Mental Models

The title of this blog is based on a quote from Charlie Munger about getting worldly wisdom from having a number of mental models

In multiple speeches, and in the book Poor Charlie’s Almanack, Munger has introduced the concept of “Elementary, Worldly Wisdom” as it relates to business and finance. Munger’s worldly wisdom consists of a set of mental models framed as a latticework to help solve critical business problems. According to Munger, only 80 or 90 important models will carry about 90% of the freight in making you a worldly-wise person.

Conveniently Farnam Street posts daily about mental models, and provides a pretty complete list below.

Each of the links should take you to the appropriate Farnam Street post.

Psychology (misjudgments)

1. Bias from Availability — including ease of recall, vividness, exposure, memory structure limitations, Von Restorff Effect, and love of a story. (introduction | all posts)
2. Bias from the most recent evidence
3. Bias from denial
4. Bias from insensitivity to base rates
5. Bias from insensitivity to sample size
6. Bias from misconceptions of change
7. Bias from insensitivity to regression
8. Bias from conjunction fallacy
9. Confirmation bias (all posts)
10. Bias from anchoring (all posts)
11. Conjunctive and disjunctive-events bias (all posts)
12. Bias from over-confidence (all posts)
13. Hindsight Bias (introduction | all posts )
14. Bias from incentives and reinforcement (all posts)
15. Bias from self-interest — self deception and denial to reduce pain or increase pleasure; regret avoidance. (all posts)
16. Bias from association (all posts)
17. Bias from liking/loving
18. Bias from disliking/hating
19. Commitment and Consistency Bias (introduction | all posts)
20. Bias from excessive fairness (all posts)
21. Bias from envy and jealousy
22. Reciprocation tendency (introduction | all posts)
23. over-influence from authority; halo effect? or is that liking?
24. Tendency to super-react to deprival; strong reacting when something we have or almost have is (or threatens to be) taken away. loss aversion?
25. Bias from contrast (all posts)
26. Bias from stress-influence (introduction | all posts)
27. Bias from emotional arousal (introduction | all posts)
28. Bias from physical or psychological pain
29. Bias from mis-reading people; character
30. Attribution Error; underestimating situation factors (including roles) when explaining reasons; one to one versus one to many relationships
31. Bias fro the status quo (introduction | all posts)
32. Do something tendency (introduction | all posts)
33. Do nothing tendency (introduction | all posts)
34. Over-influence from precision/models
35. Simplicity Bias
36. Uncertainty avoidance
37. Ideological bias (all posts)
38. Not invented here bias — thinking that our own ideas are the best ones
39. Bias from over-weighting the short-term
40. Tendency to avoid extremes
41. Tendency to solve problems using only the field we know best / favored ideas. Man with a hammer.
42. Bias from social proof (all posts)
43. Over-influence from framing effects (all posts)
44. Lollapalozza.

Other Mental Models:

1. Asymmetric Information
2. Occam’s Razor
3. Deduction and Induction
4. Basic Decision Making Process (introduction | all posts)
5. Scientific Method
6. Process versus Outcome
7. and then what?
8. The Agency Problem
9. 7 Deadly Sins
10. Network Effect

Business

1. Ability to raise prices
2. Scale
3. Distribution
4. Cost
5. Brand
6. Improving returns
7. Porters 5 forces
8. Decision trees
9. Diminishing Returns

Investing

1. Mr. Market
2. Margin of Safety
3. Circle of competence

Ecology

1. Complex adaptive systems
2. Systems Thinking

Economics

1. Utility
2. Diminishing Utility
3. Supply and Demand (introduction | all posts)
4. Scarcity
5. Opportunity Cost
6. Marginal Cost
7. Comparative Advantage (introduction | all posts )
8. Trade-offs
9. Price Discrimination
10. Positive and Negative Externalities
11. Sunk Costs
12. Moral Hazard
13. Game Theory (all posts)
14. Prisoners’ Dilemma (all posts)
15. Tragedy of the Commons (all posts)
16. Bottlenecks
17. The invisible hand

Engineering

1. Feedback loops (Introduction | posts)
2. Redundancy (Introduction | posts)

Mathematics

1. Bayes Theorem
2. Power Law
3. Law of large numbers
4. Compounding
5. Permutations
6. Combinations
7. Statistics
8. Mean, Medium, Mode
9. Distribution
10. Varability
11. Trend
12. Inversion

Statistics

1. Outliers and self fulfilling prophecy
2. Correlation versus Causation

Chemistry

1. Thermodynamics
2. Kinetics
3. Autocatalytic reactions

Physics

1. Newton’s Laws
2. Momentum
3. Quantum Mechanics
4. Critical Mass (introduction | posts)

Biology?

1. Evolution (all posts)

2009 Baupost Annual Meeting

Here are some notes from the Baupost 2009 Annual Meeting. I found them here on www.gurufocus.com.

