I recently read two very enjoyable books, The Dhando Investor, by Mohnish Pabrai, and Thinking, Fast and Slow by Daniel Kahneman.
The first is an incredible book for acquiring business and investing wisdom, and the second provides exquisite insight into the characteristics and biases of human thinking, especially decision making. I highly recommend both books to anyone seeking to become a better investor or businessperson.
I’m not going to summarize the concepts of the books, rather I am going to show you the selected ideas that I thought were particularly insightful, new, or captivating.
Let’s start with the more directly applicable highlights from The Dhando Investor:
“As we see in Chapter 15, the psychological warfare with our brains really gets heated after we buy a stock. The most potent weapon in your arsenal to fight these powerful forces is to buy painfully simple businesses with painfully simple theses for why you’re likely to make a great deal of money and unlikely to lose much. I always write the thesis down. I it takes more than a short paragraph, there is a fundamental problem. If it requires me to fire up Excel, it is a big red flag that strongly suggests that I ought to take a pass.”
Simplicity is a virtue. You should be able to write a coherent and easily understandable thesis when you consider a possible investment.
“Graham’s perspective on the importance of margin of safety seems pretty straightforward and simple. Recall that Einstein’s five ascending levels of intellect were ‘Smart, Intelligent, Brilliant, Genius, Simple.’ When we buy an asset for substantially less than what it’s worth, we reduce downside risk. Graham’s genius was that he fixated on these two joint realities:
1. The bigger the discount to intrinsic value, the lower the risk.
2. The bigger the discount to intrinsic value, the higher the return.”
Nothing new for a value investor, but these are simple and wonderful affirmative statements that one should always remember.
“Read voraciously and wait patiently, and from time to time these amazing bets will present themselves.”
This is how you should go about investing, always gathering information and keeping an eye out for those low-risk, high-uncertainty bets. Only decide to take action when an opportunity with outstanding probabilities regarding its possible outcomes presents itself.
“If I were given just two investment choices of Google or Microsoft at present prices, it is a no-brainer decision for me. I’d pick Microsoft all day long. It is a battle between an innovator versus a cloner. Good cloners are great businesses. Innovation is a crapshoot, but cloning is for sure.”
I thought this was very interesting and a little bit surprising. Nonetheless, it is important to remember that companies involved in innovation in highly competitive industries are often under much more pressure and subject to more risk than companies that are excellent at lifting and scaling rather than innovating. Pabrai emphasizes this point in the following quote.
“In seeking to make investments in the public equity markets, ignore the innovators. Always seek out businesses run by people who have demonstrated their ability to repeatedly lift and scale.”
In case you don’t understand what “lift and scale” means in this context, it means copying or acquiring a desirable method/product/service/idea from another company and adopting it as your own. I personally am fascinated by the idea of being able to “copycat” one’s way to success.
“1. Is it a business I understand very well–squarely within my circle of competence?
2. 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?
3. Is the business priced at a large discount to its intrinsic value today and in two to three years? Over 50 percent?
4. Would I be willing to invest a large part of my net worth into this business?
5. Is the downside minimal?
6. Does the business have a moat?
7. Is it run by able and honest managers?
One should only consider buying if the answer to all seven is a resounding yes. If a well-understood business is offered to you at half or less than its underlying intrinsic value two to three years from now, with minimal downside risk, take it.”
Outstanding questions any value investor should ask before investing!
“Businesses are living entities that go through ups and downs just like humans do. We don’t know exactly how the future is likely to unfold… any stock that you buy cannot be sold at a loss within two to three years of buying it unless you can say with a high degree of certainty that current intrinsic value is less than the current price the market is offering.”
This is how a value investor’s approach to selling should be. Another delightfully concise piece of advice from this book.
Keep in mind that one should make excellent purchases in the first place in order for these guidelines on selling to be of full applicability.
“…the only time a stock can be sold at a loss within two to three years of buying it is when both of the following conditions are satisfied:
1. We are able to estimate its present and future intrinsic value, two to three years out, with a very high degree of certainty.
2. The price offered is higher than present or future estimated intrinsic value.”
This is an excellent addition to the preceding quote regarding selling.
