Essays of Warren Buffet... Chapter 2

This chapter begins with the most useful concept in value investing - Mr. Market, originally introduced by Ben Graham. In Buffet's words:


"You should imagine market quoatations as coming from a remarkably accommodating fellow named Mr. Market... Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations are anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is manic depressive and can see nothing but trouble ahead for both the business and the world. One these occasions, he will name a very low price, since he is terrified that you will unload your interest on him."


And now the killer:


"Mr. Market has another endearing characteristic: He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you... Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom that you will find useful."


Buffet quotes Ben Graham again on the issue of holding: "In the short run, the market is a voting machine but in the long run it is a weighing machine." According to Buffet, the speed at which a business's success is recognized, is not that important as long as the company's intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price.


Buffet elaborates a bit on how he generally resists selling when the price is high which he contrasts with Wall Street attitude of: "You can't go break taking a profit". He explains that he is quite content to hold so long as the prospective return on equity capital of the underlying business is satisfactory. He doesn't explain this much further except for quoting David Ogilvy: "Develop your eccentricities while you are young. That way when you get old, people won't think you are going ga-ga".


The next section is an interesting one. Here Buffet talks about how a successful investor gets happier to see stocks falling. He poses a simple question: "If you expect to be net saver during the next five years, should you hope for a higher or lower stock market" ? "Even though people are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice becauses prices have risen for the "hamburgers" they will be buying soon. This reaction makes no sense... So smile when you read a headline that says "Investors lose as stocks fall"".


Arbitrage.


The next essay is on Arbitrage. This section carries a few of Buffet's experiences making and losing money in arbitrage positions, especially "risk arbitrage".


Efficient Market Theory.


In the next essay, Buffet lambasts Efficient Market Theory (EMT)... "Observing correctly that the market was frequently efficient, they [academics] went on to conclude that it was always efficient. The difference between these propositions is night and day". Buffet akins this ideology as "not even trying" when it comes to evaluating business principles of prospective investments.


Portfolio concentration - Too much of a good thing can be wonderful.


Another interesting point in this essay is related to portfolio concentration. Buffet says "we believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characterstics before buying into it". He explains that the difference between portfolion-diversification and portfoloio-concentration is really the difference in how risk is defined. Proponents of portfolio diversification define risk as the relative volatility of stock - that is, the volatility of the stock as compared to a larger universe of stocks. Under this definition, stocks whose prices have dropped severely are considered riskier. In contrast, the definition of risk accepted by proponents of portfolio concentration is from the point of view of the owner of business - "the possibility of loss or injury". I noticed that this is a recurring theme in the book - Buffet indeed thinks about his investments a lot like an owner rather than a speculator.


Buffet provides some guidance about how to evaluate risk. He cautions that these characteristics are often difficult to quantify, but that does not negate their importance:


1. The certainty with which long term economic characteristics of the business can be evaluated.
2. The certainty with which management can be evaluated...
3. The certainty with which management can be counted upon to channel the reward from the business to the shareholders rather than to themselves.
4. Purchase price,
5. Taxation, inflation, and competition.


Portfolio insurance.


Portfolio insurance is a money management strategy which dictates that ever-increasing portions of a stock portfolio, or their index future equivalents, be sold as prices decline. So, a downtick of a given magnitude produces a huge sell order. In fact, one popular corollary is to repurchase these companies, once the stock has rebounded significantly. Apparently, in the crash of October 1987, $60 to $90 billion of equities were offloaded on this hair trigger. Buffet concludes by saying that a smart investor only stands to benefit from such speculative acts of others. In fact, he can be hurt by such volatility only if he is forced, by either financial or psychological pressures, to sell at untoward times.


Value-investing: A redundancy.


This is well stated by these four rules. The business should be one (1) that you can understand, (2) with favorable long term prospects (durable competitive advantage), (3) operated by honest and competent people, (4) available at an attractive price.


When deciding what is an "attractive price", the Margin of Safety rules may come handy... "If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success".


Buffer believes that an intelligent investor buying common stocks will do better in secondary markets than he will do buying new issues. The favorable factor for secondary markets being Mr. Market. For new issues, Buffet mentions that issuing corporation has little incentive to undersell their stocks than its intrinsic value, since they can set the price and time the IPO.

Book: The Essays of Warren Buffet: Lessons for Corporate America

I recently finished reading "The Essays of Warren Buffet: Lessons for Coporate America". Given my thin knowledge of corporate finance, corporate governance, and investing, this book was quite useful. Over the next few posts I'll be presenting a few interesting ideas from the book. This first post is based on the first chapter.

