Notes

Benjamin Graham on Investing

“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

This is the definition Graham provides in both Security Analysis and The Intelligent Investor. It emphasizes all the core elements of investing we should think about before making decisions.

Warren Buffet on Making Mistakes

“I want to be able to explain my mistakes. This means I do only the things I completely understand.”

This should be our approach towards buying securities. Never buy a stock simply because it was recommended to you, or because it has risen in price. Do thorough research so that you understand both the macro and micro conditions affecting the company. This way you can understand, explain and learn from an eventual mistake.

Buffet on Future Berkshire Growth

“Our base of assets and earnings is now far too large for us to make outsized gains in the future. Eventually, size becomes its own anchor.”

It appears as though stocks of less followed (small) companies have trouble reaching “full efficiency” (Howard Marks).  It is because less people are following the stock and less detailed information is available that large “gaps” can appear.

The reason Warren Buffet must buy large companies that are simple (and have moats) is because his assets are too large to invest in such small companies anymore. With over $200 billion under management (2007), Buffet now employs a buy and hold strategy through which it is often not possible to find small inefficiently priced companies that are both fundamentally undervalued and poised for growth – through a sustained competitive advantage. The important lesson is that one should continually use capital base as a factor in determining a proper course of action.

Buffet on Risk

“Though this risk cannot be calculated with engineering precision, it can in some cases be judged with a degree of accuracy that is useful… The primary factors bearing upon this evaluation are:

A. The certainty with which the long- term economic characteristics of the business can be evaluated.

B. The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flow.

C. The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself.

D. The purchase price of the business.

E. The levels of taxation and inflation that will be experience and that will determine the degree by which an investor’s purchasing-power is reduced from his gross return.”

Buffet on two key classes MBAs programs should have

Buffett commented on the fact that nearly all business schools do nothing to train students to become better investors.

“If you want to truly succeed as an investor, learn to do two things and two things only:

1. Know how to value a business
2. Learn how to think about stock markets and understand volatility.”

Buffet on Return on Equity (Fortune Magazine)

There are only five ways to improve return on equity:

1. Higher turnover, i.e. sales
2. Cheaper Leverage
3. More leverage
4. Lower taxes
5. Wider margins on sales

Buffet on Fear and Greed

“Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful.”

Buffet on Unlocking Value (1958 Partnership Letter)

“While the degree of undervaluation is no greater than in many other securities we own, we are the largest stockholder and this has substantial advantages many times in determining the length of time required to correct the undervaluation.”

Buffet is pointing out a very important factor to consider when buying an asset at a discount of intrinsic value: the length of time required to correct the undervaluation. If it never gets corrected, or takes too long to correct, we must consider the opportunity cost of the investment. Is there a significant risk that it does not get corrected within a reasonable timeframe? Reasons include: Bankruptcy, gradual decline in growth etc…

A decline in price can be exaggerated in relation to decline of the actual or potential value. Essentially, what were are trying to do is find a situation where price has declined much more than actual value.

Buffet on his Partnership Investments

“To the extent possible, I continue to attempt to invest in situations at least partially insulated from the behavior of the general market. This policy should lead to superior results in bear markets and average performance in bull markets”

Buffet on Short Term Results (1958 Partnership Letter)

“It is obvious that we could still be sitting with a $50 stock patiently buying in dribs and drabs, and I would be quite happy with such a program although our performance relative to the market last year would have looked poor. The year when a situation such as Commonwealth results in a realized profit is, to a great extent, fortuitous. Thus our performance for any single year has serious limitations as a basis for estimating long term results. However, I believe that a program of investing in such undervalued well protected securities offers the surest means of long term profits in securities.”

This is something I think about often. If I am buying a security that is distressed and cheap – as value investors often are, it has often declined in price because many people are selling. I am not naive enough to overlook the fact that there is usually a short term reason for this. As such, declining prices that lead to “out of favor” stocks tend to follow a downward spiral: there is no way to know when the decline will stop.

If I am confident in my selection, I will see this as an opportunity to continuing buying even if my portfolio suffers in the short term. What will my clients think if the portfolio declines, if only for a short period?

Buffet clearly explains in the previous passage that by employing such a strategy, whilst performance may look poor in the short run, it will be satisfactory over the long run. Clients without liquidity issues shouldn’t be interested in where there money is a year from now, but where it is 10 years from now. Value investors may return less in a single year than most growth or performance funds, yet over a 10 year period, their records speak for themselves.

