Big money thinks small- Thoughts on investment (27)

Before reading this book, I don’t know much about Joel Tillinghast, sorry for my limited knowledge of these great investors. After the reading, I think this book is actually very good, way beyond my expecation, and I would like to share some of the thoughts. Actually, I believe the this book has so many ideas and methods in common with BEDROCK that is like a perfect text book for BEDROCK.

I always believe that learn from the master is a better way than sharing idea and thoughts with the ones who are mediocre or have so many in common with you, for instance in the similar education background, in the same investment enviroment, etc. And in that sense, Joel is a perfect guy to learn from because that he is a true believer of value investing, that he has run fund investment since 1989, that the fund he has run is focused in small cap and growth stock which is very different from other value investing gurus as Warren Buffett, that his 30 years performance beat the index massively, and that the legendary Peter Lynch acclaimed him as the greatest investor of all time.

Five Principles for Avoiding Mishaps

Joel argues that while you cannot learn to be a great investor, you can learn to shy away from mistakes and be a successful one. Joel introduces five principles for avoiding investment mishaps.

1, Do not invest emotionally, using gut feel/ Do invest patiently and rationally

2, Do not invest in things you don’t understand, using knowledge you don’t have/ Do invest in what you know

3, Do not invest with crooks or idiots/ Do invest with capable, hoest managers

4, Do not invest in faddish or fast-changing, commoditized businesses with a lot of debt/ Do invest in resilient businesses with a niche and strong balance sheet

5, Do not invest in red-hot “story” stocks/ Do invest in bargain-priced stocks.

“What Happens Next?” And “What’s It Worth?”

“What’s it worth?” is an even more involved quesiton. Many ignore the question of value because they think it’s too tough to answer. Others don’t ask it because they assume a stock’s price and value are the same. In that sense, many investors believes the only thing they need to focus is “what happens next” since what has already happened is already in the price. 

However, the central idea of value investing is that price and value are not always equal. Answering “What’s it worth?” demands patience and low turnover. But the seemingly easier path of constantly buying and selling based on “What happens next?” doesn’t work for most investors, even professionals.

Folklore and Crowds

Same as French polymath Gustave Le Bon wrote in his book The Crowd, under the influence of crowds, individuals act bizarredly, in ways they never would alone. Le Bon’s key theme is that crowds are mentally unified at the lowest, most barbaric, common denominator of their collective unconscious—instincts, passions, and feelings—never reason.

In the process of examining the reactions of other people to resolve our uncertainty, however, we are likely to overlook a subtle but important fact that those people are probably examining the social evidence, too. Especially in an ambiguous situation, the tendency for everyone to be looking to see what everyone else is doing can lead to a fascinating phenomenon called “pluralistic ignorance”.

Because investment is all about predict the future, when abound to have many uncertainties, thus, as the rule tells, where the uncertainty presents people are eager looking for social proof. In the uncertain world of investment, People are looking for help from experts, authorities, analysts, influential fund managers, other traders, even the market performance itself for social proof, inevitable causing self-reinforces and sometimes madness, due to “pluralistic ignorance” effects. One trading trick of pushing stock price to the daily limit in A share market is another example of exploiting social proof effects to cause others to follow the momentum.

Thinking Fast and Slow

In psychologist Daniel Kahneman’s stylized account of decision-making, there are two systems of mind. System I (called the “lizard brain”in popular science) recognizes patterns automatically, quickly, and effortlessly –telling you what will happen next. System II gruadgingly allocates attention to complex thoughts like estaimating a stock’s value, and understanding Kahneman.

We often believe that our decisions were arrived at rationally, when actually they are driven by pattern recognition, that is, intuition. 

System II would have nothing to work with if the lizard brain wasn’t constantly susgesting cause-and-effect relationships. Because our intuition generates feelings and predispositions so effortlessly, it often provides the illusion of truth and unjustified comfort in its beliefs. Confidence comes more often from ignorance than from knowledge.

System I ignores ambiguity and muffles doubt with a tunnel-vision focus on the evidence that is immediately visible. Kaheman calls it What You See Is All There Is. Often, instead of answering a difficult question, our minds will answer an easier one using heuristics, or shortcuts. System I is more attentive to suprises and changes than to what’s normal, average and recurring，which are more important merits for value investing. It overweights low probablities, frames decisions narrowly, and is more sensitive to losses than to gains.

Trained Intuition

In business, intuitive is defined as attuned to pattern recognition.

Aren’t Market Efficient?

Consider return and risk: economic man isn’t risk averse, but I am.

