CASE STUDY UPDATE: Journey Energy (JRNGF)

July 2, 2023

I first wrote about Journey Energy (JRNGF) on December 21, 2021 here: https://boolefund.com/case-study-journey-energy-jrngf/

Since then, the stock has gone from $1.73 to $4.13, an increase of almost 140%.  But the company’s cash flows have also increased significantly, meaning the stock is nearly as undervalued today as it was in December, 2021.

 

OIL PRICES

Here is an excellent article on oil prices and opportunities in oil by Josh Young of Bison Interests: https://seekingalpha.com/article/4606923-recession-fears-mean-opportunity-in-the-oil-market

Here is another excellent article on oil prices: https://seekingalpha.com/article/4609520-the-oil-market-is-at-the-inflection-point-for-2023

OPEC+ has not only continued to cut production targets, but it has been under-producing its targets simply because it cannot produce more.  Meanwhile, oil demand is healthy and increasing about 1% a year.

No one can predict oil prices, especially over shorter periods of time.  But demand is likely to exceed supply going forward, and inventories are likely to decline.  This probably means higher oil prices in the range of at least $75-90 per barrel (WTI).

But even if oil prices were to stay closer to $65-70, Journey Energy would still be very profitable.

If there’s a recession, oil prices could decline temporarily, but would quickly snap back.

The CEO of Journey Energy, Alex Verge, says that after a downtrend in oil prices from 2014 to 2020, oil prices are now in an uptrend that could last five to seven years.  Here is an excellent conversation with Alex Verge: https://www.youtube.com/watch?v=3H_VD7rrhTg&t=2s

One final point.  Even if car manufacturers started making only all-electric vehicles today, oil demand would keep rising for many years, as Daniel Yergin points out in The New Map.

I am, of course, in favor of the transition to a post-fossil fuel economy.  But the global economy needs a lot of oil in order to make that transition over the next several decades.

The oil and gas industry will exist in close to its current form 10 or 20 years from now, as Jeremy Grantham has noted.  (As well, most oil companies do not have more than 15-20 years of reserves.)  The fact that some investors are no longer investing in oil and gas companies means that oil and gas stocks now have even higher expected returns.

 

JOURNEY ENERGY (JRNGF)

Here is Journey Energy’s most recent investor presentation: https://www.journeyenergy.ca/wp-content/uploads/Reports/Presentations/2023_Corporate_Presentation_March_Final.pdf

The current market cap is $248.7 million, while the current enterprise value (EV) is $295.5 million.  The stock price is $4.13.

Here are the multiples:

    • EV/EBITDA = 3.06
    • P/E = 2.10
    • P/NAV = 0.38
    • P/CF = 3.20
    • P/S = 1.28

(We use P/NAV instead of P/B.  The NAV is based on total proved plus probable reserves.)

The Piotroski F_Score is 7, which is good.

Currently, TL/TA is 50.3%.  This continues to decline as Journey Energy pays down its debt.

Insider ownership is 10%.  That is worth $24.9 million.  Insiders–especially and deservedly CEO Alex Verge–will make a good deal of money if the company does well going forward.

Very importantly, Journey has a power generation business that will likely be worth at least $150 million by early 2024.  See: https://bisoninterests.com/content/f/100mm-power-generation-transaction-implies-upside-for-journey

Note:  The Bison article values the power generation business at $196 million in Canadian dollars.  That translates into $150 million in U.S. dollars.

Intrinsic value scenarios:

    • Low case: If there is a recession or a bear market, the stock could temporarily decline 50%.  This would be a major buying opportunity.
    • Mid case: JRNGF is currently at 3.20 x cash flow, but it should eventually be at least at 8 x cash flow.  That would make the stock worth $10.33, which is 150% higher than today’s $4.13.
    • High case: Journey’s power generation business will likely be worth at least $150 million by early 2024.  That would make the stock worth $12.79, which is 210% higher than today’s $4.13.
    • Very high case:  Journey’s power generation business will likely be worth at least $150 million by early 2024.  Moreover, if the oil price averages $95 (WTI), then cash flow from the oil and gas assets would increase at least 50%.  At 8 x cash flow, the stock would be worth $17.96, which is over 330% higher than today’s $4.13.

Risks

If there’s a recession, oil prices could decline temporarily but would snap back.

 

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 approaches intrinsic 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.

CASE STUDY: DDH1 (DDHLF)

June 25, 2023

DDH1 provides a complete range of specialised surface and underground drilling solutions to their mining and exploration clients globally.  The company aspires to be the world’s leading driller through innovation and a continued focus on high-quality, reliable services.  DDH1 went public on the Australian stock exchange in March 2021.

Over the last five years, EBITDA has grown at a 12.8% CAGR, while EBITDA margins have avreraged 21-22% even during the recent inflationary environment.  ROIC is 19%.

The dividend yield is 7.0% and the company is on track to buy back 10% of the shares outstanding.

DDH1 is comprised of four different drillers.  The founder of each driller still runs their respective operations and is rewarded accordingly.  Also, each founder owns shares of stock.  DDH1 overall has 193 drilling rigs and is involved in all the cycles of a mine’s life.

DDH1 is marketed under four distinct brand names:

    • DDH1 focuses on deep section, underground diamond core drilling.
    • Ranger Drilling was acquired in April 2019 and focuses on iron ore drilling.
    • Strike Drilling was acquired in June 2018 and focuses on air core and reverse circulation drilling.
    • Swick Mining Services was acquired in February 2022 and operates mainly underground drilling rigs.

DDH1 has the highest revenue per rig in the industry.

Here is a good writeup on Value Investor’s Club: https://valueinvestorsclub.com/idea/DDH1_Ltd/9486284739#description

Gold mining is cyclical, and it is likely that a long cycle of growth for gold drilling has begun.   Gold mine drilling services will be greatly needed going forward.  Here is a quote from the LBMA, the London Bullion Market Association:

In order to sustain production at or above current levels, significant capital will need to be deployed by miners in order to develop projects or expand existing operations to offset declining production from aging mines.  With current prices, which at time of writing are around $1,850/oz, well in excess of the 90th percentile of the all-in sustaining cost curve, which sits at $1,300/oz, the vast majority of gold mines are making very healthy profits.  These margins should allow the industry to deploy capital to develop new projects, with the average capital cost to construct a new gold mine approximately $200/oz over the life of mine.

***

The market cap is $233.5 million.  The company has $31.5 million in cash and $57.7 million in debt.  Enterprise value is $252.3 million.

Here are the current multiples:

    • EV/EBITDA = 2.79
    • P/E = 7.26
    • P/B = 0.91
    • P/CF = 3.77
    • P/S = 0.61

Total insider ownership is 41.8%.  Insiders have recently been buying shares.

TL/TA (total liabilities/total assets) is 28.7%, which is excellent.  ROE is 18.1%, which is good.

The Piotroski F_score is 8, which is very good.

Intrinsic value scenarios:

    • Low case: During a recession, the stock could fall 50% from $0.53 to $0.26.
    • Mid case: EV/EBITDA is 2.79, but should be at least 5.0.  That would mean the shares are worth at least $0.95, which is 80% higher than today’s $0.53.
    • High case: The stock could easily be worth a 6x EV/EBITDA, which would translate into an intrinsic value of $1.14.  That is over 115% higher than today’s $0.53.

Risks

Gold prices could fall significantly.  This seems very unlikely but is possible.

 

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 approaches intrinsic 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: jb@boolefund.com

 

 

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.

CASE STUDY: Geodrill (GEODF)

June 18, 2023

Geodrill  is a drilling company that extracts mineral samples seeking gold and other ores for major, intermediate, and junior mining companies in Africa and South America.  (Drilling for gold is 90%+ of revenues and the company operates in Burkina Faso, Cote d’Ivoire, and Mali in West Arica;  Egypt in North Africa;  and Peru and Chile in South America.)  GEODF has highly recurring revenue, produces free cash flow, and is growing at 8-12% a year on both revenues and profits.

Gold mining is cyclical, and it is likely that a long cycle of growth for gold drilling has begun.   As Geodrill produces ever more free cash flow, it can increase its dividends and share buybacks.  Also, larger drillers are likely to purchase smaller drillers, which makes GEODF a take-over candidate.

Geodrill was founded in 1998 by Dave Harper, its current CEO and largest shareholder, with one rig and one contract.  Over the last 24 years, it has grown organically into one of the leading exploration drilling companies in the world with a fleet of 76 drill rigs operating in Africa and South America.

Geodrill provides Reverse Circulation, Diamond Core, Air-Core, Deep Directional Navi Drilling, Geo-Tech, Grade Control, and Water Borehold drilling services.  Geodrill’s multi-purpose rigs can provide both Reverse Circulation  and Diamond Core drilling and can be switched mid-way through a hole with minimal effort or downtime.  This lowers customers’ costs.  GEODF also provides Air-core drilling, which is often used by junior exploration companies in early-stage exploration.

Geodrill has built an excellent reputation for reliability and quality in the drilling industry, which has translated into long-term contracts and relationships with major customers such as Kinross Gold (KGC), Newmont Mining (NEM), Barrick (GOLD), and others.

Because it can take decades to fully exploit a mine’s ore beds, these relationships last for long periods of time and are recurring in nature.  Geodrill is involved in all the cycles of a mine’s life.

Here is a good writeup on Value Investors Club: https://valueinvestorsclub.com/idea/GEODRILL_LTD/5831765918

Gold mine drilling services will be greatly needed going forward.  Here is a quote from the LBMA, the London Bullion Market Association:

In order to sustain production at or above current levels, significant capital will need to be deployed by miners in order to develop projects or expand existing operations to offset declining production from aging mines.  With current prices, which at time of writing are around $1,850/oz, well in excess of the 90th percentile of the all-in sustaining cost curve, which sits at $1,300/oz, the vast majority of gold mines are making very healthy profits.  These margins should allow the industry to deploy capital to develop new projects, with the average capital cost to construct a new gold mine approximately $200/oz over the life of mine.

***

The market cap is $108.8 million.  The company has $17.7 million in cash and $9 million in debt.  Enterprise value is $100.1 million.

Here are the current multiples:

    • EV/EBITDA = 2.60
    • P/E = 5.83
    • P/B = 0.98
    • P/CF = 5.34
    • P/S = 0.77

Total insider ownership is 50%+.  (Founder and CEO Dave Harper owns 39%.)

TL/TA (total liabilities/total assets) is 24.2%, which is excellent.  ROE is 18.7%, which is good.

The Piotroski F_score is 8, which is very good.

Intrinsic value scenarios:

    • Low case: During a recession, the stock could fall 50% from $2.36 to $1.18.
    • Mid case: 2024 EBITDA is approximately $44.8 million.  The CEO Dave Harper, who owns 39% of the shares, is looking to sell for an EV/EBITDA of at least 5.0.  That would be an EV (enterprise value) of $224.0 million.  After subtracting $9.4 million in estimated debt and after adding $42.1 million in estimated cash, the equity would be worth $256.7 million.  That translates into $5.58 per share, which is over 135% higher than today’s $2.36.
    • High case: The stock could easily be worth a 6x EV/EBITDA, which would translate into an intrinsic value of $6.55.  That is over 175% higher than today’s $2.36.

Risks

GEODF may be trading at a discount to its peers due to its exposure to the West African countries.  There are often political upheavals in these countries.  However, the groups of people involved in such upheavals still need the hard currency that mines and other commodities produce.  So far, there have been no disruptions in Geodrill’s drilling programs due to any of these regime changes.

Also, Geodrill’s newer locations in Egypt, Peru, and Chile are much more stable politically than West Africa.

Finally, if there is a recession or a bear market, the stock could drop.  But that would be a buying opportunity.

 

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 approaches intrinsic 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: jb@boolefund.com

 

 

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.

CASE STUDY: Cipher Pharmaceuticals (CPHRF)

June 11, 2023

Cipher is a specialty pharmaceutical company with a robust and diversified portfolio of commercial and early to late-stage products.  Cipher acquires products that fulfill unmet medical needs, manages the required clinical development and regulatory approval process, and markets those products directly in Canada and indirectly through partners in the U.S., and South America.

Here is a good writeup on Value Investors Club: https://valueinvestorsclub.com/idea/CIPHER_PHARMACEUTICALS_INC/1631639401

Epirus

Cipher’s core product is Epuris, a product marketed in Canada for the treatment of severe nodular acne based on the active ingredient isotretinoin.  Launched in July 2013, Epirus has grown at a very high rate every year – at 27% per year over the last 6 years – benefiting both from a growing market and consistent market share gains.  More importantly, Epuris is the market leader with 43% share in its category.  Because it is by far the best product in the market, Epuris should continue growing at high rates for the foreseeable future.

Epuris has high barriers to entry because the target market is not large enough to justify the investment it would take to bring a new competitor to market.

Absorica

Absorica is an isotretinoin product that Cipher has licensed to Sun Pharmaceuticals for the U.S. market.  For most of Cipher’s recent existence, Absorica was almost the entire company.  But Absorica’s patents expired, driving revenues on the product from $30 million to $6 million.

Many investors mistakenly believe either that (1) Absorica is the entire company, so Cipher must be worthless; or (2) What happened to Absorica will also happen to Epirus.

First, Absorica’s earnings have stabilized around $6 million a year and are unlikely to go much lower.

More importantly, as mentioned above, Epirus is by far the best product in Canada where it is a market leader, but the market is not large enough to justify the investment a competitor would have to make to create a competing product.  Note: The price of Epirus is 1/10th that of Absorica and Epirus does not have a patent.

Two phase III product candidates

Cipher has two phase III product candidates.  Cipher does not have development risk for either product since it just has the marketing rights in Canada.  Cipher has partnered with Moberg Pharmaceuticals to develop MOB-015, which is a topical treatment for a common nail fungus.  Cipher has partnered with Can-Fite BioPharma to develop CF101, a treatment for plaque psoriasis and rheumatoid arthritis.

Leadership

John Mull was the founder of CML HealthCare, a diagnostics services provider acquired by LifeLabs in 2013 for $1.22 billion.  Cipher was previously spun out of CML HealthCare.  John Mull was the former CEO of Cipher and owns 39% of the shares.  John’s son Craig is the current CEO and owns 2% of the shares.

But in between the time when John Mull stepped down as CEO and when Craig Mull took over as CEO, there were two bad acquisitions made by other CEOs.

Since taking over as CEO in 2019, Craig Mull has performed well.  He has cut costs meaningfully, maintained Epirus’s growth, extended the Absorica license to 2026, and aggressively bought back Cipher’s stock.

***

The market cap is $71.7 million.  The company has $33 million in cash and no debt.  So the enterprise value is $38.7 million.

The company has over $200 million in NOLs, which means it will not pay cash taxes for a long time.

Here are the current multiples:

    • EV/EBITDA = 3.31
    • P/E = 2.77
    • P/B = 1.10
    • P/CF = 2.66
    • P/S = 3.69

As noted earlier, insider ownership is 40%+.  Also, the company has bought back a great deal of stock.

TL/TA (total liabilities/total assets) is 12.7%, which is excellent.  ROE is 50.5%, which is outstanding.

The Piotroski F_score is 8, which is very good.

Intrinsic value scenarios:

    • Low case: During a recession, the stock could fall 50% from $2.83 to $1.42.
    • Mid case: The P/E is 2.77, but should be at least 5.  That means the stock price should be approximately $5.10, which is 80% higher than today’s $2.83.
    • High case: For a growing pharmaceutical company with a strong competitive position and a promising pipeline, the P/E arguably should be at least 7.5.  That would make the intrinsic value of the stock $7.66, which is 170% higher than today’s $2.83.
    • Very high case: With a large cash balance and significant free cash flow, the Mull’s are highly likely to make one or more acquisitions, creating a larger and more diversified pharmaceutical company.  The stock could be worth at least $10, which is over 250% higher than today’s $2.83.

Risks

Epuris’s growth could slow significantly for the first time, or a superior product could be developed in Canada.  The Mull’s could make a bad acquisition.  Revenues from the licensing portfolio could decline faster than anticipated.  New product candidates could fail to reach commercialization.

 

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 approaches intrinsic 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: jb@boolefund.com

 

 

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.

Fooled by Randomness

May 28, 2023

Nassim Nicholas Taleb’s Fooled 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’s Wheel of Fortune from Sebastien Brant’s Ship 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 avoid blowing 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 John blew 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.

Photo by Antoniodiaz

 

TWO: A BIZARRE ACCOUNTING METHOD

Taleb introduces the concept of alternative 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.

Photo by Banjong Khanyai

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 the generator).

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’s The 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 many alternative 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.

Photo by Emily2k

Taleb says:

My Monta 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 do less 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 the cross-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 the frequency of losing cannot be considered apart from the magnitude 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.

Illustration by lqoncept

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 discard outliers 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 introduces the 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 an open 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 an open 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 write The Odyssey next?

Infinite number of monkeys on typewriters.  Illustration by Robert Adrian Hillman.

 

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.

Photo by Alhovik

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 is data 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 poin, 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 the shadow 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 husband and 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 wife conditional on the information of her having been killed, rather than the unconditional 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. 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 a positive 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 between premium sellers, who sell options, and premium 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 are premium 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’t prove a 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.

Seneca 4 BC-65 AD Roman stoic philosopher, statesman, and tutor to the future Emperor Nero.  Photo by Bashta.

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 approaches intrinsic 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: jb@boolefund.com

 

 

 

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.

Invest Like Sherlock Holmes

May 21, 2023

Robert G. Hagstrom has written a number of excellent books on investing.  One of his best is The Detective and the Investor  (Texere, 2002).

Many investors are too focused on the short term, are overwhelmed with information, take shortcuts, or fall prey to cognitive biases.  Hagstrom argues that investors can learn from the Great Detectives as well as from top investigative journalists.

Great detectives very patiently gather information from a wide variety of sources.  They discard facts that turn out to be irrelevant and keep looking for new facts that are relevant.  They painstakingly use logic to analyze the given information and reach the correct conclusion.  They’re quite willing to discard a hypothesis, no matter how well-supported, if new facts lead in a different direction.

(Illustration of Sherlock Holmes by Sidney Paget (1891), via Wikimedia Commons)

Top investigative journalists follow a similar method.

Outline for this blog post:

  • The Detective and the Investor
  • Auguste Dupin
  • Jonathan Laing and Sunbeam
  • Top Investigative Journalists
  • Edna Buchanan—Pulitzer Prize Winner
  • Sherlock Holmes
  • Arthur Conan Doyle
  • Holmes on Wall Street
  • Father Brown
  • How to Become a Great Detective

The first Great Detective is Auguste Dupin, an invention of Edgar Allan Poe.  The financial journalist Jonathan Laing’s patient and logical analysis of the Sunbeam Corporation bears similarity to Dupin’s methods.

Top investigative journalists are great detectives.  The Pulitzer Prize-winning journalist Edna Buchanan is an excellent example.

Sherlock Holmes is the most famous Great Detective.  Holmes was invented by Dr. Arthur Conan Doyle.

Last but not least, Father Brown is the third Great Detective discussed by Hagstrom.  Father Brown was invented by G. K. Chesterton.

The last section—How To Become a Great Detective—sums up what you as an investor can learn from the three Great Detectives.