The key may be to find a balance. The security needs to be undervalued, but also needs to have catalysts for eventual unlocking of this value, as well as a reasonable period until the correction occurs.

The best way to deal with nervous clients may simply be withholding information about the actual stocks bought, as Buffet did with his partnership.

Buffet on the racetrack

“I’d get the Daily Racing Form ahead of time and figure out the probability of each horse winning the race. Then I would compare those percentages to the odds. But I wouldn’t look at the odds first, to avoid prejudicing myself. Sometimes you would find a horse where the odds were way, way off from the actual probability. You figure the horse has a ten percent chance of winning but it’s going off at fifteen to one.”

“The less sophisticated the track, the better. You have people betting on the jockey’s colors, and you have them betting on their birthdays, you have them betting on the horses’ names. And the trick, of course, is to be in a group where practically no one is analytical and you have a lot of data. So I would study forms like crazy when I was a kid.”

“You’re not supposed to bet every race. I’d committed the worst sin, which is that you get behind and you think you’ve got to break even that day. The first rule is that nobody goes home after the first race, and the second rule is that you don’t have to make it back the way you lost it. THis is so fundamental, you know”

Buffet said that the market was like a racetrack: if we examine his statements about horse races, we can gain valuable insight into his way of thinking about any pari-mutual system. The equivalent of his handicapping method for investments is: figure out the probabilities realted to each company’s upside, and then compare the percentages to the odds i.e price.

Another aspect of Buffets racetrack description concerns finding a group where practically no one is analytical, and you have a lot of data. In investments, this would mean finding a particular industry or market that has less analysts and less trustworthy information. Since developed markets have large amounts of information and analysts, it seems as though they may be efficient more often. Other markets (emerging) may offer better opportunities and more of an edge.

Finally, he talks about not playing every race. In investments, this simply means being patient and waiting for only the best opportunities before investing. Aside from lost opportunity, there is no downside to sitting and waiting…

Buffet on Coca Cola

“I felt as sure of the margin of safety with Coke as when I bought Union Street Railway at 40 percent of net cash. In both cases you’re getting more than you’re paying for. It’s just that one was easier to spot.”

Buffet is saying that there is no single definition of margin of safety. Although Graham’s view was that the margin of safety must be quant based, Buffet argues that elements such as Brand Equity and Management can also offer margins of safety.

Buffet on China

“The 19th century belonged to England, the 20th century belonged to the US and the 21st century belongs to Chine. Invest accordingly.”

Charlie Munger on Fundamental Metrics of Investing

“All intelligent investing is value investing.” Quite simply, value investing can be defined by two fundamental metrics:

1. Look for a business trading below its intrinsic value.
2. Invest with a margin of safety.

Munger & Buffet on  Latticework of Mental Models

“Simplicity is the end result of long, hard work, not the starting point” – Frederick Maitland

“I’ve long believed that a certain system – which almost any intelligent person can learn – works way better than the systems that most people use. What you need is a latticework of mental models in your head. And, with that system, things gradually get fit together in a way that enhances cognition” – Charlie Munger

Munger & Buffet on Circles of Competence

“If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter” – Warren Buffet

“If you have a competence, you pretty much know its boundaries already. to ask the question of whether you are past the boundary is to answer it” – Charlie Munger

“I’m no genius, I’m smart in spots, and I stay in those spots” – Thomas Watson Sr.

Munger & Buffet on Fluency and Perspective

“You need to have a passionate interest in why things are happening. That cast of mind, kept over long periods, gradually improves your ability to focus on reality. If you don’t have the cast of mind, you’re destined for failure even if you have a high I.Q.” – Charlie Munger

“The deep structure of the human mind requires that the way to full-scope competency of virtually any kind is learn it all to fluency, like it or not” – Munger

“I notice that when all a man’s information is confined to the field in which he is working, the work is never as good as it ought to be. A man has to get perspective, and he can get it from books or from people – preferably from both” – Harvey Firestone

Munger & Buffet on Limitations of Formulas

“People always want a formula – but it doesn’t work that way. You have to estimate total cash generated from now to eternity, and discount it back to today. Yardsticks such as P/Es are not enough by themselves” – Buffet

“You need a different checklist and different mental models for different companies. I can never make it easy by saying; ‘Here are three things’. You have to derive it yourself to ingrain it in your head for the rest of your life” – Munger

Howard Marks (Oaktree Capital) on Margin of Safety

“Because there’s so much we can’t know about the future, we should invest only where our analysis tells us the worst case is tolerable”

This may seem overly conservative, but under recent conditions, I agree. If there is one thing that I have learned about investing, it is that unlike other disciplines (such as golf etc…) there are no formulaic advantages that can be applied consistently. One of the reasons models can fail to work is because markets are dynamic, not static. For this reason we must change our strategy based on conditions. At the risk of over quoting: “When the facts change, I change my mind. What do you do, sir?” (JM Keynes).

