are a great example of how professional investors often react to a black-swan event–an event they did not anticipate and which has negatively impacted their investment story. They tend to dismiss it.

(2) Primacy error

Primacy error means that first impressions have a lasting and disproportional effect on a person. Because the Rabbits had a very positive first impression, they failed to update their investment thesis to incorporate new information.

(3) Anchoring

Related to primacy error is anchoring. Rabbits tended to anchor to initial information, being very slow to change their minds. Freeman-Shor:

It took one Rabbit two and a half years to change his mind on Vyke, and another Rabbit almost two years to react to Raymarine’s decline. The other never changed his mind on Vostok. Similar stubbornness occurred on many other investments.

(4) Endowment bias

As humans, we tend to overvalue our own possessions, which includes the investments we’ve made.

When there are large losses that happen quickly, they are almost impossible to accept. It’s easier to hold on to a losing position. Rabbits did not want to admit the loss by selling because they were too fixated on what they had paid for the stock.

(5) The pull of the crowd

There were many other investors who got burned on the same investments that the Rabbits got burned on. This could have contributed further to the Rabbits being unable to admit their error and sell. Freeman-Shor quotes John Maynard Keynes:

It is the long-term investor… who will in practice come in for most criticism… if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.

(6) Ego

Freeman-Shor says that the Rabbits were more interested in being right than in making money. Many professional investors are this way.

The Rabbits simply could not admit that they were wrong. Freeman-Shor observes:

The fact is, the greatest minds on the planet can be wrong. My findings suggest you should expect to be wrong at least half of the time. The very best investment minds are!

(7) Self-attribution bias

Self-attribution bias means that we blame others or external factors for our misfortunes but take full credit when things go well. This is why we tend not to learn from past mistakes, but to keep repeating them.

The Rabbits, writes Freeman-Shor, tended to blame Mr. Market (“The market is being stupid”) or Mr. Unlucky (“It wasn’t muy fault, I was unlucky because of XYZ that no one could have foreseen”).

(8) The wrong information

Freeman-Shor:

Because many of the Rabbits had been professionally investing for a couple of decades, controlling a significant amount of assets, they had Rolodexes to die for. When they found the ‘story’ behind an investment being challenged, they liked nothing better than picking up the phone and dialling the CEO on his or her personal number to get to the bottom of things. Despite being reassured by the CEO that the setback was merely a bump in the road and the media was making a mountain out of a mole hill, the Rabbits would do nothing. They neither bought more shares nor sold their holdings.

A hugely appealing temptation for more information comes from the need to abrogate responsibility in times of crisis. It is very common when a difficult decision has to be made to see the decision-maker involving more people. The more people involved, the more they can relax because if it goes wrong it was not their fault.

(9) Too big to fail

Like many investors, Rabbits found it far more difficult to walk away from a large losing investment than a small losing investment.

(10) The gambler’s fallacy

The gambler’s fallacy is the mistaken belief that after a period of poor performance, a given stock was due to perform well.

Each coin toss in a series has a 50/50 chance of coming up heads and each toss is independent of prior tosses. The gambler’s fallacy ignores this and instead involves the belief that, after a series of tails, the next toss was likely to be heads. But there’s only a 50/50 chance of this because each toss is independent.

What could the Rabbits have done differently?

Freeman-Shor writes:

The bad news is, everyone can be a Rabbit. The good news is, no one needs to be. There are a few simple things they could have done to overcome their problems.

(1) Always have a plan.

Freeman-Shor:

Investing is all about probabilities. Whether you invest should depend on the odds and the edge you think you have. Given the odds and your edge you should know exactly what you are going to do if the stock you are investing in falls or rises by 20%, 50% and so on.

When faced with a painful loss-making position, most people do nothing. They turn into a Rabbit and procrastinate, letting all their biases play havoc with their decision-making, hoping time will resolve their issues so they don’t have to.

It’s essential to have a plan.

(2) Sell or buy more

Freeman-Shor:

The only solution to a losing situation is to sell out or significantly increase your stake.

Freeman-Shor says the investor needs to ask himself or herself a key question:

If I had a blank piece of paper and were looking to invest today, would I buy into that stock given what I now know?

If the answer is “no,” then the investor must sell. If the answer is “yes,” then the investor should significantly add to the position.

Freeman-Shor notes that legendary investor Peter Lynch would (i) sell if the fundamentals were worse but the price had increased or (ii) buy if the fundamentals were better but the price had decreased. This is logical.

The real mistake the Rabbits made was doing nothing when their investment had declined in price. The logical thing is either to admit a mistake and sell, or buy more at the lower price. Freeman-Shor:

I have learnt that I cannot trust great investors to do the right thing when they are losing–like top athletes, they require coaching and management.

(3) Don’t go all in

As an investor, you should always be able to add to an investment if the price falls, assuming you have taken a fresh look at the investment and decided it’s a good one at the new price. This means you don’t want one position to become too large. Freeman-Shor quotes Mohnish Pabrai:

In my own portfolios at Pabrai Funds, I adjust for this [getting the odds wrong] by simply placing bets at 10% of assets for each bet. It is suboptimal, but it takes care of the Bet 6 being superior to Bet 2 problem. Many times the bottom three to four bets outperform the ones I felt the best about.

(4) Don’t be hasty to jump in, do be hasty to jump out

Cutting your losses early makes excellent sense, although it is difficult. Freeman-Shor writes the following, ending with a quote from Ned Davis:

Not least because selling out of a stock helps clear your head and enables you to assess a situation more objectively. It’s like taking a decongestion pill when suffering from a cold.

And buying slowly over time (known as dollar or pound-cost averaging), with a reduced position size at the outset, ensures you have plenty of ammunition left to load up when a share finally capitulates (assuming it does).

“[W]hat separates the winners from the losers? The answer is simple–the winners makes small mistakes while the losers make big mistakes.”