Chapter 1 Corporate Governance

The chapter is mainly about Buffet's frustration with the top management of firms not owned by Berkshire and how things are different at Berkshire owned firms.

He starts with talking about the significance of full and fair disclosure of company performance. He doesn't approve of any company that highlights EBITDA (Earnings Before Interest, Taxes, Depreciations, and Amortization). He says that proponents of EBITDA argue that depreciation is not truly an expense, given that it is a "non-cash" charge. He offers a convincing counter-example: imagine that at the beginning of this year a company paid all of its employees for the next 10 years of service. In the following nine years, compensation would be a "non-cash" expense - a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years 2 through 10 would simply be a bookkeeping fomality ? Buffet offers some more views on the significance of clear accounting. He finally sums up his views as follows: "We want our managers to think about what counts, and not how it is counted."

Buffer is quite critical about CEO performance and compensation. He believes that CEOs of many public companies get away with underperformance for two reasons. Fistly, there are no clear standards of CEO performance. And secondly, the system charged with monitoring the CEO - the board of directors - often doesn't do a good job. Buffet provides some interesting insights into who should and should not be in the board. According to him, a director must have 3 qualities: (1) business savvy, (2) interest in the company, and (3) care about the owners. The most important service a director can do is to watch the CEO, ensure that he/she is doing a good job, and fire the CEO asap if not. Regarding the CEO, Buffet says that his message to every CEO is to run the business as if (1) you own 100% of it, (2) it is the only asset in the world that you and your family have or will ever have, and (3) you can't sell or merge it for at least a century.

Even if you have the best management and best board, you can still come out a loser if there are issues with the line of business. Buffet cites the example of a very well managed company, Burlington textiles, that has yielded substantially below average returns over the past few decades. He : "If you want to get a reputation as a good businessman, be sure to get into a good business". He offers another handy quote about working too hard on terrible businesses: "A horseman that can count to ten is a remarkable horse - not a remarkable mathematician". Buffet has a large repository of handy quotes on this topic. For example, in Chapter 2 he cites "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact".

In the last section of this chapter, flaws in options based compensation and how that corrupts CEO performance. Buffet argues that if a midly profitable company reinvests its earnings (instead of giving dividends), it can still maintain a pretty decent stock price growth over time assuming a constant PE ratio. Consequently, managers will reap good profits from the fixed-price stock options they received when starting, even though they have merely sustained the company's slow growth. Buffet suggests that cash bonuses have all the same merits as stock options since the managers can use it to buy as much stock as they want from the open market.

Sources of Power

Interesting points from Sources of Power - How People Make Decisions, by Gary Klein.

The author tries to avoid advocating any single approach towards decision making, but instead studies how people make decisions in various circumstances. Knowledge of decision making in field is at least one take away from the book. Besides that the author analyzes the decision making process based entirely on rigorous research of real people and circumstances and presents his results. It's up to the user to draw any strong inferences or lessons from these results. The author simply ensures that the research is rigorous and relevant.

I've only read first half of the book so far. The book begins by dispelling the common belief that most decision making is comparative analysis based. In reality, most decisions, and important ones (examples cited are from military, fire fighters, ICU nurses, etc.), are of type RPD (Recognition Primed Decision). These are decisions which are essentially sequential in nature where the decision maker considers a list of options sequentially and picks the first one he likes. In fact, most such decision makers believe that they are not actually making a decision. In contrast, most outside observers get the impression that the decision maker actually made a "decision" (meaning decided based on comparative analysis).

According to author's survey of few hundred important decisions taken by individuals in serious and/or time-pressure circumstances about 80% fall into the RPD category. There are several scenarios where RPD is not the primary decision process, e.g., RPD is based on recognition for which an essential requirement is subject expertise. So when novices are making decisions they tend to be more comparative analysis based than RPD. Similarly, when the decision needs to be justified, e.g., to a higher authority, comparative analysis based decisions are more common. There are several other interesting statistics in the book regarding how the contribution of different decision making approaches varies by scenario.