We must always take into account the worst possible outcome and ascertain the likelihood of occurance. Once we have established this, we must figure out the amount of downside risk (amount lost) in the event that such a situation does indeed occur. In essence, we are thinking in terms of Expected Value (EV)

Howard Marks via Brice Newberg on “Improbable Things”

For years these memos have quoted my good friend, Bruce Newberg, as saying: “Improbable things happen all the time, and things that are supposed to happen often fail to do so”. Acting in excessive reliance on the fact that something “should happen” can kill you when it doesn’t”

“Clearly, investors only make investments because they expect them to work out, and their analysis will center on the likely scenarios. But they mustn’t fixate on that which is supposed to happen to the exclusion of other possibilities…and load up on risk and leverage to the point where negative outcomes will do them in”

Howard Marks on Leverage

“First, leverage magnifies outcomes but doesn’t add value. I’ve said that so often that I ought to stop. But just a few reminders:

  • Leverage magnifies losses as well as gains. Leverage is just a way to bet more.
  • Leverage will make for higher highs and lower lows, and it might even produce an increase in the expected value…assuming outcomes are normal. But it can’t make something a fundamentally better investment. Thus, leverage absolutely cannot be equated to the contribution to return that comes from skill in selecting investments or in restructuring company operations or finances
  • It makes no sense to expect that structures will enhance the expected return without increasing the range of outcomes and the risk of loss
  • Leverage cares an extra risk on the downside that isn’t offset by accompanying upside: the risk of ruin. Leverage, when added to losses, can lead to margin calls and meltdowns. There is no corresponding benefit. The lesson is being learned today”

“To simplify for my current purpose, risk comes from the combination of what you buy and how you finance it. You can buy very risky assets, but if you don’t lever up to do so, you’ll never lose them to a margin call. Or you can buy fundamentally safe assets, but the combination of enough leverage and a sufficiently hostile environment can cause a meltdown. In other words, investing in “safe” assets isn’t necessarily safe, particularly if you’ve borrowed to buy them”

I believe what Marks is trying to say is simple. When heavily leveraged, you can be right and still lose (margin calls). When you are not levered up, when you’re right you almost always win.

Howard Marks on Normalcy

“But while the quants’ predictions usually center on the high probability that events will fall within the normal range, the last nine months have given all of us the opportunity to witness events at the extreme.”

Investors should remember to make investments for which the worse case scenario is still acceptable.

Howard Marks on Taking Advantage of Bear Markets:

There’s a simple formula for taking maximum advantage of opportunities in a collapsing market:

(a) have a firm, well-reasoned estimate of an asset’s intrinsic value;

(b) recognize when the asset’s price falls below its value, and buy;

(c) average down if the price goes lower; and

(d) be right about the value.

Mohnish Pabrai keys to succesful Investing

1. Have a sound investment philosophy
2. A Good Search Strategy
3. Ability to value a business and assess quality of management
4. Discipline to say no
5. Patience

Mohnish Pabrai on Investing

“I consider myself a gentleman of leisure. I go into the office with no set goal of buying or selling. I just wait for something to grab my attention.”

” Only invest in businesses that are simple – ones where conservative assumptions about future cashflows are easy to figure out.”

Mohnish Pabrai on EMT (Efficient Market Theory)

“Nonetheless, I mostly agree with the EMTs. Stock prices, in most instances, do reflect the underlying fundamentals. Trying to figure out the variance between prices and underlying. instrinsic value, for most businesses, is usually a waste of time. The market is mostly efficient. However, there is a huge difference between mostly and fully efficient. It is this critical gap that is responsible for Mr. Buffet not being a street corner bum.”

Our goal is to try and identify such “gaps”, exploit them to the best of our ability, and undertake the least amount of risk possible. It still begs the question though, why aren’t markets fully efficient?

“Markets aren’t fully efficient because humans control its auction-driven pricing mechanism. Humans are subject to vicillating between extreme fear and extreme greed. When humans, as a group, are extremely fearful, the pricing of the underlying assets are likely to fall below intrinsic value; extreme greed is likely to lead to exuberant pricing.”

