Thinking Independently about Independent Thinking

Ask anyone about the key characteristics of a successful investor, the term “independent thinking” almost always comes up. This is very reasonable since a successful investor has to make contrarian bets in which the odds are mis-priced. And if you do not think independently, you will be easily swayed by the market and hence have limited ability to identify money-making opportunities, which by definition are non-obvious. Given the underperformance of most active managers, independent thinking seems to be a rare resource. But why is this the case? Taking a step back, what does it really mean to be an “independent thinker”? More importantly, is it a quality that is inborn or can it be nurtured? As we are all striving to become better investors, I think the following question is worth pondering on: How can we become better “independent thinkers”? 

I have been contemplating this very topic over the past month. In this short essay, I explore (or more like recap) the concept of independent thinking, share my thoughts on what independent thinking entails, what it is not, and in my humble opinion, how we can all improve as independent thinkers.

Anatomy of Independent Thinking

Two weeks ago, I tweeted the following question and received four replies, which together I think capture the meaning of independent thinking quite fully. 

MBI set the stage for us. Independent thinking has long been associated with “Thinking based on first principle”. This means going through the logic flow, establishing how an argument goes from A to B to C and so on, before moving all the way to Z. This is what Chris meant by “analyzing your way to conclusions” and why looking at data sources is important. Ultimately, first principle thinking is really just breaking down a topic into subtopics and examining each in a logical way. This all sounds very simple. Therefore, in a sense, the rarity of independent thinking ought to come as a surprise. Everyone with an average intelligence capable of logical deduction should be able to “think independently”. (The level of intelligence influences the ability to reason correctly or come up with better explanations. But independent thinking does not necessarily mean being correct. Otherwise, no one in the financial markets are true “independent thinkers”, given the high failure rate in investing. And in most real-life situations, we are not asked to solve calculus. One just needs to be logical. Correctness should not be part of the measurement of independent thinking.) In reality though, there is often a sense that only a small group of people are capable of thinking independently. Why is this the case? 

Before I share my own thoughts, let me first highlight what independent thinking is not: Original thinking. I do believe original thinking is a rarity. The paragon of original thinkers, in my opinion, include people like Galileo, Einstein, Darwin, etc. These truly groundbreaking scientists, through their imagination and reasoning, imposed on all of humankind a completely new way to interpret the world. This however is not the case for even the greatest investors. From Buffett to Soros, and so on, they are all followers of certain existing principles. Buffett is the most famous student of Ben Graham and Soros is a disciple of Karl Popper. The difference between them and an average investor does not come from originality. Going against the crowd does not require the conjuring of bending space and time. 

If Originality is Not the Limiting Factor, then What Is?

When we read analyst reports or a piece of opinion on the FT, we are absorbing the analysis and judgement from another person. Essentially, we jump directly to Z. While the work may be beautifully articulated and the arguments made based on underlying data points, the integrity of the analysis cannot be guaranteed. The data could have been interpreted incorrectly, or worse still, flawed data were used, or part of the data set was ignored. To fully assess the analysis, one would therefore need to directly inspect the most fundamental level of arguments, the data points. This, however, presents a challenge. The cost of examining the accuracy of data and figuring out if they are collected without any biases is high and doing so for every argument presented to you is prohibitive. Instead, we need to treat this as an optimization problem, and choose an optimal point between efficiency and effectiveness. Where a problem belongs on this continuum depends on the seriousness of the subject on hand. If you are just deciding whether a restaurant is worth trying, it is unlikely to be imperative that you understand how your friend came up with the recommendation. But when it comes to whether you should take an experimental drug for your illness, then you probably want to dig deeper into the reasoning and proof of various recommendations to make the best decision. Most problems occur when it comes to a decision that is somewhere in between these two extremes. Given our human nature of laziness, unless the issue on hand is a matter of life and death, we tend to optimize our mental activities for efficiency rather than effectiveness. I believe this is why independent thinking is hard to come by in the financial markets. The intangible consequences and high uncertainty of investing tempts us to focus more on efficiency than effectiveness in our thinking process. In other words, I believe the rarity of independent thinking is derived from a paucity of patience. 

My own recent experience drives this point. I went through some difficult times over the summer, which greatly hampered my emotional capacity. This in turn reduced my ability to focus and diminished my patience. And without patience, I simply could not even sit still and reason each step the way I would normally do for the most important tasks on hand. As a result, for the first time in my adult life, I was described as lacking in independent thinking. However, I am sure I can think independently. Just last summer, we were given a very last-minute option of deferring our start at Columbia Business School. I still remember vividly that I pondered upon this decision very intensely over a weekend in July. It was a very difficult decision. By then I had already quit my job, so if I deferred, I would need to figure out what to do in the next year. On the other hand, having Zoom classes was obviously not ideal. But who knows when things will return to normal? I talked to more than a dozen mentors and discussed it with fellow classmates before ultimately making a decision that was truly my own. My experience was of course not unique. All of my classmates made a decision that best fit their situations and personal goals. It was a clear indication that when it comes to a subject that we care deeply about, we all have the ability to think independently and then make a decision that is right for us. To fully unleash this ability, the key is then to expand our attention, focus, and patience to other domains that are (or subconsciously perceived as) less pressing. 

Let us think through “independent thinking” again, this time using the framework of patience. Imagine a person with high emotional stability and an immense amount of patience. When the question of whether Tesla is going to dominate the electric vehicle industry is presented (I just read the latest Worm Capital investor letter which discusses Tesla), first she would be free of the emotions that come along with such a heated debate. Second, without being overwhelmed, she would be emotionally capable of breaking down such a large and complicated question into units of sub-questions through the simple urge to solve a puzzle. Bears say competitors are catching up, and they cite new model launches as evidence. But does new model launches necessarily imply a successful entrance? What should one track and examine to assess whether competitors are catching up? Bulls argue Tesla has a cost advantage with its vertical integration. But does vertical integration necessarily mean lower costs? How does it lower costs? Why doesn’t the automotive industry currently utilize vertical integration if it confers a cost advantage? And so on. With her unhurried and ever-present mind, going through all the above logic will be easy. (She might not be able to find the answers. But again, going through the logic is all independent thinking entails). And with adequate patience, it would be natural for her to go to the source materials and examine the data points accordingly. In fact, she most likely will even enjoy the process! 

I believe this interpretation of “independent thinking” bodes well for aspiring investors, because unlike originality, patience can be harnessed, at least to a certain extent. 

The Start of My Spiritual Journey

I have been extremely fortunate. While I was going through difficult times, I had support from close friends and mentors. The unifying theme of all the advice I received is that I need to practice self-compassion. The emotional paralysis I experienced in the summer and its dire consequences finally woke me up. I became fully aware that if I do not soon find ways to attain equanimity, I would never achieve sustained happiness and success in life. 

