Boole Microcap Fund

September 15, 2024

ADF designs and engineers complex steel structures including airports, stadiums, office towers, manufacturing plants, warehouse facilities, and transportation infrastructure.  Some of their sample projects include:

• • Miami International Airport
  • Lester B. Pearson International Airport (Toronto)
  • Logan Airport Pedestrian Bridges
  • One World Trade Center
  • Goldman Sachs HQ
  • M&T Bank Stadium (home of the Baltimore Ravens)
  • Ford Field (home of Detroit Lions)
  • Daimler-Chrysler Automotive Plant
  • Paccar (Kenworth Trucks) Assembly Plant Expansion
  • steel bridges and overpasses in Jamaica

Complex construction projects have higher pricing.  And there’s less competition for building them because few fabricators are equipped to do this work for these reasons:

• • A more specialized labor force is needed.
  • Strange angles mean more complex welding.
  • Larger components require a larger fabrication base and more lifting capacity.
  • Other special equipment is often needed.

ADF has two facilities – a 635k sqft plant in Quebec, and a 100k sqft plant in Montana.  Roughly 90-95% of revenues have come from the United States and only 5-10% from Canada.

Important Note: Although infrastructure spending can be cyclical, management believes that it has 3-5 years of revenue growth ahead of itself based on infrastructure spending needs across North America.

Here are the metrics of cheapness:

• • EV/EBITDA = 5.30
  • P/E = 8.6
  • P/B = 2.20
  • P/CF = 5.56
  • P/S = 1.10

The market cap is $288.83 million while enterprise value is $267.61. Cash is $56.3 million while debt is $34.9 million.

The Piostroski F_Score is 8, which is very good.

Insider ownership is 46%, which is outstanding. ROE is 30.67%, which is excellent.

Intrinsic value scenarios:

• • Low case: If there’s a bear market or a recession, the stock could decline 50%. This would be a buying opportunity.
  • Mid case: The current P/E is 8.6, but it should be at least 16.  That means fair value for the stock is at least $16.43, which is over 85% higher than today’s $8.83.
  • High case: Assuming a 10x EV/EBITDA for fiscal year 2025, the stock would be worth $22.69, which is over 155% higher than today’s $8.83.

 

RISKS

• • A Republican victory in the U.S. presidential election would be a negative for infrastructure spending.  However, ADF has not yet seen the benefit of the 2021 Infrastructure Bill, meaning that ADF’s revenue growth is not reliant on new government spending over the next few years.
  • A U.S. recession is quite possible, but ADF sees 3-5 years of revenue growth ahead.

h/t devo791 of Value Investors Club, who wrote up ADF Group here: https://valueinvestorsclub.com/idea/ADF_GROUP_INC/9574466948

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: https://boolefund.com/best-performers-microcap-stocks/

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

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

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

 

 

 

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

June 30, 2024

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

Here is an outline for this blog post:

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

 

PETER CUNDILL

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

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

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

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

We do liquidation analysis and liquidation analysis only.

 

GETTING TO FIRST BASE

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

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

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

 

LAUNCHING A VALUE FUND

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

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

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

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

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

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

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

 

VALUE INVESTMENT IN ACTION

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

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

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

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

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

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

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

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

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

 

GOING GLOBAL

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

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

 

A DECADE OF SUCCESS

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

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

 

INVESTMENTS AND STRATAGEMS

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

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

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

 

LEARNING FROM MISTAKES

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

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

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

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

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

 

ENTERING THE BIG LEAGUE

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

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

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

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

 

THERE’S ALWAYS SOMETHING LEFT TO LEARN

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

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

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

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

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

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

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

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

 

PAN OCEAN

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

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

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

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

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

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

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

 

FRAGILE X

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

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

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

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

 

WHAT MAKES A GREAT INVESTOR?

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

INSATIABLE CURIOSITY

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

PATIENCE

Patience, patience, and more patience…

CONCENTRATION

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

ATTENTION TO DETAIL

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

CALCULATED RISK

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

INDEPENDENCE OF MIND

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

HUMILITY

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

ROUTINES

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

SCEPTICISM

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

PERSONAL RESPONSIBILITY

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

 

GLOSSARY OF TERMS WITH CUNDILL’S COMMENTS

Here are some of the terms.

ANALYSIS

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

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

ANALYSTS

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

BROKERS

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

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

EXTRA ASSETS

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

FORECASTING

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

INDEPENDENCE

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

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

INVESTMENT FORMULA

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

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

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

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

INVESTMENT STRATEGY

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

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

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

MANTRAS

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

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

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

MARGIN OF SAFETY

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

MARKETS

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

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

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

NEW LOWS

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

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

NOBODY LISTENING

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

OSMOSIS

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

PATIENCE

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

RISK

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

STEADY RETURNS

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

TIMING: “THERE’S ALWAYS SOMETHING TO DO”

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

VALUE INVESTING

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

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

We do liquidation analysis and liquidation analysis only.

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

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

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

WORKING LIFE

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

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

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: https://boolefund.com/best-performers-microcap-stocks/

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

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

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

 

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

My e-mail: 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.

June 23, 2024

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

Here’s the outline:

• • Prologue

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

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

Part II: Monkeys on Typewriters–Survivorship and Other Biases

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

Part III: Wax in my Ears–Living With Randomitis

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

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

 

PROLOGUE

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

GENERAL

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

MARKET PERFORMANCE

Lucky idiot	Skilled investor
Survivorship bias	Market outperformance

FINANCE

Volatility	Return (or drift)
Stochastic variable	Deterministic variable

PHYSICS AND ENGINEERING

Noise

Signal

LITERARY CRITICISM

None

Symbol

PHILOSOPHY OF SCIENCE

Epistemic probability	Physical probability
Induction	Deduction
Synthetic proposition	Analytic proposition

 

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

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

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

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

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

(Photo by Neil Lockhart)

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

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

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

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

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

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

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

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

Taleb writes:

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

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

(A lucky seven. Photo by Eagleflying)

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

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

 

TWO: A BIZARRE ACCOUNTING METHOD

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

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

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

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

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

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

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

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

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

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

 

THREE: A MATHEMATICAL MEDITATION ON HISTORY

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

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

Taleb says:

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

Taleb continues:

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

Note from a value investing point of view

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

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

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

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

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

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

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

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

 

FOUR: RANDOMNESS, NONSENSE, AND THE SCIENTIFIC INTELLECTUAL

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

 

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

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

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

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

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

Taleb continues:

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

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

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

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

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

Taleb adds:

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

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

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

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

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

 

SIX: SKEWNESS AND ASYMMETRY

Taleb presents the following Table:

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

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

Taleb comments that even professional investors misunderstand this bet:

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

(Coin toss. Photo by Christian Delbert)

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

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

Rare Events

Taleb explains his trading strategy:

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

Taleb gives an example where his strategy paid off:

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

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

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

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

Taleb notes the following:

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

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

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

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

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

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

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

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

 

SEVEN: THE PROBLEM OF INDUCTION

Taleb quotes the Scottish philosopher David Hume:

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

(Black swan. Photo by Damithri)

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

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

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

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

Taleb explains the concept of anopen society:

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

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

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

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

 

PART II: MONKEYS ON TYPEWRITERS–SURVIVORSHIP AND OTHER BIASES

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

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

 

EIGHT: TOO MANY MILLIONAIRES NEXT DOOR

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

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

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

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

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

 

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

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

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

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

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

Taleb makes two counterintuitive points:

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

Taleb concludes:

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

The mysterious letter

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

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

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

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

Taleb continues:

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

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

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

 

TEN: LOSER TAKES ALL–ONE THE NONLINEARITIES OF LIFE

Taleb writes:

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

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

(Photo by Maocheng)

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

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

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

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

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

 

ELEVEN: RANDOMNESS AND OUR BRAIN–WE ARE PROBABILITY BLIND

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

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

(Diagram by Oleg Alexandrov, via Wikimedia Commons)

Taleb:

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

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

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

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

Which is more probable?

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

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

(By svjo, via Wikimedia Commons)

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

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

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

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

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

Number of afflicted persons / Number of true and false positives

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

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

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

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

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

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

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

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

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

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

 

PART III: WAX IN MY EARS–LIVING WITH RANDOMITIS

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

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

Taleb admits that he is dominated by his emotions:

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

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

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

 

TWELVE: GAMBLERS’ TICKS AND PIGEONS IN A BOX

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

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

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

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

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

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

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

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

 

THIRTEEN: CARNEADES COMES TO ROME–ON PROBABILITY AND SKEPTICISM

Taleb writes:

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

Taleb holds that Cicero engaged in probabilistic reasoning:

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

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

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

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

 

FOURTEEN: BACCHUS ABANDONS ANTONY

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

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

Taleb concludes with some advice (stoicism):

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

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: https://boolefund.com/best-performers-microcap-stocks/

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

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

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

 

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

My e-mail: 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.

May 26, 2024

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

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

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

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

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

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

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

Furthermore, Cipher has been buying back shares very aggressively.

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

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

Here are the multiples:

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

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

Intrinsic value scenarios:

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

RISKS

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

 

BOOLE MICROCAP FUND

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

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

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

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

 

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

My e-mail: 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.

May 19, 2024

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

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

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

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

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

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

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

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

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

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

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

Intrinsic value scenarios:

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

RISKS

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

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: https://boolefund.com/best-performers-microcap-stocks/

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

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

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

 

 

 

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

April 28, 2024

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

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

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

Here are the multiples:

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

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

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

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

Intrinsic value scenarios:

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

RISKS

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

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

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: https://boolefund.com/best-performers-microcap-stocks/

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

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

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

 

 

 

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

March 17, 2024

Value investor Mohnish Pabrai wrote The Dhandho Investor: The Low-Risk Value Method to High Returns (Wiley, 2007). It’s an excellent book that captures the essence of value investing:

The lower the price you pay relative to the probable intrinsic value of the business, the higher your returns will likely be if you’re right and the lower your losses will likely be if you’re wrong.

If you have a good investment process as a value investor–whether it’s quantitative and statistical, or it involves stock-picking–then typically you’ll be right on about 60 percent of the positions. Because losses are minimized on the other 40 percent, the portfolio is likely to do well over time.

Mohnish sums up the Dhandho approach as:

Heads, I win; tails, I don’t lose much!

There is one very important additional idea that Mohnish focused on in his recent (October 2016) lecture at Peking University (Guanghua School of Management):

10-BAGGERS TO 100-BAGGERS

A 10-bagger is an investment that goes up 10x after you buy it.A100-bagger is an investment that goes up 100x after you buy it.Mohnish gives many examples of stocks–a few of which he kept holding and many of which he sold–that later became 10-baggers, 20-baggers, up to a few 100-baggers. If you own a stock that has already been a 2-bagger, 3-bagger, 5-bagger, etc., and you sell and the stock later turns out to be a 20-bagger, 50-bagger, or 100-bagger, often you have made a huge mistake by selling too soon.

Link to Mohnish’ lecture at Peking University: https://www.youtube.com/watch?v=Jo1XgDJCkh4

Here’s the outline for this blog post:

• • Patel Motel Dhandho
  • Manilal Dhandho
  • Virgin Dhandho
  • Mittal Dhandho
  • The Dhandho Framework
  • Dhandho 101: Invest in Existing Businesses
  • Dhandho 102: Invest in Simple Businesses
  • Dhandho 201: Invest in Distressed Businesses in Distressed Industries
  • Dhandho 202: Invest in Businesses with Durable Moats
  • Dhandho 301: Few Bets, Big Bets, Infrequent Bets
  • Dhandho 302: Fixate on Arbitrage
  • Dhandho 401: Margin of Safety–Always!
  • Dhandho 402: Invest in Low-Risk, High-Uncertainty Businesses
  • Dhandho 403: Invest in the Copycats rather than the Innovators
  • A Short Checklist
  • Be Generous

 

PATEL MOTEL DHANDHO

(Mohnish published the book in 2007. I will use the present tense in this blog post.)

Mohnish notes that Asian Indians make up about 1 percent of the population of the United States. Of these three million, a small subsection hails from the Indian state of Gujarat–the birthplace of Mahatma Gandhi. The Patels are from a tiny area in Southern Gujarat. Mohnish:

Less than one in five hundred Americans is a Patel. It is thus amazing that over half of all the motels in the entire country are owned and operated by Patels… What is even more stunning is that there were virtually no Patels in the United States just 35 years ago. They started arriving as refugees in the early 1970s without much in the way of capital or education. Their heavily accented, broken-English speaking skills didn’t improve their prospects either. From that severely handicapped beginning, with all the odds stacked against them, the Patels triumphed. Patels, as a group, today own over $40 billion in motel assets in the United States, pay over $725 million a year in taxes, and employ nearly a million people. How did this small, impoverished ethnic group come out of nowhere and end up controlling such vast resources? There is a one word explanation: Dhandho.

Dhandho means a low-risk, high-return approach to business. It means the upside is much larger than the downside, which is the essence of value investing.

Dhandho is all about the minimization of risk while maximizing the reward… Dhandho is thus best described as endeavors that create wealth while taking virtually no risk.

Mohnish gives a brief history of the Patels. Some Patels had gone to Uganda and were doing well there as entrepreneurs. But when General Idi Amin came to power as a dictator in 1972, things changed. The Ugandan state seized all of the businesses held by Patels and other non-natives. These businesses were nationalized, and the previous owners were paid nothing.

Because India was already dealing with a severe refugee crisis in 1972-1973, the Indian-origin population that had been tossed out of Uganda was not allowed back into India. Many Patels settled in England and Canada, and a few thousand were accepted in the United States.

In 1973, many nondescript motels were being foreclosed and then sold at distressed prices. “Papa Patel” realized that a motivated seller or bank might finance 90% of the purchase. If Papa Patel could put $5,000 down, he could get a motel on the cheap. The Patel family would run things and also live there. So they had no salaries to pay, and no rent to pay. With rock-bottom expenses, they could then offer the lowest nightly rates. This would lead to higher occupancy and high profits over time, given the very low cost structure.

As long as the motel didn’t fail, it would likely be a highly profitable venture relative to the initial $5,000 investment. If the motel did fail, Papa Patel reasoned that he and his wife could bag groceries and save close to $5,000 in a couple of years. Then Papa Patel could find another cheap motel and make the same bet. If the probability of failure is 10%, then the odds of two failures in a row would be 1%, while nearly every other scenario would involve a high return on investment. Once the first motel was solidly profitable, Papa Patel could let his oldest son take over and look for the next one to buy.

The Patels kept repeating this basic approach until they owned over half the motels in the United States.

 

MANILAL DHANDHO

The Patel formula is repeatable. It’s not just a one-time opportunity based on unique circumstances. Consider Manilal Chaudhari, also from Gujarat, says Mohnish.

Manilal had worked hard as an accountant in India. In 1991, with sponsorship from his brother, he migrated to the United States. His English was not good, and he couldn’t find a job in accounting.

His first job was working 112 hours a week at a gas station at minimum wage. Later, he got a job at a power supply manufacturing company, Cherokee International, owned by a Patel. Manilal worked full-time at Cherokee, and kept working at the gas station as much as possible. The Persian owner of the gas station, recognizing Manilal’s hard work, gave him a 10 percent stake in the business.