In my mind, for the preceding reasons, the famous Buffet quote should be changed to: “Be fearful when others are extremely greedy, and greedy when other are extremely fearful”. It is mainly during moments of extremes that one can profit at an above normal rate.

Mohnish Pabrai on Pabrai Funds

“In the early days Mr. Buffett (and Benjamin Graham) focused on buying a fair business at a cheap price. Later, with Mr. Munger’s influence, he changed to buying good businesses at a fair price. At Pabrai Funds, the ideal scenario is to buy a good business at a cheap price. That’s very hard to always do. If we can’t find enough of those, we go to buying fair businesses at cheap prices. So it has more similarity to the Buffett of the 1960s than the Buffett of 1990s. BTW, even the present day Buffett buys fair businesses at cheap prices for his personal portfolio.”

Moats are critically important. They are usually critical to the ability to generate future cash flows. Even if one invests with a time horizon of 2-3 years, the moat is quite important. The value of the business after 2-3 years is a function of the future cash it is expected to generate beyond that point. All I’m trying to do is buy a business for 1/2 (or less) than its intrinsic value 2-3 years out. In some cases intrinsic value grows dramatically over time. That’s ideal. But even if intrinsic value does not change much over time, if you buy at 50 cents and sell at 90 cents in 2-3 years, the return on invested capital is very acceptable.

If you’re buying and holding forever, you need very durable moats (American Express, Coca Cola, Washington Post etc.). In that case you must have increasing intrinsic values over time. Regardless of your initial intrinsic value discount, eventually your return will mirror the annualized increase/decrease in intrinsic value.

At Pabrai Funds, I’ve focused on 50+% discounts to intrinsic value. If I can get this in an American Express type business, that is ideal and amazing. But even if I invest in businesses where the moat is not as durable (Tesoro Petroleum, Level 3, Universal Stainless), the results are very acceptable. The key in these cases is large discounts to intrinsic value and not to think of them as buy and hold forever investments.

Mohnish Pabrai on Berkshire

If you’re a buy and hold forever investor, then having a very durable moat becomes extremely critical. Berkshire needs to invest in businesses that have very high returns on equity (Coke, Moody’s American Express), the ability to redeploy earnings at high rates of return and it needs to buy into these businesses below intrinsic value so that the annualized return is atleast the returns the businesses generate on their equity. Very very few businesses generate ROE exceeding 15-20% annually and have the ability to redeploy earnings at greater than 15-20% ROE. Thus it is unlikely Berkshire ’s stock portfolio can generate long term returns exceeding 15%. Their float helps then get higher effective returns. Buffett once said that float added about 7% to Berkshire annualized returns.

On the other hand, Buffett the individual investor can buy a cheap stock and sell it at full price and pay mostly 15% long term gains. He gets taxed once. It is very efficient. Thus Buffett bought REITs when they got cheap – and then sold them all. He bought Korean stocks when they got really cheap. He’s either already unloaded or will unload those stocks in a year or two. He generates much higher returns for his own portfolio than Berkshire does. It is much smaller and does not have the incentives Berkshire has to just do buy and hold forever investing.

So, if you bought a business worth a dollar for fifty cents and it was a below-average business with a shallow moat. Let’s assume you held the business for 2 years and during those two years intrinsic value grew by zero, but the market recognized it was worth a dollar and two years later it was trading at a dollar. Now, if you sold it after 2 years, you annualized returns is over 41%. Buy and hold forever cannot generate 40+% annualized. If you have small amounts of capital and are focused and patient, you’ll probably get a chance to take that dollar and invest it in another 50% off business and convert it into two dollars in a year or two.

Plan A is always to buy the Coke and Moody’s of the world at 50% off. If you buy these type of businesses at that discount and it takes 2-3 years to trade at intrinsic value, you’ll do very well. Intrinsic value will be much higher in 2 to 3 years. So 50 cents may be worth $1.30 or $1.40. This is always Plan A. But plan A is virtually impossible to execute across the entire portfolio because they are so very very rare.

When plan A fails, we go to plan B. Plan B is to buy at half off, regardless of business quality (as long as you’re pretty sure intrinsic value is very unlikely to decline). Most of Pabrai Funds investments over the years have been Plan B.

