The value investor's tool box

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May 21, 2015
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We at Gurufocus have quite a solid idea as to what a value investor is, what he does and how he approaches investing. Nevertheless, I have compiled a list of tools that I believe should be in every Value Investor’s toolbox, and as such are the key skills needed to achieve outperformance, and continue to improve as a value-investor.

The following is my humble attempt at identifying, analyzing and synthesizing the keys to effectively and continually beat the market.

Read and review key material. Quality over quantity

It is not news that pretty much everyone who adheres to the concepts of value investing has read The Intelligent Investor by Benjamin Graham. In fact most value investors have read a lot of the same books; The Snowball, The Dhando Investor, Poor Charlie’s Almanac to name a few. This is commendable, and one of the essential ingredients to improving one’s own performance, and eventually becoming an excellent investor is voracious reading. Charlie Munger (Trades, Portfolio) has famously quipped that his children believe that he is a book with a couple of legs sticking out. The issue at hand here is not so much whether to read – because that is an absolute must – but how and what to read. I will argue that there is a higher payoff from focusing one’s reading on a narrow array of the best books. Personally I would rather re-read chapters 8 and 20 in the Intelligent Investor, as opposed to reading something where the payoff is mediocre at best.

A few suggestions on what I have found to have increased my knowledge and are worthy of reading more than once:

  • The Essays by Oaktree Founder Howard Marks (Trades, Portfolio), which can be found on Oaktree’s website: http://www.oaktreecapital.com/memo.aspx
    These memos are a great example of employing second-level thinking: Not only asking what and how, but asking what now, and then what?
  • One Up On Wall Street by Peter Lynch
    A Classic. Easier to read than most investment books, and a very solid take on some key investment concepts such as the how to scout for investing ideas and the PEG-ratio.
  • Contrarian Investment Strategies by David Dreman (Trades, Portfolio)
    A more academic approach to investing, with a solid emphasis on behavioral investing and how to take advantage of Mr. Market’s folly.

While it is absolutely key to develop a solid backbone of investing literature from which to draw on, it is also of utmost importance to grasp key ideas from other areas. This leads me to the next essential tool in the value investor’s tool box:

Develop your latticework: Relate seemingly unrelated ideas to investing

“I couldn’t stand reaching for a small idea in my own discipline when there was a big idea right over the fence in somebody else’s discipline. So I just grabbed in all directions for the big ideas that would really work.” Charlie Munger (Trades, Portfolio).

The mental latticework is one of Munger’s central ideas, and he is famous for applying the Darwinian idea of evolution to investing. Specifically he has talked at length about how technological evolution changes the investing and business landscapes. He cites the examples of Kodak (KODK, Financial) and General Motors (GM, Financial) who both went from Blue-Chip market leaders, to wiping out shareholders, all due to technological change. Two other ideas that you see him using often are critical mass and the psychology of human misjudgment, which come from such diverse mental disciplines as physics and psychology. Any investor can clearly learn a lot from this investing legend, and there is no reason to stop at these ideas. We have already established that reading voraciously and reading the seminal texts in investing is a large step in the direction of improving your own investing performance. Another step in the right direction is “stepping over the fence” and grabbing the key ideas from other disciplines, thus developing your own mental latticework. Apart from the ideas mentioned here, there are a few more, which will do a lot of good: Compound interest, Probability Theory, Law of Large Numbers and the central ideas from Basic Economics. Over time, knowledge of these areas will accumulate to a tremendous advantage.

I firmly believe Munger’s idea of developing a mental latticework is one of his most powerful ones.

Another suitable candidate for this title is the “lollapalooza” effect: when many factors inter-play, thus creating highly powerful and unanticipated effects. In order to thoroughly understand the lollapalooza effect, however, one needs to apply second-level thinking, or ecolacy.

Filters against folly: literacy, numeracy and ecolacy

Everyone at Gurufocus is able to read, write and analyze the numbers of a given situation. These actions represent the first two skills – literacy and numeracy –Â and they characterize first-order thinking.

