Value investing thoughts on principles, process and pitfalls

VALUE INVESTING – THOUGHTS ON PRINCIPLES, PROCESS AND PITFALLS “We have complaints that institutional dominance of the stock market has put ‘the small investor at a disadvantage because he can’t compete with the trust companies’ huge resources, etc. The facts are quite the opposite. It may be that the institutions are better equipped than the individual to speculate in the market….But I am convinced that an individual investor with sound principles, and soundly advised, can do distinctly better over the long pull than large institutions.” – Benjamin Graham “If I have seen further it is by standing on the shoulders of giants.”—Sir Isaac Newton

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ABSTRACT The purpose of this paper is to discuss the merits and limitations of the value investing philosophy. The paper relies heavily on the words of the great value investors including Graham, Buffett, Klarman and Marks. In the paper, I will define what it means to be a value investor and review its five key principles—thinking like a business owner, seeking a margin of safety, recognizing the effects of reversion to the mean, understanding risk as the permanent loss of capital and the necessity of discipline.

The paper will look into the reasons so many market participants fail to follow the principles of value investing despite overwhelming evidence that it works over the long-term. Next, the paper will explore how a value investor can develop and implement a process to reach better outcomes. In doing so, the paper will address the four villains of decision making and offer ways to overcome them. Since value investing is about paying less for an asset than its true worth, I will briefly touch on approaches to determining value. Although value investors think bottoms-up, they worry top-down. Therefore, the paper will look at how value investors think about the economic cycle. In conclusion, the paper will review the principles, process and pitfalls and reiterate the merits of “value� investing.

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VALUE INVESTING There is little debate that value investing produces superior investment results over time. 1 What does value investing mean then? Here’s what Buffett had to say about the term “value investing” in his Chairman’s letter to the Shareholders of Berkshire Hathaway in 1992: “…the very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value—in the hope that it can be sold for a still-higher price—should be labeled speculation…”2 Value investing is no more and no less than the act of purchasing a security for less than it’s worth. In the words of Seth Klarman: “It is simply the process of determining the value underlying a security and then buying it at a considerable discount from that value.”3 The idea that investors should only purchase an asset that is quoted at a substantial discount to its intrinsic value seems to make perfect sense. Yet, a surprisingly large number of investors fail to appreciate and follow the principles of value investing.

PRINCIPLES Fundamental truths or propositions that serve as the foundation for a system of belief or behavior or for a chain of reasoning.

If an investor does not or is unwilling to internalize the principles of value investing, then his likelihood of achieving consistent success is diminished greatly. The principles are the foundation for developing a successful approach to investing.

Principle #1 – Think Like a Business Owner The first principle establishes how an investor should think about a company’s stock. For legendary value investors like Graham, Buffett, Klarman and Marks, stocks do not represent pieces of paper “to be traded,” but rather fractional ownership of the underlying business. This is an incredibly important distinction as it shifts the focus from the short-term (trader, speculator) to the long-term (business owner).

In order to properly analyze a company’s prospects, an investor must think—and act—like a business owner.4 Principle #2 – Seek a Margin of Safety The second principle is the central concept in value investing: Benjamin Graham’s margin of safety.

Margin of Safety is defined as the degree to which an asset is trading at a discount to its intrinsic value.

To be considered an investment, a security must be significantly undervalued relative to its current market price. Seth Klarman best explains why investors must seek a margin of safety: “It follows that value investors seek a margin of safety, allowing room for imprecision, bad luck, or analytical error in order to avoid sizable losses over time. A margin of safety is necessary 3

because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes. It is adherence to the concept of a margin of safety that best distinguishes value investors from all others, who are not as concerned about loss.”5 [emphasis added] Graham was fond of saying, if you are not investing for value, then you are speculating. A key insight imbedded in margin of safety is that value is independent of price. It was Oscar Wilde who said beware “a man who knows the price of everything and the value of nothing.” In other words, price is what you pay, value is what you get. Separating price from value helps value investors’ deal with the mood swings of the market 6. Prices may change daily, but value is created over time.7 Investors will have an advantage if they determine value first. This approach allows investors to then dispassionately wait for the market price to signal a deep discount to the pre-determined value. As all value investors know, you simply cannot create opportunities when they are not there. Investors can, however, exercise patience by tuning out the noise. By determined value ahead of time, investors reduce the risk of making cognitive mistakes that are the Achilles heel of decision making. As Buffett said, “be greedy when others are fearful.”