Mohnish Pabrai on Simple Investing

“The best investments are total no-brainers than can be explained in a short paragraph or two. THey are obvious investments. The more words and spreadsheet cells it takes to layout the case for an investment, the worse it’s likely to do. Frontline was obvious. Stewart Enterprises was obvious. Level 3 was obvious. Pinnacle Airlines was very obvious. More recently, Ipsco was very obvious and that was nearly a 300% return in less than 2 years. “

Mohnish Pabrai on Simple FCF Analysis

“Depends on the situation. In some cases you can only hang your hat on liquidation value. In other casese there is enough of a moat to focus on future cash flows, that business is worth 10x FCF plus any excess capital. I then divide by two and see if it’s available at half off. If there is growth, depending on how much and how consistent, I’d be willin gto value it at 12-15x plus excess capital.”

John Templeton On Principle of Maxium Pessimism

“People are always asking me where is the outlook good, but that’s the wrong question…”

“The right question is: Where is the outlook the most miserable? I call the Principle of Maximum Pessimism…Let me explain how is works. In almost every activity of normal life people try to go where the outlook is best…”

“You look for a job in an industry with a good future, or build a factory where prospects are best. But my contention is if you are selecting publicly traded investments, you have to do the opposite…”

“You’re trying to buy a share at the lowest possible price in relation to what the corporation is worth…And there is only one reason a share goes to a bargain price: Because other people are selling. There is no other reason…To get a bargain price, you’ve got to look for where the public is most frightened and pessimistic…”

The Theory of maximum pessimism is very useful during a bear market. Often the market overreacts and sends a stock far below its intrinsic value. One must realise that during a recessionary period, it is difficult to find a reason why certain stocks are to rise, but as Buffet says: “It is difficult at the time of purchase to know any specific reason why they should appreciate in price. However, because of this lack of glamour or anything pending which might create immediate favourable market action, they are available at very cheap prices.”

Eventually, if your analysis is correct, when the economy and markets recover, this gap to intrinsic value closes…

Seth Klarman on Investing

“Investors in a stock expect to profit in at least one of three possible ways:

  • From free cash flow generated by the underlying business, which will eventually be reflected in a higher share price or distributed dividends
  • From an increase in the multiple that investors are willing to pay for the underlying business as reflected in a  higher share price
  • Or by narrowing the gap between share price and underlying business value

Security prices sometimes fluctuate, not based on any apparent changes in reality, but on changes in investor perception”

Seth Klarman on Baupost

If only one word is to be used to describe what Baupost does, that word should be: ‘Mispricing’. We look for mispricing due to over-reaction. Value investing requires a great deal of hard work, unusually strict discipline and a long term horizon”.

Seth Klarman on Business Valuation

“Many investors insist on affixing exact values to their investments, seeking precision in an imprecise world, but business value cannot be precisely determined. Any attempt to value businesses with precision will yield values that are precisely inaccurate. The problem is that it is easy to confuse the capability to make precise forecasts with the ability to make accurate ones. Anyone with a simple, hand-held calculator can perform net present value (NPV) and internal rate of return (IRR) calculations. Typically, investors place a great deal of importance on the output, even though they pay little attention to the assumptions.”

This is a great illustration of business valuation. It also brings out a multi-disciplinary idea, namely, the basis of philosophy.

Mason Hawkins Strategy

“Our long term success has emanated from several core principles:

  • Buy a business with expected value growth
  • Parnter with capable, honorable management
  • Pay a signifcant discount for stocks
  • Invest with a minimum five year horizon, deferring taxes and minimizing transaction costs
  • Charge reasonable fees”

Lowenstein on Tips:

“Given Buffet’s holding period, tips would have been of dubious value – it is hard to conceive of a “tip” that would be relevant 5 years later. However, the “tips” rationalization absolved others who had not thought of the same ideas, and who resented Buffet’s success.

Rohit Chauhan on Investing

“In 2007, I read a book by Mohnish Pabrai (Dhando Investor) and also a few other books and comments by Warren Buffet. I kind of realised that if one is interested in making higher returns then you have to look at buying undervalued copanies and selling at intrinsic value. The portforlio churn is more and you have to work harder at finding new ideas, but the returns are higher. So I had a slight change in approach in 2007.”

The “growth investing” process attempts to identify solid companies who’s earnings will grow quickly for years to come. However, as earnings are not realised yet, the potential of such companies is based on predictions and estimatations. Therefore, their price is based largely on subjectivivity, and when expectations are not met, the stock will suffer – regardless of how well the company actually does.

Tversky and Kahneman have shown that human’s are generally extremely inefficient at predicting future events (paradox). Therefore, buying companies which are already over-valued or fair valued, simply for future earnings growth, does not seem very logical to me. I am in no way saying that this strategy does not work, I am simply saying that it seems less efficient and less accurate.

