How To Learn How To Invest

“How do I learn how to invest?”

I don’t get asked this often, but I do get asked often enough that I should have a resource on this topic on this blog. My recommendations are qualified as follows: first, when people ask me how to get started with investing, they usually mean public (US) equity markets, not real estate, commodities or venture capital so that is what I am responding to; second, when I think of investing in public equity, I think of the “value investing” approach, there are other ways to invest but I don’t understand them or I do not trust them so I don’t recommend them; third, I try to form a recommendation based off of what I wish someone had told me when I had this question, so it may fit a person better or worse based on their previous knowledge, experience and intelligence; fourth, I think people are usually looking for reading material when they ask this question and I think that’s the best way to learn what needs to be learned so that is what I recommend; finally, I have struggled for over ten years with DOING rather than THINKING/READING, so my strongest recommendation is to put this knowledge and the concepts learned into practice almost immediately and start learning through action as soon as you can– it’s the only way to build the confidence I mostly never had.

I think there are a few key things a person needs to get comfortable with in order to build a solid foundation as a student of investing practice. Personal discipline, inspiration and technical know-how are the required ingredients.

Personal discipline is about generating meaningful savings. Without savings, there is nothing to invest. And without a habit of saving, an investor will have difficulty weathering the inevitable setbacks in their portfolio, taking advantage of periodic market tumbles with dry powder and resisting the temptation to sell at the worst possible moment to fund a lifestyle need or unexpected emergency. To be a great investor, I am convinced, you must be a great saver. Capitalism is built on savings, so by learning how to save you are not only building a bright financial future for yourself but helping to tend to the foundation of modern society.

Inspiration is about seeing the end game, knowing what is possible and staying motivated through the hard work and daily grinding that are the meat and potatoes of actual investing work. By studying a master you can understand not only what it takes but what to expect from your own results. And having realistic expectations is important in a business where you are your own worst enemy and the most important entity to manage.

Technical know-how is about the mechanics of investment analysis. Having a rudimentary knowledge of accounting as the “language of business” so that you can intelligently read financial statements (the reports public companies issue about their operations) and understand what is going on, and understanding what great value investors look for when analyzing an investment opportunity in terms of safety and calculated return are the actual tools you need to “do investing.” But trying to get this information before you are disciplined about saving and inspired to pursue the hard work of investing is surely putting the cart before the horse.

The meta lesson here is patience! Something all great investors need to succeed.

For the dedicated student, I have five resources I strongly recommend to methodically take oneself through these concepts. Here they are in order.

Savings and personal discipline

The first book is The Richest Man in Babylon, by George Clason. The book is a collection of lessons about how to save and the benefits of saving in the form of parables of wisdom from ancient Babylon. The narrative is extremely dated and not Politically Correct but that is exactly what makes what might otherwise be a dry subject quite wondrous and entertaining to read. When you read The Richest Man your life will change if you previously haven’t been a saver or didn’t understand how to save; for those who do, it will strongly reaffirm what you do and help you connect how critical it is to your long-term investing plan.

The second book is The Millionaire Next Door: The Surprising Secrets of America’s Wealthy, by Thomas Stanley and William Danko. Millionaire is a statistical study of America’s self-made millionaires– how do they live? what are their habits? what are their families like? how do they make key financial decisions in their life? You will see the importance of savings and frugality as a common theme. But you will also learn that millionaires don’t live millionaire lifestyles by and large and they certainly don’t build their lives around competing with their neighbors on consumptive habits. Because investing is a long enterprise where small advantages accrue over time (and small mistakes and expenses snowball just as easily), a person who fully integrates their desire to live life patiently and without excess will have a much higher chance to be successful as an investor.

Inspiration

Okay, you’re saving money and you’re not going to let your spendthrift neighbors new car in the driveway distract you from your mission. You’re not even going to WONDER how he affords it– you know he can’t and that it doesn’t matter a wit to how you do as an investor. You’re ready to be inspired, and who better to do that job than the arch-master of modern investing, Warren Buffet? It’s time for your third learning with Buffett: The Making of an American Capitalist, by Roger Lowenstein. There is a second Buffett biography which I think is superior in a number of ways, but that is for later on. You can obsess over those details later. Lowenstein is enough right now and he still tells a good story– who was Buffett? how did he do it? what was his philosophy of investing? and what were the key episodes in his investing career that made him his billions? Reading this Buffett bio will not only make your eyes twinkle as you dream of your own pot of gold at the end of the rainbow, it will clue you in to the fact that there might be some rain along the way.

Accounting

To analyze companies on the stock exchanges, you must be able to read the financial filings they make with securities regulators. In the US, these are called 10-K (annual) and 10-Q (quarterly) reports. And these reports are typically not glossy, photo-filled corporate feel good story books nor would you want them to be– they are filled with numbers, tables and charts and they’re primarily related via accounting conventions. To understand what these financial statements are saying, you should read your fourth book, The Accounting Game: Basic Accounting Fresh from the Lemonade Stand, by Darrell Mullis and Judith Orloff. The book walks you through the accounting for a simple business, a children’s lemonade stand. You won’t be ready to audit a company or step in for your CPA friend on the weekends, but you don’t need to, you just need to understand what the difference between the three major financial statements are, what revenue is and where profit comes from, how to tell if a company has a health financial picture or otherwise, etc. That’s enough and this simple and “childish” book can get you there.

Investing mechanics

You’ve learned how to save and how to focus on yourself rather than your social circle’s economic position. You’ve read about how the grand master became the grand master and gotten a rough idea of what investing is and isn’t. And you’ve gotten the basics of accounting down so you can actually understand what you’re looking at when you peer under the hood of a public company you’re considering putting your capital to work with. But how do you actually find, analyze and make investments?

Your fifth resource is The Essays of Warren Buffett: Lessons for Corporate America, by Laurence Cunningham. This is a handy resource for the collected writings of Buffett on a variety of topics related to investing and corporate value. You can learn about what makes a business well-managed or poorly managed and from there you will be a lot less dangerous to yourself when you actually try to invest in one of these companies.

However, there is a cheaper and even more rigorous way to drink at this trough. Try Warren Buffett’s Letters to Berkshire Shareholders (1977-present) available at no cost at the Berkshire Hathaway website. Berkshire is Buffett’s public holding company and the accumulated legacy of his investing activities since the early 1950s. In these letters he lays out his principles and explains the happenings in his business in enjoyable detail and with meaningful repetition. By the time you finish these 50+ years of letters you will have a better knowledge base of how to invest successfully than 95% of market participants, of that I am confident.

And you can build on it still further by hunting down the private partnership letters Buffett wrote prior to the Berkshire days (1950s-1976), by reading the Berkshire Hathaway “Owner’s Manual” and by reading the two special letters from Buffett and his partner, Charlie Munger.

If you read, re-read and understand all of that and then actually apply it, you have learned how to invest. Now all you have to do is do it!

Shortcuts

While the recommendations above don’t represent the ten plus years I’ve devoted to studying this topic in totality, I do think they cover 80% of the conceptual ground. And it bears repeating, they cover 0% of the activity ground, to cover any of that you need to start investing, even if you don’t have 100% confidence and might make a few (small, at this point) mistakes.

For the other 20%, I have recommendations on intermediate and advanced level readings that I would not make to any but the extremely motivated or the deathly curious. And beyond those titles, I recommend nothing but a course of vigorous doing. No amount of reading can ever make up for the practical experience of attempting to find, analyze and invest in actual companies.

But some people who have asked me about this topic have, after having the above laid out for them, complained they do not have enough time. You can guess what my reaction is in that case– if you don’t have time to sharpen your axe, you are unlikely to fell any trees. And more likely, you will trip on the damn thing on the way to the forest and mash up your leg.

That being said, I realize the subject can seem intimidating the way I’ve laid it out. And I think that it’s important people get the best chance to prevent the commission of grievous errors in this domain as possible if they’re determined to act despite my apprehension. I have given some thought to a condensed list of super-accessible readings that even those short on time and discipline can get through on the way to the nirvana of being an investor.

The Quick Way To Learn About Investing

If you’re determined to jump right in to investing, there are two things you need to know:

1. How to save money
2. Whether you want to be a passive index fund investor, or an active value investor

I still think it’s critical to understand the importance of saving and how to do it. Without saving, there is no investing and I think a person who doesn’t understand this early on is going to suffer for it years later, especially if they are retirement-oriented.

As to the second question, it’s a personal decision determined by available time, motivation to learn and act and also expectations about returns. For people who just want to watch their savings grow faster than their bank account would permit but who otherwise don’t want to treat investing like a business or even a hobby, index investing is the way to go, all caveats aside. And if you’re going to go that route, you need to understand how to minimize your costs and (ironically) minimize your own involvement so you don’t make bad decisions about buying and selling at the worst possible time.

And if you think you want to take a more hands-on approach and really be an investor rather than just an sophisticated saver, then you need to get a quick tutorial on how an investor thinks about what he’s trying to do which you can immediately then begin applying as a framework to potential investments you find.

My quick path then has three primary readings:

1. The Richest Man in Babylon, by George Clason
2. The Little Book of Common Sense Investing, by John Bogle
3. The 2013 Berkshire Hathaway Shareholder Letter, “Some Thoughts About Investing” section until the row of asterisks on page 21, by Warren Buffett (free PDF)

TRMIB is still my top pick for learning about saving and how to do it. The Bogle book I think is all you need to understand what index investing is, how to do it safely and whether it is right for you. You could immediately begin an index investing program after reading that book if that’s what you wanted to do.

Rather than a book, for learning the basics of value investing, fast, I recommend the essay embedded in Buffett’s 2013 shareholder letter. It is his all-time best description of the value approach and what a value investor is trying to accomplish and therefore what he looks for in an investment. If you read that and don’t get what he is saying, start your index strategy. If you do, you’re off to the races and surely will be inspired to read and do more. But the argument he lays out is robust enough to allow you to do some immediate qualitative heavy lifting if you start looking at individual companies to invest in. It’ll be pretty clear to you if they company offers an opportunity, at current prices, that jumps Buffett’s hurdle.

The Third Way

In economic history, the socialists who realized their dreams of a planned communist economy could never work switched tactics and advocated a “Third Way”, the private-public regulated market economy. Of course, it turned out to be just as nefarious as the pure communist economy in its own way and the point is there was no real Third Way available. There was only the market economy or various flavors of central-planning chaos.

People reading this who don’t want to read 5 books and don’t want to read 3 books/essays but who still want to learn about investing might be wondering, “Oh, but isn’t there a Third Way?” Actually, in this case there might be.

Recently I reviewed The Acquirer’s Multiple: How the Billionaire Contrarians of Deep Value Beat the Market, by Toby Carlisle. This might be the best option as far as a one-stop shop for a total neophyte goes. The book assumes you know how to save and are ready to invest. From there, it offers a simple metric (the Acquirer’s Multiple) for identifying interesting investment opportunities. It explains why the metric is an indicator of value and it walks through several historical-biographical case studies of other famous investors showing how they succeeded with an opportunity indicated by this metric. The book does a great job of explaining (by both showing and telling) why value “works”, ie, the concept of mean reversion. I think these two pieces help to inspire a new investor to feel confident and motivated about looking for their own opportunities.

The book has a bias toward action. A person new to investing could read it and then immediately run a screen of low multiple stocks and begin vetting them for an investment. And it has a helpful checklist at the end of the book to improve your overall decision-making process.

If someone insisted on one book and was clearly indicating they weren’t planning to go deep and just wanted to get busy, I think they could do a lot worse than reading this book and I am not sure they could do better because I can’t think of anything else that is simple and easy to understand (written without technicality), covers the basics of value as an approach and offers a practical tool for putting the philosophy to work.

While I think it’s really dangerous to try investing without reading or understanding anything, I also know from experience it’s dangerous to overthink it and fail to act. Following the 5, 3 or 1 item approach outlined here I think gives the interested student some basis to begin acting knowledgeably and to arrange their further experience and study into a meaningful structure for organizing thought.

An Investment Confessional

Since the market low in March of 2009, I have not managed to keep pace with the passive return of the S&P 500 index. In no year in the last 8 have I met or exceeded the return of the index on a portfolio-wide basis. I would’ve been much richer by now if I had just turned my capital over to Mr. Market almost a decade ago and spent my time and energy worrying about anything but investing.

And I managed to do this primarily by being uninvested throughout this time period. I have not gone back and done a trade-by-trade and year-by-year study of my portfolio returns over this time period (I am including here my personal accounts as well as other accounts I manage) but just eye-balling it I think it’s safe to say the most exposure I’ve ever had to equities over this time period was no more than 25% of any of the portfolios and probably a lot closer to 20% on a gross capital basis. In essence, I sat out one of the biggest bull markets in history and missed an opportunity to capture a 271% total return through passive management. That’s something like 18% a year, an impressive long-term rate of return by most standards.

How did I manage to let this happen? And what have I learned from this experience? More importantly, what do I plan to do differently going forward?

The story of this mishap is complicated in my mind and is over ten years in the making. I was aware of the stock market as a concept since my early teenage years. On Friday nights after dinner my family would watch a battery of shows on PBS including “Wall Street Week with Louis Rukeyser.” I learned nothing about investing from watching this show other than there was this place called a stock market and people had a lot of opinions about what was happening there. My father was no investment guru and my clearest memory of him with regards to the stock market (aside from watching this show beside him) was him coming home during the Tech Bubble — which I did not know it as such at the time, nor did he — and saying things like, “Wow, I can’t believe it, my AOL stock doubled again today” as he set his briefcase down and went to change for dinner. He did not work to understand what was going on with the companies he owned and he did not encourage me to be curious about it.

In high school I never took one of those “business” classes where everyone plays the “stock market game” and creates a fantasy portfolio. In retrospect, this is a terrible way to introduce young people to the idea of common stock investing as most learn from it what I learned– it’s “fun”, it’s “random” (the winner was inevitably some kid who got lucky betting on things that happened to go up during the course of the game) and there are no costs if you’re wrong because everyone was playing with funny money. But I remember being disappointed I didn’t get to play, and excited when I realized I could find the website on my own and play on my own time, although I quickly gave up when I realized I had no idea how to pick a stock and was basically just rolling dice.

When I began working over the summers in between school years and accumulating some savings I began looking for yield beyond my bank account. This was during a time where a “safe” money market fund was yielding just over 5% a year. I put my savings with Vanguard’s MMF and felt quite wealthy watching it grow at 5%, not knowing what a money market fund was or why it offered more than a bank account and not knowing that with a little elbow grease I could earn much more than that as a proper stock investor.

Fast forward to sometime in college and I was much more interested in this idea of investing as a discipline. I was becoming aware of the world of finance, likely in part due to my proximity to the global center of it (“Wall Street”), in part because many classmates and friends were talking about it as a career opportunity and in part because my readings and interests and slowly taken me there. I became aware of the hedge fund industry and the idea that people made their living making investments all day long. I decided that sounded pretty interesting to me (much more on this topic in a future post I plan to write) and might be something I’d like to pursue as well.