Seth Klarman – Portfolio Manager

• They recognized 18 months ago that the opportunities were about to get really good. This was as they started seeing panic sellers and limited buyers.
• They were able to source large lumpy offerings for securities. Especially mortgages.
• There currently is a large and GROWING supply of distressed securities.
• Typically illiquid and highly complex.
• In early 2008 it was an advantage to have a large amount of assets under management.
• Feels it is the most interesting time in his career to be an investor.
• Risks continue to be numerous and enormous. Makes for great opportunities.
• Cards of the economic future have not been dealt yet.
• Stimulus will eventually have to be removed.
• In this environment they prefer debt to equity – less risk.
• Cash is building in the fund – around 30%. May raise more in the future.
• With the market rallying, it is creating a huge amount of pressure on the investment community to perform and keep up. This will create opportunities as people chase returns – not Baupost’s game – will not play it.
• It has been hard to stay away from the crowd.
• Baupost’s Goal – remain excellent.
• Value approach – always looking for bargains.
• Over the long run, the crowd is always wrong.
• Hold cash when opportunities are not presenting themselves.
• Great investments don’t just knock on the door and say “buy me.”
• What is their edge on a name?
  • Must have superior information.
  • Complexity – limits competition.
  • Ability to be long term.
  • Well founded contrarian view.
• Flexible approach – will look at ALL asset classes.
• Like to have a catalyst – reduces dependence on the market.
• Distressed debt inherently has a catalyst – maturity.
• EXCESSIVE DIVERSIFICATION DILUTES RETURNS.
• Not market neutral.
• Risk management must be a 24/7 365 job.
• Risk is NOT volatility.
• Volatility is GOOD.
• NOT true that higher risk leads to high returns.
• And.. NOT true that high returns only come from high risk.
• Risk is the probability of losing money and the amount you can lose.
• They don’t worry about career risk.
• As Jean-Marie Eveillard says.. they would rather lose half of their clients than lose half of their clients money
• No forced selling anywhere right now.
• In down markets they sow seeds, in up markets they harvest.
• Future always unpredictable.
• Need a margin of safety.
• Limit Risk with:
  • Deep analysis.
  • Bargain purchase.
  • Sensitivity analysis.
  • Don’t use any recourse leverage on the portfolio.
  • Need a catalyst.
  • Great majority of personal assets in the fund.
• It is crucial in a sound investment process to search a mile wide than a mile deep with they find something – also.. never stop digging for information.
• In employees, he values investment curiosity and intellectual honesty.
• Need to rigorously separate fact from fiction.
• Team based collaborative culture.
• Avoid organizing investment team into silos.
• Team of generalists.
• Always look for forced urgent selling.
• Don’t short many stocks. Instead they hedge for tail risk with CDS and options.
• They are happy to incur illiquidity.
• Illiquidity risk is a risk they LOVE.
• Comfortable holding cash for tomorrow’s opportunity.
• They find it is hard to un-train people so they try to hire young.
• Learning organization.
• Can’t let client pressures or market pressures distract them.
• An understanding that their clients expect certain times of underperformance.

Herb Wagner – Head of Public debt and equities

• Very focused on RMBS, CDS of all kinds, Distressed corp. debt, and equities in US and Europe.
• When your team is organized into silos, people only recommend ideas in their silo.
• Find ideas from – reading, sell side analysts, buy side friends, and existing investments.
• Best ideas are internally generated.
• Once they have an idea, it flows up to the team leaders. As part of weekly meetings they discuss everything. Everyone knows what each other are working on.
• They have traders in the office 24 hours a day. Eyes and ears of the firm.
• The edge they have is figuring out what organizations are having to sell certain securities.
• Existing Portfolio
  • 60% public
  • 5-8% equities
  • Rest is Debt
  • Structured Finance 22-25%.
• Next few years will still provide great debt opportunities.
• 1 trillion corp. debt maturing in next 4-5 years. Lots will be extended and refinanced, but lots will default.
• Loves RMBS – Most of these bonds will not trade back to par. Limits the buyers.
• The previous stretch of financial stability lead to more risk being taken. History screwed everyone. I.e. the experts modeled historical returns for home prices. How many times did you hear “home prices don’t go down”?
• RMBS
  • Technology systems are extremely important in analyzing.
  • Need to have a good sense of where housing markets will bottom.
  • They started in this space by shorting RMBS in 2007 and 2008.
  • INTEX is the best software for analyzing RMBS.
  • During the dislocation calls would come in Friday at 4pm from the dealers who were liquidating mortgage portfolios for mutual funds. They would give them 3 hrs to bid.
  • Need to understand structures.
  • Most mortgage experts don’t even understand the structures. Very confusing.
  • Analyzed housing in different collapses.
  • Looked at affordability than stressed it another 20%
  • Used a rental yield of 10%
  • Attended distressed real estate auctions in CA.
  • March 2008 Peloton blew up and that was their first purchase of RMBS – was too early.
  • They bought these bonds 20% below their mark the previous day.
  • But.. this established Baupost as a player in the market.
  • Bought many mortgages without competing bids.
  • There is still a huge shadow inventory of homes that are still to hit the market. Will drive prices down more.
  • Case Shiller makes people think that home prices have flattened out. Misleading.
  • No slowdown in delinquencies.
  • Prices will trade below affordability levels.
  • On the RMBS they have been buying, home prices can still go down another 40% and they will recover 56 cents on the dollar.
  • Modifications are a huge wild card.
  • Bought IO mortgages in the spring – been a big winner.
• SIV’s – this is the first firm I have heard talk about buying SIVs.
  • Basically a CDO with highly rated assets.
  • Borrowed short and lent long.
  • Purchased significant medium term notes of SIVs with yields of 15-50%.
  • A SIV is like sausage. Just a bunch of scraps of assets.
  • 200-400 different underlying items.
• Auto Finance companies
  • They invested 1.8 billion and made 1.2 billion in profits.
  • Ford Motor, Chrysler Finance, and GMAC.
  • First started buying at mid teen yields.. kept buying and in the heart of the crisis they were buying at 50% yields.
  • They love to buy bonds as prices are plummeting. They will just keep buying.
  • Seth has said to the team: “It is not us who is having the bad day as we are buying at lower prices than original purchase. … it is the guy who is selling that is having the bad day”.
  • They found that people pay their car loans. Loss rates remain low. Downside protection pretty good.
  • GMAC was the worst of all. Ford is the best.
• Hedging
  • Try to hedge if they can.
  • Rarely short stocks.. currently not short any stocks.
  • Not L/S fund.
  • Seek to be dollar denominated.
  • Buy insurance when it is cheap.
  • They like hedging interest rates .
  • CMS caps and if we get double digit 10 yr rates, they will make a 10X return on the hedge.

