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The Investor's Podcast (We Study Billionaires) - The Investor’s Podcast Network
TIP678: Mastering Focus Investing: Lessons From The Legends w/ Kyle Grieve
01:06:25
Kyle Grieve discusses major takeaways from the book The Warren Buffett Portfolio.
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- [00:01]
Robert Hagstrom
You're listening to tip.
- [00:03]
Kyle Grieve
If an algorithm out there could outperform the market, would you be interested in learning more about what that algorithm consists of? Now, I'm not talking about algorithmic trading or anything like that. I'm talking about tried and true fundamental characteristics and strategies that people like Buffett and many other investing legends such as John Maynard Keynes, Charlie Munger, Lou Simpson, and Bill Ruane have utilized to outperform the market by a very wide margin over long periods of time. Well, today I will be sharing a number of traits that are necessary to be considered a focus investor, which is the prototype of Warren Buffett. We'll be looking at these issues from the book the Warren Buffett Portfolio by Robert Hagstrom. We'll go over some very interesting research that the book's author, Robert Hagstrom, covered to better help investors understand the details of concentration and diversification, especially in relation to returns. You probably won't be surprised to learn that concentrated portfolios will give you the highest probability of outperforming the market. But on the flip side, there is a potential downward risk of concentrated portfolios that you should definitely be aware of, and we're going to cover that in quite a bit of detail. Another attribute of focus investing is the emphasis on psychology. I'll cover a few of Warren Buffett's biggest influences on his own psychology and what he learned from them. I'll go over four psychological shortcomings that we pretty much all exhibit to some degree and that can wreak havoc on our investing returns and on our ability to sleep well at night. We'll also cover why folks investors spend a lot of time thinking about their own psychological misjudgments and some strategies to use investor psychology to our own advantage. We'll also cover the role of patients in successful investing. Mainly, there's two distinct areas. One is ignoring market forecasts and two, in waiting for fat pitches. Now, I think patience is vital in these two areas because without patience, you're going to be looking to market forecasts to help fuel your need for action. But if you have patience, you can wait around for long durations until a fat pitch presents itself. But this is just scratching the surface of what I'll be covering today. I'll also be discussing things like what makes a focus investor and why it's an important concept why focus investors reject much of the premises of financial academia, the common characteristics of outperforming focus investors throughout history, and a whole lot more. So if you want to learn more about the benefits and execution of The Focus Investment Strategy Then listen on. You won't be disappointed. Now let's get right into this week's episode.
- [02:24]
Robert Hagstrom
Celebrating 10 years and more than 150 million downloads. You are listening to the Investors podcast network. Since 2014, we studied the financial markets and read the books that influence self made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host, Kyle Grieve.
- [02:53]
Kyle Grieve
Welcome to the Investors Podcast. I'm your host Kyle Grief and today we'll be discussing a book that deals with some of the subtle nuances of Warren Buffett's focused investing strategies. That book is called the Warren Buffett Portfolio and is written by Robert Hagstrom. This book is great because it goes over a few key areas that really differentiate what Robert calls focus investors from the rest. Focus investors engage in focus Investing and they tend to think a lot differently. This book is a wonderful guide to help you understand how these folks investors think and why thinking this way could benefit your financial health. But first let's really discuss exactly what Focus Investing is. The essence of Focus Investing has three primary components. One, you choose a few stocks that are likely to produce above average returns over the next five, 10 or 20 years. Two, you concentrate your capital on a few of these positions. And three, you maintain conviction when warranted and are very resilient to short term price fluctuations in market prices. Now let's go over each of these three tenets. You might be asking how many stocks does a focus investor need in their portfolio? Warren came up with a really good solution that would make sense provided that you are the type of investor who has an in depth understanding of a business's economics. So Warren says that five to 10 sensibly priced businesses with long term competitive advantages really all the diversification that is required to succeed in investing. Over the years I've observed what other people think about these numbers. Most people are shocked at the thought of having such a small number of position sizes. But here's the thing about diversification. The more diversified you are, the less information you really know about each position that you own. Even if you speak to the CEOs of the largest asset managers in the world, I can guarantee you that they do not have an in depth understanding of everything that they manage. Instead, they outsource that work to other people in the business so they can specialize in whatever they need to in order to continue improving the business. But as individual investors managing our portfolios or those of others, don't you think you owe it to yourself to understand everything that you own. If you do not desire to understand businesses deeply, Warren would just tell you to diversify. This has the benefit of not bothering to try to understand businesses at a deep level as you can just count on the strength of the underlying country. In Warren's case, this was the US market. But if you do decide to go the index route, there is a really big key that you must take into account. If you index, your returns will never beat the index. You'll be handcuffed to the results of the index and never stray from them. Many investors see this as a positive and to them, investing in indexes and not paying any attention to them or their result is a great strategy. But other investors want more. They want market beating returns. If you're listening to this episode, I bet a part of you is trying to beat the market with a portion of your portfolio. In that case, stock picking is the correct route and concentrated bets will help you get there. We are going to discuss some of the great data that Robert came to find while researching diversified versus Concentrated portfolios. Stick around as I know you'll enjoy the results. Third point here is on conviction. Focus investors must have conviction. After all, if you only hold a few stocks and have a large percentage of your portfolio in these positions, a few other things are also valid. It means you aren't looking to trade in and out of stocks like a kid trading snacks during lunch. It also means that once you find an idea, your ideal situation is that the business continues to perform for many, many years into the future. These two second order effects of conviction have to do with your time scale. You can't be a focus investor while simultaneously always looking to invest somewhere else. There comes a point where you need to ride with what you have and avoid the over tinkering that causes many investors to produce unsatisfactory results. A sports reference here is going to work best. So in the preseason of any professional sport, the team's manager assesses what he has to create the best possible roster. And