Daniel Kahneman Talks at Google

“Political columnists and sports pundits are rewarded for being overconfident.” —Daniel Kahneman

Thinking, Fast and Slow at Google

November 7th, 2011, the date when Daniel Kahneman held his Thinking, Fast and Slow talk at Google. If you have already read the book with the same title, you will be familiar with the different topics discussed by Kahneman in this talk. Thinking, Fast and Slow is a great book and highly recommended to each and everyone.

Since I do seem to suffer from some kind of Kahneman liking bias, I enjoyed this talk a lot. You’ll find the video at the end of this post, together with the slides from the presentation.

I have transcribed a few words (maybe not a few, but anyway…) from Kahneman’s talk, all of which you’ll find below.

 

Expert Intuition

When can you trust intuition and when can’t you? And then it becomes an issue of; is the world regular enough so that you can learn to recognize things? Or and then did that particular individual have an opportunity to learn the regularities of the world? And so, the world of chess players is highly regular. And statistically, the world of poker players is very regular. So there is an element of chance, but there are rules and the mind is so set to that if there are rules in the environment and we’re exposed to them for a long time, and we get immediate feedback on what is right and wrong, or fairly immediate feedback, we would acquire those rules. So all of us have expert intuition even if we are not physicians and we’re not chess players, master chess players. I recognize my wife’s mood from one word on the telephone. You know, most of you can do that. That’s people that you know very well. All of us recognize dangerous driver on the next lane. And you know we get cues and we don’t necessarily know what is the cue but this person is driving erratically and could do something dangerous. And this is a lot of reinforced practice and we’re very good at that. We can learn about those, there are differences. Among experts, among professionals, in the level of expertise that they have and they depend in the level of intuitive expertise that they can develop. So for example, compare anesthesiologists to radiologists. Anesthesiologists get very good feedback, an immediate feedback whenever they do anything wrong. You know they have all those measurements in real time. Radiologists get really miserable feedback about whether they’re right or wrong. So you could expect an anesthesiologist to develop intuition much more than you would expect radiologists to develop intuition. And so, that is part of the answer about intuitive expertise. We don’t need to disagree about that because we know pretty much when intuitive expertise is likely to develop. And as I said, we also, that means that intuitive expertise is not going to develop in a chaotic universe or in a chaotic world. So for example, I personally do not believe that that’s stopped, because people pick stocks to invest in can develop intuition because, simply because the market takes care of it. There isn’t enough regularity in what’s going to happen to prices for intuitions to develop. We also know about political forecasters when they forecast long-term, they are really no better than a dart-throwing monkey. And they are certainly not better than the average reader of the New York Times. Intuitions and the reasons it’s not the pundit’s fault. And that research has been done with pundits and CIA analysts and regional experts. It is really not their fault and they cannot predict the long range future 10 or 15 years . They are quite good at short-term predictions. They are really not good at all in long-term predictions. And if the world is not predictable, then you are not going to predict it. When there are marginal situations where there is some predictability, poor formulas do better than individuals. That is the domain where formulas beat individuals regularly, a domain of fairly low predictability. Because when there are weak cues, people are not very good at picking them up and are not good at using them consistently. But formulas can be generated on the basis of experience and they will do a better job than individual judgement.

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Thinking, Fast and Slow: Slides

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Thinking, Fast and Slow: YouTube Video

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System 1 and System 2

Kahneman elaborates on the two systems when answering a question in the end of the session.

Well, you know, System 1 is extremely sophisticated. So it’s not, that is in part why I don’t believe there is any simple representation in the brain of those two systems because what I’ve called System 1 operation by their characteristics include both innate responses and highly skilled responses. And the whole, the representation of world knowledge is in System 1. So it’s hard to classify one as primitive. And I should add that System 2, the reasoning system as it were is not necessarily rational. I mean, System 2 knows what it knows. It knows what we know and we don’t know a lot. So it’s not that System 2 is infallible and that all mistakes come from System 1. We make very significant mistakes when we think very seriously. Yes.

Further Kahneman Reading

Book Excerpt: Thinking, Fast and Slow, Daniel Kahneman

Prospect Theory: An Analysis of Decision under Risk by Daniel Kahneman and Amos Tversky Econometrica, 47(2), pp. 263-291, March 1979

Sunday Book Review: Two Brains Running, New York Times

Daniel Kahneman: Beware the ‘inside view’ – Book Excerpt McKinsey Quarterly

Investing by the Books: Kahneman, Daniel – Thinking fast and slow (Book review)

DealBook Interview: Stanley Druckenmiller

Stanley Druckenmiller was interviewed by Andrew Ross Sorkin on DealBook. Among other things, they talked about IBM, Amazon and Netflix. The transcript below contains these parts. 

Andrew Ross Sorkin: Help us with this. Ginni Rometty was here earlier this morning and I quoted you about your view in particular about IBM and the buybacks. When you look at IBM now, she made an argument, may have been persuasive to some, may not have been to others, about the fact that a company like that needs time to shift. She made the argument that this is not a secular shift for her company, and by the way I wouldn’t even argue she made it as a cyclical shift, she just sort of suggested that they are in a transformation period. Do you buy that?