Some of the assumptions are too idealistic as the efficient market hypothesis assumes: perfect information, perfect foresight, tastes do not change, everyone is infinitely greddy, hired hands will do the same things that owners would do, etc.

Joel believes the EMH was so compelling but cautionary tale. It’strue that the average person will earn average results, but as in any other endeavor, some are more skilled and interested than others. In every competitive game, winners are paired with losers. That does not mean the game is not worth playing. Your competition is also smart and diligent, so you need more than that to have an edge.

There is certainly no one in the market has a constant competition advantage.

What we are looking for

BEDROCK also believes is true that we should seek out undervalued stocks of growing companies we understand with honest, capable management.

Decision Biases

What You See Is All There Is

Investing forces you to reach conclusions with inadequate data. We tend to weight information based on its availability (ease of recall). Because of WYSIATI, the recent, dramatic, unexpected and personally relevant images are the first jump to mind.

Narravite Fallacy

However, on the other side of the story, we also tend to weave an explanation to the sequences of facts, or, equivalently, forcing a logical link upon them. In other words, a problem arises when we see causation where there is none. Data minining is a growth industry! 

Seek Refuting Evidence

Because we all have confirmation bias tendency, when we think something is true, we tend to seek evidence to confirm it and ignore refuting facts. The lizard brain makes quick decisions about urgent physical dangers.

With everyone digitally connected, it is increasingly hard to avoid the echo chamber. Social networks and other media explicitly try to feed you content that you like and presumably agree with. Investment has always been a clubby occupation –asset managers have similar backgrouds and shared habits of mind.

Quants and rule-based investing

Given these human frailties, some argue that rule-based investing by the numbers is the solution. Algorithms, bots and screens do take the emotion out of investing. Increasingly used by quants, these tools often function like idiot savants, doing complex things extraordinarily well while making a mess of simple tasks.

System I reflects our species’ hardwired wisdom from earlier times and makes simple tasks simple. The quants forget that stocks are not just numbers but part ownership of businesses, run by people.

Quants, having noted that low-volatility (low-vol) stocks have done well, now are maketing portfolios based on the low-vol “factor,”pushing up their prices. However, the factor worked before because historically this class of stocks was undervalued, not because the low-vol factor itself can contribute to a more successful company future. And that’s why when a sudden market crash happened,  for example in 2020 March, the volotility factor beat up, causing a massive and simutanuously sell off, triggered by the algorithms, further exacerbating the volotility and sell off.

The price for emotions

The stock market charges us for certain emotions and behaviors, and pay us for others. Consumers pay money to buy goods and services that make them feel a certain way. Even for ridiculous purchases, like Vegas gambling sprees, the consumer is said to be kong. 

If investors can select stocks that make them feel the same way, shouldn’t they be willing to give up an equivalent amount of money to do so? With volatile glamour stocks, you get the same kick as a trip to Vegas, and your losses are tax deductible. There is a hidden cost for everything that normal person desire: action, excitement, fun, comfort, social acceptance, popularity, and social exclusivity. And also, there’s also shadow income from patience, boredom, worry, courage, pain, loneliness, being a nerd, and looking like an idiot.

The most expensive emotions are seeking comfort and panic, which induce unplanned purchases and sales.

Social acceptance is perhaps the most universal comfort. Shares of the most popular and respected companies tend to sell at higher valuation multiples than others, and historically, expensive stocks have underperformed on the market.

Probably one of the reasons for stocks with higher volatility and higher growth story tend to have higher multiples, as the story gets investors excited and higher volatility can get more worlds out and generate more social proof.

On average, you are paid for being a nerd and sorting out the true situation. Even more, you are rewarded for the courage to act on an unpopular opinion that made you look like an idiot, provided it turns out to be correct.

Speculation and Momentum

In the internet age, it seems utterly ridiculous that momentum reflects slow dissemination of information or underreaction to news. More likely, momentum reflects overreaction to news, social proof, and piling on.

Momentum is a fast-paced game with a complex interplay between how far out you look, and how far out you think the crowd is looking.

Research into group behavior can pay off, but usually not with the exact data and number sought be speculators. Speculators take rising prices as proof that they were correct. Their error becomes apparent to them only in the fullness of time. People avoid reason until they have tried everything else. If you fancy that there will be a clear sign as to when the party will wind down, as most speculators do, you will surely be drawn into the thundering herd, despite knowing the inevitable result.

Patience is a virtue for investors, but speculators must worry about ideas and information going stale.

Source of certainty

If shares are partial interests in enterprises, the certainty we seek must emanate from the business itself. Training out minds on businesses rather than stock prices moves us in the right direction.

