Presentation at Indian School of Business Annual Investment Conference on “The Practice of Value Investing” held on 16th October 2015 at ITC Maratha Hotel, Mumbai
This is what Mr. Munger took from Carl Jacobi, the great 19 th century German mathematician, who found that the solutions for many difficult problems could be found if the problems were expressed in the inverse - by working backwards.
I recently came across a lovely column by John Kay in the Financial Times. He talked about the distinction between “Feynman integrity” and “Stigler conviction”. For the physicist Richard Feynman, science involved a “kind of leaning over backwards. For example, if you are doing an experiment, you should report everything that might make it invalid – not only what you think is right about it.” For George Stigler, a founder of the modern Chicago school of economics, “the successful inventor is a one – sided man. He is utterly persuaded by the …correctness of his ideas and he subordinates all other truths because they seem to be less important than the general acceptance of his truth.” This distinction, made by Isaiah Berlin on Tolstoy’s view of history, is between “foxes” who know many little things and “hedgehogs” who know one big thing.
There are a lot of things that Feynman has written that are applicable to investing including leaning over backwards. Having just finished an excellent biography of the Stoic philosopher, Seneca, it was a treat to come across two recent letters by the fund manager and author, Chris Leithner, on how the principles of Stoic philosophy can be applied to value investing. One of the techniques of Stoic philosophy is “negative visualization” or in simple language, picturing the worst-case scenario, the Stoic way of inverted thinking. Negative thinking can paradoxically produce positive results by allowing for proactive risk management. Albert Ellis, a psychotherapist called this “the negative path to contentment.” As Leithner states: “Ellis rediscovered one of the Stoic’s key insights: sometimes the best way to navigate an uncertain future is not to focus on the bright side (“best-case scenario”) but rather the sombre side (“worst-case scenario”)… The ability to manage uncertainty by pondering negative thoughts is not just the key to a more balanced life: it is a sine qua non of successful business, entrepreneurship and investment.”
Charles Ellis wrote a book “Winning the Loser’s Game” – investing is a game where outcomes in the short term tend to be dominated by luck and high transaction costs. By avoiding mistakes there is a better chance of coming out ahead. So invert and ask – how could an investor lose money buying cigar butts and how could an investor lose money by buying into a wonderful business?
From a Grahamian perspective, the “margin of safety” comes from a study of the historical record of the company. The unstated assumption was that value is static or if the company had a superior current earnings power, grew at a rate that should not be assumed to be greater than the historical growth rate of profitability. The Buffett/Munger worldview, I think, has a far greater appreciation of the value of superior earnings power combined with growth rates that could be significantly different from those achieved in the past. The emphasis, I believe, was on future intrinsic value rather than on current conservatively calculated intrinsic value. Buffett/Munger relied primarily on the sustainability of the superior business model for value creation. That sustainability obviously depended on a long competitive advantage period. Graham focused primarily on the current price for value creation. Both have their pitfalls and both have their advantages.
What is it about spiderwebs that help them achieve their strength? The silk that spiders use to build their webs, trap their prey and dangle from the ceiling is one of the strongest materials used. But it is not simply the material’s exceptional strength that makes spiderwebs so resilient; it is the material’s unusual combination of strength and stretchiness – silk’s characteristic way of first softening and then strengthening when pulled. Damage also tends to be localized, affecting just a few threads, making it a very flaw-tolerant system. I think the Grahamian system can be thought to be like a spider-web. There are so many screens that can be run using the Grahamian framework and many ideas that come out from that quantitative perspective. Some turn out to be gems and some value-traps. Ex ante, I have found it difficult to distinguish between the two. And Graham stressed on adequate diversification, again something that I have not found psychologically easy. Sometimes I have erred by having too many stocks in certain portfolios that I used to manage.
“Dragonflies have two eyes, like humans, but they are very different from ours. They are enormous with the surface covered with tiny lens, aggregating in some species upto thirty thousand. Each adjacent lens covers a different physical space and thus gives a unique perspective. The vision thus is a synthesis of these unique perspectives”. Aggregating perspectives is the key to understanding ideas in the Buffett/Munger system. But it is not easy.
It sounds simple but it is anything but. One reason is that the quality of the entry barriers and the life-cycle of the entry barriers are subject to enormous change, sometimes over short periods of time emanating from circumstances and industries over which the investor may not have sufficient awareness or knowledge. Let me give you an example. The biggest threat to conventional car makers using gasoline/ diesel engine technology is going to come from companies in the information technology space, companies like Foxconn, Tesla, Xiaomi and Apple because electric vehicles are essentially computer tablets on wheels according to innovation expert Tony Seba. This disruption may happen in the next 3-5 years. The speed of change and the disruption possibilities have never been greater in many industries. Assessing how strong entry barriers are has become the biggest challenge for investors.
Negative space, in art, is the space around and between the subject (s) of an image. Negative space may be most evident when the space around a subject, not the subject itself, forms an interesting or artistically relevant shape, and such space occasionally is used to artistic effect as the “real” subject of an image. In graphic design of printed or displayed materials, where effective communication is the objective, the use of negative space may be crucial. The best story tellers in any form can artfully shape the narrative like designers make use of “negative space”. The Buffett/Munger way of investing is a bit like looking for “negative spaces”. What lies beyond the numbers is more interesting than the numbers themselves. And in this process, when one is dealing in shadows, one can go wrong.
I think, in India, returns have not only been about current or emerging moats, but to a large extent also on the addressable growth and market opportunities that have been present in industries. Competitive advantage comes in a variety of ways – cost advantages, network effects, intangibles like brands, regulatory advantages, switching costs and even things like the culture of a company. But having a competitive advantage is not enough. It must be an increasing competitive advantage. For huge returns, a large market opportunity is also necessary. And I will show you why through this example. Imagine that you have found Aesop’s goose and it is not going to die, not going to mate, not going to eat or fall sick and will keep laying golden eggs every year worth Rs 1 crore. There are no taxes and interest rates are to remain constant at 10 percent. You decide to encash your good fortune and sell the goose for Rs 10 crores to a gold miner. Whilst the goose does have a competitive advantage (zero cost of production and a unique asset) in the gold mining business, the new owner will not become richer with the purchase, unless a way is found to get the goose to lay more than Rs 1cr worth of golden eggs every year. Competitive advantage (or an economic moat) by itself does not lead to wealth creation. Only a growing competitive advantage (deepening and widening the economic moat) does. Of course, if you were fearful and the buyer was greedy, you could have sold the goose for less than its economic worth and value would have been created on purchase.
These, I believe, are important factors, that can bring about large shifts in value migration. They require the use of mental models that fall outside the normal use of “spreadsheet” growth rates. The growth here cannot be easily predicted. I have never felt comfortable going much beyond what I can easily predict with a high degree of conviction, but I want to underscore the importance of these factors in giving huge returns to some investors. The technology and pharma sectors are ones that readily come to mind, but there have been examples of large wealth creation over short periods in other industries. Growing competitive advantage plus, if you may.
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