Q and A with Seth: Conducted by Roger Lowenstein

Q: Origins of Baupost

A: He bought first stock when he was 10 yrs old. Early on in college worked for Michael Price at Mutual Shares. Baupost was first going to be a family office. Started firm in 1982. Almost 30 yrs old.

Q: Is this crisis different than others you have seen?

A: Stands out in terms of magnitude of what happened. Decades of easy credit. Cats and dogs were getting credit cards. The government intervention is different than previous crisis’. It is huge. Gov won’t even let a garden variety recession happen. More bailouts increase risk. Sooner or later that will blow up as well. Big question keep asking himself is “was it really that easy to just print 2 trillion dollars and solve all the problems”?

Q: Interest rate risk? Has the government solved crisis or just taken on all the problems and setting us up for the “Big One”?

A: Impossible to know what they have brought upon us. A sudden and complete melt down is off the table because of their backstop. As long as they can print money we will be ok. All he cares about is being able to buy when others are panic selling. Usually the forced sellers are index funds and mutual funds.

Q: Do you worry about the dollar?

A: Spent a week in NY a few weeks ago. People were oddly optimistic. Money managers play a funny game. In that they are always trying to make money for clients. Baupost plays a different game. Only buy when the markets are getting beat up.. a long term game. Now.. he thinks there is a third game in town. A macro game. People are trying to time markets right now more than he ever remembers.

He has always worried about Fiat Currency. All governments will print money. Jim Grant influenced him greatly on being nervous about fiat currency. Baupost will own call options on Gold sometimes. He is deeply worried now but does not think it is his mandate to own bullion and miners. Will leave it up to his investors. Interesting because bonds, stocks, and gold are all saying different things. The markets are not agreeing.

Q: Last year people said that stock picking did not work. Only macro mattered. Agree?

A: Bought Ford Motor credit bonds at .40 on the dollar when in a depression they modeled getting .60 on the dollar. The main point is how much did people make this year relative to the amount of risk they took. People don’t care about risk adjusted returns anymore.

He thinks it is a tough job for consultants to sort through who was lucky this year.. vs. who was good.

Q: How did you have the courage to buy after the LEH blowup? And .. what did you do?

A: Was buying before Lehman.. after Lehman.. and since than. Also selling here and there. So many money managers need complete liquidity. He does not care if the market opens or not. Has always assumed that with the right type of issue, the market could close for months.

They bought lots of debt during the LEH crisis. Lots of Auto Finance.

Q: Any investments that stood out or “screamed” at you?

A: Only on the debt side. Equity markets were still expensive. No screaming stocks. If March 9th was really the bottom, it was a very expensive bottom relative to prior cycles… so he stuck with debt.

There was a subsidiary of AIG that was only in the mortgage business. He called them the “Thursday” bonds because he bought them on that Tuesday after the AIG collapse at .47 on the dollar. They matured at par TWO DAYS later.

Also bought another bond at .15 on dollar that has already returned .15 to him in cash and they think is worth .60. pays monthly. It is a structured product that is the senior most piece in the pool. 50% IRR for 5 yrs.

Q: Anything that did not work?

A: Does not see a bargain becoming bigger as a bigger problem. Biggest mistake was holding certain stocks into the crisis. Made them look stupid.

Q: Housing turning?

A: Still huge supply. Prime borrowers have homes that are way below loan value. Will be a long time before market recovers. Base case is another 20% decline… worse case scenario in their mind is 40% down from here.

Q: Stocks are flat for 10 years. Why don’t you own stocks?

A: Try to remain agnostic to stocks or bonds. Only buy stocks when they are cheap. Never got cheap.. certainly not cheap right now. 18X adjusted earnings. Debt however did get cheap.

Q: Do you feel that you have less of an edge in stocks?

A: Always have more of an edge where others aren’t looking or care about. Commercial R/E will get really interesting. Will just go where other aren’t. Stocks are expensive and competitive.

Q: Cash. Why?

A: Cash is more accepted now after last year. Endowments learned lessons on not having any cash. Cash is not a market time call. He uses it to buy assets.

Q: Does the cash position mean that you have too much money under management?

A: Don’t think so. Goal is not to make the highest return possible all the time. Managing 20 billion. Thinks there are advantages to size in this market. Helps in Commercial R/E and Mortgages. The negative is obviously that small ideas don’t move the needle. Will return capital at some point.

The endowment consulting business is screwed up. Endowments all benchmark themselves against how they are doing against each other. … what percentile they are in. this is dangerous because it forces everyone to chase each other and they end up taking too much risk.