 

THE DETECTIVE AND THE INVESTOR

Hagstrom writes that many investors, both professional and amateur, have fallen into bad habits, including the following:

  • Short-term thinking: Many professional investors advertise their short-term track records, and many clients sign up on this basis.  But short-term performance is largely random, and usually cannot be maintained.  What matters (at a minimum) is performance over rolling five-year periods.
  • Infatuation with speculation: Speculation is guessing what other investors will do in the short term.  Investing, on the other hand, is figuring out the value of a given business and only buying when the price is well below that value.
  • Overload of information: The internet has led to an overabundance of information.  This makes it crucial that you, as an investor, know how to interpret and analyze the information.
  • Mental shortcuts: We know from Daniel Kahneman (see Thinking, Fast and Slow) that most people rely on System 1 (intuition) rather than System 2 (logic and math) when making decisions under uncertainty.  Most investors jump to conclusions based on easy explanations, and then—due to confirmation bias—only see evidence that supports their conclusions.
  • Emotional potholes: In addition to confirmation bias, investors suffer from overconfidence, hindsight bias, loss aversion, and several other cognitive biases.  These cognitive biases regularly cause investors to make mistakes in their investment decisions.  I wrote about cognitive biases here: https://boolefund.com/cognitive-biases/

How can investors develop better habits?  Hagstrom:

The core premise of this book is that the same mental skills that characterize a good detective also characterize a good investor… To say this another way, the analytical methods displayed by the best fictional detectives are in fact high-level decision-making tools that can be learned and applied to the investment world.

(Illustration of Sherlock Holmes by Sidney Paget, via Wikimedia Commons)

Hagstrom asks if it is possible to combine the methods of the three Great Detectives.  If so, what would the ideal detective’s approach to investing be?

First, our investor-detective would have to keep an open mind, be prepared to analyze each new opportunity without any preset opinions.  He or she would be well versed in the basic methods of inquiry, and so would avoid making any premature and possibly inaccurate assumptions.  Of course, our investor-detective would presume that the truth might be hidden below the surface and so would distrust the obvious.  The investor-detective would operate with cool calculation and not allow emotions to distract clear thinking.  The investor-detective would also be able to deconstruct the complex situation into its analyzable parts.  And perhaps most important, our investor-detective would have a passion for truth, and, driven by a nagging premonition that things are not what they seem to be, would keep digging away until all the evidence had been uncovered.

 

AUGUSTE DUPIN

(Illustration—by Frédéric Théodore Lix—to The Purloined Letter, via Wikimedia Commons)

The Murders in the Rue Morgue exemplifies Dupin’s skill as a detective.  The case involves Madame L’Espanaye and her daughter.  Madame L’Espanaye was found behind the house in the yard with multiple broken bones and her head almost severed.  The daughter was found strangled to death and stuffed upside down into a chimney.  The murders occurred in a fourth-floor room that was locked from the inside.  On the floor were a bloody straight razor, several bloody tufts of grey hair, and two bags of gold coins.

Several witnesses heard voices, but no one could say for sure which language it was.  After deliberation, Dupin concludes that they must not have been hearing a human voice at all.  He also dismisses the possibility of robbery, since the gold coins weren’t taken.  Moreover, the murderer would have to possess superhuman strength to stuff the daughter’s body up the chimney.  As for getting into a locked room, the murderer could have gotten in through a window.  Finally, Dupin demonstrates that the daughter could not have been strangled by a human hand.  Dupin concludes that Madame L’Espanaye and her daughter were killed by an orangutan.

Dupin places an advertisement in the local newspaper asking if anyone had lost an orangutan.  A sailor arrives looking for it.  The sailor explains that he had seen the orangutan with a razor, imitating the sailor shaving.  The orangutan had then fled.  Once it got into the room with Madame L’Espanaye and her daughter, the orangutan probably grabbed Madame’s hair and was waving the razor, imitating a barber.  When the woman screamed in fear, the orangutan grew furious and killed her and her daughter.

Thus Dupin solves what at first seemed like an impossible case.  The solution is completely unexpected but is the only logical possibility, given all the facts.

Hagstrom writes that investors can learn important lessons from the Great Detective Auguste Dupin:

First, look in all directions, observe carefully and thoughtfully everything you see, and do not make assumptions from inadequate information.  On the other hand, do not blindly accept what you find.  Whatever you read, hear, or overhear about a certain stock or company may not necessarily be true.  Keep on with your research;  give yourself time to dig beneath the surface.

If you’re a small investor, it’s often best to invest in microcap stocks.  (This presumes that you have access to a proven investment process.)  There are hundreds of tiny companies much too small for most professional investors even to consider.  Thus, there is much more mispricing among micro caps.  Moreover, many microcap companies are relatively easy to analyze and understand.  (The Boole Microcap Fund invests in microcap companies.)

 

JONATHAN LAING AND SUNBEAM

(Sunbeam logo, via Wikimedia Commons)

Hagstrom writes that, in the spring of 1997, Wall Street was in love with the self-proclaimed ‘turnaround genius’ Al Dunlap.  Dunlap was asked to take over the troubled Sunbeam Corporation, a maker of electric home appliances.  Dunlap would repeat the strategy he used on previous turnarounds:

[Drive] up the stock price by any means necessary, sell the company, and cash in his stock options at the inflated price.

Although Dunlap made massive cost cuts, some journalists were skeptical, viewing Sunbeam as being in a weak competitive position in a harsh industry.  Jonathan Laing of Barron’s, in particular, took a close look at Sunbeam.  Laing focused on accounting practices:

First, Laing pointed out that Sunbeam took a huge restructuring charge ($337 million) in the last quarter of 1996, resulting in a net loss for the year of $228.3 million.  The charges included moving reserves from 1996 to 1997 (where they could later be recharacterized as income);  prepaying advertising expenses to make the new year’s numbers look better;  a suspiciously high charge for bad-debt allowance;  a $90 million write-off for inventory that, if sold at a later date, could turn up in future profits;  and write-offs for plants, equipment, and trademarks used by business lines that were still operating.

To Laing, it looked very much like Sunbeam was trying to find every possible way to transfer 1997 projected losses to 1996 (and write 1996 off as a lost year, claiming it was ruined by previous management) while at the same time switching 1996 income into 1997…

(Photo by Evgeny Ivanov)

Hagstrom continues:

Even though Sunbeam’s first-quarter 1997 numbers did indeed show a strong increase in sales volume, Laing had collected evidence that the company was engaging in the practice known as ‘inventory stuffing’—getting retailers to place abnormally large orders either through high-pressure sales tactics or by offering them deep discounts (using the written-off inventory from 1996).  Looking closely at Sunbeam’s financial reports, Laing also found a hodgepodge of other maneuvers designed to boost sales numbers, such as delaying delivery of sales made in 1996 so they could go on the books as 1997 sales, shipping more units than the customer had actually ordered, and counting as sales orders that had already been canceled.

The bottom line was simply that much of 1997’s results would be artificial.  Hagstrom summarizes the lesson from Dupin and Laing:

The core lesson for investors here can be expressed simply:  Take nothing for granted, whether it comes from the prefect of police or the CEO of a major corporation.  This is, in fact, a key theme of this chapter.  If something doesn’t make sense to you—no matter who says it—that’s your cue to start digging.

By July 1998, Sunbeam stock had lost 80 percent of its value and was lower than when Dunlap took over.  The board of directors fired Dunlap and admitted that its 1997 financial statements were unreliable and were being audited by a new accounting firm.  In February 2001, Sunbeam filed for Chapter 11 bankruptcy protection.  On May 15, 2001, the Securities and Exchange Commission filed suit against Dunlap and four senior Sunbeam executives, along with their accounting firm, Arthur Andersen.  The SEC charged them with a fraudulent scheme to create the illusion of a successful restructuring.

Hagstrom points out what made Laing successful as an investigative journalist:

He read more background material, dissected more financial statements, talked to more people, and painstakingly pieced together what many others failed to see.

 

TOP INVESTIGATIVE JOURNALISTS

Hagstrom mentions Professor Linn B. Washington, Jr., a talented teacher and experienced investigative reporter.  (Washington was awarded the Robert F. Kennedy Prize for his series of articles on drug wars in the Richard Allen housing project.)  Hagstrom quotes Washington:

Investigative journalism is not a nine-to-five job.  All good investigative journalists are first and foremost hard workers.  They are diggers.  They don’t stop at the first thing they come to but rather they feel a need to persist.  They are often passionate about the story they are working on and this passion helps fuel the relentless pursuit of information.  You can’t teach that.  They either have it or they don’t.

…I think most reporters have a sense of morality.  They are outraged by corruption and they believe their investigations have a real purpose, an almost sacred duty to fulfill.  Good investigative reporters want to right the wrong, to fight for the underdog.  And they believe there is a real responsibility attached to the First Amendment.

(Photo by Robyn Mackenzie)

Hagstrom then refers to The Reporter’s Handbook, written by Steve Weinberg for investigative journalists.  Weinberg maintains that gathering information involves two categories: documents and people.  Hagstrom:

Weinberg asks readers to imagine three concentric circles.  The outmost one is ‘secondary sources,’ the middle one ‘primary sources.’  Both are composed primarily of documents.  The inner circle, ‘human sources,’ is made up of people—a wide range of individuals who hold some tidbit of information to add to the picture the reporter is building.

Ideally, the reporter starts with secondary sources and then primary sources:

At these two levels of the investigation, the best reporters rely on what has been called a ‘documents state of mind.’  This way of looking at the world has been articulated by James Steele and Donald Bartlett, an investigative team from the Philadephia Inquirer.  It means that the reporter starts from day one with the belief that a good record exists somewhere, just waiting to be found.

Once good background knowledge is accumulated from all the primary and secondary documents, the reporter is ready to turn to the human sources…

Photo by intheskies

Time equals truth:

As they start down this research track, reporters also need to remember another vital concept from the handbook:  ‘Time equals truth.’  Doing a complete job of research takes time, whether the researcher is a reporter following a story or an investor following a company—or for that matter, a detective following the evidence at a crime scene.  Journalists, investors, and detectives must always keep in mind that the degree of truth one finds is directly proportional to the amount of time one spends in the search.  The road to truth permits no shortcuts.

The Reporter’s Handbook also urges reporters to question conventional wisdom, to remember that whatever they learn in their investigation may be biased, superficial, self-serving for the source, or just plain wrong.  It’s another way of saying ‘Take nothing for granted.’  It is the journalist’s responsibility—and the investor’s—to penetrate the conventional wisdom and find what is on the other side.

The three concepts discussed above—‘adopt a documents state of mind,’ ‘time equals truth,’ and ‘question conventional wisdom;  take nothing for granted’—may be key operating principles for journalists, but I see them also as new watchwords for investors.

 

EDNA BUCHANAN—PULITZER PRIZE WINNER

Edna Buchanan, working for the Miami Herald and covering the police beat, won a Pulitzer Prize in 1986.  Hagstrom lists some of Buchanan’s principles:

  • Do a complete background check on all the key players.  Find out how a person treats employees, women, the environment, animals, and strangers who can do nothing for them.  Discover if they have a history of unethical and/or illegal behavior.
  • Cast a wide net.  Talk to as many people as you possibly can.  There is always more information.  You just have to find it.  Often that requires being creative.
  • Take the time.  Learning the truth is proportional to the time and effort you invest.  There is always more that you can do.  And you may uncover something crucial.  Never take shortcuts.
  • Use common sense.  Often official promises and pronouncements simply don’t fit the evidence.  Often people lie, whether due to conformity to the crowd, peer pressure, loyalty (like those trying to protect Nixon et al. during Watergate), trying to protect themselves, fear, or any number of reasons.  As for investing, some stories take a long time to figure out, while other stories (especially for tiny companies) are relatively simple.
  • Take no one’s word.  Find out for yourself.  Always be skeptical and read between the lines.  Very often official press releases have been vetted by lawyers and leave out critical information.  Take nothing for granted.
  • Double-check your facts, and then check them again.  For a good reporter, double-checking facts is like breathing.  Find multiples sources of information.  Again, there are no shortcuts.  If you’re an investor, you usually need the full range of good information in order to make a good decision.

In most situations, to get it right requires a great deal of work.  You must look for information from a broad range of sources.  Typically you will find differing opinions.  Not all information has the same value.  Always be skeptical of conventional wisdom, or what ‘everybody knows.’

 

SHERLOCK HOLMES

Image by snaptitude

Sherlock Holmes approaches every problem by following three steps:

  • First, he makes a calm, meticulous examination of the situation, taking care to remain objective and avoid the undue influence of emotion.  Nothing, not even the tiniest detail, escapes his keen eye.
  • Next, he takes what he observes and puts it in context by incorporating elements from his existing store of knowledge.  From his encyclopedic mind, he extracts information about the thing observed that enables him to understand its significance.
  • Finally, he evaluates what he observed in the light of this context and, using sound deductive reasoning, analyzes what it means to come up with the answer.

These steps occur and re-occur in an iterative search for all the facts and for the best hypothesis.

There was a case involving a young doctor, Percy Trevelyan.  Some time ago, an older gentleman named Blessington offered to set up a medical practice for Trevelyan in return for a share of the profits.  Trevelyan agreed.

A patient suffering from catalepsy—a specialty of the doctor—came to the doctor’s office one day.  The patient also had his son with him.  During the examination, the patient suffered a cataleptic attack.  The doctor ran from the room to grab the treatment medicine.  But when he got back, the patient and his son were gone.  The two men returned the following day, giving a reasonable explanation for the mix-up, and the exam continued.  (On both visits, the son had stayed in the waiting room.)

Shortly after the second visit, Blessington burst into the exam room, demanding to know who had been in his private rooms.  The doctor tried to assure him that no one had.  But upon going to Blessington’s room, he saw a strange set of footprints.  Only after Trevelyan promises to bring Sherlock Holmes to the case does Blessington calm down.

Holmes talks with Blessington.  Blessington claims not to know who is after him, but Holmes can tell that he is lying.  Holmes later tells his assistant Watson that the patient and his son were fakes and had some sinister reason for wanting to get Blessington.

Holmes is right.  The next morning, Holmes and Watson are called to the house again.  This time, Blessington is dead, apparently having hung himself.

But Holmes deduces that it wasn’t a suicide but a murder.  For one thing, there were four cigar butts found in the fireplace, which led the policeman to conclude that Blessington had stayed up late agonizing over his decision.  But Holmes recognizes that Blessington’s cigar is a Havana, but the other three cigars had been imported by the Dutch from East India.  Furthermore, two had been smoked from a holder and two without.  So there were at least two other people in the room with Blessington.

Holmes does his usual very methodical examination of the room and the house.  He finds three sets of footprints on the stairs, clearly showing that three men had crept up the stairs.  The men had forced the lock, as Holmes deduced from scratches on it.

Holmes also realized the three men had come to commit murder.  There was a screwdriver left behind.  And he could further deduce (by the ashes dropped) where each man sat as the three men deliberated over how to kill Blessington.  Eventually, they hung Blessington.  Two killers left the house and the third barred the door, implying that the third murderer must be a part of the doctor’s household.

All these signs were visible:  the three sets of footprints, the scratches on the lock, the cigars that were not Blessington’s type, the screwdriver, the fact that the front door was barred when the police arrived.  But it took Holmes to put them all together and deduce their meaning:  murder, not suicide.  As Holmes himself remarked in another context, ‘The world is full of obvious things which nobody by any chance ever observes.’

…He knows Blessington was killed by people well known to him.  He also knows, from Trevelyan’s description, what the fake patient and his son look like.  And he has found a photograph of Blessington in the apartment.  A quick stop at policy headquarters is all Holmes needs to pinpoint their identity.  The killers, no strangers to the police, were a gang of bank robbers who had gone to prison after being betrayed by their partner, who then took off with all the money—the very money he used to set Dr. Trevelyan up in practice.  Recently released from prison, the gang tracked Blessington down and finally executed him.

Spelled out thus, one logical point after another, it seems a simple solution.  Indeed, that is Holmes’s genius:  Everything IS simple, once he explains it.

Hagstrom then adds:

Holmes operates from the presumption that all things are explainable;  that the clues are always present, awaiting discovery. 

The first step—gathering all the facts—usually requires a great deal of careful effort and attention.  One single fact can be the key to deducing the true hypothesis.  The current hypothesis is revisable if there may be relevant facts not yet known.  Therefore, a heightened degree of awareness is always essential.  With practice, a heightened state of alertness becomes natural for the detective (or the investor).

“Details contain the vital essence of the whole matter.” — Sherlock Holmes

Moreover, it’s essential to keep emotion out of the process of discovery:

One reason Holmes is able to see fully what others miss is that he maintains a level of detached objectivity toward the people involved.  He is careful not to be unduly influenced by emotion, but to look at the facts with calm, dispassionate regard.  He sees everything that is there—and nothing that is not.  For Holmes knows that when emotion seeps in, one’s vision of what is true can become compromised.  As he once remarked to Dr. Watson, ‘Emotional qualities are antagonistic to clear reasoning… Detection is, or ought to be, an exact science and should be treated in the same cold and unemotional manner.  You have attempted to tinge it with romanticism, which produces much the same effect as if you worked a love story or an elopement into the fifth proposition of Euclid.’

Image by snaptitude

Holmes himself is rather aloof and even antisocial, which helps him to maintain objectivity when collecting and analyzing data.

‘I make a point of never having any prejudices and of following docilely wherever fact may lead me.’  He starts, that is, with no preformed idea, and merely collects data.  But it is part of Holmes’s brilliance that he does not settle for the easy answer.  Even when he has gathered together enough facts to suggest one logical possibility, he always knows that this answer may not be the correct one.  He keeps searching until he has found everything, even if subsequent facts point in another direction.  He does not reject the new facts simply because they’re antithetical to what he’s already found, as so many others might.

Hagstrom observes that many investors are susceptible to confirmation bias:

…Ironically, it is the investors eager to do their homework who may be the most susceptible.  At a certain point in their research, they have collected enough information that a pattern becomes clear, and they assume they have found the answer.  If subsequent information then contradicts that pattern, they cannot bring themselves to abandon the theory they worked so hard to develop, so they reject the new facts.

Gathering information about an investment you are considering means gather all the information, no matter where it ultimately leads you.  If you find something that does not fit your original thesis, don’t discard the new information—change the thesis.

 

ARTHUR CONAN DOYLE

Arthur Conan Doyle was a Scottish doctor.  One of his professors, Dr. Bell, challenged his students to hone their skills of observation.  Bell believed that a correct diagnosis required alert attention to all aspects of the patient, not just the stated problem.  Doyle later worked for Dr. Bell.  Doyle’s job was to note the patients’ problem along with all possibly relevant details.

Doyle had a very slow start as a doctor.  He had virtually no patients.  He spent his spare time writing, which he had loved doing since boarding school.  Doyle’s main interest was historical fiction.  But he didn’t get much money from what he wrote.

One day he wrote a short novel, A Study in Scarlet, which introduced a private detective, Sherlock Holmes.  Hagstrom quotes Doyle:

I thought I would try my hand at writing a story where the hero would treat crime as Dr. Bell treated disease, and where science would take the place of chance.

Doyle soon realized that he might be able to sell short stories about Sherlock Holmes as a way to get some extra income.  Doyle preferred historical novels, but his short stories about Sherlock Holmes started selling surprisingly well.  Because Doyle continued to emphasize historical novels and the practice of medicine, he demanded higher and higher fees for his short stories about Sherlock Holmes.  But the stories were so popular that magazine editors kept agreeing to the fee increases.

Photo by davehanlon

Soon thereafter, Doyle, having hardly a single patient, decided to abandon medicine and focus on writing.  Doyle still wanted to do other types of writing besides the short stories.  He asked for a very large sum for the Sherlock Holmes stories so that the editors would stop bothering him.  Instead, the editors immediately agreed to the huge fee.

