“The difficulty lies, not in the new ideas, but in escaping the old ones” John Maynard Keynes
“If you don’t keep learning, other people will pass you by. Temperament alone won’t do it – you need a lot of curiosity for a long, long time” Charlie Munger
Michael Mauboussin: Here’s what active managers can do
“Read as many investment books as you can get your hands on. I’ve been able to learn something from almost every book I have read” Lee Ainslie
The world's greatest investors spend a lot of time reading and thinking. The tutorials that form part of the Investment Masters Class teach the common threads within their thought processes. In addition to these common threads, sometimes reading a specific book or interview highlights a novel way of looking at a company, analysing an investment or provides an insight that hadn't been considered before. The accumulation of knowledge across a broad spectrum of topics helps to build wisdom.
I've found over the years, I've learnt something from almost every book I've read. There is usually at least one or two "Investing Nuggets" to be picked up from reading. Sometimes it reinforces a view, other times it changes a previously held view and occasionally it opens up a completely new way of thinking.
I've included four 'Investing Nuggets' below ...
The Alchemy of Finance [George Soros] - "escalator up, elevator down"
Mr Soros effectively defined his own theory for markets noting "existing theories about the behaviour of stock prices are remarkably inadequate. They are of so little value to the practitioner that I am not even fully familiar with them. The fact I could get by without them speaks for itself"
The Alchemy of Finance provides an alternative explanation for asset bubbles. It helps explain why markets tend to drift higher yet decline rapidly, or as they say in the markets "Stocks take an escalator on the way up and an elevator on the way down". Why should that be so?
Soros noted that markets can become irrational when participants no longer focus on the fundamentals... "those who are inclined to fight the trend are progressively eliminated and in the end only trend followers survive as active participants. As speculation gains in importance, other factors lose their influence. There is nothing to guide speculators but the market itself, and the market is dominated by trend followers."
As all trends eventually end.. "when a long term trend loses it's momentum, short term volatility tends to rise. It is easy to see why that should be so: the trend-following crowd is disorientated"
It is then that the market can decline precipitously ... "when a change in trend is recognised, the volume of speculative transactions is likely to undergo a dramatic, not to say catastrophic, increase. While a trend persists, speculative flows are incremental; but a reversal involves not only the current flow but also the accumulated stock of speculative capital. The longer the trend has persisted, the larger the accumulation"
In conclusion .. "speculation is progressively destabilising. The destabilizing effect arises not because the speculative capital flows must be eventually reversed but exactly because they need not be reversed until much later. If they had to be reversed in short order, capital transactions would provide a welcome cushion for making the adjustment process less painful. If they need not be reversed, the participants get to depend on them so that eventually when the turn comes the adjustment becomes that much more painful"
Capital Returns [Marathon Asset Management] - "here comes the supply!"
This recent book edited by Edward Chancellor contains a collection of investment letters from the UK's Marathon Asset Management. The Global Equity Fund has delivered 9.7% pa since inception in 1986, outperforming the benchmark by almost 5% per annum.
The book is full of investing wisdom. The key theme of the book is an industry's 'capital cycle' and how that cycle impacts investment returns.
The book contains Marathon Asset Management's prescient newsletters on global house prices, credit markets and the commodity super-cycle. All of which resulted in significant investment losses for those investors oblivious to the capital cycle. Other letters reflect on capital allocation, industry dynamics, company culture, corporate management, technological disruption and the associated themes of 'network effects' and 'winner takes all'.
So what is the capital cycle?.... "The first notion is that high returns tend to attract capital, just as low returns repel it. The resulting ebb and flow of capital affects the competitive environment of industries in often predictable ways - what we like to call the capital cycle".
"The key to the 'capital cycle' approach is to understand how changes in the amount of capital employed within an industry are likely to impact upon future returns."
While most investors spend 90% of their time focussed on the demand side of the equation, which is subject to large forecasting errors, Marathon Asset Management spend the majority of their time focussed on supply which is far less uncertain.
By focussing on the magnitude of capital either entering or exiting an industry, an investor can develop an investment edge, aiding the discovery of potential investments and/or highlighting risks to an investment thesis.
Influence [Robert Cialdini] - "why can't we change our minds?'
Charlie Munger has acknowledged Robert Cialdini's bestselling book 'Influence' as filling many of the gaps in his thought process.
The book tells the fascinating story of a small cult of 30 or so members of otherwise ordinary people - housewives, college students, a high school boy, a publisher, a doctor, a hardware-store clerk - which was infiltrated by two scientific researchers.
The story tells of how the leader of the cult informed the members that she had begun to receive messages from 'Guardians', spiritual beings located on other planets. These transmissions gained significance when they began to foretell of an impending disaster - a flood that would eventually engulf the world. Although the members were alarmed at first, further messages assured them that they would be saved. Before the calamity, spacemen were to arrive on a specific date and carry off the members in flying saucers to a place of safety, presumably on another planet.
Two specific aspects of the member's behaviour was noted by the scientific researchers. Firstly, the level of commitment to the cult's belief system was very high. Evidence of such was the irrevocable steps many members had taken - quitting their jobs and giving away personal belonging ahead of the 'specific' date. Secondly, the members did surprisingly little to spread the word and avoided publicity when a newspaper started investigations when they learned of the cult.