Stanley Druckenmiller: No. I was looking at Amazon, and I was looking at IBM the other day. The last 19 quarters Amazon has missed their quarterly earnings nine times. They don’t give a damn. IBM has missed three quarters since 2006. They really care about their quarterly earnings. It’s an interesting transformation, ’cause I heard a little bit of your questions, and it’s not just the 14 quarters in a row of down sales. Their R&D has shrunk as a percentage of sales. They’re under major attack from Amazon, Palantir, all these companies out there eating away, and their R&D has shrunk in absolute terms, and as a percentage of their sales. Over the same time, I think it’s gone from like 6.2 to 5.9%, on shrinking base. Amazon on exploding sales is going from 5% to 10%. Now who’s investing for the transition? What kind of transition is that when you’re shrinking your R&D. They bought back 43 billion in stock at an average price of 189. They say they’re stored to capital and returning value to shareholders. I don’t know how you buy something at 189, and its 142. That’s not my kind of return to shareholders. But, so no, I don’t, I don’t believe in the transition.

ARS: You mention Amazon.

SD: Yeah.

ARS: Is that a stock that makes sense to you?

SD: Oh, yeah. I love Amazon.

ARS: Because?

SD: Because they’re investing their future. Bezos is a serial monopolist. He’s come up with this AWS, ok, which is absolutely exploding. I don’t know how many people here are small businessmen and women. If you’re starting a business today, you don’t need a technical department, you don’t need a back-office. You can use AWS. By the way, it’s just ripping to shreds the 10 or 15 consultant you have from IBM on your firm, that you used to need because now you’re going into the cloud. And in retail they were 22% of U.S. sales growth this year of retail, one company. And he’s just sitting there with narrow margins and when he has enough share of market, whenever he wants he can get those margins up.

ARS: But why are you convinced he’s gonna do that? He may never do that? And does it matter?

SD: What do you mean why… ’cause he’s a businessman and I see its strategy and I think it’s genius.

ARS: But you’re convinced that he will at some point…

SD: Of course, of course he will. I’d probably be dead, but of course he will.

ARS: By the way, in the similar vein, how do you feel about a company like Netflix?

SD: That man went to boat, and he walks on water as far as I’m concerned. Same thing. You know, I only heard 30 seconds, I was in the gym. When he said; if you manage for quarterly earnings you’re dead, and then somebody on CNBC says, what’s easy for to say with a stock price like that. Why do you think he has a stock price like that? Because he’s thought about the long-term and not cared about quarterly earnings and all the short-termism the whole time.

Tom Russo Talks at Google [SLIDES]

The Capacity to Suffer: Google, Amazon, Berkshire and Geico, Plus a Few Things about Equity Index Put Options and Earnings Management

This post is about Tom Russo’s talk at Google from 29th of September, 2015. The talk is about 1 hour and 11 minutes. If you do not have the time to watch this talk, please take a few minutes and read the part below transcribed from the talk, where Tom Russo explains the concept of the capacity to suffer and why this is such a powerful concept. The capacity to suffer is a mental model that I think should be added to each and every investor’s toolbox.

In the end of this post you’ll find the video itself, and also the slides shown by Russo.

Okay, let’s hear (or, rather read) what Tom Russo had to say about the concept of the capacity to suffer, and how to think about it to be able to understand it and apply it to other businesses that we will analyze in the future (emphasis added).

I’d say the best example of a company, too, that had the capacity to suffer. One is inside this room. You know, you think about all the kind of projects that Google incubates, burdening profit, with an idea, maybe, of where it’ll end up, but in some cases not even. That’s extraordinarily powerful. And you have lots to show as a result of that. That scale would be a very interesting one, because I think you have an awful lot to show for the willingness to suffer.

And Amazon. Amazon’s way out even beyond you guys. I’m not sure that they’ll ever report a profit. But they certainly have the capacity to suffer. So do their shareholders. Well, of course they get rewarded for it. The price has gone up so much.