Ecolacy, however, is a more elusive skill that very few people master – myself included – but a skill that can make all the difference between a skilled investor and a world-class investor. It is the ability to answer the question “And then what?” correctly.

For instance everyone has realized that the oil price has dropped sharply since it peaked. Falling from a high of almost $120 per barrel, it now sits in the mid-60s. The ecolacy of this situation involves knowing what effects this will have on airline stocks – i.e., a dropping oil price means lower fuel costs, which translates to cheaper flights, increased traffic. This in turn leads to increased profits (hopefully) which should translate to higher share prices as long as the oil stays at this level. This is one – quite simple – example of ecolacy, and it is not easy, but like everything else, one can improve through practice.

Garrett Hardin originally put this idea forth in his book “Filters against Folly,” and for a few examples of how to apply it, I suggest reading Howard Marks (Trades, Portfolio)’ memos. He is a true master of applying ecolacy to complex real world situations.

Be aware of Mr. Market’s moodswings

Every value investor worth his salt knows that Mr. Market is there to serve you, not to guide you. We want to buy from him when he is depressed and sell to him when he is ecstatic. Benjamin Graham writes about this subject at length better than I ever could in chapter 8 of The Intelligent Investor.

Publish and get feedback on your investment ideas

If there is one key takeaway from this entire article, then this is it. There is no way around this course of action if you wish to improve your investing abilities. It allows you to distill your thinking to clear, concise points and makes you analyze specifically why you believe a given company makes a good investment. Further, it lets an expert community – such as Gurufocus – have a look at your thought process and make suggestions as to how to improve. And if there is one thing that’s important when it comes to improving through deliberate practice, it is feedback.

Cultivate probabilistic thinking

In one of his speeches, Munger relates how one of Buffett’s biggest strengths is how he automatically thinks in terms of decision trees. This means he knows what the possible outcomes are of any given situation and knows how to figure out the odds of each one materializing. Mohnish Pabrai (Trades, Portfolio) talks about this as well, and is famous for the saying “Heads I win, tails I don’t lose much.” These are the type of odds you want when investing.

Since preservation of capital should take precedence over achieving outsized returns, it is important to emphasize that any situation where there is a reasonable chance you will lose a significant amount of your capital is simply not worth investing in because of the amount of time it will take you to get back to square one.

Kill your thesis

When you have identified an idea worth analyzing, analyzed it fully, attached probabilities to each outcome and gauged that there is not a significant chance of a large loss of capital, there is only one thing left to do:Â Kill your thesis. This is one of Bruce Berkowitz (Trades, Portfolio)’ ideas, and it essentially means that you look for any and every way that the investment might do poorly and ask question like

  • “What could make sales slow down?”
  • “Are there any macro conditions that could adversely affect the company?”
  • “What happens if the dollar suddenly retreats a lot?”

It is clearly impossible to cover every angle and anything that might go wrong, but it lets you look at the company from a new perspective and gives you some insight as to what might make the investment turn out in a less than desirable manner.

This serves two key functions. First and foremost, it lets you detect any red flags in the company that you might have missed in your initial analysis, but more importantly it allows you to detach yourself from any positive emotions you might harbor towards the company as a result of your initial analysis. This is more powerful than you think because if you go through this exercise and come out on the other side firmly believing that there is no way you come out at least even, after having done your best to kill the thesis, then the investment is airtight, and you should pursue it.

Behavioral finance

Behavioral finance has a lot to offer value investors as an intellectual discipline. Primarily because it lets, you become keenly aware of all the little biases that affects our everyday thinking:

Availability heuristic – the fact that we are more aware of something if it happened recently.

Anchoring – we think something is cheap at 50 if it was just at 100. That doesn’t mean it can’t come down to 25.

Confirmation and belief bias – the tendency to look for evidence that supports our thesis and evaluate the logical strength of an argument based on how well it supports our current belief.

Another powerful idea from behavioral finance is the idea of prospect theory. This is the idea that investors tend to hold on to losers for too long and sell winners too early because we hope that the losers will revert to their initial value and are afraid that the winners might do the same. In Warren Buffett’s words, this is plucking the flowers and watering the weeds. A clear example of investors being controlled by greed and fear, and this is one bias to be especially mindful of, as it can be detrimental to your investment results.