True Value investing is somewhat like Relative Arbitrage, in the sense that under normal conditions, convergence eventually occurs between A and B shares. In the same way, companies usually converge with their intrinsic value. What is important is the time required for the undervaluation to correct itself. If your analysis is correct and there are catalysts, this should occur (but does not always). For this reason the company should be selling at such a large discount from intrinsic value, that even if it never fully converges, one can still prevent large losses. By buying at 40 or 50% of intrinsic value, we are taking distinct advantage of mis-pricing and momentary inneficiency. By buying a company which is fair valued or cheap, we are not taking advantage of inneficiency, we are banking on future earnings growth.

Gilovich and Kahneman on Heuristics

“The core idea of the heuristics and biases program is that judgment under uncertainty is often based on a limited small number of simplifying heuristics rather than more formal and extensive algorithmic processing. These heuristics typically yield accurate judgments but can lead to systematic error.”

Joel Greenblatt on Investing:

“Investors should focus on finding areas that are ripe for mispricing. When economic forecasts are bleak, people worry, and in turn, misprice securities. Their outlook may be right, but it isn’t where I focus when investing. I focus on normal earnings power and a long-term normal environment.”

“But how should an investor think about normalizing earnings, on a long term basis going forward, when the last 8 years or so of backward data for many industries might be inflated? One thing to look for is whether margins were higher over the past few years then they were on a long term basis. That analysis would go into your normalized number.”

“The best thing to differentiate yourself in the process is not just by doing good work, but by having the discipline to not buy something just because you did the good work. Investors need the discipline to recognize when a company they have been working on is not selling fo the same discount as they have seen in the past and pass even if it is just a little big cheap. If you are disciplined, only buy when you have a large margin of safety, are are willing to stock it out for two or three years – then I think you have the right process.”

Joel Greenblatt on Valuation

  1. “While studying the footnotes is crucial, the big picture is most important: Earnings yield and ROIC are the two most important factors to consider, with the key being figuring out normalized earnings.
  2. High earnings yield, based upon normalized earnings, is important in order to have a margin of safety. High ROIC (again based on normalized earnings) simply tells you how good a business it is.
  3. Independent thinking, in-depth research, and the ability to persevere through near-term underperformance, are three keys to being a successful value investor.
  4. Worrying about near-term volatility has nothing to do with being a successful value investor.
  5. Think of a concentrated portfolio as if you lived in a small town and had $1 million to invest. If you have carefully researched to find the best 5 companies, the risk is minimal (As Charlie Munger says, “The way to minimize risk is to think.”)
  6. Special situations are just value investing with a catalyst.
  7. International investing may offer the best opportunity, at least in terms of cheapness.
  8. Finding complicated situations that no one else wants to do the work to figure out is a way to gain an advantage. (You have discussed and given examples of many such situations in your book, You Can Be a Stock Market Genius.)
  9. Looking at the numbers best way to learn about management. What have they done with the cash? What are the incentives? Is the salary too high? Is there heavy insider selling? What is their track record?
  10. Focus on understanding and buying good businesses on sale, and don’t worry about the macro economy. Everything is cyclical, so value can always be found somewhere.
  11. Focus on situations that are not of interest to big players (usually small- and mid-cap, although currently large caps are cheap; spin-offs may be such opportunities, but the key is to figure out the interests of insiders; bankruptcies, restructurings, and recapitalizations may also be such opportunities).
  12. Trust no one over 30, and no one under 30; must do your own work, rather than simply ride coat-tails.
  13. Risk is permanent loss of invested capital, and not any measurement of volatility developed by statisticians or academicians.
  14. All investing is value investing and to make a distinction between value and growth is meaningless.)
  1. How to Value a Business. (Practice, practice, practice. If Buffett taught a course, he says he would just do case study after case study.)
  2. How to Think about Market Prices.”

Joel Greenblatt on Special Situations

“The bargain created or unmasked by the special corporate event – that’s what draws me in. The quality and nature of the business – that’s what usually determines how long I stay. So trade the bad ones, invest in the good ones.”

Joel Greenblatt on Earnings based valuation

“Thus, you understand the context of value investing. The most important step, which you have already completed, is to understand the market in context. If your investments go down, but you have done your homework, then understanding this broader context means that the short-term under-performance should not bother you. Again, understanding this context is crucial when things don’t go your way. Buffett on the two things you need:

The expected return from the stock is the growth in earnings over time plus the dividend yield. Any deviation from this over time will be because the multiple on which the stock is valued in the market changes over time. For example, buying a stock with cash earnings per share of $1 at a 10 P/E multiple (10% earnings yield) may look quite attractive if one believes those earnings are sustainable and the risk free rate is only at 5%. If the company retains all earnings and grows earnings to $2 per share in 5 years, your rate of return on the stock would be the same as the growth in earnings, about 15%, because the $10 stock would now be a $20 stock if it still traded at a P/E of 10. However, the market may not have realized this business was going to grow 15% a year when you first bought it (which is probably why you could buy it at a good price) and since the prospects still look bright, the market now re-rates the stock with a 15 P/E multiple.