So the businesses that we’ll look at are more traditional. Berkshire is the best one. That’s why I learned this subject. Warren talks about it all the time. But, Geico’s a great example. Much like confectionary in China, it’s expensive, it turns out, to bring on an insured, auto insured. And so when Warren bought control of Geico, he asked the CEO why they only had two million policyholders, and the CEO said, because it’s too expensive to grown. Every new policy we put on the book loses $250 in the first year. An ongoing insured make $150 per year of operating profit for the company. So you have two million policyholders making $150 a year, so they were reporting $300 million of profits. And if they wanted to grow a million new policies the next year—because as Warren said, they had the best business, under-penetrated, the market should have more of them. So why not grow it by a million policyholders? What would happen to the operating income that year? It would go from 300 to 50 assuming that the other business didn’t grow at all. Now no public company can endure that kind of volatility. The activists would be on that thing so quickly. Inside Berkshire, it didn’t matter. Warren controls 40% plus of the stock. He’s never told investors that he’s in the business of manufacturing reported earnings. No one get stock options. He gets paid a $100,000 a year. It’s all about owner’s equity, intrinsic value, and how do you grow that with certainty as best as you can? Well, no better investment than to take that $2 million insured base up because of its persistency and its low claims, lack of adverse selection as they grew. They had a lot of room. And by the way, even though the first year cost, reported loss of a new insured was $250 upfront, the moment they signed up the net present value, lifetime value of each insured, $2,000. That’s a $150 stretched out forever, brought back. Now, so for the mere inconvenience of reporting a $250 loss upfront, they put on $2,000 of value. Warren got it. Today, 14 years later, they have 11 million policyholders. And in the annual report he said to investors, because he’s a fair partner, if you’re thinking of selling the business, your shares in Berkshire, understand that book value doesn’t capture all that we’ve got that’s good. And he said, for instance, at Geico we’ve added $20 billion of value since we bought it. Now that’s that $20 billion that comes from those 9,000,000 new insured. And the only way you get there is by having the capacity to let the income statement bear the burden. And over that time they took their annual ad spending from $30 million up to $1 billion. And you’d all know that, because watching television is really a series of Geico advertisements these days.

Another thing that Berkshire did was, the equity index put options. There’s a group that had $37 billion worth of equities, market value equities, around the world for different markets. And whatever the reason, that group had to be able to say their counterparties that $37 billion was not at risk. They needed for their collateral, whatever the reasons, to have $37 billion. And so Warren was asked to insure against the potential for that portfolio to decline in value. He sold them a put option. In return, we received $5.3 billion to invest, unfettered, for 18 years. It was non-callable and it had no collateral posting requirements, which are the killers in this business. So why did Warren get $5 billion to insure against the decline of equities over 18 years when, likely, the course of equity values is up over time? It’s because the people who needed that insurance had nowhere else to go. First, Warren had the capital. He had $50 billion of spare cash which sort of buttressed his claims-paying appeal. Other people who might take the $5 billion don’t have the capital balance sheet or the culture to provide for the ultimate payment if the world went to zero and they owed $37 billion. Warren has that, and the culture would honor that. The other thing, the more important thing, was nobody else would touch this stuff, because every quarter there is a mark to market requirement. And it absolutely crushes reported profits. So for example. After they signed it, received the $5 billion, the equity world markets collapsed and they had six quarters in a row of over $1 billion worth of charges to the income statement, some periods as much as $3 billion, because global equities collapsed. And every time it collapsed, they’d have to pass through the reported profits, the mark to market. OK. So at the end of the day he had $13 billion less in earnings cumulatively over that time. But he had $5 billion which he had to put to work. And that’s sort of the last story about Berkshire.

Another way in which you could see his capacity to suffer added enormous value was that during the crisis—well, during the period leading up to the financial crisis of 2007 and 2008, Warren, at the annual meeting, always lamented the fact that he had $50 billion cash hanging around on which he was only earning .01%. And that’s the safe return. That’s sort of the federal treasury bills that are secure. Since he kept it in cash, he might as well keep it secure. But he was only making .01%. If he had standard company practices, he never would have kept $50 billion of cash in overnight money. He would have gone out three, 10, 14, 40 years on a bond portfolio and would have had a 4% yield. He kept it at .01% because he didn’t trust inflation or credits to support having $50 billion in longer duration investments. The difference between 4% and 0.1% on $50 billion is $2 billion a year. That’s the amount he suffered by under reporting, because he kept his money in liquid treasuries. That requires a lot of suffering because $2 billion is a lot of money, even to Warren. Now ironically, to show you how American companies behave, at the same time that Warren was belly aching about only making .01%, General Electric had taken $100 billion of their borrowing and brought it into commercial paper overnight to capture those same low rates. Now it’s a different story for General Electric, though. You have businesses that have long-term funding requirements where you can’t responsibly borrow overnight to meet. You can do so if your goal is to manufacture earnings. And of a $100 billion in the overnight market, where they might be earning 2%—they may be paying two tenths of 1%, let’s say, maybe even .03% in the commercial paper market—they should have been paying 4%, exactly like Warren. In their case. they should have stretched out their liability structure. But by taking it all into commercial paper, investment bankers assured them that they could swap them out at any minute. They could go back long. They could go into yen, any currency they wanted. It was just a number after all, wasn’t it? Well, they forgot one thing, which is that overnight markets can shut down. And when Lehman burst, GE had $100 billion of overnight money that they couldn’t roll. Warren, happily, had $50 billion which he could use to help them out. And he gave them the right to $12 billion of his money at 12% with hundreds of million of shares of call options. In case the company did well, he would have the privilege of making the equity that they recklessly threatened by their non-owner minded ways. Now they were not at all unusual in this. This is what public companies do. They bring down the rest of the cost because it helps flatter. In GE’s case, that was $4 billion of manufactured income. Now this I would complain to you about. However, there’s one mega force on the landscape that’s done one worse than that, which is the United States government. We have taken our borrowing from $9 trillion to $18 trillion through QE, most of which was not invested but was transferred, to try to stimulate some kind of economic growth in the absence of a Congress that doesn’t meet. And we keep that money predominantly in overnight borrowings. The yield curve of the US Treasury is abysmally short term, and we are massively understating, when we look at our own deficit, what this country has put itself into, which is $9 trillion of additional borrowing coming through at sort of 1, maybe 1, 1.5%. And the real cost of that burden will be very apparent at some time when rates go up, uncontrollably by us, upwards beyond our control. Anyways, I hope that what, for me, has been most educational from the time I first heard Warren speak at Stanford to the present—this notion of how the capacity to reinvest surfaces is best illustrated by those three ideas in Berkshire. And there have been a whole series of businesses that have done it afterwards.