creating a stock portfolio is really the same thing. You're trying to build a roster of the best possible businesses to fit into your portfolio. They should not be players that can be easily replaceable. If you're creating a roster of replaceable players, then you really need to be more discerning about what you let into your portfolio in the first place. I personally want a portfolio where deciding who to cut is a very, very tough decision and I feel like I'm getting closer and closer to that point as I gain more experience. But deciding who to get rid of has been a lot easier over the last few years. This concentration style is far different from what is traditionally taught in financial institutions. To best understand how we should think, we must also understand why everyone feels the way they do. For that, we need to go back in time and examine the ideas of three influential people in financial academia. We start with Harry Markowitz, who developed the modern portfolio theory. This theory is based on the simple idea that return and risk are inextricably linked. Now if you want a low risk portfolio, you would construct a diversified portfolio of low covariance stocks. So covariance is a measure of the direction of a group of stocks. Let's say we have two stocks with high covariance. This basically means that they tend to move together up and they move together down. Now a low covariance would imply that these two stocks move in opposing directions. Hegstrom writes in Markowitz is thinking the risk of a portfolio is not in the variance of the individual stocks, but the covariance of the holdings. The more they move in the same direction, the greater is the chance that economic shifts will drive them all down at the same time. By the same token, a portfolio composed of risky stocks might actually be a conservative selection if the individual stock prices move differently either way, Markowitz said diversification is key. Now, since much of Wall street is educated using modern portfolio theory, it's pretty easy to see why so many fund managers have chosen to over diversify. The next priest of modern finance is Bill Sharp. Instead of looking at the entire portfolio, Sharp looked at the individual behavior of the stock market to determine its behavior. If a stock's price is more volatile than the market as a whole, the stock will make the portfolio more variable and therefore more risky. But if the stock is less volatile than the market as a whole, the stock becomes less variable and thus less volatile. With this framework, you could then measure the volatility of a portfolio. And this measure was called beta factor. Now the third priest of modern finance that Robert covers is Eugene Fama. Fama believed that stock prices are not predictable. The market is simply too efficient. And as new information becomes available, intelligent actors in the market price that in this causes prices to adjust immediately before anyone can profit. His theory states that future predictions have no place in an efficient market because share prices just adjust too quickly. When you think about the investing industry, these guys have their fingerprints all over traditional investing practices such as diversification. Reducing risks through owning low risk stocks and accepting market like returns as beating it is impossible. However, the focus investor like Buffett rejects much of the premises on which these modern financial theories are based. Buffett believes that diversification is actually appropriate for the right person in different dosages, mainly people who just aren't interested in learning about the intricacies of a business, the skill set of management, a management's competitive advantage of businesses, future prospects, etc. But for individuals who are interested in that stuff, then diversification is silly. Buffett believes that diversification actually increases risk. Buffett says, we believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he must feel with its economic characteristics before buying into it. Now to buff it, the better you understand the business and its intrinsic value, the less risk you take. And as I discussed, you cannot maximize your understanding of a business with hundreds and hundreds of names in your portfolio. Buffett's next point on risk is the interplay of intrinsic value, price and risk. Buffett has spoke about his investment in the Washington Post, where it seemed readily apparent that the business was worth about $400 million or so. However, under the theory of beta and modern portfolio theory, Warren would have increased his risk by buying the stock at $40 million rather than buying it at 80 million because the lower price had higher volatility. Now, just think about the logic of that statement and it really becomes hard to argue that some of these theories just don't make a lot of sense when you truly understand the value of a business. When it comes to the efficient market hypothesis, Hagstrom covers three areas where the theory just seems not defensible. Number one is investors are only sometimes rational, and assuming that they're always rational is just not a good representation of reality. Number two is that investors just don't process information correctly. They rely on System 1 thinking and often jump to incorrect conclusions as their default. So these incorrect assumptions may only last a short time before correcting. But it's during these times that you can really take advantage of the market. And three, the performance yardstick emphasizes short term performance. So in this light, it becomes nearly impossible to beat the market quarterly. But by extending your time horizons, outperformance does become a possibility. Buffett says, Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day. Now, the interesting thing here is that even as a focus investor who doesn't buy into all these principles of modern finance, you still need to follow them loosely. And namely, that's the Efficient market hypothesis. I still think the market is mostly efficient, but there is a difference between being mostly efficient and being always efficient. So value investors will often look for areas of the market where inefficiencies are the highest. Then they use their knowledge and patience to exploit these inefficiencies. This is what Buffett's career has been built on. If you follow the tenets of modern finance theory, it's easy to get caught up thinking more like an academic and less like a businessman. And as Benjamin Graham has famously said, investment is most intelligent when it is most business like. I prefer to think about investing through the lens of a business person and as little as possible through the lens of academics. Here's a simple four step framework to ascertain the probability of a decent return on an investment that Hagstrom developed based on Buffett's thinking. One, the certainty in evaluating a business's long term economics. Two, the certainty in management's ability to maximize a business's potential and property allocate capital. Three, the certainty that management will prioritize shareholders interests over their own. And four, the purchase price of the business. Find a business where you can be highly certain of points one through three. There won't be that many and that's perfectly okay. But once you find it, you should ensure that your purchase price is reasonable and that you're moving in the right direction in terms of that certainty. Now let's move to a more practical way of looking at some of history's greatest focus investors. Eggstrom looked at some of the most significant focus investors, historical performance and concentration levels. These investors were John Maynard Keynes, Warren Buffett, Charlie Munger, Bill Ruane and Lou Simpson. All five of these investors have incredible track records. Let me