(5) Remember there is a difference between ‘being right’ and ‘making money’

Freeman-Shor:

In investing, a lot of success can be attributed to being in the right place at the right time–otherwise known as luck.

(6) Seek out opposition

When people lose money they don’t want to be told they are wrong…

What you should really do is to speak to someone with an opposing view.

Ideally you should also sell out of the stock while you do that, so that you have removed the emotional attachment of a vested interest. This mitigates endowment bias and you can always buy the stock back later.

If you would not put money to work in a particular share today, knowing what you now know, then you have to concede that the investment is dead–and if you haven’t already sold, you absolutely should now.

(7) Be humble

Freeman-Shor notes that the Rabbits, on the whole, were incredibly smart and never said, “I don’t know.”

But this is a very dangerous mindset to have. First, it assumes the market is made up of buyers and sellers that are not equally expert, when in fact many will be. Second, ‘knowing more’ often leads to a person not seeing the wood for the trees.

Throughout history there have been many examples that demonstrate this. My favourites are Harry Warner, of Warner Bros., who in 1927 said, “Who the hell wants to hear actors talk?”, and Thomas Watson, chairman of IBM, who in 1943 said, “I think there is a world market for maybe five computers.”

Experts are surprisingly bad at forecasting. Falling for your own hype can also often lead to mistakes that the least intelligent person in the world would not be capable of. Warren Buffett, when talking about the collapse of Long-Term Capital Management, marvelled at “10 or 15 guys with an average IQ of maybe 170 getting themselves into a position where they can lose all their money.”

And crowds are often surprisingly wise–the market can be right even when everyone who makes it up is individually wrong.

Freeman-Shor mentions the jelly beans in a jar experiment. If you take a jar full of jelly beans and ask everyone in a room of 50 or 60 to guess at how many jelly beans are in the jar, typically the average guess is very close to the truth. Moreover, the best individual guess is often not even as good as the average guess, and of course there are many individual guesses that are wildly wrong. This experiment is analogous to the stock market.

Again, only 49% of the best ideas from some of the best investors–those Freeman-Shor hired–ended up being right.

(8) Keep quiet and carry on

Some investors make the mistake of talking publicly about their investments and their anticipated returns. This makes it much more difficult to change their minds if new facts warrant it.

(9) Don’t underestimate the downside–adapt to it

Many Rabbits like stocks that could shoot for the moon. However, often such stocks can get wiped out if they don’t work. Freeman-Shor suggests treating such stocks as options: Size the position as if it were an option–almost like a venture capital investment–so that, if it works, you can do well, whereas if it doesn’t work, the loss will be contained.

(10) Be open to different kinds of story

Deep value investing can produce the highest long-term returns. Freeman-Shor:

Many studies have shown that stocks with the worst stories tend to produce the highest returns.

Stated differently, value investing–investing in cheap stocks that no one likes because they have terrible stories that led to their stock price falling–produce the highest returns over time.

(11) Get sick of sick notes

Freeman-Shor suggests getting familiar with the typical excuses investors like to offer:

• • The ‘If only’ defence.
  • The ‘I would have been right but for’ defence.
  • The ‘It just hasn’t happened yet” defence.
  • The ‘Who could have foreseen at the time I invested that XYZ would happen…’ defence.
  • If it’s gone down this much already, it can’t go much lower.
  • You can always tell when a stock hits rock bottom.
  • Eventually they always come back.
  • When it rebounds slightly, I’ll sell.

(12) Be suspicious of status.

Freeman-Shor writes:

Lastly, whether you work in the investment industry or are thinking about trusting your money to someone who does, there is a bonus moral in the story of the Rabbits: it is dangerous to assume that just because an investment professional is highly educated and has years of experience, he or she will be good at making money and getting the big calls right.

IT’S ALL ABOUT CAPITAL IMPAIRMENT

Freeman-Shor says:

One of the reasons that the Rabbits held on to losing investments was fear of the unnkown: if they sold out, the shares might rally, and they would miss out. It was better to stick with a current loss than worry about that double-whammy.

This is known asambiguity aversion, and describes why people prefer to stick with intolerable situations merely because a hypothetical alternative might be worse. Better the devil you know.

Freeman-Shor again:

I believe that even the best investors often overlook the fact that a stock’s price would need a practically supernatural rise of 900% to break even if they have foolishly ridden it down 90% and done nothing.

THE LESSONS OF POKER

Freeman-Shor observes:

Stories are the biggest factor in determining what decisions we make. For the Rabbits, the stories in their heads led them to invest many millions in companies that ultimatley lost them and me vast amounts of money. Their actions post-investment were clouded by the story that led them to invest on day one.

The moral here is to try to avoid being blinded by your story. Above all, have aplan of action as to what you will do if you find yourself in a losing position, even if you still think you are right.

The key difference between the Rabbits and successful investors in this book is that when the Rabbits were losing they did nothing. As we will see with the Assassins and Hunters, they acted decisively to bail themselves out of the holes they found themselves in.

Freeman-Shor quotes Darwin:

It is not the strongest of the species that survive, nor the most intelligent, but the one most responsive to change.

Freeman-Shor then writes:

If only the Rabbits had played poker. Any poker player knows that it is not how many hands you win that matters, it’s how much you win when you win, and how much you lose when you lose.

Each hand in poker represents a story and the goal for a poker player is to try to make money with whatever story they have been given–good or bad. If the story is poor then you don’t stick with it and throw money at the problem; the odds are stacked against you. You fold your hand, cut your losses and live to fight another day.

Likewise, if you are dealt a good hand but then see the flop and realise the hand is now nowhere near as strong as you thought, you fold.

 

The Assassins: The Art of Killing Losses

Freeman-Shor quotes the legendary investor Warren Buffett’s rules for investing success:

Rule No. 1–Never lose money.

Rule No. 2–Never forget rule No.1.