Principle #3 – Reversion to the Mean The third principle of value investing is closely linked to margin of safety and is known as reversion to the mean. The idea is simply that value and price tend to converge over time. 8 Ben Graham recognized its importance and chose the words of Roman poet, Horace, as the epigraph to his classic, The Intelligent Investor: “Many shall be restored that now are fallen and many shall fall that now are in honor.” –Horace, Arc Poetica In investing terms, Legg Mason strategist Michael Mauboussin defines reversion to the mean as “an event that is not average will be followed by an event that is closer to the average.” 9 Investors have a tendency to systematically overpay for growth and underpay for value. This happens because there is a tendency to extrapolate near-term results into the future ignoring longer-term trends, which are referred to as base rates in statistics. In the short-term, the market exhibits manic-depressive characteristics, but in the longterm, the market is less emotional and driven more by fundamentals.

Mr. Market’s behavior creates regular price/value discrepancies in the short-term.10 A patient investor can exploit this price/value mismatch by engaging in what is referred to as time arbitrage. As Buffett’s philosophy evolved from Ben Graham to Philip Fisher, so did his appreciation of time’s impact on a good business: “Time is the friend of a wonderful business,” Buffett noted, “the enemy of the mediocre.”

Time arbitrage is very difficult for professional investors to practice. It is not coincidental that as the investment profession has been turned into a business over the past thirty-plus years, so too has the average holding period on Wall Street fallen from roughly seven years to seven months. The majority of Wall Street is caught-up in the “short-term performance derby.”11 Many professional investors fear career risk and have an action bias.12 These factors create frequent opportunities for patient investors who follow the value principles with discipline to uncover winning ideas.

Principle #4 – Risk as the Permanent Loss of Capital 4

The fourth principle that value investors share is their thinking on risk. Value investors define risk as the permanent loss of capital. Buffett is famous for saying, “The first rule of investing is don’t lose money; the second rule is don’t forget Rule No. 1.” Risk is neither uncertainty nor (price) volatility. Modern Portfolio Theory, which was developed by Eugene Fama and others at the University of Chicago, directly-related risk and price performance. In the context of the strong efficient market theory (EMT), this has some validity. And since value strategies have been proven to outperform, the logical extension is that value strategies are more risky. However, value investors have a different explanation. Supported by research in behavior finance, value investors link value strategies’ outperformance to a common set of biases that prevent most investors from behaving sensibly. Value investors take a more pedestrian view of risk preferring to define it as the reasoned probability that an investment loses its purchasing power over the contemplated holding period.

Principle #5 - Discipline The fifth principle of value investing is the discipline to guard against the inevitable biases we bring to the decision-making process. Pogo was right, “We have met the enemy and he is us.” This principle is as important as margin of safety in investing. Even if you intuitively understand the principles and logic behind value investing, maintaining and sustaining your discipline will prove enormously challenging.

As Buffet said, “The most important quality for an investor is temperament, not intellect... You need a temperament that neither derives great pleasure from being with the crowd or against the crowd.”13 BEHAVIORAL PITFALLS The primary reason most investors fail to follow the principles of value investing is due to behavioral missteps. Later, we will examine techniques value investors can use to sidestep common decision traps.

Buffett said, “Investing is simple, but not easy.”14 In other words, the concept that we should pay less for an asset than it is really worth is the easy part, but not letting our emotions and biases influence our choices is hard.

That the value phenomenon persists despite its principles being readily available is best explained by cognitive traps. Not surprisingly, Ben Graham was an early pioneer in recognizing this: “Our main objective will be to guide the reader against the areas of possible substantial error and to develop policies with which he will be comfortable. We shall say quite a bit about the psychology of investors. For indeed, the investor’s chief problem—and even his worst enemy—is likely to be himself.”15 [emphasis added] The effects of behavioral bias have historically been under-appreciated and under-taught. To be sure, investors are becoming much more aware of the systematic errors they make due to the research of Daniel Kahneman and his long-time collaborator Amos Tversky. Kahneman, a trained psychologist, was awarded the Nobel Prize in Economics in 2002. He and Tversky provided the empirical evidence that not only do decision-makers sometimes display irrational behavior—especially under the cloud of uncertainty—but also that we are often lazy thinkers16.

