Three Wise Men: Graham, Buffett, and Munger
Intelligent Investing is the Warren Buffett style of investing. You can call it “focus investing” or “margin-of-safety investing”. Many people (mistakenly) reduce it to “value-investing”. Whatever you call it, the idea is this: invest in a few good companies that are severely underpriced and sit on your ass (as Charlie Munger puts it) until the market values them “fairly”. To invest intelligently, you need common sense, with a heavy dose of emotional restraint and self-confidence. But we know that common sense is not common. Busy-ness is an epidemic. And emotional restraint isn’t normally associated with the world of investing. That’s why Intelligent Investing is rare. And right there is its inherent advantage over “the market”. Warren Buffett calls the mix of characteristics “rationality”. That, he believes is his edge; not I.Q. And he thinks this mix is attainable; it’s not genetic.
The term “intelligent” used here is a bit vague. I think “Bodhisattva” or “Zen” are closer, in essence. But let’s not get too spiritual just yet. Let’s go directly to the source. Benjamin Graham, Warren Buffett’s guru, coined the term and wrote a book called “Intelligent Investing”. This book laid the foundation of investing for Warren Buffett and many other great investors. It’s commonly known as the bible of value-investing. I think of it as a bible of investing in general; “value-investing” is redundant, as Warren Buffett will have you know. In the book, Benjamin Graham’s explained what he meant:
“The word “intelligent” in our title will be used throughout the book in its common and dictionary sense as meaning “endowed with the capacity for knowledge and understanding”. It will not be taken to mean “smart” or “shrewd” or gifted with unusual foresight or insight. Actually the word intelligence here presupposed is a trait more of the character than of the brain.”
Later, in the book, he went on to say:
“The investor cannot enter the arena of the stock market with any real hope of success unless he is armed with mental weapons that distinguish him in KIND – not in a fancier superior degree – from the trading public. One possible weapon is indifference to market fluctuations; such an investor buys carefully when he has money to place and then lets prices take care of themselves.”
That's easier said than done.
The Desire to be Precisely Wrong
Analytical knowledge is important, sure. But that’s probably not where we would have an edge over the market. The markets are teeming with highly analytical people with “fancy superior degrees” trying to outsmart each other. There are a lot of experts on accounting, economics and finance. Nowadays you don’t even need a fancy degree to be an “expert”. You can “wiki” most concepts in minutes. Many investors can “spread the numbers” and create fancy models in Excel or Matlab or R. In fact, many analysts create valuation “models” that forecast a specific cost line-item out to 5 years with scientific precision! That level of precision is a futile exercise, in my opinion. But the point is that you can’t "out-calculate" the market. That’s not the edge you should be striving for anyway. The goal is to be approximately right; not precisely wrong.
Character over Brains
Intelligent Investing isn’t about “mad excel skills” or a 4.0 GPA from an Ivy League school. As Ben Graham said, it’s about character traits. The biggest challenge in investing is emotional and psychological. Can you do your analysis without staring at the perpetual swings of the market? Can you remain centered as the market’s pendulum swings from over-optimism to over-pessimism? Can you remain unaffected by what Jim Cramer is shouting out? In Phil Fisher’s words: Can you “zag” when the market is “zigging”? This sounds like I’m talking about contrarianism. I’m not – you needn’t zag every time the market zigs. Normally, for most stocks or corporate bonds, the market will be approximately right, most of the time. But occasionally, just occasionally, your analysis will suggest a big gap between your appraisal of an asset and that of the market. And that’s when you bet big. That’s when, as Buffett quips, you “reach for a bucket, not a thimble”. That’s how the giants of investing have been successful. They wait, and wait, and pounce at the rare opportunity. Intelligent Investing requires an odd mix of courage and restraint. Not many cultivate it. At The Buylyst, I try to, every day.
You can imagine that this topic is broad and deep. Benjamin Graham wrote a whole book on it; two, if you count Security Analysis, which he wrote with David Dodd. I’ve tried to shrink the topic down to a few pages so you can see the trailer. The movie, dear readers, is The Buylyst.
How does The Buylyst Invest?
At this point I should mention that this discussion is geared toward the Warren Buffet style of investing – buy equity or debt (or their derivatives) in a few good companies that are severely underappreciated and underpriced. There are, of course, many avenues in investing apart from equities: sovereign bonds, corporate bonds, options, futures, commodities, real estate, and so on. Like Buffett, I think I’m better equipped to think about the prospects of a company, or of a few companies, rather than predict the direction of entire economies or entire markets. Of course, I do think about macro-economic variables, asset classes, derivatives etc. The Worldview and the Latticework of Mental Models are a manifestation of The Buylyst’s holistic approach. But when it comes to investing, I’m better at betting on specific companies. The discussion here reflects that.