Freeman-Shor then explains:

The Assassins are the investors who really lived and breathed this principle while working for me. When it came to selling losing positions so as to preserve their capital they were ruthless, like cold-hearted hitmen, pulling the trigger without emotion. Then they carried on with their lives like nothing had happened.

Hedge fund titan Stanley Druckenmiller had this to say about fellow hedge fund titan George Soros.

[He is] the best loss taker I have seen. He doesn’t care whether he wins or loses on a trade. If a trade doesn’t work, he’s confident enough about his ability to win on other trades that he can easily walk away from the position.

Freeman-Shor explains that successful investing is all about asymmetric returns:

…winning is about ensuring the upside return potential is significantly greater than the downside potential loss.

Despite that you might imagine, in reality we can all be as cold and ruthless as the Assassins.

Freeman-Shor adds:

What I liked about the Assassins was that they lived by a pair of sacred rules.

The rules were derived from their own experience and beliefs, and the key to their success was that when they were losing they would always let the rules, not their emotions or feelings, drive their decision.

They knew that when faced with the uncertainty that naturally follows when the market has turned against them, they could not rely on themselves to do the right thing.

They therefore committed to becoming slaves to the rules. When a loss occurred they would follow their commandments to the letter.

Importantly, these two rules had been well thought through when the Assassins were in an emotionally ‘cold state’. They planned well in advance; before they invested, they knew what they would do afterwards. They did this because they knew that when push came to shove they were likely to make poor decisions in a ‘hot’ (or emotionally charged) state of mind.

THE CODE OF THE ASSASSINS

(1) Kill all losers at 20-33%.

The Assassins know that it’s very tempting, when it comes time to kill a losing trade, to wait. That’s why they used a device: the stop-loss.Freeman-Shor:

The Assassins’ rules required them to put a stop-loss in place at the same time they they bought any share. If the stop-loss was triggered by a share price going down a certain amount, it automatically sold their entire stake.

Freeman-Shor comments that some investors use a “review” instead of a stop-loss, but that a stop-loss is often better. Freeman-Shor continues:

Legendary investor and art collector Roy Neuberger, whose investment firm Neuberger Berman bears his name, credits the 10% rule as part of the reason for his success. He always cuts his losses when they hit 10%–no matter what.Recognise your mistakes early and take immediate action was his mantra.

The Assassins’ rule was the same, but they despatched their losers at slightly different predetermined points depending on their own experience and preferences: almost always somewhere between 20% and 33% (it depended on the Assassin). Despite Neuberger’s rule, my findings support the Assassins’ approach. This range of stop-loss levels avoids you getting whipsawed while giving a realistic chance of being able to recover from the loss incurred.

Freeman-Shor offers a case study: Genmab, a Danish biotechnology company that specializes in creating human antibody treatments for people suffering from cancer. Two weeks after investing, the Assassin was down 30%. His stop-loss activated at -32% and he sold on Nvember 16, 2009, with the shares trading at £12.43, having originally bought the company on October 29, 2009, at £18.34. This was a good decision because the shares then fell another 49%. While it was tough to take a 30% loss so quickly, that was much better than a 65% loss.

Freeman-Shor gives another case study: Dods, a media company that provides information, organizes events, and does publishing. Dods had become the most trusted source for political data. An Assassin bought shares on December 29, 2006, at £0.51. Ten months later, his stop-loss at 39% sold out on October 31, 2007 at £0.31. After that, the stock fell another 63%. So the Assassin was clearly right to sell when his stop-loss had been triggered.

Freeman-Shor comments:

In the world of investments there is no such thing as a safe bet. If you invest in a company and think that it is bulletproof, I urge you to have an action plan to decide what to do when things go wrong–things often do.

The next case study: Royal Bank of Scotland. It is one of three banks in the UK that is permitted to issue UK banknotes. An Assassin bought shares on May 30, 2008, at £22.29. When the credit crisis started, this Assassin actually moved faster than his stop-loss, selling out at £18.62. This was a loss of 16%. The stock then lost a further 82%. Good decision by this assassin.

(2) Kill losers after a fixed amount of time.

Freeman-Shor explains the logic of this rule: Time is money.

Being in a losing position too long–even if the size of that loss hasn’t hit 20% or more–can have a devastating effect on your wealth. This was something the Assassins were acutely aware of.

DON’T SELL TOO SOON

While having a strict discipline for dealing with losing stocks is important, you don’t want to be overly strict or too quick.

Freeman-Shor gives the example of Compass Group, the world’s largest food service company. It serves billions of meals a year. One of the investors that Freeman-Shor manages bought on November 20, 2007 at £3.19. He then stold the entire stake twelve months later at £3.04, for a loss of only 5%. At the time Freeman-Shor was writing the book, the stock had already increased 143% since it was sold, which was more than the overall market increased.

Freeman-Shor offers the example of BMW. One of his investors bought BMW on April 11, 2008 at £34.95. He sold two months later on June 23, 2008, at a price of £32.35 for a loss of 7%. The stock then went up 95%.

Another example: Perelli, the Italian tyre manufacturer. One of Freeman-Shor’s investors bought on January 22, 2010 at £4.61. He sold one month later at £4.26, a loss of 8%. Perilli subsequently increased 103% as of the time Freeman-Shor was writing the book.

And: Rightmove, where people in the UK look for a property to rent or buy. One of Freeman-Shor’s investors bought shares at £5.51 on November 13, 2009. A month later, on December 30, 2009, he sold at a price of £4.91, a loss of 11%. The shares then shot up 202%.

BE CAREFUL ON YOUR NEXT INVESTMENT

When a person sells a losing investment, they often become risk-seeking, which is calledthe break-even effect. This is not a good idea.

AN ELUSIVE CADRE

Freeman-Shor writes:

The Assassins were some of the most disciplined investors I have met, and a significant factor in their ability to make money was that they cut their losses consistently. A study by Professor Frazzini supports the Assassins’ approach too: it shows that the highest investment returns were achieved by those investors that had the highest rate of selling out of losing positions. Those that realised the least amount of losing positions experienced the lowest returns.

