A Few Thoughts on Reducing Unforced Errors by John Huber, Base Hit Investing
This weekend I came across a link to an excellent Manual of Ideas interview with Allan Mecham that I’ve read before, but I decided to read through it again. There are a few key points that Mecham brings up that I think are really worth repeating, so I thought I’d highlight them here. Investing is not easy, but it should be simplistic. Here are some points worth keeping in mind:
Understand What You Are Buying
The first is the concept of understanding a business like an owner.
Mecham said something interesting when asked how he generates ideas:
“Mainly by reading a lot. I don’t have a scientific model to generate ideas. I’m weary of most screens. The one screen I’ve done in the past was by market cap, then I started alphabetically… Over the past 13+ years, I’ve built up a base of companies that I understand well and would like to own at the right price. We tend to stay within this small circle of companies, owning the same names multiple times. It’s rare for us to buy a company we haven’t researched and followed for a number of years—we like to stick to what we know.”
A friend and I have jokingly talked about the concept of a “Grandma Watchlist”, or a list of businesses that your grandma would feel comfortable owning. These are the great businesses. Unfortunately, they are also stocks that aren’t often cheap. However, I think building a list of great businesses is extremely valuable for two reasons:
- Studying a great business is never a bad idea. It helps you develop pattern recognition skills, and might help you identify successful characteristics of other businesses over time.
- More directly, studying a high quality business that you understand will allow you to act aggressively if that business ever is offered up by Mr. Market at a price that represents significant value
So this exercise of reading, researching, and building a database can be beneficial over time, and this process compounds over time. You might start with 1 business you understand well, which won’t leave you with much opportunity. But as the list grows to 3, then 5, then 10, etc… it begins to increase your opportunity set as well as your knowledge base.
My own investment strategy involves a two-fold approach of looking for the undervalued compounders that are building value (good businesses at bargain prices) as well as special situations (workout investments that possess significant value that might get realized through some corporate event or other catalyst). But I don’t think categorizing investments is that important—the key is finding bargains that you understand. While I’m focused first and foremost on locating bargains (gaps between price and value), I do spend a considerable amount of time reading and contemplating aspects of businesses.
So what I’m really after is quite simple: Good businesses that I can understand—at bargain prices. I think an underrated principle of investing is focusing on what you know. I think this will reduce unforced errors, which—like the amateur tennis player—is the best way to win.
In my hunt for bargains, I always keep an eye on a list of businesses that I know well, so that I’m prepared to act if and when they fall to a price that I know represents a sizable gap between price and value.
Be like the plumber in Bemidji, who keeps carving out his niche and stays focused on his small, but effective circle of competence.
Focus On Downside
Speaking of unforced errors, Mecham references the importance of reducing them when answering a question on mistakes investors tend to make:
“Patience, discipline, and intellectual honest are the main factors in my opinion. Most investors are their own worst enemies—buying and selling too often, ignorning the boundaries of their mental horsepower. I think if investors adopted an ethos of not fooling themselves, and focused on reducing unforced errors as opposed to hitting the next home run, returns would improve dramatically. This is where the individual investor has a huge advantage over the professional; most fund managers don’t have the leeway to patiently wait for the exceptional opportunity.”
Everyone talks about the importance of focusing on downside (just like everyone talks about understanding what you own). But I still think these concepts get implemented much less frequently than the “air time” they receive would have you believe.
Beware the Lottery Ticket Investments
The concept of focusing on the downside brings me to a tangential topic that I’d like to briefly talk about, and that is the allure of the “lottery ticket” investment. This is the type of investment that has long odds of paying off but could result in a huge payday if it works. For example, let’s say investment has a 40% chance of making 5 times your money, and a 60% chance of going to 0. In theory, this investment has a high expected value, and should be taken (if you could make this investment 10 times, 4 times out of 10 you’ll make 5 times your money, which far more than compensates for the 6 times your investment went to 0). In other words, if you bet $1 on a situation like this 10 times, you’d end up with $20 on a $10 total investment.
I’ve read many investment write-ups that are very similar to the example I just described. The investor acknowledges the risk, but then points out that in the event that the situation works out favorably, it will be a big winner. Again, in theory, this makes sense. But as Yogi Berra wisely said once: “In theory there is no difference between theory and practice. In practice there is.”
One thing I’ve observed over time is that market participants tend to overestimate the probability of the favorable outcome. It’s very easy to do this for a number of reasons: one, we are generally optimistic beings. Two, we naturally want to find a situation with high expected value like the one described above.
But since weighting the various outcomes is a very subjective exercise without a precisely calculable set of probabilities, it makes it very easy to skew these probabilities in our favor. Our desire to locate such an investment only makes this skewed analysis more likely. This makes it possible to justify an investment that in theory looks like a great bet, but in reality is just a risky bet.
Some investors have done very well making a living off of these types of situations, but if you are going to invest in these types of binary type events with two widely different potential outcomes, I think you need to be well aware of the biases described above, and be very careful when estimating the probabilities of the various outcomes.
I think in general, it’s much better to simply focus on simple situations that you understand very well—good businesses at bargain prices—and patiently keep building out your circle of competence while waiting for the proverbial fat pitch. Home runs will help increase long term returns, but they don’t need to come from swinging at really difficult pitches that are outside the strike zone.
The interview touches on these points, as well as a few other aspects of investing that are interesting. You can