And somewhere in there I came across a recommendation to read The Intelligent Investor by Benjamin Graham. Which I proceeded to do, but, despite reading the book from cover-to-cover, including the end chapter commentary by Jason Zweig that many people detest but which I think actually adds some value and can even be enjoyed as a standalone reading, I really did not understand much of what I read. And the even greater sin was that I failed to apply what little I understood.

I did not begin searching for Ben Graham stocks. I did not use his principles of risk management in constructing my own portfolio. I did not look for opportunities to spite Mr. Market and buy stocks when he was panicking and sell them when he was giddy. I did not begin looking at stocks as ownership certificates in real businesses. I did not even do any investing beyond my Vanguard MMF! For whatever reason at this stage in my life investing was a purely academic interest.

This began to change as I neared the end of college and was seriously considering a career in finance. Around this same time, I had been reading deeply of Austrian economics and had become convinced, like many who had, that we were on the precipice of a global economic calamity that would start with the housing sector and quickly come to overwhelm the banking sector. I was obsessed with this End Times prognostication and spent most of my time working to understand what was coming and thinking about an investment strategy that would stand to benefit from macro disruption. I was finally ready to take some action and I ended up doing two things.

The first thing I did was to sow doubt about my parents’ equity holdings in their mind, particularly their heavy concentration in the financial sector (prime offender: Citibank), which their broker was convinced was one of the cheapest parts of the market and thus he had increased the total exposure in their blue chip portfolio. I told them the end was coming and they should liquidate everything and go to cash. I was initially unsuccessful, but when the first hiccup in the markets occurred, my dad got worried and decided to at least follow my advice to sell all his financial stocks, including Citibank, his largest position, which the broker bleated about painfully for weeks afterward.

The second thing I did was to follow Peter Schiff’s strategy regarding the Great Decoupling of the United States from the rest of the world, and what better way than to open an account with Schiff’s firm, Europacific Capital, to buy all these great foreign stocks (especially commodity companies and infrastructure businesses) at rich commissions? I put essentially my life savings to date into this account, naively trusted my broker when he told me he’d help keep an eye on the portfolio and recommend trades to me at appropriate times, and chose five companies (“that should be plenty of diversification!”) from a list of about 15 or 20 he pulled for me on a basis that was then entirely arbitrary and is now completely unmemorable for me. All I know is I did not use any of Ben Graham’s principles or ideas and I think I feigned a knowing approach by saying the P/E ratios of the companies I was about to buy out loud, almost like an invocation, but beyond that I had little idea what these companies did, what valuation I was buying them at and how big my Margin of Safety was.

The way the story turned out is my parents were grateful and I was obliterated. I saved my parents a lot of money with the move to liquidate the financial stocks as that blunted most of the pain that was to come. After the markets had tumbled some 20-25% (and maybe about 30-40% of the total move down) they ended up liquidating the rest of the stock portfolio and held on to their high quality bonds, something that I had no opinion on despite reading Ben Graham and being pretty opinionated about most other credits in the market (I could talk your head off about CDOs and what a danger they were long before Michael Lewis wrote any books on the subject) which was a good move as interest rates went ZIRP. They really thought I was a genius and neither of us knew I just happened to be lucky. I should’ve been more clued in by what happened in my own portfolio.

My own portfolio lost a lot. At one point I was down about 70%. America did not decouple from the world and the world did not decouple from America. Everybody rode the coaster down together and because I picked economically sensitive businesses at near peak valuations it was indeed a painful ride. I had no idea what to do other than to just hold on (actually, not a bad response and much better than the typical mistake of panicking and selling to Mr. Market at the worst time). But after about two or three years of waiting after the crisis, my portfolio was still down about 50% and I decided it was time to admit I had screwed up and realize my losses. If I had just been more patient, I might have been down at most 20-25%– a bad drawdown, for sure, but much different in terms of wounded pride and sucked out capital than a 50% permanent impairment; even my crappy picks which had amounted to little more than throwing darts at a stock table would’ve caught a bid like everything else during the Great Global Reflation.

Being massively right in my parents’ case and massively wrong in my own should’ve been a good indication I didn’t know what I was doing. Instead, I took away the lesson that macro investing worked and I might actually be good at it if I could learn how to do it consistently well, and stock picking on the other hand didn’t seem to work because I had picked stocks and that went poorly for me. It was embarrassing, particularly because I had told a lot of people ahead of time what I was doing and why, but I found myself still interested in the subject and wanting to explore it more.

That was hard to do as a career because the aftermath of the global financial crisis made getting a job in the industry almost impossible. I went to work for another large company and made more idiotic macro bets while I bided my time. Somehow I was able to stifle the cognitive dissonance of reading Security Analysis at my desk at work (covered wrapped in a brown paper grocery bag, and only when I had gotten my paid work finished for the day) while buying things like the 3X leveraged short financial ETF in what was left of one of my personal accounts. I have no idea why I was reading Ben Graham’s magnum opus analyst handbook at this time or how I had even heard of it and once again I understood little of what I read despite going cover-to-cover, and applied none of it. I scraped some short-term capital gains on these stupid trades and then gave it all back and then some when my luck ran out. I finally threw in the towel and swore off “investing” for awhile as a personal practice while I continued to be interested in getting into it as a career.

After months of pestering a small global macro fund I had heard about in Texas about an analyst position, they agreed to hire me and suddenly it seemed my dreams were coming true. I was convinced this was just the beginning of a long and successful career as a professional investor and despite my initial failures at investing I was excited to come on board and learn what it was really all about.

It turned out not to be so. I learned little about financial analysis or portfolio management in a positive sense although my time spent with this firm armed me with an abundance of lessons in what not to do. The gentlemen I worked for were extremely intelligent, talented and honest and had made out like bandits during the crisis with their own successful predictions and even more successful operations, but like me they had been fooled by luck and had failed to appreciate that successful investing is a practical exercise, not a moral one. They could not let go of their critical view of economic events and the connection they had to the market and they became as embittered as they were emboldened to soldier on against the forces that be in hopes of teaching the world a lesson in folly.

That they did, but the folly was their own. Sadly, it was my folly, too, because despite seeing that it wasn’t working, I was also rather gung ho about it. I couldn’t figure out HOW to invest like that in my own portfolio, so I was mostly inactive as an investor. I also began work on another project in cognitive dissonance. This time, I had managed to figure out that Ben Graham had a student, Warren Buffett, and that there was all kinds of information out there about Buffett, his life, his investment record and his method for investing and risk management. I began drinking heavily at this fountain while taking another turn at the writings of Ben Graham. I was beginning to wonder if maybe the macro stuff was a dead end and there wasn’t something to this value investing concept. I was thinking about doing it in my own account. My timing was again almost impeccable, but I did not know it!

First though, I decided to pitch my bosses on value investing. Maybe we could balance out some of the short exposure in the portfolio with some of this Ben Graham stuff? There seemed to be a lot of opportunities out there based on some quick screens I ran. That’s when I got the dumpster diving speech.

Value investing is a lot like dumpster diving– every once in awhile you come up with a Picasso, but most of the time you come up smelling like garbage!

And besides, everyone knows Warren Buffett is an asshole and just lucky, he’s been on the side of the establishment which has put the wind in his sails, he got a bailout when his house of cards almost came tumbling down in the crisis and no one has been able to replicate his success, likely because he is working some kind of fraud. You don’t want to go there, kid, and neither will we!

My confidence was completely shot! This turned out to be the second best time to get into value investing besides the March 2009 low itself, but I had just been told this was basically the stupidest idea a person could come up with– and since I hadn’t managed to learn much from them, this was about the only idea I had. I was burned out on them, burned out on my broken dream and burned out on how bad I seemed to be at investing in general. So I called it quits.

I ended up joining the family business while I licked my wounds, egotistical and otherwise. The idea was to have a hideout while I figured out where my next heist would be. I was trying to figure out how to go be an analyst somewhere else but I didn’t know where. It seemed like I needed an education, so I began what I came to call my “Personal MBA” program, an intense, year-long effort of reading everything I could get my hands on about business, finance and investing. I’ve written about that earlier on this blog.

Buffett talks about value investing as something that a person either takes to immediately or rejects outright. While I hadn’t yet successfully employed the concepts in my investment practice, it had clearly infected my mind. The macro thing did not make sense to me at a conceptual level but the idea of studying stocks as businesses and looking for indications of cheapness that lent a margin of safety did. I think this is why I kept pushing on and went through my Personal MBA despite having no track record otherwise.

A few interesting things happened during this time period and shortly thereafter. First, I began doing real research and analysis on individual companies– I built spreadsheets and collected operating data, I read SEC filings and books about industry and company history and began to appreciate what it meant to approach the process of investing like a businessman. Second, I actually made some investments– some net-nets in the US (what remained at this stage in the game), some good companies at great prices and even a wonderful company at an un-fair price and later, a basket of foreign net-nets (my JNet strategy), along with a few special situations and some capital structure arbitrages I was coattailing on with another investor friend. While there were a few flops that either went nowhere or I lost a little on, for the most part my results on an individual investment basis were good to great and a few were even outstanding. Third, I continued believing I had some kind of crystal ball as far as market timing was concerned and I let that dominate my overall investment program– as described at the beginning of this essay, I took small, almost meaningless positions in most of the companies I invested in (aside from the JNet basket) such that when they worked, they didn’t have much of an impact on my portfolio overall and when they failed, they also didn’t have much of an impact. It was an excellent way to have nothing to show for the effort I put into it!

While this exercise helped me to build intellectual confidence, I was still not matching it with practical confidence and I doubted myself a lot along the way. What’s worse, my obligations in the family business continued to compete with my interest and efforts in investment management such that they were not only a serious distraction at times from a more meaningful and concentrated effort in this space but they were also a suitable rationalization for why I couldn’t just go all-in and really commit to my investment activity.

At one point I changed operational roles within our business and finally had no bandwidth to spare for investing. I went functionally inactive on investing for almost two years and decided ahead of time that it would be irresponsible to have the portfolios exposed even the minor amount they were at that point in time (especially because I kept not liking what I was seeing as I gazed into my crystal ball!) while I wasn’t paying any attention to them so I liquidated to concentrate on operational issues full time. Incredible, given that sitting on one’s hands is said to be the hardest part of managing a well-constructed portfolio and I missed out on even more returns, meager as they were, with this decision.

Recently I have returned to a more strategic role in the family business and it is more clear now than ever that we need someone to be working on sound capital allocation for us. The most logical person to do this is me, in part because I was the person to point out the need and in part because I’m the only person with that kind of knowledge base. But do I have the experience?

This is where we come to some of the learnings I have taken away from my journey to date. As I mentioned before, I made some grievous errors early on in my investment career. I violated the first rule of investing countless times and I am lucky to still be standing thanks in large part to my extreme propensity to save which has allowed me to accumulate savings faster than my early rate of depletion. But since that time period, when I have actually applied the value investing framework knowingly and cautiously, my results have been good and within expectation. If I had not been so lacking in confidence and tried to make up for my initial indiscretion by being over-conservative, my investment operations at scale would’ve yielded an agreeable rate of return on the capital employed. Just as I must be honest with myself about my initial mistakes, I must be honest about some of my virtues and I think I can count these decisions as part and parcel.

One standard I tried to live by in my earlier investing was perfection. I often failed to act because I could not be sure of absolutely safety and I had determined that if I ever made another mistake in my investment operations, particularly with regard to the macro environment and crystal-ball gazing, that these mistakes would be unforgivable and would reveal how I was in actuality no better, in a moral sense, than any of the other petty mortals plying this trade.

This is, after much contemplation, an unreasonable standard to try to live up to because it is impossible to act at all under this standard. To be a successful investor, one does not need to be the best– one needs to simply act prudently according to sound methods. But, as my re-reading of Benjamin Graham’s classic text recently helped me to appreciate, one must act. Facing this fact, what can I do? The best I can, is the only answer I’ve found. Given that I know how I made my earlier mistakes, and I believe I understand how I succeeded the few times I did, there is really little risk for me of reprising the role of the vaunted “fuck up artist”.

I’ve also decided to give up my crystal ball and related esoteric knowledge I don’t actually possess. In exchange, I will accept Ben Graham’s portfolio maxim of the 25/75 split, ie, that the maximum exposure to stocks or bonds in one’s portfolio at any one time ought to be no more than 75%, and the minimum exposure ought to be no less than 25%. (And I read “cash and cash-like instruments” as part of the bond allocation, which I think of as “cash yield”.) Having more than 75% exposure suggests a kind of enthusiasm which is, short of a few specific scenarios, likely to involve a speculative-gambling attitude about the future and its risks. And having less than 25% exposure (specifically to stocks) makes it hard to even consider oneself an investor and seems to be evidence of falling prey to crystal ball reading.

This part is really hard right now. “But aren’t we at all time highs for the market?” Yes, we are. It’s very painful to consider that and I feel very nervous about taking the plunge now, so to speak, only to find myself suspended in mid-air as I see the plug being pulled from the pool. I comfort myself a bit by realizing that I am not making a timing “call” in trying to follow this approach, ie, the water is fine, come on in! In fact, I am trying to do the opposite, to resist the temptation of thinking I know and to allow myself an opportunity to take risk, prudently, regardless of what I think of the “market.” The other thing I remind myself is that I will not simply start making investments to achieve some arbitrary portfolio exposure level as quickly as possible. Instead, I now have granted myself “permission” psychologically to invest up to 25% of our capital in appealing opportunities if I should find them. Before, I would’ve had to stop and ask my crystal ball for directions first.

Another thing I’ve learned is that successful investing takes patience no matter what. Even the ideas that worked out well for me on an annualized basis took several years to play out or ripen to their full value. Part of the pressure I used to put on myself in this space was figuring out how I was going to generate X% a year, that year. I didn’t know where to find such an opportunity that was that quick and that safe. It doesn’t exist. Another investment chimera. If I pick safe ideas with a strong upside option and can wait patiently fortune will favor me in time.

There are many people, value investors especially, who have outstanding long term track records who are not Warren Buffett. They are unlikely to be doing something corrupt and they do not have his unique genius. They never seem to have set out for themselves the goal that they must be the best or perfect. They’ve all made mistakes. And they’ve all continued investing in a variety of market conditions, with the wind in their face and the wind at their backs. If they can do it, I can, too.

There are also many obviously lesser people trying their hand at this. They are the gambling fanatics who aren’t even trying to hide it, and the weak minds who have donned the clothing and the diction of the sage investor but do not realize they’re only engaging with the methods at a superficial level. These people are bound for disaster, and yet many of them manage to practice as investors and even confuse other people into letting them run their money. It would be a shame to let the world be dominated by those types and it boggles the mind why they should live with confidence and cheerfully go about their business and I should not.