The losing trait of riding losing positions while taking profits on winning positions has been called thedisposition effect by Frazzini.

 

The Hunters: Pursuing Losing Shares

Instead of using a stop-loss like the Assassins, the Hunters instead would–in certain situations–buy more of a stock that had decreased. Quite often, the Hunters would end up making a profit.

It’s important to note that the Hunters committed to buying more at lower prices–if they became available–before they even bought their initial stake. Freeman-Shor explains:

The key reason for the Hunters’ approach lay in their invariably contrarian style. They were value investors. They generally found themselves buying when everyone else was seling, and this was an extension of that philosophy, another way of exploiting Mr. Market when he was acting irrationally.

SUCCESS STARTS FROM FAILURE

Many successful Hunters had at least one terrible year near the beginning of their career. The Hunters learned how to be contrarian but also to be right more often than not. (Otherwise, there’s no benefit from being a contrarian.) Just as important, the Hunters learned to admit when they had made a mistake. Freeman-Shor:

They also grew unafraid to sell if it became clear they really had made a mistake. Poor value investors I have come across refuse to adapt when they are losing and tend to support their lack of action by saying, “I got it wrong but the stock is simply too cheap to sell now.” A bad contrarian investor can make for a very committed Rabbit.

But if a stock still passed the vital ‘Would I buy this knowing what I know now?’ test, the Hunters followed their plan, and started to put their money on the side to work as the share price dropped.

SNATCHING VICTORY

Many Hunters enjoyed the game of trying to pick a bottom in a given stock. It’s often not possible to do this, but sometimes it is possible to come close. As Freeman-Shor explains, successfully investing near the bottom can often create a nice profit. The Hunters enjoyed snatching victory from the jaws of defeat.

Freeman-Shor:

Be under no illusions: being a Hunter requires patience and discipline. You have to expect a share price to go against you in the near term and not panic when it does. You have to be prepared to make money from stocks that may never recapture the original price you paid for your first lost of shares. If you know your personality is one which demands instant gratification, this approach is not for you.

Freeman-Shor quote Peter Lynch:

I’m accustomed to hanging around with a stock when the price is going nowhere. Most of the money I make is in the third or fourth year that I’ve owned something.

Freeman-Shor offers some case studies.

Aker Solutions is a Norwegian oil services company. It provides products and services related to the construction, maintenance, and operation of oil and gas fields. One of Freeman-Shor’s Hunters bought the stock on April 14, 2008, at £15.84 per share. A year and a half later, the stock was much lower. The Hunter bought significantly more on September 28, 2009, so that his average cost was only £7.61. He sold at £9.58 because he realized his original thesis was no longer true. Had he not done anything, he would have had a loss of 40%. Instead, he made a 24% profit.

Experian is an Irish company that operates globally. The company collects information on individuals and produces credit scores used by lenders. A Hunter bought the stock on June 13, 2006, at an initial price of £9.02. After the price declined, the Hunter bought more, reducing his average cost to £5.66. When he sold at £7.06, he realized a profit of 19%. Had he done nothing, he would have lost 22%. Freeman-Shor notes that the Hunter, by his actions, had turned a losing position into a winning position.

Technip is a French company that does engineering and construction for the oil and gas industry. It’s a leader in areas such as subsea drilling, laying specially built pipelines, producing floating offshore platforms, and planning the development of oil and gas fields. A Hunter bought the stock on April 11, 2008, at a price of £55.42. When the stock declined, the Hunter bought much more, reducing his average cost to £42.24. He later sold at £52.13. He realized a gain of 22%. Once again, a Hunter had turned a loss into a gain by buying more shares on the decline.

Thomson Reuters is a global media company based on New York. It provides the latest content and data to the finance industry. It also produces material to help lawyers and accountants ensure they are up-to-date on the professional education. Moreover, the company produces research for the pharmaceutical industry. A Hunter bought stock on June 13, 2006, at £22.25. The stock dropped and the Hunter bought materially more, reducing his average cost to £15.82. He sold on September 10, 2009, at £18.92. Instead of a loss of 15%, the Hunter made a profit of 17%.

HUNTING FOR THE COMPOUNDING EFFECT

Freeman-Shor mentions the Kelly criterion. Freeman-Shor doesn’t mention the details, but they’re important, so here they are:

The Kelly criterion can be written as follows:

• • F = p – [q/o]

where

• • F = Kelly criterion fraction of current capital to bet
  • o = Net odds, or dollars won per $1 bet if the bet wins (e.g., the bet may pay 5 to 1, meaning you win $5 per each $1 bet if the bet wins)
  • p = probability of winning
  • q = probability of losing = 1 – p

The Kelly criterion has a unique mathematical property: if you know the probability of winning and the net odds (payoff), then betting exactly the percentage determined by the Kelly criterion leads to the maximum long-term compounding of capital, assuming that you’re going to make a long series of bets. Betting any percentage that is not equal to that given by the Kelly criterion will inevitably lead to lower compound growth over a long period of time.

Both Warren Buffett and Charlie Munger are proponents of the essential logic of the Kelly criterion. Here’s Charlie Munger:

The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.

As for Buffett, he famously invested 40% of his hedge fund into American Express in the late 1960s. Buffett realized a large profit. Later, Buffett invested 25% of Berkshire Hathaway’s portfolio in Coca-Cola. Buffett again enjoyed a large profit of more than 10x (and counting).

Freeman-Shor notes the following:

If a stock you are invested in has fallen materially in price, but nothing else has changed–the investment thesis is still intact–your odds will have improved significantly and you should materially increase your stake in that company.

Freeman-Shor adds:

If you are a Hunter… you choose not to control risk by diversification but by thoroughly understanding the risk and returns of a particular stock or handful or stocks. Your goal is to find companies that have an unbelievably attractive, asymmetric payoff profile.

The fact that you are only investing in a few companies means that you have the opportunity to invest big on day one, and then follow up with large top-up investments should the share price fall.