In 1998, Manilal decided he wanted to buy a business. One of the employees at Cherokee (a Patel) told Manilal that he wanted to invest with him in whatever business he found. In 2001, the travel industry went into a slump and motel occupancy and prices plummeted. Manilal found a Best Western motel on sale at a terrific location. Since everyone in the extended family had been working non-stop and saving, Manilal – along with a few Patels from Cherokee – were able to buy the Best Western.

Four years later, the Best Western had doubled in value to $9 million. The $1.4 million invested by Manilal and a few Patels was now worth $6.7 million, an annualized return of 48 percent. This doesn’t include annual free cash flow. Mohnish concludes:

Now, that’s what I’d call Manilal Dhandho. He worked hard, saved all he could, and then bet it all on a single no-brainer bet. Reeling from the severe impact of 9/11 on travel, the motel industry was on its knees. As prices and occupancy collapsed, Manilal stepped in and made his play. He was on the hunt for three years. He patiently waited for the right deal to materialize. Classically, his story is all about Few Bets, Big Bets, Infrequent Bets. And it’s all about only participating in coin tosses where:

Heads, I win; tails, I don’t lose much!

 

VIRGIN DHANDHO

The year was 1984 and Richard Branson knew nothing about the airline business. He started his entrepreneurial journey at 15 and was very successful in building an amazing music recording and distribution business.

Somebody sent Branson a business plan about starting an all business class airline flying between London and New York. Branson noted that when an executive in the music business received a business plan to start an airline involving a 747 jumbo jet, he knew that the business plan had been turned down in at least three thousand other places before landing on his desk…

Branson decided to offer a unique dual-class service. But when he presented theidea to his partners and senior executives at the music business, they told him he was crazy. Branson persisted and discovered that he could lease a 747 jumbo jet from Boeing. Branson calculated that Virgin Atlantic Airlines, if it failed, would cost $2 million. His record company was going to earn $12 million that year and about $20 million the following year.

Branson also realized that tickets get paid about 20 days before the plane takes off. But fuel is paid 30 days after the plane lands. Staff wages are paid 15 to 20 days after the plane lands. So the working capital needs of the business would be fairly low.

Branson had found a service gap and Virgin Atlantic ended up doing well. Branson would repeat this formula in many other business opportunities:

Heads, I win; tails, I don’t lose much!

 

MITTAL DHANDHO

Mohnish says Rajasthan is the most colorful state of India. Marwar is a small district in the state, and the Marwaris are seen as excellent businesspeople. Lakshmi Mittal, a Marwari entrepreneur, went from zero to a $20 billion net worth in about 30 years. And he did it in an industry with terrible economics: steel mills.

Take the example of the deal he created to take over the gigantic Karmet Steel Works in Kazakhstan. The company had stopped paying its workforce because it was bleeding red ink and had no cash. The plant was on the verge of closure with its Soviet-era managers forced to barter for steel food for its workers. The Kazakh government was glad to hand Mr. Mittal the keys to the plant for nothing. Not only did Mr. Mittal retain the entire workforce and run the plant, he paid all the outstanding wages and within five years had turned it into a thriving business that was gushing cash. The workers and townsfolk literally worship Mittal as the person who saved their town from collapse.

…The same story was repeated with the Sidek Steel plant in Romania, and the Mexican government handed him the keys to the Sibalsa Mill for $220 million in 1992. It had cost the Mexicans over $2 billion to build the plant. Getting dollar bills at 10 cents–or less–is Dhandho on steroids. Mittal’s approach has always been to get a dollar’s worth of assets for far less than a dollar. And then he has applied his secret sauce of getting these monolith mills to run extremely efficiently.

Mohnish recounts a dinner he had with a Marwari friend. Mohnish asked how Marwari businesspeople think about business. The friend replied that they expect their entire investment to be returned as dividends within three years, with the principal still being worth at least the initial amount invested.

 

THE DHANDHO FRAMEWORK

Mohnish lays out the Dhando framework, including:

• Invest in existing businesses.
• Invest in simple businesses.
• Invested in distressed businesses in distressed industries.
• Invest in businesses with durable moats.
• Few bets, big bets, and infrequent bets.
• Fixate on arbitrage.
• Margin of safety–always.
• Invest in low-risk, high-uncertainty businesses.
• Invest in the Copycats rather than the Innovators.

Let’s look at each point.

 

DHANDHO 101: INVEST IN EXISTING BUSINESSES

Over a long period of time, owning parts of good businesses via the stock market has been shown to be one of the best ways to preserve and grow wealth. Mohnish writes that there are six big advantages to investing in stocks:

• When you buy stock, you become a part owner of an existing business. You don’t have to do anything to create the business or to make the business run.
• You can get part ownership of a compounding machine. It is simple to buy your stake, and the business is already fully staffed and running.
• When people buy or sell entire businesses, both buyer and seller typically have a good idea of what the business is worth. It’s hard to find a bargain unless the industry is highly distressed. In the public stock market, however, there are thousands and thousands of businesses. Many stock prices change by 50% or more in any given year, but the intrinsic value of most businesses does not change by 50% in a given year. So a patient investor can often find opportunities.
• Buying an entire business usually takes serious capital. But buying part ownership via stock costs very little by comparison. In stocks, you can get started with a tiny pool of capital.
• There are likely over 100,000 different businesses in the world with public stock available.
• For a long-term value investor, the transaction costs are very low (especially at a discount broker) over time.

 

DHANDHO 102: INVEST IN SIMPLE BUSINESSES

As Warren Buffett has noted, you generally do not get paid extra for degree of difficulty in investing. There is no reason, especially for smaller investors, not to focus on simple businesses. By patiently looking at hundreds and hundreds of microcap stocks, eventually you can find a 10-bagger, 20-bagger, or even a 100-bagger. And the small business in question is likely to be quite simple. With such a large potential upside, there is no reason, if you’re a small investor, to look at larger or more complicated businesses. (The Boole Microcap Fund that I manage focuses exclusively on micro caps.)

It’s much easier to value a simple business because it usually is easier to estimate the future free cash flows. The intrinsic value of any business–what the business is worth–is the sum of all future free cash flows discounted back to the present. This is called the discounted cash flow (DCF) approach. (Intrinsic value could also mean liquidation value in some cases.)

You may need to have several scenarios in your DCF analysis–a low case, a mid case, and a high case. (What you’re really looking for is a high case that involves a 10-bagger, 20-bagger, or 100-bagger.) But you’re still nearly always better off limiting your investments to simple businesses.

Only invest in businesses that are simple–ones where conservative assumptions about future cash flows are easy to figure out.

 

DHANDHO 201: INVEST IN DISTRESSED BUSINESSES IN DISTRESSED INDUSTRIES

The stock market is usually efficient, meaning that stock prices are usually accurate representations of what businesses are worth. It is very difficult for an investor to do better than the overall stock market, as represented by the S&P 500 Index or another similar index.

Stock prices, in most instances, do reflect the underlying fundamentals. Trying to figure out the variance between prices and underlying intrinsic value, for most businesses, is usually a waste of time. The market is mostly efficient. However, there is a huge difference between mostly and fully efficient.

Because the market is not always efficient, value investors who patiently examine hundreds of different stocks eventually will find a few that are undervalued. Because public stock markets are highly liquid, if an owner of shares becomes fearful, he or she can quickly sell those shares. For a privately held business, however, it usually takes months for an owner to sell the position. Thus, a fearful owner of public stock is often more likely to sell at an irrationally low price because the sale can be completed right away.

Where can you find distressed businesses or industries? Mohnish offers some suggestions:

• Business headlines often include articles about distressed businesses or industries.
• You can look at prices that have dropped the most in the past 52 weeks. You can also look at stocks trading at low price-to-earnings ratios (P/Es), low price-to-book ratios (P/Bs), high dividend yields, and so on. Not every quantitatively cheap stock is undervalued, but some are. There are various services that offer screening such as Value Line.
• You can follow top value investors by reading 13-F Forms or through different services. I would only note that the vast majority of top value investors are not looking at microcap stocks. If you’re a small investor, your best opportunities are very likely to be found among micro caps. Very few professional investors ever look there, causing microcap stocks to be much more inefficiently priced than larger stocks. Also, micro caps tend to be relatively simple, and they often have far more room to grow. Most 100-baggers start out as micro caps.
• Value Investors Club (valueinvestorsclub.com) is a club for top value investors. You can get free guest access to all ideas that are 45 days old or older. Many cheap stocks stay cheap for a long time. Often good ideas are still available after 45 days have elapsed.

 

DHANDHO 202: INVEST IN BUSINESSES WITH DURABLE MOATS

A moat is a sustainable competitive advantage. Moats are often associated with capital-light businesses. Such businesses (if successful) tend to have sustainably high ROIC (return on invested capital)–the key attribute of a sustainable competitive advantage. Yet sometimes moats exist elsewhere and sometimes they are hidden.

Sometimes the moat is hidden. Take a look at Tesoro Corporation. It is in the oil refining business–which is a commodity. Tesoro has no control over the price of its principle raw material, crude oil. It has no control [of the price] over its principal finished good, gasoline. Nonetheless, it has a fine moat. Tesoro’s refineries are primarily on the West Coast and Hawaii. Refining on the West Coast is a great business with a good moat. There hasn’t been a refinery built in the United States for the past 20 years. Over that period, the number of refineries has gone down from 220 to 150, while oil demand has gone up about 2 percent a year. The average U.S. refinery is operating at well over 90 percent of capacity. Anytime you have a surge in demand, refining margins escalate because there is just not enough capacity.

…How do we know when a business has a hidden moat and what that moat is? The answer is usually visible from looking at its financial statements. Good businesses with good moats… generate high returns on capital deployed in the business. (my emphasis)

But the nature of capitalism is that any company that is earning a high return on invested capital will come under attack by other businesses that want to earn a high return on invested capital.

It is virtually a law of nature that no matter how well fortified and defended a castle is, no matter how wide or deep its moat is, no matter how many sharks or piranhas are in that moat, eventually it is going to fall to the marauding invaders.

Mohnish quotes Charlie Munger:

Of the fifty most important stocks on the NYSE in 1911, today only one, General Electric, remains in business… That’s how powerful the forces of competitive destruction are. Over the very long term, history shows that the chances of any business surviving in a manner agreeable to a company’s owners are slim at best.

Mohnish adds:

There is no such thing as a permanent moat. Even such invincible businesses today like eBay, Google, Microsoft, Toyota, and American Express will all eventually decline and disappear.

…It takes about 25 to 30 years from formation for a highly successful company to earn a spot on the Fortune 500… it typically takes many blue chips less than 20 years after they get on the list to cease to exist. The average Fortune 500 business is already past its prime by the time it gets on the list.

If you’re a small investor, searching for potential 10-baggers or 100-baggers among microcap stocks makes excellent sense. You want to find tiny companies that much later reach the Fortune 500. You don’t want to look at companies that are already on the Fortune 500 because the potential returns are far more likely to be mediocre going forward.

 

DHANDHO 301: FEW BETS, BIG BETS, INFREQUENT BETS

Claude Shannon was a fascinating character–he often rode a unicycle while juggling, and his house was filled with gadgets. Shannon’s master’s thesis was arguably the most important and famous master’s thesis of the twentieth century. In it, he proposed binary digit or bit, as the basic unit of information. A bit could have only two values–0 or 1, which could mean true or false, yes or no, or on or off. This allowed Boolean algebra to represent any logical relationship. This meant that the electrical switch could perform logic functions, which was the practical foundation for all digital circuits and computers.

The mathematician Ed Thorp, a colleague of Shannon’s at MIT, had discovered a way to beat the casinos at blackjack. But Thorp was trying to figure out how to size his blackjack bets as a function of how favorable the odds were. Someone suggested to Thorp that he talk to Shannon about it. Shannon recalled a paper written by a Bell Labs colleague of his, John Kelly, that dealt with this question.

The Kelly criterion can be written as follows:

• F = p – [q/o]

where

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

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

Thorp proceeded to use the Kelly criterion to win quite a bit of money at blackjack, at least until the casinos began taking countermeasures such as cheating dealers, frequent reshuffling, and outright banning. But Thorp realized that the stock market was also partly inefficient, and it was a far larger game.

Thorp launched a hedge fund that searched for little arbitrage situations (pricing discrepancies) involving warrants, options, and convertible bonds. In order to size his positions, Thorp used the Kelly criterion. Thorp evolved his approach over the years as previously profitable strategies were copied. His multi-decade track record was terrific.

Ed Thorp examined Buffett’s career and concluded that Buffett has used the essential logic of the Kelly criterion by concentrating his capital into his best ideas. Buffett’s concentrated value approach has produced an outstanding, unparalleled 65-year track record.

Thorp has made several important points about the Kelly criterion as it applies to long-term value investing. The Kelly criterion was invented to apply to a very long series of bets. Value investing differs because even a concentrated value investing approach will usually have at least 5-8 positions in the portfolio at the same time. Thorp argues that, in this situation, the investor must compare all the current and prospective investments simultaneously on the basis of the Kelly criterion.

Mohnish gives an example showing how you can use the Kelly criterion on your top 8 ideas, and then normalize the position sizes.

Say you look at your top 8 investment ideas. You use the Kelly criterion on each idea separately to figure out how large the position should be, and this is what you conclude about the ideal bet sizes:

• Bet 1 – 80%
• Bet 2 – 70%
• Bet 3 – 60%
• Bet 4 – 55%
• Bet 5 – 45%
• Bet 6 – 35%
• Bet 7 – 30%
• Bet 8 – 25%

Of course, that adds up to 400%. Yet for a value investor, especially running a concentrated portfolio of 5-8 positions, it virtually never makes sense to buy stocks on margin. Leverage cannot make a bad investment into a good investment, but it can turn a good investment into a bad investment. So you don’t need any leverage. It’s better to compound at a slightly lower rate than to risk turning a good investment into a bad investment because you lack staying power.

So the next step is simply to normalize the position sizes so that they add up to 100%. Since the original portfolio adds up to 400%, you just divide each position by 4:

• Bet 1 – 20%
• Bet 2 – 17%
• Bet 3 – 15%
• Bet 4 – 14%
• Bet 5 – 11%
• Bet 6 – 9%
• Bet 7 – 8%
• Bet 8 – 6%

(These percentages are rounded for simplicity.)

As mentioned earlier, if you truly know the odds of each bet in a long series of bets, the Kelly criterion tells you exactly how much to bet on each bet in order to maximize your long-term compounded rate of return. Betting any other amount will lead to lower compound returns. In particular, if you repeatedly bet more than what the Kelly criterion indicates, you eventually will destroy your capital.

It’s nearly always true when investing in a stock that you won’t know the true odds or the true future scenarios. You usually have to make an estimate. Because you never want to bet more than what the Kelly criterion says, it is wise to bet one half or one quarter of what the Kelly criterion says. This is called half-Kelly or quarter-Kelly betting. What is nice about half-Kelly betting is that you will earn three-quarters of the long-term returns of what full Kelly betting would deliver, but with only half the volatility.

So in practice, if there is any uncertainty in your estimates, you want to bet half-Kelly or quarter-Kelly. In the case of a concentrated portfolio of 5-8 stocks, you will frequently end up betting half-Kelly or quarter-Kelly because you are making 5-8 bets at the same time. In Mohnish’s example, you end up betting quarter-Kelly in each position once you’ve normalized the portfolio.

Mohnish quotes Charlie Munger again:

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

When running the Buffett Partnership, Warren Buffett invested 40% of the partnership in American Express after the stock had been cut in half following the salad oil scandal. American Express had to announce a $60 million loss, a huge hit given its total market capitalization of roughly $150 million at the time. But Buffett determined that the essential business of American Express–travelers’ checks and charge cards–had not been permanently damaged. American Express still had a very valuable moat.