Be a contrarian

This means that stocks get more interesting as the price decreases and vice versa. To me this is the only sensible perspective because of the inverse relationship between value and price. I agree with Buffett’s quip that it’s better to get a wonderful business at a fair price, than the other way around. Nevertheless, I firmly believe that as long as your capital base is relatively limited, acting in a contrarian manner is the most profitable way of going about your investing.

Being a contrarian has a few key implications that are worth considering. First, it means you need to keep your cool and not let price dictate your opinion of a stock but rather view a drop in price as another one of Mr. Market’s inevitable and unceasing gyrations.

In order to keep one's cool, it is paramount not to fall prey to anchoring or availability bias. Conduct your own independent research in order to streamline your thinking and separate the ideas where the price drop is warranted and when it is not. This means asking questions such as: “Is the earning power of the company permanently impaired?” and “Is there a real risk of a permanent loss of capital?” If the answer to any of the questions is in the affirmative, then it is time to reevaluate the potential of the investment you are considering.

Circle of competence

One tool that any value investor must absolutely and undoubtedly always carry in his or her toolbox is the circle of competence and the ability to stay well within its boundaries. This wisdom is as old as it is true. If you don’t understand the business, i.e. what drives sales and costs, who the main competitors are, and what they primary industry dynamics are, then don’t invest in the company. It is not the size of your circle of competence that will determine your investing outcome but rather knowing where it starts and where it ends and only investing in that area.

Manage a portfolio – even if it’s just a practice one

This will help you keep track of your results and let you feel the effects of the gyrations of the market. No matter how much money you manage, for whom and what the goal is, there is no substitute for practice. After all this is what it is all about – investing your money, in order to get more money back at a later date.

A case from the real world

My own experience says that working with the tools I have listed above is easier said than done. I was long Excel Maritime Carriers (EXMCQ, Financial) until it went bankrupt. This is a good example to synthesize what I’ve expounded on so far in this article.

In 2011 I had watched patiently as EXMCQ dropped from a price of around 6 dollars a pop in 2010, to 3 dollars in mid-2011 amid general market turmoil. I had been watching the entire shipping sector for a while and the Baltic Dry Index (which measures day rates for Shipping Freight) had dropped and looked ripe for a comeback. EXMCQ was trading at around a price to book of around 0,5, and I figured there were enough hard assets to ensure a general margin of safety. I also thought that I was being a clever contrarian, so I did the write-up, analyzed all the fundamentals and figured it was low hanging fruit ripe for the picking. However, there were a few problems with my thinking in this situation.

Behaviorally, I anchored on price and showed recency bias. I figured the stock would quickly climb back to 6 – meaning I’d double my money easily – as general market conditions in the shipping sector recovered along with the stock market. The problem was that I had forgotten to ask the question of what happens if they don’t? What happens if the earnings power is permanently impaired, or the sector stays in the toilet for too long and EXM doesn’t stay afloat? (Pardon my pun)

Or – even worse –Â if I did ask these questions I didn’t understand the consequences well enough, meaning I only applied first-order thinking. I didn’t realize that the ships were worth nowhere near as much as they were listed on the balance sheet. I also didn’t realize that there would be a significant haircut on this already diminished value. Further, I didn’t realize that there were a lot of debtors who were senior to me as a stockholder in a potential bankruptcy and that they would get paid before I did. So these things taken together created a lollapalooza effect, which meant that my margin of safety I thought I had evaporated, quickly and effectively.

Summing up it clear I committed a few of value investing’s cardinal sins: I overstepped my circle of competence, in terms of overestimating how much I knew about financing in the shipping sector. I also did not realize how my brain is wired and fell victim to some of the oldest behavioral biases in the book.

Another thing I did not do a very good job of was killing my own thesis, which would have saved me tremendous time, effort and money if I had just started out by asking the right questions.

And lastly I inadvertently invested without having an adequate margin of safety. These things taken together usually results in a significant and permanent loss of capital, which is exactly what I experienced.