It has been a long, odd journey to get where I am today. Of course I wish that I had learned these lessons earlier, or in some other way and in so doing to have been spared this trying ordeal to manifest my own confidence. But one of my goals is to learn to live my life without apology or regret and I’ve come to realize that taking the path I took is simply one of the data of my life. I’ve accepted it and I am ready to make good on what I’ve learned by putting the lessons learned to work today, not “when the time is right.” The best time to live life as wisely as one knows how is always today, not tomorrow.

Review – The Acquirer’s Multiple

The Acquirer’s Multiple: How the Billionaire Contrarians of Deep Value Beat the Market

by Tobias Carlisle, published 2017

I received a free copy of this book from the author.

I spend a lot more time thinking about the best way to introduce people to the world of value investing than I actually get requests for such information, though I do receive occasional requests for advice. The reason is not just because I am a pedantic thinker but because I spent a very long time acquiring my own knowledge on this subject, with many wrong turns and wasted efforts and I have always wondered, “Is there a better way?”

Toby Carlisle’s “The Acquirer’s Multiple” may just be that better way.

But first, let me explain the most up-to-date advice I have been vending, and keep in mind, this advice is not intended as “how to be a good investor/make good investments” because I am not a registered investment adviser nor would I attempt to impersonate one– this is just my opinion of “how best to learn about investing”. I think I can dispense that advice as an opinion without running afoul of the authorities because I am just talking about ways to acquire certain knowledge. At least I hope so!

My suggestion is to read the following titles, in this order:

1. The Richest Man in Babylon: Now Revised and Updated for the 21st Century (Paperback) – Common
2. The Millionaire Next Door: The Surprising Secrets of America’s Wealthy
3. Buffett: The Making of an American Capitalist
4. The Accounting Game: Basic Accounting Fresh from the Lemonade Stand
5. The Essays of Warren Buffett: Lessons for Corporate America, Fourth Edition (or more specifically, Buffett’s Shareholder Letters from Berkshire Hathaway, and his private partnerships, available on the Berkshire website)

Perhaps at a later date I will spend some time writing a post explaining in greater detail why I recommend these resources in this order to an aspiring student of (value) investing, but for now I will simply say that the first two explain how to save and how to develop the psychological discipline and personal habits that permit one to save money, and you must have savings if you want to fuel an investment program. The second lesson is in inspiration, to study the life of the greatest master of investing in the modern era to understand both what is possible, and what it takes, to be great at investing. The third lesson is a rudimentary knowledge of accounting, “the language of business” because if you’re going to be investing in businesses you ought to have a clue what is going on.

Only then, young grasshopper, are you ready for your fourth (but not final) lesson, which is to learn the methods and principles of (value) investing itself. And I can think of no greater expositor of these principles than the great master himself once again, Warren Buffett, especially because you can read along as his company develops and see the wondrous workings of these principles in “real time”.

But even this can be an overwhelming introduction for a noobie who doesn’t realize what a deep pool they’re wading into in asking the question. For the action-oriented, then, I offer a 3-Point Plan of Investment Attack which includes:

1. The Richest Man in Babylon
2. The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns (Little Books. Big Profits)
3. The 2013 Berkshire Hathaway Shareholder Letter, “Some Thoughts About Investing”

This short list will teach you how to save money so you have fuel for your investment machine, and then it provides the basic knowledge needed to decide if you want to be a humble Sunday-driver investor and do passive index investing, or if you want to be a more racy investor and pick your own businesses to invest in the way a true value investor would.

Pedantic as I am, where the heck does Toby’s book fit into all of this?! Well, I think now I can whittle my 3-Point Plan down to 2-Points: The Richest Man in Babylon, and The Acquirer’s Multiple. And I might be able to turn my original 5 item foundations into a 3 item list, using Richest Man, Accounting Game and The Acquirer’s Multiple as the set of texts. Here’s why.

Toby has done something incredible with this book. He has boiled a deeply studied, highly opinionated, multi-trillion dollar field of human endeavor down to its most essential, best researched and expertly practitioned concepts and he’s done it all in simple language that I am convinced even a complete neophyte would find approachable. He has included a number of delightful graphics that help to illustrate these simple concepts about how typical market participants behave and where investment value comes from that, for the first time in my life, I actually found increased my understanding of what I already knew rather than confused me (note: charts, data tables, etc., usually just distract me and I skip them, I am a mostly verbal knowledge acquirer). You really can’t go wrong jumping in this way.

The best part, however, is that he has curated some dramatic and action-packed biographical stories demonstrating how successful billionaire investors have put these ideas into practice. This checks the “inspiration” box I mentioned earlier because it helps the reader see how these ideas were translated into action and it gives confidence that you, too, could stand to benefit in this way.

And finally, he repeats (yes, the book is repetitious) all the neatly summarized concepts into one final summary list at the end of the book that involves 9 rules for a value investor to live by. I am confident that if a new investor referred to this list again and again at each point in his investment research and portfolio management process and asked himself, “Am I living true to this list?” he would be very satisfied with himself over a long period of time if his answer was “Yes”. And if the answer were “No”, then he’d understand exactly what he needed to do to get back on course.

I know Toby personally. He is a highly intelligent fellow, his passion for these ideas and the subject are intense and, if you ask me, he lands firmly in the “Graham” side of the “Graham-Fisher” spectrum of value investing (discussed a bit in the text) that all value investors and followers of Warren Buffett debate endlessly. And that is why I was so pleased that the conclusion of the book included an admonition to “check yourself before you wreck yourself”, so-to-speak. The Acquirer’s Multiple principle itself couldn’t be simpler, but Toby knows, as do all great investors in the Grahamian-tradition, that true risk lies in the behavior and biases of the investor himself, particularly an investor who can’t follow simple principles he knows to be true because he insists on trying to outsmart them.

Don’t try to outsmart what can be simple (though never easy!)… like reading 5 books on the art of investing when you could maybe get away with just two or three. And I am now convinced that Toby’s book should be one of them.

Review – The Snowball

The Snowball: Warren Buffett and the Business of Life

by Alice Schroeder, published 2008, 2009 (condensed and updated)

This is my second reading of The Snowball. I enjoyed it almost as much as the first, five years ago, and definitely took away different things from this reading than I did last time. At that time, I was just finishing my “personal MBA”  deep-dive into value investing and was interested in Schroeder’s Buffett bio mainly for the information and insight it would yield into Buffett’s approach and track record as an investor. I was surprised to come away from that reading realizing that the book was a moral parable in the form of a man’s life (an incredibly successful, well-known and near-worshipped man) and my second journey through the book was more focused on the question “How should I think about living my life?” than the question “How should I think about investing?”

I found the book most exciting to read and most interesting personally in the exploration of Buffett’s origins and the detailed narrative about the first twenty years of the partnerships that proceeded his investment in Berkshire Hathaway. As the story wore on and it became more about managing what he had and dealing with the consequences of choices wrought long ago, I found myself losing interest, particularly as the Salomon and Long-Term Capital Management sagas carried on for a mind-numbing fifty-plus pages in total.

Buffett’s childhood was far more unusual than I cared to notice in my first reading. He was obsessed with business, investing and the impact of statistics in life not just from a young age, but in ways that were extraordinary even for someone to be described as “doing X from a young age” would imply by itself. Obsessed is not a word I use lightly here. The young Buffett was probably an odd creature to be around, even for people who loved him or found him interesting or were of unusual talent and ability themselves. This seems confirmed in later years when so many people familiar with him describe feeling exhausted after spending just a few hours with him. It helped me to realize how unfair and pointless trying to compare yourself to a person like Buffett is.

When asked by Bill Gates, Sr., at a dinner what single word they’d use to describe the outcome of their life and their success, Buffett said, “Focus.” As Schroeder describes in many places in the book, and especially at length in the final chapter, “focus” means something completely different when Buffett says it versus anyone of lesser ability and different personality. When Buffett says “focus” he means “to the exclusion of all else, with relentless, all-consuming energy, without tiring or being distracted.” There is no balance working behind the scenes. He gave up a lot of “normal” things most other people would insist on or desire in distinction to that which they were focused on, not as a sacrifice but as an inevitability of his personality.

The most obvious and tragic is his relationship with his family and his relationship with himself. Most other people who are driven towards success in their field and the monetary rewards that typically come with it offer up the excuse of their family as their motivation, honestly or not. This wasn’t the case for Buffett, and achieving supremacy in his profession and in his personal net worth really didn’t do anything to enhance his relationship with his family or the way he cared for them. It is indicated on numerous occasions what kind of tradeoff he would’ve had to make to be more involved with his family, and he never did it. It’s an excellent reminder for someone who sees themselves as driven to achieve that these tradeoffs are real and accepting a “lower rate of return” in one’s efforts is a necessary (and happy?) price to pay to maintain a relationship with one’s family, which itself is valuable.

Buffett’s relationship with himself is also instructive in this regard. Many people wonder how money can’t solve most problems, and why people who are super wealthy continue to eat poorly, exercise infrequently and maintain the same limited psychological state and insecurities they possessed before they achieved glory. The answer again is simple– in the drive toward massive wealth, things get set aside and often it is the improvement of the self as a holistic unit that is set aside first in order to claim excess in one aspect.

Of course, we can’t expect Buffett to be perfect. Nobody is, and the point of mentioning this isn’t to point out the man’s flaws, but to explain them. You can’t have Buffett and have these issues resolved to everyone’s satisfaction. They come with the territory. If you want to be “focused” like Buffett, plan on neglecting your family and yourself, quite a bit. That’s only a judgment if you think those things are objectively more important than wealth or self-actualization in the area of generating wealth. That’s not really a judgment I want to make here and I think it misses the point.

Yet, Buffett’s flaws make for a fascinating lesson in a different way. Though Buffett was unusual, and exceptional, and completely driven toward a single-minded purpose from a young age, the path was far from certain that he would need to tread to get to wherever it was that he would end up going. It’s easy to sit here today reading a book published almost ten years ago, recounting events that unfolded over the past eighty, and see what was inevitable as inevitable. But Buffett made mistakes. Many of them, along the way. That’s what’s truly remarkable, that he made mistakes and still arrived where he did. It’s a good salve for a person carrying around the perfectionist fallacy. Give it a rest and get going, you can make some mistakes and still end up alright if Buffett is any example.

I love reading stories like this, stories of flawed people of unusual ability who managed to achieve something heroic even if their life wasn’t truly ideal. I love knowing it can be done. I love knowing what the pitfalls and the tradeoffs are, so I can be mindful of them myself. I love the way I can give myself permission to not achieve what they achieved (in kind or in magnitude) having the benefit of hindsight to see what it truly took that I can’t give, or won’t.

But most of all, I just love watching someone create something from nothing. That creative energy is uniquely human and what I admire most about our species and this little project called “civilization” that we’re all tinkering away on. The Snowball is not as great an investment manual as I originally thought it was (for that, I’d recommend Buffett’s BRK shareholder letters, along with or after reading Graham’s Security Analysis and The Intelligent Investor), but it is an epic moral profile and a captivating read overall because of it.

Notes – The Snowball, By Alice Schroeder: Part V, Chap. 43-52

The following are reading notes for The Snowball: Warren Buffett and the Business of Life, by Alice Schroeder (buy on Amazon.com). This post covers Part V: The King of Wall Street, Chap. 43-52

The modern Buffett

In Part V of the Snowball, we see Buffett’s transformation from the early, cigar butt-picking, Grahamian value-minded Buffett, through the filter of his Fisherite partner, Charlie Munger, into the mega cap conglomerator and franchise-buyer Buffett who is popularly known to investors and the public the world round.

It is in this part that we also see Buffett make one of his biggest missteps, a stumble which almost turns into a fall and which either way appears to shock and humble the maturing Buffett. It is in this era of his investing life that we see Buffett make some of his biggest rationalizations, become entangled in numerous scandals he never would’ve tolerated in his past and dive ever deeper into the world of “elephant bumping” and gross philanthropy, partly under the tutelage of his new best friend and Microsoft-founder, Bill Gates.

The lesson

Buffett made a series of poor investments but ultimately survived them all because of MoS. There will be challenges, struggles, and stress. But after the storm, comes the calm.

The keys to the fortress

From the late seventies until the late nineties, despite numerous economic and financial cycles Buffett’s fortune grew relentlessly under a seemingly unstoppable torrent of new capital:

Much of the money used for Buffett’s late seventies spending spree came from a bonanza of float from insurance and trading stamps

This “float” (negative working capital which was paid to Buffett’s companies in advance of services rendered, which he was able to invest at a profit in the meantime) was market agnostic, meaning that its volume was not much affected by the financial market booming or crashing. For example, if you owe premiums on your homeowner’s insurance, you don’t get to suspend payment on your coverage just because the Dow Jones has sold off or the economy is officially in a recession.

The growth in Buffett’s fortune, the wilting of his family

Between 1978 and the end of 1983, the Buffetts’ net worth had increased by a stunning amount, from $89 million to $680 million

Meanwhile Buffett proves he’s ever the worthless parent:

he handed the kids their Berkshire stock without stressing how important it might be to them someday, explaining compounding, or mentioning that they could borrow against the stock without selling it

Buffett had once written to a friend when his children were toddlers that he wanted to see “what the tree has produced” before deciding what to do about giving them money

(he didn’t actively parent though)

Buffett’s private equity shop

Another tool in Buffett’s investment arsenal was to purchase small private companies with dominant franchises and little need for capital reinvestment whose excess earnings could be siphoned off and used to make other investments in the public financial markets.

Continuing on with his success in acquiring the See’s Candy company, Buffett’s next private equity-style buyout involved the Nebraska Furniture Mart, run by a devoted Russian immigrant named Rose Blumkin and her family. And, much like the department store chain he once bought for a song from an emotionally-motivated seller, Buffett beat out a German group offering Rose Blumkin over $90M for her company, instead settling with Buffett on $55M for 90% of the company, quite a discount for a “fair valuation” of practically an entire business in the private market, especially considering the competing bid.

An audit of the company after purchase showed that the store was worth $85M. According to Rose Blumkin, the store earned $15M a year, meaning Buffett got it for 4x earnings. But Rose had buyers remorse and she eventually opened up a competing shop across the street from the one she had sold, waging war on the NFM until Buffett offered to buy her out for $5M, including the use of her name and her lease.

One secret to Buffett’s success in the private equity field? Personality:

“She really liked and trusted me. She would make up her mind about people and that was that.”