Warren Buffett wrote in his 1993 letter to the shareholders of Berkshire Hathaway:

If you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification make no sense for you. It is apt to simply hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices–the businesses he understands best and that present the least risk, along with the greatest profit potential.

Freeman-Shor concludes by pointing out that coaches would be quite helpful for investors:

I find it bizarre that top athletes and sportsmen and women have coaches but the majority of investment professionals do not.

How can they expect to improve their game if they do not have constructive feedback?

 

PART II. I’M WINNING–WHAT SHOULD I DO?

The Raiders: Snatching at Treasure

Freeman-Shor writes:

Raiders occupy a thin line between success and disaster. These are investors who like nothing better than taking a profit as soon as practical. They are the stock market equivalent of gold-age adventurers: having penetrated through the dense jungle, found the lost temple or buried treasure, they fill their pockts with all the ancient coins and gems they can–then turn tail and run.

Unlike gold-age adventurers, they are rarely chased by angry locals or rivals. The only boulders rolling after them are in their imaginations. They are terrified of getting caught and losing everything, and to ensure they at least come away with something end up leaving countless chests and swagbags of treasure behind completely unnecessarily.

Freeman-Shor continues:

I discovered the Raiders when I noticed the rather distressing fact that one of my investors had an incredible success rate–almost 70% of his ideas were correct, which is truly phenomenal–but he hadn’t made me any money.

I broke down the data for his investments and discovered that whenever he made a small gain, say 10%, he would immediately sell the stock and take the profit.

Interestingly, he was a hedge fund manager and in his own trading was an expert at shorting shares–and staying short. But when it came to long-only investments, he and the other Raiders lacked a key habit that the successful investors I worked with possessed. He did not embrace the right tail of the distribution curve. In ordinary terms, the Raiders did not run their winners.

Freeman-Shor then gives some examples.

Chicago Bridge & Iron is a multinational company that does energy industry infrastructure projects. One of the Raiders bought the stock on September 3, 2009, at £10.66. A month later, on October 5, 2009, he sold at £12.29. A few years later, the stock was at £30.38. The stock had increased 147% since the Raider had so prematurely sold it.

British American Tobacco manufactures and sells tobacco products, including the brands Lucky Strike, Pall Mall, Vogue, John Player, Benson & Hedges, and Kent. One of Freeman-Shor’s Raiders bought on July 3, 2009, at £19.96. Two and a half months later, on September 21, 2009, he sold at £21.75, a profit of 9%. A few years later, the stock was at £37.93, 74% higher than where the Raider had sold it.

Swedish Match is a world leader in chewable tobacco. The Raider bought on October 10, 2008, when the shares were at €10.56. This investor sold after two months on December 16, 2008, at €10.18, a 4% loss. He decided to buy back in on June 24, 2009, at €11.23, before selling on April 22, 2010, at €17.54, for a profit of 56%. A couple of years later, the stock was at €25.88, a further increase of 49%.

Novo Nordisk is a Danish pharmaceutical company and a world leader in diabetes medication (insulin) and care equipment (injection devices and needles). The company is also a leader in hemophilia care and hormone-replacement therapy. One of Freeman-Shor’s investors bought on April 22, 2009, at €35.71. He later sold on December 4, 2009, at €45.32, a profit of 27%. A couple of years later, the stock was at €124.92, a further increase of 175%. This Raider had made a huge error, assuming the intrinsic value of the stock was near €124.92 or higher.

Freeman-Shor summarizes by saying that Raiders are right most of the time, but still lose money because their losses are bigger than their gains. If they could learn to stick with winning ideas, they would be winning investors. Freeman-Shor comments:

…the most successful investors I worked with, those that made the most money, all had one thing in common: the presence of a couple of big winners in their portfolios. Any approach that does not embrace the possibility of winning big is doomed.

WHY DO INVESTORS SELL TOO SOON?

(1) It feels so good. Selling for a profit feels nice. We get a hit from testosterone and dopamine.

(2) I’m bored. As Peter Lynch observed:

[I]t’s normally harder to stick with a winning stock… than it is to believe in it after the price goes down.

(3) Frustration. It’s very difficult to patiently wait for years. One factor ishyperbolic discounting, which makes people prefer $1 today versus $2 tomorrow.

(4) Fear. Because ofloss aversion, we tend to feel the pain of a loss at least twice as much as the pleasure of an equivalent gain. When a Raider’s investment starts doing well, he often fears what might happen if he doesn’t sell.

(5) Short-termism. There isrecency bias. Freeman-Shor:

My own fund–the Old Mutual European Best Ideas fund–is a good example of this. If you took a three-year view from 2009 to 2011 you would have said I was a superstar. If you viewed my performance during August 2011, or for the year 2011 alone, you would have said quite the reverse.

The flows my fund experienced showed just this. Shortly after delivering those three-year performance figures I had over $200 million invested into my fund. But during August 2011, clients withdrew tens of millions of dollars.

Since 2011 the performance of the fund has been strong and, surprise surprise, we have attacted inflows again.

Imposing different time frames on an investment can produce very different results–and Raiders invariably impose short-term ones. This can be deadly for winning trades.

(6) Risk aversion. People are risk-averse when winning–and tend to take profits–and they are risk-seeking when losing. When winning, selling is appealing because the certainty of a small victory is better than the uncertainty of a loss or greater victory. When losing, risk is appealing because anything is better than a certain loss.

WHY YOU SHOULDN’T SELL EARLY

(1) Rarity value. Freeman-Shor:

All the successful investors I have managed made money because they won big in a few names, while ensuring the bad ideas did not materially hurt them.

… Stock market returns over time showkurtosis, which means fat tails are larger than would be expected from a normal distribution curve. This means that a few big winners and losers distort the overall market return–and an investor’s return. If you are not invested in those big winners your returns are drastically reduced.