So, I began to practice meditation, which now I do every morning. And I picked up the books “The Surrender Experiment” and “The Power of Now”, thanks to the recommendations of two important mentors. The inspiring story of Michael Singer has compelled me to emulate him in surrendering to the flow of life, while Eckhart Tolle’s teaching has opened my mind to, well, the Power of Now. The act of surrendering and staying present-minded frees me from regrets of the past and fear of the future. As a result, I already began to sense that I am becoming more focused on the topic at hand. Being more present minded not only allows me to be more efficient, but it also makes me more patient. I am in much less of a hurry all the time and can think things through more clearly. Fear of being judged and worry of being wrong have both lessened since I now pay less attention to imaginary feelings in the future. The above is all work-in-progress for me. But I believe it will eventually culminate in my improvement as an independent thinker. Ultimately, I hope, paraphrasing Josh, to be “different without expending energy”. 

I also resumed journaling. Heeding the advice from another mentor, I now journal around three topics daily: (1) Time allocation in the day. We are what we do regularly. Thus, monitoring how we spend our time on a daily basis is critical. A review at the end of the day gives us a chance to assess our use of the most limited resource and make changes accordingly; (2) Emotional state of the day. Keeping a record of how my emotions fluctuate allows me to catch red flags of a bad emotional trend earlier; and (3) Investment related ideas and learnings. In terms of the medium of taking notes, I find it easiest to do my journaling digitally. I have been using the app Day One, which I think does the job very well.  

Conclusion: Temperament Means More Than I Realized

We all know that temperament is more important than intelligence in investing. But we usually say so since temperament determines how well one reacts to fluctuations in stock prices and whether one can stay rational in face of emotional distress. What I did not fully appreciate is how it can also affect one’s research process by influencing independent thinking. 

I am happy that I have embarked on this spiritual journey. Regardless of its actual effect on improving my independent thinking, just becoming calmer will be a big plus already. I hope you will join me. But I encourage you to find the way to improve your patience that works best for you.

Finally, I want to thank every person that has supported me over the past few months. I would not have been able to recover as soon as I have without any of you. Thank you all very much.

What is Good?

This blog is about fundamental investing. As the first post to rekindle this blog, I believe a discussion on the very core of fundamental investing would be most appropriate. And for investing, nothing is more fundamental than understanding a business — The core function of the fundamental investor is not stock analysis but business analysis. It is only through understanding a business that one can assign a range of value to it.

But what is the exact linkage between business quality and valuation? Why do investors tend to assign a higher valuation multiple to businesses of higher quality? Sometimes if the valuation is cheap enough, investors might be willing to overlook some of the deficiencies of a business. But as Buffett said: time is the friend of a good business but the enemy of a bad one. What does he mean? And why does owning a good business matter?

Actually, what does “good” mean?

I hope to provide my answers to the above questions in this post.

Like most investors, I have learnt a ton from Warren Buffett. But what I am summarizing below comes more from Geoff Gannon, whom I consider my most important mentor on investing. I will not be able to write better articles on the philosophy of investing than Geoff. And it would have been easier to just refer the reader to the relevant blog posts from Geoff (He is one of the earliest investment bloggers ever) Unfortunately, he has shut down his blog. (And he has transitioned to http://www.focuscompounding.com) Below, I attempt to summarize his thoughts on a very simple concept that most of you should already understand but do not think in the same angle.

What Is the Definition of “Good”?

When I was young and first learnt about businesses, I was mostly magnatized by companies that generate the biggest revenues. I naively thought that revenue and size itself signifies the quality of a business. Later on, I discovered “margins”. And I would try to memorize the typical margin levels of different businesses, and rank them accordingly — the higher the margin, the better the business I supposed.

But then I discovered Buffett. As I learnt more and more about him, I realized something is amiss. If revenue and margins are paramount, why does Buffett acquire businesses that produce slim margins? Why doesn’t he only favor companies that produce the most revenues?

The Key Metric – ROIC

The reason is that revenues and margins are just parts of the real key metric for a business — the Return on Invested Capital (ROIC). ROIC can be broken down into Revenue times EBIT Margin divided by Invested Capital. In other words, what was missing for me is that I did not pay attention to the amount of assets required to run a business.

This emphasis on ROIC should make intuitive sense. After all, choosing which business to get into is not all that different from picking a stock: you favor an asset that has better economics and a higher return profile. The only difference is that you compare the earnings with the required amount of assets to run the business rather than compare the stock price return with the price you paid. Essentially, you are imagining that you own the business in full or even start it from scratch — How much startup capital would one need to invest into this business for it to generate this amount of earnings? ROIC is the metric that answers the above questions. And since capital is scarce, it is obviously a better proposition if a business requires less capital to generate a given amount of earnings. (There are many other ways to measure the return on assets of a business. Why is ROIC preferred? We will leave this topic for another post)

The above is almost self-evident and widely used as a framework for analyzing businesses. But it is not always correctly used. If we look at ROIC simply as a historical or static metric, it actually has no bearing on what valuation the company should trade at. And this is a mistake even experienced investment managers may make. They mistake past glories of a business with what investors can benefit from in the future. They forgot that a company’s historical ROIC only benefited past owners while the current investors can only gain from future returns.

The Tax on Growth

Now, here comes one of the key insights Geoff taught me. He very much pays attention to the return a business generates from its assets. Yet, he doesn’t look at it the way most investors do. Instead, he flips it. Let’s use a simple example to illustrate this point:

Imagine we have two companies with the following characteristics:

Company A
Asset: $100
EBIT: $20

Company B
Asset: $100
EBIT $10

We also assume the two companies are both very well run and have reached a scale and level of efficiency that no further margin improvements or gains in capital efficiency can be achieved. This means the current return profiles reflect the optimal economics of the businesses.

Many investors will look at the two companies and conclude that Company A is the better business because it has a higher ROIC of 20% versus 10% for Company B. Geoff would agree with that conclusion, but not with the exact same reason. Instead, he sees Company A as the better business because it requires less resources to grow. In other words, he thinks of ROIC as the “tax for growth”. A higher ROIC implies a lower “tax”. This is a crucial concept as it explains why a company which has a higher ROIC can potentially be valued at a higher multiple.

Let’s return to the above example. Here we assume both Company A and Company B aim to grow earnings at 10% a year. How much capital would each company need to retain to achieve this growth target? Growing earnings by 10% to $11 would require an asset base of $110 (as we assume ROIC remains the same). To get to this level of asset, unless Company B increases its leverage, it would need to retain 100% of its earnings. On the other hand, Company A, also needing an asset base of $110, would only need to retain half of its earnings. The other $10 it generated can then be taken out of the business and returned to its shareholders. In Geoff’s mind, the tax for growth for Company B is at 100% but only 50% for Company A.

The long-term return of holding a stock can be approximated by the following equation: yield of capital returned + earnings growth + multiple expansion. If we assume multiple expansion to be nonexistent, adding a yield of capital returned to the same earnings growth rate will only add to the overall return of the stock to the investor.