Buffett explained his reasoning in several letters to limited partners, as quoted by Mohnish here:

We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could change the underlying value of the investment.

We are obviously only going to go to 40% in very rare situations–this rarity, of course, is what makes it necessary that we concentrate so heavily, when we see such an opportunity. We probably have had only five or six situations in the nine-year history of the partnerships where we have exceeded 25%. Any such situations are going to have to promise very significant superior performance… They are also going to have to possess such superior qualitative and/or quantitative factors that the chance of serious permanent loss is minimal…

There’s virtually no such thing as a sure bet in the stock market. But there are situations where the odds of winning are very high or where the potential upside is substantial.

One final note: In constructing a concentrated portfolio of 5-8 stocks, if at least some of the positions are non-correlated or even negatively correlated, then the volatility of the overall portfolio can be reduced. Some top investors prefer to have about 15 positions with low correlations.

Once you get to at least 25 positions, specific correlations typically tend not to be an issue, although some investors may end up concentrating on specific industries. In fact, it often may make sense to concentrate on industries that are deeply out-of-favor.

Mohnish concludes:

…It’s all about the odds. Looking out for mispriced betting opportunities and betting heavily when the odds are overwhelmingly in your favor is the ticket to wealth. It’s all about letting the Kelly Formula dictate the upper bounds of these large bets. Further, because of multiple favorable betting opportunities available in equity markets, the volatility surrounding the Kelly Formula can be naturally tamed while still running a very concentrated portfolio.

In sum, top value investors like Warren Buffett, Charlie Munger, and Mohnish Pabrai–to name just a few out of many–naturally concentrate on their best 5-8 ideas, at least when they’re managing a small enough amount of money. (These days, Berkshire’s portfolio is massive, which makes it much more difficult to concentrate, let alone to find hidden gems among micro caps.)

You have to take a humble look at your strategy and your ability before deciding on your level of concentration. The Boole Microcap Fund that I manage is designed to focus on the top 15-25 ideas. This is concentrated enough so that the best performers–whichever stocks they turn out to be–can make a difference to the portfolio. But it is not so concentrated that it misses the best performers. In practice, the best performers very often turn out to be idea #9 or idea #17, rather than idea #1 or idea #2. Many top value investors–including Peter Cundill, Joel Greenblatt, and Mohnish Pabrai–have found this to be true.

 

DHANDHO 302: FIXATE ON ARBITRAGE

The example often given for traditional commodity arbitrage is that gold is selling for $1,500 in London and $1,490 in New York. By buying gold in New York and selling it in London, the arbitrageur can make an almost risk-free profit.

In merger arbitrage, Company A offers to buy Company B at, say, $20 per share. The stock of Company B may move from $15 to $19. Now the arbitrageur can buy the stock in Company B at $19 in order to capture the eventual move to $20. By doing several such deals, the arbitrageur can probably make a nice profit, although there is a risk for each individual deal.

In what Mohnish callsDhandho arbitrage, the entrepreneur risks a relatively small amount of capital relative to the potential upside. Just look at the earlier examples, including Patel Motel Dhandho, Virgin Dhandho, and Mittal Dhandho.

Heads, I win; tails, I don’t lose much!

 

DHANDHO 401: MARGIN OF SAFETY–ALWAYS!

Nearly every year, Buffett has hosted over 30 groups of business students from various universities. The students get to ask questions for over an hour before going to have lunch with Buffett. Mohnish notes that students nearly always ask for book or reading recommendations, and Buffett’s best recommendation is always Ben Graham’s The Intelligent Investor. As Buffett told students from Columbia Business School on March 24, 2006:

The Intelligent Investor is still the best book on investing. It has the only three ideas you really need:

• Chapter 8–The Mr.Market analogy. Make the stock market serve you. The C section of the Wall Street Journal is my business broker–it quotes me prices every day that I can take or leave, and there are no called strikes.
• Chapter 8–A stock is a piece of a business. Never forget that you are buying a business which has an underlying value based on how much cash goes in and out.
• Chapter 20–Margin of Safety. Make sure that you are buying a business for way less than you think it is conservatively worth.

The heart of value investing is an idea that is directly contrary to economic and financial theory:

• The bigger the discount to intrinsic value, the lower the risk.
• The bigger the discount to intrinsic value, the higher the return.

Economic and financial theory teaches that higher returns always require higher risk. But Ben Graham, the father of value investing, taught just the opposite: The lower the price you pay below intrinsic value, the lower your risk and the higher your potential return.

Mohnish argues that the Dhandho framework embodies Graham’s margin of safety idea. Papa Patel, Manilal, and Branson all have tried to minimize the downside while maximizing the upside. Again, most business schools, relying on accepted theory, teach that low returns come from low risk, while high returns require high risk.

Mohnish quotes Buffett’s observations about Berkshire’s purchase of Washington Post stock in 1973:

We bought all of our [Washington Post (WPC)] holdings in mid-1973 at a price of not more than one-fourth of the then per-share business value of the enterprise. Calculating the price/value ratio required no unusual insights. Most security analysts, media brokers, and media executives would have estimated WPC’s intrinsic business value at $400 to $500 million just as we did. And its $100 million stock market valuation was published daily for all to see. Our advantage, rather, was attitude: we had learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business value.

…Through 1973 and 1974, WPC continued to do fine as a business, and intrinsic value grew. Nevertheless, by year-end 1974 our WPC holding showed a loss of about 25%, with a market value of $8 million against our cost of $10.6 million. What we had bought ridiculously cheap a year earlier had become a good bit cheaper as the market, in its infinite wisdom, marked WPC stock down to well below 20 cents on the dollar of intrinsic value.

As of 2007 (when Mohnish wrote his book), Berkshire’s stake in the Washington post had grown over 33 years from the original $10.6 million to a market value of over $1.3 billion–more than 124 times the original investment. Moreover, as of 2007, the Washington Post was paying a modest dividend (not included in the 124 times figure). The dividend alone (in 2007) was higher than what Berkshire originally paid for its entire position. Buffett:

Most institutional investors in the early 1970s, on the other hand, regarded business value as of only minor relevance when they were deciding the prices at which they would buy or sell. This now seems hard to believe. However, these institutions were then under the spell of academics at prestigious business schools who were preaching a newly-fashioned theory: the stock market was totally efficient, and therefore calculations of business value–and even thought, itself–were of no importance in investment activities. (We are enormously indebted to those academics: what could be more advantageous in an intellectual contest–whether it be bridge, chess, or stock selection–than to have opponents who have been taught that thinking is a waste of energy?)

At any given time, a business is in either of two states: it has problems or it will have problems. Virtually every week there are companies or whole industries where stock prices collapse. Many business problems are temporary and not permanent. But stock investors on the whole tend to view business problems as permanent, and they mark down the stock prices accordingly.

You may be wondering: Due to capitalist competition, nearly all businesses eventually fail, so how can many business problems be temporary? When we look at businesses experiencing problems right now, many of those problems will be solved over the next three to five years. Thus, considering the next three to five years, many business problems are temporary. But the fate of a given business over several decades is a different matter entirely.

 

DHANDHO 402: INVEST IN LOW-RISK, HIGH-UNCERTAINTY BUSINESSES

The future is always uncertain. And that’s even more true for some businesses. Yet if the stock price is low enough, high uncertainty can create a good opportunity.

Papa Patel, Manilal, Branson, and Mittal are all about investing in low-risk businesses. Nonetheless, most of the businesses they invested in had a very wide range of possible outcomes. The future performance of these businesses was very uncertain. However, these savvy Dhandho entrepreneurs had thought through the range of possibilities and drew comfort from the fact that very little capital was invested and/or the odds of a permanent loss of capital were extremely low… Their businesses had a common unifying characteristic–they were all low-risk, high-uncertainty businesses.

In essence, says Mohnish, these were all simple bets:

Heads, I win; tails, I don’t lose much!

Wall Street usually hates high uncertainty, and often does not distinguish between high uncertainty and high risk. But there are several distinct situations, observes Mohnish, where Wall Street tends to cause the stock price to collapse:

• High risk, low uncertainty
• High risk, high uncertainty
• Low risk, high uncertainty

Wall Street loves the combination of low risk and low uncertainty, but these stocks nearly always trade at high multiples. On the other hand, Dhandho entrepreneurs and value investors are only interested in low risk and high uncertainty.

Mohnish discusses an example of a company he was looking at in the year 2000: Stewart Enterprises (STEI), a funeral service business. Leading companies such as Stewart Enterprises, Loewen, Service Corp. (SRV), and Carriage Services (CSV) had gone on buying sprees in the 1990s, acquiring mom-and-pop businesses in their industry. These companies all ended up with high debt as a result of the acquisitions. They made the mistake of buying for cash–using debt–rather than buying using stock.

Loewen ended up going bankrupt. Stewart had $930 million of long-term debt with $500 million due in 2002. Wall Street priced all the funeral service giants as if they were going bankrupt. Stewart’s price went from $28 to $2 in two years. Stewart kept coming up on the Value Line screen for lowest price-to-earnings (P/E) ratios. Stewart had a P/E of less than three, a rarity. Mohnish thought that funeral services must be a fairly simple business to understand, so he started doing research.

Mohnish recalled reading an article in the mid-1990s in the Chicago Tribune about the rate of business failure in various industries. The lowest rate of failure for any type of business was funeral homes. This made sense, thought Mohnish. It’s not the type of business that aspiring entrepreneurs would dream about, and pre-need sales often make up about 25 percent of total revenue. It’s a steady business that doesn’t change much over time.

Stewart had roughly $700 million in annual revenue and owned around 700 cemeteries and funeral homes. Most of its business was in the United States. Stewart’s tangible book value was $4 per share, and book value was probably understated because hard assets like land were carried at cost. At less than $2 per share, Stewart was trading at less than half of stated tangible book value. By the time the debt was due, the company would generate over $155 million in free cash flow, leaving a shortfall of under $350 million.

Mohnish thought through some scenarios and estimated the probability for each scenario:

• 25% probability: The company could sell some funeral homes. Selling 100 to 200 might take care of the debt. Equity value > $4 per share.
• 35% probability: Based on the company’s solid and predictable cash flow, Stewart’s lenders or bankers might decide to extend the maturities or refinance the debt–especially if the company offered to pay a higher interest rate. Equity value > $4 per share.
• 20% probability: Based on Stewart’s strong cash flows, the company might find another lender–especially if it offered to pay a higher interest rate. Equity value > $4 per share.
• 19% probability: Stewart enters bankruptcy. Even assuming distressed asset sales, equity value > $2 per share.
• 1% probability: A 50-mile meteor comes in or Yellowstone blows or some other extreme event takes place that destroys the company. Equity value = $0.

The bottom line, as Mohnish saw it, was that the odds were less than 1% that he would end up losing money if he invested in Stewart at just under $2 per share. Moreover, there was an 80% chance that the equity would be worth at least $4 per share. So Mohnish invested 10 percent of Pabrai Funds in Stewart Enterprises at under $2 per share.

A few months later, Stewart announced that it had begun exploring sales of its international funeral homes. Stewart expected to generate $300 to $500 million in cash from this move. Mohnish:

The amazing thing was that management had come up with a better option than I had envisioned. They were going to be able to eliminate the debt without any reduction in their cash flow. The lesson here is that we always have a free upside option on most equity investments when competent management comes up with actions that make the bet all the more favorable.

Soon the stock hit $4 and Mohnish exited the position with more than 100% profit.

It’s worth repeating what investor Lee Ainslee has said: Good management tends to surprise on the upside, while bad management tends to surprise on the downside.

Frontline

In 2001, Mohnish noticed two companies with a dividend yield of more than 15 percent. Both were crude oil shippers: Knightsbridge (VLCC) and Frontline (FRO). Mohnish started reading about this industry.

Knightsbridge had been formed a few years earlier when it ordered several tankers from a Korean shipyard. A very large crude carrier (VLCC) or Suezmax at the time cost $60 to $80 million and would take two to three years to be built and delivered. Knightsbridge would then lease the ships to Shell Oil under long-term leases. Shell would pay Knightsbridge a base lease rate (perhaps $10,000 a day per tanker) regardless of whether it used the ships or not. On top of that, Shell paid Knightsbridge a percentage of the difference between a base rate and the spot market price for VLCC rentals, notes Mohnish. So if the spot price for a VLCC was $30,000 per day, Knightsbridge might receive $20,000 a day. If the spot was $50,000, it would get perhaps $35,000 a day. Mohnish:

At the base rate, Knightbridge pretty much covered its principal and interest payments for the debt it took on to pay for the tankers. As the rates went above $10,000, there was positive cash flow; the company was set up to just dividend all the excess cash out to shareholders, which is marvelous…

Because of this unusual structure and contract, when tanker rates go up dramatically, this company’s dividends go through the roof.

Mohnish continues:

In investing, all knowledge is cumulative. I didn’t invest in Knightsbridge, but I did get a decent handle on the crude oil shipping business. In 2001, we had an interesting situation take place with one of these oil shipping companies called Frontline. Frontline is the exact opposite business model of Knightsbridge. It has the largest oil tanker fleet in the world, among all the public companies. The entire fleet is on the spot market. There are very few long-term leases.

Because it rides on the spot market on these tankers, there is no such thing as earnings forecasts or guidance. The company’s CEO himself doesn’t know what the income will be quarter to quarter. This is great, because whenever Wall Street gets confused, it means we likely can make some money. This is a company that has widely gyrating earnings.

Oil tanker rates have ranged historically from $6,000 a day to $100,000 a day. The company needs about $18,000 a day to breakeven… Once [rates] go above $30,000 to $35,000, it is making huge profits. In the third quarter of 2002, oil tanker rates collapsed. A recession in the United States and a few other factors caused a drop in crude oil shipping volume. Rates went down to $6,000 a day. At $6,000 a day Frontline was bleeding red ink, badly. The stock went from $11 a share to around $3, in about three months.

Mohnish notes the net asset value of Frontline:

Frontline had about 70 VLCCs at the time. While the daily rental rates collapsed, the price per ship hadn’t changed much, dropping about 10 percent or 15 percent. There is a fairly active market in buying and selling oil tankers. Frontline had a tangible book value of about $16.50 per share. Even factoring in the distressed market for ships, you would still get a liquidation value north of $11 per share. The stock price had gone from $15 to $3… Frontline was trading at less than one-third of liquidation value.

Keep in mind that Frontline could sell a ship for about $60 million, and the company had 70 ships. Frontline’s annual interest payments were $150 million. If it sold two to three ships a year, Frontline could sustain the business at the rate of $6,000 a day for several years.

Mohnish also discovered that Frontline’s entire fleet was double hull tankers. All new tankers had to be double hull after 2006 due to regulations following the Exxon Valdez spill. Usually single hull tankers were available at cheaper day rates than double hull tankers. But this wasn’t true when rates dropped to $6,000 a day. Both types of ship were available at the same rate. In this situation, everyone would rent the double hull ships and no one rented the single hull ships.