break it down for you. So John Maynard Keynes managed the Chess Fund during the Great Depression and World War II and his average annual return was 13.2% versus the UK market's performance of negative 0.5%. Now, Warren Buffett managed the Buffett partnerships between 1957 and 1969. During that time his annual returns were 30.4% versus the Dow's return of only 8.6%. Charlie Munger had a partnership which was active from 1962 until 1975. And in that partnership he generated annual returns of 24.3% versus the Dow's return of 6.4%. Bill Ruane, a friend of Warren Buffett, managed the Sequoia Fund. Hagstrom lists his performance between 1971 and 1997. Sequoia Fund had annual returns of 19.6% versus the S&P 500 return of 14 and a half percent. And lastly, Lou Simpson. He managed Geico's investment portfolio from 1980 to 1996, and he generated a whopping 24.7% annual return versus 17.8% for the S&P 500. Now, these numbers are exceptional, but really the most important point here is just the generalities that a lot of these investors shared. So, for instance, risk management was a major focus. But instead of worrying about modern portfolio theory, they focused on buying businesses with significant intrinsic value and price gaps. They specifically thought about businesses that they believed had the characteristics necessary to continue outperforming the market only over long periods of time. They focused their portfolios on just a few names, which definitely caused volatility in their yearly returns, but overperformance in the long term. Now, Robert received some criticism from skeptics regarding the results of these investors, who said that 5 is just too much of a small sample size to really draw any reliable conclusions. Now, Robert agreed, and he actually found a Compustat database and examined 12,000 portfolios instead of just five. Now, this study broke each portfolio into quartiles designed to contain a different concentration of stocks. So there are 3,000 portfolios, each of 250 stocks, 100 stocks, 50 stocks and 15 stocks. Robert then calculated the average annual rate of return for each portfolio group over two periods of time, which were 10 and 18 years. Then he compared the results of the S&P 500 for the time samples. The conclusion was pretty profound. In every case, when we reduced the number of stocks in a portfolio, we began to increase the probability of generating returns that were higher than the market's rate of return. Now, there are some very important takeaways here. All the portfolios as a group generated similar returns. When looking at the overall sample size of 3000, however, the exciting part regards increasing the probability of generating returns above the market's rate of return. The fewer stocks in a portfolio generated the highest best returns, but also the lowest low returns. These results lead us to two conclusions. One, you increase the probability of outperforming the index with a focused portfolio, and two, you increase the probability of underperforming the index with a focused portfolio. Now, the key here is to really optimize for point one while protecting yourself from point two. And the best way to do this is to become an expert business analyst. Suppose you can discern what makes one business superior over competitors like the five investors who I just mentioned. In that case, you tip the odds in your favor of avoiding any significant losers who can drain your long term performance. If you go the focused investor route, you also must be aware that you will lose against the index with some regularity. So you must remember that the goal is to maximize high absolute returns over the long period and not to beat the index over just a short, you know, 90 day period. Nobody beats the index quarter to quarter anyway, so I always really find it puzzling that people try to do this. The last point I want to discuss here in this section was the role of frictional costs. Robert didn't actually take this into account for the Compustat study. However, he did note that the fees involved in buying and selling 250 stocks are obviously going to be much more prominent on an absolute and relative basis than a 15 stock portfolio. He said that if he'd considered that adjustments would have been necessary for the portfolio, that would have actually widened the gap even further. As an investor, you can really just use diversification to your advantage. If you're a newer investor, use diversification as you familiarize yourself with an investing strategy that just resonates with you. You could keep the bulk of your capital in index funds and then slowly add to individual stocks once you become more comfortable with them. Let's take a quick break and hear from today's sponsors. Are you feeling like investing in real estate is out of reach? Well, you're not alone. Concerns about experience, capital and time hold back many investors. That's why Connect Invest was created to make real estate investing accessible to investors just like you. Connect Invest is an easy to use online platform that lets you participate in real estate through short notes. These investments help fund a diversified real estate portfolio exclusively in the US Covering everything from acquisitions to construction and development. 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- [19:14]
Robert Hagstrom
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- [21:19]
Kyle Grieve
All right, back to the show. If you are an investor who doesn't hold index funds but is diversified into say 50 or 100 or more more names, maybe you start trying to figure out which businesses that you understand best, then slowly add to your highest conviction ideas while removing your lower conviction ideas. Or maybe removing ideas that are outside of your circle of competence. Or maybe you are a concentrated investor with single digit names but realize that you don't have the time to really understand a business. In this case, maybe allocating a portion of your portfolio to index funds is smart. Until you find enough time to be much more comfortable with just a few businesses, the possibilities really are endless. Just realize that even though focus investors tend to favor concentration, you personally don't have to if you don't feel that it is the right time. I mentioned here that these super investors of Buffettville had some volatile results, and this leads very well into the next session of the book I want to cover, which is Measuring Performance. I'll connect the two of these things to you very shortly here, but first we need to get something out of the way. So dogmatic thinking in investing has caused the less sophisticated investor to believe that the squiggles in the value of the portfolio is the optimal performance measure. But Warren Buffett disagrees. He thinks, and I agree with him, that market prices are frequently nonsensical. So using nonsensical feedback to determine individual performance just doesn't seem like the way to measure performance. Now let's go back to the super investors that we mentioned earlier. Out of all five of these examples, Buffett, during his partnership days was the only one who never faced a year where he underperformed the benchmark. But how did the rest fare? Here are the percentage of the years that these investors actually underperform the market. So Keynes underperformed 33%, Munger underperformed 36% of the time, Ruane underperformed 37% of the time, and Lou Simpson underperformed 24% of the time. So this shows that focus investors with very enviable track records will still underperform the market at least one quarter of the time. And if that's not hard enough, all these investors besides Lou Simpson had three to four consecutive years of underperformance at some point during their investing career. So this means that they had to field questions from their