Concentration and Diversify

Anyone who is extremely successful must have extraordinary skill and luck. Diversification reduces the effects of luck for investors. To magnify the effects of skill, investors must carefully select for outstandingly favorable odds, bet heavily on them, and skip mediocre opportunities. Concentrating portfolios also amplifies the effect of luck, but this can hurt or help.

Leadership Skills and Integrity

The value of a business depends on the quality of its management, and good mangers are skillful and honest. If they are not skillful, they’ll squander your capital. If they lack integrity, they’ll steal it.

So how do we test for skill? Joel characterized into two markers: distinctive capability and capital allocation.

Companies are not well run if they are not constantly striving to be ever more unique valuable to customers. Unless customers would miss a company if it went away, it eventually will. Companies need products distinctive enough to justify high profit margins, plus a barrier to entry to protect those high profits. Without distinctiveness, business have fewer opportunities to deploy capital profitably.

And we are looking for companies that are great stewards of capital. Relative to the capital invested, they make high profits. If they acquire businesses, they find like-minded people and don’t overpay. When they are short of great uses for capital, they return it by paying dividends or buying back shares.

Distinctive Character

Focus on the character rather than business strategy or positioning. In brief, character doesn’t change, and positioning does. 

A company’s character needs to be assessed only once, whereas tracking a company’s strategy and tactics demands constant updates. Most companies lack a strong character. This does not mean that they will be poor investments – only that they are less apt to be exceptional.

Share Buybacks

Like dividends, share buybacks distribute wealth; they don’t create it. Unlike dividends, however, share buybacks can redistribute wealth among shareholders. If shares are repurchased at intrinsic value, the transaction is fair to all. But when shares are repurchased at a premium over intrinsic value, value is taken away from loyal shareholders and given to those who depart. When shares are repurchased at a discount from intrinsic value, shelling shareholders lose and the remaining shareholders gain. 

And one thing to mention, technology companies especially try to offset the dilution from hefty employee stock option grants. As share prices rise and options become more in the money, accountants consider a rising fraction of the shares under option to be outstanding. To keep a constant share count, shares will be bought back most urgently at the peak. Many companies have issued shares under option at lower prices and later repurchased them at higher prices.

Four elements of value

According to the discounted cash flow formula, the value of a security is the sum of its free cash flows from now until the end of time, discounted at a fair rate of return. Joel believes the four elements of value are 1, profitability of income; 2, life span; 3, growth; and 4, certainty.

Elevated profitability reflects a product that buyers want that, for whatever reason, they cannot get elsewhere.

Longevity is shortened by periods when the immediate demand for a company’s product falls. Whether the sale is lost to a competitive supplier or substitute product or is deferred cyclically, the result is the same.

Growth reflects either substitution away from a competing product or a product that allows users to do something that they could not do before.

Certainty reflects contracts and the general inertia of institutions are human behavior.

The investment challenge is to avoid getting carried away with unrealistic expectations. History suggests that many companies will turn out to have a terminal value of zero.

DCF and A peek into the future

The discounted cash flow method is often used carelessly, treating nearly certain events and nearly impossible events as equals. Some projections are quite reliable while others are rubbish; investors need to identify the trustworthy information and separate it from conjecture and babble. Descriptions of events that are already happening are generally more credible than extrapolations into the distant future; the further you look into the future, the more likely your forecasts will turn out to be wrong.

Another problem with DCF is that an estimate of value is only as reasonable as discount rate used. A perpetual annuity is worth one-third more if the discount rate is 6 percent rather than 8, and this variance might create, or destroy, a margin of safety. 

Certainty and an Unknowable Future

Joel believes the noncyclical demand, government regulation, monopoly power, brand loyalty, and a relatively unchanging product are the sources for certainty. When regulation or monopoly power shields business from competition, the risk of market share battles and price wars are lessened. Strong brands imply loyal customers and a measure of pricing power. Products that evolve (and are not commodities) are less vulnerable to substitution and shifts in market-share.

Whether your visibility into the future comes from laws, monopoly power, contracts, customers, or habits, it relies on human behavior, with all its foibles. 

Change makes life exciting, but companies that must change constantly are destined to make wrong decisions at some point and succumb.

What we are looking for in conclusion

Joel made a conclusion for investment that: you want low P/E stocks that are also high quality and growing, with a high degree of certainty about the long-term outlook.

Here I would revise the world ‘low P/E’ to a satisfactory or justifiable valuation, as P/E sometimes can be extremely misleading especially when we are dealing with growth stocks at early stages.

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