Owners of the single hull ships were likely get jittery and to sell the ships as long as rates stayed at $6,000 a day. If they waited until 2006, Mohnish explains, the ability to rent single hull ships would be much lower. And by 2006, scrap rates might be quite low if a large number of single hull ships were scrapped at the same time. The net result is that there is a big jump in scrapping for single hulled tankers whenever rates go down. Mohnish:

It takes two to three years to get delivery of a new tanker. When demand comes back up again, inventory is very tight because capacity has been taken out and it can’t be added back instantaneously. There is a definitive cycle. When rates go as low as $6,000 and stay there for a few weeks, they can rise to astronomically high levels, say $60,000 a day, very quickly. With Frontline, for about seven or eight weeks, the rates stayed under $10,000 a day and then spiked to $80,000 a day in fourth quarter 2002. The worldwide fleet of VLCCs in 2002 was about 400 ships. Over the past several decades, worldwide oil consumption has increased by 2 percent to 4 percent on average annually. This 2 percent to 4 percent is generally tied to GDP growth. Usually there are 10 to 12 new ships added each year to absorb this added demand. When scrapping increases beyond normal levels, the fleet is no longer increasing by 2 percent to 4 percent. When the demand for oil rises, there just aren’t enough ships. The only thing that’s adjustable is the price, which skyrockets.

Pabrai Funds bought Frontline stock in the fall of 2002 at $5.90 a share, about half of liquidation value of $11 to $12. When the stock moved up to $9 to $10, Mohnish sold the shares. Because he bought the stock at roughly half liquidation value, this was a near risk-free bet: Heads, I win a lot; tails, I win a little!

Mohnish gives a final piece of advice:

Read voraciously and wait patiently, and from time to time amazing bets will present themselves.

Important Note: Had Mohnish kept the shares of Frontline, they would have increased dramatically. The shares approached $120 within a few years, so Mohnish would have made 20x his initial investment at $5.90 per share had he simply held on for a few years.

As noted earlier, Mohnish recently gave a lecture at Peking University (Guanghua School of Management) about 10-baggers to 100-baggers, giving many examples of stocks like Frontline that he had actually owned but sold way too soon. Link: https://www.youtube.com/watch?v=Jo1XgDJCkh4

 

DHANDHO 403: INVEST IN THE COPYCATS RATHER THAN THE INNOVATORS

What Mohnish calls copycats are businesses that simply copy proven innovations. The first few Patels figured out the economics of motel ownership. The vast majority of Patels who came later simply copied what the first Patels had already done successfully.

Mohnish writes:

Most entrepreneurs lift their business ideas from other existing businesses or from their last employer. Ray Kroc loved the business model of the McDonald brothers’ hamburger restaurant in San Bernardino, California. In 1954, he bought the rights to the name and know-how, and he scaled it, with minimal change. Many of the subsequent changes or innovations did not come from within the company with its formidable resources–they came from street-smart franchisees and competitors. The company was smart enough to adopt them, just as they adopted the entire concept at the outset.

 

A SHORT CHECKLIST

Mohnish gives a list of good questions to ask before buying a stock:

• Is it a business I understand very well–squarely within my circle of competence?
• Do I know the intrinsic value of the business today and, with a high degree of confidence, how it is likely to change over the next few years?
• Is the business priced at a large discount to its intrinsic value today and in two to three years? Over 50 percent?
• Would I be willing to invest a large part of my net worth into this business?
• Is the downside minimal?
• Does the business have a moat?
• Is it run by able and honest managers?

If the answers to these questions are yes, buy the stock. Furthermore, writes Mohnish, hold the stock for at least two to three years before you think about selling. This gives enough time for conditions to normalize and thus for the stock to approach intrinsic value. One exception: If the stock increases materially in less than two years, you can sell, but only after you have updated your estimate of intrinsic value.

In any scenario, you should always update your estimate of intrinsic value. If intrinsic value is much higher than the current price, then continuing to hold is almost always the best decision. One huge mistake to avoid is selling a stock that later becomes a 10-bagger, 20-bagger, or 100-bagger. That’s why you must always update your estimate of intrinsic value. And don’t get jittery just because a stock is hitting new highs.

A few more points:

• If you have a good investment process, then about 2/3 of the time the stock will approach intrinsic value over two to three years. 1/3 of the time, the investment won’t work as planned–whether due to error, bad luck, or unforeseeable events–but losses should be limited due to a large margin of safety having been present at the time of purchase.
• In the case of distressed equities, there may be much greater potential upside as well as much greater potential downside. A few value investors can use this approach, but it’s quite difficult and typically requires greater diversification.
• For most value investors, it’s best to stick with companies with low or no debt. You may grow wealth a bit more slowly this way, but as Buffett and Munger always ask, what’s the rush? Buffett and Munger had a friend Rick Guerin who owned a huge number of Berkshire Hathaway shares, but many of the shares were on margin. When Berkshire stock got cut in half–which will happen occasionally to almost any stock, no matter how good the company–Guerin was forced to sell much of his position. Had Guerin not been on margin, his non-margined shares in Berkshire would later have been worth a fortune (approaching $1 billion).
• Your own mistakes are your best teachers, explains Mohnish. You’ll get better over time by studying your own mistakes:

While it is always best to learn vicariously form the mistakes of others, the lessons that really stick are ones we’ve stumbled through ourselves.

 

BE GENEROUS

Warren Buffett and Bill Gates are giving away most of their fortune to help many people who are less fortunate. Bill and Melinda Gates devote much of their time and energy (via the Gates Foundation) to saving or improving as many human lives as possible.

Mohnish Pabrai and his wife started the Dakshana Foundation in 2005. Mohnish:

I do urge you to leverage Dhandho techniques fully to maximize your wealth. But I also hope that… you’ll use some time and some of that Dhandho money to leave this world a little better place than you found it. We cannot change the world, but we can improve this world for one person, ten people, a hundred people, and maybe even a few thousand people.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: https://boolefund.com/best-performers-microcap-stocks/

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

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

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

 

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

My e-mail: 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.

March 10, 2024

Jeremy Siegel is the author of The Future for Investors (Crown Business, 2005). Warren Buffett commented: “Jeremy Siegel’s new facts and ideas should be studied by investors.” (Although the book was published in 2005, most of the facts and ideas still hold.)

 

INTRODUCTION

Siegel summarizes the main lesson from his previous book, Stocks for the Long Run:

My research showed that over extended periods of time, stock returns not only dominate the returns on fixed-income assets, but they do so with lower risk when inflation is taken into account. These findings established that stocks should be the cornerstone of all long-term investors’ portfolios.

As you extend forward in time, especially to three or four decades, the real return from stocks is roughly 6.5 to 7 percent, which will nearly always be better than any other investment, such as fixed-income or gold. Siegel has given many talks on Stocks for the Long Run, and he reports that two questions always come up:

• Which stocks should I hold for the long run?
• What will happen to my portfolio when the baby boomers retire and begin liquidating their portfolios?

Siegel says he wrote The Future for Investors in order to answer these questions. He studied all 500 firms that constituted the S&P 500 Index when it was first formulated in 1957. His conclusions – that the original firms in the index outperformed the newcomers (those added later to the index) – were surprising:

These results confirmed my feeling that investors overprice new stocks, many of which are in high technology industries, and ignore firms in less exciting industries that often provide investors superior returns. I coined the term the growth trap to describe the incorrect belief that the companies that lead in technological innovation and spearhead economic growth bring investors superior returns.

The more I investigated returns, the more I determined that the growth trap affected not just individual stocks, but also entire sectors of the market and even countries. The fastest-growing new firms, industries, and even foreign countries often suffered the worst return. I formulated the basic principle of investor return, which specifies that growth alone does not yield good returns, but only growth in excess of the often overly optimistic estimates that investors have built into the price of stock. It was clear that the growth trap was one of the most important barriers between investors and investment success.

As regards the aging of the baby-boom generation, Siegel argues that growth in developing countries (like China and India) will keep the global economy moving forward. Also, as citizens in developing countries become wealthier, they will buy assets that baby-boomers are selling. Siegel also holds that information technology will be central to global economic growth.

I am not going to discuss baby-boomer retirement any further in this blog post. I would only note that there is a good chance that economically significant innovation could surprise on the upside in the next few decades. See, for instance, The Second Machine Age, by Erik Brynjolfsson and Andrew McAfee (W. W. Norton, 2016). As Warren Buffett has frequently observed, the luckiest people in history are those being born now. Life in the future for most people is going to be far better than at any previous time in history.

 

THE GROWTH TRAP

Siegel opens the first chapter by noting the potential impact of improving technology:

The future for investors is bright. Our world today stands at the brink of the greatest burst of invention, discovery, and economic growth ever known.

Yet investors must be careful to avoid the growth trap:

The growth trap seduces investors into overpaying for the very firms and industries that drive innovation and spearhead economic expansion. This relentless pursuit of growth – through buying hot stocks, seeking exciting new technologies, or investing in the fastest-growing countries – dooms investors to poor returns. In fact, history shows that many of the best-performing investments are instead found in shrinking industries and in slower-growing countries.

Although technology has created amazing wealth and well-being, investing in new technologies is generally a poor investment strategy. Siegel explains:

How can this happen? How can these enormous economic gains made possible through the proper application of new technology translate into substantial investment losses? There’s one simple reason: in their enthusiasm to embrace the new, investors invariably pay too high a price for a piece of the action. The concept of growth is so avidly sought after that it lures investors into overpriced stocks in fast-changing and overly competitive industries, where the few big winners cannot begin to compensate for the myriad of losers.

To illustrate his point, Siegel compares Standard Oil of New Jersey (now ExxonMobil) with the new-economy juggernaut, IBM. Consider the growth rates of these companies from 1950 to 2003:

Growth Measures	IBM	Standard Oil	Advantage
Revenue/Share	12.19%	8.04%	IBM
Dividends/Share	9.19%	7.11%	IBM
Earnings/Share	10.94%	7.47%	IBM
Sector Growth	14.65%	-14.22%	IBM

IBM performed much better fundamentally than Standard Oil of New Jersey. Moreover, from 1950 to 2003, the technology sector rose from 3 percent of the market to almost 18 percent, while oil stocks shrank from 20 percent of the market to 5 percent. Therefore, it seems clear that an investor who had to choose between IBM and Standard Oil in 1950 should have chosen IBM. But this would have been the wrong decision.

Over the entire period, Standard Oil of New Jersey had an average P/E of 12.97, while IBM had an average P/E of 26.76. Also, Standard Oil had an average dividend yield of 5.19%, while IBM had an average dividend yield of 2.18%. As a result, the total returns for the two stocks were as follows:

Return Measures	IBM	Standard Oil	Advantage
Price Appreciation	11.41%	8.77%	IBM
Dividend Return	2.18%	5.19%	Standard Oil
Total Return	13.83%	14.42%	Standard Oil

Siegel explains:

IBM did very well, but investors expected it to do well, and its stock price was consistently high. Investors in Standard Oil had very modest expectations for earnings growth and kept the price of its shares low, allowing investors to accumulate more shares through the reinvestment of dividends. The extra shares proved to be Standard Oil’s margin of victory.

Here are Siegel’s broad conclusions on the S&P 500 Index:

• The more than 900 new firms that have been added to the index since it was formulated in 1957 have, on average, underperformed the original 500 firms in the index.
• Long-term investors would have been better off had they bought the original S&P 500 firms in 1957 and never bought any new firms added to the index. By following this buy-and-never-sell approach, investors would have outperformed almost all mutual funds and money managers over the last half century.
• Dividends matter a lot. Reinvesting dividends is the critical factor giving the edge to most winning stocks in the long run… Portfolios invested in the highest-yielding stocks returned 3 percent per year more than the S&P 500 Index, while those in the lowest-yielding stocks lagged the market by almost 2 percent per year.
• The return on stocks depends not on earnings growth but solely on whether this earnings growth exceeds what investors expected, and those growth expectations are embodied in the price-to-earnings, or P/E ratio. Portfolios invested in the lowest-P/E stocks in the S&P 500 Index returned almost 3 percent per year more than the S&P 500 Index, while those invested in the high-P/E stocks fell 2 percent per year behind the index.
• The growth trap holds for industry sectors as well as individual firms. The fastest-growing sector, the financials, has underperformed the benchmark S&P 500 Index, while the energy sector, which has shrunk almost 80 percent since 1957, beat this benchmark index. The lowly railroads, despite shrinking from 21 percent to less than 5 percent of the industrial sector, outperformed the S&P 500 Index over the last half century.
• The growth trap holds for countries as well. The fastest-growing country over the last decade has rewarded investors with the worst returns. China, the economic powerhouse of the 1990s, has painfully disappointed investors with its overpriced shares and falling stock prices.

 

THE TRIED AND TRUE

But how, you will ask, does one decide what [stocks are] ‘attractive’? Most analysts feel they must choose between two approaches customarily thought to be in opposition: ‘value’ and ‘growth.’… We view that as fuzzy thinking… Growth is always a component of value [and] the very term ‘value investing’ is redundant.

– Warren Buffett, Berkshire Hathaway annual report, 1992

What was the best-performing stock from 1957 to 2003? Siegel answers that it was Philip Morris. Siegel observes:

The superb returns in Philip Morris illustrate an extremely important principle of investing: what counts is not just the growth rate of earnings but the growth of earnings relative to the market’s expectation. One reason investors had low expectations for Philip Morris’s growth was because of its potential liabilities. But its growth has continued apace. The low expectations combined with high growth and a high dividend yield provide the perfect environment for superb investor returns.

What were the top-performing S&P 500 Survivors from 1957 to 2003?

Rank	2003 Name	Accumulation of $1,000	Annual Return
1	Philip Morris	$4,626,402	19.75%
2	Abbott Labs	$1,281,335	16.51%
3	Bristol-Myers Squibb	$1,209,445	16.36%
4	Tootsie Roll Industries	$1,090,955	16.11%
5	Pfizer	$1,054,823	16.03%
6	Coca-Cola	$1,051,646	16.02%
7	Merck	$1,003,410	15.90%
8	PepsiCo	$866,068	15.54%
9	Colgate-Palmolive	$761,163	15.22%
10	Crane	$736,796	15.14%
11	H. J. Heinz	$635,988	14.78%
12	Wrigley	$603,877	14.65%
13	Fortune Brands	$580,025	14.55%
14	Kroger	$546,793	14.41%
15	Schering-Plough	$537,050	14.36%
16	Proctor & Gamble	$513,752	14.26%
17	Hershey Foods	$507,001	14.22%
18	Wyeth	$461,186	13.99%
19	Royal Dutch Petroleum	$398,837	13.64%
20	General Mills	$388,425	13.58%
	S&P 500	$124,486	10.85%

Siegel points out that most of the top twenty performers have strong brands, but are not technology companies per se. Siegel discusses some of these great companies:

Number four on this list is a most unlikely winner – a small manufacturer originally named the Sweets Company of America. This company has outperformed the market by 5 percent a year since the index was formulated. The founder of this firm, an Austrian immigrant, named its product after his five-year-old daughter’s nickname, Tootsie….

The surviving company with the sixth highest return produces a product today with the exact same formula as it did over 100 years ago, much like Tootsie Roll…. Although the company keeps the formula for its drinks secret, it is no secret that Coca-Cola has been one of the best companies you could have owned over the last half century.

…Pepsi also delivered superb returns to its shareholders, coming in at number eight and beating the market by over 4 percent per year.

Two others of the twenty best-performing stocks also manufacture products virtually unchanged over the past 100 years: the William Wrigley Jr. Company and Hershey Foods. Wrigley came in at number twelve, beating the market by almost 4 percent per year, whereas Hershey came in at seventeen, beating the market by 3 percent a year.

