The Unrepentant Recalcitrant

Lessons for an accidental entrepreneur

Archive for the tag “Berkshire Hathaway”

Charlie Munger on Inverting: The Rose and it’s Thorn

Back in the last ice age, when I was an intern at my hospital, green both in experience and complexion (it was my first night on call…and I was, lets say a little nauseous with fear!), I asked my resident “ Are you sure you should be leaving me alone with sick people who might die?”

 

Yeah, confidence was my middle name as you can tell.

 

My resident gave me some of the best advice I have ever got.

 

“ Worry about whats going to kill them and take care of it urgently. Keep them alive at all costs. Everything else will take care of itself.”

 

Fear and good advice concentrated my mind like nothing else, and I learned to worry about “The Dreaded Downside” (in this case, death).

 

Fast forward to today and my behavior has been modeled this way:

 

1. Imagine a scenario that requires action.

2. Imagine what is the worst possible outcome(s) of this scenario.

3. Ask yourself how you can prevent/mitigate/evaluate and control such a situation.

4. Put plans in place for this.

5. Initiate said plans if the scenario materializes.

6. Watch how the alternative best case scenarios take care of themselves.

 

Its been an unpleasant surprise to me just how few people understand this concept.

 

People think rosy thoughts and don’t want to consider the thorns that come with the roses.

 

Big mistake!

 

Charlie Munger and Warren Buffet have spoken about this thought process when evaluating investments.

 

They call it “inversion”

 

Lets say you are looking at company A (or starting a company called A!)

 

Something about this has attracted you and you believe there is a reason to invest, right?

 

This is the “Rose”

 

What could happen to your thesis that would make this all come crumbling down?

 

These are the “Thorns”

 

Play out these scenarios. Understand their likelihood, understand how you would recognize them and take corrective action.

 

Once you have this information, you are better equipped to make decisions and more likely to get the desired outcome or to at least limit downside loss.

 

If they don’t materialize, and your thesis becomes correct, nothing more is required!

 

Munger does this each time when looking at an investment to fully understand his risk and whether the investment should be made.

 

Its the same for managers in companies and for entrepreneurs from a decisions perspective.

 

How do I know this works?

 

How successful are Munger’s stock picks?

 

I thought that would persuade you!

 

What I find most interesting in the preceding discussion is how universal and singular the truth is. 

 

It cuts across disciplines and scenarios and is always axiomatic*.

 

This is the universal thread that I attempt to point out in my blog. It’s all connected.

 

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*Axiom: That which does not require a demonstration of proof. Contrast with a “theorem” which has been proven or a “hypothesis” which awaits proof.

 

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Principles of Value Investing

Toto, I have a feeling we’re not in Kansas anymore.

Yes boys and girls, put away your Excel spreadsheets and gather round the fire.

As Steve Jobs liked to say, “I’m going to tell you three things. No big deal. Just three things.”

That’s it folks.

Three Principles.

1. P/V
2. EVA
3. Rain Falls Down

( Bonus: They apply universally and are equally and importantly relevant to entrepreneurship as well.)

Before you swoon in admiration of my unparalleled genius, I want to be clear that these ideas and even the phraseology are not mine.

This is what I learned from my master, my Yoda. (Thanks Tom, for changing my life!)

Yes folks, this changed my life. If you pay attention, it might do it for you.

And then again for those of you too lazy to listen, it might not. YMMV.

 

Definitions first and details later. Ok?

 

1. P/V : Price/Value

The fundamental metric of all investing. The ratio of the price you pay for the value you get. This needs to be less than one at all costs and the lower it is, the larger your margin of safety (remember margin of safety?: https://unrepentantlyrecalcitrant.wordpress.com/2013/10/10/all-investing-is-value-investing-the-rest-is-speculation/).

All of Wall Street that makes money off of you, conflates price and value. It is the fundamental thesis of those that believe the markets are efficient.

(If you believe that, what in gods name are you doing on my blog? Go visit that fool Cramer on CNBC or something!)

Price is what you pay, value is what you get.

The lower the price and the higher the value, the better the deal.

Buffet talks about buying a dollar for fifty cents.

That’s a P/V of 0.5

Awesome.

I will discuss the estimation of value in some detail in a later post.

 
2. EVA : Economic Value Added

Also known as Abnormal Earnings ( Economists always think that profit is an abnormal situation!), EVA is defined as:

Return on Invested Capital – Cost of Capital = EVA

As an example, if your capital costs you 9% ( say a bank loan for your business) and you are able to generate 9.9% return ( savvy investing or your business profits), you have an EVA of 10%

Needless to say, it should be a positive number!

Before you laugh at that, I will in the future show you why most businesses (the majority) are not getting a positive number and as a result have a zero EVA (bad!) or even a negative EVA ( yes, they are destroying capital!).

If you are an aspiring entrepreneur, you must (MUST) have plans for a positive EVA! If not, don’t even bother. More on this later.

 
3. Rain Falls Down:

A little more fuzzy than the others, this statement underlines that certain things are an inevitability.

You must prepare for them and account for them in your estimation of value and decision to invest ( or grow your business).

Your resistance to rain clouds and gravity is useless. Rain will fall down.

 
Simple so far, no?

Remember, Value investing is simple but it’s not easy! Oh No!

I will take each of these points and expand on them in future posts.

I will review the only economic principle(s) that matter ( YES, most of economics is a massive waste of your time!)

The only thing I can’t help you with is mental toughness.

(You need to review Kipling’s poem again and internalize it!: https://unrepentantlyrecalcitrant.wordpress.com/2013/10/06/rudyard-kipling-was-a-value-investor/)

Oh, one last thing. You know that money you saved up to buy the latest Excel program?