The consultants only know how to measure return. They need to focus on risk adjusted return. It is all about generating returns with less risk. That is where the cash comes in.

Q: Do you have a benchmark for your fund?

A: Walked out of a meeting with a client when they wanted to talk with him about what benchmark to use for Baupost. Thought it was a waste of his time and he could not add any value there. He does not want to think about any benchmark other than risk adjusted returns.

Q: Should endowments hedge on their own or leave it to their managers?

A: Hard job for endowments. They have to spend a lot of time worrying about the character of their managers. This is a waste of their time. Its too bad they have to do this because a few bad apples.

Wall Street exists to “rip peoples eyeballs out”. Don’t try hedging yourself. You will get screwed. Also committees are entirely too slow. They will screw it up because they usually want to hedge at times that they feel they need it. This is all wrong. You hedge when you feel you don’t need it. That is when insurance is the cheapest. You want to sell your insurance when others are desperate to buy insurance. This is hard to do.

Finds it interesting that endowment kept adding to their VC and PE managers when it was obvious that it was not a good time to do it. They did it so they would not lose their slot. These asset classes are only good to invest in when people don’t want to be illiquid.

Q: From a public policy standpoint is there anything the government can do to reduce risk?

A: Having a risk regulator makes him laugh. No one will see the risks when things are good. No politician will be able to slow things down when it looks as though everything is good. If anyone would have tried to slow down housing in 2005/2006 they would have been looked at as crazy. Politicians will never take away a punch bowl.

Too big to fail is a disaster for the world. He thought that one positive to the pay czar is it could cause people to not want to be bankers. They need to make higher capital ratios and banks less profitable.

Q: So.. does that mean that JP Morgan should be told it cannot be in the derivative business?

A: The US needs to let AIG go bust. They need to do it NOW. Interventions were well intentioned but highly arbitrary. Let CIT fail, but GMAC gets another loan? That is fishy.

In the past, the reason the US was such a good place to invest has all been wiped over the last 12 months: rule of law, unions benefiting over creditors.. this is hurting our credibility.

General Q & A:

Q: How do you invest your cash

A: Short treasuries

Q: More thoughts on liquidity?

A: thinks it is a great time to make illiquid investments. There is a bubble in people fearing illiquid investments. This is the time to do it because no one else wants to.

Seven Traits of Great Investors

Mark Sellers lists seven traits for great investors in this speech (which I found on beearly.com).

1. ability to buy stocks while others are panicking and sell stocks while others are euphoric
2. obsessive about playing the game and wanting to win
3. willingness to learn from past mistakes
4. sense of risk based on common sense
5. have confidence in their own convictions and stick with them, even when facing criticism
6. have both sides of your brain working, not just the left side (the side that’s good at math and organization)
7. ability to live through volatility without changing your investment thought process.

The full article is posted below.

So You Want To Be The Next Warren Buffett? How’s Your Writing?

By Mark Sellers

First of all, I want to thank Daniel Goldberg for asking me to be here today and all of you for actually showing up. I haven’t been to Boston in a while but I did live here for a short time in 1991 & 1992 when I attended Berklee School of Music. I was studying to be a jazz piano player but dropped out after a couple semesters to move to Los Angeles and join a band. I was so broke when I lived here that I didn’t take advantage of all the things there are to do in Boston, and I didn’t have a car to explore New England. I mostly spent 10-12 hours a day holed up in a practice room playing the piano. So whenever I come back to visit Boston, it’s like a new city to me.

One thing I will tell you right off the bat: I’m not here to teach you how to be a great investor. On the contrary, I’m here to tell you why very few of you can ever hope to achieve this status.

If you spend enough time studying investors like Charlie Munger, Warren Buffett, Bruce Berkowitz, Bill Miller, Eddie Lampert, Bill Ackman, and people who have been similarly successful in the investment world, you will understand what I mean.

I know that everyone in this room is exceedingly intelligent and you’ve all worked hard to get where you are. You are the brightest of the bright. And yet, there’s one thing you should remember if you remember nothing else from my talk: You have almost no chance of being a great investor. You have a really, really low probability, like 2% or less. And I’m adjusting for the fact that you all have high IQs and are hard workers and will have an MBA from one of the top business schools in the country soon. If this audience was just a random sample of the population at large, the likelihood of anyone here becoming a great investor later on would be even less, like 1150th of 1% or something. You all have a lot of advantages over Joe Investor, and yet you have almost no chance of standing out from the crowd over a long period of time.

And the reason is that it doesn’t much matter what your IQ is, or how many books or magazines or newspapers you have read, or how much experience you have, or will have later in your career. These are things that many people have and yet almost none of them end up compounding at 20% or 25% over their careers.

I know this is a controversial thing to say and I don’t want to offend anyone in the audience. I’m not pointing out anyone specifically and saying “You have almost no chance to be great.” There are probably one or two people in this room who will end up compounding money at 20% for their career, but it’s hard to tell in advance who those will be without knowing each of you personally.

On the bright side, although most of you will not be able to compound money at 20% for your entire career, a lot of you will turn out to be good, above average investors because you are a skewed sample, the Harvard IVIBAs. A person can learn to be an above-average investor. You can learn to do well enough, if you’re smart and hard working and educated, to keep a good, high-paying job in the investment business for your entire career. You can make millions without being a great investor. You can learn to outperform the averages by a couple points a year through hard work and an above- average IQ and a lot of study. So there is no reason to be discouraged by what I’m saying today. You can have a really successful, lucrative career even if you’re not the next Warren Buffett.

