2018 Year-End Value Investing Note - Use your own compass

Investing-wise this year was likely exciting for you - it was for us. Whether you owned Canadian oil and gas stocks (yikes), were riding the marijuana train, or just paying plain old large caps swinging 20% month-over-month, your portfolio was likely… movin’. Of course there are those that bet their life savings on Bitcoins (yuck) or CryptoKitties (at least cute) and were hoping to pay their rent with it must have had even more excitement (but are likely not readers here).

2018 Lesson - Have your own compass

Recently we mentioned Guy Spier, friend of Mohnish Pabrai and manager of the Aquamarine Fund.

He is quite a prolific speaker but according to himself he is “probably best known for having lunch with Warren Buffett”. Back in 2008 he (along with Mohnish) paid $650,100 to have lunch with Warren Buffett (as part of the annual charity lunch auction). You can read his thoughts about the lunch here - https://observer.com/2015/12/my-lunch-with-warren-buffett-changed-my-life

His key takeaway was this:

The most memorable piece of wisdom that Warren shared that day was about the need to live by an “inner scorecard,” instead of worrying how others think of you. He illustrated this by asking: “Would you prefer to be considered the best lover in the world and know privately that you’re the worst—or would you prefer to know privately that you’re the best lover in the world, but be considered the worst?” It was clear that he operates entirely according to his inner scorecard, living and investing in ways that perfectly suit his personality and his values. For me, this was his greatest lesson.

2018 was a wild ride. And as we go through waves of fads, booms and busts it is important to have a central compass. The core theme of my own investing to date is having to go against the grain to find things that truly are cheap and not just a value trap. Of course, some out there rode Bitcoin and marijuana into the sunset and of course I wish them the best on their beach adventures. But I know I wouldn’t have been “right” or “wrong” but just lucky if I made money on those. And that’s just fine with me.

“It’s not greed that drives the world, but envy.” - Warren Buffett

Guy Spier 101

Guy Spier gives a good overview of his views on value investing in a 2016 talk and we definitely recommend you take a look. This was at the Ben Graham Centre for Value Investing.

Priceless: The Myth of Fair Value (and How to Take Advantage of It) Book Review

How much would you pay to rent a condo in downtown Toronto? How about the U.S. island of Saipan (a fun little island 7,800 miles from Washington D.C.)? You probably can only give a reasonable answer to at most one of these places, and even then you would probably answer it with a question like “In what neighborhood?”.

Like most, you would start looking at comparables. What is the going rate these days? According to BNN, the average monthly rent in Toronto is about $2,166, while googling around about Saipan finds places for $500. “Oh this must make sense from a supply and demand standpoint”. Maybe.. If you sat down and compared 4 or 5 condos in either one of these markets you could make a reasonable decision about which is the best value compared to the others.

But what about the fact that you’re starting at $2,166 or $500? As you will learn when you read Priceless: The Myth of Fair Value (and How to Take Advantage of It): , humans are q) very good at understanding relative value but are horrible about understanding absolute value, and 2) we can be easily misled about what “absolute’ value is.

“Put it this way, our ratio-based senses are eminently reasonable. There is an Achilles’ heel. The price of being so acutely sensitive to ratios and contrasts is a relative insensitivity to the absolute.”

As we talk about frequently on this blog, humans are terribly fallible, and we are particularly fallible to incentives and prices. Charlie Munger (Vice-Chairman of Berkshire Hathaway) even has this as his #1 Standard Cause of Human Misjudgement!

“Number 1: Under-recognition of the power of what psychologists call ‘reinforcement’ and economists call ‘incentives.’ Well you can say, “Everybody knows that.” Well I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.”

For the full story on Munger’s List see - http://www.canadianvalueinvestors.com/behavioural-finance/

When talking about investing, being as conscious as you can be of how prices work and can influence you and others is extremely important – both from understanding what a business is worth and understanding the actual business and its model.

The author William Poundstone has done a great job of putting together the foundations. It provides entertaining overview of the beginnings of Behavioral Economics, covering Ward Edwards, credited as one of the founders of behavioral decision theory, to Amos Tversky and Daniel Kahneman, the creators of the Prospect Theory. It also gives numerous case studies of how people as a whole can be consistently manipulated (and how even if you are aware of this you can still be susceptible).

For example, the book covers numerous examples of anchoring, such as the ID Number experiment by University of Virginia psychologist Timothy Wilson (“basic anchoring effect”).