Using the above example, we can understand why despite growing at the same rate, Company A deserves a premium. In addition to the 10% growth your company achieves, it is also returning a proportion of earnings to you every year. And you can choose to reinvest those cash flows elsewhere to further compound your money.

(Alternatively, Company A, with the higher ROIC, will be able to achieve a higher level of growth if it also reinvests all of its earnings)

The importance of looking at ROIC as the tax of growth is that it forces you to appreciate a high ROIC only if the company has ways to reinvest at this level. Otherwise, ROIC is just an archaeological record.

This mindset, for instance, would have stopped some investors from getting too excited about highly mature companies with very high ROICs but absolutely no room for reinvestments. In such a case, what an investor needs to understand is what the company will do with its earnings. Will it just pile up the cash? Or are the earnings paid out as dividends? Or does the company look to invest in new business areas whose return is unknown? Your long-term buy-and-hold return in the stock is only as good as the incremental return the company gets far into the future.

Lower tax rate is obviously better than a higher one. And negative is even better! This is becoming more commonplace these days as the SaaS business model turns more mainstream. A more traditional example would be the advertising agencies. These companies receive payments from clients before offering their products or services. And of course, there is the prime example that made Buffett extraordinary rich: insurance, in which the company receives premiums before paying out insurance claims. For such companies, the faster they grow, the more cash inflows they generate.

The Longer The Better

The power of compounding comes with time, and meaningful value creation only happens if a business can sustain a high incremental ROIC and achieve healthy growth rates for a long period of time. The maths is undeniable. But figuring out how incremental ROIC will trend and whether a company can sustain a high incremental ROIC are where the real difficulty of investing lies in.

This is why we study competitive advantages, competition dynamics, demand durability, management’s capital allocation strategy and so on. All that you learn about is to understand 1) What kind of return a business will get on its retained earnings; 2) How fast it can grow; and 3) How much cash will be returned to shareholders in the meantime.

The Question on Position Sizing/Diversification and… Lessons Learnt

I haven’t written a post for quite some time. I currently have a few topics in mind. Hopefully, I will have them written down in a short period of time.

As a starter, I would like to talk about diversification/position sizing, which is something I have been thinking heavily about. But first, let me explain why I came to contemplate this.

It has something to do with the investment record I have thus far compiled. And it can be described in one single word: abysmal. Yes, more than terrible, my record until now has been really abysmal.

I have really just meaningfully invested in three stocks since 5th September 2013, the day I bought my first stock. China Agrotech, Weight Watchers (WTW) and Town Sports International (CLUB). A lot more money (in relation to my net worth) was invested in the latter two. But all of them have given me more than 50% of losses. (>~70% for the later two) Realized loss for the first and unrealized for the latter two. Naturally, it bugs me and gets me into thinking what went wrong?! Self-afflicting and self-condemning aside, at least we ought to figure out what we can learn from our mistakes.

I made the first investment solely on my own. It was cheap. Maybe dirt cheap, since it was a net-net when I first found it. However, it turns out to be some sort of a fraud. The stock stopped trading after one of its creditors (I think it’s Standard Chartered) demanded they repay their loan. I summarised my lesson on a previous post. The focus here will thus be the latter two.

I invested in both WTW and CLUB alongside Geoff and Quan, both of them I consider my mentors. While WTW has awesome business economics and CLUB only has a so-so one, they were both cheap enough to get anyone’s attention when we bought into them. Yet, at the same time, they were both cheap for a reason. As weight-loss businesses, they were in constant need of replenishing their customer base. But they just haven’t been doing a good job at that. Some of that is due to new technology (like free apps and wearable technology attacting WTW’s basic business), and some of it comes from new exercise regimes (like studios taking customers away from CLUB’s traditional gyms) Worse still, they are also carrying meaningful amount of debt. So why did we still like them?

Basically, we believe they had certain moats around them that will make the challenges only temporary. We also believe both have the capacity to handle their debt obligation. The verdict for whether they can handle their debt is still out because they don’t have to repay or refinance their debt in a few years. But with both their revenue declining non-stop, we have been very wrong about their moat so far. And we may well be proved wrong about their capacity to handle their debt for the same ultimate reason.

The argument for WTW’s moat is simply that they are the most effective weight losing program out there. While free app is easy to get and use, they just aren’t as effective. People don’t stay with something they got for free easily long. And without sticking with the same program, there is no way you can lose meaningful weight with it. We have always envisioned it will take three or more years for things to get back to normal. Or in other words, for the fad in free apps to die down. But what about Apple Watch? With wearable technology maybe starting to get ingrained in people’s lives, wouldn’t there be more ways for such free apps to do its damage in the longer run? Or maybe as a gadget, it does help people lose weight easier, but can’t replace the psychological help found in a weight watchers program? I don’t know the answer to be honest. Geoff and Quan think the initial thesis is still pretty much intact. I personally ain’t as certain about it anymore.

CLUB, on the other hand, is all about economies of scale. They have the densest network of gyms in NYC. And it’s almost impossible to replicate it without throwing a lot of money into the sea. Even if studios really can gain traction in the longer term, we reckoned that they will certainly have enough time to convert their gyms into studios. Moreover, they were at the lower range in terms of leverage historically. But after more than 1.5 years, things just weren’t getting any better for either of them. We all agree CLUB is in the weaker position between the two. And that’s because in addition to its debt, it also has high operating leverage in operating leases. Now, that’s really a problem.

For WTW, it at least can adjust its marketing cost by its own will to gain more time for a turnaround. Maybe, in theory, CLUB can really gradually convert all their gyms into another format that fits what customers are looking for at the moment. But in reality, CLUB may already be bust before they can do anything close to that. Not only did we already lose money in CLUB, we also “lost money” in an opportunity cost fashion of missing the price uptick in LTM, another gym operator, due to the LBO of that company. CLUB, LTM and WTW are not the only stocks that Geoff and Quan (and later, we) looked into. If you take a look at the market price changes of everything that was looked at, you would certainly point out how silly it was for us to have actually invested in these two. (Quan has talked about the experience so far in this post, http://gannonandhoangoninvesting.com/blog/2015/4/23/stock-picks-review-and-lessons-learned. You can see how the other stocks performed there) This begs the question for us. Should we have been more diversified?

All the three of us were pretty concentrated with our investments. I just agreed with them that going for a more concentrated portfolio is the way to a better than decent investment record. If you pile up a list of investors that have a long term track record of compounding money in the 20s percent per year for over a decade, you will mostly come up with a list of investors that favor concentration. For instance, Joel Greenblatt, Eddie Lampert, Bill Ackman, Glenn Greenberg, Ted Weschler, Allan Mecham, and so on… They all basically had a pretty concentrated portfolio of having most of their capital in below 10 stocks.