Many years later, Doyle was quite tired of Holmes and Watson after having written fifty-six short stories and four novels about them.  But readers never could get enough.  And the stories are still highly popular to this day, which attests to Doyle’s genius.  Doyle has always been credited with launching the tradition of the scientific sleuth.

 

HOLMES ON WALL STREET

Sherlock Holmes is the most famous Great Detective for good reason.  He is exceptionally thorough, unemotional, and logical.

Holmes knows a great deal about many different things, which is essential in order for him to arrange and analyze all the facts:

The list of things Holmes knows about is staggering:  the typefaces used by different newspapers, what the shape of a skull reveals about race, the geography of London, the configuration of railway lines in cities versus suburbs, and the types of knots used by sailors, for a few examples.  He has authored numerous scientific monographs on such topics as tattoos, ciphers, tobacco ash, variations in human ears, what can be learned from typewriter keys, preserving footprints with plaster of Paris, how a man’s trade affects the shape of his hands, and what a dog’s manner can reveal about the character of its owner.

(Illustration of Sherlock Holmes with various tools, by Elena Kreys)

Consider what Holmes says about his monograph on the subject of tobacco:

“In it I enumerate 140 forms of cigar, cigarette, and pipe tobacco… It is sometimes of supreme importance as a clue.  If you can say definitely, for example, that some murder has been done by a man who was smoking an Indian lunkah, it obviously narrows your field of search.”

It’s very important to keep gathering and re-gathering facts to ensure that you haven’t missed anything.  Holmes:

“It is a capital mistake to theorize before you have all the evidence.  It biases the judgment.”

“The temptation to form premature theories upon insufficient data is the bane of our profession.”

Although gathering all facts is essential, at the same time, you must be organizing those facts since not all facts are relevant to the case at hand.  Of course, this is an iterative process. You may discard a fact as irrelevant and realize later that it is relevant.

Part of the sorting process involves a logical analysis of various combinations of facts.  You reject combinations that are logically impossible.  As Holmes famously said:

“When you have eliminated the impossible, whatever remains, however improbable, must be the truth.”

Often there is more than one logical possibility that is consistent with the known facts.  Be careful not to be deceived by obvious hypotheses.  Often what is ‘obvious’ is completely wrong.

Sometimes finding the solution requires additional research.  Entertaining several possible hypotheses may also be required.  Holmes:

“When you follow two separate chains of thought you will find some point of intersection which should approximate to the truth.”

But be careful to keep facts and hypotheses separate, as Holmes asserts:

“The difficulty is to detach the frame of absolute undeniable facts from the embellishments of theorists.  Then, having established ourselves upon this sound basis, it is our duty to see what inferences may be drawn and what are the special points upon which the whole mystery turns.”

For example, there was a case involving the disappearance of a valuable racehorse.  The chief undeniable fact was that the dog did not bark, which meant that the intruder had to be familiar to the dog.

Sherlock Holmes As Investor

How would Holmes approach investing?  Hagstrom:

Here’s what we know of his methods:  He begins an examination with an objective mind, untainted by prejudice.  He observes acutely and catalogues all the information, down to the tiniest detail, and draws on his broad knowledge to put those details into context.  Then, armed with the facts, he walks logically, rationally, thoughtfully toward a conclusion, always on the lookout for new, sometimes contrary information that might alter the outcome.

It’s worth repeating that much of the process of gathering facts can be tedious and boring.  This is the price you must pay to ensure you get all the facts.  Similarly, analyzing all the facts often requires patience and can take a long time.  No shortcuts.

 

FATHER BROWN

Hagstrom opens the chapter with a scene in which Aristide Valentin—head of Paris police and the most famous investigator in Europe—is chasing Hercule Flambeau, a wealthy and famous French jewel thief.  Both Valentin and Flambeau are on the same train.  But Valentin gets distracted by the behavior of a very short Catholic priest with a round face.  The priest is carrying several brown paper parcels, and he keeps dropping one or the other, or dropping his umbrella.

When the train reaches London, Valentin isn’t exactly sure where Flambeau went.  So Valentin decides to go systematically to the ‘wrong places.’  Valentin ends up at a certain restaurant that caught his attention.  A sugar bowl has salt in it, while the saltcellar contains sugar.  He learns from a waiter that two clergymen had been there earlier, and that one had thrown a half-empty cup of soup against the wall.  Valentin inquires which way the priests went.

Valentin goes to Carstairs Street.  He passes a greengrocer’s stand where the signs for oranges and nuts have been switched.  The owner is still upset about a recent incident in which a parson knocked over his bin of apples.

Valentin keeps looking and notices a restaurant that has a broken window.  He questions the waiter, who explains to him that two foreign parsons had been there.  Apparently, they overpaid.  The waiter told the two parsons of their mistake, at which point one parson said, ‘Sorry for the confusion.  But the extra amount will pay for the window I’m about to break.’  Then the parson broke the window.

Valentin finally ends up in a public park, where he sees two men, one short and one tall, both wearing clerical garb.  Valentin approaches and recognizes that the short man is the same clumsy priest from the train.  The short priest suspected all along that the tall man was not a priest but a criminal.  The short priest, Father Brown, had left the trail of hints for the police.  At that moment, even without turning around, Father Brown knew the police were nearby ready to arrest Flambeau.

Father Brown was invented by G. K. Chesterton.  Father Brown is very compassionate and has deep insight into human psychology, which often helps him to solve crimes.

He knows, from hearing confessions and ministering in times of trouble, how people act when they have done something wrong.  From observing a person’s behavior—facial expressions, ways of walking and talking, general demeanor—he can tell much about that person.  In a word, he can see inside someone’s heart and mind, and form a clear impression about character…

His feats of detection have their roots in this knowledge of human nature, which comes from two sources:  his years in the confessional, and his own self-awareness.  What makes Father Brown truly exceptional is that he acknowledges the capacity for evildoing in himself.  In ‘The Hammer of God’ he says, ‘I am a man and therefore have all devils in my heart.’

Because of this compassionate understanding of human weakness, from both within and without, he can see into the darkest corners of the human heart.  The ability to identify with the criminal, to feel what he is feeling, is what leads him to find the identity of the criminal—even, sometimes, to predict the crime, for he knows the point at which human emotions such as fear or jealousy tip over from acceptable expression into crime.  Even then, he believes in the inherent goodness of mankind, and sets the redemption of the wrongdoer as his main goal.

While Father Brown excels in understanding human psychology, he also excels at logical analysis of the facts.  He is always open to alternative explanations.

(Frontispiece to G. K. Chesterton’s The Wisdom of Father Brown, Illustration by Sydney Semour Lucas, via Wikimedia Commons)

Later the great thief Flambeau is persuaded by Father Brown to give up a life of crime and become a private investigator.  Meanwhile, Valentin, the famous detective, turns to crime and nearly gets away with murder.  Chesterton loves such ironic twists.

Chesterton was a brilliant writer who wrote in an amazing number of different fields.  Chesterton was very compassionate, with a highly developed sense of social justice, notes Hagstrom.  The Father Brown stories are undoubtedly entertaining, but they also deal with questions of justice and morality.  Hagstrom quotes an admirer of Chesterton, who said:  ‘Sherlock Holmes fights criminals;  Father Brown fights the devil.’  Whenever possible, Father Brown wants the criminal to find redemption.

Hagstrom lists what could be Father Brown’s investment guidelines:

  • Look carefully at the circumstances;  do whatever it takes to gather all the clues.
  • Cultivate the understanding of intangibles.
  • Using both tangible and intangible evidence, develop such a full knowledge of potential investments that you can honestly say you know them inside out.
  • Trust your instincts.  Intuition is invaluable.
  • Remain open to the possibility that something else may be happening, something different from that which first appears; remember that the full truth may be hidden beneath the surface.

Hagstrom mentions that psychology can be useful for investing:

Just as Father Brown’s skill as an analytical detective was greatly improved by incorporating the study of psychology with the method of observations, so too can individuals improve their investment performance by combining the study of psychology with the physical evidence of financial statement analysis.

 

HOW TO BECOME A GREAT DETECTIVE

Hagstrom lists the habits of mind of the Great Detectives:

Auguste Dupin

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

Sherlock Holmes

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

Father Brown

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

Hagstrom argues that these habits of mind, if diligently and consistently applied, can help you to do better as an investor over time.

Furthermore, the true hero is reason, a lesson directly applicable to investing:

As I think back over all the mystery stories I have read, I realize there were many detectives but only one hero.  That hero is reason.  No matter who the detective was—Dupin, Holmes, Father Brown, Nero Wolfe, or any number of modern counterparts—it was reason that solved the crime and captured the criminal.  For the Great Detectives, reason is everything.  It controls their thinking, illuminates their investigation, and helps them solve the mystery.

Illustration by yadali

Hagstrom continues:

Now think of yourself as an investor.  Do you want greater insight about a perplexing market?  Reason will clarify your investment approach.

Do you want to escape the trap of irrational, emotion-based action and instead make decisions with calm deliberation?  Reason will steady your thinking.

Do you want to be in possession of all the relevant investment facts before making a purchase?  Reason will help you uncover the truth.

Do you want to improve your investment results by purchasing profitable stocks?  Reason will help you capture the market’s mispricing.

In sum, conduct a thorough investigation.  Painstakingly gather all the facts and keep your emotions entirely out of it.  Skeptically question conventional wisdom and ‘what is obvious.’  Carefully use logic to reason through possible hypotheses.  Eliminate hypotheses that cannot explain all the facts.  Stay open to new information and be willing to discard the best current hypothesis if new facts lead in a different direction.  Finally, be a student of psychology.

 

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 approaches intrinsic 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: jb@boolefund.com

 

 

 

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

The Best Way to Build Wealth

May 14, 2023

The best way to build wealth is through long-term investing.  The more wealth you have, the more freedom you have to achieve your goals in life.

A smart long-term investment for many investors is an S&P 500 index fund.  It’s just basic arithmetic, as Jack Bogle and Warren Buffett frequently point out: https://boolefund.com/warren-buffett-jack-bogle/

But you can get much higher returns—at least 18% per year (instead of 10% per year)—by investing in cheap, solid microcap stocks.

Because most professional investors have large assets under management, they cannot even consider investing in microcap stocks.  That’s why there continues to be a wonderful opportunity for enterprising investors.  Microcaps are ignored, which causes most of them to become significantly undervalued from time to time.

Warren Buffett obtained the highest returns of his career when he invested primarily in microcap stocks.  Buffett says that he could get 50 percent a year today if he were managing a small enough sum so that he could focus on microcap stocks: https://boolefund.com/buffetts-best-microcap-cigar-butts/

Check out 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—are microcap stocks, which are stocks with market caps below $500 million.  What jumps out is the equal weighted returns of the 9th and 10th size deciles from 1927 to 2020:

Microcap equal weighted returns = 15.8% per year

Large-cap equal weighted returns = ~10% per year

In actuality, the annual returns from microcap stocks will be 1-2% lower because of the cost of entering and exiting positions.  So it’s better to 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.

 

VALUE SCREEN: +2-3%

By consistently applying a value screen—e.g., low EV/EBITDA, low P/E, low P/S, etc.—to a microcap strategy, you can add 2-3% per year.

 

IMPROVING FUNDAMENTALS: +2-3%

You can further increase performance by screening for improving fundamentals.  One powerful 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 implement a simple screen for value, that adds at least 2% a year.  If you then screen for improving fundamentals, that boosts performance by at least another 2% a year.

In brief, if you invest systematically in undervalued microcap stocks with improving fundamentals, you can get at least 18% a year.  That compares quite well to the 10% a year you could get from an S&P 500 index fund.

What’s the difference between 10% a year and 18% a year?  If you invest $100,000 at 10% a year for 30 years, you end up with $1.7 million, which is quite good.  If you invest $100,000 at 18% a year for 30 years, you end up with $14.3 million, which is significantly better.

Please contact me with any questions or comments.

    • My email: jb@boolefund.com.
    • 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.  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 approaches intrinsic 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.

The Most Important Thing

May 7, 2023

Howard Marks is one of the great value investors.  The Most Important Thing is a book Marks created based on his memos to clients.  Marks noticed that in his meetings with clients, he would often say, “The most important thing is X,” and then a bit later say, “The most important thing is Y,” and so on.  So the book, The Most Important Thing, has many “most important things,” all of which truly are important according to Marks.

Outstanding books are often worth reading at least four or five times.  The Most Important Thing is clearly outstanding, and is filled with investment wisdom.  As a result, this blog post is longer than usual.  It’s worth spending time to absorb the wisdom of Howard Marks.

 

INTRODUCTION

Marks writes:

Where does an investment philosophy come from?  The one thing I’m sure of is that no one arrives on the doorstep of an investment career with his or her philosophy fully formed.  A philosophy has to be the sum of many ideas accumulated over a long period of time from a variety of sources.  One cannot develop an effective philosophy without having been exposed to life’s lessons.  In my life I’ve been quite fortunate in terms of both rich experiences and powerful lessons.

Marks adds:

Good times teach only bad lessons: that investing is easy, that you know its secrets, and that you needn’t worry about risk.  The most valuable lessons are learned in tough times.

 

SECOND-LEVEL THINKING

Marks first points out how variable the investing landscape is:

No rule always works.  The environment isn’t controllable, and circumstances rarely repeat exactly.  Psychology plays a major role in markets, and because it’s highly variable, cause-and-effect relationships aren’t reliable.

The goal for an investor is to do better than the market over time.  Otherwise, the best option for most investors is simply to buy and hold low-cost broad market index funds.  Doing better than the market requires an identifiable edge:

Since other investors may be smart, well-informed and highly computerized, you must find an edge they don’t have.  You must think of something they haven’t thought of, see things they miss or bring insight they don’t possess.  You have to react differently and behave differently.  In short, being right may be a necessary condition for investment success, but it won’t be sufficient.  You must be more right than others… which by definition means your thinking has to be different.

Marks gives some examples of second-level thinking:

    • First-level thinking says, ‘It’s a good company; let’s buy the stock.’ Second-level thinking says, ‘It’s a good company, but everyone thinks it’s a great company, and it’s not.  So the stock’s overrated and overpriced; let’s sell.’
    • First-level thinking says, ‘The outlook calls for low growth and rising inflation. Let’s dump our stocks.’   Second-level thinking says, ‘The outlook stinks, but everyone else is selling in panic.  Buy!’
    • First-level thinking says, ‘I think the company’s earnings will fall; sell.’ Second-level thinking says, ‘I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.’

Marks explains that first-level thinking is generally simplistic.  By contrast, second-level thinking requires thinking of the full range of possible future outcomes, along with estimating probabilities for each possible outcome.  Second-level thinking means understanding what the consensus thinks, why one has a different view, and the likelihood that one’s contrarian view is correct.  Marks observes that second-level thinking is far more difficult than first-level thinking, thus few investors truly engage in second-level thinking.  First-level thinkers cannot expect to outperform the market.  Marks:

To outperform the average investor, you have to be able to outthink the consensus.  Are you capable of doing so?  What makes you think so?

Marks again:

The upshot is simple: to achieve superior investment results, you have to hold nonconsensus views regarding value, and they have to be accurate.  That’s not easy.

 

UNDERSTANDING MARKET EFFICIENCY

Marks holds a view of market efficiency similar to that of Buffett:  The market is usually efficient, but it is far from always efficient.  Marks says that the market reflects the consensus view, but the consensus is not always right:

In January 2000, Yahoo sold at $237.  In April 2001 it was $11.  Anyone who argues that the market was right both times has his or her head in the clouds; it has to have been wrong on at least one of those occasions.  But that doesn’t mean many investors were able to detect and act on the market’s error.

Marks summarizes his view:

The bottom line for me is that, although the more efficient markets often misvalue assets, it’s not easy for any one person – working with the same information as everyone else and subject to the same psychological influences – to consistently hold views that are different from the consensus and closer to being correct.  That’s what makes the mainstream markets awfully hard to beat – even if they aren’t always right.

Marks makes an important point about riskier investments:

Once in a while we experience periods when everything goes well and riskier investments deliver the higher returns they seem to promise.  Those halcyon periods lull people into believing that to get higher returns, all they have to do is make riskier investments.  But they ignore something that is easily forgotten in good times: this can’t be true, because if riskier investments could be counted on to produce higher returns, they wouldn’t be riskier.

Marks notes that inefficient prices imply that for each investor who buys at a cheap price, another investor must sell at that cheap price.  Inefficiency essentially implies that each investment that beats the market implies another investment that trails the market by an equal amount.

Generally it is exceedingly difficult to beat the market.  To highlight this fact, Marks asks a series of questions:

    • Why should a bargain exist despite the presence of thousands of investors who stand ready and willing to bid up the price of anything that is too cheap?
    • If the return appears so generous in proportion to the risk, might you be overlooking some hidden risk?
    • Why would the seller of the asset be willing to part with it at a price from which it will give you an excessive return?
    • Do you really know more about the asset than the seller does?
    • If it’s such a great proposition, why hasn’t someone else snapped it up?

Market inefficiency alone, argues Marks, is not a sufficient condition for outperformance:

All that means is that prices aren’t always fair and mistakes are occurring: some assets are priced too low and some too high.  You still have to be more insightful than others in order to regularly buy more of the former than the latter.  Many of the best bargains at any point in time are found among the things other investors can’t or won’t do.

Marks ends this section by saying that a key turning point in his career was when he concluded that he should focus on relatively inefficient markets.  (Note:  micro-cap stocks is one area that is relatively inefficient, which is why I created the Boole Microcap Fund.)

A few notes about deep value (contrarian value) investing:

In order to buy a stock that is very cheap in relation to its intrinsic value, some other investor must be willing to sell the stock at such an irrationally low price.  Sometimes such sales happen due to forced selling.  The rest of the time, the seller must be making a mistake in order for the value investor to make a market-beating investment.

Many deep value approaches are fully quantitative, however.  (Deep value is also called contrarian value.)  The quantitative deep value investor is not necessarily making an exceedingly detailed judgment on each individual deep value stock – a judgment which would imply that the value investor is correct in this particular case, and that the seller is wrong.  Rather, the quantitative deep value investor forms a portfolio of the statistically cheapest 20 or more stocks.  All of the studies have shown that a basket of quantitatively cheap stocks does better than the market over time, and is less risky (especially during down markets).

One of the best papers on quantitative deep value investing is Lakonishok, Shleifer, and Vishny (1994), “Contrarian Investment, Extrapolation, and Risk.”  Link: http://scholar.harvard.edu/files/shleifer/files/contrarianinvestment.pdf

A concentrated deep value approach, by contrast, typically involves the effort to select the most promising and the cheapest stocks available.  Warren Buffett and Charlie Munger both followed this approach when they were managing smaller amounts of capital.  They would typically have between 3 and 8 positions making up nearly the entire portfolio.  (Joel Greenblatt also used this approach when he was managing smaller amounts.  Greenblatt produced a ten-year record of 50.0% gross per year using a concentrated value approach focused on special situations.  See Greenblatt’s book, You Can Be a Stock Market Genius.)

 

VALUE

Marks begins by saying that “buy low; sell high” is one of the oldest rules in investing.  But since selling will occur in the future, how can one figure out a price today that will be lower than some future price?  What’s needed is an ability to accurately assess the intrinsic value of the asset.  The intrinsic value of a stock can be derived from the price that an informed buyer would pay for the entire company, based on the net asset value or the earnings power of the company.  Writes Marks:

The quest in value investing is for cheapness.  Value investors typically look at financial metrics such as earnings, cash flow, dividends, hard assets and enterprise value and emphasize buying cheap on these bases.  The primary goal of value investors, then, is to quantify the company’s current value and buy its securities when they can do so cheaply.