But you can’t compound money at 20% forever unless you have that hard-wired into your brain from the age of 10 or 11 or 12. I’m not sure if it’s nature or nurture, but by the time you’re a teenager, if you don’t already have it, you can’t get it. By the time your brain is developed, you either have the ability to run circles around other investors or you don’t. Going to Harvard won’t change that and reading every book ever written on investing won’t either. Neither will years of experience. All of these things are necessary if you want to become a great investor, but in and of themselves aren’t enough because all of them can be duplicated by competitors.

As an analogy, think about competitive strategy in the corporate world. I’m sure all of you have had, or will have, a strategy course while you’re here. Maybe you’ll study Michael Porter’s research and his books, which is what I did on my own before I entered business school. I learned a lot from reading his books and still use it all the time when analyzing companies.

Now, as a CEO of a company, what are the types of advantages that help protect you from the competition? How do you get to the point where you have a wide “economic moat”, as Buffett calls it?

Well one thing that isn’t a source of a moat is technology because that can be duplicated and always will be, eventually, if that’s the only advantage you have. Your best hope in a situation like this is to be acquired or go public and sell all your shares before investors realize you don’t have a sustainable advantage. Technology is one type of advantage that’s short-lived. There are others, such as a good management team or a catchy advertising campaign or a hot fashion trend. These things produce temporary advantages but they change over time, or can be duplicated by competitors.

An economic moat is a structural thing. It’s like Southwest Airlines in the 1 990s — it was so deeply ingrained in the company culture, in every employee, that no one could copy it, even though everyone kind of knew how Southwest was doing it. If your competitors know your secret and yet still can’t copy it, that’s a structural advantage. That’s a moat.

The way I see it, there are really only four sources of economic moats that are hard to duplicate, and thus, long-lasting. One source would be economies of scale and scope. Wal-Mart is an example of this, as is Cintas in the uniform rental business or Procter & Gamble or Home Depot and Lowe’s. Another source is the network affect, ala eBay or Mastercard or Visa or American Express. A third would be intellectual property rights, such as patents, trademarks, regulatory approvals, or customer goodwill. Disney, Nike, or Genentech would be good examples here. A fourth and final type of moat would be high customer switching costs. Paychex and Microsoft are great examples of companies that benefit from high customer switching costs.

These are the only four types of competitive advantages that are durable, because they are very difficult for competitors to duplicate. And just like a company needs to develop a moat or suffer from mediocrity, an investor needs some sort of edge over the competition or he’ll suffer from mediocrity.

There are 8,000 hedge funds and 10,000 mutual funds and millions of individuals trying to play the stock market every day. How can you get an advantage over all these people? What are the sources of the moat?

Well, one thing that is not a source is reading a lot of books and magazines and newspapers. Anyone can read a book. Reading is incredibly important, but it won’t give you a big advantage over others. It will just allow you to keep up. Everyone reads a lot in this business. Some read more than others, but I don’t necessarily think there’s a correlation between investment performance and number of books read. Once you reach a certain point in your knowledge base, there are diminishing returns to reading more. And in fact, reading too much news can actually be detrimental to performance because you start to believe all the crap the journalists pump out to sell more papers.

Another thing that won’t make you a great investor is an MBA from a top school or a CFA or PhD or CPA or MS or any of the other dozens of possible degrees and designations you can obtain. Harvard can’t teach you to be a great investor. Neither can my alma mater, Northwestern University, or Chicago, or Wharton, or Stanford. I like to say that an I\’IBA is the best way to learn how to exactly, precisely, equal the market return. You can reduce your tracking error dramatically by getting an MBA. This often results in a big paycheck even though it’s the antithesis of what a great investor does. You can’t buy or study your way to being a great investor. These things won’t give you a moat. They are simply things that make it easier to get invited into the poker game.

Experience is another over-rated thing. I mean, it’s incredibly important, but it’s not a source of competitive advantage. It’s another thing that is just required for admission. At some point the value of experience reaches the point of diminishing returns. If that wasn’t true, all the great money managers would have their best years in their 60s and 70s and 80s, and we know that’s not true. So some level of experience is necessary to play the game, but at some point, it doesn’t help any more and in any event, it’s not a source of an economic moat for an investor. Charlie Munger talks about this when he says you can recognize when someone “gets it” right away, and sometimes it’s someone who has almost no investing experience.

So what are the sources of competitive advantage for an investor? Just as with a company or an industry, the moats for investors are structural. They have to do with psychology, and psychology is hard wired into your brain. It’s a part of you. You can’t do much to change it even if you read a lot of books on the subject.

The way I see it, there are at least seven traits great investors share that are true sources of advantage because they can’t be learned once a person reaches adulthood. In fact, some of them can’t be learned at all; you’re either born with them or you aren’t.

Trait #1 is the ability to buy stocks while others are panicking and sell stocks while others are euphoric. Everyone thinks they can do this, but then when October 19, 1987 comes around and the market is crashing all around you, almost no one has the stomach to buy. When the year 1999 comes around and the market is going up almost every day, you can’t bring yourself to sell because if you do, you may fall behind your peers. The vast majority of the people who manage money have IVIBAs and high IQs and have read a lot of books. By late 1999, all these people knew with great certainty that stocks were overvalued, and yet they couldn’t bring themselves to take money off the table because of the “institutional imperative,” as Buffett calls it.