I also came to think about diversification because of my current new job, where I am being fed a lot more attractive opportunities than ever before. When you are given 10+ names a time, you would naturally think whether it’s actually better just buy all of them instead of trying to make a judgement on which one to pick. Then, there is the fact that Buffett once held 40 stocks at a time during his partnership days.

That was the question I asked myself. Was it wrong to be so concentrated?

And here’s how I came to my own conclusion on the subject. I don’t think the degree of concentration was wrong. A more diversified portfolio of owning everything we looked into would have yielded much better results that what I have gotten so far for sure. But that’s missing the point. That’s not the real lessons that is being offered here. Now, to the real lessons from my investing failure. Really, instead of not diversifying, we simply made the most sinful mistake in investing. Selection mistake. One that is due from greed.

A declining business is usually not a good investment proposition. It’s only “usually” because in cases where you can control the pace of decline of the business or there are some structural characteristics ensuring a gradual decline and easily adjustable cost base, then you can probably exit the business in a profitable way. But in cases where there is essentially a “customer problem”? Then sorry. At best it would be a terrible experience before you break even at the end; and at worst, permanent loss of money. Adding leverage to it makes things maybe ten times worse and much more skewed to the worst scenario. Well, if you add in more than one layers of debt? You are primed for a disaster.

By customer problem, I meant a fickle customer base where they don’t naturally like your product/services or are susceptible to fads and trends. Geoff and Quan did mention they have to replace 1/3 of their customer base every year. This challenge never really caught my attention until now. If CLUB instead is a company that sells cigarettes, soda, chocolate, system software and so on, it would be a totally different story now… That’s lesson number 1 for me.

The second one is more general. As I pointed out, CLUB has been primed for disaster all along. And the major reason why it’s in a worse situation than WTW is it has both debt and operating lease. So what if CLUB owns all the places that hold its gyms?! Ah… maybe then they can deal with the turnaround with much greater ease. That sounds obvious to us now. How I wish I was this wise before. Essentially, we did study a gym operator without debt. And that is Life Time Fitness (LTM). Unlikes CLUB, it operates huge facilities that pretty much act like a country club to its members. They own most of their facilities, with many already mortgage-free. And yes, we believed it’s a better buy-and-hold candidate from the start. Yet, we still went for CLUB in lieu of LTM. WHY? Well, the answer is simple. We were greedy. That’s it. Instead of choosing something that is much safer, we opted for the one that provides the higher leveraged yield. And I, specifically, was lusting for the potential 3 bagger built into the stock of CLUB.

I thought I read enough about “focusing on the downside and the upside will take care of itself”. Turns out I was as clueless as ever. Maybe there really are things you cannot learn from books, but only from pain. Don’t be greedy is the lesson number 2 for me.

Diversifying is only a way of hiding from the real mistake of making a wrong selection here. While the above points out my own personal experience isn’t a logical argument for diversification. It doesn’t mean I have successfully argue against diversification. In fact, I don’t think I will ever be able to do so. But I did finally come up with my own personal view on the subject.

My own answer for that comes from my new working experience in a hedge fund and an excellent answer I got from Geoff. (Which you can read from here: http://gannonandhoangoninvesting.com/blog/2015/5/19/when-should-you-diversify) I think most importantly, the level of correct diversification, for me personally, is pretty much limited by my own time and ability to absorb information needed to support that level of diversification.

From a risk management perspective, the biggest advantage of diversifying more is reducing the impact of a blow from any single investment. However, to successfully implement a more diversified portfolio, I think you have to first pass the hurdle of getting enough time to understand all that are in your portfolio. The problem I am starting to experience is I simply don’t know enough about a few of the investments currently in the portfolio of the hedge fund I am working in now. When a piece of negative news crops up about any one of them, I simply have to do a lot of work before I can add valuable comments to the team. (Trust me, when you are managing other people’s money, even if it’s only a 5% position, you want to know everything and make the right decision of either selling or averaging down) Having too many stocks in your portfolio simply dilutes the effort you put into each stock.

Or so I thought. But Geoff reminded me this isn’t necessarily the case. In fact, what is the most brilliant part of his response as mentioned above is that you can hold 10 or 30 stocks and still be putting up the same effort before you buy each stock. The only difference is you will have to hold, on average, each stock much longer if you were to hold 30 of them instead of 10. The key is not to dilute your effort you put into each stock.

The second important factor is of course the amount of bargains being offered by Mr. Market. It makes natural sense to buy more in times like 2009 when many obviously high quality businesses are selling on the cheap, or when you can find stocks that have a long history of profitability selling below net cash. Being stubborn and study every one of them to unnecessary levels of depth will be a costly mistake for sure. But barring such obvious cases or unusual times, real bargains should be scarce.

Combining the above two points, it just seems better to concentrate a bit more to me.

Warren Buffett and “Rule #1: Don’t Lose Money”

I have a setting on my Google account that helps me track all news on Warren Buffett. (I also follow, who else?, Bill Ackman and Sardar Biglari)

And there was this very interesting title that appears on my email yesterday. “1 Piece of Advice From Warren Buffett That You Can Ignore” (Read more: http://www.fool.com/how-to-invest/personal-finance/2014/12/13/1-piece-of-advice-from-warren-buffett-that-you-can.aspx#ixzz3M1ltzJPC)

Now Warren Buffett is my greatest hero. But I do not exactly treat him like a God. And whenever there is an opportunity to learn about investing, I usually pound at it. I was actually excited to see there might be some interesting angles into what we should NOT learn from the greatest.

Unfortunately, I was disappointed.

In the article, the author points to the famous “Rule #1: Never lose money” as the thing he would advise us not to follow. To defend his proposition, he is basically telling us that it’s okay to be wrong, and the Utopian strategy of never losing money will not work and perhaps entails you to put your whole portfolio into US treasuries.

Now, this is interesting. I basically agree with his points. It’s just that his misunderstanding of Buffett’s quote makes me feel compelled to write this post.

First of all, I actually never recall the actual quote being “Never lose money”. Instead, I always think it is “Rule #1: Don’t lose money” And there is a huge difference between the two. When Buffett espouses his investment philosophy, he always tells us that even though he aims at crossing the one foot bar, he will keep making mistakes. It was never a shame thing for him to admit his own mistakes, as you can read from his shareholder letters. For a man so willing to admit his own mistakes, it sounds strange for him to ask people to never lose money. In other words, it’s simply wrong to imply from this perhaps erroneous quote that Buffett believes losing money is unacceptable.

So what is Buffett really saying?

He is talking about “Don’t lose money”. And that is a totally different idea. This is actually a really really important idea from Buffett. So it is better we do not misunderstand him. The notion behind this famous saying is not to ask people to never lose any money, but to remind people what to really focus on. And that’s to frame your mind into thinking about the downside, instead purely of the upside.