If you buy a business when the short term earnings prospects are -X% but the long term prospects are +X%, you will do quite well. An investor should learn to tune out the noise and focus on the long term, making sure that X will be positive in the long run. The market focuses on the short term and may not realize the business is going to grow at a certain rate after the negative macro or micro factors subsides. This is a great way to let the market serve you.

If you buy when the market is already anticipating 15% growth per year, your investment will depend on that anticipation/estimation. You will not be protected, and will not be dependent as much on fundamentals. It is for this reason that you will often see a stock’s price decline if it has positive growth of 10% when expectations were 15%…”

Sanjay Bakshi On Frequency

I read a side note written in the BFBV Newsletter recently. It said: “I plan to do this infrequently, adopting the idea from Outstanding Investor Digest, surely one of the greatest investment newsletters. OID is published whenever the publisher feels he has something useful to send to his subscribers. No pressure to publish means no pressure to fill up the pages with useless text”.

This approach can be applied to investing. An individual should not feel pressure (in the way that most money managers do) to be active. Instead, the investor should take his time and invest only when he feels he has found something great to invest in; there is no pressure to fill up on useless investments.

Stable Boy Selections on TGT and Valuation

“The problem with your comments about Target are that (1) recessionary effects are irrelevant and already accounted for in the stock price and (2) Walmart has no smart activist investor to push the price toward intrinsic value. I have explained the first point many times. A company is worth the sum of its cash flows from now until the end of the world discounted to the present–thus value neither declines in a recession nor increases in a boom. The public’s constant exposure to the news (with all of its poor reasoning) assures that they will never understand this simple principle. ——-, your employment with ——- may put you in an even worse position.”

“Target was recently selling below its real estate value, let alone its earning power. It is essentially in the same situation as Sears Holdings, except that the earning power is more predictable.”

“Ultimately the problem with your comments is that they are all qualitative. It is surprising to hear this from someone with a quantitative bent. You can take it as an axiom that the most salient thoughts (as most qualitative thoughts are) tend to be factored into the stock price.”

Sham Gad on Investing

“There is no way that you will lose any money if you just sit still and do nothing. Wait for Mr. Market to serve you instead of guide you.

“The above statement presents two takeaways:

1. The “price is what you pay/value is what get” concept. As Ben Graham alluded, every stock is a good investment at one price. One has to be patient and disciplined not to overpay. A good company (Google) is not necessarily a good investment ($500+ per share, over 40x P/E, etc.).

2. Be willing to watch your investment decline by 50% and sit still….or buy more. Buffett once remarked that you should be able to see your investment decline by half and have the conviction to buy more if your analysis and reasoning are right. (Remember that I am implying that nothing has occurred to change the intrinsic value – and that you would have caught such a deterioration way before such a drop).”

How else should you look at buying shares in a business?

Ultimately, investments generate profits in three ways:

1. From the free cash flow generated by the underlying business, which will eventually be reflected in a higher share price or distributed as dividends.

2. From an increase in the multiple that investors are willing to pay for the underlying business as reflected in a higher share price.

3. Or by closing the gap between share price and underlying business value.”

Sham Gad, only three types of investments exist

1. under priced,
2. fairly priced, and
3. overpriced.

Value investors, by nature, engage in only three activities:

1. Buy the under priced assets
2. Hold or sell the fairly priced assets.
3. Avoid the over priced assets.

Macro Man on the Chinese Stimulus

“Predictably, markets have seized on the headline figure (which equates to roughly $586 billion) and rallied risk assets without bothering to consider the substance of the program. Given that much of the stimulus appears to be focused on rural housing and infrastructure (which, again, was going to see plenty of investment anyways), it’s not immediately clear to Macro Man why the announcement merits a 2% rally in S&P futures, for example, other than a knee-jerk “buy first, ask questions later” reaction.”

Moontrader on Bottoms

“The bottom is not an event, or marked by it: the bottom is a process.”