(2) Beat your rivals. Honing your ability to let winners run can give you a very significant advantage as an investor.

(3) You cannot trust your next investment. The odds of picking a winning trade–based on the results of some of the best investors in the world working for Freeman-Shor–are roughly 49%. This means the odds of picking five winning investments in a row are roughly 2.8%. So if you have a winning investment, stick with it as long as possible.

(4) Winners can keep winning. The research says that a momentum strategy can be a winning strategy. A stock that has gone up over 6 months or a year often continues to go up. Of course, no stock goes up forever, so even though you should let a winner run–as long as the investment thesis is intact and the intrinsic value is higher than the current stock price–you should eventually sell unless it’s a company with a sustainably high return on equity (ROE).

(5) You can never predict big winners when you first invest. Freeman-Shor:

Many legendary investors did not predict their biggest winners–and have admitted it. Some all-time greats even built their investment style around not knowing how big a winner might be: Jesse Livermore became of of the wealthiest men in America in the 20th century by adopting a simple trend-following approach.

In effect he bought stocks that were being bid up and rode them up, never knowing if it would turn out to be a big winner when he initiated the position.

TOO PROFESSIONAL

Some reasons why professional investors tend to sell too soon.

(1) Bonuses. Many fund managers are paid an annual bonus. (It would make much more sense to pay a bonus–and allow the bonus to be large–every five or ten years.)

(2) Expectations. Some fund managers feel the outperformance cannot continue. The error being made is that essentially no investor can predict their biggest winners ahead of time. So it’s best to stick with a winner as long as the investment thesis is intact and the estimated intrinsic value is high enough (or the company has a sustainably high ROE).

(3) Forecasting. Often when fund managers look one or two years ahead and use conservative assumptions, the estimated intrinsic value is not much higher than the current stock price. This makes it difficult to stick with the big winners.

(4) Relativity. Unfortunately, many fund managers are evaluated on a shorter-term basis. This makes them obsess over shorter-term results. However, the biggest winners often increase the most in year 3 or year 4 or later. A fund manager worried about 6-month or 1-year performance will tend to miss the biggest winners.

Freeman-Shor writes:

So being assessed on a relative basis leads fund managers to pay alot of attention to how they are performing relative to both the benchmark index and their peer group. Worse still, some do this on a daily basis. They know the value of their holdings almost to the hour.

And it leads to a lot of unnecessary early selling. It helps professional investors think that stocks are riskier than they actually are. By monitoring a stock they are invested in several times a day, they notice the share price moves up and down quite a bit. The price seems volatile.

But what if you just reviewed an investment every ten years? You would probably find that the stock has made you quite a lot of money. Moreover, because you did not check the stock price during that ten-year period, you did not notice the price moving up and down every day. You never experienced the pain of a 20% fall in one day–perhaps 50% in a year. You were completely unaware of the volatility of the ride you were on. You therefore come to the conclusion that investing in the stock market is not risky at all.

My note: Fidelity did a study of its accounts and it found that the best-performing accounts belonged to people who either forgot they had an account or to people who had died.

 

The Connoisseurs: Enjoying Every Last Drop

Freeman-Shor writes:

The Connoisseurs are the last and most successful investment tribe I discovered among the top investors who worked for me. These are the investors whose performance lived up to the billing–or exceeded it. They did not get paralysed by unexpected losses or carried away with victories. They treated every investment like a vintage of wine: if it was off, they got rid of it immediately, but if it was good they knew it would only get better with age. They usually drank the odd bottle now and then, to tide them over–but otherwise they sat back and waited.

It takes a long of nerve to do nothing or merely trim a position when winning. Everything points to us being hard-wired to sell out of an investment when we have made a reasonable profit.

…

Taking small profits along the journey like a Connoisseur allows us to get instant gratification without ruining our long-term wealth aspirations. This ‘trick’ is one that I have seen in action and which allowed my best investors to stay in absolutely phenomenal winners.

HOW TO RIDE WINNERS

Freeman-Shor:

In terms of hit rate, as a group [Connoissers] actually had a worse record than the average for my investors. Six out of ten ideas the Connoisseurs invested in lost money. The trick was that when they won, they won big. They rode their winners far beyond most people’s comfort zone.

How to be like a Connoisseur:

(1) Find unsurprising companies.

The Connoisseurs’ approach was to identify companies with a view to holding them for ten or more years. They would buy businesses that they viewed as low ‘negative surprise’ companies. In other words, it was hard to envisage anything that could cause these companies to fail in generating profits over the years ahead.

Even if in the future they had terrible management at the helm, that management would have to be extraordinarily incompetent to destroy the profit-making ability of the enterprise. The companies were effectively money-printing machines.

The future growth of earnings was seen as very predictable, and because the Connoisseurs believed earnings growth drove stock prices, the stock price should therefore drift higher over time.

The main risk of buying these stocks was if they were rated highly at the outset (i.e. with high price/earnings ratio). This could mean that the company fundamentally performs as expected but the share price doesn’t follow earnings upwards due to it getting derated.

(2) Look for big upside potential. Where many investors go wrong is in investing in a lot of ideas with limited upside potential. Since your win rate may be between 40% and 49%, it’s essential to focus only on stocks with the biggest upside potential–or stocks trading at the greatest discount to intrinsic value.

(3) Invest big–and focused. Connoisseurs could end up with 50% of their portfolio in just two stocks. Freeman-Shor:

Having massive belief in a couple of names meant they were prepared to ride the stocks with big positions even when they were up 200% or more. Their success was testament to Stanley Druckenmiller’s comment that “position size can be more important than entry price.”

This is one of the reasons that I allow each of my current investors to invest up to 25% of the money I give them in a single idea.

Freeman-Shor quotes New Market Wizards:

When you have tremendous conviction on a trade, you have to go for the jugular. It takes courage to be a pig. It takes courage to ride a profit with huge leverage. As far as Soros is concerned, when you’re right on something, you can’t own enough.