I’d love to spend all day discussing our investment methodology. Luckily for you, I won’t. To condense the scope of this massive topic, we’ll look to Warren Buffett (yet again), to help me manage this undertaking. Here’s one of his countless invaluable one-liners – the quips that carry much more heft than the its size would suggest:
“Ignore the chatter, minimize costs, invest as if you would in a farm”
That is the most succinct summary of Intelligent Investing I’ve seen. Based on this quip, I’ll split this discussion in those 3 sections. We’ll go in reverse order: 1) Investing as if we would in a farm, 2) Minimizing Costs (and Risks) and then 3) Ignoring the Chatter. Each section comes with a “checklist”, which isn’t meant to be exhaustive. The lists are peppered with links to more detailed discussions about specific topics, should you want to explore further. Please do.
Again, this is just a trailer.
Investing as if we would in a Farm
- Be aware of the world at large: read, think, observe, question, diversify sources of information, “scuttlebutt”, travel, and repeat all that. Often. Form your latticework of mental models. Form your worldview. Broaden them. Hone them. Merge them. Did I say read?
- Find good companies that at least have these characteristics:
- A strong castle: a worthy product or service that either needs to exist or improves lives, or the world, significantly. What is the company’s competitive advantage?
- A wide moat: the company is adept that maintaining and renewing its competitive advantage. What does it take to keep its competitive advantage durable?
- Top-notch Management: They should be worldly, wise, and never run out of ideas for new products and services. Most important, they should always have a good idea about protecting the firm’s competitive advantage. They should always widen the moat.
- Estimate intrinsic value. And while doing so…
- Don’t worry about current market price. Don’t worry about “consensus opinion” (hint: 6 or 7 analyst opinions don’t qualify as “consensus”, by definition).
- Actually, don’t worry about what anyone else thinks. Do your homework.
- Be conservative. Assume management won’t be able to keep all its promises. Assume things won’t work out brilliantly for the company. Is the company still cheap?
- Don’t obsess over your “valuation model”. If changing simple inputs like discount rates or tax rates changes the intrinsic value estimate significantly, it’s a useless model. If calculations get to too cumbersome, it’s probably best to stay away from this opportunity. No need for false precision. In fact, Charlie Munger has never seen Warren Buffett build a spreadsheet model.
- How to value a company? This is how it’s done at The Buylyst. Take a look – it’s good weekend reading.
- Buy the stock or bond or asset if the current price is at a significant discount (at least 25%) to your conservative estimate of intrinsic value. That’s Margin of Safety. Don’t compromise on that, even if you find the product or service or the CEO to be terribly exciting. Don’t become hostage to greed – it’s not good despite what Gordon Gekko says. It doesn’t work. It doesn’t clarify.
- Once you’ve done your homework, stick to your guns, unless significant changes pop up in the company or the ecosystem in which it operates.
- Don’t worry about volatility. It can be your friend. By definition, Volatility is symmetric, which means price movements can be jagged and dramatic on the way up too!
- If the price approaches your estimate of intrinsic value, revisit your thesis and your target price. Don’t worry about the “bears”. Don’t worry about the “bulls” either. There may not be a rising tide. And if there is one, it may not lift your boat. Again, greed is not good. FOMO is a killer.
Minimizing Costs and Risks
- Good buys will be rare. There’s no need to buy every day or every week or even every month. So, trade occasionally.
- “Big opportunities come infrequently. When it’s raining gold reach for a bucket, not a thimble.” – Warren Buffett
- Assume that you will be holding the company for a long, long time. Maybe forever. Usually, market prices and intrinsic values tend to converge (if the thesis is right) within a couple of years. But be prepared to hold the company, like an owner of a farm, into your old age.
- Don’t over-diversify. Diversification beyond a point is counterproductive because it stretches the analyst to think across too many companies. It doesn’t mitigate risk at that point; it just adds to it.
- Diversify, even over-diversify, your sources of information and your data; scuttlebutt, by all means. But there’s no need to over-diversify your number of holdings.
- “What’s wrong with conventional diversification? For one thing, it greatly increases the chances that you will buy something you don’t know enough about. “Know-something” investors, applying the Buffett tenets, would do better to focus their attention on just a few companies—five to 10, Buffett suggests. For the average investor, a legitimate case can be made for investing in 10 to 20 companies.” From The Warren Buffett Way by Robert Hagstrom
- That brings us to the question: What risk are we talking about? The only risk that matters is permanent loss of capital. That could happen if your thesis is wrong and/or you’ve let your emotions run wild. The Buylyst has a more detailed discussion about Risk. But here is the BuyGist:
- What makes investing risky? Too many unknowns, most of which are not measurable with any real degree of accuracy.
- But Wall Street and Academia love to quantify it, precisely, with Volatilty, VaR, Stress Tests and a whole lotta fancy jargon. That’s false precision; false comfort. And it’s mostly useless.
