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To Become a Better Investor, Think Like Darwin (nautil.us)
116 points by t23 on May 18, 2017 | hide | past | web | favorite | 38 comments

None of this is new news, this is exactly what The Intelligent Investor and Margin of Safety are based on: that the market is irrational.

To go further, this is what Warren Buffett made his first few millions off of what is considered "cigar butt" investing. These are stocks trading below their Net Current Asset Value (NCAV). That means take all of their cash, real estate, equipment... those are your net current assets. Now take a subset of those stocks, and you find some at such steep discounts that they are trading below the cash they are holding. How is that possibly rational?

To put that in perspective with a contrived example would be Apple, currently trading at $153 with a market cap of nearly $800B, $250B of that is in cash. Now imagine Apple is trading at $45 a share. That would value Apple at $235B...but if they liquidated the company, they would have more than that in the cash alone! And that is exactly the kinds of companies that folks like Ben Graham and Warren Buffett invested in, because they were so cheap, and probably not even great businesses, but had "one less puff" (hence cigar butt) in them before they closed up shop, were acquired, etc.

Now, one retort might be that these guys were investing in two of the worst markets in the history of the US economy - Ben Graham came out of the Great Depression and Warren Buffett from the bear market of 61-62. But there are still examples of this today. Seth Klarman's fund (which still exists today) has only had 3 down years and is considered to be one of the greatest investors since Buffett. These investments still exist, and it's all based on buying cheap when the market has irrationally priced them at a sale.

Don't forget your looking at the winners not the median returns for that category of investor. A company with 100 Million in liquid assets can easily be facing a 200 Million dollar lawsuit tomorrow.

The company would have a reserve for their expected costs of the suit. If they reserved $200M, then they would have a negative net worth. As an investor you should make your own estimates as well.

Your assuming the company know about this, and it's public information, both of which add quite a bit of lag time and thus investor risk.

Assessing risk is an important part of valuing companies. Lawsuits usually don't materialize out of thin air, and when they do, they usually aren't very strong cases.

One great historical case for Buffett was the Salad Oil Scandal. American Express stock plummeted because it had guaranteed loans backed by salad oil inventories that turned out to be fraudulent. It was facing a huge loss for the time, some were even afraid it might go out of business.

But Buffett went to lunch and saw customer after customer still using Amex cards to pay for their meals. He realized that the charge card part of Amex was still really valuable, and did the math on what the credit card business was worth and their maximum possible losses from their loans would be, and realized the stock was hugely undervalued and bought a ton.

Every business has remote risks of crazy bad things happening, it's why you diversify your portfolio if you are an active investor.

Most value investors you've heard of aren't really value investors, they're activist hedge fund managers who try to "catalyze the unclaimed inherent value" in a company by bullying them (through board seats) to course-correct the company...or they're a fund that's trying to match the market rather than beat it (most mutual funds), because they're so risk-averse or have such a poor strategy that they don't have faith it will work.

Yeah I've never understood how value investors account for hidden liabilities. Perhaps you have to be very good at reading financial statements.

As valuearb pointed out, value investing basically comes down to reading 10Ks and 10Qs which are freely available on the SEC database. You read those to get the complete financial health of a company, and using those numbers, calculate what you believe to be the fair value of a company.

"Well if it's a belief, then isn't value investing just as much speculation as anything else?"

That's where the term Margin of Safety comes in. The financials of a company provide a delta, some min and max of where the company can go. When you plug in your estimates, and that delta's minimum is still less than the current price of the stock, esp by a significant margin, then you've picked a winner...more specifically, a winner over the next few years. Remember, plenty of events can occur between now and when your value is realized, and one of the other traits of a strong value investor is the ability to weather the storm. Oftentimes these companies with sufficient margin of safety will continue to fall in price before they rise again, one cannot time the market for the zenith nor the nadir of a stock's price.

Public companies are required to report on all of their liabilities. You read the quarterly and annual reports and intelligently assess which risks are significant or not, and how to discount for them.

Beyond that you spend time thinking about their business and what could go wrong. If there is something obvious to you they didn't disclose, that would tend to mean management is untrustworthy or incompetent, two other huge risks.

Buffett spends lots of hours reading reports away from CNN and computers and distractions. I'm sure he talks to Charlie and others regularly about things that concern him and gets different perspectives.

Again, a lot can happen in a week let alone 3 months between annual reports. The secret of Buffet's success is not limited to value investing he had quite a bit of early leverage and of course is also quite old now which give plenty of time to compound gains.

It's difficult to compound gain at 19% for 50 years--the S&P only did 10%. The secret of Buffett's success, which he explains in every letter, is that he bought an insurance company. As long as you are diligent in writing non-money-losing policies, you get the premiums up front and pay later. So you have all this float that you can do something with. But he also picks good companies, picks good managers, and is careful to make sure that the financial incentive for the manager is the same as the financial incentive for Berkshire, which is not the case with most executive packages.