Buffett’s special privileges

On hiding Rose Blumkin’s financial privacy: Buffet had no worries about getting a waiver from the SEC

Buffett got special dispensation from the SEC to not disclose his trades until the end of the year “to avoid moving markets”

The gorilla escapes its cage

Another theme of Buffett’s investing in the late 1980s and 1990s was his continual role as a “gorilla” investor who could protect potential LBO-targets from hostile takeover bids. The first of these was his $517M investment for 15% of Tom Murphy-controlled Cap Cities/ABC, a media conglomerate. Buffett left the board of the Washington Post to join the board of his latest investment.

Another white knight scenario involved Buffett’s investment in Ohio conglomerate Scott Fetzer, which Berkshire purchased for $410M.

Then Buffett got into Salomon Brothers, a Wall Street arbitrage shop that was being hunted by private equity boss Ron Perelman. Buffett bought $700M of preferred stock w/ a 9% coupon that was convertible into common stock at $38/share, for a total return potential of about 15%. It even came with a put option to return it to Salomon and get his money back.

But Buffett had stepped outside of his circle of competence:

He seemed to understand little of the details of how the business was run, and adjusting to a business that wasn’t literally made of bricks-and-mortar or run like an assembly line was not easy for him… he had made the investment in Salomon purely because of Gutfreund

Buffett’s disgusting ignorance and hypocrisy

Buffett:

I would force you to give back a huge chunk to society, so that hospitals get built and kids get educated too

Buffett decides to sell the assets of Berkshire’s textile mills– on the books for $50M, he gets $163,122 at the auction. He refused to face his workers and then had the gall to say

“The market isn’t perfect. You can’t rely on the market to give every single person a decent living.”

Buffett on John Gutfreund:

an outstanding, honorable man of integrity

Assorted quotes

Peter Kiewit, a wealthy businessman from Omaha, on reputation:

A reputation is like fine china: expensive to acquire, and easily broken… If you’re not sure if something is right or wrong, consider whether you’d want it reported in the morning paper

Buffett on Wall St:

Wall Street is the only place people ride to in a Rolls-Royce to get advice from people who take the subway

Review – Quantitative Value

Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors + website

by Wesley R. Gray and Tobias E. Carlisle, published 2012

The root of all investors’ problems

In 2005, renowned value investing guru Joel Greenblatt published a book that explained his Magic Formula stock investing program– rank the universe of stocks by price and quality, then buy a basket of companies that performed best according to the equally-weighted measures. The Magic Formula promised big profits with minimal effort and even less brain damage.

But few individual investors were able to replicate Greenblatt’s success when applying the formula themselves. Why?

By now it’s an old story to anyone in the value community, but the lesson learned is that the formula provided a ceiling to potential performance and attempts by individual investors to improve upon the model’s picks actually ended up detracting from that performance, not adding to it. There was nothing wrong with the model, but there was a lot wrong with the people using it because they were humans prone to behavioral errors caused by their individual psychological profiles.

Or so Greenblatt said.

Building from a strong foundation, but writing another chapter

On its face, “Quantitative Value” by Gray and Carlisle is simply building off the work of Greenblatt. But Greenblatt was building off of Buffett, and Buffett and Greenblatt were building off of Graham. Along with integral concepts like margin of safety, intrinsic value and the Mr. Market-metaphor, the reigning thesis of Graham’s classic handbook, The Intelligent Investor, was that at the end of the day, every investor is their own worst enemy and it is only by focusing on our habit to err on a psychological level that we have any hope of beating the market (and not losing our capital along the way), for the market is nothing more than the aggregate total of all psychological failings of the public.

It is in this sense that the authors describe their use of “quantitative” as,

the antidote to behavioral error

That is, rather than being a term that symbolizes mathematical discipline and technical rigor and computer circuits churning through financial probabilities,

It’s active value investing performed systematically.

The reason the authors are beholden to a quantitative, model-based approach is because they see it as a reliable way to overcome the foibles of individual psychology and fully capture the value premium available in the market. Success in value investing is process-driven, so the two necessary components of a successful investment program based on value investing principles are 1) choosing a sound process for identifying investment opportunities and 2) consistently investing in those opportunities when they present themselves. Investors cost themselves precious basis points every year when they systematically avoid profitable opportunities due to behavioral errors.

But the authors are being modest because that’s only 50% of the story. The other half of the story is their search for a rigorous, empirically back-tested improvement to the Greenblattian Magic Formula approach. The book shines in a lot of ways but this search for the Holy Grail of Value particularly stands out, not just because they seem to have found it, but because all of the things they (and the reader) learn along the way are so damn interesting.

A sampling of biases

Leaning heavily on the research of Kahneman and Tversky, Quantitative Value offers a smorgasbord of delectable cognitive biases to choose from:

• overconfidence, placing more trust in our judgment than is due given the facts
• self-attribution bias, tendency to credit success to skill, and failure to luck
• hindsight bias, belief in ability to predict an event that has already occurred (leads to assumption that if we accurately predicted the past, we can accurately predict the future)
• neglect of the base case and the representativeness heuristic, ignoring the dependent probability of an event by focusing on the extent to which one possible event represents another
• availability bias, heavier weighting on information that is easier to recall
• anchoring and adjustment biases, relying too heavily on one piece of information against all others; allowing the starting point to strongly influence a decision at the expense of information gained later on

The authors stress, with numerous examples, the idea that value investors suffer from these biases much like anyone else. Following a quantitative value model is akin to playing a game like poker systematically and probabilistically,

The power of quantitative investing is in its relentless exploitation of edges

Good poker players make their money by refusing to make expensive mistakes by playing pots where the odds are against them, and shoving their chips in gleefully when they have the best of it. QV offers the same opportunity to value investors, a way to resist the temptation to make costly mistakes and ensure your chips are in the pot when you have winning percentages on your side.

A model development

Gray and Carlisle declare that Greenblatt’s Magic Formula was a starting point for their journey to find the best quantitative value approach. However,

Even with a great deal of data torture, we have not been able to replicate Greenblatt’s extraordinary results

Given the thoroughness of their data collection and back-testing elaborated upon in future chapters, this finding is surprising and perhaps distressing for advocates of the MF approach. Nonetheless, the authors don’t let that frustrate them too much and push on ahead to find a superior alternative.

They begin their search with an “academic” approach to quantitative value, “Quality and Price”, defined as:

Quality, Gross Profitability to Total Assets = (Revenue – Cost of Goods Sold) / Total Assets

Price, Book Value-to-Market Capitalization = Book Value / Market Price

The reasons for choosing GPA as a quality measure are:

• gross profit measures economic profitability independently of direct management decisions
• gross profit is capital structure neutral
• total assets are capital structure neutral (consistent w/ the numerator)
• gross profit better predicts future stock returns and long-run growth in earnings and FCF

Book value-to-market is chosen because:

• it more closely resembles the MF convention of EBIT/TEV
• book value is more stable over time than earnings or cash flow

The results of the backtested horserace between the Magic Formula and the academic Quality and Price from 1964 to 2011 was that Quality and Price beat the Magic Formula with CAGR of 15.31% versus 12.79%, respectively.

But Quality and Price is crude. Could there be a better way, still?

Marginal improvements: avoiding permanent loss of capital

To construct a reliable quantitative model, one of the first steps is “cleaning” the data of the universe being examined by removing companies which pose a significant risk of permanent loss of capital because of signs of financial statement manipulation, fraud or a high probability of financial distress or bankruptcy.

The authors suggest that one tool for signaling earnings manipulation is scaled total accruals (STA):

STA = (Net Income – Cash Flow from Operations) / Total Assets

Another measure the authors recommend using is scaled net operating assets (SNOA):

SNOA = (Operating Assets – Operating Liabilities) / Total Assets

Where,

OA = total assets – cash and equivalents

OL = total assets – ST debt – LT debt – minority interest – preferred stock – book common equity

They stress,

STA and SNOA are not measures of quality… [they] act as gatekeepers. They keep us from investing in stocks that appear to be high quality

They also delve into a number of other metrics for measuring or anticipating risk of financial distress or bankruptcy, including a metric called “PROBMs” and the Altman Z-Score, which the authors have modified to create an improved version of in their minds.

Quest for quality

With the risk of permanent loss of capital due to business failure or fraud out of the way, the next step in the Quantitative Value model is finding ways to measure business quality.

The authors spend a good amount of time exploring various measures of business quality, including Warren Buffett’s favorites, Greenblatt’s favorites and those used in the Magic Formula and a number of other alternatives including proprietary measurements such as the FS_SCORE. But I won’t bother going on about that because buried within this section is a caveat that foreshadows a startling conclusion to be reached later on in the book:

Any sample of high-return stocks will contain a few stocks with genuine franchises but consist mostly of stocks at the peak of their business cycle… mean reversion is faster when it is further from its mean

More on that in a moment, but first, every value investor’s favorite subject– low, low prices!

Multiple bargains

Gray and Carlisle pit several popular price measurements against each other and then run backtests to determine the winner:

• Earnings Yield = Earnings / Market Cap
• Enterprise Yield(1) = EBITDA / TEV
• Enterprise Yield(2) = EBIT / TEV
• Free Cash Flow Yield = FCF / TEV
• Gross Profits Yield = GP / TEV
• Book-to-Market = Common + Preferred BV / Market Cap
• Forward Earnings Estimate = FE / Market Cap

The result:

the simplest form of the enterprise multiple (the EBIT variation) is superior to alternative price ratios

with a CAGR of 14.55%/yr from 1964-2011, with the Forward Earnings Estimate performing worst at an 8.63%/yr CAGR.

Significant additional backtesting and measurement using Sharpe and Sortino ratios lead to another conclusion, that being,

the enterprise multiple (EBIT variation) metric offers the best risk/reward ratio

It also captures the largest value premium spread between glamour and value stocks. And even in a series of tests using normalized earnings figures and composite ratios,

we found the EBIT enterprise multiple comes out on top, particularly after we adjust for complexity and implementation difficulties… a better compound annual growth rate, higher risk-adjusted values for Sharpe and Sortino, and the lowest drawdown of all measures analyzed

meaning that a simple enterprise multiple based on nothing more than the last twelve months of data shines compared to numerous and complex price multiple alternatives.

But wait, there’s more!

The QV authors also test insider and short seller signals and find that,

trading on opportunistic insider buys and sells generates around 8 percent market-beating return per year. Trading on routine insider buys and sells generates no additional return

and,

short money is smart money… short sellers are able to identify overvalued stocks to sell and also seem adept at avoiding undervalued stocks, which is useful information for the investor seeking to take a long position… value investors will find it worthwhile to examine short interest when analyzing potential long investments

This book is filled with interesting micro-study nuggets like this. This is just one of many I chose to mention because I found it particularly relevant and interesting to me. More await for the patient reader of the whole book.

Big and simple

In the spirit of Pareto’s principle (or the 80/20 principle), the author’s of QV exhort their readers to avoid the temptation to collect excess information when focusing on only the most important data can capture a substantial part of the total available return:

Collecting more and more information about a stock will not improve the accuracy of our decision to buy or not as much as it will increase our confidence about the decision… keep the strategy austere

In illustrating their point, they recount a funny experiment conducted by Paul Watzlawick in which two subjects oblivious of one another are asked to make rules for distinguishing between certain conditions of an object under study. What the participants don’t realize is that one individual (A) is given accurate feedback on the accuracy of his rule-making while the other (B) is fed feedback based on the decisions of the hidden other, invariably leading to confusion and distress. B comes up with a complex, twisted rationalization for his  decision-making rules (which are highly inaccurate) whereas A, who was in touch with reality, provides a simple, concrete explanation of his process. However, it is A who is ultimately impressed and influenced by the apparent sophistication of B’s thought process and he ultimately adopts it only to see his own accuracy plummet.

The lesson is that we do better with simple rules which are better suited to navigating reality, but we prefer complexity. As an advocate of Austrian economics (author Carlisle is also a fan), I saw it as a wink and a nod toward why it is that Keynesianism has come to dominate the intellectual climate of the academic and political worlds despite it’s poor predictive ability and ferociously arbitrary complexity compared to the “simplistic” Austrian alternative theory.

But I digress.

Focusing on the simple and most effective rules is not just a big idea, it’s a big bombshell. The reason this is so is because the author’s found that,

the Magic Formula underperformed its price metric, the EBIT enterprise multiple… ROC actually detracts from the Magic Formula’s performance [emphasis added]

Have I got your attention now?

The trouble is that the Magic Formula equally weights price and quality, when the reality is that a simple price metric like buying at high enterprise value yields (that is, at low enterprise value multiples) is much more responsible for subsequent outperformance than the quality of the enterprise being purchased. Or, as the authors put it,

the quality measures don’t warrant as much weight as the price ratio because they are ephemeral. Why pay up for something that’s just about to evaporate back to the mean? […] the Magic Formula systematically overpays for high-quality firms… an EBIT/TEV yield of 10 percent or lower [is considered to be the event horizon for “glamour”]… glamour inexorably leads to poor performance

All else being equal, quality is a desirable thing to have… but not at the expense of a low price.

The Joe the Plumbers of the value world

The Quantitative Value strategy is impressive. According to the authors, it is good for between 6-8% a year in alpha, or market outperformance, over a long period of time. Unfortunately, it is also, despite the emphasis on simplistic models versus unwarranted complexity, a highly technical approach which is best suited for the big guys in fancy suits with pricey data sources as far as wholesale implementation is concerned.

So yes, they’ve built a better mousetrap (compared to the Magic Formula, at least), but what are the masses of more modest mice to do?

I think a cheap, simplified Everyday Quantitative Value approach process might look something like this:

1. Screen for ease of liquidity (say, $1B market cap minimum)
2. Rank the universe of stocks by price according to the powerful EBIT/TEV yield (could screen for a minimum hurdle rate, 15%+)
3. Run quantitative measurements and qualitative evaluations on the resulting list to root out obvious signals to protect against risk of permanent loss by eliminating earnings manipulators, fraud and financial distress
4. Buy a basket of the top 25-30 results for diversification purposes
5. Sell and reload annually

I wouldn’t even bother trying to qualitatively assess the results of such a model because I think that runs the immediate and dangerous risk which the authors strongly warn against of our propensity to systematically detract from the performance ceiling of the model by injecting our own bias and behavioral errors into the decision-making process.

Other notes and unanswered questions

“Quantitative Value” is filled with shocking stuff. In clarifying that the performance of their backtests is dependent upon particular market conditions and political history unique to the United States from 1964-2011, the authors make reference to

how lucky the amazing performance of the U.S. equity markets has truly been… the performance of the U.S. stock market has been the exception, not the rule

They attach a chart which shows the U.S. equity markets leading a cohort of long-lived, high-return equity markets including Sweden, Switzerland, Canada, Norway and Chile. Japan, a long-lived equity market in its own right, has offered a negative annual return over its lifetime. And the PIIGS and BRICs are consistent as a group in being some of the shortest-lifespan, lowest-performing (many net negative real returns since inception) equity markets measured in the study. It’s also fascinating to see that the US, Canada, the UK, Germany, the Netherlands, France, Belgium, Japan and Spain all had exchanges established approximately at the same time– how and why did this uniform development occur in these particular countries?