“Wilson and company tried to find out how subtle a ‘background’ anchor could be. In one experiment, volunteers were given questionnaires with adhesive notes attached. Written on each sticker was a four-digit ‘ID Number” between 1928 and 1935. One group of participants was required simply to copy this number onto the questionnaire. They were then asked to estimate the number of physicians in the local phone book. The average estimate was 221 doctors.

The important thing here is that the ID code was just a number that happened to be there, not a meaningful part of the problem. Other groups were given slightly different instructions that caused them to pay a little more attention to the ID number. Some were told to note whether the ID number was written in red or blue ink (on the pretext that this would determine which page of the questionnaire to fill out). For these people the average answer was 343 doctors. A split second’s extra attention to the number has raised the estimate 55%. (All the ID numbers were big. As anchors they would have pulled the estimate up). Another group was asked to note whether the ID number was in the range of 1920 through 1940 (they all were)….This group [averaged] 527. One group was asked [first] whether the number of physicians…was greater or less than their ID number, and then give their estimate of the number of physicians. This group’s average was 755….

The researches later asked some participants whether they thought their judgements might have been influenced by the ID number of the adhesive sticker. The answer, overwhelmingly, was no.”

Another fun example is the Beer Problem posed to university students by Joel Huber and Christopher Puto, then a professor and grad at Duke University’s school of business.

“Joe Sixpack is reaching for a brew on the market shelf. There’s a premium beer that costs $2.60, and a bargain brand that’s only $1.80. The premium beer is “better”…rated at 70 out of 100 in quality, while the bargain brand is only 50. Which should Joe buy?….The students preferred the premium beer by a 2-to-1 margin….

Another group chose among three beers, the two above and a third with a rock-bottom price of $1.70 and a quality rating in the basement (40). Yet it affected what they did choose. The proportion of students choosing the original bargain beer rose to 47%, up from 33%. The existence of the super-cheap beer legitimized the bargain beer.

In another set of trials, the three choices were the original bargain and premium beers, and a super-premium beer. Like many upscale products, this was much more expensive ($3.40) and only a little better in quality (rated 75). 10% said they’d choose the super-premium beer. An astonishing 90% chose the premium beer. Now nobody wanted the bargain beer. It was like pulling the string on a marionette. Huber and Puto found they could make students want one beer or the other, just by adding a third choice that few or no one wanted.

There are numerous examples of every day life things that can be adjusted to change your decision. The book covers restaurant menus, strategies used by luxury goods companies like Prada, lawsuits, and even negotiation strategies. It also includes some techniques on how to avoid falling for these traps, like Antidotes for Anchoring where you force yourself to Consider the Opposite, or the Buddy System – techniques that can be applied to analyzing companies.

As we here focus (primarily) on understanding businesses, the real question always comes down to “how much is the business worth?” In turn, it’s worth doing everything you can to understand how humans think of prices.  

If you like this book it would also be worth checking out Misbehaving: The Making of Behavioral Economics by Richard Thaler.

Saturday Morning Video - Petter Johansson: When you make a choice, are you really sure you know why?

When you make decisions, you like to believe you made them for a reason. This is particularly true of investing. I bought this stock for rational reasons, right?

We recommend watching this TED Talk by Petter Johansson, which discusses Choice Blindness. His experiments explore that our rationale for the decisions we make might not be as strong as we would like to believe, and that we can actually end up justifying opinions that we didn't even make (as you will see in the video).

So what this [first] experiment shows is, OK, so if we fail to detect that our choices have been changed, we will immediately start to explain them in another way. And what we also found is that the participants often come to prefer the alternative, that they were led to believe they liked.
So first of all, a lot of what we call self-knowledge is actually self-interpretation. So I see myself make a choice, and then when I’m asked why, I just try to make as much sense of it as possible when I make an explanation. But we do this so quickly and with such ease that we think we actually know the answer when we answer why. And as it is an interpretation, of course we sometimes make mistakes. The same way we make mistakes when we try to understand other people. So beware when you ask people the question “why” because what may happen is that, if you asked them, “So why do you support this issue?” “Why do you stay in this job or this relationship?” — what may happen when you ask why is that you actually create an attitude that wasn’t there before you asked the question.

Of course, when you're investing, you need to remember you are fallible. That's why we here believe 1) You have to be very careful how you frame questions when learning about something from someone and 2) document your own decisions and reflect on your answers later, and 3) use a checklist whenever possible (see Checklist Manifesto).

The first principle is that you must not fool yourself and you are the easiest person to fool.
— Richard Feynman

The Contrast Principle and Investing (“Is a market crash coming?”)

As Donald Trump noted on August 3rd on Twitter:

“Business is looking better than ever with business enthusiasm at record levels. Stock Market at an all-time high. That doesn't just happen!”