investors and from themselves if their strategy was still viable. Now, in a recent chat with Scott Barbie on tip 651, he discussed how he dealt with a brutal drawdown of 72%. He mentioned that although the prices for many of his holdings had decreased substantially, he saw incredibly high divergences in price and value of his portfolio. The businesses he owned were oozing with value, many of the names he held were trading below the levels of cash per share. So clearly Scott understood the value of what he owned and held through the market's punishment. And a fascinating thing happened as a result. In 2009. His fund generated 91% returns, which got him on the COVID of the Wall Street Journal. When asked about what he did to achieve these results, he said, well, I feel very sheepish about that because I didn't do anything. I just held the same thing and the stock price went down because they were purging out shares. Now if you like mental models as I do, this is a perfect example of regression to the mean. Due to some of the harrowing down years, he had a higher probability of that being followed by some very high highs. But let's get back to Keynes, Munger, Simpson and ruin. If we looked at their results regarding their percentage of time underperforming the market and the multi year drawdowns, what can we assume about the ability to work in today's environment? Hexam writes, they would probably be canned to their clients profound loss. Yet following the argument that the focus strategy does sometimes mean enduring several weak years, we run into a very real problem. How can we tell, using price performance as our sole measure, whether we are looking at a very bright manager who is having a poor year or even a poor three years but will do well over the long haul, or one who is just starting a string of bad years? Well, we can't. To address this problem, we need to change how we think about our time horizons. Price can't be the only measuring stick we use and making short term judgments on performance has to be tabled. In Buffett's mind, measuring the performance of a private company is the same as measuring the performance of a publicly traded company. This is the optimal way to measure performance. If you owned a private business and had no daily ticker, you would focus on the profits or cash flow of the business as that would be the number that would concern you the most. So why should stocks be any different? Robert looked at some of the data to see if stock prices and earnings had any correlation. He looked at 1200 companies ranging between 3 and 18 years and measured the correlation of the price and earnings. For instance, a correlation of 0.36 meant a 36% variance in price explained by the variance in earnings. So here's what he found. In each time cohort. With stocks that were held for 3 years, the correlation ranged from 0.131 to 0.36. With stocks held for 5 years, the correlation increased from a range of 0.374 to 0.599. With stocks held for 10 years, the correlation again increased from 0.593 to 0.695. And with stocks held for 18 years, the correlation was about 0.688. So this shows that for long term focused investors, buying businesses with increasing earnings is highly likely to cause the price to move up in lockstep with the increase in earnings. Now this research is in line with Buffett's view on price and value. While price will definitely track in an uneven and unpredictable fashion, it still will track and the tracking improves over long time periods. Buffett says in any given year the relationship can gyrate capriciously. Hagstrom notes that Ben Graham has already given us this lesson when he wrote that in the short run the market is a voting machine, but in the long run it is a weighing machine. So as individual investors, how can we use the private business mindset to determine performance? Once again, Warren Buffett has a solution for us. So he uses a mental model called Look Through Earnings to get an idea of how your business's profits are growing. The original machination of the Look Through Earnings was explicitly created just for Berkshire Hathaway as it included the operating earnings of its privately held subsidiaries. This is still a good meta model as it allows you to look at the entirety of your businesses to see if the value of the entire portfolio is improving. But as stock investors, we only need to consider how he incorporated Look Through Earnings specifically on his public equity portfolio. Retained earnings carry no value Under GAAP accounting for an operating business, all earnings were reported as you'd expect them to be. But for publicly owned businesses, these retained earnings still belong to Berkshire Hathaway, but they were actually absent from the income statement. But these retained earnings have obvious value because if they were reinvested into the business at high rates of return, the company would increase in value and increase return retained earnings as a result. So here's what he did you find the total retained earnings of each of your holdings. Since you own a fractional share of business, you own a fractional share of the retained earnings. Let's say you own 50% of a company with $100 million in retained earnings. That means your share of retained earnings is $50 million. Now let's say the same business increases its retained earnings to $120 million the following year. Now your share of those earnings has grown to $60 million. Any investor's goal is to think of their portfolio as a holding company that increases retained earnings over time. The thinking is that if retained earnings increase at say a 15% per annum, the value of their holding company will also increase at about 50% per annum. You can also track this by simply adding earnings growth and dividend yield as Francois Rochon does at Giverny Capital. Warren believes that thinking in this manner will keep investors focused on the long term and avoid short term biases. The final point on measuring performance I'll mention is using your portfolio as a measuring stick. In this case, Charlie Munger had some just wonderful advice. What Buffett is saying is something very useful to practically any investor. For an ordinary individual, the best thing you already have should be your measuring stick. And then another really good point, he said. Here was the job of a portfolio manager who is a long term owner of securities and believes the future stock prices eventually match with underlying economics and that manager might well be you is to always find ways to raise the benchmark. That's an enormous thought conserver, says Munger, and it's not taught at business school. By and large now I just love thinking in this light for my own portfolio. If a new business comes across my inbox, I always have to determine if it's better than my worst current holding. If it's superior, then adding it to my portfolio should actually raise the entire benchmark of my portfolio. But if it's inferior, then buying it will actually decrease the quality of my portfolio as a whole. Now, if the rates of return are equal, I will usually always side with what I already own because it generally means I already understand it at a much better level. So this discussion of the circle of competence leads me to the next chapter of the Warren Buffett portfolio, which covers Warren Buffett's tool belt. So let's start by talking about the circle of competence. The circle of competence is an interesting concept because it will defer based on your own life experience and personal preferences. The key with investing in your circle of competence is to simply identify and leverage advantages that you will have over the majority of other investors. I can tell you from personal standpoint that I don't think there are many subjects that I have much of an edge in. As I learn more about a business, the