Tuesday, December 29, 2015

Munger on Efficient Markets, Indexing, & Stock Pickers

Charlie Munger said the following at the 2015 Daily Journal (DJCO) shareholder meeting:*

If all you had to do was figure out which companies were better than others, an idiot could make a lot of money. But they keep raising the prices to where the odds change.

I always knew that. They were teaching my colleagues that the stock market was so efficient that nobody could beat it....I knew it was bull. When I was young I never went near a business school so I didn't get polluted by the craziness.


I never believed it. I never believed there was a talking snake in the Garden of Eden. I had a gift for recognizing twaddle, and there's nothing remarkable about it. I don't have any wonderful insights that other people don't have. I just avoided idiocy slightly more consistently than others.

Other people are trying to be smart; all I'm trying to be is non-idiotic. I've found that's all you have to do to get ahead in life, be non-idiotic and live a long time. It's harder to be non-idiotic than most people think.

Later at the same meeting, he also had the following to say about indexing and stock pickers...

In the world as it is, indexing has gained a lot. It probably should have gained a lot, because it's quite rational. It's bad for a lot of people who would otherwise be earning money as stock pickers. It probably should have been bad for those people.

Money earned alongside investors isn't the problem. It's when, all too often, the money manager does well mostly from fees collected over time whether or not the average investor in a particular fund does well. Naturally, a money manager will do even better when the fund they manage performs well. So the incentives would seem aligned. Yet the range of outcomes for the investor putting money at risk, in most cases, is far different than that of a money manager. An equity investor generally has plenty of downside risk. With most fee arrangements that's just not the case for a money manager. Exceptions no doubt exist but the range of outcomes of a typical money manager -- often without the need to put their own capital at risk --  is usually good or better.

If you stop to think about it, civilized man has always had soothsayers, shamans, faith healers, and God knows what all. The stock picking industry is four or five percent super rational, disciplined people, and the rest of them are like faith healers or shamans.

And that's just the way it is, I'm afraid. It’s nice that they keep an image of being constructive, sensible people when they're really would-be faith healers. It keeps their self respect up.

Worse yet, it turns out many market participants don't even gauge their own performance objectively.

In fact, a study of investors showed that they overestimated "their returns by more than 11 percentage points per year. The average investor painfully lags an index fund and thinks he's Warren Buffett, basically."

Surprising? I certainly think so. That's why it likely deserves careful consideration:

"The thing that doesn't fit is the thing that's the most interesting, the part that doesn't go according to what you expected." - From The Pleasure of Finding Things Out by Nobel Prize winning physicist Richard Feynman

In other words, this particular bias -- like most -- may not be just someone else's problem.** So it's probably, at a minimum, not a bad idea to at least keep in mind. Simply being aware of the tendency is insufficient but it's a start. Deliberately taking steps to counteract such a bias can't hurt even if becoming completely immune may be difficult at best.

How's the portfolio objectively doing? Is all the extra complexity and effort actually yielding a clear benefit in terms of risk and reward? Am I ignoring certain things in order to feel better about all the effort that went into subpar results?

Choosing to avoid these kind of questions might prove costly in the long run.

Historically, the likelihood of doing well compared to index funds over the long run just hasn't been all that great. Some might think that's somehow going to change going forward but, at the very least, some skepticism seems warranted. The fact is too many who choose to pick individual stocks end up being overly optimistic about their abilities/prospects and, as a result, spend a lot of energy and time to little avail or worse.

Lots of unnecessary extra work.

Zero or even negative incremental reward.

The compounded long-term impact of frictional costs will always be a significant factor.

Reduce them wherever possible.


No position in DJCO

* From some excellent notes taken at the meeting earlier this year. Not a transcript.
** This has been covered, at least to some extent, in some earlier posts.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Tuesday, December 8, 2015

Competition & Moats - Part II

In a post a few months back I included the following Warren Buffett quote:

"We like to own castles with large moats filled with sharks and crocodiles that can fend off marauders -- the millions of people with capital that want to take our capital. We think in terms of moats that are impossible to cross, and tell our managers to widen their moat every year, even if profits do not increase every year."

Competition & Moats

Over the longer haul equity investing* mostly comes down to whether a business possesses durable advantages, has attractive economics, and can be bought -- outright or on a per-share basis -- at the right price.

Buffett once wrote:

"Severe change and exceptional returns usually don't mix. Most investors, of course, behave as if just the opposite were true. That is, they usually confer the highest price-earnings ratios on exotic-sounding businesses that hold out the promise of feverish change."

In fact, in enough cases to matter, businesses in rapidly changing/expanding industries -- usually with lots of growth potential -- cause investors to focus on the upside and, as a result, they tend pay a high multiple of earnings that, all risks considered, more than reflects the potential with too little consideration for lesser possibilities.