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Seth Klarman said, “Psychological influences are a dominating factor governing investor behavior. They matter as much as—and at times more than—underlying in determining security prices.”17 [emphasis added] As long as investors have cognitive biases, contrarian, mean reverting investment strategies will create opportunities for value investors to consistently exploit.

On the one hand, discipline is required because the market is not always efficient. On the other, patience is required because sometimes the market is efficient. Warren Buffett captured this best in his 1998 Letter to Berkshire Shareholders: “Observing correctly that the market was frequently efficient, [academics and Wall Street pros] went on to conclude incorrectly that it was always efficient. The difference between those propositions is night and day.”18 The “Market” occasionally quotes prices that reflect its emotional state-of-mind rather than the facts.

Value investors can take advantage of this mismatch between price and value. For example, investors’ persistently overvalue glamour stocks and undervalue ugly, boring and unfashionable stocks, thus creating opportunities on the short and long side. Value investors are careful not to “throw the baby out with the bath water.”

All investors now and then will fall victim to behavioral pitfalls. That’s the bad news. The good news is research shows many traps are systematic, meaning decision makers can learn to overcome them.

Developing and implementing a good process is the surest way to improve outcomes.

PROCESS19 “Even once we are aware of our biases, we must recognize that knowledge does not equal behavior. The solution lies in designing and adopting an investment process that is at least partially robust to behavior decision-making errors.”—James Montier, author and top-rated strategist “One should not appraise human action on the basis of its results” –Bernoulli Process is defined as a series of actions or steps taken in order to achieve a particular end. Having a welldefined, thoughtful process is so important in value investing because outcomes never tell the whole story and behavioral biases complicate reaching good decisions. Process is about getting to consistently good decisions.

Much of what we understand about good decision making has been learned in the past thirty-plus years.

In their wonderful book, Decisive: How to Make Better Choices in Life and Work, Chip and Dan Heath explain that good decision making is about exploring alternative points of view, recognizing uncertainty and searching for evidence that contradicts our own beliefs. The enemy of good decision making is clearly behavioral.20 Humans are cognitive misers21—we too often substitute intuition and instinct for logic and reason and we overly rely on heuristics or mental shortcuts such as narrow framing, availability bias, confirmation bias, overconfidence and hindsight bias.22 Daniel Kahneman in his marvelous book, Thinking, Fast and Slow, found that “The normal state of your mind is that you have intuitive feelings and opinions about almost everything that comes your way.”23 Unfortunately, in most situations, intuition and repetition are 6

unreliable teachers’ at best and at worst poor substitutes for following a well-defined decision-making process.24 The following steps will help an investor make better decisions. 25 Step #1 – Accurately Assess the Situation First, a decision maker needs to assess the situation. A good decision maker must accurately “frame” the question being addressed. Poor decision makers tend to define problems in ways that cause them to overlook their best options.26 Step #2 – Gather Information and Consider It Thoroughly Second, a decision maker must gather needed information and consider it thoroughly. During this phase, the decision maker must recognize there is always a level of uncertainty in the process. Rather than spending hours on collecting endless amounts of information, decision makers need to spend more time on information that is actually important. In investing, there are usually two or three important drivers.

Jay Russo and Paul Schoemaker, authors of Winning Decisions, note that decision makers often believe, incorrectly, that more information provides a clearer picture of the future and therefore improves the process. In reality, additional information often only confuses the process and more often than not leads to overconfidence. Decision makers also may fail to collect key information because they have too much confidence in their own judgments.27 Step #3 – Appreciate that the Future will have a Range of Possible Outcomes Third, a decision maker needs to think of the future not as a point outcome, but as a range of potential outcomes. Decision makers who reject absolutes in favor of probabilistic outcomes tend to reach better conclusions. As Michael Mauboussin said in his fascinating book, More Than You Know, “investors need to train themselves to consider a sufficiently wide range of outcomes.”28 If we analyze alternative points of view, then we reduce the effects of availability and confirmation bias. Good decision makers need to actively look for dis-confirming information and thus minimize confirmation bias. We need reminders to focus our attention on options we otherwise might have missed and resisted or overlooked and ignored.