world around me, and reflect on my own life experience, I have begun to paint a picture not only of what I understand, but also what I want to add to what I already know, Munger says. Each of you will have to figure out where your talents lie and you'll have to use your advantages. But if you try to succeed in what you're worst at, you're going to have a very, very lousy career. I can almost guarantee it. And I think this is why a lot of investors just have a hard time finding success in the markets Instead of focusing on investing in what they already know about, they search for stocks which give the highest possible returns. But this just removes the risk element from investing. And whether you see it or not, that risk is going to always be present. When you understand something very, very well, you also understand the potential downside. And this downside recognition can really, really help you avoid investing in things with the possibility of losing a lot of money. But just because you don't understand something doesn't mean that you can never invest in it. Investing is a lifelong process. And if you want to learn more about a business or it's in industry, just go buy some books, listen to those on podcasts, watch YouTube videos, or go read some articles or talk to people in the industry. I think if you do this long enough, you can really understand many things at a pretty high level. And then also speaking, I think sometimes we look at analysts, and while some of their analysis might seem impressive, some of it's not quite as impressive. And a lot of times, while they may seem smart, and maybe they are smart, their actual knowledge on a specific business or industry just isn't as high as you think it would be. And yours would surprisingly be at a much higher level. So the next tool I want to discuss is the importance of valuing a business. The notion is very simple, but definitely abused. So in order to value a business, all you need to know is the future cash flows for the entire lifespan of a business discounted to present value. And that is all you need to get intrinsic value. Now, you may have noticed I said that this is an abused figure. Let me tell you why I think that is. I think it's nearly impossible to find a business that you can accurately predict cash flows out into eternity. For. For this reason, investors come up with all sorts of wild evaluations of businesses based on things like growth rates that are nearly impossible to forecast a year from now, let alone 10 or 20 years. So while I think this method is still one of the better ways to determine a business's value, it's important to remember that it really is just an approximation. If you can find wide discrepancies between your approximation and the price you offer yourself, the best possible situation, and the highest possible margin of safety. So let's move to the next tool, which is the ability to evaluate management. Hagstrom mentions that the highest compliment that Buffett can give a manager is to say that the manager thinks like the owner of a company. I think this is just such a valuable evaluation tool. It's really easy to go out Find managers out there who talk the talk but don't walk the walk. A manager who goes out and buys shares of a business on the open market is a huge signal that the manager thinks of themselves as an owner. If a manager is constantly talking about how cheap their business is and owns a negligible amount of shares of the business, then you have a pretty good signal that the manager is not managing the business as an owner. So there are three areas that Buffett focuses on when assessing management. One is rationality. Is the manager rationally allocating capital? Are they spending money on areas of the business that offer the highest returns? Are they spending money for the long term wellbeing of the business? Or are they destroying the businesses long term health to chase short term incentives? Number two is candor. Does a CEO only mention the positives even when they've made a massive blunder? Do they refuse to accept the responsibility for past errors and do they deflect hard questions or outright refuse to answer them? And three is resisting the institutional imperative. Are they contrarians? Are they doing things that the industry is refusing to do that would make sense for the betterment of the long term health of the business? Or are they just following what everyone else is doing and spending money in areas that they have no business spending? So here are a few tips that Robert writes in regard to Buffett that I think will help you get a better view of management talents. Review annual reports from a few years back. Pay special attention to what management said then about strategies for the future. Then after you do that, you compare those plans to today's results and just look at how they were realized. You could also just compare the strategies of a few years ago and look at this year's strategies and ideas and just look at how the thinking has changed over that time period. You can compare the annual reports of the company that you're interested in with reports from similar companies in the same industry. It's not always easy to find exact duplicates of companies, but even relative performance comparisons can really yield good results and insights. Now there was a business I own that I won't bother mentioning by name, but I didn't use the framework that I just mentioned above after I bought it, which is very unfortunate because if I had used that framework I probably would have saved me a lot of time, headache and money. But oh well. So if I look back, management had an initiative for a host of its products that it thought it would carry the business into the future and be responsible as kind of these growth levers. But when you fast forward just a few years into the future, basically all these growth initiatives would just been thrown out the window. They didn't bother mentioning them at all. And even for the few years that they actually did discuss it, things just weren't moving very fast. And I think it was very clear to them that even though these growth initiatives were what they wanted to be, value added for the business, they just weren't. And so they eventually just just got rid of them. And to me this is just a massive red flag. Don't fault me, this is when I was newer to investing, but it would have been a big enough red flag for me to just not buy it in the first place. Now on the other hand, maybe you go back in time and see that a business such as Lululemon, which Clay and I spoke about on tip, episode 627 has this initiative that goes back to 2020. So they call it the Power of Three initiative. So the three initiatives here were product Innovation, guest experience, and market expansion. If you actually Fast forward to 2024, they're actually already version of this initiative because they crushed the goals of the first initiative years before it needed to be done. So these are the types of stories and management teams that I think you should be looking for. The final tool I want to discuss here is the never ending debate on growth and value. Charlie Munger has one of the best quotes this subject that I've ever read. The whole concept of dividing it up into value and growth strikes me as twaddle. It's convenient for a bunch of pension fund consultants to get fees prattling about and a way for one advisor to distinguish himself from another other. But to me, all intelligent investing is value investing. Charlie's point here about consultants using these kinds of terms is profound. I think a lot of complexity in investing has been invented by third party interests that are incentivized to make themselves look smart. Paying someone to tell you that all intelligent investing is value investing isn't nearly as sexy as paying a million