Freeman-Shor comments:

It is no use having a small investment in a big winner; you have to have a large position size to generate big returns.

(4) Don’t be scared. One key to sticking with a big winner and not being attracted by another great investment is to take small profits as the potential big winner is going up. But the bulk of the potential big winner should be maintained and not sold.

(5) Make sure you have a pillow. Freeman-Shor writes about having a high boredom threshold:

Meeting some of my Connoisseurs could be very, very boring because nothing ever changed. They would talk about the same stocks they had been invested in for the past five years or longer…

The fact is, most of us will find it difficult to emulate the Connoisseurs because we feel the need to do something when we get to the office (or home trading desk) every day. We look at stock price charts, listen to the latest market news on Bloomberg TV, and fool ourselves into believing we could add value from making a few small trades here and there. It is very hard to do nothing but focus on the same handful of companies every year, only researching new ideas on the side.

Many of us, seeing we have made a profit of 40% in one of our stocks, start actively looking for another company to invest the money into–instead of leaving it invested. This is precisely why lots of investors never become very successful.

Freeman-Shor next gives some real-life examples.

Shoprite Holdings is the largest food retailer in Africa. It also operates furniture outlets, fast food outlets, and pharmacies. It is the Wal-Mart of Africa. One of the Connoisseurs invested in Shoprite on May 20, 2009, at £3.96 per share. He sold the position three years later on August 9, 2012, at £13.10 per share. This was a return of 231% in only three years. This investor trimmed along the way and realized an overall profit of 104%.

Spirax-Sarco Engineering is a UK company that builds and maintains steam and industrial fluid plants. The company’s products–which include boilder and pipeline control valves and clean steam generators–are being used more and more. One of the Connoisseurs had known about this company for decades. He bought a position on November 30, 2007, at £9.63. He sold five years later on October 22, 2012, at £19.70. The Connoisseur trimmed along the way and so realized a profit of 70% by selling at an average price of £16.40.

Rotork is a UK-based business and the world’s leading manufacturer of valve actuators, whether electric, pneumatic, or hydraulic. The Connoisseur had known about the company for a long time. He bought a position on November 30, 2007, at £9.84. He sold five years later at £25.18. Because the investor took profits along the way, he realized an average selling price of £17.26, banking a profit of 74%.

President Chain Stores is a Taiwanese company. The company is an international food conglomerate operating in Taiwan and China. It’s similar to Wal-Mart. One of the Connoisseurs established a position on June 15, 2006, at £1.37 per share. He sold five years later on August 23, 2011, with the shares at £3.73. Because he trimmed along the way, the investor realized an average selling price of £3.17. This was a profit of 132%.

Kasikornbank is a commercial bank in Thailand. Through its wholly-owned subsidiaries, it does everything from investment banking to securities brokerage, fund management, hire purchase, and machinery/equipment leasing. A Connoiser initiated a position on June 20, 2008, at £1.09. He sold two years later on November 1, 2010, when the shares were at £2.65. Because the investor sold along the way, his average selling price was £1.88. Thus, he realized a profit of 79%.

Freeman-Shor writes an important point:

Remember, despite their successful approach, only one-in-three of the Connoisseurs’ ideas made money. In other words, every Connoisseur was also an Assassin or a Hunter when it came to losses.

CLUES FROM THEFORBES RICH LIST

Most people on the Forbes rich list not only have created a wonderful business, but also have never sold out. Many of these folks received buyout offers along the way, but they decided not to sell. Freeman-Shor:

Over the past decade or so, I would imagine Bezos has been approached by hundreds, possibly thousands of other companies wanting to buy Amazon from him. Could you have resisted if someone offered you $10m or $100m for your company? Resisting temptation and staying invested in a great idea is critical. Had Jeff sold out earlier when he was building Amazon, we may never have heard about him today.

Freeman-Shor adds:

When you are winning, dedication and discipline is what you require. The Pareto principle, otherwise known as the 80/20 rule, states that 80% of the effects come from 20% of the causes. It helps explain why great investors can be wrong most of the time and still make money. A few big winners make a massive difference to the eventual outcome.

WHY MANY FUND MANAGERS ARE DOOMED TO FAIL

Freeman-Shor writes that many fund managers find it nearly impossible to be Connoisseurs.

Firstly, many professional investors over-diversify when they invest because they are managing career risk. Most are judged by their bosses and employers based on how they perform against an index or peer group over ashort period of time. This militates against concentrating investments in potential long-term winners.

Secondly, regulators–based on investment theories from the 1970s–have put into place rules that prohibit professional fund managers from holding large positions in just a handful of their very best money-making ideas.

Why?

Because they believed diversified portfolios represent less risk than a concentrated portfolio of stocks. The reality, however, is that all you are doing is swapping one type of risk for another. You are exchanging company specific risk (idiosyncratic risk), which may be very low depending on the type of company you invest in, for market risk (systematic risk).

Risk hasn’t been reduced, it has been transferred.

The legendary investor Warren Buffett has written that if you know the companies you’re investing in very well and if you’ve focused only on your very best ideas, risk is actually lower than if you added more ideas about which you had both less conviction and less knowledge.

ACADEMIC SUPPORT FOR ‘BEST IDEAS’ INVESTING

There was a paper that looked at the performance of investment managers’ best ideas. They found:

• • The single highest-conviction stock of every manager taken together outperformed the market, as well as the other stocks in those managers’ portfolios, by approximately 1-4% a quarter. That is a staggering 4-16% a year. Over a ten-year time frame, that means these stocks could have outperformed the market by a phenomenal 48-341%!
  • The managers’ top five stocks also outperformed the market, as well as the other stocks in those managers’ portfolios, significantly.
  • The managers’ worst ideas–those stocks with the lowest weighting–performed significantly worse than the managers’ best ideas.

The study also found that there was little overlap in terms of the specific best ideas of the investors they studied. The bottom line: Success comes from investing inyour best idea.