Wrigley is the largest gum manufacturer in the world, commanding an almost 50 percent share in the global market and selling in approximately 100 countries. Hershey is currently the number-one U.S.-based publicly traded candy maker (Mars, a private firm, is number one, followed by Swiss-based Nestle).

…Heinz is another strong brand name, one that is virtually synonymous with ketchup. Each year, Heinz sells 650 million bottles of ketchup and makes 11 billion packets of ketchup and salad dressings – almost two packets for every person on earth. But Heinz is just not a ketchup producer, and it does not restrict its focus to the United States. It has the number-one or –two branded business in fifty different countries, with products such as Indonesia’s ABC soy sauce (the second-largest-selling soy sauce in the world) and Honig dry soup, the best-selling soup brand in the Netherlands.

Colgate-Palmolive also makes the list, coming in at number nine. Colgate’s products include Colgate toothpastes, Speed Stick deoderant, Irish Spring soaps, antibacterial Softsoap, and household cleaning products such as Palmolive and Ajax.

No surprise that Colgate’s rival, Procter & Gamble, makes this list as well, at number sixteen. Procter & Gamble began as a small, family-operated soap and candle company in Cincinnati, Ohio, in 1837. Today, P&G sells three hundred products, including Crest, Mr. Clean, Tide, and Tampax, to more than five billion consumers in 140 countries.

…Number twenty on the list is General Mills, another company with strong brands, which include Betty Crocker, introduced in 1921, Wheaties (the ‘Breakfast of Champions’), Cheerios, Lucky Charms, Cinnamon Toast Crunch, Hamburger Helper, and Yoplait yogurt.

What is true about all these firms is that their success came through developing strong brands not only in the United States but all over the world. A well-respected brand name gives the firm the ability to price its product above the competition and deliver more profits to investors.

…Besides the strong consumer brand firms, the pharmaceuticals had a prominent place on the list of best-performing companies. It is noteworthy that there were only six health care companies in the original S&P 500 that survive to today in their original corporate form, and all six made it onto the list of best performers. All of these firms not only sold prescription drugs but also were very successful in marketing brand-name over-the-counter treatments to consumers, very much like the brand-name consumer staples stocks that we have reviewed.

…When these six pharmaceuticals are added to the eleven name-brand consumer firms, seventeen, or 85 percent, of the twenty top-performing firms from the original S&P 500 Index, feature well-known consumer brand names.

 

INVESTOR EXPECTATIONS

What really matters for investors is the price paid today compared to all future free cash flows. But investors very regularly overvalue high-growth companies and undervalue low-growth or no-growth companies. This is the key reason value investing works. As Siegel writes:

Expectations are so important that without even knowing how fast a firm’s earnings actually grow, the data confirm that investors are too optimistic about fast-growing companies and too pessimistic about slow-growing companies. This is just one more confirmation of the growth trap.

Thus, if you want to do well as an investor, it is best to stick with companies trading at low multiples (low P/E, low P/B, low P/S, etc.). All of the studies have confirmed this. See: https://boolefund.com/the-ugliest-stocks-are-the-best-stocks/

Siegel did his own study, dividing S&P 500 Index companies into P/E quintiles. From 1957 to 2003, the lowest P/E quintile – bought at the beginning of each year – produced an average annual return of 14.07% (with a risk of 15.92%), while the highest P/E quintile produced an average annual return of 9.17% (with a risk of 19.39%). The S&P 500 Index averaged 11.18% (with a risk of 17.02%)

If you’re doing buy-and-hold value investing – as Warren Buffett does today – then you can pay a higher price as long as it is still reasonable and as long as the brand is strong enough to persist over time. Buffett has made it clear, however, that if he were managing a small amount of money, he would focus on microcap companies available at cheap prices. That would generate the highest returns, with 50% per year being possible in micro caps for someone like Buffett. See: https://boolefund.com/buffetts-best-microcap-cigar-butts/

Siegel discusses GARP, or growth at a reasonable price:

Advocates here compute a very similar statistic called the PEG ratio, or price-to-earnings ratio divided by the growth rate of earnings. The PEG ratio is essentially the inverse of the ratio that Peter Lynch recommended in his book, assuming you add the dividend yield to the growth rate. The lower the PEG ratio, the more attractively priced a firm is with respect to its projected earnings growth. According to Lynch’s criteria, you would be looking for firms with lower PEG ratios, preferably 0.5 or less, but certainly less than 1.

It’s important to note that earnings growth is very mean-reverting. In other words,most companies that have been growing fast do NOT continue to do so, but tend to slow down quite a bit. That’s why deep value investing – simply buying the cheapest companies (based on low P/E or low EV/EBIT), which usually have low- or no-growth – tends to produce better returns over time than GARP investing does. This is most true, on average, when you invest in cheap microcap companies.

Deep value microcap investing tends to work quite well, especially if you also use the Piotroski F-Score to screen for cheap microcap companies that also have improving fundamentals. This is the approach used by the Boole Microcap Fund. See: https://boolefund.com/cheap-solid-microcaps-far-outperform-sp-500/

One other way to do very well investing in micro caps is to try to find the ones that will grow for a long time. It’s much more difficult to use this approach successfully than it is to buy cheap microcap companies with improving fundamentals. But it is doable with enough patience and discipline. See MicroCapClub.com if you want to learn about some microcap investors who use this approach.

 

GROWTH IS NOT RETURN

Most investors seem to believe that the fastest-growing industries will yield the best returns. But this is simply not true. Siegel compares financials to energy companies:

Of the ten major industries, the financial sector has gained the largest share of market value since the S&P 500 Index was founded in 1957. Financial firms went from less than 1 percent of the index to over 20 percent in 2003, while the energy sector has shrunk from over 21 percent to less than 6 percent over the same period. Had you been looking for the fastest-growing sector, you would have sunk your money in financial stocks and sold your oil stocks.

But if you did so, you would have fallen into the growth trap. Since 1957, the returns on financial stocks have actually fallen behind the S&P 500 Index, while energy stocks have outperformed over the same period. For the long-term investor, the strategy of seeking out the fastest-growing sector is misguided.

Siegel continues by noting that the GICS (Global Industrial Classification Standard) breaks the U.S. and world economy down into ten sectors: materials, industrials, energy, utilities, telecommunication services, consumer discretionary, consumer staples, health care, financial, and information technology. (Recently real estate has been added as an eleventh sector.)

Just as the fastest-growing companies, as a group, underperform the slower growers in terms of investment returns, so new companies underperform the tried and true. Siegel explains what his data show:

These data confirm my basic thesis: the underperformance of new firms is not confined to one industry, such as technology, but extends to the entire market. New firms are overvalued by investors in virtually every sector of the market.

Siegel also answers the question of why energy did so well, despite shrinking from over 21 percent to less than 6 percent of the market:

Why did the energy sector perform so well? The oil firms concentrated on what they did best: extracting oil at the cheapest possible price and returning the profits to the shareholders in the form of dividends. Furthermore investors had low expectations for the growth of energy firms, so these stocks were priced modestly. The low valuations combined with the high dividends contributed to superior investor returns.

Technology firms have experienced high earnings growth. Yet investors have tended to expect even higher growth going forward than what subsequently occurs. Thus we see again that investors systematically overvalue high-growth companies, which leads to returns that trail the S&P 500 Index. Technology may be the best example of this phenomenon. Technology companies have grown very fast, but investors have generally expected too much going forward.

The financial sector is another case of high growth but disappointing (or average) returns. Much of the growth in financials has come from new companies joining the sector and being added to the index. Siegel:

The tremendous growth in financial products has spurred the growth of many new firms. This has caused a steady increase in the market share of the financial sector, but competition has kept the returns on financial stocks close to average over the whole period.

To conclude his discussion of the various sectors, Siegel writes:

The data show that three sectors emerge as long-term winners. They are health care, consumer staples, and energy. Health care and consumer staples comprise 90 percent of the twenty best-performing surviving firms of the S&P 500 Index. These two sectors have the highest proportion of firms where management is focused on bringing quality products to the market and expanding brand-name recognition on a global basis.

The energy sector has delivered above-average returns despite experiencing a significant contraction of its market share. The excellent returns in this sector are a result of two factors: the relatively low growth expectations of investors (excepting the oil and gas extractors during the late 1970s) and the high level of dividends.

 

TECHNOLOGY: PRODUCTIVITY CREATOR AND VALUE DESTROYER

Siegel opens the chapter by remarking:

Economic growth is not the same as profit growth. In fact, productivity growth can destroy profits and with it stock values.

Siegel continues:

Any individual or firm through its own effort can rise above the average, but every individual and firm, by definition, cannot. Similarly, if a single firm implements a productivity-improving strategy that is unavailable to its competition, its profits will rise. But if all firms have access to the same technology and implement it, then costs and prices will fall and the gains of productivity will go to the consumer.

Siegel notes that Buffett had to deal with this type of issue when he was managing Berkshire Hathaway, a textile manufacturer. Buffett discussed plans presented to him that would improve workers’ productivity and lower costs:

Each proposal to do so looked like an immediate winner. Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable investments in our highly profitable candy and newspaper businesses.

Yet Buffett realized that the proposed improvements were available to all textile companies. Buffett commented in his 1985 annual report:

[T]he promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide. Viewed individually, each company’s investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.

Eventually, after a decade, Buffett realized he had to close the company. (He had kept it open for a decade out of concern for the employees, and because management was doing an excellent job with the hand it was dealt.) Siegel comments:

Buffett contrasts his decision to close up shop with that of another textile company that opted to take a different path, Burlington Industries. Burlington Industries spent approximately $3 billion on capital expenditures to modernize its plants and equipment and improve its productivity in the twenty years following Buffett’s purchase of Berkshire. Nevertheless, Burlington’s stock returns badly trailed the market. As Buffett states, ‘This devastating outcome for the shareholders indicates what can happen when much brain power and energy are applied to a faulty premise.’

Siegel then draws a broader conclusion about technology:

Historical economic data indicate that the fruits of technological change, no matter how great, have ultimately benefited consumers, not the owners of firms. Productivity lowers the price of goods and raises the real wages of workers. That is, productivity allows us to buy more with less.

Certainly, technological change has transitory effects on profits. There is usually a ‘first mover’ advantage. When one firm incorporates a new technology that has not yet been implemented by others, profits will increase. But as others avail themselves of this technology, competition ensures that prices will fall and profits will revert to normal.

 

WINNING MANAGEMENTS IN LOSING INDUSTRIES

Siegel quotes Peter Lynch:

As a place to invest, I’ll take a lousy industry over a great industry anytime. In a lousy industry, one that’s growing slowly if at all, the weak drop out and the survivors get a bigger share of the market. A company that can capture an ever-increasing share of a stagnant market is a lot better off than one that has to struggle to protect a dwindling share of an exciting market.

Many investors try to look for an industry with a bright future, and then select a company that will benefit from this growth. As we’ve already seen, this doesn’t work in general because investors systematically overvalue high-growth companies.

A deep value investment strategy looks for companies at low multiples, with terrible performance. These companies, as a group, have done much better than the market over time.

Although a deep value approach works well even if it is entirely quantitative – which is what Ben Graham, the father of value investing, often did – it can work even better if you can identify a winning management. Siegel explains:

… some of the most successful investments of the last thirty years have come from industries whose performances have been utterly horrendous.

These companies have bucked the trend. They all rose above their competitors by following a simple approach: maximize productivity and keep costs as low as possible.

Siegel gives Southwest Airlines as an example. Investors have lost more money in the airline industry than in any other. But Southwest Airlines established itself as ‘the low-fare airline.’ It accomplished this by being the low-cost airline. It offered only single-class service, with no assigned seats and no meals. It only operated city-to-city where demand was high enough. And it only used Boeing 737’s. As a result of being the low-cost and low-fare airline, the business performedwell and the stock followed.

Siegel also mentionsthe example of Nucor, which pioneered the use of ‘minimill’ technology and the recycling of scrap steel. While the steel industry as a whole underperformed the market by close to 4 percent a year for thirty years, Nucor outperformed the market by over 5 percent a year over the same time period. According to Jim Collins and others, at least 80 percent of Nucor’s success had to do with the leadership and culture of the company. At Nucor, executives actually received fewer benefits than regular workers:

• All workers were eligible to receive $2,000 per year for each child for up to four years of postsecondary education, while the executives received no such benefit.
• Nucor lists all of its employees – more than 9,800 – in its annual report, sorted alphabetically with no distinctions for officer titles.
• There are no assigned parking spots and no company cars, boats, or planes.
• All employees of the company receive the same insurance coverage and amount of vacation time.
• Everybody wears the same green spark-proof jackets and hard hats on the floor (in most integrated mills, different colors designate authority).

Siegel quotes Buffett:

It is the classic example of an incentive program that works. If I were a blue-collar worker, I would like to work for Nucor.

In stark contrast, Bethlehem Steel had executives using the corporate fleet for personal reasons, like taking children to college or weekend vacations. Bethlehem also renovated a country club with corporate funds, at which shower priority was determined by executive rank, notes Siegel.

Siegel concludes his discussion of Southwest Airlines and Nucor (and Wal-Mart):

The success of these firms must make investors stop and think. The best-performing stocks are not in industries that are at the cutting edge of the technological revolution; rather, they are often in industries that are stagnant or in decline. These firms are headed by managements that find and pursue efficiencies and develop competitive niches that enable them to reach commanding positions no matter what industry they are in. Firms with these characteristics, which are often undervalued by the market, are the ones that investors should want to buy.

Another great example of a company implementing a low-cost business strategy is 3G Capital, a Brazilian investment firm. (3G was founded in 2004 by Jorge Paulo Lemann, Carlos Alberto Sicupira, and Marcel Herrmann Telles.) 3G is best known for partnering with Buffett’s Berkshire Hathaway for its acquisitions, including Burger King, Tim Hortons, and Kraft Foods. When 3G acquires a company, they typically implement deep cost cuts.

 

REINVESTED DIVIDENDS: THE BEAR MARKET PROTECTOR AND RETURN ACCELERATOR

Siegel explains what can happen to a dividend-paying stock during a bear market: If the stock price falls more than the dividend, then the higher dividend yield can then be used to reinvest, leading to a higher share count than otherwise. The Great Depression led to a 25-year period – October 1929 to November 1954 – during which stocks plunged and then took a long time to recover. Most investors did not do well, often because they could not or did not hold on to their shares. But investors with dividend-paying stocks who reinvested those dividends did quite well, as Siegel notes:

Instead of just getting back to even in November 1954, stockholders who reinvested their dividends (indicated as ‘total return’) realized an annual rate of return of 6 percent per year, far outstripping those who invested in either long- or short-term government bonds. In fact, $1,000 invested in stocks at the market peak turned into $4,440 when the Dow finally recovered to its old high on that November day a quarter century later. Although the price appreciation was zero, the $4,400 that resulted solely from reinvesting dividends was almost twice the accumulation in bonds and four times the accumulation in short-term treasury bills.

Siegel concludes:

There is an important lesson to be taken from this analysis. Market cycles, although difficult on investors’ psyches, generate wealth for long-term stockholders. These gains come not through timing the market but through the reinvestment of dividends.

Bear markets are not only painful episodes that investors must endure; they are also an integral reason why investors who reinvest dividends experience sharply higher returns. Stock returns are generated not by earnings and dividends alone but by the prices that investors pay for these cash flows. When pessimism grips shareholders, those who stay with dividend-paying stocks are the big winners.