—Tom Russo, Talks at Google, September 29th, 2015

Tom Russo Talks at Google: Slides + Video

Click image below for full PDF of the slides shown by Tom Russo at his talk.

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Further Reading

Tom Russo on Wealth Track – Long-Term Value
Nestle and Capacity to Suffer
Walmart and the Importance of Capacity to Reinvest

Tom Gayner Talks at Google, Part III

This is the last part of my posts about Tom Gayner’s talk at Google. See here for part I and here for part II.

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The Q&A session in Tom Gayner’s talk at Google starts at 26.36 and last for about half an hour. Below is the first question about how to evaluate management.

Question #1 – Evaluating Management

“So you mentioned evaluating management, you think about character and integrity. First question is, how do you actually, specifically evaluate that? And for us that can actually interact with management of companies, and we just look at prices and stuff like that, how do we actually go about figuring that out?”

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Answer #1 – Evaluating Management

“Well again, I’m looking around the room and I’m seeing that I’m older than you, but I’m married, and I’ve been married a long time. Just by show of hands, some of the people who are married? A bunch of you. How did you decide who you’re going to marry? You dated. And what’s the point of dating? It’s not really to see a movie, or go to a restaurant or ballgame or roller skating, or whatever you did. It’s really to spend time with somebody, to see if their values overlap enough with yours, that you’ll be able to get along for a long period of time. That’s the whole point of dating.

And with management teams, and people running businesses, in effect, what I’m doing, is analogous to the idea of dating. It’s trying to find people running these businesses where our values, at least in the worlds of commerce, overlap enough that I’m happy for them to have the responsibility and authority to run that business as they see fit.

Now you mentioned a limitation, that you suggest that I’m able to get an appointment and see people who run business and interact with the managers, and to some degree, that’s true. But at the same time, I really spend a lot more time reading about people, and using the exact same resources that you would have access to as well. So I read the annual reports. I read the proxy statements. I read magazine articles. And I try to think and just sort of look, and get a gut feel and make some judgement and discernment about whether these people are acting in a way that’s reasonable and makes sense to me.

And your calibration is going to be somewhat different than mine. You’re just different. All of us are going to set those things that we think are important and where we think the bounds of behavior should be differently. Because we’re all different, but you have them. And I encourage you to think about things in that dimension, because one of the things you’ll find is, you’ll make a judgement. Your judgement will not be perfect, but by virtue of the times you get it wrong, when make an error, you’ll learn something. It’s like, ooh, I don’t like that so much. And that will be a marker to you, that the next time you see it, you will be sensitized to it and it will help you make better judgements.

In looking at you guys, when I first started in the investment business, I have a wonderful mentor namned Ned Reynolds. And this was a gentleman who’s probably 70 years old and I was brand new in the investment business. And he was a very interesting character, and it’s not like he was formally my mentor, he was nice. He was kind and he was just helpful to people. And one day I happened to be standing next to him on a hot, summer day in Richmond, Virginia. And not much was going on. We were just sort of, market was open, and in those days, you didn’t have the CNBC with the ticker tape, but you actually had a physical ticker tape in a brokerage office, so it would create this sort of hum and drone of this tape going by. And he was standing there. And he had his arms folded like this, and he really wasn’t engaged in conversation with me. He was standing by my side, was not making eye contact, but I had been in the business for three months at this point. And he said, Tom, the secret to success in the investing is lasting the first 30 years.”

There are a few more question, all worth listening to. Click image below to listen.

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Tom Gayner Talks at Google, Part II

“…I’m cheap, and I really hate losing money.” —Tom Gayner, Talks at Google, June 22nd, 2015

This is the second post about Tom Gayner’s talk at Google. See here for the first one. In this post we’ll learn some more about Tom’s evolvement as an investor, four-point view of what he looks for in a business before making an investment.

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Tom Gayner’s Evolution as a Value Investor: From Quantitiative Bias to the Four-Point View

In the first part of the talk Tom discusses how he started out and evolved as an investor, how his investment approach has developed through the experience he’s gotten through the years (emphasis added).