Go get a great dinner instead.

You ain’t gonna need Excel anymore.

All Investing is value investing. The rest is speculation

Value Investing. Growth Investing. Momentum Investing. Trading. Real Estate. Precious Metals. Shorting.

A million different ways to lose your money (We should include failed startups to this now shouldn’t we? Heh Heh).

I am going to review some of the lessons I have learned about investing over several future posts but lets spend some time clarifying what we are talking about. Being exact is helpful in a situation where we are surrounded with many different voices in chaotic confusion.

An asset is something that puts money in your pocket either today or in the future. Today it might be cash in your pocket, and in the future it may be the result of an investment, a gamble or a speculation.

Value Investing (or Investing) is the act of acquiring an asset for less than what its worth. Once the asset reaches the point where it is valued at what it is worth (or more), we have made a profit. Agreed?

Speculation is the act of (well speculation, I guess!) an informed (yes, informed…maybe incorrect but informed) betting on the movement in the price of an asset or a presumed asset. If the speculation is correct, a profit is made, and if not, a loss is suffered.

Gambling is the act of largely (not uniquely, no) uninformed speculation that most often results in losses for the gambler and winnings for the counter-party. The counter-party may be a speculator or an investor.

Now lets be theoretical for just a second and invoke math (or maths, if you are British). The only guarantee of profit in the above scenarios comes from buying an asset for less than its worth, i.e. value investing. Its more complicated than that but lets start with the numbers.

When you speculate, you position a bet to take into account certain unperceived or less perceived visions of a future wherein the asset you purchase will sell for more than you paid for it, regardless of whether it is worth what you paid or what the next person pays you for it (Greater fool theory).

That last bit is important. Its important because it underlies the idea of “margin of safety”. The concept of margin of safety says that you have purchased an asset for so much less than it is worth, that even in the likelihood that the greater fool theory did not apply, you would either minimize your losses or make a profit when the asset is fully valued.

A value investor lives or dies by his margin of safety.

A speculator is less concerned by it.

A gambler does not even know it exists.

Every situation where you buy an asset for less than its worth is therefore an example of value investing (stocks in 2009, real estate in 2010, Europe for the longest time etc).

Every time you don’t do that but you believe something good will happen to you, (i.e. currency trading, buying and selling gold, real estate in 2007, European debt over the past few years etc), you are speculating. There is nothing wrong with it, but its good to know what you are doing very clearly isn’t it?

The difference then between these two methods of generating wealth is therefore predicated on whether there is a difference between the price of an asset and its intrinsic value. That in turn is predicated on the estimation of value, the most important item in our arsenal.

Let me be very clear on this so there is no doubt where I stand. If you are unable to ascertain the value of an asset, you are a speculator and if you don’t even know that there may be an intrinsic value that you are missing, you are a gambler and one that will lose to the house every single time.

Every single time.

You have no business investing/speculating/gambling if you are unable to ascertain value.

Am I clear?

Would you perform surgery on yourself without going to medical school?

Exactly. (sigh..I can see the gamblers in the audience going..Hmm.. Why not give it a try?)

If you insist on doing this without the fundamental knowledge of valuation, I have some news for you. You have a name on Wall Street.

Sucker. Muppet (if the counter party is Goldman Sachs).

Warren Buffet says and I paraphrase “Every game has a sucker. If you don’t know who that sucker is, its you. Sucker”

I know the wider world thinks buying and selling stocks and “playing” the market is easy. Dead Wrong.

The market makes its money off of you.

Ok, lets summarize what I said so far.

The least risk (or most sure way) to generate positive returns is by investing and specifically by buying an asset for less than it is worth.

Speculation done well is an art that is beautiful to behold. Some of the richest people in the world are successful speculators. However, its extraordinarily difficult to do and to do it consistently over time is a rare feat. When you see the best at their game, its sometimes difficult to tell whether they speculated or whether they are very savvy value investors.

Most speculators are lousy and should be reclassified as gamblers.

Its more risky and much more stressful.

I don’t need to say anymore about gambling, do I?

Whats next?

In future posts I will discuss the concepts of valuation, its pitfalls and what you must learn in order to perform a reasonably good valuation.

We will then go over the principles of value investing (There are only three principles, my wide eyed acolytes, so don’t worry!!).

Among these posts in the future, I will discuss why these principles can and should be generalized to entrepreneurship and perhaps even to the Right Thinking principles I have been discussing so far.

Flood me with your comments, but please only positive ones.

I have a fragile ego.

Charlie Munger on Wrestling with Pigs

Charlie Munger is the long time associate and friend of Warren Buffet and an investing legend in his own right.

I hope to be talking about him a lot on this blog, not just because I believe he is a great investor but also because I believe he is one of the foremost proponents of what I like to call “Right Thinking”.

Right Thinking is not about how to pick stocks or how to startup companies or take your profits. Right Thinking is about how to go about thinking about all of these things and so much more.

It’s the framework of your thoughts and actions that will determine your satisfaction with the end result and your success.

I am going to adapt his quote on Pigs but I keep the meaning in all seriousness.

Charlie says, “Don’t wrestle with Pigs. You will both get very dirty. Trouble is, the Pig will enjoy it”

Be careful whom you associate with. It may be expeditious, it may even seem like you have no choice at the time.

You may believe you can get out of the relationship any time you choose.

But you are going to get very dirty.

It never ends well.

Each of you reading this know who these pigs are, and which of you are considering wrestling with some.

That shit will not come off easy.

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