The same logic applies to individual stocks. If a company is a long-term survivor (or leader), then short-term bad news causing the stock to drop will enhance your long-term returns if you’re reinvesting dividends. This is also true if you’re dollar-cost averaging.

In theory, share repurchases when the stock is low can work even better than dividends because share repurchases create tax-deferred gains. In practice, Siegel observes, management is often not as committed to a policy of share repurchases as it is to paying dividends. Once a dividend is being paid, the market usually views a reduced dividend unfavorably. Also, shareholders can track dividends more easily than share repurchases. In sum, when a stock is low, it is usually better for shareholders if they can reinvest dividends instead of relying on management to repurchase shares.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: https://boolefund.com/best-performers-microcap-stocks/

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

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

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

 

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

My e-mail: 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.

March 3, 2024

Ian Cassell and Sean Iddings are successful microcap investors who co-authored the book, Intelligent Fanatics Project: How Great Leaders Build Sustainable Businesses (Iddings Cassel Publishing, 2016). Ian Cassell is the founder of www.MicroCapClub.com.

If a microcap company is led by an intelligent fanatic, then it has a good chance of becoming a much larger company over time. So, for a long-term investor, it makes sense to look for an intelligent fanatic who is currently leading a microcap company. Cassel:

I want to find Reed Hastings in 2002, when Netflix (NFLX) was a $150 million market cap microcap (now worth $38 billion). I want to find Bruce Cozadd in 2009, when Jazz Pharmaceuticals (JAZZ) was a $50 million market cap microcap (now worth $9 billion).

All great companies started as small companies, and intelligent fanatics founded most great companies. So how do we find these rare intelligent fanatics early? We find them by studying known intelligent fanatics and their businesses. We look for common elements and themes, to help us in our search for the next intelligent fanatic-led business.

The term intelligent fanatic is originally from Charlie Munger. Cassel defines the term:

CEO or management team with large ideas and fanatical drive to build their moat. Willing and able to think and act unconventionally. A learning machine that adapts to constant change. Focused on acquiring the best talent. Able to create a sustainable corporate culture and incentivize their operations for continual progress. Their time horizon is in five- or ten-year increments, not quarterly, and they invest in their business accordingly. Regardless of the industry, they are able to create a moat [– i.e., a sustainable competitive advantage].

Cassel and Iddings give eight examples of intelligent fanatics:

• Father of Sales and Innovation: John H. Patterson–National Cash Register
• Retail Maverick: Simon Marks–Marks & Spencer
• Original Warehouse Pioneer: Sol Price–Fedmart and Price Club
• King of Clever Systems: Les Schwab–Les Schwab Tire Centers
• Low-Cost Airline Wizard: Herb Kelleher–Southwest Airlines
• Cult of Convenience: Chester Cadieux–QuikTrip
• Leader of Steel: Kenneth Iverson–Nucor
• Human Capital Allocators: 3G Partners–Garantia…

Cassel and Iddings conclude by summarizing the intelligent fanatic model.

 

FATHER OF SALES AND INNOVATION: JOHN H. PATTERSON

Patterson purchased control of National Manufacturing Company, the originator of the cash register, in 1885, five years after the company had been formed. Prospects did not appear good at all:

Everything was against a business selling cash registers at that time. There was virtually no demand for cash registers. Store owners could not justify the cost of the machine, which in today’s dollars would be roughly $1,000. Patterson’s peers mocked his purchase of such a poor business, yet Patterson had a bold vision of what the cash register market could be, and he knew it would make a significant impact.

Patterson had had a great experience with the cash register. His store in Coalton, Ohio, had immediately turned losses into profits simply by buying and installing a cash register. It is hard to imagine now but employee theft at retail operations was common, given the primitive form of record keeping in those days. Patterson knew the power of the cash register and needed to help merchants understand its value, too.

Patterson believed in staying ahead of what the current market was demanding:

We have made a policy to be just a short distance ahead, for the cash register has always had to make its market. We had to educate our first customers; we have to educate our present-day customer; and our thought has always been to keep just so far ahead that education of the buyer will always be necessary. Thus the market will be peculiarly our own–our customers will feel that we are their natural teachers and leaders.

…We are always working far ahead. If the suggestions at the tryout demonstrate that the model will be much more valuable with changes or improvements, then send them out again to be tried. And we keep up this process until every mechanical defect has been overcome and the model includes every feasible suggestion.

Few people at the time believed that the cash register would be widely adopted. But Patterson predicted at least one cash register for every four hundred citizens in a town. He was basically right.

Patterson started out working at the store on the family farm. He was frustrated by the poor recordkeeping. The employee books never reconciled.

Patterson then got a job as a toll collector at the Dayton office on the Miami and Erie Canal. There were always arguments, with the bargemen complaining about higher tolls at certain locations. Patterson solved the issue by developing a system of receipts, all of which would be sent to toll headquarters.

Patterson had extra time as a toll collector, so he started selling coal and wood out of his office. He learned that he could differentiate himself by selling quality coal delivered on time and in the right quantity. He also used the best horses, the best scales, and the best carts. He made sure everything was quality and high-class. His main challenge was that he never seemed to have enough cash since he was always reinvesting in the business, including advertising.

Eventually Patterson and his brother owned three coal mines, a store, and a chain of retail coal yards. He had trouble with his mine store in Coalton, Ohio. Revenues were high, but there were no profits and debt was growing. He discovered that some clerks were only charging for half the coal. Patterson bought two cash registers and hired new clerks. Six months later, the debt was almost zero and there were profits.

Patterson then entered a venture to take one-third of the profits for operating the Southern Coal and Iron Company. Unfortunately, this proved to be a disaster. Patterson lost three years of his life and half his investment.

Meanwhile, Patterson had purchased stock in the cash register manufacturer National Manufacturing Company. Patterson was also on the board of the company. Patterson came up with a plan to increase sales, but the controlling shareholder and CEO, George Phillips, did not agree. Patterson sold most of his stock.

But Patterson still believed in the idea of the cash register. He was able to buy shares in National Manufacturing Company from George Phillips. Patterson became the butt of Dayton jokes for buying such a bad business. Patterson even tried to give his shares back to Phillips, but Phillips wouldn’t take them even as a gift. So Patterson formed the National Cash Register Company.

Patterson started advertising directly to prospects through the mail. He then sent highly qualified salesmen to those same prospects. Patterson decided to pay his salesmen solely on commission and with no cap on how much they could make. This was unconventional at the time, but it created effective incentives. Patterson also bought expensive clothes for his salesmen, and at least one fine gown for the salesman’s wife. As a result, the salesmen became high-quality and they also wanted a better standard of living.

Moreover, Patterson systematized the sales pitches of his salesmen. This meant even salesmen with average ability could and did evolve into great salesmen. Patterson also designated specific territories for the salesmen so that the salesmen wouldn’t be competing against one another.

Patterson made sure that salesmen and also manufacturing workers were treated well. When he built new factories, he put in wall-to-wall glass windows, good ventilation systems, and dining rooms where employees could get decent meals at or below cost. Patterson also made sure his workers had the best tools. These were unusual innovations at the time.

Patterson also instituted a profit-sharing plan for all employees.

National Cash Register now had every worker aligned with common goals: to increase efficiency, cut costs, and improve profitability.

Patterson was always deeply involved in the research and development of the cash register. He often made sketches of new ideas in a memo book. He got a few of these ideas patented.

NCR’s corporate culture and strategies were so powerful that John H. Patterson produced more successful businessmen than the best university business departments of the day. More than a dozen NCR alumni went on to head large corporations, and many more went on to hold high corporate positions.

Cassel and Iddings sum it up:

Patterson was a perpetual beginner. He bought NCR without knowing much of anything about manufacturing – except that he wanted to improve every business owner’s operations. From his experiences, he took what he knew to be right and paid no attention to convention. John Patterson not only experimented with improving the cash register machine but also believed in treating employees extremely well. Many corporations see their employees as an expense line item; intelligent fanatics see employees as a valuable asset.

When things failed or facts changed, Patterson showed an ability to pivot…

…He was able to get every one of his workers to think like owners, through his profit-sharing plan. Patterson was always looking to improve production, so he made sure that every employee had a voice in improving the manufacturing operations.

 

RETAIL MAVERICK: SIMON MARKS

Marks & Spencer was started by Michael Marks as a small outdoor stall in Leeds. By 1923, when Michael’s son Simon was in charge, the company had grown significantly. But Simon Marks was worried that efficient American competitors were going to wage price wars and win.

So Marks went to the U.S. to study his competitors. (Walmart founder Sam Walton would do this four decades later.) When Marks returned to Britain, he delivered a comprehensive report to his board:

I learned the value of more commodious and imposing premises. I learned the value of checking lists to control stocks and sales. I learned that new accounting machines could help to reduce the time formidably, to give the necessary information in hours instead of weeks. I learned the value of counter footage and how in the chain store operation each foot of counter space had to pay wages, rent, overhead expenses, and profit. There could be no blind spots insofar as goods are concerned. This meant a much more exhaustive study of the goods we were selling and the needs of the public. It meant that the staff who were operating with me had to be reeducated and retrained.

Cassel and Iddings:

…Simon Marks had been left a company with a deteriorating moat and a growing list of competitors. He had the prescience and boldness to take a comfortable situation, a profitable, growing Marks & Spencer, and to take risks to build a long-term competitive edge. From that point on, it could have been observed that Simon Marks had only one task – to widen Marks & Spencer’s moat every day for the rest of his life and to provide investors with uncommon profits.

Simon Marks convinced manufacturers that the retailer and manufacturer, by working together without the wholesale middleman, could sell at lower prices. Marks made sure to maintain the highest quality at the lowest prices, making up for low profit margins with high volume.

Simon Marks was rare. He was able to combine an appreciation for science and technology with an industry that had never cared to utilize it, all the while maintaining ‘a continuing regard for the individual, either as a customer or employee, and with a deep responsibility for his welfare and well-being.’ Marks & Spencer’s tradition of treating employees well stretched all the way back to Michael Marks’s Penny Bazaars in the covered stalls of Northern England… To Simon Marks, a happy and contented staff was the most valuable asset of any business.

Simon Marks established many policies to better Marks & Spencer’s labor relations, leading to increased employee efficiency and productivity…

Marks introduced dining rooms to provide free or low-cost meals to employees of stores. Marks even put hair salons in stores so the female workforce could get their hair done during lunch. He also provided free or reduced-cost health insurance. Finally, he set up the Marks & Spencer Benevolent Trust to provide for the retirement of employees. These moves were ahead of their time and led to low employee turnover and high employee satisfaction.

 

ORIGINAL WAREHOUSE PIONEER: SOL PRICE

Sol Price founded Price Club in 1976. The company lost $750,000 during its first year. But by 1979, revenues reached $63 million, with $1.1 million in after-tax profits.

The strategy was to sell a limited number of items – 1,500 to 5,000 items versus 20,000+ offered by discounters – at a small markup from wholesale, to a small group of members (government workers and credit union customers).

Before founding Price Club, Sol Price founded and built FedMart from one location in 1954 into a company with $361 million in revenue by 1975.

…Thus, when Sol Price founded Price Club, other savvy retailers, familiar with this track record, were quick to pay close attention. These retailers made it their obligation to meet Price, to learn as much as possible, and to clone Price’s concept. They knew that the market opportunity was large and that Sol Price was an intelligent fanatic with a great idea. An astute investor could have done the same and partnered with Price early in 1980 by buying Price Club stock.

One savvy retailer who found Sol Price early in the development of Price Club was Bernard Marcus, cofounder of Home Depot. After getting fired from the home improvement company Handy Dan, Marcus met with Price, in the late 1970s. Marcus was looking for some advice from Price about a potential legal battle with his former employer. Sol Price had a similar situation at FedMart. He told Marcus to forget about a protracted legal battle and to start his own business.

Marcus borrowed many ideas from Price Club when he cofounded Home Depot. Later, Sam Walton copied as much as he could from Price Club when he founded Walmart. Walton:

I guess I’ve stolen – I actually prefer the word borrowed – as many ideas from Sol Price as from anyone else in the business.

Bernie Brotman tried to set up a deal to franchise Price Clubs in the Pacific Northwest. But Sol Price and his son, Richard Price, were reluctant to franchise Price Club. Brotman’s son, Jeff Brotman, convinced Jim Sinegal, a long-time Price Club employee, to join him and start Costco, in 1983.

Brotman and Sinegal cloned Price Club’s business model and, in running Costco, copied many of Sol Price’s strategies. A decade later, Price Club merged with Costco, and many Price Club stores are still in operation today under the Costco name.

Back in 1936, Sol Price graduated with a bachelor’s degree in philosophy. He got his law degree in 1938. Sol Price worked for Weinberger and Miller, a local law firm in San Diego. He represented many small business owners and learned a great deal about business.

Thirteen years later, Price founded FedMart after noticing a nonprofit company, Fedco, doing huge volumes. Price set up FedMart as a nonprofit, but created a separate for-profit company, Loma Supply, to manage the stores. Basically, everything was marked up 5% from cost, which was the profit Loma Supply got.

FedMart simply put items on the shelves and let the customers pick out what they wanted. This was unusual at the time, but it helped FedMart minimize costs and thus offer cheaper prices for many items.

By 1959, FedMart had grown to five stores and had $46.3 million in revenue and nearly $500,000 in profits. FedMart went public that year and raised nearly $2 million for expansion.

In 1962, Sam Walton had opened the first Walmart, John Geisse had opened the first Target, and Harry Cunningham had opened the first Kmart, all with slight variations on Sol Price’s FedMart business model.

By the early 1970s, Sol Price wasn’t enjoying managing FedMart as much. He remarked that they were good at founding the business, but not running it.

While traveling in Europe with his wife, Sol Price was carefully observing the operations of different European retailers. In particular, he noticed a hypermarket retailer in Germany named Wertkauf, run by Hugo Mann. Price sought to do a deal with Hugo Mann as a qualified partner. But Mann saw it as a way to buy FedMart. After Mann owned 64% of FedMart, Sol Price was fired from the company he built. But Price didn’t let that discourage him.

Like other intelligent fanatics, Sol Price did not sit around and mourn his defeat. At the age of 60, he formed his next venture less than a month after getting fired from FedMart. The Price Company was the name of this venture, and even though Sol Price had yet to figure out a business plan, he was ready for the next phase of his career.

…What the Prices [Sol and his son, Robert] ended up with was a business model similar to some of the concepts Sol had observed in Europe. The new venture would become a wholesale business selling merchandise to other businesses, with a membership system similar to that of the original FedMart but closer to the ‘passport’ system used by Makro, in the Netherlands, in a warehouse setting. The business would attract members with its extremely low prices.

During the first 45 days, the company lost $420,000.

Instead of doing nothing or admitting defeat, however, Sol Price figured out the problem and quickly pivoted.

Price Club had incorrectly assumed that variety and hardware stores would be large customers and that the location would be ideal for business customers. A purchasing manager, however, raised the idea of allowing members of the San Diego City Credit Union to shop at Price Club. After finding out that Price Club could operate as a retail shop, in addition to selling to businesses, the company allowed credit union members to shop at Price Club. The nonbusiness customers did not pay the $25 annual business membership fee but got a paper membership pass and paid an additional 5% on all goods. Business members paid the wholesale price. The idea worked and sales turned around, from $47,000 per week at the end of August to $151,000 for the week of November 21. The Price Club concept was now proven.