Marks also notes that successful value investing requires an estimate of current net asset value, or the current earnings power, that is unrecognized by the consensus.  Successful growth investing, by contrast, requires an estimate of future earnings that is higher than what the consensus currently thinks.  Often the rewards for successful growth investing are higher, but a successful value investing approach is much more repeatable and achievable.

Buying assets below fair value, however, does not mean those assets will outperform right away.  Thus value investing requires having a firmly held view, because quite often after buying, cheap assets will continue to underperform the market.  Marks elaborates:

If you liked it at 60, you should like it more at 50… and much more at 40 and 30.  But it’s not that easy.  No one’s comfortable with losses, and eventually any human will wonder, ‘Maybe it’s not me who’s right.  Maybe it’s the market.’…”

Thus, successful value investing requires not only the consistent ability to identify assets available at cheap prices; it also requires the ability to ignore various signals (many of which are subconscious) flashing the message that one is wrong.  As Marks writes:

Value investors score their biggest gains when they buy an underpriced asset, average down unfailingly and have their analysis proved out.  Thus, there are two essential ingredients for profit in a declining market: you have to have a view on intrinsic value, and you have to hold that view strongly enough to be able to hang in and buy even as price declines suggest that you’re wrong.  Oh yes, there’s a third: you have to be right.

 

THE RELATIONSHIP BETWEEN PRICE AND VALUE

Many investors make the mistake of thinking that a good company is automatically a good investment, while a bad company is automatically a bad investment.  But what really matters for the value investor is the relationship between price and value:

For a value investor, price has to be the starting point.  It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price.  And there are few assets so bad that they can’t be a good investment when bought cheaply enough.

In the 1960’s, there was a group of stocks called the Nifty Fifty – companies that were viewed as being so good that all one had to do was buy at any price and then hold for the long term.  But it turned out not to be true for many stocks in the basket.  Moreover, the early 1970’s led to huge declines:

Within a few years, those price/earnings ratios of 80 or 90 had fallen to 8 or 9, meaning investors in America’s best companies had lost 90 percent of their money.  People may have bought into great companies, but they paid the wrong price.

Marks explains the policy at his firm Oaktree:

‘Well bought is half sold.’

By this we mean we don’t spend a lot of time thinking about what price we’re going to be able to sell a holding for, or to whom, or though what mechanism.  If you’ve bought it cheap, eventually those questions will answer themselves.  If your estimate of intrinsic value is correct, over time an asset’s price should converge with its value.

Marks, similar to Warren Buffett and Charlie Munger, holds that psychology plays a central role in value investing:

Whereas the key to ascertaining value is skilled financial analysis, the key to understanding the price/value relationship – and the outlook for it – lies largely in insight into other investor’s minds.  Investor psychology can cause a security to be priced just about anywhere in the short run, regardless of its fundamentals.

The safest and most potentially profitable thing is to buy something when no one likes it.  Given time, its popularity, and thus its price, can only go one way: up.

A successful value investor must build systems or rules for self-protection because all investors – all humans – suffer from psychological biases, which often operate subconsciously.  For more on cognitive biases, see the following two blog posts:

Cognitive Biases

The Psychology of Misjudgment

Marks continues:

Of all the possible routes to investment profit, buying cheap is clearly the most reliable.  Even that, however, isn’t sure to work.  You can be wrong about the current value.  Or events can come along that reduce value.  Or deterioration in attitudes or markets can make something sell even further below its value.  Or the convergence of price and intrinsic value can take more time than you have…

Trying to buy below value isn’t infallible, but it’s the best chance we have.

 

UNDERSTANDING RISK

As Buffett frequently observes, the future is always uncertain.  Prices far below probable intrinsic value usually only exist when the future is highly uncertain.  When there is not much uncertainty, asset prices will be much higher than otherwise.  So high uncertainty about the future is the friend of the value investor.

On the other hand, in general, assets that promise higher returns always entail higher risk.  If a potentially higher-returning asset was obviously as low risk as a U.S. Treasury, then investors would rush to buy the higher-returning asset, thereby pushing up its price to the point where it would promise returns on par with a U.S. Treasury.

A successful value investor has to determine whether the potential return on an ostensibly cheap asset is worth the risk.  High risk is not necessarily bad as long as it is properly controlled and as long as the potential return is high enough.  But if the risk is too high, then it’s not the type of repeatable bet that can produce long-term success for a value investor.  Repeatedly taking too much risk – by sizing positions too large relative to risk-reward – virtually guarantees long-term failure.

Consider the Kelly criterion.  If the probability of success and the returns from a potential investment can be quantified, then the Kelly criterion tells one exactly how much to bet in order to maximize the long-term compound returns from a long series of such bets.  Betting any other amount than what the Kelly criterion says will inevitably lead to less than the maximum potential returns.  Most importantly, betting more than what the Kelly criterion says guarantees zero or negative long-term returns.  Repeatedly overbetting guarantees long-term failure.  For more about the Kelly criterion, see:  https://boolefund.com/the-dhandho-investor/

This is why Howard Marks, Warren Buffett, Charlie Munger, and other great value investors often point out that minimizing big mistakes is more important for long-term investing success than hitting home runs.  Buffett and Munger apply the same logic to life itself:  avoiding big mistakes is more important than trying to hit home runs.  Buffett:  “You have to do very few things right in life so long as you don’t do too many things wrong.”

Again, Marks points out, while riskier investments promise higher returns, those higher returns are not guaranteed, otherwise riskier investments wouldn’t be riskier!  The probability distribution of potential returns is wider for riskier investments, typically including some large potential losses.  A certain percentage of future outcomes will be zero or negative for riskier investments.

Marks agrees with Buffett and Munger that the best definition of risk is the potential to experience loss.

Of course, as John Templeton, Ray Dalio, and other great investors observe, even the best investors are typically only right two-thirds of the time, while they are wrong one-third of the time.  Thus, following a successful long-term value investing framework where one consistently and carefully pays cheap prices for assets still entails being wrong roughly one-third of the time.  Being wrong often means that the lower probability future negative scenarios do in fact occur a certain percentage of the time.  Back luck does happen a certain percentage of the time.  (Mistakes in analysis or psychology also happen.)

It’s important to bet big when the odds are heavily in one’s favor.  But one should be psychologically prepared to be wrong roughly one-third of the time, whether due to bad luck or to mistakes.  The overall portfolio should be able to withstand at least a 33% error rate.

More Notes on Deep Value

Investors are systematically too pessimistic about companies that have been doing poorly, and systematically too optimistic about companies that have been doing well.  This is why a deep value (contrarian value) approach, if applied systematically, is very likely to produce market-beating returns over a long enough period of time.

Marks explains:

Dull, ignored, possibly tarnished and beaten-down securities – often bargains exactly because they haven’t been performing well – are often ones value investors favor for high returns…. Much of the time, the greatest risk in these low-luster bargains lies in the possibility of underperforming in heated bull markets.  That’s something the risk-conscious value investor is willing to live with.

Measuring Risk-Adjusted Returns

Marks mentions the Sharpe ratio – or excess return compared to the standard deviation of the return.  While not perfect, the Sharpe ratio is a solid measure of risk-adjusted return for many public market securities.

It’s important to point out again that risk can no more be objectively measured after an investment than it can be objectively measured before the investment.  Marks:

The point is that even after an investment has been closed out, it’s impossible to tell how much risk it entailed.  Certainly the fact that an investment worked doesn’t mean it wasn’t risky, and vice versa.  With regard to a successful investment, where do you look to learn whether the favorable outcome was inescapable or just one of a hundred possibilities (many of them unpleasant)?  And ditto for a loser: how do we ascertain whether it was a reasonable but ill-fated venture, or just a wild stab that deserved to be punished?

Did the investor do a good job of assessing the risk entailed?  That’s another good questions that’s hard to answer.  Need a model?  Think of the weatherman.  He says there’s a 70 percent chance of rain tomorrow.  It rains; was he right or wrong?  Or it doesn’t rain; was he right or wrong?  It’s impossible to assess the accuracy of probability estimates other than 0 and 100 except over a very large number of trials.

Marks believes (as do Buffett, Munger, and other top value investors) that there is some merit to the expected value framework whereby one attempts to identify possible future scenarios and the probabilities of their occurrence:

If we have a sense for the future, we’ll be able to say which outcome is most likely, what other outcomes also have a good chance of occurring, how broad the range of possible outcomes is and thus what the ‘expected result’ is.  The expected result is calculated by weighing each outcome by its probability of occurring; it’s a figure that says a lot – but not everything – about the likely future.

Again, though, having a reasonable estimate of the future probability distribution is not enough.  One must also make sure that one’s portfolio can withstand a run of bad luck; and one must recognize when one has experienced a run of good luck.  Marks quotes his friend Bruce Newberg (with whom he has played cards and dice):

There’s a big difference between probability and outcome.  Probable things fail to happen – and improbable things happen – all the time.

This is one of the most important lessons to know about investing, asserts Marks.

Marks defines investment performance:

… investment performance is what happens when a set of developments – geopolitical, macro-economic, company-level, technical and psychological – collide with an extant portfolio.  Many futures are possible, to paraphrase Dimson, but only one future occurs.  The future you get may be beneficial to your portfolio or harmful, and that may be attributable to your foresight, prudence or luck.  The performance of your portfolio under the one scenario that unfolds says nothing about how it would have fared under the many ‘alternative histories’ that were possible.

A portfolio can be set up to withstand 99 percent of all scenarios but succumb because it’s the remaining 1 percent that materializes.  Based on the outcome, it may seem to have been risky, whereas the investor might have been quite cautious.

Another portfolio may be structured so that it will do very well in half the scenarios and very poorly in the other half.  But if the desired environment materializes and it prospers, onlookers can conclude that it was a low-risk portfolio.

The success of a third portfolio can be entirely contingent on one oddball development, but if it occurs, wild aggression can be mistaken for conservatism and foresight.

Marks again:

Risk can be judged only by sophisticated, experienced second-level thinkers.

The past seems very definite: for every evolving set of possible scenarios, only one scenario happened at each point along the way.  But that does not at all mean that the scenarios that actually occurred were the only scenarios that could have occurred.

Furthermore, most people assume that the future will be like the past, especially the more recent past.  As Ray Dalio says, the biggest mistake most investors make is to assume that the recent past will continue into the future.

Marks also reminds us that the “worst-case” assumed by most investors is typically not negative enough.  Marks relates a funny story his father told about a gambler who bet everything on a race with only one horse in it.  How could he lose?

Halfway around the track, the horse jumped over the fence and ran away.  Invariably things can get worse than people expect.

Taking more risk usually leads to higher returns, but not always.

And when risk bearing doesn’t work, it really doesn’t work, and people are reminded what risk’s all about.

 

RECOGNIZING RISK

The main source of risk, argues Marks, is high prices.  When stock prices move higher, for instance, most investors feel more optimistic and less concerned about downside risk.  But value investors have the opposite point of view: risk is typically very low when stock prices are very low, while risk tends to increase significantly when stock prices have increased significantly.

Most investors are not value investors:

So a prime element in risk creation is a belief that risk is low, perhaps even gone altogether.  That belief drives up prices and leads to the embrace of risky actions despite the lowness of prospective returns.

Marks emphasizes that recognizing risk – which comes primarily from high prices – has nothing to do with predicting the future, which cannot be done with any sort of consistency when it comes to the overall stock market or the economy.

Marks also highlights, again, how the psychology of eager buyers – who are unworried about risk – is precisely what creates greater levels of risk as they drive prices higher:

Thus, the market is not a static arena in which investors operate.  It is responsive, shaped by investors’ own behavior.  Their increasing confidence creates more that they should worry about, just as their rising fear and risk aversion combine to widen risk premiums at the same time as they reduce risk.  I call this the ‘perversity of risk.’

In a nutshell:

When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not risky at all.  Broadly negative opinion can make it the least risky thing, since all optimism has been driven out of its price.

And, of course, as demonstrated by the experience of Nifty Fifty investors, when everyone believes something embodies no risk they usually bid it up to the point where it’s enormously risky.  No risk is feared, and thus no reward for risk bearing – no ‘risk premium’ – is demanded or provided.  That can make the thing that’s most esteemed the riskiest.

Marks again:

This paradox exists because most investors think quality, as opposed to price, is the determinant of whether something’s risky.  But high quality assets can be risky, and low quality assets can be safe.  It’s just a matter of the price paid for them…

 

CONTROLLING RISK

Outstanding investors, in my opinion, are distinguished at least as much for their ability to control risk as they are for generating return.

Great investors generate high returns with moderate risk, or moderate returns with low risk.  If they generate high returns with “high risk,” but they do so consistently for many years, then perhaps the high risk “either wasn’t really high or was exceptionally well-managed.”  Mark says that great investors such as Buffett or Peter Lynch tend to have very few losing years over a relatively long period of time.

It’s important, notes Marks, to see that risk leads to loss only when lower probability negative scenarios occur:

… loss is what happens when risk meets adversity.  Risk is the potential for loss if things go wrong.  As long as things go well, loss does not arise.  Risk gives rise to loss only when negative events occur in the environment.

We must remember that when the environment is salutary, that is only one of the environments that could have materialized that day (or that year).  (This is Nassim Nicholas Taleb’s idea of alternative histories…)  The fact that the environment wasn’t negative does not mean that it couldn’t have been.  Thus, the fact that the environment wasn’t negative doesn’t mean risk control wasn’t desirable, even though – as things turned out – it wasn’t needed at that time.

The absence of losses does not mean that there was no risk.  Only a skilled investor can look at a portfolio during good times and tell how much risk has been taken.

Bottom line: risk control is invisible in good times but still essential, since good times can so easily turn into bad times.

Marks says that an investment manager adds value by generating higher than market returns for a given level of risk.  Achieving the same return as the market, but with less risk, is adding value.  Achieving better than market returns without undue risk is also adding value.

Many value investors, such as Marks and Buffett, somewhat underperform during up markets, but far outperform during down markets.  The net result over a long period of time is market-beating performance with very little incremental risk.  But it does take some time in order to see the value-added.

Controlling the risk in your portfolio is a very important and worthwhile pursuit.  The fruits, however, come only in the form of losses that don’t happen.  Such what-if calculations are difficult in placid times.

Marks:

On the other hand, the intelligent acceptance of recognized risk for profit underlies some of the wisest, most profitable investments – even though (or perhaps due to the fact that) most investors dismiss them as dangerous speculations.

Marks’ firm Oaktree invests in high yield bonds.  High yield bonds can be good investments over time if the prices are low enough:

I’ve said for years that risky assets can make for good investments if they’re cheap enough.  The essential element is knowing when that’s the case.  That’s it: the intelligent bearing of risk for profit, the best test for which is a record of repeated success over a long period of time.

Risk bearing per se is neither wise nor unwise, says Marks.  Investing in the more aggressive niches with risk properly controlled is ideal.  But controlling risk always entails being prepared for bad scenarios.

Extreme volatility and loss surface only infrequently.  And as time passes without that happening, it appears more and more likely that it’ll never happen – that assumptions regarding risk were too conservative.  Thus, it becomes tempting to relax rules and increase leverage.  And often this is done just before the risk finally rears its head…

Marks quotes Nassim Taleb:

Reality is far more vicious than Russian roulette.  First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands of chambers instead of six.  After a few dozen tries, one forgets about the existence of the bullet, under a numbing false sense of security… Second, unlike a well-defined precise game like Russian roulette, where the risks are visible to anyone capable of multiplying and dividing by six, one does not observe the barrel of reality… One is thus capable of unwittingly playing Russian roulette – and calling it by some alternative ‘low risk’ name.

A good example, which Marks does mention, is large financial institutions in 2004-2007.  Virtually no one thought that home prices could decline on a nationwide scale, since they had never done so before.

Of course, it’s also possible to be too conservative.  You can’t run a business on the  basis of worst-case assumptions.  You wouldn’t be able to do anything.  And anyway, a ‘worst-case assumption’ is really a misnomer; there’s no such thing, short of a total loss.  Now, we know the quants shouldn’t have assumed there couldn’t be a nationwide decline in home prices.  But once you grant that such a decline can happen… what should you prepare for?  Two percent?  Ten?  Fifty?

Marks continues:

If every portfolio was required to be able to withstand declines on the scale we’ve witnessed this year [2008], it’s possible no leverage would ever be used.  Is that a reasonable reaction?

Even if we realize that unusual, unlikely things can happen, in order to act we make reasoned decisions and knowingly accept that risk when well paid to do so.  Once in a while, a ‘black swan’ will materialize.  But if in the future we always said, ‘We can’t do such-and-such, because the outcome could be worse than we’ve ever seen before,’ we’d be frozen in inaction.

… It’s by bearing risk when we’re well paid to do so – and especially by taking risks toward which others are averse in the extreme – that we strive to add value for our clients.

 

BEING ATTENTIVE TO CYCLES

    • Rule number one: most things will prove to be cyclical.
    • Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.

Marks explains:

… processes in fields like history and economics involve people, and when people are involved, the results are variable and cyclical.  The main reason for this, I think, is that people are emotional and inconsistent, not steady and clinical.

Objective factors do play a large part in cycles, of course – factors such as quantitative relationships, world events, environmental changes, technological developments and corporate decisions.  But it’s the application of psychology to these things that causes investors to overreact or underreact, and thus determines the amplitude of the cyclical fluctuations.

Marks continues:

Economies will wax and wane as consumers spend more or less, responding emotionally to economic factors or exogenous events, geopolitical or naturally occurring.  Companies will anticipate a rosy future during the up cycle and thus overexpand facilities and inventories; these will become burdensome when the economy turns down.  Providers of capital will be too generous when the economy’s doing well, abetting overexpansion with cheap money, and then they’ll pull the reins too tight when things cease to look as good.

Investors will overvalue companies when they’re doing well and undervalue them when things get difficult.

 

AWARENESS OF THE PENDULUM

Marks holds that there are two risks in investing:

the risk of losing money and the risk of missing opportunity.

Most investors consistently do the wrong things at the wrong time:  when prices are high, most investors rush to buy; when prices are low, most investors rush to sell.  Thus, the value investor can profit over time by following Warren Buffett’s advice:

Be fearful when others are greedy.  Be greedy when others are fearful.

Marks:

Stocks are cheapest when everything looks grim.  The depressing outlook keeps them there, and only a few astute and daring bargain hunters are willing to take new positions.

 

COMBATING NEGATIVE INFLUENCES

Marks writes as follows:

Many people possess the intellect needed to analyze data, but far fewer are able to look more deeply into things and withstand the powerful influence of psychology.  To say this another way, many people will reach similar cognitive conclusions from their analysis, but what they do with those conclusions varies all over the lot because psychology influences them differently.  The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.  Investor psychology includes many separate elements, which we will look at in this chapter, but the key thing to remember is that they consistently lead to incorrect decisions.  Much of this falls under the heading of ‘human nature.’

Cognitive Biases

As humans, we all have psychological tendencies or cognitive biases that were mostly helpful to us during much of our evolutionary history, but that often lead us to make bad judgments in many areas of modern life.

Marks writes about the following psychological tendencies:

    • Greed
    • Fear
    • Self-deception
    • Conformity to the crowd
    • Envy
    • Ego or overconfidence
    • Capitulation

How might these psychological tendencies have been useful in our evolutionary history?  