On the 'specific' date at the specified time, not surprisingly, no spaceship turned up. The group seemed near dissolution. As cracks emerged in the believers confidence, the researchers witnessed a pair of remarkable incidents. The cult leader told the members she had received an urgent message from the Guardians stating the "little group had spread so much light that God had saved the world from destruction". Having previously shunned publicity, the cult leader then at once called the newspaper, to spread urgent message. The other members followed suit placing calls to media outlets.
Mr Cialdini noted the group members had gone too far, and given up too much for their efforts to see them destroyed. From a young women with a three-year old child:
"I have to believe the flood is coming on the twenty-first because I've spent all my money. I quit my job, I quit computer school .. I have to believe"
So massive was the commitment to the cult that no other truth was tolerable. The member's previous beliefs should have been destroyed from the physical reality that no saucer had landed, no spacemen had arrived and no flood had come. In fact, nothing had happened as prophesized.
There was but one way out of the corner for the group. They had to establish another type of proof for the validity of their beliefs: social proof. The fact the leader was still believing let other members also believe.
The story provides an explanation as to why analysts and investors can remain non-fussed in light of obvious disconfirming news about an investment - they are too committed. The fact other investors and analysts remain non-fussed reinforces the behaviour. Watching stocks fail to respond to what should be negative news maybe a case in point. Everyone is watching each other.
Common Stocks and Uncommon Profits [Phil Fisher] - "small price really"
Phil Fisher's writings are recommended by many of the great investors including Warren Buffett and Charlie Munger.
In 'Common Stocks and Uncommon Profits', Phil Fisher's analysis of factors that can sustain high profit margins reminded me of Berkshire's AGM this year when Munger, reflecting on competitive structure, commented that he preferred Precision Castparts to the reinsurance industry. He noted Precision Castparts customers "would be totally crazy to hire some other supplier because Precision Castparts is so much more reliable and so much better".
Mr Fisher observed the characteristics that can sustain high profit margins. He noted that a company can create in its customers the habit of almost automatically specifying it's products for re-order in a way that makes it rather uneconomical for a competitor to dispace them.
To achieve this the company must have a reputation for quality and reliability in the product which the customer recognises is very important for the proper conduct of his activities. Furthermore it is likely an inferior or malfunctioning product would cause serious problems. In addition, it is important there are no competitors serving more than a minor segment of the market so the dominant company is nearly synonymous with the source of supply. Finally, the cost of the product should only be quite a small part of the customer's total cost of operations such that moderate price reductions yield only very small savings for the purchaser relative to the risk of taking a chance on an unknown supplier.
Mr Fisher went even further to note that even this was not enough to sustain an above-average profit margin year after year. The product needs to be sold to many small customers rather than a few large ones. The customers must be sufficiently specialized in their nature that it would be unlikely for a potential competitor to feel they could be reached through advertising media such as magazines or television. The company can be then displaced only by informed salesmen making individual calls. Yet the size of each customer's orders make such a selling effort totally uneconomical!
Such a company can, through marketing, maintain an above-average profit margin almost indefinitely unless a major shift in technology or a slippage in its own efficiency should displace it.
A Zebra in Lion Country [Ralph Wanger] - "who benefits from the technology"
Ralph Wanger's 1996 book 'A Zebra in Lion Country' chapter “Downstream from Technology” discusses the opportunities and obstacle of new technology. In the current era of disruption it's worth thinking through the implications for investing.
Many of the Investment Masters avoid technology due to short product cycles and the risk of technological obsolescence. As Mr Wanger notes.. “New products are dangerous, especially in the computer field as technological breakthroughs bring price slashing every year. "
Mr Wanger continues ... “What I have always looked for instead are the downstream users of new technologies. I’ve bought the stocks of companies that buy, use, and exploit the computers and electronics to reduce costs, revitalise their businesses, and add functionality to their products.”
“Since the Industrial Revolution began, going downstream – investing in businesses that will benefit from new technology rather than investing in the technology companies themselves – has often proved the smarter strategy”
“Those who really made money out of the new technology (of steam locomotives) were not the transportation people but those who bought real estate in Chicago in the 1880’s and 1890’s."
“Recognizing a transforming technology and then investing downstream from it should be a key concept for any direct stock investor.”
“With the internet small companies can now compete against giants”
“The armoured knights couldn’t beat armies of commoners with muskets, and the corporate nobility of today is similarly vulnerable to upstart companies with smart, energetic, and competitive management”
The alibility for companies to harness technology is not a new phenomena. Charlie Munger recognised the enormous value of technology .. with the introduction of the VHS player..
“Disney is an amazing example of autocatalysis .. They had all those movies in the can. They owned the copyright. And just as Coke could prosper when refrigeration came, when the video cassette was invented, Disney didn’t have to invent anything except take the thing out of the can and stick it on the cassette. And every parent and grandparent wanted his descendants to sit around and watch that stuff at home on video cassette. So Disney got this enormous tail wind from life. And it was billions of dollars worth of tail wind”
More recently we've witnessed an exponential increase in digital disruption. The combination of Youtube, Facebook and Amazon webservers has allowed Dollar Shave Club to take on the once invincible Gillette. High speed internet has allowed Netflix to monetise the world's population causing havoc for free-to-air TV and cable operators. The internet and GPS has allowed Uber to disrupt the global taxi industry. Facebook and Google have disrupted the global advertising markets.
The future will bring increasing threats to old world industries who are not embracing technological change and at the same time will provide the potential for significant investment opportunities. Look downstream.