The second character trait of a great investor is that he is obsessive about playing the game and wanting to win. These people don’t just enjoy investing; they live it. They wake up in the morning and the first thing they think about, while they’re still half asleep, is a stock they have been researching, or one of the stocks they are thinking about selling, or what the greatest risk to their portfolio is and how they’re going to neutralize that risk. They often have a hard time with personal relationships because, though they may truly enjoy other people, they don’t always give them much time. Their head is always in the clouds, dreaming about stocks. Unfortunately, you can’t learn to be obsessive about something. You either are, or you aren’t. And if you aren’t, you can’t be the next Bruce Berkowitz.

A third trait is the willingness to learn from past mistakes. The thing that is so hard for people and what sets some investors apart is an intense desire to learn from their own mistakes so they can avoid repeating them. Most people would much rather just move on and ignore the dumb things they’ve done in the past. I believe the term for this is “repression.” But if you ignore mistakes without fully analyzing them, you will undoubtedly make a similar mistake later in your career. And in fact, even if you do analyze them it’s tough to avoid repeating the same mistakes.

A fourth trait is an inherent sense of risk based on common sense. Most people know the story of Long Term Capital Management, where a team of 60 or 70 PhDs with sophisticated risk models failed to realize what, in retrospect, seemed obvious: they were dramatically overleveraged. They never stepped back and said to themselves, “Hey, even though the computer says this is ok, does it really make sense in real life?” The ability to do this is not as prevalent among human beings as you might think. I believe the greatest risk control is common sense, but people fall into the habit of sleeping well at night because the computer says they should. They ignore common sense, a mistake I see repeated over and over in the investment world.

Trait #5: Great investors have confidence in their own convictions and stick with them, even when facing criticism. Buffett never get into the dot-com mania thought he was being criticized publicly for ignoring technology stocks. He stuck to his guns where everyone else was abandoning the value investing ship and Barron’s was publishing a picture of him on the cover with the headline “What’s Wrong, Warren?” Of course, it worked out brilliantly for him and made Barron’s look like a perfect contrary indicator. Personally, I’m amazed at how little conviction most investors have in the stocks they buy. Instead of putting 20% of their portfolio into a stock, as the Kelly Formula might say to do, they’ll put 2% into it. Mathematically, using the Kelly Formula, it can be shown that a 2% position is the equivalent of betting on a stock has only a 51% chance of going up, and a 49% chance of going down. Why would you waste your time even making that bet? These guys are getting paid $1 million a year to identify stocks with a 51% chance of going up? It’s insane.

Sixth, it’s important to have both sides of your brain working, not just the left side (the side that’s good at math and organization.) In business school, I met a lot of people who were incredibly smart. But those who were majoring in finance couldn’t write worth a damn and had a hard time coming up with inventive ways to look at a problem. I was a little shocked at this. I later learned that some really smart people have only one side of their brains working, and that is enough to do very well in the world but not enough to be an entrepreneurial investor who thinks differently from the masses. On the other hand, if the right side of your brain is dominant, you probably loath math and therefore you don’t often find these people in the world of finance to begin with. So finance people tend to be very left-brain oriented and I think that’s a problem. I believe a great investor needs to have both sides turned on. As an investor, you need to perform calculations and have a logical investment thesis. This is your left brain working. But you also need to be able to do things such as judging a management team from subtle cues they give off You need to be able to step back and take a big picture view of certain situations rather than analyzing them to death. You need to have a sense of humor and humility and common sense. And most important, I believe you need to be a good writer. Look at Buffett; he’s one of the best writers ever in the business world. It’s not a coincidence that he’s also one of the best investors of all time. If you can’t write clearly, it is my opinion that you don’t think very clearly. And if you don’t think clearly, you’re in trouble. There are a lot of people who have genius IQs who can’t think clearly, though they can figure out bond or option pricing in their heads.

And finally the most important, and rarest, trait of all: The ability to live through volatility without changing your investment thought process. This is almost impossible for most people to do; when the chips are down they have a terrible time not selling their stocks at a loss. They have a really hard time getting themselves to average down or to put any money into stocks at all when the market is going down. People don’t like short- term pain even if it would result in better long-term results. Very few investors can handle the volatility required for high portfolio returns. They equate short-term volatility with risk. This is irrational; risk means that if you are wrong about a bet you make, you lose money. A swing up or down over a relatively short time period is not a loss and therefore not risk, unless you are prone to panicking at the bottom and locking in the loss. But most people just can’t see it that way; their brains won’t let them. Their panic instinct steps in and shuts down the normal brain function.

I would argue that none of these traits can be learned once a person reaches adulthood. By that time, your potential to be an outstanding investor later in life has already been determined. It can be honed, but not developed from scratch because it mostly has to do with the way your brain is wired and experiences you have as a child. That doesn’t mean financial education and reading and investing experience aren’t important. Those are critical just to get into the game and keep playing. But those things can be copied by anyone. The seven traits above can’t be.

Ok, I know that’s a lot of information and I want to leave time for questions so I’ll stop there.

Investing Wisdom from Seth Klarman

Noisefree investing has posted some letters to investors from Seth Klarman’s Baupost Group. The letters are dated from 1995 to 1998. Some (of the many) great quotes are below.

… we prefer investments, when we can find them at attractive prices, that involve a catalyst for the realization of underlying value

Our policy is to continue to protect ourselves from serious market declines through the purchase of out-of-the-money put options.