When food was often scarce, being greedy by hoarding food (whether at the individual or community level) made sense.  When a movement in the grass occasionally meant the presence of a dangerous predator, immediate fear (this fear is triggered by the amygdala even before the conscious mind is aware of it) was essential for survival.  When hunting for food was dangerous, often with low odds of success, self-deception – accompanied by various naturally occurring chemicals – helped hunters to persevere over long periods of time, regardless of high danger and often regardless of injury.  (Chemical reactions could often cause an injured hunter not to feel the pain much.)  If everyone in one’s hunting group, or in one’s community, was running away as fast as possible, following the crowd was usually the most rational response.  If a starving hunter saw another person with a huge pile of food, envy would trigger a strong desire to possess such a large pile of food, whether by trying to take it or by going on a hunting expedition with a heightened level of determination.  When hunting a dangerous prey, with low odds of success, ego or overconfidence would cause the hunter to be convinced that he would succeed.  From the point of view of the community, having self-deceiving and overconfident hunters was a net benefit because the hunters would persevere despite often low odds of success, and despite inevitable injuries and deaths among individual hunters.

How do these psychological tendencies cause people to make errors in modern activities such as investing?

Greed causes people to follow the crowd by paying high prices for stocks in the hope that there will be even higher prices in the future.  Fear causes people to sell or to avoid ugly stocks – stocks trading at low multiples because the businesses in question are facing major difficulties.

As humans, we have an amazingly strong tendency towards self-deception:

    • The first principle is that you must not fool yourself, and you are the easiest person to fool. – Richard Feynman
    • Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true. – Demosthenes, as quoted by Charlie Munger

There have been many times in history when self-deception was probably crucial for the survival of a given individual or community.  I’ve mentioned hunters pursuing dangerous prey.  A much more recent example might be Winston Churchill, who was firmly convinced – even when virtually all the evidence was against it – that England would defeat Germany in World War II.  Churchill’s absolute belief helped sustain England long enough for both good luck and aid to arrive:  the Germans ended up overextended in Russia, and huge numbers of American troops (along with mass amounts of equipment) arrived in England.

Like other psychological tendencies, self-deception not only was important in evolutionary history, but it still often plays a constructive role.  Yet when it comes to investing, self-deception is clearly harmful, especially as the time horizon is extended so that luck evens out.

Conformity to the crowd is another psychological tendency that many (if not most) investors seem to display.  Marks notes the famous experiment by Solomon Asch.  The subject is shown lines of obviously different lengths.  But in the same room with the subject are shills, who unbeknownst to the subject have already been instructed to say that two lines of obviously different lengths actually have the same length.  So the subject of the experiment has to decide between the obvious evidence of his eyes – the two lines are clearly different lengths – and the opinion of the crowd.  A significant number (36.8 percent) ignored their own eyes and went with the crowd, saying that the two lines had equal length, despite the obvious fact that they didn’t.

(The experiment involved a control group in which there were no shills.  Almost every subject – over 99 percent – gave the correct answer under these circumstances.)

Greed, conformity, and envy together operate powerfully on the brain of many investors:

Time and time again, the combination of pressure to conform and the desire to get rich causes people to drop their independence and skepticism, overcome their innate risk aversion and believe things that don’t make sense.

A good example from history is the tulip mania in Holland, during which otherwise rational people ended up paying exorbitant sums for colorful tulip bulbs.  The South Sea Bubble is another example, during which even the extremely intelligent Isaac Newton, after selling out early for a solid profit, could not resist buying in again as prices seemed headed for the stratosphere.  Newton and many others lost huge sums when prices inevitably returned to earth.

Envy has a very powerful and often negative effect on most human brains.  And as Charlie Munger always points out, envy is particularly stupid because it’s a sin that, unlike many other sins, is not any fun at all.  There are many people who could easily learn to be very happy – grateful for blessings, grateful for the wonders of life itself, etc. – who become miserable because they fixate on other people who have more of something, or who are doing better in some way.  Envy is fundamentally irrational and stupid, but it is powerful enough to consume many people.  Buffett: “It’s not greed that drives the world, but envy.”  Envy and jealousy have for a very long time caused the downfall of human beings.  This certainly holds true in investing.

Ego is another powerful psychological tendency humans have.  As with the other potential pitfalls, many of the best investors – from Warren Buffett to Ray Dalio – are fundamentally humble.  Overconfidence (closely related to ego) is a very strong bias that humans have, and if it is not overcome by learning humility and objectivity, it will kill any investor eventually.  Marks writes:

In contrast, thoughtful investors can toil in obscurity, achieving solid gains in the good years and losing less than others in the bad years.  They avoid sharing in the riskiest behavior because they’re so aware of how much they don’t know and because they have their egos in check.  This, in my opinion, is the greatest formula for long-term wealth creation – but it doesn’t provide much ego gratification in the short run.  It’s just not that glamorous to follow a path that emphasizes humility, prudence, and risk control.  Of course, investing shouldn’t be about glamour, but often it is.

Capitulation is a final phenomenon that Marks emphasizes.  In general, people become overly negative about a stock that is deeply out of favor because the business in question is going through hard times.  Moreover, when overly negative investors are filled with fear and when they see everyone selling in a panic, they themselves often sell near the very bottom.  Often these investors know analytically that the stock is cheap, but their emotions (fear of loss, conformity to the crowd, etc.) are too strong, so they disbelieve their own sound logic.  The rational, contrarian, long-term value investor does just the opposite:  he or she buys near the point of maximum pessimism (to use John Templeton’s phrase).

Similarly, most investors become overly optimistic when a stock is near its all-time highs.  They see many other investors who have done well with the sky-high stock, and so they tend to buy at a price that is near the all-time highs.  Again, many of these investors – like Isaac Newton – know analytically that buying a stock when it is near its all-time highs is often not a good idea.  But greed, envy, self-deception, crowd conformity, etc. (fear of missing out, dream of a sure thing), overwhelm their own sound logic.  By contrast, the rational, long-term value investor does the opposite:  he or she sells near the point of maximum optimism.

Marks gives a marvelous example from the tech bubble of 1998-2000:

From the perspective of psychology, what was happening with IPOs is particularly fascinating.  It went something like this: The guy next to you in the office tells you about an IPO he’s buying.  You ask what the company does.  He says he doesn’t know, but his broker told him its going to double on the day of issue.  So you say that’s ridiculous.  A week later he tells you it didn’t double… it tripled.  And he still doesn’t know what it does.  After a few more of these, it gets hard to resist.  You know it doesn’t make sense, but you want protection against continuing to feel like an idiot.  So, in a prime example of capitulation, you put in for a few hundred shares of the next IPO… and the bonfire grows still higher on the buying from new converts like you.

 

CONTRARIANISM

To buy when others are despondently selling and to sell when others are euphorically buying takes the greatest courage, but provides the greatest profit. – Sir John Templeton

Superior value investors buy when others are selling, and sell when others are buying.  Value investing is simple in concept, but it is very difficult in practice.

Of course, it’s not enough just to be contrarian.  Your facts and your reasoning also have to be right:

You’re neither right nor wrong because the crowd disagrees with you.  You’re right because your data and reasoning are right – and that’s the only thing that makes you right.  And if your facts and reasoning are right, you don’t have to worry about anybody else. – Warren Buffett

Or, as Seth Klarman puts it:

Value investing is at its core the marriage of a contrarian streak with a calculator.

Only by being right about the facts and the reasoning can a long-term value investor hold (or add to) a position when everyone else continues to sell.  Getting the facts and reasoning right still involves being wrong roughly one-third of the time, often due to bad luck but also sometimes due to mistakes in analysis or psychology.  But getting the facts and reasoning right leads to ‘being right’ roughly two-third of the time.

‘Being right’ usually means a robust process correctly followed – both analytically and psychologically – and the absence of bad luck.  But sometimes good luck plays a role.  Either way, a robust process correctly followed should produce positive results (on both an absolute and relative basis) over most rolling five-year periods, and over nearly all rolling ten-year periods.

It’s never easy to consistently follow a careful, contrarian value investing approach.  Marks quotes David Swensen:

Investment success requires sticking with positions made uncomfortable by their variance with popular opinion… Only with the confidence created by a strong decision-making process can investors sell speculative excess and buy despair-driven value.

… Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom.

Marks puts it in his own words:

The most profitable investment actions are by definition contrarian:  you’re buying when everyone else is selling (and the price is thus low) or you’re selling when everyone else is buying (and the price is high).  These actions are lonely and… uncomfortable.

Marks writes about the paradoxical nature of investing:

The thing I find most interesting about investing is how paradoxical it is: how often the things that seem most obvious – on which everyone agrees – turn out not to be true.

The best bargains are typically only available when pessimism and uncertainty are high.  Many investors say, ‘We’re not going to try to catch a falling knife; it’s too dangerous… We’re going to wait until the dust settles and the uncertainty is resolved.’  But waiting until uncertainty gets resolved usually means missing the best bargains, as Marks says:

The one thing I’m sure of is that by the time the knife has stopped falling, the dust has settled and the uncertainty has been resolved, there’ll be no great bargains left.  When buying something has become comfortable again, its price will no longer be so low that it’s a great bargain.  Thus, a hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron.

It’s our job as contrarians to catch falling knives, hopefully with care and skill.  That’s why the concept of intrinsic value is so important.  If we hold a view of value that enables us to buy when everyone else is selling – and if our view turns out to be right – that’s the route to the greatest rewards earned with the least risk.

 

FINDING BARGAINS

It cannot be too often repeated:

A high-quality asset can constitute a good or bad buy, and a low-quality asset can constitute a good or bad buy.  The tendency to mistake objective merit for investment opportunity, and the failure to distinguish between good assets and good buys, gets most investors into trouble.

What is the process by which some assets become cheap relative to intrinsic value?  Marks explains:

    • Unlike assets that become the subject of manias, potential bargains usually display some objective defect. An asset class may have weaknesses, a company may be a laggard in its industry, a balance sheet may be over-levered, or a security may afford its holders inadequate structural protection.
    • Since the efficient-market process of setting fair prices requires the involvement of people who are analytical and objective, bargains usually are based on irrationality or incomplete understanding. Thus, bargains are often created when investors either fail to consider an asset fairly, or fail to look beneath the surface to understand it thoroughly, or fail to overcome some non-value-based tradition, bias or stricture.
    • Unlike market darlings, the orphan asset is ignored or scorned. To the extent it’s mentioned at all by the media and at cocktail parties, it’s in unflattering terms.
    • Usually its price has been falling, making the first-level thinker as, ‘Who would want to own that?’ (It bears repeating that most investors extrapolate past performance, expecting the continuation of trends rather than the far-more-dependable regression to the mean.  First-level thinkers tend to view price weakness as worrisome, not as a sign that the asset has gotten cheaper.)
    • As a result, a bargain asset tends to be one that’s highly unpopular. Capital stays away from it or flees, and no one can think of a reason to own it.

Where is the best place to look for underpriced assets?  Marks observes that a good place to start is among things that are:

    • little known and not fully understood;
    • fundamentally questionable on the surface;
    • controversial, unseemly or scary;
    • deemed inappropriate for ‘respectable’ portfolios;
    • unappreciated, unpopular and unloved;
    • trailing a record of poor returns; and
    • recently the subject of disinvestment, not accumulation.

Marks:

To boil it all down to just one sentence, I’d say the necessary condition for the existence of bargains is that perception has to be considerably worse than reality.  That means the best opportunities are usually found among things most others won’t do.  After all, if everyone feels good about something and is glad to join in, it won’t be bargain-priced.

Marks started a fund for high yield bonds – junk bonds – in 1978.  One rating agency described high yield bonds as “generally lacking the characteristics of a desirable investment.”  Marks points out the obvious: “if nobody owns something, demand for it (and thus the price) can only go up and…. by going from taboo to even just tolerated, it can perform quite well.”

In 1987, Marks formed a fund to invest in distressed debt:

Who would invest in companies that already had demonstrated their lack of financial viability and the weakness of their management?  How could anyone invest responsibly in companies in free fall?  Of course, given the way investors behave, whatever asset is considered worst at a given point in time has a good likelihood of being the cheapest.  Investment bargains needn’t have anything to do with high quality.  In fact, things tend to be cheaper if low quality has scared people away.

 

PATIENT OPPORTUNISM

Marks makes the same point that Warren Buffett and Charlie Munger often make: Most of the time, by far the best thing to do is absolutely nothing.  Finding one good idea a year is enough to get outstanding returns over time.  Writes Marks:

So here’s a tip: You’ll do better if you wait for investments to come to you rather than go chasing after them.  You tend to get better buys if you select from the list of things sellers are motivated to sell rather than start with a fixed notion as to what you want to own.  An opportunist buys things because they’re offered at bargain prices.  There’s nothing special about buying when prices aren’t low.

Marks took five courses in Japanese studies as an undergraduate business major in order to fulfill his requirement for a minor.  He learned the Japanese value of mujo:

mujo means cycles will rise and fall, things will come and go, and our environment will change in ways beyond our control.  Thus we must recognize, accept, cope and respond.  Isn’t that the essence of investing?

… What’s past is past and can’t be undone.  It has led to the circumstances we now face.  All we can do is recognize our circumstances for what they are and make the best decisions we can, given the givens.

Marks quotes Buffett, who notes that there are no called strikes in investing:

Investing is the greatest business in the world because you never have to swing.  You stand at the plate; the pitcher throws you General Motors at 47!  U.S. steel at 39!  And nobody calls a strike on you.  There’s no penalty except opportunity.  All day you wait for the pitch you like; then, when the fielders are asleep, you step up and hit it.

It’s dumb to invest when the opportunities are not there.  But when the overall market is high, there are still a few ways to do well as a long-term value investor.  If one is able to ignore short-term volatility and focus on the next five to ten years, then one can invest in undervalued stocks.

If one’s assets under management are small enough, then there can be certain parts of the market where one can still find excellent bargains.  An example would be micro-cap stocks, since very few professional investors look there.  (This is the focus of the Boole Microcap Fund.)

Another example of potentially cheap (albeit volatile) stocks in an otherwise expensive stock market is old-related companies.  Energy companies recently were as cheap as they’ve ever been.  See: https://www.gmo.com/americas/research-library/resource-equities/?utm_source=linkedin&utm_medium=social&utm_campaign=insights_resource_equities

 

KNOWING WHAT YOU DON’T KNOW

We have two classes of forecasters: Those who don’t know – and those who don’t know they don’t know. – John Kenneth Galbraith

Marks, like Buffett, Munger, and most other top value investors, thinks that financial forecasting simply cannot be done with any sort of consistency.  But Marks has two caveats:

    • The more we concentrate on smaller-picture things, the more it’s possible to gain a knowledge advantage. With hard work and skill, we can consistently know more than the next person about individual companies and securities, but that’s much less likely with regard to markets and economies.  Thus, I suggest people try to ‘know the knowable.’
    • An exception comes in the form of my suggestion, on which I elaborate in the next chapter, that investors should make an effort to figure out where they stand at a moment in time in terms of cycles and pendulums. That won’t render the future twists and turns knowable, but it can help one prepare for likely developments.

 

Marks has tracked (in a limited way) many macro predictions, including U.S. interest rates, the U.S. stock market, and the yen/dollar exchange rate.  He found quite clearly that most forecasts were not correct.

I can elaborate on two examples that I spent much time on (when I should have stayed focused on finding individual companies available at cheap prices):

    • the U.S. stock market
    • the yen/dollar exchange

A secular bear market for U.S. stocks began (arguably) in the year 2000, when the 10-year Graham-Shiller P/E – also called the CAPE (cyclically adjusted P/E) – was over 30, its highest level in U.S. history.  The long-term average CAPE is around 16.  Based on over one hundred years of history, the pattern for U.S. stocks in a secular bear market would be relatively flat or lower until the CAPE approached 10.  However, ever since Greenspan started running the Fed in the 1980’s, the Fed has usually had a policy of stimulating the economy and stocks by lowering rates or keeping rates as low as possible.  This has caused U.S. stocks to be much higher than otherwise.  For instance, with rates today staying near zero, U.S. stocks could easily be twice as high as or three times as high as “normal” indefinitely, assuming the Fed decides to keep rates low for many more years.  As Buffett has noted, near-zero rates for many decades would eventually mean price/earnings ratios on stocks of 100.

In any case, in the year 2012 to 2013, some of the smartest market historians (including Russell Napier, author of Anatomy of the Bear) started predicting that the S&P 500 Index would fall towards a CAPE of 10 or lower, which is how every previous U.S. secular bear market concluded.  It didn’t happen in 2012, or in 2013, or in 2014, or in 2015, or in 2016, or in 2017, or in 2018, or in 2019.  (Also, the stock market decline in early 2020 was a temporary response to the coronavirus.)  Eventually the U.S. stock market will experience another major bear market.  But by the time that happens, it may start from a level over 4,000 or 4,500 in the next year or two, and it may not decline below 2000, which is actually far above the level from which the smartest forecasters (such as Russell Napier) said the decline would begin.

Robert Shiller, the Nobel Prize-winning economist who perfected the CAPE (Shiller P/E), said in 1996 that U.S. stocks were high.  But if an investor had gone to cash in 1996, they wouldn’t have had any chance of being ahead of the stock market until 2008 to 2009, more than 10 years later during the biggest financial crisis since the Great Depression.

Shiller has recently explained the CAPE with more clarity: http://www.businessinsider.com/robert-shiller-on-stocks-2013-1

When the CAPE is high, as it is today, the long-term investor should still have a large position in U.S. stocks.  But the long-term investor should expect fairly low ten-year returns, a few percent per annum, and they also should some investments outside of U.S. stocks.  Shiller also has observed that certain sectors in the U.S. economy can be cheap (low CAPE).  Many oil-related stocks, for example, are very probably quite cheap today (mid 2021) relative to their long-term normalized earnings power.

The main point here, though, is that forecasting the next bear market or the next recession with any precision is generally impossible.  Another example would be the Economic Cycle Research Institute (https://www.businesscycle.com/), which predicted a U.S. recession around 2011-2012 based on its previously quite successful set of leading economic indicators.  But they were wrong, and they later admitted that the Fed printing so much money not only may have kept the U.S. barely out of recession, but also may have led to distortions in the economic data, making ECRI’s set of leading economic indicators no longer as reliable.

As for the yen/dollar exchange, the story begins in a familiar way:  some of the smartest macro folks around predicted (in 2010 and later) that shorting the yen vs. the U.S. dollar would be the “trade of the decade,” and that the yen/dollar exchange would exceed 200.  But it’s not 2021, and the yen/dollar exchange rate has come nowhere near 200.

The “trade of the decade argument” was the following:  the debt-to-GDP in Japan has reached stratospheric levels, , government deficits have continued to widen, and the Japanese population is actually shrinking.  Since long-term GDP growth is a function of population growth plus innovation, it should become mathematically impossible for the Japanese government to pay back its debt without a significant devaluation of their currency.  If the BOJ could devalue the yen by 67% – which would imply a yen/dollar exchange rate of well over 200 – then Japan could repay the government debt in seriously devalued currency.  In this scenario – a yen devaluation of 67% – Japan effectively would only have to repay 33% of the government debt.  Currency devaluation – inflating away the debts – is what most major economies throughout history have done.

The bottom line as regards the yen is the following:  Either Japan must devalue the Yen by 67% – implying a yen/dollar exchange rate of well over 200 – or Japan will inevitably reach the point where it is quite simply impossible for it to repay a large portion of the government debt.  That’s the argument.  There could be other solutions, however.  The human economy is likely to be much larger in the future, and there may be some way to help the Japanese government with its debts.  After all, the situation wouldn’t seem so insurmountable if Japan could grow its population.  But this might happen in some indirect way if the human economy becomes more open in the future, perhaps involving the creation of a new universal currency.