dollars to some consultant for a spiffy PowerPoint presentation extolling the differences between growth and value. The key here is to understand the basics of investing and then ignore the unnecessary complexity that you will constantly come across. I often read about investing and think that I'm a fool for not understanding some sort of arcane lingo or subject that I'm reading about. Then I remember that it's completely irrelevant for me to think that way because Charlie Warren and other business people wouldn't spend a second thinking in that Fashion. Previously mentioned metrics like Beta and Sharpe ratios come to mind. I have never used these metrics in my own investing, and the only time I've ever spent thinking about them was in preparation for this chat with you today. Part of the advantage of learning investing on your own is that it's easier to come to grips with this great Charlie Munger quote. I think that one should recognize reality even when one doesn't like it. Indeed, especially when one doesn't like it. If you pay money and invest time into a formal finance education, it becomes harder to embrace reality when your education is based on academic concepts that I've already covered. As Warren and Charlie pointed out on numerous occasions, they disagree with many significant premises taught in financial academia. Now, here's what Munger said about finance theory. We try to think like Fermat and Pascal would if they'd never heard of modern finance theory. Which leads us to the next subject that I want to discuss, which is the mathematics of investing. Now, before I scare you away with talks of math, please let me put your mind at ease. I won't be going over anything overly complex, just a few mathematical notions that are worth understanding to optimize your decision making, the same way that Buffett and Munger have done for so many decades. So the most important mathematical concept is to think in probabilities. Luckily, it's quite simple to learn, and you probably have already used it many times in your life to a certain degree. But let's go over here to make sure you understand how it applies specifically to the world of investing. So in investing, nothing is absolute. We're always forced to think in probabilities because even the best company, while the possibility may be small, can be put through the wringer. If we factor that into our investing analysis process, it will greatly help in making sure that the risk we take with an investment isn't too much. You can see the language of probability written all over statements by Buffett. He said, when we are unsure about a situation but still want to express our opinion, we often preface our remarks with things like the chances are or probably or it's very likely. When we go one step further and attempt to quantify those general expressions, then we are dealing with probabilities. Probabilities are the mathematical language of uncertainty. Okay, so now that we understand why probability is so important, how do we calculate it? Now, in a practical way, the answer here is going to be Bayesian analysis. So this analysis gives us a logical way to consider a set of outcomes of which all are possible, but only one will actually occur. Let's go over a quick example here to help you understand it best. Let's take a quick break and hear from today's sponsors.
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Robert Hagstrom
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- [43:54]
Kyle Grieve
So let's imagine that you are looking at a business that listeners of TIP will be familiar with, which is Evolution ab. For this example, we're going to use three different types of scenarios that many of you probably will be familiar with. So that's going to be a bear case, a base case, and a bull case. For the sake of simplicity, we're going to just assign each of these scenarios a 33% probability of occurring. You may or may not agree with these numbers, but it's my show, so you're going to have to bear with me here. So let's briefly discuss what could happen to reach each scenario. So in the bear case, let's say Evolution loses some of its competitive advantages as other gaming operators take their business to other businesses. As a result, their net income decreases as they lose customers and current clients just become static. They fail to start adding new ones. In this case due to decreased earnings, let's say the share price goes down about 20%. In the base case, the business continues doing what it has done historically. On a smaller growth projection, they continue growing earnings by about 15% and are further boosted by a 3% dividend yield and a 2% buyback yield. This causes the share price to improve 20%. In the bull case, the business extends its competitive advantage versus competitors. Let's say they lock up even more regulated market share. They boost their earning growth to 25% along with a 3% dividend yield and a 2% buyback yield. This scenario causes the share price to improve by 40%. So now that we know the probability of the event and what will happen to the share Price, we can bring this back now to just a single number. So the bear case has a 33% chance to reduce the share price by 20%. The base case has a 33% chance to increase the share price by 20%. And the bull case has a 33% chance to Increase the share price by 40%. Now, the share price as of August 29th is around 1,067 SEK. So what we do here is we multiply 1067 by 80%, which is our bear case. Basically, you know, we're reducing the price by 20%, so that's 80%. In the base case, we're going to multiply that by 120%. And in the bull case, we're going to multiply that by 140%. So the next steps is we just multiply the value of each scenario happening by the probability. So we made 33% our probability of all three of these scenarios. And then you sum up all the numbers from there, we get a price of around 1200 SEK, which is an 11% premium compared to the current price. So Buffett thinks this way. Take the probability of loss and the amount of possible loss from the probability of gain times the amount of possible gain. This is what we're trying to do. It's imperfect, but that's what it's all about. If you change the probabilities or the expected outcome, the premium will go up or down. On the example that I just gave. Now, this means that thinking in probabilities requires you to make adjustments to your assumptions. Over time, there's going to be new events that occur that maybe will decrease the chances of your bear scenario, or maybe they'll make your bull scenario even more likely, or maybe even more bullish. Once you think about investing in terms of these kinds of decision trees, you really amp up the ability to make great decisions and protect yourself from risk. Hagstrom gives an excellent example of Warren Buffett and Wells Fargo. The gist of it was that in the bear situation, Wells Fargo would actually just break even. And the possibility that Buffett attributed to that scenario was low at just 10%. So this would give him a 90% probability of his base and bull case happening. So this means that the downside was that he didn't lose anything. And the upside offered a return that was acceptable to Warren Buffett and Berkshire Hathaway. So this kind of just really plays into Mohnish Prabhai's concept of asymmetric bets, where you can't lose too much money if you're wrong, and you win a lot when you're right. So the next section that I want to discuss is how to use this Bayesian analysis in the markets. If we run Bayesian analysis and see that the market is not seeing what we are seeing in terms of value, how do we determine when to make a bet? Charlie Munger famously said that the stock market is like a peri mutual system that you see at a racetrack. The odds of a bet change based on what is bet, just like the odds of an