Another fascinating item was Table 12.6, displaying “Selected Quantitative Value Portfolio Holdings” of the top 5 ranked QV holdings for each year from 1974 through 2011. The trend in EBIT/TEV yields over time was noticeably downward, market capitalization rates trended upward and numerous names were also Warren Buffett/Berkshire Hathaway picks or were connected to other well-known value investors of the era.

The authors themselves emphasized that,

the strategy favors large, well-known stocks primed for market-beating performance… [including] well-known, household names, selected at bargain basement prices

Additionally, in a comparison dated 1991-2011, the QV strategy compared favorably in a number of important metrics and was superior in terms of CAGR with vaunted value funds such as Sequoia, Legg Mason and Third Avenue.

After finishing the book, I also had a number of questions that I didn’t see addressed specifically in the text, but which hopefully the authors will elaborate upon on their blogs or in future editions, such as:

1. Are there any reasons why QV would not work in other countries besides the US?
2. What could make QV stop working in the US?
3. How would QV be impacted if using lower market cap/TEV hurdles?
4. Is there a market cap/TEV “sweet spot” for the QV strategy according to backtests? (the authors probably avoided addressing this because they emphasize their desire to not massage the data or engage in selection bias, but it’s still an interesting question for me)
5. What is the maximum AUM you could put into this strategy?
6. Would more/less rebalancing hurt/improve the model’s results?
7. What is the minimum diversification (number of portfolio positions) needed to implement QV effectively?
8. Is QV “businesslike” in the Benjamin Graham-sense?
9. How is margin of safety defined and calculated according to the QV approach?
10. What is the best way for an individual retail investor to approximate the QV strategy?

There’s also a companion website for the book available at: www.wiley.com/go/quantvalue

Conclusion

I like this book. A lot. As a “value guy”, you always like being able to put something like this down and make a witty quip about how it qualifies as a value investment, or it’s intrinsic value is being significantly discounted by the market, or what have you. I’ve only scratched the surface here in my review, there’s a ton to chew on for anyone who delves in and I didn’t bother covering the numerous charts, tables, graphs, etc., strewn throughout the book which serve to illustrate various concepts and claims explored.

I do think this is heady reading for a value neophyte. And I am not sure, as a small individual investor, how suitable all of the information, suggestions and processes contained herein are for putting into practice for myself. Part of that is because it’s obvious that to really do the QV strategy “right”, you need a powerful and pricey datamine and probably a few codemonkeys and PhDs to help you go through it efficiently. The other part of it is because it’s clear that the authors were really aiming this book at academic and professional/institutional audiences (people managing fairly sizable portfolios).

As much as I like it, though, I don’t think I can give it a perfect score. It’s not that it needs to be perfect, or that I found something wrong with it. I just reserve that kind of score for those once-in-a-lifetime classics that come along, that are infinitely deep and give you something new each time you re-read them and which you want to re-read, over and over again.

Quantitative Value is good, it’s worth reading, and I may even pick it up, dust it off and page through it now and then for reference. But I don’t think it has the same replay value as Security Analysis or The Intelligent Investor, for example.

Review – The Intelligent Investor

The Intelligent Investor: A Book Of Practical Counsel; The Definitive Book On Value Investing

by Benjamin Graham, published 1973, 2003, 2006

All you need to know about intelligent investing

Graham’s layman’s manual for thoughtful investing in common stocks and bonds is a long book, chock full of useful theory and wisdom-gained-by-experience as well as numerous “case studies” which serve to illustrate Graham’s points. While it’s all worth considering, the truth is that certain parts of the book shine more brightly than others and, following the 80/20 principle, are clearly more valuable overall.

Starting out

The Intelligent Investor is of course a practical guide to sound investment, but it is also a work of philosophy. Buried throughout the book are invaluable caveats that are easy to overlook yet deserve to get full billing because they can spare an amateur a lot of headaches down the road. In the book’s introduction, there are two such provisos quite nearby one another, the first being,

be prepared to experience significant and perhaps protracted falls as well as rises in the value of [your] holdings

and the second being,

while enthusiasm may be necessary for great accomplishments elsewhere, on Wall Street it almost invariably leads to disaster

Subtle, but profound, these two warnings are Graham’s opening salvo on the subject of investor psychology, or more accurately, the investor’s own psychology. It will be a common thread running throughout TII— your biggest risk in investing is yourself and your psychological reaction to events impacting your portfolio.

Translating the first message, Graham is trying to gird the investor for the inevitabilities of the market, where volatility is constant in both directions. The key, as you will see, is to master volatility by recognizing that the upward variety is not necessarily proof of a good decision and the downward variety is not punishment but an opportunity to buy at bargain prices.

The second message is even more important– successful investing requires an even-keeled temperament and reasonable expectations about long-term success. The game is about expecting little and learning to be pleasantly surprised, rather than expecting a lot and constantly being disappointed. Most of your fellow market participants are excitable folks and their optimistic expectations will work with yours to crowd out any chance at realizing value, while you’ll always have plenty of room to maneuver on your own if you seek out the waters everyone of which everyone else has become bored.

The last warning is to be consistent and disciplined, to never abandon your principles in dire times because that is in fact when they become most valuable:

Through all their vicissitudes and casualties, as earth-shaking as they were unforeseen, it remained true that sound investment principles produced generally sound results

This is again a psychological appeal. When everyone else is losing their shirts, and their minds, forgetting what they’re doing and why, it will pay the long-term investor great dividends to be mindful of who he is and by what principles he invests as his conservatism is always in due time rewarded.

Security analysis 101

While the best treatment of Graham’s principles of security analysis are given in great detail in his treatise of the same name, [amazon text=Security Analysis&asin=0070140650], The Intelligent Investor does come with several basic recommendations on how to perform basic security analysis for issues under consideration for inclusion in one’s portfolio.

Bond analysis

The key to bond investing is interest coverage, as without it a bond is in default and its principal value is imperiled. Therefore, the primary analytical factor is the number of times total interest charges have been covered by available earnings in years past. Typically two values are consulted:

1. average coverage for a period of years (7)
2. minimum coverage in the poorest year

Graham recommends 4x for public utilities, 5x for transportation companies, 7x for industrials and 5x for retail concerns, before income taxes on an average of 7 years basis, and 3x, 4x, 5x and 4x, respectively, measured by the poorest year.

On an after-tax basis, Graham recommends 2.65x for public utilities, 3.2x for transportation companies, 4.3x for industrials, and 3.2x for retail companies on an average of 7 years basis, and 2.1x, 2.65x, 3.2x and 2.65x, respectively, measured by the poorest year.

Additional factors for consideration are:

1. size of the enterprise – something large and robust, so that depletions in revenue do not imperil the business as a whole
2. equity ratio – the market price of equity versus the total debt, which shows the amount of “cushion” for losses standing in front of the debt
3. property value – this is the asset value on the balance sheet, though “experience has shown that in most cases safety resides in the earning power”

Stock analysis

Some basic principles of stock selection and analysis are considered in more detail below, based upon whether one is determined to be a defensive or an enterprising investor. For now, it is sufficient to quote Graham on the subject in the following manner:

The investor can not have it both ways. He can be imaginative and play for the big profits that are the reward for the vision proved sound by the event; but then he must run a substantial risk of major or minor miscalculation. Or he can be conservative, and refuse to pay more than a minor premium for possibilities as yet unproved; but in that case he must be prepared for the later contemplation of golden opportunities for gone

In essence, Graham is outlining the philosophy of “growth” versus “value” investing and stock analysis– attempting to forecast the future, or being content one is not paying too much for what he’s got based on an assessment of the past.

Keeping the shirt you have: the defensive investor

In Graham’s mind, there are two kinds of investors– the defensive investor, who is passive and seeks primarily to protect his capital, and the enterprising investor, who treats his investing like a professional business and expects similarly profitable results for his efforts. First, let’s talk about the defensive investor.

The defensive investor must confine himself to the shares of important companies with a long record of profitable operations and in strong financial condition

Specifically, Graham lists 4 criteria for selecting common stocks for the defensive investor’s portfolio:

1. diversification – minimum of 10, maximum of 30 separate issues
2. standing – companies which are large, prominent and conservatively financed (over $10B mkt cap and in the top third or quarter of their industry by market share or some other competitive metric)
3. dividends – a long record of continuous payments
4. price – no more than 25x avg earnings of past 7 yrs, nor 20x LTM earnings

Additionally, Graham warns against excessive trading or portfolio turnover:

if his list has been competently selected in the first instance, there should be no need for frequent or numerous changes

Graham also defines risk early on, saying,

the risk attached to an ordinary commercial business is measured by the chance of its losing money

and that further, a defensive investor should never compromise their standards of safety and quality in order to “make some extra income.” Safety first, income/returns second, or you’re likely to wind up with neither in the long run.

In terms of selecting individual stocks for the defensive investor’s portfolio, Graham suggests 7 criteria:

1. adequate size of enterprise – generally speaking, small companies are excluded and medium size companies are included if their market/industry position is robust
2. sufficiently strong financial condition – 2:1 current ratio, and LT debt < net current assets (working capital)
3. earnings stability – some earnings for the common stock in each year over the past decade
4. dividend record – uninterrupted payments for the past 20 years
5. earnings growth – minimum of 1/3 increase in per-share earnings in the past ten years using three year average at the beginning and end
6. moderate P/E – no more than 15x avg earnings of past 3 years
7. moderate P/A – price should be < 150% of TBV, though may be higher if earnings multiplier is below 15, never to be greater as a combined ratio than 22.5 ( P/E * P/B <= 22.5)

The purpose is to eliminate companies which are: too small, with a weak financial position, with earnings deficits or with inconsistent dividend histories. In general, these factors should combine to create a stock portfolio which, in the aggregate, has an earnings yield (earnings/price) at least as high as the current high-grade bond rate.

At all times, remember that the defensive investor is

not willing to accept the prospects and promises of the future as compensation for a lack of sufficient value in hand

and that, generally speaking, rather than emphasizing the “best” stocks,

let him emphasize diversification more than individual selection

Making more and better shirts: the enterprising investor

Like the defensive investor, Graham counsels the enterprising investor to think firstly of not losing what they’ve got. But in this sense, the enterprising investor has a new tool in his kit that expands his realm of possible investment options while still maintaining safety of principal– the search for “bargain” priced opportunities, the idea here being that the price being offered for a security is a steep discount (generally 30% or greater) than the indicated “intrinsic” or underlying value of the security itself based upon its asset or earnings power fundamentals (with any luck, both).

About bonds and preferred stocks, Graham suggests that preferreds never be bought without at least a 30% discount, and a similar discount on a high-yield bond. More importantly,

experience clearly shows that it is unwise to buy a bond or preferred which lacks adequate security merely because the yield is attractive […] it is bad business to accept an acknowledged possibility of a loss of principal in exchange for a mere 1 or 2% of additional yearly income

About IPOs, Graham says to never touch them, however, busted IPOs can present interesting opportunities later on down the line:

Some of these issues may prove excellent buys– a few years later, when nobody wants them and they can be had at a small fraction of their true worth

With regards to selecting equity securities, Graham lays out three “recommended fields” for enterprising investors:

1. large cap contrarianism
2. “bargain” issues
3. special situations

Digging in further, let’s take a closer look at large cap contrarianism. The idea here is to focus on companies that are well-known but are currently experiencing an earnings hiccup or some other negative news or general investor boredom that leaves them unpopular and trading at a lower than average multiple. The value in these companies are that,

they have the resources in capital and brain power to carry them through adversity and back to a satisfactory earnings base [and] the market is likely to respond with reasonable speed to any improvement shown

A good example of this principle in practice would be a situation such as buying well-known, large cap companies whose shares had strongly sold off during the financial panic of late 2008, early 2009.

According to Graham, a bargain issue is one in which the indicated value is 50% higher than the current price. Bargains can be detected one of two ways, either by estimating future earnings potential and applying an appropriate multiple and comparing this to current trading price for shares, or else by studying the value of the business for a private owner, which involves particular emphasis on the value of the assets (or the tangible book value of the shares).

For an earnings-based bargain, Graham adds some further criteria, such as:

he should require an indication of at least reasonable stability in earnings over the past decade or more — ie, no year of earnings deficit — plus sufficient size and financial strength to meet possible setbacks in the future

with the ideal being a large, prominent company selling below its past average price and P/E multiple.

Special situations encapsulate a range of investment activities, from liquidations (workouts), to hedging and merger arbitrage activities. While Graham sees this area as one offering special rewards to dedicated and knowledgeable investors, he advises that the trend is one towards increasing professionalization and thus even the enterprising investor is best to leave this area alone unless he has special confidence and competence in the area.

Of special emphasis is the idea of focus and dedication, that is to say, one is either an enterprising investor or a defensive one, but not some of both:

The aggressive investor must have a considerable knowledge of security values– enough, in fact, to warrant viewing his security operations as equivalent to a business enterprise. There is no room in this philosophy for a middle ground, or a series of gradations, between passive and aggressive status. Many, perhaps most, investors seek to place themselves in such an intermediate category; in our opinion that is a compromise that is more likely to produce disappointment than achievement

When considering individual stock selections for the enterprising investors portfolio, Graham reminds the reader that

Extremely few companies have been able to show a high rate of uninterrupted growth for long periods of time. Remarkably few, also, of the larger companies suffer ultimate extinction

To the last point, it is fascinating to see in the footnote commentary by Jason Zweig how many of Graham’s various example companies used throughout the book disappeared not due to bankruptcy, but because they were at some point acquired and absorbed wholesale into the operations of another business.

Several categories of equity selection stand out as particularly valuable for the enterprising investor in Graham’s eyes:

1. arbitrages – purchase of one security and simultaneous sale of one or more other securities into which it is to be exchanged under a plan of reorganization, merger or the like
2. liquidations – purchase of shares which are to receive one or more cash payments in liquidation of the companies assets; should present a minimum of 20% annual return w/ 80% probability of working out or higher
3. related hedges – purchase of convertible bonds or convertible preferred shares and simultaneous sale of the common stock into which they are exchangeable
4. NCAV – 2/3 or less of net current asset value (current assets – TOTAL liabilities); portfolios should have wide diversification, often of 100 securities or more, and require patience
5. contrarian cyclical investing – buying important cyclical enterprises when the current situation is unfavorable, near-term prospects are poor and the low price fully reflects the current pessimism

Graham also recommended a special set of 5 criteria for selecting “bargain” issues of small or less well-known enterprises, which can be generated from lists from a stock guide or a stock screen beginning with companies trading for a P/E multiple of 9 or less:

1. financial condition – current ratio of 1.5:1 and debt <= 110% of working capital
2. earnings stability – no deficit in the last five years
3. dividend record – some current dividend
4. earnings growth – last year’s earnings greater than 5 years ago
5. price – less than 120% of TBV

Graham notes that diversity is key to safety in these operations and such companies should be bought on a “group basis”.