We firmly believe that one of Baupost’s biggest risks, and, needless to say, that of other investors, is that we will buy too soon on the way down. Sometimes cheap stocks become a whole lot cheaper; it simply hasnt happened lately. (And when that happens, expensive stocks will fare far worse.)

We will not stray from our rigid value investment discipline. We buy absolute bargains when they become available, and sell when they are no longer bargains. We hold cash when there is nothing better to do, and we hedge against the risk of a dramatic and sustained downturn in the market.

Risk is also mitigated by both our constant emphasis on investment fundamentals and on knowing why each investment we make is available at a seeming bargain price. We regard investing as an arrogant act; an investor who buys is effectively saying that he or she knows more than the seller and the same or more than other prospective buyers. We counter this necessary arrogance (for indeed, a good investor must pull confidently on the trigger) with an offsetting dose of humility, always asking whether we have an apparent advantage over other market participants in any potential investment. If the answer is negative, we do not invest.

Rather than own a little bit of everything, we have always tended to place our eggs in a few dozen baskets and watch them closely. These bargain-priced opportunities are selected one at a time, bottom up, which provides a margin of safety in case of error, bad luck or disappointing business results.

Cash provides protection in a storm and ammunition to take advantage of newly created opportunities, but holding cash involves the considerable opportunity cost of foregoing presently attractive investments.

It is only in a bear market that the value investing discipline becomes especially important because value investing, virtually alone among strategies, gives you exposure to the upside with limited downside risk.

In a stormy market, the value investing discipline becomes crucial, because it helps you find your bearings when reassuring landmarks are no longer visible.

But the value investing discipline tells you exactly what to analyze, price versus value, and then what to do, buy at a considerable discount and sell near full value. And, because you cannot tell what the market is going to do, a value investment discipline is important because it is the only approach that produces consistently good investment results over a complete market cycle.

If an undervalued stock drops after you buy it and you are confident in your analysis, you simply buy more.

The payoff to fundamental analysis rises proportionately with the difficulty of performing it. [talking about investing in emerging market or areas where information is less readily available]

In investing, nothing is certain. The best investments we have ever made, that in retrospect seem like free money, seemed not at all that way when we made them.

We continue to be willing to give up a portion of our upside to protect against serious downside exposure.

MCF worth US$71 a share

An old presentation (dated 2007) from Seller’s Capital, which presents the investment case for Contango Oil & Gas.

View this document on Scribd

Echostar worth US$46 – US$55

Another pick from Tilson is Echostar, a spin off from Dish Networks. Which is trading at a discount to liquidation value.

At the beginning of 2008, satellite TV company EchoStar Communications split into two: Dish Network (DISH) and EchoStar Corp. (SATS), which is a collection of satellites, set-top box businesses and a number of investments, cash and marketable securities, all managed by legendary founder Charles Ergen. Our slides on this company are in Appendix F.

Subscribers to the Dish Network install a dish, pay a monthly fee of approximately $30 and receive lots of television channels. In 2006 there was a strong expectation that Dish Network was going to merge with one of the telcos so, in preparation for that, EchoStar Corp. was formed and received all of the assets that a telco would not want to buy, thereby making Dish Network a more attractive acquisition.

SATS has the typical spin-off dynamics: it’s smaller than the original company, had a relatively unnatural initial shareholder base that sold the stock, and management has tended to sandbag the expectations for the company so that their options are struck at a low price.

At today’s stock price, the company is being valued at its cash and investment securities, meaning an investor is paying nothing for the company’s businesses, technology and investments. This includes eight satellites (six owned and two leased, with an original cost of $1.6 billion), a high value, hard-toreplace asset.

It also includes a set-top box manufacturing business – these are the boxes that Dish Network buys – with $1.7 billion in trailing 12-month revenue. In a normal income statement environment, that revenue stream would probably be worth $2-3 billion, but the boxes are sold on a cost-plus basis to DISH, so until DISH is acquired or SATS starts selling these boxes to other customers, that business is not worth a lot today – but it has a tremendous amount of potential value.

At today’s stock price, the company is being valued at its cash and investment securities, meaning an investor is paying nothing for the company’s businesses, technology and investments. This includes eight satellites (six owned and two leased, with an original cost of $1.6 billion), a high value, hard-toreplace asset.

It also includes a set-top box manufacturing business – these are the boxes that Dish Network buys – with $1.7 billion in trailing 12-month revenue. In a normal income statement environment, that revenue stream would probably be worth $2-3 billion, but the boxes are sold on a cost-plus basis to DISH, so until DISH is acquired or SATS starts selling these boxes to other customers, that business is not worth a lot today – but it has a tremendous amount of potential value.

We think SATS will start selling to other customers because it has other technologies to make better boxes. When SATS was a wholly owned subsidiary of Dish Network, no one other than Dish would buy the boxes because Dish was as competitor. Now that SATS is an independent company, we expect it will have eventually have success selling boxes to other companies.

Finally, SATS has some other interesting technologies such as Sling Media.

In summary, we think SATS is hugely undervalued, but there are no natural buyers. As a spin-off, it was likely heavily owned by hedge funds and, given that the stock was down 54% in 2008, many were likely dumping it. There’s a big margin of safety since the company can be liquidated for more than it’s trading for.

Link to the full letter with slides about Echostar at the end.