investment change based on the market's mood. And in terms of the market's mood, it's the same thing. You know, if the market's really, really euphoric, it means more people are going to be buying, meaning they're going to be driving the price up and it's going to get more and more expensive. So let's go back to the racetrack analogy here. So let's say a favorite horse pays 2 to 1 at the racetrack, while the long shot might pay 100 to 1. If I ask you which one you take, you might make a choice, but it really isn't enough information to know which horse is the better bet. In the market. We often see mispricings a business, let's say, with a price of $1, but let's say this same business has a value of $10. This is going to be a very, very attractive bet versus, let's say the same business is now priced at $20 with a $10 value. So when the odds are in your favor due to these large mispricings is when you really want to pounce on opportunities, because these opportunities don't come around very often. So I'd like to close this section off with yet another great Charlie Munger quote discussing the importance of thinking in decision trees. Without question, Buffett's success is tied closely to numbers. One of the advantages of a fellow like Buffett, whom I worked with all these years, confesses Charlie, is that he automatically thinks in terms of decision trees and the elementary math of permutations and combinations. Speaking of Charlie Munger, one of the greatest contributions to the world, and not just in the lens of investing, was his presentation on the psychology of human misjudgment, which is, broadly speaking, the next area that I want to cover in today's episode. The book covers two of Buffett's big influences in investing and understanding the psychology of markets. The first person being Benjamin Graham, and the second person being Charlie Munger. So Benjamin Graham had three important principles that I think have really, really helped shape how Buffett thinks about investor psychology. Let's go over those. The first one is to look at stocks as businesses. This means that once you purchase a stock, think of yourself as a partner with the business and its management team and not just the owner of a stock certificate or a bunch of blinking numbers on a screen that you should just sell to another person on a whim. I think this mental model really helps you try to build a fictional relationship with management, which can help you maintain a lot higher conviction. So second one here is the margin of safety concept. Now, the margin of safety is a concept which gives you a competitive edge in investing when you can just buy things for less than they're worth. So this accomplishes two things. One, it allows you to make more money when you were right as the wider gap between price and value that closes the more money that you're going to make. And then secondly, it minimizes your downside risk when you were wrong due to the already cheap price that you are paying. I was just chatting with the tip Mastermind community today actually about this book a little bit, and one of the interesting points that came up was that value investors often lag during bull markets and outperform during bear markets. And I think this is the exact reason is that they have this margin of safety. So during bear markets, if the market as a whole goes down, a lot of the reasoning for that decrease in price will be that expensive stocks see these huge reductions in price, but for value investors, they have more businesses in their portfolio that are already cheap. And so they're the ones that are least likely to go down in during market sell offs. So the third one here is the investor's mindset. When you think about investing as a business person, Buffett says that you're 99% ahead of the rest of the market. And that's just an enormous advantage. Thinking like a business person means you put the same type of work, analysis, energy and mental effort into buying a private business as you would a stock. Arguably, Graham's biggest contribution to investing was flipping traditional wisdom in regards to price fluctuations Instead of being sad and depressed when the price of a stock goes down. He taught us to use this to our advantage when we could identify even wider mispricings due to the depressed mood of the market. The key here is to not participate in the market's mood and develop your own perception of what an individual business is worth. When the market has soured on an idea that you really, really like, then you can pounce on it because the price is going to come down. Now, the next person to help shape Warren's view on the psychology of the market is Charlie Munger. Of course, Munger has all sorts of incredibly useful thinking tools and one of his best known tools is his two track analysis. So to use this framework, you really only need to answer two questions. One, what are the factors that really govern the interests involved rationally considered? And two, what are the subconscious influences where the brain at a subconscious level is automatically doing things which by and large are useful but which often malfunction? Let's run this on a business, Broadcom. First, let's look at some of the rational factors of this business. So the EPS has declined from $0.80 to $0.50 just in the last year. Its stock price is up 76% in the last year and it recently had a 10 for 1 stock split. Now let's look at some of the psychological misjudgments that could be factored in here that might be responsible for this event. So the Business recently mentioned AI 51 times in a call, even though it's not a pure play AI business. So if we go back to something like the tech bubble and we look at the halo effect of adding.com to your name, you can kind of see where I think this halo effect might also be happening in today's markets where mentioning AI gives you this positive effect because it's associated with AI play such as Nvidia. But the fact is, while this business can talk about AI for until it's blue in the face, it doesn't mean it's an AI company and it doesn't mean that it's going to be getting the type of fundamental benefits that other AI companies are going to get be getting. So the next psychological misjudgment that could be at play here is social proof. So investors love a high place as it's just new and exciting. So some investors will actually feel left out when they don't take part. Now businesses can take part in the potential upside of joining in one of these rallies when investors all just want to fit in with the herd. And so that's why a business like Broadcom, even though it's not a pure play AI business, it might not even necessarily be that they're trying to manipulate the market or anything. Management, for all we know, could also just be very enthusiastic about AI and they want to try to figure out ways to use their product in an AI arena. Please be of note, I don't really know like anything about Broadcom. I'm just going over some of the metrics that I found that were based on facts and then just looking at some of the psychological misjudgments here. So the final one here is just loving tenancy. So investors out there who might already own businesses like Nvidia might now be looking for similar businesses that offer upside that they hope will approximate what Nvidia did for them. So since they already judge these types of businesses as favorable, because obviously Nvidia has had this massive stock price appreciation, this can dampen the realistic fundamental situations of adjacent businesses such as Broadcom. So this analysis is highly valuable and worth running constantly. I know I should probably be doing this a lot more often. I really think it helps you think more rationally and better understand psychological misjudgments, which are just rife in the investing world. And then the