A balancing act: the portfolio

As a broad strategic principle, Graham recommended that defensive and enterprising investors alike seek to allocate a minimum of 25% and a maximum of 75% of their portfolio into stocks and the remaining amount into bonds. In most cases, an even 50-50 split is recommended. The rule of thumb used to guide allocations above or below 50% is that, as the investor determines the “general price level” of the market to be higher than is prudent, he should allocate toward 75% bonds and 25% stocks, whereas when he determines this price level to be much lower than is reasonable (say, in the midst of a bear market), he should allocate toward 75% stocks and 25% bonds.

As Graham says on page 197,

the chief advantage, perhaps, is that such a formula will give him something to do

Remember, you are your biggest risk. Graham was concerned that without “something to do”, an investor might “to do” his portfolio to death with over activity, over-thought or over-worry.

This is a useful insight, but is Graham’s portfolio balancing technique still valid in today’s era of higher inflation risks?

Without stepping on the maestro’s toes too much in saying this, my thinking is that it is increasingly less valid. As Graham himself warns throughout the book, bonds provide no protection against inflation and, while inflation is not “good” for stocks in real terms, the ability to participate in increased earnings is at least better than having a fixed coupon payment in an inflationary environment.

In this sense, an allocation toward 100% stocks makes more sense, assuming we are entering a period of protracted inflationary pressures such as we are.

That being said, Graham’s warning about having something to do is still worth considering. Having kicked the legs out from under the “rebalancing act(ivity)”, perhaps a good substitute would be a continual turning over of rocks in the search for new investment ideas for the enterprising investor. For the defensive investor, the best course of action may be to enjoy the benefits of doing something through dollar-cost averaging, that is, making a little bit of his total intended investment each month or quarter rather than all at once. Another idea might be to allocate 10 or 15% of his portfolio into a MMF or equivalent when he feels the market is rising beyond prudent levels. But the thing that has never sat right with me about Graham’s reallocation technique is that, while in principle it makes sense, in practice it comes down to base attempts at market-timing that always end up generating unsatisfactory results.

Better to focus on Graham’s other major portfolio strategy tenet, which is diversification. Graham is a supporter of diversification for defensive and enterprising investors alike, mostly because it can serve to shield them from their own ignorance or over-enthusiasm. More specifically, many of Graham’s favored techniques (such as special situations, net-nets and bargain securities), while bearing overall pleasing risk/reward balances, nevertheless never bring certainty of either one and for this reason he believes developing a diversified portfolio of such opportunities is the best way for an investor to protect themselves from permanently losing a large part of their capital on one idea.

Saving the best for last: Mr. Market and the Margin of Safety concept

Mr. Market-mania

Markets are made up of people, and people are emotionally volatile. As a result, financial markets are volatile as well. While the vast majority of the time prices tend to move slightly above and slightly below an established trend line, at other times they can swing wildly off course in either direction:

the investor may as well resign himself in advance to the probability rather than the mere possibility that most of his holdings will advance, say, 50% or more from their low point and decline the equivalent one third [ X * 1.5 * .66 = ~X] or more from their high point at various periods in the next five years

Graham also warns against what might be termed the Paradox Of Market Goodwill:

The better a company’s record and prospects, the less relationship the price of its shares will have to their book value. But the greater the premium above book value, the less certain the basis of determining its intrinsic value–ie, the more this “value” will depend on the changing moods and measurements of the stock market

In Graham’s mind, the solution is to

concentrate on issues selling at a reasonably close approximation to their tangible-asset value– say, at not more than one-third above that figure [130% of TBV]

as a general principle of careful investing for the defensive investor. But there is more. Graham represents additional criteria based on the consideration of the firm’s earnings power, outlining what value-blogger Nate Tobik of Oddball Stocks likes to call the “two pillar” method:

A stock does not become a sound investment merely because it can be bought at close to its asset value. The investor should demand, in addition, a satisfactory ratio of earnings to price, a sufficiently strong financial position, and the prospect that its earnings will at least be maintained over the years

In terms of mastering an investor’s own psychology when facing the market, asset values reign supreme, however, because

the investor with a stock portfolio having such book values behind it can take a much more independent and detached view of stock-market fluctuations than those who have paid high multipliers of both earnings and tangible assets. As long as the earnings power of his holdings remains satisfactory, he can give as little attention as he pleases to the vagaries of the stock market. More than that, at times he can use these vagaries to play the master game of buying low and selling high

By Graham’s reasoning, buying a stock close to book value puts him in the same position as an individual offered an opportunity to buy into a private business’s book. Because he has paid a fair, businessman’s price, he doesn’t have to worry about what someone else thinks of his ownership stake, only the operating performance and financial strength of his chosen enterprise.

From a psychological standpoint, it is the high ground and much sought after.

But what is this “master game” of which Graham speaks? It is nothing more than the most masterly metaphor of the entire investing world, Mr. Market.

The idea of Mr. Market is that of a manic depressive business partner who on any given day may offer to buy your stake in the joint business for far more than you think it’s worth, or to sell you his stake for far less than you think it’s worth. The key to taking advantage of Mr. Market is to avoid trying to guess and anticipate why his mood ever suits him, instead relying on your own judgment and thinking about the value of the underlying enterprise regardless of Mr. Market’s various mood swings.

It’s worth quoting Graham at length on this subject:

The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more. Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons’ mistakes of judgement

Further:

the existence of a quoted market gives the investor certain options that he does not have if his security is unquoted. But it does not impose the current quotation on an investor who prefers to take his idea of value from some other source [such as his own study of the fundamentals]

[…]

price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies

In other words, once you have made your investment, the only value of further quotations is to be appraised of another opportunity to buy (if prices decline sharply from that point) or of an opportunity to sell at a profit (if prices rise sharply from that point).

The rest of the time, you can judge the soundness of your decision by studying whether the operating performance of the business plays out according to your expectations. If the underlying business performs as you anticipated over a long period of time, you only need wait for the market to recognize your good judgment. However, if the business steadily deteriorates in a surprising fashion, you may have a basis upon which to second-guess your original judgment. But a falling stock market price would not be the primary indicator in such a situation, nor would a rising one signal you have done well.

Margin of Safety, the central concept of investment

The intellectual principle of the margin of safety involves “inverting” a stock and thinking about it like a bond.

The margin of safety for bonds may be calculated, alternatively, by comparing the total value of the enterprise with the amount of debt

For example, if a business owes $X, but is valued at $3X, the business could shrink by 2/3rds before imperiling the position of the debt holders.

Similarly,

when a company has outstanding only common stock that under depression conditions is selling for less than the amount of bonds that could safely be issued against its property and earning power

the common stock can be considered to enjoy a margin of safety as large as that of a good bond.

Broadly, margin of safety can be thought of as the consistent earnings power of the equity, wherein

the margin of safety lies in an expected earning power considerably above the going rate for bonds

A proxy measure here would be to look at the earnings rate, or earnings yield (earnings/price) and compare this to the going rate on a similar bond.

Another, more general way to think about Margin of Safety is that it is the difference between how much you pay for something versus the calculated intrinsic value you determine that thing to have. In this sense, the Margin of Safety is always price dependent and will be higher at lower prices and lower at higher prices, relatively speaking.

And the Margin of Safety works in tandem with the principle of diversification:

Even with a margin in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for a profit than for a loss– not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business

The emphasis is always on finding an adequate margin of safety in order to protect your principal because if you do that, the returns will tend to take care of themselves:

To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.

Special note on market-timing

There isn’t much more to it than this:

if he places his emphasis on timing, in the sense of forecasting, [the investor] will end up as a speculator and with a speculator’s financial results

In case you’re wondering, that’s a bad thing in Graham’s mind because he is convinced that all but the most talented and luckiest speculators lose out in the end because they do not pay attention to safety of principal.

Review – Free Capital

Free Capital: How 12 Private Investors Made Millions In The Stock Market

by Guy Thomas, published 2011

A methodical review of investors and their strategies

The greatest strength of “Free Capital” is its organization and layout– it’s truly like visiting an expertly-designed website in that the author has organized his investor interviews by four major descriptive categories:

• geographers; top-down investors who begin with a macro thesis then look for companies and financial instruments which will benefit from that trend
• surveyors; bottoms-up investors who start looking at individual companies and then sometimes check to see what kind of macro conditions might affect them
• activists; investors who tend to get personally involved with their investments, taking large stakes and developing a close relationship with management
• eclectics; people who don’t really fit any mold, but might be day-traders, value investors, sometimes activists, etc.

Within each categorical section are profiles of 12 (in total) investors that Guy Thomas spoke with, many of whom are anonymous, most of whom he came into contact with via investor message boards he participates on, and all of whom are UK-based and have managed to grow their capital into millions even over the last decade or less.

Though many were once employed by others and some came from financial backgrounds, all are now independent, full-time investors who live off of their investment returns and it is this kind of self-directed lifestyle and the resources which are needed to finance it that primarily lend themselves to the book’s title.

What’s really great is that in each chapter, Guy Thomas begins with a quick “tearsheet” profile of the investor’s strategy, key phrases, holding period, etc., then neatly organizes the interview material into background on the investor’s life and development as a financial person, outlines their strategy, experiences and any particularly demonstrative coups or failures they’ve enjoyed (or suffered) and finally and extremely helpfully, summarizes all the material again in a table at the end with the major themes or ideas explored for quick reference.

As if this weren’t enough, Guy Thomas has written a lengthy (and for once, interesting) introduction to the book that serves as a combination summary of the main themes of the book as well as a how-to manual for those looking to get the most out of their reading. Thomas is correct in suggesting that the book can be read all the way through as a complete work, or explored at random based on what, if anything, sounds interesting to the reader.

It’s touches like this that show a thoughtfulness on the part of the author that leave the reader painfully aware of their absence in comparison to many other books in the genre. Frankly, it’d be nice if authors and publishers took Thomas’s lead on this point!

My favorite part: inspiration

I was excited to dig into the book in part because a friend had mentioned it to me and had commented favorably on it. He said a lot of the material covered wouldn’t be original but that I might find it inspirational to read other people’s stories of how they got where they are.

Maybe it’s where I am in my life right now, maybe it’s the subtle suggestion my friend made planted in my mind, or maybe it’s the shining spot for the book but the inspiration was one of the most important things I took away from the book. Some of the profiles were admittedly unhelpful (such as the day-trader, an investment style I can’t see any point in) or just not interesting to me (a few of the investors followed research processes I don’t have the time or motivation to emulate), but there were a couple I identified with, which made me feel empowered and hopeful about myself as I read them.

I particularly liked the two named investors, John Lee (who is a dividend-oriented value investor of sorts) and Peter Gyllenhammar (who bankrupted himself twice before hitting his stride and amassing his current fortune). I believe all of the investors lives and experiences illustrated this point well, but these two in particular were examples of the phrase “Patience is a virtue.” If a man can dust himself off after two bankruptcies and still make something of himself he can probably do just about anything given the time and the patience. Seeing as how I haven’t suffered personal bankruptcy (yet) I felt greatly advantaged to learn from this example of perseverance and triumph over failure.

Wise aphorisms

Another theme oft explored in “Free Capital” is the role simplicity plays in good investing. To that effect, I found a lot of great investing ideas captured in brief, simple aphorisms that made them both easily digestible and sufficiently memorable to make use of them myself in my own deliberations. Some examples include:

• Good investing “requires only a few good decisions” (a helpful reminder given the way many seem to imply that a true investor is marked by the numerousness and hyperactivity of his ideas)
• An activist is an investor who goes looking for trouble
• “Quiet freedom is itself exotic” (in this way, independent investors lead quite adventuresome and even exciting lives!)
• Exposure to some chances can only arise through deliberate and possibly unpopular and eccentric choices
• Investment skill consists in not knowing everything, but in judicious neglect: making wise choices about what to overlook
• Freedom is like income that cannot be taxed
• To make good decisions, you need to look actively for reasons not to buy a company. And then invest only in those where you can live with the reasons
• Time is a limited resource with strongly diminishing returns. The first hour you spend researching a company is much more important than the tenth hour
• If an investment decision requires detailed calculations, you should pass, because it’s probably too close
• The sun shines even on the poor man

Also of note is the author’s book-companion blog, which goes into a bit more detail on some of the investment themes captured in the book and which I’ve found to be a good supplement to the reading seeing that I was still interested to learn more even after I put it down.

Conclusion

“Free Capital” is a unique offering. It has a styling and organization that many books in its genre lack and I hope this effort is continued in any future titles from the author. And it treads original ground in profiling anonymous, “everyman” successful investors that no one has heard of yet who have interesting stories, experiences and lessons to share all their own. We can all learn from more than just Warren Buffett, after all.

It’s not without its flaws, of course. As the author himself states, the book doesn’t cover losing investors, people who took some of the risks investors profiled took, and failed, or who took other risks that didn’t turn out right, and then explores what lessons can be learned from their shortcomings. This probably could be a worthwhile book in itself, as there is a growing literature on “failure studies” and as the first lesson every investor must learn is “don’t lose what you’ve got”, learning of common mistakes to avoid could be helpful. Additionally, as an avid deep value (Benjamin Graham) guy myself, I could’ve done without the day trader and some of the other guys who seem like GARPy, momentum-based swing traders with short time horizons and questionable “value” metrics.

But those are minor quibbles and things that Guy Thomas could easily rectify by simply writing us more great books to read! Overall, “Free Capital” was entertaining, at times enlightening and best of all, extremely gracious with my free time as I read the entire thing in just three or four hours. Given the focus on the value of time in the book, I appreciated the fact that I could digest the meat of the book and walk away with some great insights to help my own investing… and still have time left in the day to get other things done!

Notes – The Snowball, By Alice Schroeder: Part IV, Chap. 34-42

The following are reading notes for The Snowball: Warren Buffett and the Business of Life, by Alice Schroeder. This post covers Part IV: Susie Sings, Chap. 34-42

Buffett unwinds, but does not relax

In 1970, Buffett decided to unwind his partnerships, partly because he seemed to have plenty of his own capital to manage at this point and no longer needed the headaches that came with fiduciary leverage, partly because the labyrinthine holdings of the partnership were becoming a regulatory compliance headache and partly, no doubt, because of Buffett’s ill mood toward future return potential offered by the market at that point in time.

In his 1969 letter Buffett made another of his unusual market forecasts which, as infrequently as they’ve appeared over the course of his career, nonetheless seem to mark intermediate tops and frothy market conditions. In it, Buffett said,

I now believe there is little choice for the average investor between professionally managed money in stocks and passive investment in bonds

As his partners were left with the choice of holding onto their stock or selling, Buffett, the most sophisticated of the partners, left them with one clue as to what he recommended, announcing that he intended to continue buying the stock of Berkshire Hathaway and others which had become his investment holding vehicles.