“And similar to, I think, many people as they begin go down the path of trying to become an investor, I had a very strong quantitative bias in selecting investments. And one of the ways I would describe that, and one of the tendencies that we all have, especially when we’re starting out for a variety of reasons, is to have quantitative metrics that you can rely on. And one of the reasons that would be the case is when you’re starting out and you haven’t done this a whole lot, you’d really like to have some confidence supplied by something external that you’re on the right path. And if you can do some well-established, well-trod paths of disciplines of things that have worked—boy that seems like a pretty good basis to make a decision and to think about what’s going to happen in the future. And there is absolutely nothing in the world wrong with that. I encourage that. That’s really the best way to start, but I think that is only a partial step along the journey of becoming an accomplished investor. That worked spectacularly well for Ben Graham in the 1930s, who’s the grandfather of all investing and the professor who really taught Warren Buffett the disciplines of investing. But that was a period of time when we were just coming out of the Depression, and there were a lot of securities that were mathematically and quantitatively cheap. So it was a great technique, a great discipline. It had not been practiced, but that pond has gotten a little over-fished.

So today, while it’s important to know the technical skills, to know the accounting, to know things like the net working capital, and to think about price earnings ratios and price to book value ratios, and have the series of quantitative metrics that would tell you that something is cheap, that’s good as far as it goes. But is doesn’t tell you enough. There are more things. And I call the notion of doing that sort of work, which is the first step, and you really should do it—that’s the idea of spotting value. So it’s a picture of time stands still. When you’re looking at a picture of something that you think is worth this, and it’s selling for this. So there’s a price gap there. And you want to buy it at this, and you think it will get to that. And that’s great if it works, but that’s a picture. What I have evolved to, and the path that I’ve been on for a long time—and the reason I got on that path is because I found that that notion of spotting value and thinking that there’s value gaps would close right after I showed up to buy some stock, it didn’t work. So it’s not as if I found that technique, and I learned that, and it worked, and produced great wealth. It didn’t.

So you gotta take the next step and try to figure something else out. So I moved from spotting value to spotting the creation of value, value creators as opposed to value spotters. So instead of a snapshot, instead of a picture, how about a movie. What’s this movie going to look like? How’s this reel going to unfurl over time? So instead of saying that I firmly believe that something is worth this, I’m now asking myself, well, what will it be worth next year? And the year after that? And the decade after that? And to have some sense of something that is increasing in value over time at an appropriate rate. Well, that’s what I’m really hunting for and that’s what I’m really trying to find and spot. And I think this has applications, not just for investing, but for leadership, for management, for relationships that you would have on a social, as well as a professional basis, so it’s an integrated though as to how my life is unfurling.

So with that sort of thought in mind, I came up with a four-point view of what it is that I’m specifically looking for, and how I specifically think about things that I might investing in. So the first thing that I look to invest in is a profitable business with good returns on capital, that doesn’t use too much leverage to do it. And again, each and every one of those words came about because I made a mistake somewhere along the line. Things did not work and as a consequence, it was a hard, searing lesson where I lost some of my own money. […] I’m cheap, and I really hate losing money.”

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A Four-Point View to Business Analysis and Investing

The four-point view is Tom’s framework for how to analyze a business and consists of the things that he wants to see in a certain business before committing his money and making an investment. The four points, or lenses as he also calls them, are:

  1. Profitable business that earns good returns on capital with not too much leverage
  2. Management
  3. Reinvestment dynamics
  4. Price

The First Lens: Profitable business that earns good returns on capital with not too much leverage 

The starting point is to look for a demonstrated record of profitability. Since the purpose of a business is to serve others, to create value for its customers. The mark of a business doing that well, is a profit. In this case, an unprofitable business means one of two things: 1) the products or services are not needed or wanted (lack of demand), or 2) not very good at what they do (lack of skills).

If we take a look at the factors of leverage we have 1) the refinancing risk (risk of no refinancing of debt during times when the market doesn’t want to supply any), and 2) character of the people responsible for any decisions about leverage.

The second factor of leverage about character, and why character is important when thinking about debt and leverage goes back to the time when Markel started to buy non-insurance business. Back then Tom got some “spectacularly good piece of advice” from an elderly gentleman he once talked to who said:

“If you’re looking to buy businesses, don’t buy businesses where they use a lot of debt. And I wondered why. And he said, well, if you want to make sure that you’re dealing with high-quality, high-integrity people, generally speaking, high-quality, high-integrity people don’t use a lot of debt. Or not so much that, but if you’re a bad person, if you were sort of a little bit of a crook or had a little bit of larceny in your heart, it’s unlikely that you would use 100% equity finance. Because when it’s equity financed it means it’s your own money. When it’s debt, you’re running your business on other people’s money. He says crooks don’t steal their own money, they steal other people’s money. So when you see a business that sort of relies on a bunch of debt to operate and be successful, that adds a layer of concern or diligence that you have to do, you have to think about, that you don’t have to do if you look at a business that just doesn’t use much debt. So it’s a margin of safety. That’s a word and a phrase that Ben Graham used quite a bit in thinking about investing, by looking at companies that don’t use much debt. That really protects your downside and protects you from bad things happening.”