other important part about thinking about these psychological misjudgments is obviously we can attribute them to the investing world as a whole and the market as a whole. But I think probably even the more powerful use case of it is in self reflection where you're looking at yourself and seeing where you could possibly be making these mistakes. Because I can guarantee you you are making them. We all do at some point in time. And I think the quicker that you can identify these mistakes, the less risk you expose yourself to and hopefully you'll lose less money and be able to reallocate that into better bets. So Robert Hags from mentions four specific misjudgments that he thinks are a big part of behavioral finance. So the first one here is overconfidence. So investors believe that they are more intelligent than everyone else, even though base rates would suggest otherwise. The second one here is overreaction bias. Investors tend to overreact to bad news and underreact to good news. If short term news is poor, investors will overreact and punish the share price. And often good news might actually take years to show while the stock market refuses to account for it. The third one is loss aversion. Investors feel the pain of loss twice as powerfully as the joy of gain. This is why many investors will hold on to their loser stocks, hoping to recoup their losses when cutting the cord is often the most rational decision. I've definitely been responsible for this mistake in the past and it definitely cost me money having to wait around for a stock to improve its fundamentals. When looking back, the writing was just on the wall that it was very, very unlikely to happen. So the fourth one is mental accounting. So this refers to our habit of shifting Our perspective on money, as surrounding circumstances change, we tend to mentally put money into different accounts and that determines how we think about using it. So this concept of mental accounting is interesting and I want to touch on a little bit more here because it has some very profound effects, I think, in financial history. So Edward Chancellor, in his excellent, excellent book the Price of Time, mentions that easy money ends up leading to speculative manias. Now I think part of this can actually be attributed to mental accounting. When money is easier to come by, it can be thought of as being found money, especially in the low interest rates that we've lived in here for the past few years. This changes investors perception of money versus having to work hard for it or not being able to have access to it as easily. As a result, people invest money differently and often into perilous and speculative investments that eventually blow up in their face. So one thing that you'll notice about these four biases is that they require large amounts of self awareness if you hope to try and combat them on your own. And this is precisely what Warren Buffett does. While he's thinking. Hagstrom writes about Buffett. He puts his faith in his own research rather than in luck. His actions derive from carefully thought out goals and he is not swept off course by short term events. He understands the true elements of risk and accepts the consequences with confidence. So when you are investing, I think you should go into it knowing that both you and the market will be biased at times. The key is that you can control your own behavior and develop your own self awareness. The market unfortunately will continue making the same errors over and over again. So the game plan should be one, have guidelines to help you avoid making the most common mistakes and two, recognize other people's mistakes in time to profit from them. So the simplest way to avoid common mistakes is just to first understand them and then think about if you could be making them. And that doesn't necessarily only need to be in the realm of investing, that could be in anything in life. But I think the more you think about biases that you could be making and mistakes that you're making, the more of a habit you make it and the easier that it becomes to identify these biases in yourself and in others. Now, in terms of assessing others mistakes, once you realize how you personally could be making the mistakes, it becomes a lot easier to identify them in other people. Think about specific businesses and what is assumed in their current stock price. If you know a business very well, you may understand that the assumption the market is making are just very short term in nature or could theoretically be outright wrong. And that is how you profit from other people's mistakes in the stock market. The final chapter I want to discuss is why investors as a whole have had such a hard time outperforming the market. So Hagstrom here uses a very good metaphor to describe this problem. During a 29 year period in the early 1900s, there were nine seasons when a baseball player hit over.400 in a season. But after that period, only one player has ever done it, who was Ted Williams. So famed scientist and baseball fanatic Stephen Jay Gould hypothesized that the reason for this was that all baseball players simply have improved at a very rapid rate. And because everyone got better together, it erased the ability for these outlier performances. Peter Bernstein, who wrote one of the best books on risk I've ever read, which was against the gods, said that a lack of above average performance by professional money managers is a result of the ever increasing level of investment management education and knowledge. As more and more people become more and more skilled at investing, the odds of a breakout performance by a few superstars just diminishes. Now, while outperformance is very, very hard, admittedly it's not impossible. Bernstein mentions that one key to becoming a.400 hitter is to make concentrated bets, as we've discussed throughout this episode. Now, while the sample size is small, the five investors that were outlined in this book would probably all be considered. 400 hitters. And the thing is, is that all five of these people used a very similar investing strategy. Peter Bernstein says here, to become a.400 hitter, the portfolio manager must be willing to make the kinds of concentrated bets that are essential if the aim is to provide high excess returns. So to sum this book up, and to give you the best chance of hitting.400, Robert gives eight wonderful pieces of advice. One, think of stocks as businesses. Two, increase the size of your investments. Three, reduce portfolio turnover. Four, develop alternative performance benchmarks. Five, learn to think in probabilities. Six, recognize the psychology of misjudgment. Seven, ignore market forecasts. And eight, wait for the fat pitch. Now, while these maxims seem easy to hear and understand, following them in reality is not. Which is why just so few investors follow them. They can't for various reasons, whether that's psychological because of regulatory constraints or just because of plain dogmatic thinking. But the best part about being an individual investor is that you have the ability to truly do what you want with your own money and follow as rational system as you deem possible. Good luck out there. That's all I have for you today. If you want to interact with me on Twitter, follow me at irrationalmrks or on LinkedIn under Kyle Grieve. If you enjoy my episodes, please feel free to drop me a line and let me know how I can make your listening experience even better. Thanks again for tuning in.
- [62:14]
Robert Hagstrom
Thank you for listening to tip. Make sure to follow we study billionaires on your favorite podcast app and never miss out on episodes.
- [62:23]
Kyle Grieve
To access our show notes, transcripts or.
- [62:26]
Robert Hagstrom
Courses, go to theinvestorspodcast.com this show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.