We tend to jump to conclusions that are readily available, failing to consider information that is “just offstage.”

Step #4 – Learn from Experience Lastly, good decision makers learn from experience. Hindsight bias (selective memory) makes learning difficult. As decision makers, we have a tendency to pat ourselves on the back when things work out, but blame (bad) luck when things don’t. This works to protect our fragile egos, but it doesn’t do anything to make us better decision makers. Rather, it is a misunderstanding of the roles of skill and luck and fails to consider the process used to reach such decisions/outcomes. For many untrained decision makers, Kahneman said, “what you see is all there is.”

PROCESS VS. OUTCOME “Individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better overall results, and more thoughtful decision-making 7

can be encouraged by evaluating decisions on how well they were made rather than on outcome.” –Robert Rubin, Harvard Commencement Address, 2001 “The quality of the decision can be evaluated by the logic and information I used in arriving at my decision. Over time, if one makes good, quality decisions, one will generally receive better outcomes...”

–Jeffrey Ma, a leader of MIT’s blackjack team Jay Russo and Paul Schoemaker in Winning Decisions illustrate the process-versus-outcome message with a simple two-by-two matrix. The matrix makes clear that outcomes should not be blindly substituted for determining whether a process is good or bad. The authors point out that a good process can lead to “deserved success” or a “bad break,” whereas a poor process can lead to “dumb luck” or “poetic justice.”

The point is that because of probabilities, good decisions will sometimes lead to bad outcomes, and bad decisions will sometimes lead to good outcomes.29 Over the long haul, however, process dominates outcome.

When it comes to investing, Michael Mauboussin is a leader in bridging the academic and practical divide. Here is what he had to say about investors who make good decisions: “First, they focus on process and not outcomes. In other words, they make the best decisions they can with the information they have, and then let the outcomes take care of themselves. Second, they always seek to have the odds in their favor. Finally, they understand the role of time. You can do the right thing for some time and it won’t show up in results. You have to be able to manage money to see another day—that is, preserve options for future play—and take a longterm view.”30 There are three things that influence outcomes. The first is the thinking and decision process or “deciding.” The second is the implementation and other factors under our control or the “doing.” And the third is chance, which is uncontrollable or “luck.”31 As much as we hate to admit it, luck plays a role in all activities.31 To see this, ask yourself if you can fail on purpose. If you can’t, then you know luck is involved in outcomes. Investors who fail to appreciate the role of luck in outcomes are less likely to have a good process.

In More Than You Know, Mauboussin concludes: “Luck may or may not smile on us, but if we stick to a good process for making decisions, then we can learn to accept the outcomes of our decisions with equanimity.”32 GOOD DECISION-MAKING TECHNIQUES There are several simple, but extremely effective actions a value investor can take to immediately improve outcomes over time. These techniques will help minimize human error in reaching positive outcomes.

Technique #1 – Keep a Decision Journal The first technique is to keep a decision journal. Daniel Kahneman was asked what a person could do to improve his decision-making process. His answer was simple: visit a corner drugstore, buy a 10₵ notebook and write down your decisions. An analyst should write down what they expect to happen, why 8

they expect it to happen, the “analysis,” and even how they feel about it, emotionally and physically Moreover, concerns, objections and alternatives should be noted. A diary provides accurate and honest feedback and helps prevent hindsight bias. Kahneman recognized that the feedback a journal could provide is the single most powerful way to improve differential skill.33 Technique #2 – Use a Checklist The second is to develop and use a checklist.34 A checklist is a series of steps, a list, which must be done before proceeding. Checklists should be short, the rule of thumb—no more than 5-9 items and fit onto one page. The language should be simple, exact, and familiar to the users. Checklists are best when they try to identify, prevent and solve problems. 35 In decision making, it’s vital to collect and analyze data properly to be effective. I have included a sample checklist for investing in Appendix B. Technique #3 – Pre-mortems The third is the use of pre-mortems. Social psychologist Gary Klein who developed the idea of a premortem highlights three benefits. First, they stop decision makers from focusing on a single—usually optimistic—outcome about how the future will unfold. Second, they compel decision makers to pay attention to uncertainty surrounding their decision. And third, they counteract overconfidence. 36 As John Maynard Keynes said, “The difficulty lies not so much in developing new ideas as in escaping from old ones.”

