The Unrepentant Recalcitrant

Lessons for an accidental entrepreneur

Archive for the tag “Psychology”

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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Economic Principles are Slaves to Psychology, not Math

Pity the poor entrepreneur who embarks on a path of business education!

Whether its by way of starting a company, studying for a MBA, or even a million other paths, business education holds some surprises for us unwashed (read: unsophisticated) masses.

Two whole fields exist to dazzle you! Microeconomics and Macroeconomics. Its all exceedingly complicated and not for the faint of brain, you are told.

Some of the smartest people I have met have been economists by profession. Very bright, very quantitative and eager to explain the world of money.
There is however a 800 pound gorilla in the room.

And that is, that economists are almost without exception unable to describe economic reality.

Under most real world conditions, their models don’t work and their math fails them.

Why?

Let an ignorant doctor tell you the one thing he understands better than anything else.

Mathematical formulas are inadequate as models of human behavior.

Economics is at its heart, human behavior applied to a special situation.

Math cannot help you brother.

Don’t tie yourself up in contortions trying to force that economic model to give you testable hypotheses!

Instead, just watch how we behave as social animals and you will get a much better sense of what is happening and what will happen in the future.

Want to master economics and the nature of markets?

Watch “Animal Planet” and throw away your models!

Go to the zoo and say hello to those 800 pound gorillas! You will learn more about how markets behave watching them, than you will watching CNBC.

Trust me, I’m a biologist.

Valuation and its Discontents

The cornerstone of investing and entrepreneurship and perhaps even of life, is valuation.

Thats not hyperbole.

Think about it. You are valuing and weighing all day long, every day.

Obviously you need to value stocks and bonds if you are to invest.

Its also evident you want to understand how much your business is worth if you have a startup.

But there is more.

Whats that house you want to buy worth?

How about the car you purchased last year?

Do you value your collectibles? Your art?

How do you do that?

Lets go into uncharted territory.

Do you value your relationships? Looking for a girlfriend?

What is she worth?

(Its only a little tongue in cheek. Later, someday I’ll explain why. For now, we will stick with inanimate objects!)

As I described in an earlier post, we are putting a value or worth on assets (remember assets?).

Value and worth, as I have said before need not necessarily be the same as the price of the asset.

If its less than the price of the asset, we have an investable opportunity. Otherwise we don’t.

Lets use the value of a company stock as an example.

What is it worth?

There are many ways to determine this but a few that are important to consider.

Lets talk about four of them.

1. Asset Valuation
2. Liquidation Value
3. Replacement (or Competing) Value
4. Discounted Cash Flow Valuation

Asset valuation:

One way to assess value is to add up the worth of all the things the company owns…its buildings, its inventory, its machines and its cash and calculate its total asset value.

Lets say, you are in the middle of a depression. Companies are selling cheap (ca 1929).

It was possible to pick up companies at the time for less than the sum of their parts.

Benjamin Graham, the father of value investing made his fortune this way.

Liquidation Value:

A second way, in the case of a company that is being broken down and sold for its parts (liquidation value) is the total value of its assets minus some discount to account for the fact that everything it owns may not bring market value since it will be sold at fire sale prices.

More on this another day.

Replacement Value or the Valuation to Compete:

A third way to calculate value is to see the business as competition to us, and ask the following question:

“What would I need to do to build up a business just like this one and compete with it?”

Now that would include the asset value mentioned above but also the resources that have been deployed to build the brand(s), market the product(s), establish the customer and wholesaler relationships and distribution channels (among other things).

There is some hand waving involved here of course but its easy to see that the value of these intangibles (and semi intangibles) will add to the raw asset value we have described above.

Discounted Cash Flow valuation:

Finally, we can determine value by asking this question?

“If I owned this asset, what amount of money would I earn from it over a set period of time?”

If you owned a stock, what is the total value of dividends you would receive for it over time?

If you owned a whole business, what profit would you be able to get out of it every year for the duration of your ownership?

For each of these questions, we can (theoretically) construct a model of “cash flows“, i.e. the flow of money into your pocket over time.

Add that cash up.

Remember, you don’t have the cash in your pocket today. Its going to take time to get it all.

Over that time, you will live without that spending power.

So, the raw total of that cash must be “discounted” over the period you will need to get it into your pocket.

This is, in a word the discounted cash flow model of earnings (DCF) that allows you to estimate the value of an investment.
The discounted cash flow model of valuation (DCF) is de facto the most important method to understand, when valuing an asset that brings earnings.

Its incorrect to value a business with sales any other way (except in the situations I noted above).

I will speak more about DCF in later posts as it comprises the “V” in the “P/V” formula I introduced in the previous post.

I will leave you with a few final thoughts.

1. You cannot fully value an asset without cash flows (or the future promise of cash flows).

2. If you cannot fully value an asset, you cannot be sure of the relationship of Price to Value (P/V).

3. If you cannot estimate P/V and ensure a margin of safety, you are unable to ascertain whether an asset is investable.

4. If you decide to purchase the asset anyway, you have not invested. Rather you have speculated or gambled. Be clear on this.

5. Ergo, any asset without cash flows is not likely to be an investment.

Let me repeat that last statement.

An asset without cash flows is not likely to be an investment.
(Ahh…the chaos that idea will create!)

Arjuna and The Eye of the Sparrow: Without Focus, There is No Success

Arjuna and the Eye of the Sparrow (From boloji.com)

Arjuna and the Eye of the Sparrow (From boloji.com)

Another story from the Mahabharata.

Today my story is even older than the story of Abhimanyu (https://unrepentantlyrecalcitrant.wordpress.com/2013/10/02/the-story-of-abhimanyu-why-you-must-have-an-exit-strategy/).

It’s a story from the childhood of Arjuna, Abhimanyu’s father.

Arjuna, a warrior prince, and his brothers and cousins are being trained in archery and warcraft by the great teacher Drona.

Drona assembles the young princes together, places a wooden sparrow on the branch of a tree and asks the princes to aim for the eye of the bird.

He asks one of the princes to come forward, draw his bow and then asks, “Tell me what you see?”

The prince responds, “I see the bird, the branches and the tree.”

“What else do you see?” asks the venerable teacher. “Tell me everything you see”.

“I see the sky, the clouds, the sun..Oh Drona” responds the prince.

Drona then asks the next prince in line the same question.

“What do you see?”

“I see the bird, the tree, the sun and the skies..Oh Drona.”

One by one the princes are asked the same question and they describe everything they see.

Then its Arjuna’s turn.

“What do you see boy?” asks Drona.

“Blackness, my teacher. I see blackness”.

“What else do you see?”

“Nothing but blackness, my teacher. That is all I can see.”

Drona presses Arjuna. “What is this blackness Arjuna?”

“It is the blackness in the center of the eye of the sparrow, my lord. I can see nothing else.”

“Shoot” says Drona. “You will be a Master Archer someday.”

And he was. The best archer in the world. A warrior without equal.

Look for this in your lives my dear readers.

Look for the blackness in the eye of the sparrow.

See nothing else, do nothing else, dream nothing else.

Perfect this and you will be perfect at what you do.

A Master without peer.

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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