The “implacable acquirer”

Buffett’s four main holdings at this time were Berkshire Hathaway, Blue Chip Stamps, National Indemnity (an insurance company) and Diversified Retail Holdings. But it was through these companies that Buffett would eventually come to own and control many others, using the earnings of each to buy even more of the next. The key in each situation was that the holdings were either capable of generating investable float, or else they were generating excellent free cash flows that could be redirected away from the core business into ownership of others.

Buffett learned this “Russian doll” strategy in part from a little-known investor named Gurdon W. Wattles, whose control company, American Manufacturing, was used to take controlling stakes in numerous other companies such as Mergenthaler Linotype, Crane Co., and Electric Auto-Lite, many of which Buffett gladly road the coattails on. Buffett claimed he followed the man for ten or fifteen years and that he saw himself as simply standing on the shoulders of a giant in emulating his acquisition approach.

The beauty of this investment technique is that the cash flows are largely market-agnostic– aside from the impact of a general business recession, they would keep generating new cash to be invested to matter what the larger market was doing, which was excellent because when the market was swooning under the weight of panicky investors, Buffett had ample resources to take deep dives on any number of absurdly cheap, high quality companies he might want.

Combined with the power of compounding, his reinvestable cash flows and float would continually increase over time.

Buffett and Mungers’ sweet teeth

One of Buffett and Mungers’ most famous coups of this era was their purchase of See’s Candies. Demanding $30M for assets worth $5M, the true value of See’s was captured in its goodwill with customers, built on its uncompromising quality standards. Buffett believed this goodwill meant the company had “uncapped pricing power”– with current earnings to acquisition price generating a 9% “yield” on investment, the deal was good, but on top of that earnings were growing 12% per year organically and Buffett was convinced that prices could be steadily raised each year to increase the rate of earnings growth beyond the rate of growth in unit volumes.

If the price increases could be met and earnings growth would continue, Buffett and Munger were looking at something that would earn not $4M on a $25M acquisition price, but $6-7M plus additional growth over time. Because the business required very little ongoing maintenance or growth capex, almost all of the earnings were investable free cash flow that Buffett and Munger could use to make additional investments and acquisitions.

Extra! Extra! Buffett buys the Washington Post and becomes board member for Kay Graham

Whether it was because of his early childhood experiences as a newspaper delivery boy or because of his belief in the pseudo-monopolistic economics of newspapers, Buffett found himself drawn to the Washington Post and other media enterprises as an investment. According to the author, newspapers were the perfect investment for Buffett because they allowed him to play all the roles he so enjoyed at once: relentless collector, preacher and cop.

Prior to his engagement, the WaPo was earning $4M per year on $85M in revenues. Run by a talented but psychologically troubled Kay Graham, Buffett was the beneficiary of temporary troubles at the paper which pushed its stock price from a high of $38/share to a low of $16. Buffett bought in big blocks whenever they were available and aimed all along at taking a seat on the board.

In the meantime, he was investing in other newspaper and media companies, breaking his no-IPO rule and buying stock in Affiliated Publications (publisher of the Boston Globe) at a negotiated discount, as well as Booth Newspapers, Scripps Howard and Harte-Hanks Communications.

By 1973 he had accumulated 5% of the shares of WaPo and he wrote a letter to Kay Graham announcing his ownership and advising her that he planned to increase it substantially, telling her that

Writing a check separates conviction from conversation

But Buffett faced challenges from other board members who were protective of Graham, untrustworthy of Buffett and bent on protecting their own turf, such as the great Lazard banker Andre Meyer. Despite controlling the voting stock A shares, even Graham herself became paranoid and defensive at one point and Buffett, to calm her nerves, agreed not to purchase anymore stock without her permission even though he’d already spent almost $10.7M to acquire 12% of the company.

He also made a play for the Buffalo Evening News, one of two newspapers in the Buffalo market. But this investment quickly became complicated as the BEN suffered not only numerous anti-competitive lawsuits from the other local paper, but massive labor disruptions as well. Buffett’s investment quickly turned into a loser whose cash-consumption multiplied rapidly with each passing year, creating a real moment of truth for Buffett and Munger who had, until this time, constructed a nearly flawless investment record.

In Buffett’s mind, the critical element in the equation was customer habit,

You’re gauging the likelihood of people changing their habits… the question is, at what point does it become more of a habit for them to buy the other paper?

Ultimately, their insight on customer habit was correct and their saving grace. Despite losing tens of millions initially on their investment of $35.5M, after surviving the labor disputes and the eventual bankruptcy of the local rival, Buffett’s Buffalo Evening News earned $19M pretax in 1983, more than all the previous losses combined.

Things get sticky with the SEC

In the mid-1970s, Buffett and Munger found themselves in a compromising position with the SEC. Supposedly tipped off by angry competitors and customers of Blue Chip Stamps, the SEC began a cursory investigation of claims about insider dealings between Buffett, Munger and Wesco Financial which eventually turned into a full-blown investigation of every single part of their combined business operations.

The details are complicated and irrelevant at this point, but at the time it was Buffett and Munger’s first real hair-raising legal experience and despite their good intentions and attempts at sweet-talking and playing innocent, they found the SEC investigators to be fairly ruthless in their inquiries and accusations.

The net result was Buffett and Munger’s decision to clean up their ownership structure and simplify it by merge more of their companies into the umbrella holding company of Berkshire Hathaway.

But one can’t help but wonder about the timing– just as Buffett was making his move on the Washington Post and beginning to enter the world of the Washington power elite, had someone decided to give Buffett a scare, to show him just how delicate his “conservative” investment empire really was, and to compel his obedience to the power elite agenda going forward?

More Buffett investments

Here is a running list of Buffett investments over the period of 1970-1983:

• Berkshire Hathaway
• Blue Chip Stamps
• Diversified Retail Holdings
• National Indemnity
• Cornhusker Casualty
• National Fire & Marine
• The Washington Post
• See’s Candies
• Scripps Howard
• Harte-Hanks Communications
• Affiliated Publications
• Booth Newspapers
• San Jose Water Works
• Source Capital
• Wesco Financial
• National Presto
• Vornado Realty Trust
• Interpublic
• J. Walter Thompson
• Oglivy & Mather
• Studebaker-Worthington
• Handy & Harman
• Multimedia, Inc.
• Coldwell Banker
• Pinkerton’s, Inc.
• Detroit International Bridge
• Buffalo Evening News
• The Illinois National Bank and Trust Company of Rockford
• GEICO
• Munsingwear
• Data Documents (a private investment)

A collapsing personal life

With regards to Buffett’s personal life, Part IV is so far the saddest of all. It is in this stage of Buffett’s life and investment career that he really begins to lose touch with his children and his spouse, Susie. Though married in name, the couple are de facto separated and living their own independent lives, with Buffett traveling constantly and spending a lot of time “elephant bumping” with Kay Graham in Washington and Susie leaving her now empty nest in Omaha to take up her own apartment in racy San Francisco.

Buffett’s children are distant from him, physically and emotionally and the life choices and dysfunction of each seem to demonstrate quite clearly what an absentee father he was. Sadly, Susie turns to an affair (or two) in her search for companionship and even Buffett eventually caves and shacks up with his caretaker, Astrid Menks, a friend of Susie’s in Omaha.

Buffett expresses deep regret about this part of his life, realizing too late to salvage the situation what damage his indifference had caused.

If there’s a lesson here, it is that life always requires balance for it to be happy and worthwhile. What good is knowing you’re the world’s greatest (and soon to be wealthiest) investor, if it comes at the cost of agonizing sadness when your marriage falls apart and your children no longer seem to know much of you?

Other important investment ideas

In no particular order, below are a few more quotes on important investment ideas, as shared by Buffett and other investors, in Part IV.

Buffett on uncertainty:

The future is never clear, you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values

Buffett on reputation:

Over a lifetime, you’ll get a reputation for either bluffing or not bluffing. And therefore, I want it to be understood that I don’t do it [bluff]

Tom Murphy on the value of stock as a currency:

Warren never gave his stock away; neither did I if I could possibly avoid it. You don’t get rich that way. [Commentary by Alice Schroeder] Giving stock in exchange for TV Guide was saying, in a literal sense, that they thought it would earn more in the future than whatever share of Berkshire Buffett swapped for it. Paying with stock showed a sort of contempt for your own business versus whatever it was that you were buying– that is, unless you were paying with stock that had gotten wildly overpriced

Buffett’s advice to Graham on acquisitions, channeled through Alice Schroeder:

It was always a mistake to pay too much for something you wanted. Impatience was the enemy… [there was] immense value in buying their company’s own stock when it was cheap to reduce the shares outstanding

Bill Ruane on the investment business:

In this business you have the innovators, the imitators, and the swarming incompetents

Buffett on Wattles and coattailing:

There’s nothing wrong with standing on other people’s shoulders

Notes – The Snowball, By Alice Schroeder: Part III, Chap. 20-33

The following are reading notes for The Snowball: Warren Buffett and the Business of Life, by Alice Schroeder. This post covers Part III: The Racetrack, Chap. 20-33

Racing On

The third part of The Snowball opens with Warren Buffett on the verge of starting his infamous partnerships, the precursor to his Berkshire Hathaway holding company conglomerate. On the way, he took a few short detours and learned lessons all over the place, some of them completely unrelated to the art of investing. For example, witnessing the implosion of his father’s political career and campaign, Warren realized:

• allies are essential
• commitments are so sacred that by nature they should be rare
• grandstanding rarely gets anything done

And from his father-in-law, Doc Thompson, the young Buffett learned

always surround yourself with women. They’re more loyal and they work harder

Meanwhile, Buffett’s young wife and mother-to-be, Susie Thompson, was learning just how deep the rabbit hole went when it came to Warren’s insecurities:

Leila [Buffett’s emotionally unbalanced mother] convinced both Warren and Doris that deep down they were worthless… [Buffett] was riddled with self-doubt. He had never felt loved, and she saw that he did not feel lovable

The depth of Buffett’s personal insecurities not only explain a lot about his later behavior and public persona, but they also provide a couple of startling questions to ponder, namely:

• how did a person with such fundamental self-confidence issues nevertheless summon the self-confidence necessary to trust his own investment thinking?
• being as insecure as he appeared to be, how much better of an investor might Warren Buffett have been had he not been carrying around such a handicap?

Who is Charlie Munger?

In Part III, we begin to get a more detailed picture of Buffett’s soon-to-be-infamous partner, Charlie Munger, as well as the subtle but fundamental ways in which his own thinking about investing and business analysis came to influence and then dominate Buffett’s own style. A mathematics major at the University of Michigan at age 17, following the incident at Pearl Harbor, the young Munger enlisted in the military and found himself as an Army meteorologist in Nome, Alaska. He took up poker where he learned to bet big when he had the odds and fold fast when he did not. He later attended Harvard Law School where he claims he graduated “without learning anything.”

After law school, he was obsessed with the idea of achieving social prominence, choosing Los Angeles as a place that was growing and full of opportunity but not so big and developed that he’d never be noticed. Munger’s life, like Buffett’s, was not without personal tragedy. His first marriage fell apart right around the time his 8-year-old son came down with a terminal illness. Munger had to watch these two pillars of his life dissolve simultaneously.

He later became obsessed with children and raised eight of them with his second wife. Munger was a compulsive reader and thinker, known to his family as a “book with legs” and was constantly found reading books on science and the achievements of great figures. Munger was interested in making money early on. When he was a young lawyer and earning about $20/hr he realized his most valuable client was himself so, in the style of [amazon text=The Richest Man In Babylon&asin=0451205367], Munger decided to “sell himself an hour each day”, which he used to pursue real estate and construction projects as well as other investment opportunities. Munger had

a considerable passion to get rich, not because I wanted Ferraris– I wanted the independence

Buffett was patient with Munger. Even though Munger was his senior by several years, Munger pleadingly inquired about whether he could do what Buffett was doing in Los Angeles. Not only did Buffett tell him he could and should, he proceeded to build a relationship with him that involved hours of phone conversations everyday as the two came up with different business ideas together. As Munger described Buffett, and his fascination with him,

That is no ordinary human being

In other words, they seemed to be soulmates, a truly odd couple.

The Munger Effect

Charlie Munger entered Buffett’s life and investment world at a critical juncture in Buffett’s development as a capital allocator.

Until 1958, his straightforward route was to buy a stock and wait for the cigar butt to light. Then he usually sold the stock, sometimes with regret, to buy another he wanted more, his ambitions limited by his partnerships’ capital

But as his total AUM approached $1M with his partnerships and personal money, Buffett had a new scale that let him branch out into new styles of investing. His investments began to become concentrated, elaborate and time-consuming, such as the Sanborn Maps episode. Munger himself started his own partnership in 1962 with his poker buddy Jack Wheeler  who was a trader on the floor of the Pacific Stock Exchange and $300,000 in capital he had accumulated through real estate investments. He eventually gave up his law practice at age 41 and decided to pursue investing full-time. He also used Wheeler’s membership on the exchange to lever up (at a ratio of 95/100) when he felt sure about his investments, something Buffett was not willing to do early on.

Munger’s early investment style involved net-nets, arbitrage and even the acquisition of small businesses. But his real interest lay in buying “great businesses”, which he identified by:

• strength of management
• durability of brand
• cost to compete/replicate the firm
• did not require continual investment
• created more cash than it consumed

To find these businesses, Munger asked everyone he met, “What is the greatest business you’ve ever heard of?”

As the market for net-nets dried up in the mid-60s and Buffett’s capital swelled, he found more and more he had to look at the kinds of great businesses that Charlie Munger favored, changing his focus from statistical cheapness (quantitative investing) to competitive advantage (qualitative investing).

With his capital ballooning, Buffett began looking at the acquisition of entire businesses as a more attractive option. In 1966, this twinkle in Buffett’s eye became Diversified Retailing Company, Inc., an 80/10/10-ownership holding company owned by Buffett, Munger and Sandy Gottesman, whose first acquistion was a $12M Baltimore department store called Hochschild-Kohn, financed 50% with bank borrowings, a “second-class department store” at a “third-class price”. However, the store had no competitive advantage, as the partners soon learned, and was continually caught up in a game of “standing tiptoe at a parade” as every innovation by a competitor had to be quickly imitated (at additional capital expense) lest customers shop elsewhere. It was here that Buffett and Munger learned that the essential skill of retailing was merchandising, not finance, and that retailing, like restaurants, is

a wearing marathon in which, every mile, fresh, aggressive competition could leap in and race ahead of you

Having learned their lesson, their next foray into Associated Cotton Shops, “a set of third-class stores for a fourth-class price” 80 in number led by Benjamin Rosner, a “true merchandiser” found them with a retail operation generating $44M in sales and approximately $2M/yr in earnings. Buffett made a deal to buy the stores for $6M, a sale which was ultimately made by Rosner in part to screw over his female business partner who drove him nuts, causing him to purposefully sell the business for less than it was worth just to get back at her. Buffett and Munger also insisted that Rosner stay on the manage the company for them.