Indeed. We are not macro folks here. When I think about long-term hold ideas I think about how certain macro factors will affect a business (How would they handle higher interest rates? What is a company’s customer base vs demographics like? Etc..). However, I do not make day-to-day decisions because of macro factors and daily noise like S&P year-end targets and the latest economic forecast for GDP growth next quarter.

However, even with this attitude we are all subject to psychological biases like the Contrast Principle. Robert Cialdini’s book, Influence: The Psychology of Persuasion (a must read) has my favorite explanation:

If we are talking to a beautiful woman at a cocktail party and are then joined by an unattractive one, the second woman will strike us as less attractive than she actually is.

The same principal applies in reverse and to investing. Is that stock you are looking at actually cheap? Compared to what? The last ten grossly overpriced companies you looked at? You might consider yourself a value investor and frugal but if every single one of your neighbors on your block has a Lamborghini you might start to think a Mercedes-Benz C class is a “cheap” and economical car (it is less than half the price!). It’s only human nature.

Frankly, I’m worried about getting caught up in the market and decided to sit down and make note of where we are today. How is Mr. Market feeling? Let’s take a look at: 1) The S&P PE Ratio, 2) The Shiller PE Ratio, and 3) the VIX or volatility index.

1) The S&P PE Ratio

Looking at the S&P PE (price to earnings) multiple gives you an indication of what people in the overall market are willing to pay for a dollar of earnings. A great source is: http://www.multpl.com and this is where the next two charts below are from.

Currently the S&P PE multiple is about 25x, or, inversely, if you buy a stock today the stock is “earning” 1/25 or 4%. Is this cheap? It’s all relative. As I look today 30-year U.S. government bonds (the closest thing we have to “risk free”) are trading around ~2.85% and 20-years are trading at a bit less. Is ~1%- over treasuries enough of a risk premium? Maybe earnings growth will be strong but are we about to start a wave of growth eight years into a bull market while interest rates are at generational lows?

2) Shiller PE Ratio

Another measure that I like more is the Shiller PE Ratio, a more conservative ratio where it takes the average inflation-adjusted earnings from the previous ten years. At around ~30x today it is lining up ominously with Black Tuesday.

3) VIX

Another commonly used measure is the Chicago Board Options Exchange (CBOE) Volatility Index, or “VIX,” showing how volatile S&P options investors expect it to be over the next 30 days. It is at a 10-year low meaning people just don’t seem very concerned with volatility and, in turn, aren’t pricing much volatility in.

Source: http://www.cboe.com/products/vix-index-volatility/vix-options-and-futures/vix-index

So where does this leave us?

  • While overall earnings have increased, a big part of the stock market boom is multiple increases, where people are just willing to pay more for the same dollar of earnings than they were ten years ago.
  • We are eight years into a bull market in an environment of very low interest rates, very high valuations, and not much volatility priced into the market.
  • Based on the Contrast Principle, some stocks out there today might look “cheap” compared to current bond rates or the overall market, but would sure look expensive compared to comparable stocks ten years ago. 

Some argue that “it is different this time” because interest rates are so low that these high PE multiple are justified. I would agree that to be technically true, but that also means the market is dependent on rates staying low (as they now start to go up) and earnings to stay strong and very stable (eight years into a bull market).

Where are we going? I would never claim to know where markets are going, but I would say that there is not much cushion or room for error from an overall valuation standpoint. However, I also think that there are opportunities in any environment (such as a wind-up situation or a turnaround for example). I just have to make sure that what I am buying really is “cheap” and not just a bit less overpriced.

In the words of Benjamin Graham:

“A serious investor is not likely to believe that the day-to-day or even the month-to-month fluctuations of the stock market make him richer or poorer. But what about the longer-term and wider changes? Here practical questions present themselves, and the psychological problems are likely to grow complicated. A substantial rise in the markets is at once a legitimate reason for satisfaction and a cause for prudent concern, but it may also bring a strong temptation toward imprudent action. Your shares have advanced, good! You are richer than you were, good! But has the price risen too high, and should you think of selling? Or should you kick yourself for not having bought more shares when the level was lower? Or–worst thought of all–should you now give way to the bull-market atmosphere, become infected with the enthusiasm, the overconfidence and the greed of the great public (of which, after all, you are part), and make larger and dangerous commitments? Presented thus in print, the answer to the last question is a self-evident no, but even the intelligent investor is likely to need considerable will power to keep from following the crowd”.

The Intelligent Investor, Revised Edition, page 196-197.