Sol Price’s idea was to have the smallest markup from cost possible and to make money on volume. This was unconventional.

Price also sought to treat his employees well, giving them the best wages and providing the best working environment. By treating employees well, he created happy employees who in turn treated customers well.

Instead of selling hundreds of thousands of different items, Sol Price thought that focusing on only a few thousand items would lead to greater efficiency and lower costs. Also, Price was able to buy in larger quantities, which helped. This approach gave customers the best deal. Customers would typically buy a larger quantity of each good, but would generally save over time by paying a lower price per unit of volume.

Sol Price also saved money by not advertising. Because his customers were happy, he relied on unsolicited testimonials for advertising. (Costco, in turn, has not only benefitted from unsolicited testimonials, but also from unsolicited media coverage.)

Jim Sinegal commented:

The thing that was most remarkable about Sol was not just that he knew what was right. Most people know the right thing to do. But he was able to be creative and had the courage to do what was right in the face of a lot of opposition. It’s not easy to stick to your guns when you have a lot of investors saying that you’re not charging customers enough and you’re paying employees too much.

Over a thirty-eight year period, including FedMart and then Price Club until the Costco merger in 1993, Sol Price generated roughly a 40% CAGR in shareholder value.

 

KING OF CLEVER SYSTEMS: LES SCHWAB

Les Schwab knew how to motivate his people through clever systems and incentives. Schwab realized that allowing his employees to become highly successful would help make Les Schwab Tire Centers successful.

Schwab split his profits with his first employees, fifty-fifty, which was unconventional in the 1950s. Schwab would reinvest his portion back into the business. Even early on, Schwab was already thinking about massive future growth.

As stores grew and turned into what Schwab called ‘supermarket’ tire centers, the number of employees needed to manage the operations increased, from a manager with a few helpers to six or seven individuals. Schwab, understanding the power of incentives, asked managers to appoint their best worker as an assistant manager and give him 10% of the store’s profits. Schwab and the manager each would give up 5%.

…Les Schwab was never satisfied with his systems, especially the employee incentives, and always strove to develop better programs.

…Early on, it was apparent that Les Schwab’s motivation was not to get rich but to provide opportunities for young people to become successful, as he had done in the beginning. This remained his goal for decades. Specifically, his goal was to share the wealth. The company essentially has operated with no employees, only partners. Even the hourly workers were treated like partners.

When Schwab was around fifteen years old, he lost his mother to pneumonia and then his father to alcohol. Schwab started selling newspapers. Later as a circulation manager, he devised a clever incentive scheme for the deliverers. Schwab always wanted to help others succeed, which in turn would help the business succeed.

The desire to help others succeed can be a powerful force. Les Schwab was a master at creating an atmosphere for others to succeed through clever programs. Les always told his manager to make all their people successful, because he believed that the way a company treated employees would directly affect how employees would treat the customer. Schwab also believed that the more he shared with employees, the more the business would succeed, and the more resources that would eventually be available to give others opportunities to become successful. In effect, he was compounding his giving through expansion of the business, which was funded from half of his profits.

Once in these programs, it would be hard for employees and the company as a whole not to become successful, because the incentives were so powerful. Schwab’s incentive system evolved as the business grew, and unlike most companies, those systems evolved for the better as he continued giving half his profits to employees.

Like other intelligent fanatics, Schwab believed in running a decentralized business. This required good communication and ongoing education.

 

LOW-COST AIRLINE WIZARD: HERB KELLEHER

The airline industry has been perhaps the worst industry ever. Since deregulation in 1978, the U.S. airline industry alone has lost $60 billion.

Southwest Airlines is nearing its forty-third consecutive year of profitability. That means it has made a profit nearly every year of its corporate life, minus the first fifteen months of start-up losses. Given such an incredible track record in a horrible industry, luck cannot be the only factor. There had to be at least one intelligent fanatic behind its success.

…In 1973, the upstart Texas airline, Southwest Airlines, with only three airplanes, turned the corner and reached profitability. This was a significant achievement, considering that the company had to overcome three and a half years of legal hurdles by two entrenched and better-financed competitors: Braniff International Airways had sixty-nine aircraft and $256 million in revenues, and Texas International had forty-five aircraft with $32 million in revenues by 1973.

As a young man, Herb ended up living with his mother after his older siblings moved out and his father passed away. Kelleher says he learned about how to treat people from his mother:

She used to sit up talking to me till three, four in the morning. She talked a lot about how you should treat people with respect. She said that positions and titles signify absolutely nothing. They’re just adornments; they don’t represent the substance of anybody… She taught me that every person and every job is worth as much as any other person or any other job.

Kelleher ended up applying these lessons at Southwest Airlines. The idea of treating employees well and customers well was central.

Kelleher did not graduate with a degree in business, but with a bachelor’s degree in English and philosophy. He was thinking of becoming a journalist. He ended up becoming a lawyer, which helped him get into business later.

When Southwest was ready to enter the market in Texas as a discount airline, its competitors were worried.

With their large resources, competitors did everything in their power to prevent Southwest from getting off the ground, and they were successful in temporarily delaying Southwest’s first flight. The incumbents filed a temporary restraining order that prohibited the aeronautics commission from issuing Southwest a certificate to fly. The case went to trial in the Austin state court, which did not support another carrier entering the market.

Southwest proceeded to appeal the lower court decision that the market could not support another carrier. The intermediate appellate court sided with the lower court and upheld the ruling. In the meantime, Southwest had yet to make a single dollar in revenues and had already spent a vast majority of the money it had raised.

The board was understandably frustrated. At this point, Kelleher said he would represent the company one last time and pay every cent of legal fees out of his own pocket. Kelleher convinced the supreme court to rule in Southwest’s favor. Meanwhile, Southwest hired Lamar Muse as CEO, who was an experienced, iconoclastic entrepreneur with an extensive network of contacts.

Herb Kelleher was appointed CEO in 1982 and ran Southwest until 2001. He led Southwest from $270 million to $5.7 billion in revenues, every year being profitable. This is a significant feat, and no other airline has been able to match that kind of record in the United States. No one could match the iron discipline that Herb Kelleher instilled in Southwest Airlines from the first day and maintained so steadfastly through the years.

Before deregulation, flying was expensive. Herb Kelleher had the idea of offering lower fares. To achieve this, Southwest did four things.

• First, they operated out of less-costly and less-congested airports. Smaller airports are usually closer to downtown locations, which appealed to businesspeople.
• Second, Southwest only operated the Boeing 737. This gave the company bargaining power in new airplane purchases and the ability to make suggestions in the manufacture of those plans to improve efficiency. Also, operating costs were lower because everyone only had to learn to operate one type of plane.
• Third, Southwest reduced the amount of time planes were on the ground to 10 minutes (from 45 minutes to an hour).
• Fourth, Southwest treats employees well and is thus able to retain qualified, hardworking employees. This cuts down on turnover costs.

Kelleher built an egalitarian culture at Southwest where each person is treated like everyone else. Also, Southwest was the first airline to share profits with employees. This makes employees think and act like owners. As well, employees are given autonomy to make their own decisions, as an owner would. Not every decision will be perfect, but inevitable mistakes are used as learning experiences.

Kelleher focused the company on being entrepreneurial even as the company grew. But simplifying did not include eliminating employees.

Southwest Airlines is the only airline – and one of the few corporations in any industry – that has been able to run for decades without ever imposing a furlough. Cost reductions are found elsewhere, and that has promoted a healthy morale within the Southwest Airlines corporate culture. Employees have job security. A happy, well-trained labor force that only needs to be trained on one aircraft promotes more-efficient and safer flights. Southwest is the only airline that has a nearly perfect safety record.

Kelleher once told the following story:

What I remember is a story about Thomas Watson. This is what we have followed at Southwest Airlines. A vice president of IBM came in and said, ‘Mr. Watson, I’ve got a tremendous idea…. And I want to set up this little division to work on it. And I need ten million dollars to get it started.’ Well, it turned out to be a total failure. And the guy came back to Mr. Watson and he said that this was the original proposal, it cost ten million, and that it was a failure. ‘Here is my letter of resignation.’ Mr. Watson said, ‘Hell, no! I just spent ten million on your education. I ain’t gonna let you leave.’ That is what we do at Southwest Airlines.

One example is Matt Buckley, a manager of cargo in 1985. He thought of a service to compete with Federal Express. Southwest let him try it. But it turned out to be a mistake. Buckley:

Despite my overpromising and underproducing, people showed support and continued to reiterate, ‘It’s okay to make mistakes; that’s how you learn.’ In most companies, I’d probably have been fired, written off, and sent out to pasture.

Kelleher believed that any worthwhile endeavor entails some risk. You have to experiment and then adjust quickly when you learn what works and what doesn’t.

Kelleher also created a culture of clear communication with employees, so that employees would understand in more depth how to minimize costs and why it was essential.

Communication with employees at Southwest is not much different from the clear communication Warren Buffett has had with shareholders and with his owned operations, through Berkshire Hathaway’s annual shareholder letters. Intelligent fanatics are teachers to every stakeholder.

 

CULT OF CONVENIENCE: CHESTER CADIEUX

Warren Buffett:

Back when I had 10,000 bucks, I put 2,000 of it into a Sinclair service station, which I lost, so my opportunity cost on it’s about 6 billion right now. A fairly big mistake – it makes me feel good when Berkshire goes down, because the cost of my Sinclair station goes down too.

Chester Cadieux ran into an acquaintance from school, Burt B. Holmes, who was setting up a bantam store – an early version of a convenience store. Cadieux invested $5,000 out of the total $15,000.

At the time, in 1958, there were three thousand bantam stores open. They were open longer hours than supermarkets, which led customers to be willing to pay higher prices.

Cadieux’s competitive advantage over larger rivals was his focus on employees and innovation. Both characteristics were rooted in Chester’s personal values and were apparent early in QuikTrip’s history. He would spend a large part of his time – roughly two months out of the year – in direction communication with QuikTrip employees. Chester said, ‘Without fail, each year we learned something important from a question or comment voiced by a single employee.’ Even today, QuikTrip’s current CEO and son of Chester Cadieux, Chet Cadieux, continues to spend four months of his year meeting with employees.

Cassel and Iddings:

Treat employees well and incentivize them properly, and employees will provide exceptional service to the customers. Amazing customer service leads to customer loyalty, and this is hard to replicate, especially by competitors who don’t value their employees. Exceptional employees and a quality corporate culture have allowed QuikTrip to stay ahead of competition from convenience stores, gas retailers, quick service restaurants, cafes, and hypermarkets.

Other smart convenience store operators have borrowed many ideas from Chester Cadieux. Sheetz, Inc. and Wawa, Inc. – both convenience store chains headquartered in Pennsylvania – have followed many of Cadieux’s ideas. Cadieux, in turn, has also picked up a few ideas from Sheetz and Wawa.

Sheetz, Wawa, and QuikTrip all have similar characteristics, which can be traced back to Chester Cadieux and his leadership values at QuikTrip. When three stores in the same industry, separated only by geography, utilize the same strategies, have similar core values, and achieve similar success, then there must be something to their business models. All could have been identified early, when their companies were much smaller, with qualitative due diligence.

One experience that shaped Chester Cadieux was when he was promoted to first lieutenant at age twenty-four. He was the senior intercept controller at his radar site, and he had to lead a team of 180 personnel:

…he had to deal with older, battle-hardened sergeants who did not like getting suggestions from inexperienced lieutenants. Chester said he learned ‘how to circumvent the people who liked to be difficult and, more importantly, that the number of stripes on someone’s sleeves was irrelevant.’ The whole air force experience taught him how to deal with people, as well as the importance of getting the right people on his team and keeping them.

When Cadieux partnered with Burt Holmes on their first QuikTrip convenience store, it seemed that everything went wrong. They hadn’t researched what the most attractive location would be. And Cadieux stocked the store like a supermarket. Cadieux and Holmes were slow to realize that they should have gone to Dallas and learned all they could about 7-Eleven.

QuikTrip was on the edge of bankruptcy during the first two or three years. Then the company had a lucky break when an experienced convenience store manager, Billy Neale, asked to work for QuikTrip. Cadieux:

You don’t know what you don’t know. And when you figure it out, you’d better sprint to fix it, because your competitors will make it as difficult as possible in more ways than you could ever have imagined.

Cadieux was smart enough to realize that QuikTrip survived partly by luck. But he was a learning machine, always learning as much as possible. One idea Cadieux picked up was to sell gasoline. He waited nine years until QuikTrip had the financial resources to do it. Cadieux demonstrated that he was truly thinking longer term.

QuikTrip has always adapted to the changing needs of its customers, demographics, and traffic patterns, and has constantly looked to stay ahead of competition. This meant that QuikTrip has had to reinvest large sums of capital into store updates, store closures, and new construction. From QuikTrip’s inception, in 1958, to 2008, the company closed 418 stores; in 2008, QuikTrip had only five hundred stores in operation.

QuikTrip shows its long-term focus by its hiring process. Cadieux:

Leaders are not necessarily born with the highest IQs, or the most drive to succeed, or the greatest people skills. Instead, the best leaders are adaptive – they understand the necessity of pulling bright, energetic people into their world and tapping their determination and drive. True leaders never feel comfortable staying in the same course for too long or following conventional wisdom – they inherently understand the importance of constantly breaking out of routines in order to recognize the changing needs of their customers and employees.

QuikTrip interviews about three out of every one hundred applicants and then chooses one from among those three. Only 70% of new hires make it out of training, and only 50% of those remaining make it past the first 6 months on the job. But QuikTrip’s turnover rate is roughly 13% compared to the industry average of 59%. These new hires are paid $50,000 a year. And QuikTrip offers a generous stock ownership plan. Employees also get medical benefits and a large amount of time off.

Cadieux’s main goal was to make employees successful, thereby making customers and eventually shareholders happy.

 

LEADER OF STEEL: F. KENNETH IVERSON

Ken Iverson blazed a new trail in steel production with the mini mill, thin-slab casting, and other innovations. He also treated his employees like partners. Both of these approaches were too unconventional and unusual for the old, slow-moving, integrated steel mills to compete with. Ken Iverson harnessed the superpower of incentives and effective corporate culture. He understood how to manage people and had a clear goal.

In its annual report in 1975, Nucor had all of its employees listed on the front cover, which showed who ran the company. Every annual report since then has listed all employees on the cover. Iverson:

I have no desire to be perfect. In fact, none of the people I’ve seen do impressive things in life are perfect… They experiment. And they often fail. But they gain something significant from every failure.

Iverson studied aeronautical engineering at Cornell through the V-12 Navy College Training Program. Iverson spent time in the Navy, and then earned a master’s degree in mechanical engineering from Purdue University. Next he worked as an assistant to the chief research physicist at International Harvester.

Iverson’s supervisor told him you can achieve more at a small company. So Iverson started working as the chief engineer at a small company called Illium Corp. Taking chances was encouraged. Iverson built a pipe machine for $5,000 and it worked, which saved the company $245,000.

Iverson had a few other jobs. He helped Nuclear Corporation of America find a good acquisition – Vulcraft Corporation. After the acquisition, Vulcraft made Iverson vice president. The company tripled its sales and profits over the ensuing three years, while the rest of Nuclear was on the verge of bankruptcy. When Nuclear’s president resigned, Iverson became president of Nuclear.