The Second Lens: Management

This second point is about the management team that runs a business. The two attributes(“…one without the other is worthless.  “) to look for when assessing management are :

  • Character/integrity
  • Ability

“If you have people that are talented, who are whip-smart, who are very skilled at what they do, but yet have a character or integrity flaw of some sort—well, they may do well, but you as as their outside, silent, non-controlling partner are not. That will not end well.”

The Third Lens: The Reinvestment Dynamics of a Business

The third principle is about the reinvestment dynamics of the business, and here it’s all about the power of compound interest. Tom quotes Einstein and says:

“Einstein said it was the most powerful force in the universe, compound interest. Einstein further went on to say, that those who understand compound interest earn it and those who do not understand it pay it.”

This third point is addressed by answering the question: What is the reinvestment dynamics of the business, that is, what’s the compounding feature?

One example Tom discusses to show how to think about the reinvestment dynamics of a business is the restaurant business and  the spectacular five-star, gourmet, lovely restaurant typically owned by the people who are there every day compared to McDonald’s.

“They’re not chains of the best restaurants in the world, from sort of a gourmet perspective. Usually the owner is the chef, or right there in the front of the house. And he’s there all the time. So that business, that restaurant can be very successful. But typically, that is not a model that is set up to be able to replicate it again and again and again and again and again. It may provide a very nice living for the owner and their family, and employ their family, and great service to the world, great food, great prices, all that sort of stuff, but it’s not replicable. So there are some businesses that you’ll see that are like that, that are boutiques in some form or fashion. It’s a limiting factor to really be able to apply capital and see it grow.

[…]

But go back in time 50 years, and at the start of McDonald’s. And then another McDonald’s and another McDonald’s and another McDonald’s. One right after the other. That’s a perfect example of where that reinvestment dynamic kicks in.

So what I’m looking at something, I’m thinking how big can this be? How scalable is it? How replicable is it? Because in order for you to really apply a bunch of capital to it, it has to be something that you can keep reinvesting in.”

Tom encourages people to always think about things in more than one dimension and in a spectrum (maybe you could call it something like a business quality spectrum).

“Things, generally speaking, are not binary. They’re not yes or no. They’re not white or black. They’re shades of gray all the way along the line. So a perfect business is one that earns very good returns on its capital, and can take that capital that it makes and then reinvest that and keep compounding at the same sort of a rate year after year after year. That’s the North Star. That would be the absolute perfection.

The worst kind of business is the one that doesn’t earn very good returns on capital, and yet seems to need gobs of it all the time. And again, this might be old data because the world seems to change, but I used to joke that airlines fit that category. So there were all these airlines, and they realize what was coming and going. And people seem to want to always get in the business, but they never really make good returns on capital. These days they are. Whether they will continue to do so or not, I don’t know. But that’s kind of the spectrum of business, so I just try to get as close to this end of the spectrum as possible.

Now in the real world, this does not really exist very often or very frequently and oftentimes it’s very richly priced when you see it. But how close can you get to it? Because the second-best business in the world, is one that earns very good returns on capital. It can’t reinvest it, but the management knows that. They’re intellectually honest that they have to do something else with the money. And what are their choices? Well, they can make acquisitions, they can pay dividends, they can buy their own stock. But they are thoughtful and they know that. And Berkshire really is the best example of a company that had that in place, where you had the genius at the top who knew that the original business, which was a textile business—whatever money that made, it was best to invest that somewhere else. And that’s what Buffett has done for 50 years, is to reinvest the cash flows of the various businesses that come feed into Berkshire in other places, so that is the maestro-like effect that he has had.

So that’s a legitimate way of handling the notion that you can’t reinvest in the business that you have, but you can be thoughtful about what you do to that money when it comes in it.”

S3

The Fourth Lens: Price/Valuation

The fourth principle is about price and valuation. As Tom says, this is the fourth lens, but a lot of people start out with this one:

“And that’s really where a lot of people start in investing because there are books you can read. There are spreadsheets that you can do. There are well-trod paths you can follow that talk about what’s a reasonable price earnings ratio, what’s a reasonable price to book ratio, or what’s a reasonable dividend—all these quantitative factors. And those are all good, but as I said, they’re not enough. They go into the thinking. They go into the thought process of whether this is a good investment or not, but the mistake that I see—there’s two types of mistakes you could make when you’re doing your valuation work.”

The two mistakes that Tom mentions are, number one, that you pay too much for something, more than it’s worth. But this is not the worst thing, it’s more of an error you can recover from. Mistake number two, even worse than mistake number one, is according to Tom, the hidden cost that comes from having thought about the value of a business, but you never buying into it, and where the business itself keeps on compounding over time.