“Within three years of buying, there is likely to be convergence between intrinsic value and price–leading to a handsome annualized return. Anytime this gap narrows to under 10 percent, feel free to sell the position and exit. You must sell once the market price exceeds intrinsic value. The only exception is tax considerations. If you’re looking at short-term gains as a result, you should hold on until long-term gains can be realized or the price is enough of a premium over intrinsic value to cover the extra tax bite.”
Oh boy, convergence of intrinsic value and price! The grand reward of the value investor. These are good guidelines on how to sell a stock.
Now let’s examine some ideas less directly aimed at offering value investing wisdom from the book Thinking, Fast and Slow. Although this book was not specifically aimed at investors, I believe that many (and especially my selection of highlights) insights the book has to offer are intriguing and possibly quite useful to a value investment practice/philosophy.
“Why are experts inferior to algorithms? One reason, which Meehl suspected, is that experts try to be clever, think outside the box, and consider complex combinations of features in making their predictions. Complexity may work in the odd case, but more often than not it reduces validity. Simple combinations of features are better. Several studies have shown that human decision makers are inferior to a prediction formula even when they are given the score suggested by the formula! They feel that they can overrule the formula because they have additional information about the case, but they are wrong more often than not.”
Again, we see the virtue of simplicity.
“…intuition adds value… but only after a disciplined collection of objective information and disciplined scoring of separate traits.”
This quote is referring to a system used to interview new soldiers in the Israeli army and determine where they would best fit. I believe this view of intuition’s role in judgment has a close connection to security analysis, where overemphasis on intuition may often be a culprit in misevaluating a stock.
“Emotional learning may be quick, but what we consider as ‘expertise’ usually takes a long time to develop. The acquisition of expertise in complex tasks such as high-level chess, professional basketball, or firefighting is intricate and slow because expertise in a domain is not a single skill but rather a large collection of miniskills.”
I’m hypothesizing that an expert security analyst is similar to other experts, and therefore possesses many many “miniskills.” When we strive for improvement, we should strive for improvement in the details, and that is what will set the final product (or analysis in this case) apart.
“It is wrong to blame anyone for failing to forecast accurately in an unpredictable world. However, it seems fair to blame professionals for believing they can succeed in an impossible task. Claims for correct intuitions in an unpredictable situation are self-delusional at best, sometimes worse. In the absence of valid cues, intuitive ‘hits’ are due either to luck or to lies. If you find this conclusion surprising, you still have a lingering belief that intuition is magic. Remember this rule: intuition cannot be trusted in the absence of stable regularities in the environment.”
Beware of experts and their intuitions! Think skeptically, and ignore forecasts which are unfounded!
“The damage caused by overconfident CEOs is compounded when the business press anoints them as celebrities; the evidence indicates that prestigious press awards to the CEO are costly to stockholders. The authors [Malmendier and Tate] write, ‘We find that firms with award-winning CEOs subsequently underperform, in terms both of stock and of operating performance. At the same time, CEO compensation increases, CEOs spend more time on activities outside the company such as writing books and sitting on outside boards, and they are more likely to engage in earnings management.’”
I thought this was really interesting. Perhaps value investors should be on the look out for overconfident CEOs, especially when CEOs having been recognized for being outstanding by receiving awards or seem to be especially involved in activities not related to the company.
“Both in explaining the past and in predicting the future, we focus on the causal role of skill and neglect the role of luck. We are therefore prone to an illusion of control.
We focus on what we know and neglect what we do not know, which makes us overly confident in our beliefs.”
There is an element of luck in investing performance, and that is undeniable. The second sentence of this quote is incredibly important for all investors, and is a difficulty that an investor should always be aware of. Overconfidence in your beliefs will most likely result in foolish investments.
“The successful execution of a plan is specific and easy to imagine when one tries to forecast the outcome of a project. In contrast, the alternative of failure is diffuse, because there are innumerable ways for things to go wrong. Entrepreneurs and the investors who evaluate their prospects are prone both to overestimate their chances and to overweight their estimates.”
Put a little extra effort into making sure you give those less desirable possible outcomes of an investment their proper weighting when determining an investment’s attractiveness (because we have a tendency to do the opposite).
Well, those were my very selective highlights from these two books!
Thanks for reading!