Once the plenitude of RPD is established, the book delves into the details of how RPD works and what are the various components of the RPD process. Probably the most significant model the book introduces is that of simulation. Simulation is useful in two scenarios:

1. In the scenario recongnition phase where the available data is matched with past experience to decide which scenario we are in. Simulation helps by arranging and explaning a set of sequence of events such that the end result is the current scenario. This knowledge of the past, or what brought us here, is often critical in deciding where we are headed in the future. The author also introduces the notion of "expectancies" - once a simulation has been made to arrive at our current position, the decision maker can generate a set of expectancies and watch out for them in the future. If certain expectancies do not happen, or certain unexpected things keep happening, then that might be a good reason to worry that the simulation (and hence our perception of the current scenario and future) may be incorrect. The author amply illustrates this point using the example of the Libyan passenger airliner whose pilots failed to verify the expectancies, the fire fighter who figured that something was not right and pulled his team out of the house just before the entire first floor went crashing into the basement (he was not told that the house had a basement), etc.
   
2. Simulation is also fundamental in predicting and analyzing the effect of the decision. The power to do useful and realistic simulations can be very useful in making important decisions. Future simulation, like other aspects of RPD (like scenario recognition) require a good deal of experience. However, in most cases creative ideas can play an important role in the simulation - coming up with a creative insight into a problem and being able to simulate its effect can be very valuable in solving difficult problems. The author gives the example of the newborn baby with a blocked throat, the fire fighter who chose to make a rescue by removing the car's roof, etc.
   

The second half of the chapter on simulation is very interesting. Here the author makes some summary observations based on experiences drawn from different experiments. One of the topics covered here is about expertise. Who is an expert ? How do experts use and leverage simulation, etc. Here are some points:

• Experts are constantly improving themselves by doing simulations, mental or aided by paper, computer, etc.
• Pre-mortem (crystal ball). The author defines pre-mortem as the process of assuming that something failed even before actually doing it and then trying to figure out how the failure might have happened. In their experience, they found that pre-mortem often generates new/interesting insight into the problem. It's called the crystall ball approach also since a powerful analogy is that of looking at the future in a crystal ball and finding that something failed.
• Post-mortem. The author uses this concept in a more general sense. They do a postmortem of a task after the task but before results are out and then after results are out.
  
• An important trait of experts is the gut to doubt the data. This is highlighted using numerous examples throughout the book. The data available for making decisions may not always be accurate or timely. In such scenarios, the decision maker has to leverage his past experience not only for decision making, but also for weeding out inconsistencies in the data or outright doubting the data. In some ways, this is a higher form of expertise. There are several examples of this, e.g., the firefighter doubting their knowledge of the fire and pulling out the entire team before the floor collapsed into the basement, or the Naval ship crew not doubting the fact that a passenger airliner was emitting millitary frequencies making them believe that it's a millitary aircraft, etc.

The Vincennes shootdown is one of the classic examples of decision making going wrong under complex scenarios. The incident is but a combination of multiple smaller incidents and provides valuable insight into decision making. For one, half of the ship crew had already made up their mind that the object they are handling is really a missile and they were looking for reasons to justify it. This shows how individuals often make gut decisions subconsiously and then attempt to justify them by contorting evidence. Secondly, the ship crew did not doubt inconsistent, unlikely data, most importantly the millitary frequency coming from the passenger airliner was due to an error in placing the instrument, it was not double checked. Thirdly, it shows that under severe time pressure, better decision support systems are needed in order to avoid making wrong decisions, e.g., in this case better visualization and analysis tools.

Digital Planet May 20th

Not a very interesting episode except for the part on "Predicate Encryption". I think the seminal work in this area is http://eprint.iacr.org/2007/404

I don't understand how this is any different from general access control lists. True, since the data is encrypted, even if someone gets access to the entire data, they can only access the part they are authorized to access, but a software layer enforcing access control lists also essentially enforces the same semantics.

Digital Planet May 27

Listening to Digital Planet podcast for May 27th, I learned a few things:

1. Virtual worlds are more pervasive than I thought. Previously, I used to consider only Second Life as a virtual world and not social networking websites. But coming to think of it, there is significant overlap between the two, and for many reasons, people are creating new virtual worlds, often targeted to specific class of users, like young children, students, teens, etc. E.g., Lego Corp. has a virtual world where you can play with legos. BBC has one for kids, and so on. In fact there was a whole "Children in Virtual Worlds" conference that this edition focussed on. The podcast mainly discussed safety, "active moderation" (moderator is a character in the VW himself), "CCTV moderation" (moderators is outside but silently watching - considered a bad thing).

2. Another interesting item was the psychological analysis of friendships and relationships in the virtual world. The conclusion was that in a VW, like in a real world, friendships happen based on shared experiences. So, to create a "tighter" social network, you need more shared experiences - yes, it's all about the experience, shared ones.