“As human beings we tend to have very vivid memories of things that we did, that happened recently. We tend to not have vivid memories and not do well about thinking about the things that didn’t happen to us or things that we didn’t do. And we can brush away those experiences relatively easily, because we don’t have firsthand experience with it. So we probably all have stories about something and the older you get, the more stories you’ll have like this, where you thought about something or you thought something might have been a good idea, or you though that might have been a good business, or you thought that would have been a good stock. In a certain point in time. But for whatever reason, pricing or whatever, you did’t buy it at that time, and then you never got around to buying it. Those are the things that really hurt. That money that you didn’t make, will end up being a far bigger subtraction from your theoretical end net worth, than the things that you did buy that perhaps did not work as well as you hoped it would.”

TAGTG1

The up-coming third post, the last one about Tom Gayner’s talk at Google, is going to be about the Q&A session.

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

Tom Gayner Talks at Google, Part I

Tom Gayner: The Evolution of a Value Investor

On June 22nd, 2015, Tom Gayner from Markel visited Talks at Google. The theme of the talk was The evolution of a value investor, and for about approximately 60 minutes, Tom—who started out as a CPA and now is at Markel—shares his ideas and thoughts about investing, tells the story of how he evolved as an investor, and also lays out his four points, or what he calls the four lenses, and talks about what he looks for in a certain business in coming up with a decision to invest or not.

The following are the main topics of Tom’s talk:

  • The language of business: Accounting
  • Quantitative selection bias (Quantitative figures are good, but they’re not enough.)
  • The Four Lenses for Analyzing a Business
  • Q&A Session

The Language of Business: Accounting

In this post, except for the link to the talk, I just want to share what Tom had to say about accounting, and why it’s an important part for all investors.

So, Tom starts his talk by briefly discussing the importance of accounting as the language of business, and goes on to give his answer to the question from people who’s trying to figure out what they want to do:

“Among the things that would be a reasonable choice for what you’re studying, would be accounting. And people ask me “why accounting?” And I say, well, if you’re going to go to Germany and you wanted to be a successful person in Germany, what would be the very first thing you should do? And my answer is, you should learn German, because that is the language that people are going to communicate in, and work in, in Germany. So if you want to go to Germany, and want to be a success of any sort, I think it would be very hard to do that without having a working knowledge of German. Well similarly, in business, and by business, let’s translate that further to investing, the language of business is accounting. So to understand what’s going on, you don’t need to be a CPA, but I think it’s important to have a rudimentary knowledge of what accounting is and how it works, and what words and numbers mean when they’re in the context of financial statements and business, the language of accounting.” [4.23-5.24]

TAGTG1

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

Howard Marks Talks at Google [SLIDES]

“One of my favorite sayings is ‘Never forget the six foot tall man who drowned crossing the stream that was five feet deep on average. We can’t live by the averages. We can’t say, well, I’m happy to survive on average. We gotta survive on the bad days. You gotta survive. And if you’re a decision maker, you have to survive long enough for the correctness of your decision to become evidence. And you can’t count on it happening right away. Overpriced is not the same thing as going down tomorrow.” —Howard Marks, Authors at Google, March 27th, 2015

Authors at Google: Howard Marks, The Most Important Thing Illuminated

Click image below for full PDF of slides from this session.

TAGHW15

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

On Value Investing: A Conversation with Joel Greenblatt W’79 WG’80

Info about the video from YouTube:

Joel Greenblatt W’79 WG’80, Managing Partner and Co-CIO of Gotham Asset Management speaks with Howard Marks, W’67, Chairman, Oaktree Capital Management L.P.

The Howard Marks Investor Series at The Wharton School brings high-profile investors to the Philadelphia campus once per semester to share their real-world, practical investment perspectives with graduate and undergraduate Wharton students and other members of the Penn community.

5GQ: Michael Shearn – The Investment Checklist [TRANSCRIPT]

“…the number of questions is not so much the important, but it’s just that the quality of the questions and then come to having that analytical judgement on which questions are important for a particular company.” —Michael Shearn

In this post you find the most recent interview from 5GQ with Michael Shearn, the author of The Investment Checklist: The Art of In-Depth Research.

I have transcribed the first two questions, question number one beeing about what part in a 10k to look at and the second question about how many checklist items there are in Michael’s own investment checklist.

For questions number three to five I have transcribed only the question, so you can see what they’re about and go to the video interview to hear Michael’s answers to these questions.

 

  • 5GQ1Q1: What part of the 10k do you spend the most time with? There’s so much information in there, what section do you think that investors maybe aren’t paying enough attention to you?
  • A1: When I look at a 10-K, my goal is I wanna understand what the business does. I also want to know how how does it make money. So one of the first thing we look at is, we go to the income tax footnote, and what we wanna see is: Do they make money? Because under the income tax footnote, that’s usually about note 12 or around there, they have a line item called “Current taxes” and that’s the money that they send to the IRS. So if a company is not making money, they’re not gonna be, on a cash basis, they’re not gonna be sending any money to the IRS. So that’s kind of the first stop in the 10-K, to see if there even making money.Just to give you a historical example I remember looking at Enron, and looking at that footnote and it was negative. They were not making any money.