Exactly, leverage happened to work out really well for him, but true big the same idea can easily end up with you broke.


Leverage is only minor component of his late career success, and insurance float could never have gotten him broke. It's totally unlikely like a loan from your broker.

His late career has been less impressive vs is early career. Also, float can dry up if insurance sales drop. So in many ways it's worse than a loan from your broker it's got totally random size fluctuations. He just happened to be really lucky / skilled at running an insurance company over time so that this was not an issue. However, that says more about running an insurance company than investing.

If his results declined after he bought insurance companies, how does that say he was lucky/skilled at running them, and how did he gain any benefits from the leverage they afforded?

The reality is his late career is less impressive only in one way, annualized returns, and it's more impressive in virtually every other way. He started out with less than a million in investors money, and his 40% returns with the Buffett Partnership were probably with an average of $10M to $20M total.

Nowadays his public stock portfolio was $122B at year end 2016. That limits the stock market investments he can make to a tiny fraction of stocks. He's not going to buy hundreds of stocks, not even dozens. He wants to focus in his dozen or so best ideas. So he want to be able to put $10B to work in each and there are very few public companies with market caps and trading volumes large enough to allow him to do that. So problem #1 is that he went from a market of 5,000+ stocks he could choose from to maybe a few hundred, reduced opportunities that directly hurts his returns.

Worse, how can he accumulate $10B worth of a company before he's forced to publicly disclose his purchases. If he's forced to disclose prematurely, his future returns dwindle due to free-riders driving the purchase price up before he's done. That's big problem #2.

The fact that he's still beating the market carrying these heavy chains is more impressive to me than the fact he whipped it at 3x higher rates when he could buy anything he wanted.

But, take out those 40% years and his returns are much closer to the stock indexes.

While managing billions at minimal risk he is not making nearly 17% returns. He is doing OK but again your looking at a statistical outlier so you can't separate skill and luck as much as you might think.

His returns from Berkshire Hathaway has averaged 19% over the last 52 years (from 1965), vs a 9.7% market return over the same period.

His 40% returns were in the Buffett Partnerships, which ran for 12 years from mid 50s to late 60s, and aren't counted in Berkshires results.

Doubling the market return rate over 52 years is huge outperformance. For an investor it's roughly doubling every 3.5 years instead of 7.5 years.

Add in the fact he crushed the market by nearly 4x a year for an earlier 12 years and his immense skill is undeniable. He would be statistically implausible if the world had trillions of investors.

Not sure what you mean by early leverage given he used virtually no leverage throughout his career. Insurance float is basically the only form he's used and didn't start that until the middle of his career.

His annualized returns running the Buffett Partnerships with zero leverage were close to 40% per year for the dozen or so years they were operating.

And everyone compounds gains just by holding index funds for long periods. Buffett compounds them far faster because he has substantially higher returns than the market.

Could it be the moral cost that is factored in when valuing companies under their cash value?

Some companies come with liabilities that are not in the books; such as having promised to guarantee their workers wages or retirement for decades. If you buy the company and close up shop, you might either be liable to cover these "soft costs" or you might cause political harm to your own operation.

Yahoo, for long, had a market cap much below the value of all of its assets (including $BABA). One reason why it was undervalued was because the market didn't believe that they could dispose of their $BABA assets without incurring a huge tax penalty.

Interesting example. Do you have a link to more info? In general, where do you read such analysis? Seems like the kind of thing that would be discussed on a HN for finance people.

Just search around in HN for, say, "Yahoo core business", in the last couple of years.

Here's one story: https://www.usatoday.com/story/money/markets/2015/12/03/yaho...

Some of Matt Levine's Bloomberg finance newsletter touches on that, and there's a bigger writeup as well: https://origin-www.bloombergview.com/articles/2015-12-02/yah...

>but if they liquidated the company, they would have more than that in the cash alone!

Someone has to buy that though, right?

I'm sure a ton of people would buy a lot of pieces of a liquidated Apple, but what other effects on the economy does a suddenly-liquidated Apple have since it's such a major company? Does Apple take any other companies with it?

The only way to insulate yourself completely and still benefit is to only own Apple shares, otherwise, Apple going down is going to affect the rest of your position.

What if they continue to trade below the cash that they are holding for 10+ years?

Plus, since they use tax havens, what happens to that cash if someone did liquidate Apple? Wouldn't it have to come back to America and would be taxed heavily?

Real cigar butts are usually tiny companies that no cross effects on the economy at large. Their risk is that they hold the cash for 10 years, or worse, burn it all trying a whole new business model (self driving cars!).

The returns can be very good, but you do need to diversify out to 10 to 20 holdings to limit risk from one going south or taking forever.

Buffett stopped investing in cigar butts because his portfolio got too big and the risk/return ratio wasn't always great. His big change was leaving Graham's philosophies for Mungers, and focusing on getting great businesses at a fair price rather than fair businesses at a great price.