- The buylyst definition of Risk: Chances of Permanent Loss X Size of Permanent Loss. I can attempt to quantify it. But I’d rather not take comfort in false precision. So, the focus is on minimizing it.
- Risk Management: Observe the world, keep your eyes and ears open. Be mindful. Think, Read, stick to your Circle of Competency and, above all, practice with ferocity the 3 magic words of Intelligent Investing – Margin of Safety.
Ignoring the Chatter
- If you’re an Intelligent Investor, you’ve bet on businesses that have a major discrepancy between price and value. The market may disagree with you for a long time. That can get uncomfortable. But it’s important to stay steadfast. Ignoring the chatter is the hardest part of Intelligent Investing. And that’s why it’s the rarest.
- “You are neither right or wrong because the crowd disagrees with you. You are right because of your data and reasoning.” – Benjamin Graham
- Benjamin Graham had also written about the concept of “Mr. Market”, who should be ignored if you’ve done your homework on an investment. Charlie Munger described Mr. Market the best:
- “Of course, the best part of [Benjamin Graham's approach] was his concept of "Mr. Market". Instead of thinking the market was efficient, Graham treated it as a manic-depressive who comes by every day. And some days "Mr. Market" says, "I'll sell you some of my interest for way less than you think is worth." And other days, he comes by and says "I'll buy your interest at a price that's way higher than what you think it's worth." And you get the option of deciding whether you want to buy more, sell part of what you already have, or do nothing at all. To Graham, it was a blessing to be in a business with a manic-depressive who gave you this series of options all the time. That was a very significant mental construct. And it's been very useful to Buffett, for instance, over his whole adult lifetime.
- Munger mentioned “market efficiency”. This has been the big, raging debate in finance over the last three or four decades. Proponents of the “Efficient Market Hypothesis” – mostly academics – believe that “prices in the stock market instantaneously incorporate all available information; so, there is no point in analyzing stocks. There are no good individual mis-pricings. You’re better off just betting on the overall market…”. I don’t believe that markets are always efficient. Neither do Warren Buffett, Charlie Munger, George Soros, Howard Marks…or any of the giants of investing. They all think, in varying degrees, that financial markets are quite inefficient. Efficiency, to them, refers mostly to the speed at which information is incorporated. They agree that information is reflected very quickly in stock prices, but they have doubts whether the information is always incorporated correctly. Warren Buffett summarizes the problem succinctly:
- “When the price of a stock can be influenced by a ‘herd’ on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.”
- You can safely ignore Wall-Street research, otherwise known as Sell-Side research. These big brokerage houses are in the business of “market-making”. The more a stock changes hands, the more trading there is, the more money they make. Their research arm is there to help their market-making desks sell a stock. Incentives are just not aligned. Is it any wonder then that most of sell-side recommendations are “Buy”? Of course, there are highly intelligent analysts on Wall Street. In fact, most of them are. But it’s usually incentives that drive decisions, not IQ or squeaky-clean moral codes. Personally, I like to get advice from people who have skin in the game.
- I don’t usually follow any advice given by bloggers, newsletters or columnists on many investment websites. They’re usually not forthcoming about their backgrounds, their philosophy, or their incentives. In fact, those are the thing I’m trying to fix with The Buylyst. You know my background, my philosophy, and my incentives. Why would I take advice from people who are not invested in their own brilliant idea?
- This must be mentioned again because it’s important – don’t worry about volatility. If you believe in your data and analyses, volatility can be your friend.
Zagging while Others Zig
Ultimately, I like Intelligent Investing because I’m curious about the world. If you’re like me – if you’re intellectually curious, if you’re interested in observing the world and reading and thinking about it, and what people (businesses) are doing to solve the world’s problems, then intelligent investing is for you. The “markets”, then, are simply a conduit for your worldviews. This is not how the investing world thinks. But it is how Warren Buffett thinks. And how Charlie Munger thinks. If you begin to appreciate the Warren Buffett way of investing, you’ll be in the minority. And you’ll have to comfortable with that. You’ll have to be comfortable zagging when others are zigging. In investing, that’s a good thing.
The concept of Intelligent Investing has been around for decades. The most successful investor in the world is its most enthusiastic proponent. It’s surprising, then, that most don’t follow his lead. Buffett thinks that may be a good thing – more irrational people means more investment opportunities. While I’m doing my part to evangelize Intelligent Investing, secretly I hope that the most investors out there are not that Intelligent, in the sense of the word described above. I’d like to stay rational while others are driven by fear and greed. I’d like to stick to soda while others take tequila shots.
“Rationality is essential when others are making decisions based on short-term greed or fear,” says Buffett. “That is when the money is made.”
At The Buylyst, of course, you are well on your way to becoming an Intelligent Investor.
Many Happy Returns.