View this document on Scribd

Winn Dixie – undervalued?

Whitney Tilson appears to be a fan of Winn Dixie, the supermarket operator. His hedge fund T2 Partners owns 494,170 shares (see recent SEC 13-F filing) in the company, making it his fifth largest position.

Below is a excert from his letter to investors which outlines his investment thesis

Winn-Dixie operates 521 supermarkets, 70% in Florida and the rest in Alabama, Louisiana, Georgia and Mississippi. Thanks to poor management, run-down stores and fierce competition, the company, which had 1,000 stores at the time, filed for bankruptcy in early 2005. Having shed all of its debt and approximately half of its stores, Winn-Dixie emerged from bankruptcy in late 2006 under the leadership of Peter Lynch, who for the previous three years had been the President and COO of Albertsons, where he’d been in charge of operations, merchandising and marketing for the company’s 2,500 stores. While there, he had led a 200-store asset rationalization and $500 million expense reduction program.

During bankruptcy, Winn-Dixie shed its worst stores and is now investing in the remaining ones (it plans to remodel 75 annually until all of its stores have been remodeled), with good results so far: in the most recently reported quarter, gross margins rose, same-store comps at newly remodeled supermarkets were +11.6% and overall same store sales were +3.0%.

Winn-Dixie’s stock is remarkably cheap in our view. It has a market capitalization of around $860 million, but an enterprise value of $700 million after netting out cash of $162 million (the company has no debt, though it does have lease-related liabilities). That’s cheap for a company with more than $7.3 billion in revenues and projected EBITDA this year of $110-$125 million, even before factoring the value of the company’s $550 million net operating loss carryforward from the bankruptcy.

Even if one counts lease liabilities as debt, Winn-Dixie’s enterprise value is a mere 12% of sales, which is far below its peers.

Winn-Dixie has a much stronger balance sheet than these companies (all but these have 6 – 36x more debt than cash), but Winn-Dixie trades at a far lower EV/S multiple due to its lower margins.

If we thought Winn-Dixie’s margins had no room for improvement, then we wouldn’t own the stock at today’s price. However, we see no reason why, over the next couple of years, as Winn-Dixie continues to remodel stores and grow sales, its EBITDA margin won’t double (at which point, it would still be well below normal industry levels), which we believe will result in at least a doubling of the stock.

Eventually, we think Winn-Dixie will show sales and income growth to a point where it will be a nice acquisition for a company seeking to expand in the rapidly growing southeast region. There are probably three natural suitors.

Here is a link to the full letter:

View this document on Scribd

And a link to his article on Seeking Alpha

Sonae Capital worth €4 – €6 a share

Todd Sullivan at Valueplays posted about Sonae Capital in October last year.

Sonae Capital is a spin off of tourism assets and various other related businesses from Sonae Group, a large company based in Portugal.

The company now trades at €0.70 a share, up from a low of €0.42 in March 2009 and a high of €1.80 in Feburary 2008.

Talked about Joel Greenblatt and his assertion that spinoff’s:

• Outperform market by 10% a year for 1st three years
• Largest gain is in second year

Used Marriott (MAR) / Host Marriott International (HST) as a Case Study

• Abandoned by institutions
• Too small
• Made 4x money on deal

Sonae Group (SON.LS)

• Portugal’s largest employer
• Head, Belmiro (country’s second richest person)is very highly regarded.
• Spun out Sonae Capital (SONC.LS)
• Belmiro moved from larger company to the spin company.

Sonae Capital

• 250m share outstanding
• Belmiro owns 55%
• Pabrai own 7%
• 100+ real estate portfolio. Includes fitness centers, wind farms, marina, apartments etc.

Bought Troia Resort in 1997 in bankruptcy from government for nothing but the promise to develop.

• Has 1110 acres, Top 100 in World golf course, 18km beach, Roman Ruins, nature reserve and cleanest swimming water in Portugal.
• 170m Euros invested in it and now worth 500m to 1b Euros.
• One of a kind asset

Palacia Hotel

• 35m Euro investment
• Member if “Leading Hotels in the World”
• Valued at 100m Euros

Aqulaz Hotal

• 4 Star hotel
• Worth 50m Euros

Other Real Estate worth 412m Euros
Other businesses worth 250m Euros.

Total value of 1.2 to 1.8b Euros.  Intrinsic value after debt subtracted equals 955m to 1.5b Euros.

Per share equals 3.82 to 6.20 value vs .69 markets price (all in Euros). In other words, you can buy a dollar bill here for 12-20 cents.

GGP worth US$10 – US$30

The Manual of Ideas blog has posted Bill Ackman’s (Pershing Square Capital) presentation on General Growth Properties.

GGP owns of over 200 malls, operates a management and leasing businss (that services other mall owners) and is a land developer.

GGP voluntarily entered bankrupty on the 16th of April. This was due to the disruption in the credit markets which meant GGP could not refinance its debt.

The presentation lays out a case for the company being worth between US$10 and US$30, on the basis its assets are worth more than they liabilities and it just needs reorganise its debt.

GGP currently trades at around US$2.

View this document on Scribd

Sometimes the riskiest thing to do is not take any risks

Quote from 37signals blog, about why underdogs should take more risks.

Sometimes the riskiest thing to do is not take any risks. If you’re outmatched by the competition, isn’t it silly not to take a chance? If you’re an underdog in your niche or industry, playing it safe and imitating the established players will probably doom you to failure.