Never mind the worst possible outcomes.

The most dynamic industries might promise lots of growth but can also attract lots of competition, fresh capital, and have rules that are yet to be written. A new technology can naturally prove to be a great benefit for the world. Yet that's hardly a guarantee the capitalists involved will end up being justly rewarded. Look no further than the auto manufacturers and airlines for just two good examples. What's been better for the world those two industries or tobacco? What's generally been the better long-term investment?**

Some industries end up with multiple participants who build sustainable advantages. Others tend to have one big winner and lots of losers. For one it's a feast...for the rest it's famine. Worst of all some industries never seem to develop sound economics even for the so-called winners. With such unpredictability, identifying a sound investment beforehand -- with all risks and alternatives carefully considered -- without paying too much or making big misjudgments is easier said than done. This might makes things exciting but also inherently unpredictable with wide range of outcomes. Not exactly compatible with balancing risk and reward. In other words, lots of upside to be sure but also lots of downside.

Those who don't appropriately weigh the full range of outcomes tend to overpay for the privilege of ownership.

Insufficient margin of safety.

This is, at the very least, worthy of some consideration the next time an investment with exciting growth prospects comes along. Investing well is partly dependent on avoiding the big and costly errors.

It's worth emphasizing -- and I've covered variations of this in a number of prior posts -- growth is not the emphasis here. Growth can naturally be a fine thing under the right circumstances. Yet some seem will to assume that all growth is good growth. Well, at times, the importance of growth can be more than just a bit overrated.

There are certainly high growth businesses that end up building durable advantages over time.

Many examples of this exist from the past twenty years alone and, no doubt, there will be many more in the coming decades.

The tough part is figuring out how to reliably identify them beforehand and acquiring shares at an attractive enough price. That'd be attractive enough to own long-term and protect against misjudgments, the unknown, and the unknowable. In other words, that shares can be bought below what they're currently worth and produce a more than satisfactory long-term result. Also, if the shares do need to be sold a long time down the road (a "forever" holding period might be preferred but isn't always possible or even wise), a merely decent price compared to future -- much higher -- per share intrinsic value should be all that is required. Market participants who knowingly buy an expensive stock with the hope being to sell as it gets even more expensive have an entirely different emphasis. Market prices are not in a participants control. So it's unwise to be dependent on unusually high prices to achieve expected results. Buffett once said:

"Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results."

Now, it's not as if investing in something with exciting prospects can't work out extremely well.

For some investors -- due to their specific background and abilities -- investing in such things will be the appropriate place to risk their capital. It's just important to know when investing in such things doesn't really play to one's own strengths.

Those who build the next transformational business naturally deserve lots of respect. That doesn't necessarily mean it makes sense to invest in their efforts. Admiration from a distance can be, depending on circumstances and abilities, the right way to go.

An investment decision-making process must have enough discipline built in to prevent large and permanent losses of capital.

It's knowing what one knows as much as what one does not.

Some will choose to focus on identifying the next big winner.

Efforts to reduce costly errors often deserve more attention.

Once again...easier said than done.

Sometimes, rapidly changing competitive dynamics will result in serious damage to a business that once seemed like an invincible powerhouse with a fortress built around them.

Other times, even if not completely unaffected by the changing technological and competitive landscape, the business will adapt and continue to do just fine.

Figuring this out, at least for me, is what makes investing so challenging and worthwhile in the first place.

Some other things worth considering:

One or two big misjudgments can more than offset what's otherwise worked out well.

The relationship between risk and reward isn't as straightforward as some seem to think. Higher risk investments don't represent some kind of direct path to higher returns. Instead, they're more likely to be related to a wider range of outcomes.

A recipe for both large and unnecessary mistakes as well as possible big gains.

Risk and reward is not necessarily correlated in a positive manner.

Finding a business with rapid growth prospects -- along with core economics likely to remain sound for a very long time -- that can be bought at the right price (a plain discount to estimated value) isn't impossible but it's easy to underestimate what the worst possible outcomes could be.

Anyone can, after the fact, explain why something worked as an investment.

Only after the fact is it usually "obvious".

Cognitive and other biases -- in the context of investing -- are not necessarily just someone else's problem.


* The emphasis here NOT being on speculation. Instead, it's what an asset can produce over a very long time horizon. It's on whether something can be bought now and produce a satisfactory result primarily based on how intrinsic value changes over time. Those who try to guess what stock prices might do -- whether using fundamental analysis or not -- over the next few years or less are attempting to do something I have no view on whatsoever. There's nothing inherently wrong with speculation but it just doesn't have all that much in common with investment.
** This historical reality reveals little about the future: Different times, different competitive dynamics, different market prices....among other things. The point being that expecting what's good for the world to be directly correlated with future investment returns can be a big mistake.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.