In any case, for the past five to ten years, and even longer, it has been argued that either the yen/dollar would eventually exceed 200 (thus inflating away as much as 67% of the debt), or the Japanese government would inevitably default on JGB’s (Japanese government bonds).  In either case, the yen should collapse relative to the U.S. dollar, meaning a yen/dollar of well over 200.  This has been described as “the trade of the decade,” but it may not happen for several decades.

In the end, one could have spent decades trying to short the Yen or trying to short JGB’s, without much to show for it.  Or one could have spent those decades doing value investing:  finding and buying cheap stocks, year in and year out.  Decades later, value investing would almost certainly have produced a far better result, and with a relatively low level of risk.

The same logic applies to market timing, or trying to profit on the basis of predicting bull markets, bear markets, recessions, etc.  For the huge majority of investors, they would get much better profits, at relatively low risk, by following a value investing approach (whether by investing in a value fund, or by applying the value approach directly to stocks) or simply investing in low-cost broad market index funds.

In Sum

In sum, financial forecasting cannot be done with any sort of consistency.  Every year, there are many people making financial forecasts, and so purely as a matter of chance, a few will be correct in a given year.  But the ones correct this year are almost never the ones correct the next time around, because what they’re trying to predict can’t be predicted with any consistency.  Marks writes thus:

I am not going to try to prove my contention that the future is unknowable.  You can’t prove a negative, and that certainly includes this one.  However, I have yet to meet anyone who consistently knows what lies ahead macro-wise…

One way to get to be right sometimes is to always be bullish or always be bearish; if you hold a fixed view long enough, you may be right sooner or later.  And if you’re always an outlier, you’re likely to eventually be applauded for an extremely unconventional forecast that correctly foresaw what no one else did.  But that doesn’t mean your forecasts are regularly of any value…

It’s possible to be right about the macro-future once in a while, but not on a regular basis.  It doesn’t do any good to possess a survey of sixty-four forecasts that includes a few that are accurate; you have to know which ones they are.  And if the accurate forecasts each six months are made by different economists, it’s hard to believe there’s much value in the collective forecasts.

Marks gives one more example: How many predicted the crisis of 2007-2008?  Of those who did predict it – there was bound to be some from pure chance alone – how many of those then predicted the recovery starting in 2009 and continuing until early 2020?  The answer is “very few.”  The reason, observes Marks, is that those who got 2007-2008 right “did so at least in part because of a tendency toward negative views.”  They probably were negative well before 2007-2008, and more importantly, they probably stayed negative afterwards, during which the U.S. stock market increased (from the low) more than 400% as the U.S. economy expanded from 2009 to early 2020.

 

Marks has a description for investors who believe in the value of forecasts.  They belong to the “I know” school, and it’s easy to identify them:

    • They think knowledge of the future direction of economies, interest rates, markets and widely followed mainstream stocks is essential for investment success.
    • They’re confident it can be achieved.
    • They know they can do it.
    • They’re aware that lots of other people are trying to do it too, but they figure either (a) everyone can be successful at the same time, or (b) only a few can be, but they’re among them.
    • They’re comfortable investing based on their opinions regarding the future.
    • They’re also glad to share their views with others, even though correct forecasts should be of such great value that no one would give them away gratis.
    • They rarely look back to rigorously assess their record as forecasters.

Marks contrasts the confident “I know” folks with the guarded “I don’t know” folks.  The latter believe you can’t predict the macro-future, and thus the proper goal for investing is to do the best possible job analyzing individual securities.  Marks points out that if you belong to the “I don’t know” school, eventually everyone will stop asking you where you think the market’s going.

You’ll never get to enjoy that one-in-a-thousand moment when your forecast comes true and the Wall Street Journal runs your picture.  On the other hand, you’ll be spared all those times when forecasts miss the mark, as well as the losses that can result from investing based on overrated knowledge of the future.

Marks continues by noting that no one likes investing on the assumption that the future is unknowable.  But if the future IS largely unknowable, then it’s far better as an investor to acknowledge that fact than to pretend otherwise.

Furthermore, says Marks, the biggest problems for investors tend to happen when investors forget the difference between probability and outcome (i.e., the limits of foreknowledge):

    • when they believe the shape of the probability distribution is knowable with certainty (and that they know it),
    • when they assume the most likely outcome is the one that will happen,
    • when they assume the expected result accurately represents the actual result, or
    • perhaps most important, when they ignore the possibility of improbable outcomes.

Marks sums it up:

Overestimating what you’re capable of knowing or doing can be extremely dangerous – in brain surgery, transocean racing or investing.  Acknowledging the boundaries of what you can know – and working within those limits rather than venturing beyond – can give you a great advantage.

 

HAVING A SENSE FOR WHERE WE STAND

Marks believes that market cycles – inevitable ups and downs – cannot be predicted as to extent and (especially) as to timing, but have a profound influence on us as investors.  The only thing we can predict is that market cycles are inevitable.

Marks holds that as investors, we can have a rough idea of market cycles.  We can’t predict what will happen exactly or when.  But we can at least develop valuable insight into various future events.

So look around, and ask yourself: Are investors optimistic or pessimistic?  Do the media talking heads say the markets should be piled into or avoided?  Are novel investment schemes readily accepted or dismissed out of hand?  Are securities offerings and fund openings being treated as opportunities to get rich or possible pitfalls?  Has the credit cycle rendered capital readily available or impossible to obtain?  Are price/earnings ratios high or low in the context of history, and are yield spreads tight or generous?  All of these things are important, and yet none of them entails forecasting.  We can make excellent investment decisions on the basis of present observations, with no need to make guesses about the future.

Marks likens the process of assessing the current cycle with “taking the temperature” of the market.  Again, one can never precisely time market turning points, but one can at least become aware of when markets are becoming overheated, or when they’ve become unusually cheap.

It may be more difficult today to take the market’s temperature because of the policy of near-zero (or negative) interest rates in many of the world’s major economies.  This obviously distorts all asset prices.  As Buffett remarked recently, if U.S. rates were going to stay near zero for many decades into the future, U.S. stocks would eventually be much higher than they are today.  Zero rates indefinitely would easily mean price/earnings ratios of 100 (or even 200).

Stanley Druckenmiller, one of the most successful macro investors, has consistently said that the stock market is driven in large part not by earnings, but by central bank liquidity.

In any case, timing the next major bear market is virtually impossible, as acknowledged by the majority of great investors such as Howard Marks, Warren Buffett, Charlie Munger, Seth Klarman, Bill Ackman, and others.

What Marks, Buffett, and Munger stress is to focus on finding cheap stocks.  Pay cheap enough prices so that, on average, one can make a profit over the next five years or ten years.  At some point – no one knows precisely when – the U.S. stock market is likely to drop roughly 30-50%.  One must be psychologically prepared for this.  And one’s portfolio must also be prepared for this.

If one is able to buy enough cheap stocks, while maintaining a focus on the next five years or ten years, and if one is psychologically prepared for a big drop at some point, which always happens periodically, then one will be in good position.

Note:  Cheap stocks (whether oil-related or otherwise) typically have lower correlation than usual with the broader stock market.  Even if the broader market declines, some cheap stocks may do much better on both a relative and absolute basis.

Finally, some percentage in cash may seem like a wise position to have in the event of a major (or minor) bear market.  The tricky part, again, is what percentage to have in cash and when.  Many excellent value investors have had 50% or more in cash since 2012 or 2013. Since 2012, the market has more than doubled.  So cash has been a significant drag on the performance of investors who have had large cash positions.

For these reasons, many great value investors – including Marks, Buffett, Munger, and many others – simply never try to time the market.  Many of these value investors essentially stay fully invested in the cheapest stocks they can find.  Over a very long period of time, many studies have shown that hedges, short positions, and cash lower the volatility of the portfolio, but also lower the long-term returns.  Given how many smart people have been hedging since 2012,  the eight or so years up until early 2020 have provided yet another clear example of why market timing is impossible to do with any consistency.

Henry Singleton, described by both Buffett and Munger as being the best capital allocator (among CEO’s) in U.S. history, compounded business value at Teledyne at incredible rates for decades by buying stocks (including Teledyne) when they were cheap.  Singleton’s amazing track record included the 1970’s, when the broader U.S. stock market went virtually nowhere.  Singleton was a genius (100 points away from being a chess grandmaster).  On the subject of market timing, Singleton has said:

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

 

APPRECIATING THE ROLE OF LUCK

Luck – chance or randomness – influences investment outcomes.  Marks considers Nassim Taleb’s Fooled by Randomness to be essential reading for investors.  Writes Marks:

Randomness (or luck) plays a huge part in life’s results, and outcomes that hinge on random events should be viewed as different from those that do not.

Marks quotes Taleb:

If we have heard of [history’s great generals and inventors], it is simply because they took considerable risks, along with thousands of others, and happened to win.  They were intelligent, courageous, noble (at times), had the highest possible obtainable culture in their day – but so did thousands of others who live in the musty footnotes of history.

A central concept from Taleb is that of “alternative histories.”  What actually has happened in history is merely a small subset of all the things that could have happened, at least as far as we know.  As long as there is a component of indeterminacy in human behavior (not to mention the rest of reality), one must usually assume that many “alternative histories” were possible.  From the practical point of view of investing, given a future that is currently unknowable in many respects, one must develop a reasonable set of scenarios along with estimated probabilities for each scenario.  And, when judging the quality of past decisions, one must think carefully about various possible (“alternative”) histories, of which what actually happened appears to be a small subset.

Thus, the fact that a stratagem or action worked – under the circumstances that unfolded – doesn’t necessarily prove that the decision behind it was wise.

 

Marks says he agrees with all of Taleb’s important points:

    • Investors are right (and wrong) all the time for the ‘wrong reason.’ Someone buys a stock because he or she expects a certain development; it doesn’t occur; the market takes the stock up anyway; the investor looks good (and invariably accepts credit).
    • The correctness of a decision can’t be judged from the outcome. Neverthelss, that’s how people assess it.  A good decision is one that’s optimal at the time it’s made, when the future is by definition unknown.  Thus, correct decisions are often unsuccessful, and vice versa.
    • Randomness alone can produce just about any outcome in the short run. In portfolios that are allowed to reflect them fully, market movements can easily swamp the skillfulness of the manager (or lack thereof).  But certainly market movements cannot be credited to the manager (unless he or she is the rare market timer who’s capable of getting it right repeatedly).
    • For these reasons, investors often receive credit they don’t deserve. One good coup can be enough to build a reputation, but clearly a coup can arise out of randomness alone.  Few of these “geniuses” are right more than once or twice in a row.
    • Thus, it’s essential to have a large number of observations – lots of years of data – before judging a given manager’s ability.

Over the long run, the rational investor learns, refines, and sticks with a robust investment process that reliably produces good results.  In the short run, when a good process sometimes leads to bad outcomes (often due to bad luck but sometimes due to a mistake), one must simply be stoic and patient.

Marks continues:

The actions of the ‘I know’ school are based on a view of a single future that is knowable and conquerable.  My ‘I don’t know’ school thinks of future events in terms of a probability distribution.  That’s a big difference.  In the latter case, we may have an idea which one outcome is most likely to occur, but we also know there are many other possibilities, and those other outcomes may have a collective likelihood much higher than the one we consider most likely.

Marks concludes:

    • We should spend our time trying to find value among the knowable – industries, companies and securities – rather than base our decisions on what we expect from the less-knowable macro world of economies and broad market performance.
    • Given that we don’t know exactly which future will obtain, we have to get value on our side by having a strongly held, analytically derived opinion of it and buying for less when opportunities to do so present themselves.
    • We have to practice defensive investing, since many of the outcomes are likely to go against us. It’s more important to ensure survival under negative outcomes than it is to guarantee maximum returns under favorable ones.
    • To improve our chances of success, we have to emphasize acting contrary to the herd when it’s at extremes, being aggressive when the market is low and cautious when it’s high.
    • Given the highly indeterminate nature of outcomes, we must view strategies and their results – both good and bad – with suspicion until proved over a large number of trials.

 

INVESTING DEFENSIVELY

Unlike professional tennis, where a successful outcome depends on which player hits the most winners, successful investing generally depends on minimizing mistakes more than it does on finding winners.

… investing is full of bad bounces and unanticipated developments, and the dimensions of the court and the height of the net change all the time.  The workings of economies and markets are highly imprecise and variable, and the thinking and behavior of the other players constantly alter the environment.  Even if you do everything right, other investors can ignore your favorite stock; management can squander the company’s opportunities; government can change the rules; or nature can serve up a catastrophe.

Marks argues that successful investing is a balance between offense and defense, and that this balance often differs for each individual investor.  What’s important is to stick with an investment process that works over the long term:

… Few people (if any) have the ability to switch tactics to match market conditions on a timely basis.  So investors should commit to an approach – hopefully one that will serve them through a variety of scenarios.  They can be aggressive, hoping they’ll make a lot on the winners and not give it back on the losers.  They can emphasize defense, hoping to keep up in good times and excel by losing less than others in bad times.  Or they can balance offense and defense, largely giving up on tactical timing but aiming to win through superior security selection in both up and down markets.

And by the way, there’s no right choice between offense and defense.  Lots of possible routes can bring you to success, and your decision should be a function of your personality and leanings, the extent of your belief in your ability, and the peculiarities of the markets you work in and the clients you work for.

Marks argues that defense can be viewed as aiming for higher returns, but through the avoidance of mistakes and through consistency, rather than through home runs and occasional flashes of brilliancy.

Avoiding losses first involves buying assets at cheap prices (well below intrinsic value).  Another element to avoiding losses is to ensure that one’s portfolio can survive a bear market.  If the five-year or ten-year returns appear to be high enough, an investor still may choose to play more offense than defense, even when he or she knows that a bear market is likely within five years or less.  But one must be fully prepared – psychologically and in one’s portfolio – for many already very cheap stocks to get cut in half or worse during a bear market.

Again, some investors can accept higher volatility in exchange for higher long-term returns.  One must know oneself.  One must know one’s clients.  One must really think through all the possible scenarios, because things can get much worse than one can imagine during bear markets.  And bear markets are inevitable.

There is always a trade-off between potential return and potential downside.  Choosing to aim for higher long-term returns means accepting higher downside volatility over shorter periods of time.

But it’s important to keep in mind that many investors fail not due to lack of home runs, but due to having too many strikeouts.  Overbetting is thus a common cause of failure for long-term investors.  We know from the Kelly criterion that overbetting guarantees zero or negative long-term returns.  Therefore, it’s wise for most investors to aim for consistency – a high batting average based on many singles and doubles – rather than to aim for the maximum number of home runs.

Put differently, it is easier for most investors to minimize losses than it is to hit a lot of home runs.  Thus, most investors are much more likely to achieve long-term success by minimizing losses and mistakes, than by hitting a lot of home runs.

Investing defensively can cause you to miss out on things that are hot and get hotter, and it can leave you with your bat on your shoulder in trip after trip to the plate.  You may hit fewer home runs than another investor… but you’re also likely to have fewer strikeouts and fewer inning-ending double plays.

Defensive investing sounds very erudite, but I can simplify it: Invest scared!  Worry about the possibility of loss.  Worry that there’s something you don’t know.  Worry that you can make high-quality decisions but still be hit by bad luck or surprise events.  Investing scared will prevent hubris; will keep your guard up and your mental adrenaline flowing; will make you insist on adequate margin of safety; and will increase the chances that your portfolio is prepared for things going wrong.  And if nothing does go wrong, surely the winners will take care of themselves.

 

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 approaches intrinsic value sooner or an error has been discovered.

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

 

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

My e-mail: jb@boolefund.com

 

 

 

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.

Walter Schloss: Cigar-Butt Specialist

April 30, 2023

Walter Schloss generated one of the best investment track records of all time—close to 21% (gross) annually over 47 years—by investing exclusively in cigar butts (deep value stocks).  Cigar-butt investing usually means buying stock at a discount to book value, i.e., a P/B < 1 (price-to-book ratio below 1).

The highest returning cigar butt strategy comes from Ben Graham, the father of value investing.  It’s called the net-net strategy whereby you take current assets minus all liabilities, and then invest at 2/3 of that level or less.

  • The main trouble with net nets today is that many of them are tiny microcap stocks—below $50 million in market cap—that are too small even for most microcap funds.
  • Also, many net nets exist in markets outside the United States.  Some of these markets have had problems periodically related to the rule of law.

Schloss used net nets in the early part of his career (1955 to 1960).  When net nets became too scarce (1960), Schloss started buying stocks at half of book value.  When those became too scarce, he went to buying stocks at two-thirds of book value.  Eventually he had to adjust again and buy stocks at book value.  Though his cigar-butt method evolved, Schloss was always using a low P/B to find cheap stocks.

(Photo by Sky Sirasitwattana)

One extraordinary aspect to Schloss’s track record is that he invested in roughly 1,000 stocks over the course of his career.  (At any given time, his portfolio had about 100 stocks.)  Warren Buffett commented:

Following a strategy that involved no real risk—defined as permanent loss of capital—Walter produced results over his 47 partnership years that dramatically surpassed those of the S&P 500.  It’s particularly noteworthy that he built this record by investing in about 1,000 securities, mostly of a lackluster type.  A few big winners did not account for his success.  It’s safe to say that had millions of investment managers made trades by a) drawing stock names from a hat; b) purchasing these stocks in comparable amounts when Walter made a purchase; and then c) selling when Walter sold his pick, the luckiest of them would not have come close to equaling his record. There is simply no possibility that what Walter achieved over 47 years was due to chance.

Schloss was aware that a concentrated portfolio—e.g., 10 to 20 stocks—could generate better long-term returns.  However, this requires unusual insight on a repeated basis, which Schloss humbly admitted he didn’t have.

Most investors are best off investing in low-cost index funds or in quantitative value funds.  For investors who truly enjoy looking for undervalued stocks, Schloss offered this advice:

It is important to know what you like and what you are good at and not worry that someone else can do it better.  If you are honest, hardworking, reasonably intelligent and have good common sense, you can do well in the investment field as long as you are not too greedy and don’t get too emotional when things go against you.

I found a few articles I hadn’t seen before on The Walter Schloss Archive, a great resource page created by Elevation Capital: https://www.walterschloss.com/

Here’s the outline for this blog post:

  • Stock is Part Ownership;  Keep It Simple
  • Have Patience;  Don’t Sell on Bad News
  • Have Courage
  • Buy Assets Not Earnings
  • Buy Based on Cheapness Now, Not Cheapness Later
  • Boeing:  Asset Play
  • Less Downside Means More Upside
  • Multiple Ways to Win
  • History;  Honesty;  Insider Ownership
  • You Must Be Willing to Make Mistakes
  • Don’t Try to Time the Market
  • When to Sell
  • The First 10 Years Are Probably the Worst
  • Stay Informed About Current Events
  • Control Your Emotions;  Be Careful of Leverage
  • Ride Coattails;  Diversify

 

STOCK IS PART OWNERSHIP;  KEEP IT SIMPLE

A share of stock represents part ownership of a business and is not just a piece of paper or a blip on the computer screen.

Try to establish the value of the company.  Use book value as a starting point.  There are many businesses, both public and private, for which book value is a reasonable estimate of intrinsic value.  Intrinsic value is what a company is worth—i.e., what a private buyer would pay for it.  Book value—assets minus liabilities—is also called “net worth.”

Follow Buffett’s advice: keep it simple and don’t use higher mathematics.

(Illustration by Ileezhun)

Some kinds of stocks are easier to analyze than others.  As Buffett has said, usually you don’t get paid for degree of difficulty in investing.  Therefore, stay focused on businesses that you can fully understand.

  • There are thousands of microcap companies that are completed neglected by most professional investors.  Many of these small businesses are simple and easy to understand.