    But after that you know the other section, this is something I’ve learned recently, is the risk section, because it’s really, if you think about pharmaceutical drugs, there’s funny commercials where they’re always talking about all the risks, the things that can happen to you. They are pretty much disclosing a full amount of things that can happen. The same thing happens in the 10k under the risk section, and what happens is that it’s very easy to gloss over those risks because they are written in very plain language, and so it’s very important that kind of spend a lot of time there because every company that has failed or had a problem, the problem has been in the risk section, it’s always in there. But what happen is that the language is written in such a way where it’s not alarming and it’s kind of innocuous language. So what we do is that we look at the risks and we read it and we try to understand; Has this company encountered any of these risks before, is there an historical example that we can look to, to see kind of how that risk affects the company or is this something we don’t know how it’s gonna affect the company?

    So we where recently looking at a company called FXCM, it kind of hit our screen so to speak and as we were reading articles about what was going on at the company the stock dropped quite a bit. They talked about exactly an article reference one of the risks that they had to make up their clients equity accounts if they ever got negative. But when we went to go read the footnote it was very innocuous, it kind of was written in such a way that it was very difficult to catch. So I think, you know for me, how it works, I really pay attention to the risk section because it really gives you a good insight into what could go wrong and you can do your worst case scenarios and things like that. … The lawyers make sure you cover all of them. … So you kind of really have to weigh those things and what’s real real big risks and what’s not. But I take the first part not the second part about stock fluctuations or clustering and things like that. It’s more the business risk section.”

  • Q2: How many checklist items do you have for your personal investment checklist?
  • A2: I look at a checklist more as a research process. What it allows us to do is a series of questions that allows us to examine the business from a lot of different perspectives. So we’re not looking at in, you know, in the past I spent a lot of time just focusing on whether the company had a competitive advantage and I’d ignore things like the customer side or the management side. And just kind of on that one thing. So the questions really help you get a holistic view of a business. But really the goal of it and the goal of the questions is, you kind of want to understand the distribution of the cash flows for a business. Are they narrow? Or are they wide? So there’s questions in there like fixed cost base that would tell you that they had a wide range, so you would know the earnings would fluctuate quite a bit. So it’s kind of a far as a number of questions and it really becomes kind of a judgement call. So for certain companies for example, let’s think of FactSet, a service that I subscribe to. I’m not gonna be really asking a lot of questions about their suppliers. But if I was looking at a metals recycler, well suppliers are very important ’cause they’re recycling metals, so the supply of the metal is very important or where they can get aluminum and to turn into steel so the questions kind of way depending on the company. But I will say there’s two questions I think must be answered for every company, and I think they carry a lot of the weigh. And the first question is: How dependent are the customers on the product or the service? That let you know, let’s say a restaurant, we’re not all dependent up on it. But it allows you to understand the degree to which those cash flows are gonna vary. Because if the customers are stuck to your product the more narrow distribution cash flow and the less surprises. But if your customers are not as dependent, they could use other areas, and you know there’s gonna be a lot more variation so you can prepare in advance for that. Second question, we always like to know who we’re partners with. Is management that we’ve evolved in our investment strategy we have learned to us it’s really the most important component so we spend a lot of time answering that question as well. But, you know, the number of questions is not so much the important, but it’s just that the quality of the questions and then come to having that analytical judgement on which questions are important for a particular company. So if you’re worried about the CEO and that they’re very aggressive in their accounting, well you will spend a lot of time on the accounting side. We just generally pass on those kind of companies. But say you’re a value investor and look at all different kinds of companies, you would have to spend a lot of time on adjusting the financial statements to make sure, to see what they’re really earning, because you know they’ve been aggressive in their accounting. So it’s really, it kind of depends on the company.

The remaining questions (not transcribed in this post) are:

  • A3: The subtitle of your book is the art of in-dept research and it really struck me while I was reading your book that the real art involved is a lot of these little adjustments that you can make to the numbers that you’re looking at when you’re performing you’re analysis to normalize things to get some kind of an idea of like how to approach what is happening in the real world, like economically versus the accounting. Other than just the obvious, you know, be conservative or find a margin of safety. Do you have any tips for us on have to make analytical adjustments?
  • A4: I think this is one of the greatest problems to solve as an investor, in a person doing research. There’s forty thousand stocks roughly in the world. You don’t have the time to be an expert on every single one of them. How do you go about narrowing down your universe to screening for the ones we think they’re gonna give you the best bang for your research buck so to speak? 
  • A5: If you think about investing like a horse race, where it’s a para-mutual betting basically, so you don’t always have to know who’s the fastest horse necessarily, but it’s the odds of winning versus the payout. I feel like your book gave an amazing insight into picking the fastest horse, a great checklist of all the different things that make up for a great business to buy, but I’d like to hear a little about how the price factors in in that context of horse-betting where it’s not all about the fastest horse. 

From having looked at the first two questions, let’s turn to the last one outside of the five ordinarily questions.

  • Q6: What book would you like to recommend? 

theInvChecklist