(A little sidetrack here: Even though Buffett is the most followed investor of all time, he is actually not that well understood. There are a lot of superficial “explanation” of Buffett on the Internet. To really learn from him it’s important to know what to absorb and equally important, what not to. Two great sources that come to my mind immediately are Alice Schroeder and Geoff Gannon.)

If you go to YouTube and search for Alice Schroeder, you will find a value investing congress video featuring Alice. That is one of the most important videos on investing you will find on YouTube. One point for you to really digest is what Alice points out as one of a few unique things about Buffett’s investment process: (not quoting from the video at all) Now Buffett is different. Unlike almost everyone else, instead of looking at the upside, Buffett immediately skips looking at a lot of investments because of the potential cat risk involved. He does so by asking one simple question before doing any work on a prospective investment. The question is basically: What are the odds that this investment could fail because of catastrophe risk? In other words, what are the major things that could go wrong? And if he feels like that he can’t size that risk up, he will not consider investing at all, no matter the upside.

Going back to the Motley Fool article, the author obviously lost money with his early investments because he didn’t spend much time thinking about the downside. He thought he would never lose money, in lieu of trying to not lose money by focusing on the downside.  

Now, that is not a good example to follow. The author’s last advice, “…never losing money is a Buffetism that I believe can be easily ignored”, is another one to not follow.

Bill Ackman and Activist Investing

I didn’t intend to write about Bill Ackman again so soon. But that was until I read another article mentioning Mr. Ackman.

“How activist hedge funds ‘on steroids’ have become a boardroom enemy” – That’s the title of the article from Financial Post. (http://business.financialpost.com/2014/11/15/how-activist-hedge-funds-on-steroids-have-become-a-boardroom-enemy/)

The gist of the article is briefly this: With the current, renewed hot trend of activist investing, many “experts” believe the majority of corporates are under danger of assault. Activists, due to their mandate of only serving themselves, in the quest for their own profits, usually put shareholders’ interests behind their own. As such, they tend to seek short term performance rather than long term ones. The article also mentioned a study done by a professor from Columbia showing activists do not help generate long term outperformance to their targets.

Without reading the actual study, as well as given what we know about human nature, I am not here to contend that activist investing is doubtless an act of virtue. I think it depends. Yet, I believe it would definitely be wrong to suggest activist investing, per se, is detrimental.

How can it be? Really?

As mentioned, the biggest accusation against activist investing is that they tend to flip their investments. They pressure the board to pay out cash, buyback stocks, cut cost and so on, then cash in the resulting gain and leave the company behind in a weaker form. Because of their presence, management cannot focus on implementing the correct long term strategies. What all this means is that activists are inclined to attend to their own self interest while hurting that of the majority shareholders. Right. But are activist the only portions of the whole human race that exhibit such self serving biases?? Are you telling me management teams are all public servants to shareholders, carefully attending to shareholders’ needs without an iota of exploitation??? Oh, where has that famous agency problem gone????

People, when condemning activist investors, love to mention the book “Barbarians at the Gate”, which documents brilliantly the saga of the LBO of RJR. (Disclaimer: I love the book) They find it the perfect illustration of what private investors can do to destroy values with the aid of billions in capital the lack of mandate to protect shareholder interests. Indeed, that drama showcased the greed from people in KKR and other players involved. What is interesting is how often people forget the management team of RJR back was among the players involved in the deal. The excesses of the management doesn’t look like a lesson on how to treat shareholders’ assets to me. While there are laws protecting shareholders’ interests in the USA, the fact is simply that laws are not always effective. I don’t believe this is a point that I need to elaborate on.

Moreover, as Ackman himself has repeated many times during different interviews, the modern day activist investing playbook requires the support of other shareholders in a company. It’s no longer the era when a corporate raider can simply takeover a company secretly and tear it apart. In order for an activist to be successful, it usually requires a vote of support from other passive shareholders. And how can this be a bad thing? Are you suggesting the other shareholders are not sophisticated enough to make the right call here? If so, then why should you believe they are sophisticated enough to choose the right CEO at the first place or wise enough to assess the management team on a ongoing basis? 

Certainly, the article’s use of Ackman as the main “antagonist” gave me the biggest reason to write this post. Using Ackman is simply wrong or maybe even deceptive. Again, people love to show one aspect while hiding the other. Knowingly, Ackman made a mistake in JC Penny (but it wasn’t only his mistake. Watch his interview with Charlie Rose last year for this). However, Ackman made billions in Canadian Pacific, GGP and most recently Allergan. The two former cases are perfect examples of an activist bringing long term value into the deal. And no, Ackman aims to hold his core investments for four to six years. When you point out that the average holding period for an activist is 9 months, please use an investor who usually holds an investment that long as your main example.

Another point I want to point out concerns the quote from Claude Lamoureux, former CEO of the Ontario Teachers Pension Plan and co-founder of the Canadian Coalition for Good Governance. He said he prefers the long term strategy of Warren Buffett to that of Ackman’s. Both are my heroes. And while their strategies do usually differ, that doesn’t mean Warren must disagree with what someone like Ackman or even Icahn wants companies to do. The best proof is Apple. Warren mentioned on CNBC once that Steve Jobs consulted him what to do with all the billions in cash Apple has. After some Socratic style of questions, Warren obviously hinted that buying back Apple shares would be an intelligent thing to do if Jobs believed his company’s shares were massively undervalued. Oh! Doesn’t that sound familiar? The only difference is Carl Icahn and David Einhorn did actually voice out their opinion publicly. One might even argue that, in this case, Warren hasn’t been doing enough to create shareholder value!

I believe it’s futile to discuss whether activist investing in general is good or bad. I find it a necessary thing to help balance the advantages management teams having no skin in the game usually have over shareholders who do. But of course, their growing power can also be misused. The only scenario in which I believe a valid debate is warranted is when we are discussing a specific case of activist investing. Only with the specifications of a specific case, can we really judge whether the activist is creating real value or not.

In a word, I believe activist investing is just like a knife. People can use it for surgery, eating, surviving and so on. And people can also use it for torturing, stealing or even murdering. Is knife a necessary tool to us? Yes. But is it good or bad? It depends.

Bill Ackman and Investment Risks

Bill Ackman of Pershing Square Capital Management is my favourite hedge fund manager among currently active hedge fund managers.

To be honest, I completely idolize him. The biggest attraction to me is the way he invests. He takes a concentrated, value approach. He doesn’t pay much attention to the macro environment. And he only looks for good companies, those that are cash-flow generative, dominant, not levered, resilient throughout economic cycles. Basically, he invests the way our biggest hero, Warren Buffett, would. (Except Ackman likes to effect changes) And that absolutely absorbs me.
Ackman is more than 30 years younger than Buffett. But he keeps things simple the way Buffett does and then goes on to create so much value. I can almost imagine him in college thinking to himself: I am going to do what Buffett has done. Basically I am saying he has done the thing I really want to do myself. And his successful example simple rings such a big bell in me, always giving me a huge sense of motivation to work hard. (Of course, I am sure Ackman is a much more competent guy than I am)

I simply believe any moves he makes is of immense learning value to us value investors. Obviously, given his high profile, most of his investments are already well discussed in the media. So I do not plan to get into that now. But there is one thing I would like to discuss in this post.