 

HAVE PATIENCE;  DON’T SELL ON BAD NEWS

Hold for 3 to 5 years.  Schloss:

Have patience.  Stocks don’t go up immediately.

Schloss again:

Things usually take longer to work out but they work out better than you expect.

(Illustration by Marek)

Don’t sell on bad news unless intrinsic value has dropped materially.  When the stock drops significantly, buy more as long as the investment thesis is intact.

Schloss’s average holding period was 4 years.  It was less than 4 years in good markets when stocks went up more than usual.  It was greater than 4 years in bad markets when stocks stayed flat or went down more than usual.

 

HAVE COURAGE

Have the courage of your convictions once you have made a decision.

(Courage concept by Travelling-light)

Investors shun companies with depressed earnings and cash flows.  It’s painful to own stocks that are widely hated.  It can also be frightening.  As John Mihaljevic explains in The Manual of Ideas (Wiley, 2013):

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

A related worry is that if a company is burning through its cash, it will gradually destroy net asset value.  Ben Graham:

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

It’s true that an individual cigar butt (deep value stock) is more likely to underperform than an average stock.  But because the potential upside for a typical cigar butt is greater than the potential downside, a basket of cigar butts (portfolio of at least 30) does better than the market over time and also has less downside during bad states of the world—such as bear markets and recessions.

Schloss discussed an example: Cleveland Cliffs, an iron ore producer.  Buffett owned the stock at $18 but then sold at about that level.  The steel industry went into decline.  The largest shareholder sold out because he thought the industry wouldn’t recover.

Schloss bought a lot of stock at $6.  Nobody wanted it.  There was talk of bankruptcy.  Schloss noted that if he had lived in Cleveland, he probably wouldn’t have been able to buy the stock because all the bad news would have been too close.

Soon thereafter, the company sold some assets and bought back some stock.  After the stock increased a great deal from the lows, then it started getting attention from analysts.

In sum, often when an industry is doing terribly, that’s the best time to find cheap stocks.  Investors avoid stocks when they’re having problems, which is why they get so cheap.  Investors overreact to negative news.

 

BUY ASSETS NOT EARNINGS

(Illustration by Teguh Jati Prasetyo)

Schloss:

Try to buy assets at a discount [rather] than to buy earnings.  Earnings can change dramatically in a short time.  Usually assets change slowly.  One has to know much more about a company if one buys earnings.

Not only can earnings change dramatically; earnings can easily be manipulated—often legally.  Schloss:

Ben made the point in one of his articles that if U.S. Steel wrote down their plants to a dollar, they would show very large earnings because they would not have to depreciate them anymore.

 

BUY BASED ON CHEAPNESS NOW, NOT CHEAPNESS LATER

Buy things based on cheapness now.  Don’t buy based on cheapness relative to future earnings, which are hard to predict.

Graham developed two ways of estimating intrinsic value that don’t depend on predicting the future:

  • Net asset value
  • Current and past earnings

Professor Bruce Greenwald, in Value Investing (Wiley, 2004), has expanded on these two approaches.

  • As Greenwald explains, book value is a good estimate of intrinsic value if book value is close to the replacement cost of the assets.  The true economic value of the assets is the cost of reproducing them at current prices.
  • Another way to determine intrinsic value is to figure out earnings power—also called normalized earnings—or how much the company should earn on average over the business cycle.  Earnings power typically corresponds to a market level return on the reproduction value of the assets.  In this case, your intrinsic value estimate based on normalized earnings should equal your intrinsic value estimate based on the reproduction value of the assets.

In some cases, earnings power may exceed a market level return on the reproduction value of the assets.  This means that the ROIC (return on invested capital) exceeds the cost of capital.  It can be exceedingly difficult, however, to determine by how much and for how long earnings power will exceed a market level return.  Often it’s a question of how long some competitive advantage can be maintained.  How long can a high ROIC be sustained?

As Buffett remarked:

The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.  The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.

A moat is a sustainable competitive advantage.  Schloss readily admits he can’t determine which competitive advantages are sustainable.  That requires unusual insight.  Buffett can do it, but very few investors can.

As far as franchises or good businesses—companies worth more than adjusted book value—Schloss says he likes these companies, but rarely considers buying them unless the stock is close to book value.  As a result, Schloss usually buys mediocre and bad businesses at book value or below.  Schloss buys “difficult businesses” at clearly cheap prices.

Buying a high-growing company on the expectation that growth will continue can be quite dangerous.  First, growth only creates value if the ROIC exceeds the cost of capital.  Second, expectations for the typical growth stock are so high that even a small slowdown can cause the stock to drop noticeably.  Schloss:

If observers are expecting the earnings to grow from $1.00 to $1.50 to $2.00 and then $2.50, an earnings disappointment can knock a $40 stock down to $20.  You can lose half your money just because the earnings fell out of bed.

If you buy a debt-free stock with a $15 book selling at $10, it can go down to $8.  It’s not great, but it’s not terrible either.  On the other hand, if things turn around, that stock can sell at $25 if it develops its earnings.

Basically, we like protection on the downside.  A $10 stock with a $15 book can offer pretty good protection.  By using book value as a parameter, we can protect ourselves on the downside and not get hurt too badly.

Also, I think the person who buys earnings has got to follow it all the darn time.  They’re constantly driven by earnings, they’re driven by timing.  I’m amazed.

 

BOEING:  ASSET PLAY

(Boeing 377 Stratocruiser, San Diego Air & Space Museum Archives, via Wikimedia Commons)

Cigar butts—deep value stocks—are characterized by two things:

  • Poor past performance;
  • Low expectations for future performance, i.e., low multiples (low P/B, low P/E, etc.)

Schloss has pointed out that Graham would often compare two companies.  Here’s an example:

One was a very popular company with a book value of $10 selling at $45.  The second was exactly the reverse—it had a book value of $40 and was selling for $25.

In fact, it was exactly the same company, Boeing, in two very different periods of time.  In 1939, Boeing was selling at $45 with a book of $10 and earning very little.  But the outlook was great.  In 1947, after World War II, investors saw no future for Boeing, thinking no one was going to buy all these airplanes.

If you’d bought Boeing in 1939 at $45, you would have done rather badly.  But if you’d bought Boeing in 1947 when the outlook was bad, you would have done very well.

Because a cigar butt is defined by poor recent performance and low expectations, there can be a great deal of upside if performance improves.  For instance, if a stock is at a P/E (price-to-earnings ratio) of 5 and if earnings are 33% of normal, then if earnings return to normal and if the P/E moves to 15, you’ll make 900% on your investment.  If the initial purchase is below true book value—based on the replacement cost of the assets—then you have downside protection in case earnings don’t recover.

 

LESS DOWNSIDE MEANS MORE UPSIDE

If you buy stocks that are protected on the downside, the upside takes care of itself.

The main way to get protection on the downside is by paying a low price relative to book value.  If in addition to quantitative cheapness you focus on companies with low debt, that adds additional downside protection.

If the stock is well below probable intrinsic value, then you should buy more on the way down.  The lower the price relative to intrinsic value, the less downside and the more upside.  As risk decreases, potential return increases.  This is the opposite of what modern finance theory teaches.  According to theory, your expected return only increases if your risk also increases.

In The Superinvestors of Graham-and-Doddsville, Warren Buffett discusses the relationship between risk and reward.  Sometimes risk and reward are positively correlated.  Buffett gives the example of Russian roulette.  Suppose a gun contains one cartridge and someone offers to pay you $1 million if you pull the trigger once and survive.  Say you decline the bet as too risky, but then the person offers to pay you $5 million if you pull the trigger twice and survive.  Clearly that would be a positive correlation between risk and reward.  Buffett continues:

The exact opposite is true with value investing.  If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case.  The greater the potential for reward in the value portfolio, the less risk there is.

One quick example:  The Washington Post Company in 1973 was selling for $80 million in the market.  At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more.  The company owned the Post, Newsweek, plus several television stations in major markets.  Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy.

Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater.  And to people that think beta measures risk, the cheaper price would have made it look riskier.  This is truly Alice in Wonderland.  I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million than $80 million.

Link: https://bit.ly/2jBezdv

Most brokers don’t recommend buying more on the way down because most people (including brokers’ clients) don’t like to buy when the price keeps falling.  In other words, most investors focus on price instead of intrinsic value.

 

MULTIPLE WAYS TO WIN

A stock trading at a low price relative to book value—a low P/B stock—is usually distressed and is experiencing problems.  But there are several ways for a cigar-butt investor to win, as Schloss explains:

The thing about buying depressed stocks is that you really have three strings to your bow:  1) Earnings will improve and the stocks will go up;  2) somebody will come in and buy control of the company;  or 3) the company will start buying its own stock and ask for tenders.

Schloss again:

But lots of times when you buy a cheap stock for one reason, that reason doesn’t pan out but another reason does—because it’s cheap.

 

HISTORY;  HONESTY;  INSIDER OWNERSHIP

Look at the history of the company.  Value line is helpful for looking at history 10-15 years back.  Also, read the annual reports.  Learn about the ownership, what the company has done, when business they’re in, and what’s happened with dividends, sales, earnings, etc.

It’s usually better not to talk with management because it’s easy to be blinded by their charisma or sales skill:

When we buy into a company that has problems, we find it difficult talking to management as they tend to be optimistic.

That said, try to ensure that management is honest.  Honesty is more important than brilliance, says Schloss:

…we try to get in with people we feel are honest.  That doesn’t mean they’re necessarily smart—they may be dumb.

But in a choice between a smart guy with a bad reputation or a dumb guy, I think I’d go with the dumb guy who’s honest.

Finally, insider ownership is important.  Management should own a fair amount of stock, which helps to align their incentives with the interests of the stockholders.

Speaking of insider ownership, Walter and Edwin Schloss had a good chunk of their own money invested in the fund they managed.  You should prefer investment managers who, like the Schlosses, eat their own cooking.

 

YOU MUST BE WILLING TO MAKE MISTAKES

(Illustration by Lkeskinen0)

You have to be willing to make mistakes if you want to succeed as an investor.  Even the best value investors tend to be right about 60% of the time and wrong 40% of the time.  That’s the nature of the game.

You can’t do well unless you accept that you’ll make plenty of mistakes.  The key, again, is to try to limit your downside by buying well below probable intrinsic value.  The lower the price you pay (relative to estimated intrinsic value), the less you can lose when you’re wrong and the more you can make when you’re right.

 

DON’T TRY TO TIME THE MARKET

No one can predict the stock market.  Ben Graham observed:

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

(Illustration by Maxim Popov)

Or as value investor Seth Klarman has put it:

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

Perhaps the best quote comes from Henry Singleton, a business genius (100 points from being a chess grandmaster) who was easily one of the best capital allocators in American business history:

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

Singleton built Teledyne using extraordinary capital allocation skills over the course of more than three decades, from 1960 to the early 1990’s.  Fourteen of these years—1968 to 1982—were a secular bear market during which stocks were relatively flat and also experienced a few large downward moves (especially 1973-1974).  But this long flat period punctuated by bear markets didn’t slow down or change Singleton’s approach.  Because he consistently bought very good value, on the whole his acquisitions grew significantly in worth over time regardless of whether the broader market was down, flat, or up.

Of course, it’s true that if you buy an undervalued stock and then there’s a bear market, it may take longer for your investment to work.  However, bear markets create many bargains.  As long as you maintain a focus on the next 3 to 5 years, bear markets are wonderful times to buy cheap stocks (including more of what you already own).

In 1955, Buffett was advised by his two heroes, his father and Ben Graham, not to start a career in investing because the market was too high.  Similarly, Graham told Schloss in 1955 that it wasn’t a good time to start.

Both Buffett and Schloss ignored the advice.  In hindsight, both Buffett and Schloss made great decisions.  Of course, Singleton would have made the same decision as Buffett and Schloss.  Even if the market is high, there are invariably individual stocks hidden somewhere that are cheap.

Schloss always remained fully invested because he knew that virtually no one can time the market except by luck.

 

WHEN TO SELL

Don’t be in too much of a hurry to sell… Before selling try to reevaluate the company again and see where the stock sells in relation to its book value.

Selling is hard.  Schloss readily admits that many stocks he sold later increased a great deal.  But he doesn’t dwell on that.

The basic criterion for selling is whether the stock price is close to estimated intrinsic value.  For a cigar butt investor like Schloss, if he paid a price that was half book, then if the stock price approaches book value, it’s probably time to start selling.  (Unless it’s a rare stock that is clearly worth more than book value, assuming the investor was able to buy it low in the first place.)

If stock A is cheaper than stock B, some value investors will sell A and buy B.  Schloss doesn’t do that.  It often takes four years for one of Schloss’s investments to work.  If he already has been waiting for 1-3 years with stock A, he is not inclined to switch out of it because he might have to wait another 1-3 years before stock B starts to move.  Also, it’s very difficult to compare the relative cheapness of stocks in different industries.

Instead, Schloss makes an independent buy or sell decision for every stock.  If B is cheap, Schloss simply buys B without selling anything else.  If A is no longer cheap, Schloss sells A without buying anything else.

 

THE FIRST 10 YEARS ARE PROBABLY THE WORST

John Templeton’s worst ten years as an investor were his first ten years.  The same was true for Schloss, who commented that it takes about ten years to get the hang of value investing.

 

STAY INFORMED ABOUT CURRENT EVENTS

(Photo by Juan Moyano)

Walter Schloss and his son Edwin sometimes would spend a whole day discussing current events, social trends, etc.  Edwin Schloss said:

If you’re not in touch with what’s going on or you don’t see what’s going on around you, you can miss out on a lot of investment opportunities. So we try to be aware of everything around us—like John Templeton says in his book about being open to new ideas and new experiences.

 

CONTROL YOUR EMOTIONS;  BE CAREFUL OF LEVERAGE

Try not to let your emotions affect your judgment.  Fear and greed are probably the worst emotions to have in connection with the purchase and sale of stocks.

Quantitative investing is a good way to control emotion.  This is what Graham suggested and practiced.  Graham just looked at the numbers to make sure they were below some threshold—like 2/3 of current assets minus all liabilities (the net-net method).  Graham typically was not interested in what the business did.

On the topic of discipline and controlling your emotions, Schloss told a great story about when Warren Buffett was playing golf with some buddies:

One of them proposed, “Warren, if you shoot a hole-in-one on this 18-hole course, we’ll give you $10,000 bucks.  If you don’t shoot a hole-in-one, you owe us $10.”

Warren thought about it and said, “I’m not taking the bet.”

The others said, “Why don’t you?  The most you can lose is $10. You can make $10,000.”

Warren replied, If you’re not disciplined in the little things, you won’t be disciplined in the big things.”

Be careful of leverage.  It can go against you.  Schloss acknowledges that sometimes he has gotten too greedy by buying highly leveraged stocks because they seemed really cheap.  Companies with high leverage can occasionally become especially cheap compared to book value.  But often the risk of bankruptcy is too high.

Still, as conservative value investor Seth Klarman has remarked, there’s room in the portfolio occasionally for a super cheap, highly indebted company.  If the probability of success is high enough and if the upside is great enough, it may not be a difficult decision.  Often the upside can be 10x or 20x your investment, which implies a positive expected return even when the odds of success are 10%.

 

RIDE COATTAILS;  DIVERSIFY

Sometimes you can get good ideas from other investors you know or respect.  Even Buffett did this.  Buffett called it “coattail riding.”

Schloss, like Graham and Buffett, recommends a diversified approach if you’re doing cigar butt (deep value) investing.  Have at least 15-20 stocks in your portfolio.  A few investors can do better by being more concentrated.  But most investors will do better over time by using a quantitative, diversified approach.

Schloss tended to have about 100 stocks in his portfolio:

…And my argument was, and I made it to Warren, we can’t project the earnings of these companies, they’re secondary companies, but somewhere along the line some of them will work out.  Now I can’t tell you which ones, so I buy a hundred of them.  Of course, it doesn’t mean you own the same amount of each stock.  If we like a stock we put more money in it.  Positions we are less sure about we put less in… We then buy the stock on the way down and try to sell it on the way up.

Even though Schloss was quite diversified, he still took larger positions in the stocks he liked best and smaller positions in the stocks about which he was less sure.

Schloss emphasized that it’s important to know what you know and what you don’t know.  Warren Buffett and Charlie Munger call this a circle of competence.  Even if a value investor is far from being the smartest, there are hundreds of microcap companies that are easy to understand with enough work.

(Image by Wilma64)

The main trouble in investing is overconfidence: having more confidence than is warranted by the evidence.  Overconfidence is arguably the most widespread cognitive bias suffered by humans, as Nobel Laureate Daniel Kahneman details in Thinking, Fast and Slow.  By humbly defining your circle of competence, you can limit the impact of overconfidence.  Part of this humility comes from making mistakes.

The best choice for most investors is either an index fund or a quantitative value fund.  It’s the best bet for getting solid long-term returns, while minimizing or removing entirely the negative influence of overconfidence.

 

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 approaches intrinsic 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: jb@boolefund.com

 

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

The Education of a Value Investor

April 23, 2023

I have now read The Education of a Value Investor, by Guy Spier, several times.  It’s a very honest and insightful description of Guy Spier’s evolution from arrogant and envious youth to kind, ethical, humble, and successful value investor in the mold of his heroes—including the value investors Mohnish Pabrai, Warren Buffett, and Charlie Munger.

Spier recounts how, after graduating near the top of his class at Oxford and then getting an MBA at Harvard, he decided to take a job at D. H. Blair, an ethically challenged place.  Spier realized that part of his job was to dress up bad deals.  Being unable to admit that he had made a mistake, Spier ended up tarnishing his reputation badly by playing along instead of quitting.

Spier’s story is about the journey “from that dark place toward the Nirvana where I now live.”

Besides the lesson that one should never do anything unethical, Spier also learned just how important the environment is:

We like to think that we change our environment, but the truth is that it changes us.  So we have to be extraordinarily careful to choose the right environment….

 

THE PERILS OF AN ELITE EDUCATION

Spier observes that having an education from a top university often does not prevent one from making foolish and immoral decisions, especially when money or power is involved:

Our top universities mold all these brilliant minds.  But these people—including me—still make foolish and often immoral choices.  This also goes for my countless peers who, despite their elite training, failed to walk away from nefarious situations in other investment banks, brokerages, credit-rating agencies, bond insurance companies, and mortgage lenders.

Having stumbled quite badly, Spier felt sufficiently humbled and humiliated that he was willing to reexamine everything he believed.  Thus, in the wake of the worst set of decisions of his life, Spier learned important lessons about Wall Street and about himself that he never could have learned at Oxford or Harvard.

For one thing, Spier learned that quite a few people are willing to distort the truth in order to further their “own narrow self-interest.”  But having discovered Warren Buffett, who is both highly ethical and arguably the best investor ever, Spier began to see that there is another way to succeed.  “This discovery changed my life.”

 

WHAT WOULD WARREN BUFFETT DO?  WHAT WOULD CHARLIE MUNGER DO?  WHAT WOULD MARCUS AURELIUS DO?

Spier argues that choosing the right heroes to emulate is very powerful:

There is a wisdom here that goes far beyond the narrow world of investing.  What I’m about to tell you may be the single most important secret I’ve discovered in all my decades of studying and stumbling.  If you truly apply this lesson, I’m certain that you will have a much better life, even if you ignore everything else I write…

Having found the right heroes, one can become more like them gradually if one not only studies them relentlessly, but also tries to model their behavior.  For example, it is effective to ask oneself:  “What would Warren Buffett do if he were in my shoes right now?  What would Charlie Munger do?  What would Marcus Aurelius do?”