Atilla Demiray on Trading

“Observe, analyze, experiment and diagnose your mistakes… This is the learning loop”

“Hedging is another way to insure ignorance. (the other one is diversification)”

“Hypothetical assumptions will not change the facts. Consider a gambler, flipping a coin. He is right 50% of the time. So the coin works 50% of the time. That is in fact better than Technical Analysis (TA) because an overused tool in the stock market works less than a dice roll.

Of course your TA will work sometimes. But often, it is not the TA that is working, it is the randomness of the process, and you believe that it is your TA working.”

Mortimer J. Adler on Learning

“No one, not even the best teacher, can help us to learn anything unless we oursleves make the primary effort to learn it.”

On Independent Thinking

“You are neither right or wrong because the crowd disagrees with you. You are right because your data and reasoning are right” – Benjamin Graham

“The most difficult thing in business is first getting yourself to thinking and then getting others to thinking” – Harvey Firestone

“Apply logic to help avoid fooling youself. Charlie will not accept anything I just say because I say it, although most of the world will” – Warren Buffet

“Never fool yourself, and remember that you are the easiest person to fool” – Richard Feynman

On the Relationship between Poker and Investing

Thinking of intrinsic value in terms of “ranges” is similar to the way poker players think about poker hands.

You will never be successful at poker if you try and pin down the exact hand people have, you don’t need to. You simply need to find an accurate range, and if that range is worse than yours, you bet – and bet heavily.

In investing, you’ll never be very successful if you continually try and pin a precise number on intrinsic value, you don’t need to. You just need to find out if the range is far above market price…and if it is, you bet – and bet heavily.

On Objectivity

Have you ever noticed they way your outlook changes when you’re evaluating other peoples’ decisions or actions? When looking at another investors stock selection, we are quick to examine all the weak links, the loop holes. Whether there are actually there or not is a different story, but the point is that we engage in a constructive (or possibily destructive) analytical process unnafected by subjective biases (unless of course we are short on the stock).

Approaching your own stock selections in this manner can be very beneficial, even though it is a lot easier said than done. The gradual process of achieving objective thinking is something all investors should strive for.

On Mental Models

By using mental models, we are developing a new form of differential equations (optimization theory). In this new methods though, the differential equations are replaced or complemented by “big ideas” from different subjects such as economics, psychology, philosophy etc… The goal is a somewhat simplified version, which still manages to remove the extreme simplicity associated with using only a small number of heuristics.

On Selling

“While valuations of public companies can go through dramatic change in a matter of a few minutes, real business changes takes months, if not years. The gas station has seen dramatic drop-offs in cash flows and the future is murky. We need to allow enough time for the clouds to clear” – Mohnish Pabrai

While this is true on the downside, its also true on the upside. Therefore, on the upside, the market valuation of the business is likely to change, perhaps substantially so, long before the real business changes occur. Most of the time, investors don’t realise this.

On Short Term Prices

Short term market prices are based largely on expactations. Humans are notoriously bad at predicting the future (how was know what isn’t so). For this, focusing on short term movements is fairly futile….

On Presenting your Analysis

The analysis report or presentation should include:

  • Investment Thesis
  • Investment Catalysts
  • Industry Landscape and Competitive Advantage
  • Primary Research
  • Valuation
  • Risks and Weak Links

Begin with an Investing Thesis. This should start with a very short passage describing the business, their history and what how they make money (ex: Ternium manufactures flat and long steel products in Argentina, Mexico, Guatemala and the United States. The company is one of the largest steel production companies in Latin America with production capacity of 10.8 million tons. Its primary place of operations is in Mexico and Argentina.) It should also include all the relevant financial figures on sales, revenue, earnings, growth etc…

The next step is writing about the investment catalysts. It is great to find an undervalued company, but this will not do you much good financially if the price doesn’t close on intrinsic value. Catalysts include both macro and micro factors, business model etc…

The industry landscape should include all the relevant statistics on the industry and competitors (market growth etc…)

Primary research is essential to assure that the information used to come to your conclusions was unbiased and as objective as possible. Valuation should include the various methods such as earnings based, asset based, cashflow based and relative valuation.The risks section should include any elements which could contribute to drastic decrease or permanent loss of capital. The current and future financial situation of the business should be examined here.

Benjamin Graham on the Long-Term

Graham professed that investors should buy companies when the current situation is unfavorable, the near term prospects poor and the low price fully reflects the current pessimism .

Jim Rogers on getting out of the crisis

“You cannot solve a problem that is based on too much debt and too much consumption, by offering a solution that creates more debt and more consumption.” – Jim Rogers


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