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That is: Portfolio construction or the degree of portfolio concentration.

I have read a number of articles proclaiming how risky Ackman’s investing style is. One article cited one investment professional saying Ackman’s close-to-40% allocation in Allergan is a prime example of reckless risk management. Other examples include how Ackman lost $500+million in JC Penney and once more than 90% in the Target investment. Clearly, they are equating a concentrated portfolio as risky investing. And pointed out two examples as proof of this claim.

But is this correct? I doubt so.

One way of rebutting their claim is to think about how Ackman performed during the financial crisis. If you think someone is running a very risky portfolio, wouldn’t it show during one of the worst market condition ever happened? The fact is Ackman outperformed the market during that period of time. He was down in 2008, but less so than the market. And his hedge fund certainly didn’t blow up. I am quite sure most people who owned a more diversified portfolio performed worse than Ackman did during those dark days.

The key is what you own, instead of how many you own.

Indeed, I am not specifically saying a concentrated portfolio is the only way to go. (Even though I do personally prefer so) But what I am trying to say is it’s totally unintelligent to discuss how risky one’s portfolio is without talking about the quality of the investments that person owns. Certainly, you should also think about whether he/she is employing excessive leverage or not. (In the case of Ackman, he rarely uses any)

The only thing we can derive from the number of investments one has in his/her portfolio is the fluctuation of that portfolio will generally be bigger than a more diversified one. (i.e. higher volatility) However, it’s important not to confuse volatility with risk. Risk, as both Buffett and Ackman contend, is the probability of facing a permanent loss. Whether the price of the asset goes up or down widely between the time of your purchase and the time of your sale should be irrelevant, as long as you are not bound to act stupidly during that period, either due to leverage or some other reasons.

Since Ackman specifically looks for quality businesses with some fixable problems, alongside his willingness to do things actively, including effecting changes in top management and changing capital allocation strategies, both of which actually act as a safety net to one’s investment, is Ackman really running excess risk?

When should you start investing?

This is a big question for me lately, because of my parents’ disapproval for starting to invest right away. Like most other conservative Asian parents, they prefer I start investing on paper first before I really tap into the real world.

That I strongly disagree.

Investing is really an art, much more than it is a science.

Science you can learn from theories, art you can’t.

Recall any extracurricular activities you had learnt in your childhood. Say drawing, cycling or dancing. Did you ever learn them through understanding the physical dynamics of body movements or theories of aesthetics? No. Da Vinci didn’t become a master because he learnt all about the theories of aesthetics before he started drawing. Instead, he started very very early and kept practicing. Yes, practicing is the correct word.

Certainly, people can argue through intense and continuous practice of valuation, the benefit will be there without the need of really putting money into the ideas. This is a good point if valuation is all there is for investing. Unfortunately, it is not. In fact, many a time something will be obviously cheap no matter what way you value it. Some time it’s a simple fact that something is crazily undervalued. And that something being a high quality business that meets every single possible test. Yet, Mr. Market can still ignore it or even hate it.

Why?

That’s because of human psychology. Human invests with emotion. There are times when you are tempted to speculate. There are times when a sudden big drop in the stock price induces fear in you and make you do dumb things. And there are times when you simply forgo a good investment opportunity just because the stock price started to increase an iota above the price you would like to pay. All this can only be experienced when you truly do own the stock, no matter the amount. Those emotions are only as real as your investments are.

So instead of investing on paper, you can start with a relatively small sum. That will do the trick of avoiding a huge loss because of your rookie mistakes.

Just like fighting or coming up with strategies for a war, you can’t really learn about investing unless you do invest.

China Agrotech – How cheap should a bad business be?

Warren Buffett once said book value has nothing to do with their investment decisions in Berkshire. Of course, if you have studied Buffett long enough, you know that’s not always true for him personally. During his early career, heavily influenced by Ben Graham, he would mostly invest in businesses trading below book value or at least showing a lot of support from that book value.

The reason book value is no longer that important is because Buffett has turned to love business franchises a lot more. Such businesses, ranging from Coca-Cola, American Express to See’s Candies have a lot of their values tied up in their brand names, know-how and other intangible items, most of which are not shown in accounting.

But if you are to invest in less glamorous businesses, book value should be more important. This is especially true for asset heavy, commodity businesses. Unlike asset light or franchise businesses, their values are accounted more in their book.

Of course, this doesn’t mean such businesses should naturally trade at their book value. That will depend on their return on equity. Briefly speaking, any company that can attain a ROE of 8% – 12% are usually worth trading at book value, taking into account a relatively conservative balance sheet.  As such, a better than average company based on ROE should trade above book, and one in a lousier business deserves to be traded below book.

But for a lousy business, how deep should a discount to book be?

Today, we will try to answer this question with an ugly business, China Argotech (1073.HK).

Company Introduction

China Agrotech Holdings Limited is an investment holding company with three major business segments:

A) Agricultural resources operation

• This includes the manufacturing and selling, purchase and distribution of agricultural resources products, as well as
• The provision of plant protection and consultancy services for the related products.

B) Trading of non-agricultural resources products, and

• This includes the exporting of commodities such as coal and industrial chemicals. This is a “strategic move” made by the company in around 2005, in response to the China’s accession into WTO. Fearing being marginalized as China moved toward globalization, the company thought it should be a good idea to engage in international trades.

C) Seedling operations

• This is their latest operation. A result from the acquisition of Present Sino Group, whose business includes nursing, planting and sale of landscape seedlings in the PRC.

We will refer to them as segment A, segment B and segment C respectively.

Business Performance

China Agrotech is in very bad businesses. For the past 10 years, its gross margin has been in the range of 5.4% to 9.9%. This is mostly a result of thin margins in both agricultural resources products trading and non-agricultural resources products trading.

For the fiscal year of 2013, segment A delivered a total turnover of nearly HKD 4 billion. The company likes to break the agricultural resources operation down into fertilizers and pesticides. The aggregate turnover for fertilizers was around HKD3.58 billion, with a gross margin of around 4.2%. The pesticide business generated around HKD411 million in revenue, with a higher gross margin at 8.2%. And as a whole the gross margin was around 4.6%, down from 5.7% from a year ago.

Segment B looks even worse. The margin of commodity trading is 1.6% in 2013, down from 2.6% a year earlier. Given the tough business operation in this segment, the company has been reducing this business, resulting in a 47% decrease in revenue to around HKD600 million. And this segment has been money losing for the fiscal year 2012 and 2013.