Nuclear Corporation changed its name to Nucor. Iverson cut costs. Although few could have predicted it, Nucor was about to take over the steel industry. Iverson:

At minimum, pay systems should drive specific behaviors that make your business competitive. So much of what other businesses admire in Nucor – our teamwork, extraordinary productivity, low costs, applied innovation, high morale, low turnover – is rooted in how we pay our people. More than that, our pay and benefit programs tie each employee’s fate to the fate of our business. What’s good for the company is good – in hard dollar terms – for the employee.

The basic incentive structure had already been in place at Vulcraft. Iverson had the sense not to change it, but rather to improve it constantly. Iverson:

As I remember it, the first time a production bonus was over one hundred percent, I thought that I had created a monster. In a lot of companies, I imagine many of the managers would have said, ‘Whoops, we didn’t set that up right. We’d better change it.’ Not us. We’ve modified it some over the years. But we’ve stayed with that basic concept ever since.

Nucor paid its employees much more than what competitors paid. But Nucor’s employees produced much, much more. As a result, net costs were lower for Nucor. In 1996, Nucor’s total cost was less than $40 per ton of steel produced versus at least $80 per ton of steel produced for large integrated U.S. steel producers.

Nucor workers were paid a lower base salary – 65% to 70% of the average – but had opportunities to get large bonuses if they produced a great deal.

Officer bonuses (8% to 24%) were tied to the return on equity.

Nonproduction headquarter staff, engineers, secretaries, and so on, as well as department managers, could earn 25% to 82% of base pay based on their division’s return on assets employed. So, if a division did not meet required returns, those employees received nothing, but they received a significant amount if they did. There were a few years when all employees received no bonuses and a few years when employees maxed out their bonuses.

An egalitarian incentive structure leads all employees to feel equal, regardless of base pay grade or the layer of management an employee is part of. Maintenance workers want producers to be successful and vice versa.

All production workers, including managers, wear hard hats of the same color. Everyone is made to feel they are working for the common cause. Nucor has only had one year of losses, in 2009, over a fifty-year period. This is extraordinary for the highly cyclical steel industry.

Iverson, like Herb Kelleher, believed that experimentation – trial and error – was essential to continued innovation. Iverson:

About fifty percent of the things we try really do not work out, but you can’t move ahead and develop new technology and develop a business unless you are willing to take risks and adopt technologies as they occur.

 

HUMAN CAPITAL ALLOCATORS: 3G PARTNERS

3G Partners refers to the team of Jorge Paulo Lemann, Carlos Alberto “Beto” Sicupira, and Marcel Hermann Telles. They have developed the ability to buy underperforming companies and dramatically improve productivity.

When the 3G partners took control of Brahma, buying a 40% stake in 1989, it was the number two beer company in Brazil and was quickly losing ground to number one, Antarctica. The previously complacent management and company culture generated low productivity – approximately 1,200 hectoliters of beverage produced per employee. There was little emphasis on profitability or achieving more efficient operations. During Marcel Telles’s tenure, productivity per employee multiplied seven times, to 8,700 hectoliters per employee. Efficiency and profitability were top priorities of the 3G partners, and the business eventually held the title of the most efficient and profitable brewer in the world. Through efficiency of operations and a focus on profitability, Brahma maintained a 20% return on capital, a 32% compound annual growth rate in pretax earnings, and a 17% CAGR in revenues over the decade from 1990 to 1999… Shareholder value creation stood at an astounding 42% CAGR over that period.

…Subsequent shareholder returns generated at what eventually became Anheuser-Busch InBev (AB InBev) have been spectacular, driven by operational excellence.

Jorge Paulo Lemann – who, like Sicupira and Telles, was born in Rio de Janeiro – started playing tennis when he was seven. His goal was to become a great tennis player. He was semi-pro for a year after college. Lemann:

In tennis you win and lose. I’ve learned that sometimes you lose. And if you lose, you have to learn from the experience and ask yourself, ‘What did I do wrong? What can I do better? How am I going to win next time?’

Tennis was very important and gave me the discipline to train, practice, and analyze… In tennis you have to take advantage of opportunities.

So my attitude in business was always to make an effort, to train, to be present, to have focus. Occasionally an opportunity passed and you have to grab those opportunities.

In 1967, Lemann started working for Libra, a brokerage. Lemann owned 13% of the company and wanted to create a meritocratic culture. But others disagreed with him.

In 1971, Lemann founded Garantia, a brokerage. He aimed to create a meritocratic culture like the one at Goldman Sachs. Lemann would seek out top talent and then base their compensation on performance. Marcel Telles and Beto Sicupira joined in 1972 and 1973, respectively.

Neither Marcel Telles nor Beto Sicupira started off working in the financial markets or high up at Garantia. Both men started at the absolute bottom of Garantia, just like any other employee…

Jorge Paulo Lemann initially had a 25% interest in Garantia, but over the first seven years increased it to 50%, slowly buying out the other initial investors. However, Lemann also wanted to provide incentives to his best workers, so he began selling his stake to new partners. By the time Garantia was sold, Lemann owned less than 30% of the company.

Garantia transformed itself into an investment bank. It was producing a gusher of cash. The partners decided to invest in underperforming companies and then introduce the successful, meritocratic culture at Garantia. In 1982, they invested in Lojas Americanas.

Buying control of outside businesses gave Lemann the ability to promote his best talent into those businesses. Beto Sicupira was appointed CEO and went about turning the company around. The first and most interesting tactic Beto utilized was to reach out to the best retailers in the United States, sending them all letters and asking to meet them and learn about their companies; neither Beto nor his partners had any retailing experience. Most retailers did not respond to this query, but one person did: Sam Walton of Walmart.

The 3G partners met in person with the intelligent fanatic Sam Walton and learned about his business. Beto was utilizing one of the most important aspects of the 3G management system: benchmarking from the best in the industry. The 3G partners soaked up everything from Walton, and because the young Brazilians were a lot like him, Sam Walton became a mentor and friend to all of them.

In 1989, Lemann noticed an interesting pattern:

I was looking at Latin America and thinking, Who was the richest guy in Venezuela? A brewer (the Mendoza family that owns Polar). The richest guy in Colombia? A brewer (the Santo Domingo Group, the owner of Bavaria). The richest in Argentina? A brewer (the Bembergs, owners of Quilmes). These guys can’t all be geniuses… It’s the business that must be good.

3G always set high goals. When they achieved one ambitious goal, then they would set the next one. They were never satisfied. When 3G took over Brahma, the first goal was to be the best brewer in Brazil. The next goal was to be the best brewer in the world.

3G has always had a truly long-term vision:

Marcel Telles spent considerable time building Brahma, with a longer-term vision. The company spent a decade improving the efficiency of its operations and infusing it with the Garantia culture. When the culture was in place, a large talent pipeline was developed, so that the company could acquire its largest rival, Antarctica. By taking their time in building the culture of the company, management was ensuring that the culture could sustain itself well beyond the 3G partners’ tenure. This long-term vision remains intact and can be observed in a statement from AB InBev’s 2014 annual report: ‘We are driven by our passion to create a company that can stand the test of time and create value for our shareholders, not only for the next ten or twenty years but for the next one hundred years. Our mind-set is truly long term.’

3G’s philosophy of innovation was similar to a venture capitalist approach. Ten people would be given a small amount of capital to try different things. A few months later, two out of ten would have good ideas and so they would get more funding.

Here are the first five commandments (out of eighteen) that Lemann created at Garantia:

• A big and challenging dream makes everyone row in the same direction.
• A company’s biggest asset is good people working as a team, growing in proportion to their talent, and being recognized for that. Employee compensation has to be aligned with shareholders’ interests.
• Profits are what attract investors, people, and opportunities, and keep the wheels spinning.
• Focus is of the essence. It’s impossible to be excellent at everything, so concentrate on the few things that really matter.
• Everything has to have an owner with authority and accountability. Debate is good, but in the end, someone has to decide.

Garantia had an incentive system similar to that created by other intelligent fanatics. Base salary was below market average. But high goals were set for productivity and costs. And if those goals are achieved, bonuses can amount to many times the base salaries.

The main metric that employees are tested against is economic value added – employee performance in relation to the cost of capital. The company’s goal is to achieve 15% economic value added, so the better the company performs as a whole, the larger is the bonus pool to be divided among employees. And, in a meritocratic culture, the employees with the best results are awarded the highest bonuses.

Top performers also are given a chance to purchase stock in the company at a 10% discount.

The 3G partners believe that a competitive atmosphere in a business attracts high-caliber people who thrive on challenging one another. Carlos Brito said, ‘That’s why it’s important to hire people better than you. They push you to be better.’

 

THE INTELLIGENT FANATICS MODEL

Cassel and Iddings quote Warren Buffett’s 2010 Berkshire Hathaway shareholder letter:

Our final advantage is the hard-to-duplicate culture that permeates Berkshire. And in businesses, culture counts.

One study found the following common elements among outperformers:

What elements of those cultures enabled the top companies to adapt and to sustain performance? The common answers were the quality of the leadership, the maintenance of an entrepreneurial environment, prudent risk taking, innovation, flexibility, and open communication throughout the company hierarchy. The top-performing companies maintained a small-company feel and had a long-term horizon. On the other hand, the lower-performing companies were slower to adapt to change. Interviewees described these companies as bureaucratic, with very short-term horizons.

Cassel and Iddings discuss common leadership attributes of intelligent fanatics:

Leading by Example

Intelligent fanatics create a higher cause that all employees have the chance to become invested in, and they provide an environment in which it is natural for employees to become heavily invested in the company’s mission.

…At Southwest, for example, the company created an employee-first and family-like culture where fun, love, humor, and creativity were, and continue to be, core values. Herb Kelleher was the perfect role model for those values. He expressed sincere appreciation for employees and remembered their names, and he showed his humor by dressing up for corporate gatherings and even by settling a dispute with another company through an arm wrestling contest.

Unblemished by Industry Dogma

Industries are full of unwritten truths and established ways of thinking. Industry veterans often get accustomed to a certain way of doing or thinking about things and have trouble approaching problems from a different perspective. This is the consistency and commitment bias Charlie Munger has talked about in his speech ‘The Psychology of Human Misjudgment.’ Succumbing to the old guard prevents growth and innovation.

…All of our intelligent fanatic CEOs were either absolute beginners, with no industry experience, or had minimal experience. Their inexperience allowed them to be open to trying something new, to challenge the old guard. The CEOs developed new ways of operating that established companies could not compete with. Our intelligent fanatics show us that having industry experience can be a detriment.

Teaching by Example

Jim Sinegal learned from Sol Price that ‘if you’re not spending ninety percent of your time teaching, you’re not doing your job.’

Founder Ownership Creates Long-Term Focus

The only way to succeed in dominating a market for decades is to have a long-term focus. Intelligent fanatics have what investor Tom Russo calls the capacity to suffer short-term pain for long-term gain…. As Jeff Bezos put it, ‘If we have a good quarter, it’s because of work we did three, four, five years ago. It’s not because we did a good job this quarter.’ They build the infrastructure to support a larger business, which normally takes significant up-front investment that will lower profitability in the short term.

Keep It Simple

Jorge Paulo Lemann:

All the successful people I ever met were fanatics about focus. Sam Walton, who built Walmart, thought only about stores day and night. He visited store after store. Even Warren Buffett, who today is my partner, is a man super focused on his formula. He acquires different businesses but always within the same formula, and that’s what works. Today our formula is to buy companies with a good name and to come up with our management system. But we can only do this when we have people available to go to the company. We cannot do what the American private equity firms do. They buy any company, send someone there, and constitute a team. We only know how to do this with our team, people within our culture. Then, focus is also essential.

Superpower of Incentives

Intelligent fanatics are able to create systems of financial incentive that attract high-quality talent, and they provide a culture and higher cause that immerses employees in their work. They are able to easily communicate the why and the purpose of the company so that employees themselves can own the vision.

…All of this book’s intelligent fanatic CEOs unleashed their employees’ fullest potential by getting them to think and act as owners. They did this two ways: they provided a financial incentive, aligning employees with the actual owners, and they gave employees intrinsic motivation to think like owners. In every case, CEOs communicated the importance of each and every employee to the organization and provided incentives that were simple to understand.

Experimentation

Intelligent fanatics and their employees are unstoppable in their pursuit of staying ahead of the curve. They test out many ideas, like a scientist experimenting to find the next breakthrough. In the words of the head of Amazon Web Services (AWS), Andy Jassy, ‘We think of (these investments) as planting seeds for very large trees that will be fruitful over time.’

Not every idea will work out as planned. Jeff Bezos, the founder and CEO of Amazon, said, ‘A few big successes compensate for dozens and dozens of things that did not work.’ Bezos has been experimenting for years and often has been unsuccessful…

Productive Paranoia

Jim Collins describes successful leaders as being ‘paranoid, neurotic freaks.’ Although paranoia can be debilitating for most people, intelligent fanatics use their paranoia to prepare for financial or competitive disruptions. They also are able to promote this productive paranoia within their company culture, so the company can maintain itself by innovating and preparing for the worst.

Decentralized Organizations

Intelligent fanatics focus a lot of their mental energy on defeating bureaucracies before they form.

…Intelligent fanatics win against internal bureaucracies by maintaining the leanness that helped their companies succeed in the first place… Southwest was able to operate with 20% fewer employees per aircraft and still be faster than its competitors. It took Nucor significantly few workers to produce a ton of steel, allowing them to significantly undercut their competitors’ prices.

Dominated a Small Market Before Expanding

Intelligent fanatics pull back on the reins in the beginning so they can learn their lessons while they are small. Intelligent fanatic CEOs create a well-oiled machine before pushing the accelerator to the floor.

Courage and Perseverance in the Face of Adversity

Almost all successful people went through incredible hardship, obstacles, and challenges. The power to endure is the winner’s quality. The difference between intelligent fanatics and others is perseverance…

Take, for instance, John Patterson losing more than half his money in the Southern Coal and Iron Company, or Sol Price getting kicked out of FedMart by Hugo Mann. Herb Kelleher had to fight four years of legal battles to get Southwest Airlines’ first plane off the ground. Another intelligent fanatic, Sam Walton, got kicked out of his first highly successful Ben Franklin store due to a small clause in his building’s lease and had to start over. Most people would give up, but intelligent fanatics are different. They have the uncanny ability to quickly pick themselves up from a large mistake and move on. They possess the courage to fight harder than ever before…

 

CULTURE: THE ONLY TRUE SUSTAINABLE COMPETITIVE ADVANTAGE

Intelligent fanatics demonstrate the qualities all employees should emulate, both within the organization and outside, with customers. This allows employees to do their jobs effectively, by giving them autonomy. All employees have to do is adjust their internal compass to the company’s true north to solve a problem. Customers are happier, employees are happier, and if you make those two groups happy, then shareholders are happier.

…Over time, the best employees rise to the top and can quickly fill the holes left as other employees retire or move on. Employees are made to feel like partners, so the success of the organization is very important to them. Partners are more open to sharing new ideas or to offering criticism, because their net worth is tied to the long-term success of the company.

Companies with a culture of highly talented, driven people continually challenge themselves to offer best-in-class service and products. Great companies are shape-shifters and can maneuver quickly as they grow and as the markets in which they compete change.

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: https://boolefund.com/best-performers-microcap-stocks/

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

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

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

 

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

My e-mail: 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.

February 11, 2024

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 approachesintrinsic 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.