This is a surprisingly powerful principle: modeling the right heroes.  It can work just as well with eminent dead people, as Munger has pointed out.  One can relentlessly study and then model Socrates or Jesus, Epictetus or Seneca, Washington or Lincoln.  With enough studying and enough effort to copy / model, one’s behavior will gradually improve to be more like that of one’s chosen heroes.

 

ENVIRONMENT TRUMPS INTELLECT

Our minds are not strong enough on their own to overcome the environment:

… I felt that my mind was in Omaha, and I believed that I could use the force of my intellect to rise above my environment.  But I was wrong: as I gradually discovered, our environment is much stronger than our intellect.  Remarkably few investors—either amateur or professional—truly understand this critical point.  Great investors like Warren Buffett (who left New York and returned to Omaha) and Sir John Templeton (who settled in the Bahamas) clearly grasped this idea, which took me much longer to learn.

For long-term value investors, the farther away from Wall Street one is, the easier it is to master the skills of patience, rationality, and independent thinking.

 

CAUSES OF MISJUDGMENT

Charlie Munger gave a talk in 1995 at Harvard on 24 causes of misjudgment.  At the time, as Spier writes, this worldly wisdom—combining powerful psychology with economics and business—was not available anywhere else.  Munger’s talk provides deep insight into human behavior.  Link to speech: http://www.rbcpa.com/mungerspeech_june_95.pdf

Decades of experiments by Daniel Kahneman, Amos Tversky, and others have shown that humans have two mental systems: an intuitive system that operates automatically (and subconsciously) and a reasoning system that requires conscious effort.  Through years of focused training involving timely feedback, some people can train themselves to regularly overcome their subconscious and automatic biases through the correct use of logic, math, or statistics.

But the biases never disappear.  Even Kahneman admits that, despite his deep knowledge of biases, he is still automatically “wildly overconfident” unless he makes the conscious effort to slow down and to use his reasoning system.

 

LUNCH WITH WARREN

Guy Spier and Mohnish Pabrai had the winning bid for lunch with Warren Buffett—the proceeds go to GLIDE, a charity.

One thing Spier learned—directly and indirectly—from lunch with Warren is that the more one genuinely tries to help others, the happier life becomes.  Writes Spier:

As I hope you can see from my experience, when your consciousness or mental attitude shifts, remarkable things begin to happen.  That shift is the ultimate business tool and life tool.

At the lunch, Warren repeated a crucial lesson:

It’s very important always to live your life by an inner scorecard, not an outer scorecard.

In other words, it is essential to live in accord with what one knows at one’s core to be right, and never be swayed by external forces such as peer pressure.  Buffett pointed out that too often people justify misguided or wrong actions by reassuring themselves that ‘everyone else is doing it.’

Moreover, Buffett said:

People will always stop you from doing the right thing if it’s unconventional.

Spier asked Buffett if it gets easier to do the right thing.  After pausing for a moment, Buffett said: ‘A little.’

Buffett also stressed the virtue of patience when it comes to investing:

If you’re even a slightly above average investor who spends less than you earn, over a lifetime you cannot help but get very wealthy—if you’re patient.

Spier realized that he could learn to copy many of the successful behaviors of Warren Buffett, but that he could never be Warren Buffett.  Spier observes that what he learned from Warren was to become the best and most authentic version of Guy Spier.

 

HANDLING ADVERSITY

One effective way Spier learned to deal with adversity was by:

…studying heroes of mine who had successfully handled adversity, then imagining that they were by my side so that I could model their attitudes and behavior.  One historical figure I used in this way was the Roman emperor and Stoic philosopher Marcus Aurelius.  At night, I read excerpts from his Meditations.  He wrote of the need to welcome adversity with gratitude as an opportunity to prove one’s courage, fortitude, and resilience.  I found this particularly helpful at a time when I couldn’t allow myself to become fearful.

Moreover, Spier writes about heroes who have overcome serious mistakes:

I also tried to imagine how Sir Ernest Shackleton would have felt in my shoes.  He had made grievous mistakes on his great expedition to Antarctica—for example, failing to land his ship, Endurance, when he could and then abandoning his first camp too soon.  Yet he succeeded in putting these errors behind him, and he ultimately saved the lives of everyone on his team.  This helped me to realize that my own mistakes were an acceptable part of the process.  Indeed, how could I possibly pilot the wealth of my friends and family without making mistakes or encountering the occasional storm?  Like Shackleton, I needed to see that all was not lost and to retain my belief that I would make it through to the other side.

 

CREATING THE IDEAL ENVIRONMENT

Overcoming our cognitive biases and irrational tendencies is not a matter of simply deciding to use one’s rational system.  Rather, it requires many years of training along with specific tools or procedures that help reduce the number of mistakes:

Through painful experience… I discovered that it’s critical to banish the false assumption that I am truly capable of rational thought.  Instead, I’ve found that one of my only advantages as an investor is the humble realization of just how flawed my brain really is.  Once I accepted this, I could design an array of practical work-arounds based on my awareness of the minefield within my mind. 

No human being is perfectly rational.  Every human being has at one time or another made an irrational decision.  We all have mental shortcomings:

…The truth is, all of us have mental shortcomings, though yours may be dramatically different from mine.  With this in mind, I began to realize just how critical it is for investors to structure their environment to counter their mental weaknesses, idiosyncrasies, and irrational tendencies.

Spier describes how hard he worked to create an ideal environment with the absolute minimum of factors that could negatively impact his ability to think rationally:

Following my move to Zurich, I focused tremendous energy on this task of creating the ideal environment in which to invest—one in which I’d be able to act slightly more rationally.  The goal isn’t to be smarter.  It’s to construct an environment in which my brain isn’t subjected to quite such an extreme barrage of distractions and disturbing forces that can exacerbate my irrationality.  For me, this has been a life-changing idea.  I hope that I can do it justice here because it’s radically improved my approach to investing, while also bringing me a happier and calmer life.

As we shall see in a later chapter, I would also overhaul my basic habits and investment procedures to work around my irrationality.  My brain would still be hopelessly imperfect. But these changes would subtly tilt the playing field to my advantage.  To my mind, this is infinitely more helpful than focusing on things like analysts’ quarterly earnings reports, Tobin’s Q ratio, or pundits’ useless market predictions—the sort of noise that preoccupies most investors.

 

LEARNING TO TAP DANCE

Spier, like Pabrai, believes that mastering the game of bridge improves one’s ability to think probabilistically:

Indeed, as a preparation for investing, bridge is truly the ultimate game.  If I were putting together a curriculum on value investing, bridge would undoubtedly be a part of it…

For investors, the beauty of bridge lies in the fact that it involves elements of chance, probabilistic thinking, and asymmetric information.  When the cards are dealt, the only ones you can look at are your own.  But as the cards are played, the probabilistic and asymmetric nature of the game becomes exquisite…

With my bridge hat on, I’m always searching for the underlying truth, based on insufficient information.  The game has helped me to recognize that it’s simply not possible to have a complete understanding of anything.  We’re never truly going to get to the bottom of what’s going on inside a company, so we have to make probabilistic inferences.

Chess is another game that can improve one’s cognition in other areas.  Spier cites the lesson given by chess champion Edward Lasker:

When you see a good move, look for a better one.  

The lesson for investing:

When you see a good investment, look for a better investment.

Spier also learned, both from having fun at games such as bridge and chess, and from watching business people including Steve Jobs and Warren Buffett, that having a more playful attitude might help.  More importantly, whether via meditation or via other hobbies, if one could cultivate inner peace, that could make one a better investor.

The great investor Ray Dalio has often mentioned transcendental meditation as leading to a peaceful state of mind where rationality can be maximized and emotions minimized.  See: https://www.youtube.com/watch?v=zM-2hGA-k5E

Spier explains:

To give you an analogy, when you drop a stone in a calm pond, you see the ripples.  Likewise, in investing, if I want to see the big ideas, I need a peaceful and contented mind.

 

INVESTING TOOLS

Having written about various ways that he has made his environment as peaceful as possible—he also has a library full of great books (1/3 of which are unread), with no internet or phone—Spier next turns to ‘rules and routines that we can apply consistently.’

In the aftermath of the financial crisis, I worked hard to establish for myself this more structured approach to investing, thereby bringing more order and predictability to my behavior while also reducing the complexity of my decision-making process.  Simplifying everything makes sense, given the brain’s limited processing power…

Some of these rules are broadly applicable; others are more idiosyncratic and may work better for me than for you.  What’s more, this remains a work in progress—a game plan that I keep revising as I learn from experience what works best.  Still, I’m convinced that it will help you enormously if you start thinking about your own investment processes in this structured, systematic way.  Pilots internalize an explicit set of rules and procedures that guide their every action and ensure the safety of themselves and their passengers.  Investors who are serious about achieving good returns without undue risk should follow their example.

Here are Spier’s rules:

Rule #1—Stop Checking the Stock Price

A constantly moving stock price influences the brain—largely on a subconscious level—to want to take action.  But for the long-term value investor, the best thing is almost always to do nothing at all.  Thus, it is better only to check prices once per week, or even once per quarter or once per year:

Checking the stock price too frequently uses up my limited willpower since it requires me to expend unnecessary mental energy simply resisting these calls to action.  Given that my mental energy is a scarce resource, I want to direct it in more constructive ways.

We also know from behavioral finance research by Daniel Kahneman and Amos Tversky that investors feel the pain of loss twice as acutely as the pleasure from gain.  So I need to protect my brain from the emotional storm that occurs when I see that my stocks—or the market—are down.  If there’s average volatility, the market is typically up in most years over a 20-year period.  But if I check it frequently, there’s a much higher probability that it will be down at that particular moment…. Why, then, put myself in a position where I may have a negative emotional reaction to this short-term drop, which sends all the wrong signals to my brain?

… After all, Buffett didn’t make billions off companies like American Express and Coca-Cola by focusing on the meaningless movements of the stock ticker.

 

Rule #2—If Someone Tries to Sell You Something, Don’t Buy It

The brain will often make terrible decisions in response to detailed pitches from gifted salespeople.

Rule #3—Don’t Talk to Management

Beware of CEO’s and other top management, no matter how charismatic, persuasive, and amiable they seem.  Most managers have natural biases towards their own companies.

Rule #4—Gather Investment Research in the Right Order

We know from Munger’s speech on the causes of human misjudgment that the first idea to enter the brain tends to be the one that sticks.

Spier starts with corporate filings—‘meat and vegetables’—before consuming news and other types of information.

Rule #5—Discuss Your Investment Ideas Only with People Who Have No Axe to Grind

The idea is to try to find knowledgeable people who can communicate in an objective and logical way, minimizing the influence of various biases.

Rule #6—Never Buy or Sell Stocks When the Market is Open

This again relates to the fact that flashing stock prices push the brain subconsciously towards action:

When it comes to buying and selling stocks, I need to detach myself from the price action of the market, which can stir up my emotions, stimulate my desire to act, and cloud my judgment.  So I have a rule, inspired by Mohnish, that I don’t trade stocks while the market is open.  Instead, I prefer to wait until trading hours have ended.

Rule #7—If a Stock Tumbles after You Buy It, Don’t Sell It for Two Years

When you’ve lost a lot of money, many negative emotions occur.

Mohnish developed a rule to deal with the psychological forces aroused in these situations: if he buys a stock and it goes down, he won’t allow himself to sell it for two years.

…Once again, it acts as a circuit breaker, a way to slow me down and improve my odds of making rational decisions.  Even more important, it forces me to be more careful before buying a stock since I know that I’ll have to live with my mistake for at least two years.  That knowledge helps me to avoid a lot of bad investments.  In fact, before buying a stock, I consciously assume that the price will immediately fall by 50 percent, and I ask myself if I’ll be able to live through it.  I then buy only the amount that I could handle emotionally if this were to happen.

Mohnish’s rule is a variation on an important idea that Buffett has often shared with students:

I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it, so that you had 20 punches—representing investments that you got to make in a lifetime.  And once you’d punched through the card, you couldn’t make any more investments at all.  Under those rules, you’d really think carefully about what you did, and you’d be forced to load up on what you’d really thought about.  So you’d do much better.

Rule #8—Don’t Talk about Your Current Investments

Once we’ve made a public statement, it’s psychologically difficult to back away from what we’ve said.  The automatic intuitive system in our brains tries to quickly remove doubt by jumping to conclusions.  This system also tries to eliminate any apparent inconsistencies in order to maintain a coherent—albeit highly simplified—story about the world.

But it’s not just our intuitive system that focuses on confirming evidence.  Even our logical system—the system that can do math and statistics—uses a positive test strategy:  When testing a given hypothesis, our logical system looks for confirming evidence rather than disconfirming evidence.  This is the opposite of what works best in science.

Thus, once we express a view, our brain tends to see all the reasons why the view must be correct and our brain tends to be blind to reasons why the view might be wrong.

 

AN INVESTOR’S CHECKLIST

Atul Gawande, a former Rhodes scholar, is a surgeon at Brigham and Women’s Hospital in Boston, a professor of surgery at Harvard Medical School, and a renowned author.  He’s ‘a remarkable blend of practitioner and thinker, and also an exceptionally nice guy.’  In December 2007, Gawande published a story in The New Yorker entitled “The Checklist”:  http://www.newyorker.com/magazine/2007/12/10/the-checklist

One of Gawande’s main points is that ‘intensive-care medicine has grown so far beyond ordinary complexity that avoiding daily mistakes is proving impossible even for our super-specialists.’

Gawande then described the work of Peter Pronovost, a critical-care specialist at Johns Hopkins Hospital.  Pronovost designed a checklist after a particular patient nearly died:

Pronovost took a single sheet of paper and listed all of the steps required to avoid the infection that had almost killed the man.  These steps were all ‘no-brainers,’ yet it turned out that doctors skipped at least one step with over a third of their patients.  When the hospital began to use checklists, numerous deaths were prevented.  This was partly because checklists helped with memory recall, ‘especially with mundane matters that are easily overlooked,’ and partly because they made explicit the importance of certain precautions.  Other hospitals followed suit, adopting checklists as a pragmatic way of coping with complexity.

Mohnish Pabrai and Guy Spier, following Charlie Munger, realized that they could develop a useful checklist for value investing.  The checklist makes sense as a way to overcome the subconscious biases of the human intuitive system.  Moreover, humans have what Spier calls “cocaine brain”:

the intoxicating prospect of making money can arouse the same reward circuits in the brain that are stimulated by drugs, making the rational mind ignore supposedly extraneous details that are actually very relevant.  Needless to say, this mental state is not the best condition in which to conduct a cool and dispassionate analysis of investment risk.

An effective investor’s checklist is based on a careful analysis of past mistakes, both by oneself and by others.

My own checklist, which borrows shamelessly from [Mohnish Pabrai’s], includes about 70 items, but it continues to evolve.  Before pulling the trigger on any investment, I pull out the checklist from my computer or the filing cabinet near my desk to see what I might be missing.  Sometimes, this takes me as little as 15 minutes, but it’s led me to abandon literally dozens of investments that I might otherwise have made…

As I’ve discovered from having ADD, the mind has a way of skipping over certain pieces of information—including rudimentary stuff like where I’ve left my keys.  This also happens during the investment process.  The checklist is invaluable because it redirects and challenges the investor’s wandering attention in a systematic manner…

That said, it’s important to recognize that my checklist should not be your checklist.  This isn’t something you can outsource since your checklist has to reflect your own unique experience, knowledge, and previous mistakes.  It’s critical to go through the arduous process of analyzing where things have gone wrong for you in the past so you can see if there are any recurring patterns or particular areas of vulnerability.

It is very important to note that there are at least four categories of investment mistakes, all of which must be identified, studied, and learned from:

  • A mistake where the investment does poorly because the intrinsic value of the business in question turns out to be lower than one thought;
  • A mistake of omission, where one fails to invest in a stock that one knows is cheap;
  • A mistake of selling the stock too soon.  Often a value investment will fail to move for years.  When it finally does move, many value investors will sell far too soon, sometimes missing out on an additional 300-500% return (or even more).  Value investors Peter Cundill and Robert Robotti have discussed this mistake.
  • A mistake where the investment does well, but one realizes that the good outcome was due to luck and that one’s analysis was incorrect.  It is often difficult to identify this type of mistake because the outcome of the investment is good, but it’s crucial to do so, otherwise one’s future results will be penalized.

Here is the value investor Chris Davis talking about how he and his colleagues frame their mistakes on the wall in order never to forget the lessons:  http://davisfunds.com/document/video/mistake_wall

Davis points out that, as an investor, one should always be improving with age.  As Buffett and Munger say, lifelong learning is a key to success, especially in investing, where all knowledge is cumulative.   Frequently one’s current decisions are better and more profitable as a result of having learned the right lessons from past mistakes.

 

DOING BUSINESS THE BUFFETT-PABRAI WAY

Buffett:

Hang out with people better than you, and you cannot help but improve.

Pabrai likes to quote Ronald Reagan:

There’s no limit to what you can do if you don’t mind who gets the credit.

Buffett also talks about the central importance of treating others as one wishes to be treated:

The more love you give, the more love you get.

Spier says that this may be the most important lesson of all.  The key is to value each person as an end rather than a means.  It helps to remember that one is a work in progress and also that one is mortal.  Pabrai:

I am but ashes and dust.

Spier explains that he tries to do things for people he meets.  Over time, he has learned to distinguish givers from takers.

The crazy thing is that, when you start to live this way, everything becomes so much more joyful.  There is a sense of flow and alignment with the universe that I never felt when everything was about what I could take for myself…

I’m not telling you this to be self-congratulatory as there are countless people who do so much more good than I do.  The point is simply that life has improved immeasurably since I began to live this way.  In truth, I’ve become increasingly addicted to the positive emotions awakened in me by these activities… One thing is for sure: I receive way more by giving than I ever did by taking.  So, paradoxically, my attempts at selflessness may actually be pretty selfish.

 

THE QUEST FOR TRUE VALUE

Buffett calls it the inner scorecard and Spier calls it the inner journey:

The inner journey is that path to becoming the best version of ourselves that we can be, and this strikes me as the only true path in life.  It involves asking questions such as:  What is my wealth for?  What give my life meaning?  And how can I use my gifts to help others?

Templeton also devoted much of his life to the inner journey.  Indeed, his greatest legacy is his charitable foundation, which explores ‘the Big Questions of human purpose and ultimate reality,’ including complexity, evolution, infinity, creativity, forgiveness, love, gratitude, and free will.  The foundation’s motto is ‘How little we know, how eager to learn.’

In my experience, the inner journey is not only more fulfilling but is also a key to becoming a better investor.  If I don’t understand my inner landscape—including my fears, insecurities, desires, biases, and attitude to money—I’m likely to be mugged by reality.  This happened early in my career, when my greed and arrogance led me to D. H. Blair…. [also later in New York with envy]

By embarking on the inner journey, I became more self-aware and began to see these flaws more clearly.  I could work to overcome them only once I acknowledged them.  But these traits were so deepseated that I also had to find practical ways to navigate around them.

The important thing is to understand not only human biases in general, but also one’s own unique brain.  Also, some lessons can only be learned through difficult experiences—including mistakes:

Adversity may, in fact, be the best teacher of all.  The only trouble is that it takes a long time to live through our mistakes and then learn from them, and it’s a painful process.

It doesn’t matter exactly how you do the inner journey, just that you do it.

[The] real reward of this inner transformation is not just enduring investment success.  It’s the gift of becoming the best person we can be.  That, surely, is the ultimate prize. 

 

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 approaches intrinsic 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: jb@boolefund.com

 

 

 

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.