CategoryInvesting Philosophy

Found this new article from ‘Michael J. Mauboussin‘ from Legg Mason capital management ( Links to his other articles can be found on the sidebar and his website).

A highly relevant article for an investor, especially if one is looking at improving his expertise (not necessarily trying to become an expert)
Found the following excerpts very interesting (emphasis mine, comments in italics)

• What it takes to become an expert appears remarkably consistent across domains. In field after field, researchers find expertise requires many years of deliberate practice. Most people don’t become experts because they don’t put in the time.
• Experts train their experiential system. Repeated practice allows experts to internalize many facets of their domain, freeing cognitive capacity.
• Intuition is only reliable in stable environments. In domains that are nonlinear or nonstationary, intuition is much less useful.
• Expert investors exist. Unfortunately, it is not clear that their skill sets are transferable. Expert investors are likely a product of both mental hard wiring and hard work.

And

Experts are not casual about their domain. They build their lives around deliberate practice and practice every day, including weekends. But experts also report sleep and rest as critical elements of their results, and they avoid overtraining or overexertion. Evidence shows that performance diminution in cognitive tasks coincides more with reductions in deliberate practice than with aging.

As it turns out, expertise requires about ten years, or ten to twenty thousand hours of deliberate practice. Little evidence exists for expert performance before ten years of practice. 3 Even prodigies like Bobby Fischer (chess), Amadeus Mozart (music) and Wayne Gretzky (sports) required a decade of practice to generate world class results – So I have a long way to go. But I enjoy the process of learning, so it is both fun and profitable

I have always had a mental block against low return commodity / cyclical businesses (highly influenced by warren buffett’s writings).

Other than the fact that investing in such businesses requires being tuned to the business cycle and overall requires more work in tracking such businesses, I have found it difficult to value such businesses. It would be naïve to use PE or such simplistic ratios because these ratios would mislead you completely. During the peak of cycle, due to operating leverage the earnings shoot up and the PE drops to single digit, making the stock appear cheap. The reverse happens when the business cycle turns.

Developing a DCF model also has been difficult, because I have found it difficult to predict future free cash flows for such companies (I assume that would require having a reasonable grasp of the business cycle in terms of demand supply picture, inventory levels, pricing etc).

In contrast businesses like FMCG, paints, pharma have good returns, low or non-existent cyclicality. I have found such businesses easy to understand, project for some years out and value them. In addition, for the past few years such business were available at throwaway prices. As warren buffet says (I like to quote him a lot), “degree of difficulty does not count in investing, being right counts more. Better to invest in a simple business with a single knowable variable, than a complex business which have multiple complex factors driving it” (I have paraphrased from memory).

So why this change of heart. For one, it is an intellectual challenge. I would like to understand and value such businesses, even if do not invest in them. In addition, it increases the investible universe for me.

It could a long time for me to confidently value such businesses. The ‘business analysis’ excel is an effort in that direction. I also have a detailed valuation file (which I will post shortly), which I use to value an individual company. Hopefully towards the end of this effort I should be able to use it to value a commodity/ cyclical business.

I was reading an interview (or maybe annual meeting transcript) of warren buffet sometime back and he was asked about the discount rate he uses in the DCF (discounted cash flow) calculations.

He indicated that he uses the long term treasury risk free rate. In addition, for him a decision to buy is really a go/No go decision. If he can understand the company, its economics and predict its future for 10 years or more, and if the value is screaming at him, he goes ahead. Otherwise he passes.

I have changed my decision process after reading the above comment because it makes sense for a small investor like me. If I can understand the economics of a company (which rules out a huge number as my circle of competence is small) and if the decision is a slam dunk , I go ahead and commit my money. Else I pass. Now that has resulted in my leaving a lot of companies which were close and later did very well in terms of stock price. But in the end I would rather be sure of my decision than tweak my DCF model, fiddle with my discount rate and build hypothetical assumptions of good growth and at the first downward blip , not have the confidence to hold on to the stock.

The above go/No go approach has resulted in my leaving out pharma companies, a lot of commodity companies etc. But then for a retail investor like me who needs a few good ideas a year and does not have to show a quarterly performance like a fund manager, why take the risk and the heart burn ?