In 1967, Buffett increased his control of the Buffett Partnerships while simultaneously weeding out 32,000 shares worth of investors who preferred a 7.5% debenture to Berkshire stock, ensuring that those who remained were in for growth and the risks that came with it.

Miscellany of the markets

As Buffett’s investment strategy changed over the 1950s and 1960s and his level of sophistication rose, he picked up a number of useful techniques for gaining informational edges in the market and making successful investments:

• coat-tail riding – Buffett became a notorious borrower of good ideas and was not too proud to keep an eye on people who demonstrated deal-making intelligence in the past, such as Ben Graham and Jay Pritzker, assuming they’d continue to make good judgments in the future
• detective-work/sleuthing – Buffett was the only person digging through the Moody’s Manuals at their company headquarters, or going to the shareholder meetings of small companies, or even meeting with executives of small companies to get an idea of who was running these companies
• no self-imposed market cap restrictions – Buffett looked at EVERY company he came across, no matter how small, looking for opportunities others weren’t focused on; he was particularly fond of the “Pink Sheets” publications
• consulting lists of registered shareholders – Buffett would buy blocks of companies he was interested in by hunting down individual shareholders and convincing them to unload the shares to him
• collecting scarce things – Buffett’s National American Fire Insurance investment taught him “the value of gathering as much as possible of something scarce”, both undervalued stocks and information related to said stocks
• proxy-investing – Buffett would often have his friends buy stocks he was interested in to hide his identity as the main buyer accumulating a position
• benefit from sentiment – when the market hit a fever pitch in the 1960s, Buffett went into fundraising overdrive and raised as much capital as he could while people were eager to invest
• use psychology to your advantage – as Buffett’s success unfolded, he forced would-be partners to ask him to allow them to invest with him, which put him psychologically in control
• preservation of capital – Buffett would willingly forgo the chance of profit to avoid too much risk, viewing it as a “holy imperative”; his partner Munger believed unless you were already wealthy you could afford to take risk if the odds were right
• haystack of gold – a concept imparted to him by friend Herb Wolf, the idea was if you’re looking for a gold needle in a haystack of gold it is not better to find the gold needle; obscurity was not virtue
• expense control – Buffett only took on overhead as needed, and in ways that could be easily turned back off or were free to begin with; he made extensive use of “soft-dollars” in his brokerage commissions to buy research from his favorite sleuth brokers
• profile visibility – when he was buying small companies early in his career, Buffett valued secrecy and anonymity, but as he began to target bigger companies he saw the value of a public profile and cultivated a relationship with Carol Loomis, a financial markets journalist

Buffett’s partnerships

Buffett had a total of 9 official partnerships that later became the infamous Berkshire Hathaway. However, he also set up an early partnership with his father, Howard, called Buffett & Buffett, which

formalized the way they had occasionally bought stocks together. Howard contributed some capital, and Warren’s contribution was a token amount of money, but mostly ideas and labor

Why was Buffett interested in managing money? Two reasons. One, Buffett had a strong aversion to working for others and he understood that

The overseer of capital was not an employee

Two, Buffett was obsessed with becoming a millionaire. Managing money for others and collecting a fee on profits generated would allow him to grow his own capital faster than if he were earning a return on just the money that was actually his. In other words, agreeing to manage money for others was a way to leverage his own investment returns.

Buffett started with 7 official partnerships, which were essentially all mini-hedge funds under his exclusive control, and which he viewed as “compounding machines”, meaning once the money went in it should not come out, which is why he managed most of his own wealth separately (as he would be living off his trading gains). And Buffett was so obsessed with compounding he decided to rent rather than own his own home, to free more capital for compounding.

The seven initial partnerships and several follow-on partnerships were as follows:

1. May 1, 1956, Buffett Associates Ltd., starting capital of $105,100, seven partners: Doc Thompson, Doris Buffett, Truman Wood, Chuck Peterson, Elizabeth Peterson, Dan Monen and Warren Buffett; Buffett charged 50% performance fee on returns over 4% (4% returns being guaranteed as a minimum by Buffett); added $8,000 in capital in 1960 from Buffett’s aunt and uncle
2. September 1, 1956, Buffett Fund, Ltd., starting capital of $120,000, partnered with Homer Dodge, a former Graham-Newman investor
3. Late 1956, B-C, Ltd., starting capital of $55,000, partnered with John Cleary, Howard Buffett’s secretary in Congress
4. June 1957, Underwood, starting capital of $85,000, partnered with Elizabeth Peterson; 1960, another $51,000 from connections of Chuck Peterson’s
5. August 5, 1957, Dacee, starting capital of $100,000, partnered with the Davis Family
6. May 5, 1958, Mo-Buff, starting capital of $70,000, partnered with Dan Monen (who had withdrawn his capital from partnership #1 to do a special investment with Buffett on National American), later joined by the Sarnats and Estey Graham with another $25,000 in capital
7. February 1959, Glenoff, starting capital of $50,000, partnered with Casper Offutt, Jr., John Offutt and William Glenn
8. August 15, 1960, Emdee, starting capital of $110,000, partnered with  11 local doctors
9. 1960, Ann Investments, starting capital of ??, partnered with a prominent member of a local Omaha family
10. 1960, Buffett-TD, starting capital of $250,000, partnered with Mattie Topp and two daughters plus son-in-law (MT owned the fanciest dress shop in town)
11. May 16, 1961, Buffett-Holland, starting capital of ??, partnered with Dick and Mary Holland, friends he had met through his lawyer Dan Monen
12. May 1, 1962, Buffett dissolves all partnerships into Buffett Partnership, Ltd. (BPL), beginning the year with $7.2M in net assets

His total starting capital across all of his partnerships was $580,000 and he

never deviated from the principles of Ben Graham. Everything he bought was extraordinarily cheap, cigar butts all, soggy stogies containing one free puff

Truly, one man’s junk is another man’s treasure.

Buffett’s investments

The “racetrack” period of Buffett’s life marked Buffett’s gradual transformation from a Grahamian “cigar butt” (Net-Net) investor to the well-known “growing franchise” investor of today. As Buffett’s assets under management (AUM) grew and the general market conditions of the era changed, so, too, did Buffett’s idea of a good investment. Below is a list of some of Buffett’s investments for his partnerships, as well as his personal and peripheral portfolios:

• Greif Bros. Cooperage; originally purchased for the B&B partnership in the early 1950s
• Western Insurance; purchased for Buffett’s personal portfolio in the early 1950s, Buffett actually sold his GEICO position to raise money to invest in this company earning $29/share and selling for $3/share, “He bought as much as he could”
• Philadelphia and Reading Coal & Iron Company; controlled by Graham-Newman, Buffett has discovered it on his own and had invested $35,000 by the end of 1954; it was not worth much as a business but was throwing off a lot of excess cash; Buffett learned about the value of capital allocation with this company
• Rockwood & Co.; controlled by Jay Pritzker, the company was offering to exchange $36 of chocolate beans for shares trading at $34, a classic arbitrage opportunity; unlike Graham, Buffett didn’t arbitrage but instead bought 222 shares and held them, figuring Pritzker had a reason he was buying the stock, “inverting” the scenario; the stock ended up being worth $85/share, earning Buffett $13,000 vs. the $444 he would’ve received from the arbitrage
• Union Street Railway; a net-net he discovered through Ben Graham, had about $60/share in net current assets against a selling price of $30-35/share, Buffett ultimately made $20,000 on this investment through sleuthing and speaking to the CEO in person
• Jeddo-Highland Coal Company (mentioned as an idea Buffett investigated on a road trip)
• Kalamazoo Stove and Furnace Company (mentioned as an idea Buffett investigated on a road trip)
• National American Fire Insurance, earning $29/share, selling for around $30/share, Buffett first bought five shares for $35/share, and later realized that paying $100/share would bring out the sellers because it would make them whole (financially and psychologically) after being sold the stock years earlier
• Blue Eagle Stamps, a failed investment scheme between Buffett and Tom Knapp, they eventually spent $25,000 accumulating these “rare” stamps that weren’t worth more than their face value ultimately
• Hidden Splendor, Stanrock, Northspan, uranium plays that Buffett described as “shooting fish in a barrel”
• United States & International Securities and Selected Industries, two “cigar butt” mutual funds recommended to him by Arthur Wisenberger, a well known money manager of the era; in 1950, represented 2/3 of Buffett’s assets
• Davenport Hosiery, Meadow River Coal & Land, Westpan Hydrocarbon, Maracaibo Oil Exploration, all stocks Buffett found through the Moody’s Manuals
• Sanborn Maps, in 1958 represented 1/3 of his partnerships’ capital; the stock was trading at $45/share but had an investment portfolio worth $65/share; Buffett acquired control of the board in part through proxy leverage; ultimately he prevailed over management and had part of the investment portfolio exchanged for the 24,000 shares he controlled
• Dempster Mill Manufacturing, sold for $18/share with growing BV of $72/share, Buffett’s strategy as with many net-nets was to buy the stock as long as it was below BV and sell anytime it rose above it and if it remained cheap, keep buying it until you owned enough to control it and then liquidate at a profit; he and his proxies gained control of 11% of the stock and got Warren on the board, then bought out the controlling Dempster family, creating a position worth 21% of the partnership’s assets; the business was sliding and at one point he was months away from losing $1M on the investment, but was ultimately rescued by Harry Bottle, a new manager brought in on Charlie Munger’s recommendation; the business eventually recovered through strict working capital controls and began producing cash, which Buffett augmented by borrowing about $20/share worth of additional money and used it to purchase an investment portfolio for the company; he later sold the company for a $2M profit
• Merchants National Property, Vermont Marble, Genesee & Wyoming Railroad, all net-nets he later sold to Walter Schloss to free up capital
• British Columbia Power, selling for $19/share and being taken over by the Canadian government at $22/share, this merger arb was recommended by Munger and Munger borrowed $3M to lever up his returns on this “sure thing”
• American Express, one of Buffett’s first “great company at a good price” investments, the firm’s reputation was temporarily tarnished in the aftermath of the soybean oil scandal; Buffett did scuttlebutt research and realized the public still believed in American Express, and as trust was the value of its brand, the company still had value; Buffett eventually invested $3M in the company and it represented the largest investment in the partnership in 1964, 1/3 of the partnership by 1965 and a $13M position in 1966
• Texas Gulf Producing, a net-net Buffett put $4.6M into in 1964
• Pure Oil, a net-net Buffett put $3.5M into in 1964
• Berkshire Hathaway, the company was selling at a discount to the value of its assets ($22M BV or $19.46/share) and Buffett’s original intent was to buy it and liquidate it, which he started accumulating 2000 shares for $7.50/share; the owner, Seabury Stanton had been tendering shares with the company’s cash flow, so Buffett tried to time his transactions, buying when it was cheap and tendering when it was dear; he continued purchasing stock assuming Seabury would buy him out via tender offers, the two eventually agreed to a $11.50 tender but Seabury reneged at the last moment, changing the bid to $11 and 3/8, sending Buffett into a rage and causing him to abandon his original strategy in favor of acquiring the entire company; he eventually bought out Otis Stanton’s two thousand shares and had acquired enough to gain control with 49% of Berkshire
• Employers Reinsurance, F.W. Woolworth, First Lincoln Financial, undervalued stocks he found in Standard & Poor’s weekly reports
• Disney, which he bought after meeting Walt Disney and being impressed by his singular focus, love of work and the priceless entertainment catalog
• A portfolio of shorts to hedge against a potential market collapse in the mid 60s, totally $7M and consisting of Alcoa, Montgomery Ward, Travelers Insurance and Caterpillar Tractor
• Near the end of 1968, as the market became more and more overvalued, Buffett relented and bought some of the “blandest, most popular stocks that remained reasonably priced” such as AT&T ($18M), BF Goodrich ($9.6M), United Brands ($8.4M) and Jones & Laughlin Steel ($8.7M)
• Blue Chip Stamps, a “classic monopoly” Buffett and Munger discovered in 1968, the company was involved in a lawsuit that the pair thought would be resolved in the company’s favor, and it also possessed “float” which could be invested in more securities, Munger and his friend Guerin each purchased 20,000 shares while Buffett acquired 70,000 for the partnership, in part through share swaps with other companies that owned Blue Chip stock for their own stock; the lawsuit was eventually resolved and the $2M investment produced a $7M profit
• Illinois National Bank & Trust, a highly profitable bank that still issued its own bank notes, it was managed by Eugene Abegg, an able steward of the company whose retainer was one condition for Buffett’s investment in the company
• The Omaha Sun and other local newspapers, which Buffett figured he’d make an 8% yield on, his motivation for buying seemed to be primarily connected to his desire to be a newspaper publisher
• The Washington Monthly, a startup newsmagazine that Buffett lost at least $50,000 on, again, as a vanity project

Buffett’s AUM

Below is a record of the growth of Buffett’s personal wealth, partnership AUM and performance fees accrued:

• 1954, Buffett’s total personal capital stood at approximately $100,000
• 1956, Buffett was 26 years old and had $174,000 of personal capital, growing his money by more than 61% per year for six years since he entered Columbia with $9,800 in capital
• 1959, partnership returns beat the market by 6%
• 1960, partnership assets stood at $1.9M and returns beat the market by 29%, and Buffett’s reinvested partnership fees had earned him $243,494 (13% of partnership assets belonged to him)
• 1962, Buffett was a millionaire and his outside investments totalled over $500,000, which he added with the rest of his money into the BPL partnership; he had acquired more than a million dollars in six years and owned 14% of the partnership
• 1964, $5M in new capital for the partnerships, and $3M in investment earnings, Buffett’s personal net worth was $1.8M and BPL had $17.5M in capital
• 1965, ended the year with assets of $37M, including $3.5M in profit on American Express, Buffett had earned more than $2.5M in fees, bringing his total stake to $6.8M
• 1966, $6.8M in additional capital investments in the partnerships, with total capital amounting to $44M, some of which was set aside as cash for the first time in Buffett’s career
• 1967, Buffett’s personal net worth was $9M and he had generated $1.5M in fees in 1966
• 1968, the partnership was worth $105M thanks to additional capital infusions and investment returns
• 1969, Buffett’s net worth was $26M

The Desert Island Challenge

Buffett and his investor friends came up with the following challenge that is a helpful mental tool for thinking about the investment problem:

If you were stranded on a desert island for ten years, he asked, in what stock would you invest? The trick was to find a company with the strongest franchise, one least subject to the corroding forces of competition and time: Munger’s idea of a great business.