Given the difficult nature of these businesses and the global financial crisis that further worsened the margins of agricultural products and commodities, China Agrotech elected to diversify into the seedling operations (segment C) in late 2010. It purchased Present Sino Group for an aggregate consideration of HKD 1 billion, financed by the issuance of promissory notes (HKD200 million) and convertible debt (HKD800 million) from a group of 9 vendors.

This leads us to two very uncomfortable highlights.

1) The founder and chairman of China Agrotech is one of the vendors. And the two securities are sold a big chunk to him. As such, in effect, the firm is acquiring this business with credit from one of its original owners, alongside a few other parties.

2) The purchase agreement included a clause stating the seller guaranteed profits of HKD120 million in 2011 and HKD150 million in 2012.

Segment C does seem to offer a much better margin. The only problem is they are still trying to get enough scale, finding the right product mix and just to learn about running this business smoothly. For 2011 and 2012, this segment was money losing. (Thus the guarantee money was received in both years) The tide turned last year, when this segment generated HKD218 million in revenue and HKD33.5 million in net profits. A net margin of 15.4%. But problems are still present. In the latest interim report filing, revenue from seedling operation dwindled, due to company’s exploring a better product mix and changing sales strategy.

Overall, the company has been on a real (disastrous) downfall for the past 8 years. It’s currently earning an ROIC of around 4.6%. The figure has been dropping continuously.

The problems with China Agrotech, roughly speaking, are threefold.

1) When it expanded between 2006 and 2009, working capital had to be expanded faster than resulting additional income.

2) Its manufacturing operation of agricultural resources products deteriorated significantly from 2009 onward. It once earned more than 16% operating margins in 2008, but currently is not profitable.

3) The seedling operation has not performed as expected. With an asset base of around HKD1.27 billion, it only generated around HKD20 million in operating profits in fiscal 2013.

Why could China Agrotech still be an interesting opportunity?

Given its current abysmal performance, the only reason one can find China Agrotech interesting is because of its valuation.

First, let’s take a deeper look at China Agrotech’s balance sheet.  All figures are from the latest interim report.

In December 2013, China Agrotech had

1. HKD 1.4 billion in non-current asset including goodwill

• Of which HKD1.1 billion is in biological asset (referring to segment C, or seedling operation)
• And goodwill at HKD 87.9 million

2. HKD 5 billion in current asset

• Of which HKD3.9 billion is in trade and over receivables
• And HKD 165 million is in cash and cash equivalent

3. HKD 3.95 billion in current liabilities

• Of which HKD 2.78 billion in trade and other payables
• And 1.07 billion in bank loans

4. HKD 735.4 million in convertible bond outstanding

As such, we can conclude China Agrotech has a net current asset value (current asset minus all liabilities of around HKD 394.501 million (current asset minus non-interest bearing current liabilities).

So where is Mr. Market valuing China Agrotech? At HKD 190 million!!

That’s a discount of more than 50%!

Their current assets mostly include of trade/loan receivables, deposits and prepayments as well as advancements to suppliers. Inventory is a very small part of the current asset. Other than that, there are restricted bank deposits and cash. (The following figures are from the 2013 annual report, because the latest interim filing has no breakdown)

o   Loan receivables at around HKD 1.1 billion

o   Deposits and prepayments at HKD 538 million

o   Advances to suppliers at HKD 1.66 billion

As stated in the annual report, the loan receivables are usually due within six months. They never had to set aside more than 5% of it as bad debt. And usually can recover them later on. The advances to suppliers are usually utilitized within a year. The only uncertain part of it is the deposits and prepayments. What this means is their current asset is rather liquid, and not a lot of adjustments or discount ought to be applied. Since ideally, they can just stop running the business, and stop advancing around HKD 2 billion, that amount alone can retire all the trade payables. After another six months, when all existing receivables are received, that can be used to pay back bank loans. The restricted bank deposits and cash can then be given back to shareholders and so on.

And looking at the current liability side, it mostly consists of bank loans and trade and other payables. But of course, no discount should be made on the debt side anyway.

There is more good news actually.

If you look at the segment results. You see both the agricultural products manufacturing and trading of non-agricultural products to be money losing. The former contributed a meaningful income in the previous years. But even if that scenario doesn’t come about again, and we only shut down that operation as well as the importing of commodities, that will add another HKD 44 million income. And very interestingly, their consultancy business is highly profitable. Generating from HKD 10 – 30+ million a year in come. That operation alone could be worth HKD 200 million.

And you can buy the whole thing at around that price, along with the biological assets that is valued at more than HKD 1 billion! What else should you look?

At around 10% book value, even it’s a terrible business, should it be worth so little?!

NO!!! Or… Should it????????

Yes, that was certainly my thinking for the past 8 months. I first bought the stock when the whole thing was valued around HKD 300 million. In the first three months or so, it went up 40% at one point. And I didn’t sell at the time. My reasoning was that since it was still so cheap, given the low downside and super high upside, why should I cash in? I know it’s a terrible business. But since I don’t have any other good ideas yet, why not just hold on it for a while? Then there was the news that unlisted warrants was sold to Goldin Special Situation Fund warrants with a strike price at HKD 0.45 per warrant. Goldin seems to be a good operation when I did a google check on them. And if they demand a strike price at HKD 0.45 per warrant for each share, why should I sell at the HKD 0.20s?

Then month after month, the stock price started falling. I finally got the time to do this write-up a few days ago. And that was when I really do the necessary due diligence. I checked the biological assets and I looked up the chairman. What I found was horrendous to say the least.

Key Finding #1

From the research on the biological asset acquisition, we found that the chairman could be a dishonest and self-interested one, as he does not seem to put shareholders’ interest as the priority. In fact, from some news and investment forums, it is found that the chairman paid a much smaller amount, around HKD91 million, to acquire the biological asset in early 2010. This asset was then actually merely valued at HKD 270 million at the time. But China Agrotech later acquired this asset for a total consideration of HKD 1 billion in late 2010. In other words, the chairman made a quite profit of more than HKD 900 million from the shareholders! There was also litigation about a part of the biological asset that was then quickly valued at more than HKD 800 million. The plaintiff claimed he was unfairly treated and was forced to accept a much lower price. The litigation was settled on 27^th February 2012.

Key Finding #2

There were numerous blog posts about how fraudulent this operation could be. Good points were made regarding the acquisition of biological assets, possible overvaluation of the biological assets and regular issuance of shares regardless of prices. Just a simple check on Morningstar will show China Agrotech has more than doubled their share counts in the past 8 years or so.

Key Finding #3

We found China Agrotech to be very closely related with Chaoda Modern Agriculture. For instance, according to New Economics in Beijing, they were both underwritten by the bank ICEA. And since they are in the same value chain, they could very well be “doing business” together, like Agrotech selling fertilizers to Chaoda and whatnot. Indeed, at the beginning when China Agrotech first got listed in Hong Kong, all its products were said to have the label of Chaoda on them. And Chaoda pledged they would keep buying products from China Agrotech and was their biggest customer then. The wife of the chairman of Chaoda was also once a director in China Agrotech. Interestingly, they also share the same office floor here in Hong Kong.  And the two companies are both from Fujian, China, which is allegedly famous for being the homeland of a number of Chinese frauds.