The authors of the paper conclude:

What if each mutual fund manager had only to pick a few stocks, their best ideas? Could they outperform under those circumstances? We document strong evidence that they could, as the best ideas of the active managers generate up to an order of magnitude more alpha than their portfolio as a whole.

The paper also notes:

The poor overall performance of mutual fund managers in the past is not due to a lack of stock-picking ability, but rather to institutional factors that encourage them to over diversify, i.e. pick more stocks than their best alpha-generating ideas.

Again:

…the organization of the money management industry appears to make it optimal for managers to introduce stocks into their portfolios that are not outperformers… [in other words] managers attempt to maximise profits by maximizing assets under management… while investors benefit from concentration… managers under most commonly-used fee structures are better off with a more diversified portfolio.

DANGERS OF BEING A CONNOISSEUR

Freeman-Shor notes that while being a Connoisseur generates the highest returns, it is not easy and there are dangers, three in particular:

(1) You can be too late. After a stock has increased a greal deal, at some point it won’t and the investor may be too late. I would add: As long as the intrinsic value is higher than the current stock price, or as long as the ROE is sustainably high (if you’re buying a higher quality business as your value investment strategy) and the stock price reasonable, then you should be OK.

(2) Momentum can be illusory–and end abruptly. See the previous point.

One must also beware of bubbles. Freeman-Shor mentions the book by Charles Mackay,Extraordinary Popular Delusions and the Madness of Crowds (1841).

His research showed how people lose the ability to think rationally under pressures of crowd behavior. At the height of a bull market or in the depths of a bear market people become herd-minded.

…

This suggests that sipping some of those profits over time makes a lot of sense. While you stay invested and therefore have the potential to win big, you are mitigating the potential damage should the shares disappoint.

(3) You can get stuck. If panic takes over, it can be difficult to sell.

 

CONCLUSION: THE HABITS OF SUCCESS

Freeman-Shor writes:

Having had the privilege of investing over a billion dollars with the best investors in the world, and managing them on a daily basis for over eight years, my preconceptions about successful investors have been shattered.

I discovered that the success enjoyed by top investors is not due to possessing a special gift, nor from having a privileged upbringing (though some who worked for me did). Nor is it down to being born geniuses, though many were very smart. Instead, any success ultimately came down to just one thing: execution.

This was the common thread that connected all of them. And the secrets of successful execution were really just a matter of habit.

…

Each had learned the unseen art of executing ideas in a way that meant that even if they were wrong most of the time, they would still make a lot of money.

These successful investors didn’t have any clairvoyant forecasting abilities, but they knew what to do when they were winning or losing. Freeman-Shor:

If they were losing they knew they had to materially adapt, like a poker player being dealt a poor hand. A losing position was feedback from the market showing them that they were wrong to invest when they did. They knew that doing nothing, or a little, was futile. They had each independently developed a habit of significantly reducing or materially buying more shares when they were losing.

When winning, to take an analogy from baseball, the successful investors knew they had to try to hit a home run, as opposed to stealing first base. This meant that they had developed the hidden habit of being resolved to stay invested in a winning position even when inside they were burning to take the profits they had made, and their inner voice was screaming, ‘Take the profit before you lose it!’

Freeman-Shor adds the following:

Success in investing is open to anyone, whatever their level of education or background, whether old or young, experienced or inexperienced. You simply need to materially adapt when losing and remain faithful when winning.

If you have the discipline to do that, you can succeed.

I have no doubt that many professional investors reading this will neither change the way they invest nor adopt the winning habits I have revealed. They will consider them too simple or common. Most think they are just too smart and that they know best. They are overconfident in the same way all drivers think they are better than average. It’s their loss.

Freeman-Shor makes an additional, important point:

Some people may worry that adopting the habits of the successful investing tribes means losing their identity–or looking to invest with ideas that aren’t really theirs. The good news is that the investors within each group all had radically different opinions about almost everything. Their habits of execution overlapped, but the ideas that got them into an investment in the first place could not have been more different.

 

THE WINNER’S CHECKLIST: THE FIVE WINNING HABITS OF INVESTMENT TITANS

(1) BEST IDEAS ONLY. You should only invest in your very best ideas. Period. One or two big winners is essential for success.

(2) POSITION SIZE MATTERS. Again, it’s essential not to over-diversify. Invest only in your very best ideas. But have a handful of these ideas, not just one, because sometimes there are unforseen events or bad luck.

(3) BE GREEDY WHEN WINNING. You have to let your winners run. Embrace the possibility of the big win. Embrace the right tail, the statistical long shots, of the distribution curve. Give your investments the possibility of growing into ‘ten baggers.’

(4) MATERIALLY ADAPT WHEN YOU ARE LOSING. Either add significantly to a losing position or sell out. If you add more, you can turn a loser into a winner.

(5) ONLY INVEST IN LIQUID STOCKS. How liquid a stock is depends in part on how much you’re investing. If you’re investing $10 million or less, then most of the best investments will be microcap stocks.

 

THE LOSER’S CHECKLIST: THE FIVE LOSING HABITS OF MOST INVESTORS

(1) INVEST IN LOTS OF IDEAS. As noted earlier, Warren Buffett has pointed out that you should concentrate on your best ideas and that adding more ideas than that would onlyincrease risk anddecrease returns. Or as Charlie Munger said:

Wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results.

(2) INVEST A SMALL AMOUNT IN EACH IDEA. This is related to the previous point. If you do not invest big in your best ideas, you won’t be able to do very well because a few big winners are what make the difference between an extraordinary track record and a mediocre one.

(3) TAKE SMALL PROFITS. If you sell too much of your best ideas before giving them a chance to really run, you are cutting off your best chance for excellent overall results.

(4) STAY IN AN INVESTMENT IDEA AND REFUSE TO ADAPT WHEN LOSING

(5) DO NOT CONSIDER LIQUIDITY

 

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.

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 roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approachesintrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). 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: [email protected]

 

 

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.