What Knowledge Matters? by Tom Macpherson, Dorfman Value Investments
In 1888, a Harvard professor in biology gave a speech at the Lowell Foundation about the abilities of species to survive and thrive in a constantly evolving environment. During that speech he made a point that most successful species are good at two defined behaviors – finding nutrition and reproducing. Other specialized behaviors – from eating only plants from the yew tree to shooting insects from the sky with squirts of water – were interesting but essentially dangerous in species’ survival and proliferation. As a more modern biologist wrote – first bread and water then caviar.
I bring this up because we think some of the best value investors focus on bread and water issues before becoming grazers of knowledge across multiple subject matters. Over the past two decades, fields have developed that bring the art of consilience to new heights. Everything from behavioral economics to fractal theory is allowing investors to see investing from entirely new angles. We are a huge fan of these new areas of research. That being said, we think it’s far too easy to fall into the trap that all this knowledge is vital to being a better investor. Much like the species in the lecture, great investors understand that a lot of information is interesting or intriguing but not essential to their survival.
A lesson in survival
At the height of the market bubble in 2007, Bill Miller was riding high at Legg Mason where his Value Trust outperformed the S&P 500 from 1991 to 2005. An extraordinarily impressive result. By 2006 he had bought a huge yacht named “Utopia” and was sitting on top of the world. In his own words he had created what he thought were essential models to help understand and predict worst-case scenarios ranging from a war in the Middle East to a repeat of the Cuban Missile Crisis. All of these were fine intellectual exercises in their own right. The problem was they passed over one of the most vital aspects of corporate life – the credit markets. His models in no way took into account some of the more basic functions of corporate strategy and operations related to debt. It almost seemed impossible that one of the core underlying foundations of our economies could be so badly at risk.
In this way, Miller had been guilty of what was spoken about at Harvard back in the 19th century: that successful species find ways to be good at the core biological functions that really matter – nutrition and reproduction. Without these basics well in hand species will inevitably decline and move towards extinction. Access to capital – whether through the public exchanges or private credit markets – is one of these. The 2008/2009 credit crisis demonstrated that far too many companies relied on their existence to extremely risky nutrition – cheap credit.
So how did a person so bright as Bill Miller get it wrong? How did such a manager produce such abysmal results? It should be pointed out Miller wasn’t alone. Many classic value investors posted truly catastrophic results in the same time frame. We humbly suggest there is some core knowledge that value investors must master and use as the basis for investment research and decision-making. Without these to build on, we are liable to be too clever by half. New knowledge works best when integrated into the core necessities for survival.
Food and water for the value investor
What are the knowledge parallels in value investing to the core values of nutrition and reproduction? We believe there are five (5) fields essential to making sure you understand how your investments have access to the resources necessary to survive (nutrition) and thrive (reproduction).
Mathematics and Statistics
Like it or not, numbers are the language of business. Without understanding a base level of mathematics and statistics, you will be unable to understand the underlying strength and growth abilities of your holdings. You don’t need to be the next Nobel Prize winner in the field, but a core set of tools will be essential to speaking the language of business. Mathematics tells us the dietary needs and intake of our holdings.
Necessary Subjects: Time/Value of Money, regression to the mean, distribution and standard deviation, basic accounting including credit/debit and financial statements.
The ability to understand how others – and more importantly yourself – make decisions is a huge skill to offset both bad decisions and obtain an advantage over other investors. Nearly everyone overestimates their ability at decision making. Understanding yourself better is the start of real downside protection.
Necessary Subjects: Inversion theory, the dynamics of incentives, decision trees, how you make decisions yourself.
As we learned in 2008/2009, credit is the lifeblood of so many aspects of the modern economy. Ranging from airline lease agreements to synthetic collateralized debt obligations (CDO), credit has become so arcane and deeply embedded in our finances that even the slightest ripple can produce extreme results. We believe the absence of knowledge in this area is the number one risk to value investing today.
Necessary Subjects: Forms of credit, use of credit, credit markets, risks related to credit, interdependencies of debt agreements.
Risk and Risk Mitigation
Inevitably we think we have a better understanding – and protection – against risk than we even remotely plan against for the future. The lack of understanding risk interdependencies has been one of the cheap culprits in nearly every market bubble since the South Seas crisis in the 18th century.
Necessary Subjects: Definition of risk, risk interdependencies, risk mitigation, understanding the difference between risk and uncertainty.
Excellent Writing Skills
Writing skills are far more important than just penning a nifty article to be published here on GuruFocus. Great writing requires investors to comprehend complex issues, structure arguments and counterarguments, synthesize findings and explain issues with exceptional clarity. The writings of Warren Buffett and other guru investors can be deceivingly simple in their wisdom. Don’t be fooled by this. Behind such writing is almost always an exceptional mind.
Necessary Subjects: Critical thinking, writing style, written comprehension
Much like our Harvard professor, we would posit that increasing your knowledge alone does not make you a better investor. By focusing on what is necessary for a company to survive (and thrive), we can mitigate risk by not investing in companies that face possible extinction. We have nothing against all the new fields of research we see out there, but it’s important to realize that knowledge is only valuable if it builds on the foundation of core concepts. We think some of the greatest investors focus on the nutrition and reproduction skills of their investment holdings. When we see investors or corporate management carried away in intricate systems analysis or arcane financial planning, we usually step away and force ourselves to go back to basics. In this time of ever growing complexity and data, we think this can provide us as individual investors a true advantage over the larger players. And that certainly lessens the risk of our own extinction.
As always we look forward to your thoughts and comments.