I've been reading intelligent investor and there's something I don't understand - maybe you can explain. I get that the point here is if the company were liquidated you would get a positive return but how often does that happen? Yes in principle you're getting something at a discount but you can't exit - not like it can go to Apple HQ and demand a withdrawal commensurate with your equity? So why does it matter?

They are not as common today because we are in a huge bull market, but they can still be found:


I think this is silly gobbledygook. The author seems to argue that you pull out of stocks when expected volatility rises. Well expected volatility can be a trailing indicator. The market has low volatility because investors expect great times, yet it suddenly crashes and loses 20%, and volatility skyrockets because investors basically believe that patterns continue forever and expect the market to continue to fall.

So now you sell, at 20% below peak prices. Maybe prices continue to fall, maybe not, but it's unlikely expected volatility will fall until the market starts climbing again significantly, say 20%. So then you buy back in, well above the lows.

Essentially this seems like a sell low, buy high mechanism, sell on dips, and buy on spikes.

Value investing means you invest in only what you can reasonably estimate a value for. You buy when the price is substantially less than it's value. You sell when value and price are similar.

Selling a stock you though was worth $10 and bought at $7, because it goes to $6 doesn't make sense if you believe in your original valuation. Buying it back because it goes to $9 doesn't make sense either.

If you cannot confidently assess value, you shouldn't be doing anything but buying and holding index funds.

The last chapter, to me, was the most interesting, and I would have liked it if author had expanded on this:

"If we need 100,000 people to cure cancer, to deal with Alzheimer’s, to figure out fusion energy and climate change…I don’t know of any other way to do that other than financial markets: equity, debt, proper financing and proper payout of returns. I think that in many cases [finance] probably is the gating factor"

How do you attribute finance as an organising/motivating factor to solve some of these problems? Energy, and patented medicine, yes I can see that - but pollution and climate change?

I guarantee you that the solution to climate change will come from markets. Not some utopian ideal of all the countries of the world coming together to stop polluting but some person trying to get rich that creates a business that makes non polluting energy more affordable than fossil fuels.

I'm not sure we will have a solution to climate change (or other types of pollution) before it's too late.

The main problem, in my view, with pollution is that we find ourselves in a situation where short term gains (or negligence) are creating long term problems with significant consequences that we have no inherent motivation or evolutionary reward pathways to address.

In the case of energy one could argue that markets will drive the cost of solar below fossil fuels, which I agree with, though not convinced about the time scale, especially on energy storage front. With other types of pollution I don't see the market doing much at all.

When you have a hammer, everything looks like a nail.

Never mind that most of the biggest contributions to science had nothing to do with the market economy...

They have, but it's a second order connection.

Academic institutions didn't spring up out of charity but due to general idea of the rulers of the day that it will make their and their subjects lives better. This including both financial and non-financial gains, both affecting economy in general though not linked to it in detail.

This is why most big academic centers are government funded and not privately funded - and it's always a high risk game and few businesses like high risk. (Even startups, most go for low hanging fruit and quick returns. Academia in total is supposed to go for long game with high payout instead.)

Patents came out of the left field, to protect and enhance private research, provide more incentive to do so, cover the huge costs which few private companies could otherwise bear without exclusivity. (Because private company has to make profit while government funding does not necessarily directly because it has huge buffers of cash and social capital.)

>Academic institutions didn't spring up out of charity //

Are you sure? Didn't the library of Alexandria invite academics and give them bed-and-board to stay and study? (It may have been one of the other early libraries??) With the aim to expand human knowledge. Yes wealth will always have a relationship with knowledge/wisdom but that doesn't mean supporting academia has to have other than altruistic basises.

Weren't a lot of early academic institutions monastic, seeing accrual of knowledge as a service to the world by leading to greater understanding of the creator? (Which you kinda intimate.) Isn't that "charity"?

I don't think arrangements at the library of Alexandria are known in that kind of detail. (I've read a couple books about it, and most of the sources they use are from much later.) It was founded and funded by the Ptolemies as what you could plausibly call the first research university. Probably it was some combination of knowledge-is-power (it was an era of technical progress -- e.g. you know Eratosthenes and the size of the Earth? Eratosthenes was head of the library, and his work included basically inventing geography https://en.wikipedia.org/wiki/Eratosthenes#.22Father_of_geog... a subject of obvious interest to a new bureaucratic state), prestige, and genuine curiosity/cultivation on the part of the first few Ptolemies.

>"If we need 100,000 people to cure cancer, to deal with Alzheimer’s, to figure out fusion energy and climate change"

Look through their dissertations and publication history. Categorize as "put name on NHST-using paper or not". You will narrow it down to about 10 potential recipients.

I don't have the back data to test this, so I would not invest in this manner...

"The Egyptians built some beautiful pyramids, but they did that with hundreds of thousands of slaves over decades."

This is now actually disproved. Made me doubt quite a bit about if the rest of the article (and his book) is actually based on any evidence or just the author's personal views.

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