Unfortunately, Chaoda was one of the biggest frauds ever in the Hong Kong market. They had crazy figures like 60+% gross margin for an agricultural business. And boasted great performance for a while. Yet, it was delisted several years ago because they can’t find a new auditor after PwC quitted. Even though they still seem to be operating, shareholders have already lost most, if not all, of their money in the firm.

Source about Chaoda’s fraud practices: http://www.scribd.com/fullscreen/134943059?access_key=key-2ojq9cxgxcembgjr85ll&allow_share=true&escape=false&view_mode=scroll

Key Finding #4

Several very recent posts (written around March 2014) were found about their seedling operations being a real scam. They mention that wages of workers in these seedling sites were not being paid. Three of the forestry sites are claimed to be out of business already. And the company is described as an empty shell and could face bankruptcy soon. These could very well only be rumors though, since actual news cannot be found.

Key Finding #5

Their auditor quitted two years ago. They say it’s because of a fee dispute. But I found that most accountant firms use this excuse to avoid auditing fraudulent companies anymore, so as to avoid embarrassing the company immediately.

As such, I am super worried about whether the company could be a fraud or not! I am no longer sure if I can even trust their numbers! (Most sources for other key findings are not shown here because they are all in Chinese)

Conclusion – Beware of Free lunch

Remember what was the real topic of this essay? How cheap should a bad business be worth?

Initially, my answer was the amount needed to give you a return over investment that reaches your hurdle rate. If you want 10% and the business is earning 5%, then buy it at half the invested capital amount.

Yet this thinking is terribly wrong. As shown by my abysmal first try investing. I was totally blind by the illusory safety offered by the price. But the ultimate safety should never come from the price alone. In other words, value investing works not because we buy the cheapest stocks. Fraudulent companies that are already suspected by Mr. Market can be very cheap indeed. And certainly if you time it right, you can make a fortune from them. But can you really endure the process of buying a company that has a notorious CEO? Run by possible crooks? I can’t. As such, the ultimate safety from an investment is the business quality of the company you are buying. Don’t look for the cheapest one. Look for the best companies that are offered by Mr. Market at the cheapest price. Don’t just look at value and disregard quality. And if you do insist on paying more attention to price than quality? Then remember to diversify.

In this world, there simply is no free lunch. Buying a company at 0.1 times book value, with so much more asset on the book is as close to a free lunch as there can be. And my experience shows it really wasn’t a free lunch. I didn’t even do the necessary due diligence to check the biological asset or background check of the company or the Chairman! It had been a very dear learning experience to me personally. I really hope you can learn from mine without such a huge cost.

So how cheap should a bad business be?

Bad business should only be as cheap as their business and management qualities allow them to be. 

Antifragility and Value Investing

I am reading the book, Antifragile by Nassim Taleb recently. I love his writing style and all of you know about the Black Swan. This book however, should be even more important.

While I was reading The Black Swan, Taleb’s messages of our inability to predict the future, as well as luck playing a huge role in our lives gave me some shivering senses. I don’t like the idea of not being able to control my own life. Neither do I like the idea that Buffett has only been lucky in his life. While Taleb’s messages make perfect sense, I thought in order to retain my love of investing, I might need to dishonestly forget about his books (including his first book Fooled by Randomness). If there is always the possibility of a black swan coming, how can we be sure of any investments? If there is always a blind spot for us, how can we run a concentrated portfolio anymore? I was confused and felt perhaps a bit desperate. (I have long hoped my future will rest upon value investing)

Luckily, it turns out I was simply dumb. If you go on to read the book that completes the messages from The Black Swan, you will how antifragility has all do with value investing. I just didn’t get the real message at the first place.

According to Taleb, “robust” is not the opposite of “fragile” as many would have suggested. Fragile is a state where your potential loss will be larger than potential gain under the uncertain future ahead. Imagine you are mailing your oversea cousins a set of expensive silverware through air. You would try to package the set the best way you can, sticking all those “Fragile, please handle with care” labels on the box. Simply put, you would be pretty worried about any serious turbulence during the flight that could cause damage to your silverware. That, is what we call a state of fragility. Robust, instead is one that fears no harm. Perhaps you are trying to send some sponge to your cousins overseas. (Even though it’s highly unlikely to worth the air fee….) No matter how much the flight is going to be affected by possible turbulence, your sponge should stay intact. However, the real opposite is not to be unaffected by unpredictable and detrimental effect. To really become the opposite of being fragile, you need to be able to benefit from such possible effects. Or more accurately, your potential gain needs to be more than your potential loss.

And with that, you should how Buffett has been practicing the notion of antifragility almost all his life. The real idea behind buying a dollar bill for 50 cents is really antifragility. With a silly and cheap price, the unpredictable future events will be more beneficial to the value investor than not. If you buy a company below its net current asset value, it’s usually one that has not been doing that well lately. Any change or any reversion to the mean will push toward a better state of business and make it more valuable. Staving away from leverage will make u less vulnerable to sudden changes in the business environment.

In face of our inability to know the future and having only incomplete information, buying value stocks is the way to invest.

What is Investing? (Part 3)

Now let’s try to wrap up this very elementary discussion of what investing is really about.

With my last two posts, we discussed two key points.

1. Be future oriented –> think about the business, be a businessman

2. Getting more in the future –> demand a margin of safety every time

Basically, that is what investing is all about. Just buy a business that you understand, while having a reasonable estimate to its future profitability and buying it at a lower price than your conservative estimation of its true/fair/intrinsic value.

It all sounds very simple! But then, why aren’t all investor billionaires?!

Okay, good question.

And the answer is simple: There is always the human/psychological part in human that makes it difficult.

People panic when their holdings decrease in value, albeit no significant change in the business itself that warrants the decrease in market value. People care too much about what others are saying. People don’t focus on finding those attractive investments. People care too much about what the company will earn next week. I could list a hundred more… But you get the picture. We are our own real enemies in the end.

To make people stronger mentally, the great Ben Graham did another marvelous thing for us, by introducing this famous character: Mr. Market.

He told us to imagine he is our business partner, pretty emotional and erratic. Some day when he is hyper, he will offer to buy your stake at a high price, or sell his at that same price. But when he feels gloomy, like the world is going to end, the price will be low. Your job, as  a real investor, is to take advantage of him. Remember, as Buffett asked, to think Mr. Market as someone here to serve you but not instruct you.

Now that rounds up our most elementary discussion of (value) investing.

This journey is just starting. Knowing the framework can take you less than a minute. Getting good at it takes time, though. But it’s not unreachable for most of us. Let’s take a deeper look into several questions most of you should have now next time.