Technique #4 – Prospective Hindsight The fourth is the use of prospective hindsight described by Chip and Dan Heath in Decisive. Prospective hindsight is like pre-mortems in that it works backward from a certain future. The idea is to ask what had to be true for this outcome to be realized or unrealized. It spurs more insight by forcing a decision maker into filling in the blanks between today and the future event rather than speculating about an event that may or may not happen. By doing so, it usually improves explanations for why events might happen.

Technique #5 – Counterfactual Thinking The fifth technique is the use of counterfactual thinking. A big problem in decision making is once we know what happened hindsight bias naturally envelops us. One way to avoid this is to engage in counterfactual thinking—a careful consideration of what could have happened, but didn’t. History is largely a narrative of cause and effect.37 After the fact, the connections that appear (perceive) as hardened fact (reality), so we must make a distinct effort to consider how things could have turned out differently.

THE FOUR VILLIANS OF DECISION MAKING As Ben Graham said, “You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”38 In their book Decisive, Chip and Dan Heath list their version of the "four villains of decision making,” which, not surprisingly, are common behavioral mistakes. These four decision traps are: narrow framing, confirmation bias, short-term emotional dependence and overconfidence. As decision makers, we tend to spotlight one alternative at the expense of others. Charlie Munger once said, “To a man with a hammer, every problem looks like a nail.” The danger of confirmation bias is obvious, but deceptively difficult to 9

overcome. We tell ourselves we are interested in the truth and gathering information always seems scientific, but secretly we want reassurance and the data may be distorted. Next, our emotions tend to fail us when we need them most. Lastly, we tend to think we know more than we really do about how the future will unfold.39 As decision makers we tend to be overconfident in our predictions. For these reasons, I’d like to repeat what Seth Klarman said about margin of safety: “It follows that value investors seek a margin of safety, allowing room for imprecision, bad luck, or analytical error in order to avoid sizable losses over time. A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes. It is adherence to the concept of a margin of safety that best distinguishes value investors from all others, who are not as concerned about loss.”40 [emphasis added] PROCESS & INVESTING Benjamin Graham and David Dodd wrote in their classic text, Security Analysis, “the careful study of available facts with an attempt to draw conclusions therefrom based on established principles and sound logic”41 is the basis for good decision making. They preached a descriptive, critical and selective threestep process consisting of gathering facts intelligently, examining the merits of standards and passing judgment on the attractiveness of the security. 42 In many ways, their process is remarkably similar to those described by researchers of decision making several decades later.

In the context of making quality investment decisions, analysts are likely to find the gathering information phase the most important. The legendary short-seller, Jim Chanos, teaches his analysts to start with the source documents—the SEC filings—then go to the press releases, earnings calls and other research. In other words, “work your way out [since] most people work their way in.” 43 In this way, the analyst will have the advantage of looking at the most unbiased sources first. Chanos went on to say, “people on earnings calls will try and spin things, and analyst reports will obviously have a point of view. All of that is fine, because hopefully you will have first read the unvarnished facts.”44 A good decision making process will avoid relying on intuition when making investment decisions.

Intuition works well in predicable environments where there is lots of repetition and quick, accurate feedback of your choices. Intuition breaks down in complex adaptive systems like the stock market. 45 We cannot control outcomes, which always have an element of skill and luck. But we can control the quality of our decisions by following a well-defined, thoughtful process. It is only when the tide goes out that we discover who has been swimming naked. 46 DETERMINING VALUE “I’d prefer to be approximately right rather than precisely wrong.” –John Maynard Keynes You don’t need to know a man’s exact weight to know he’s fat.” –Benjamin Graham Academics define value according to common financial ratios like low price-to earnings (P/E), low bookto-value (B/V) and low price-to-cash flow (P/CF). Investors may find these metrics useful for screening, but they offer little in the way of actually determining value. Value investors seek value chiefly through the principle of margin of safety. However, the concept does not describe how value is to be determined.

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Financial analysis—determining value—is not an exact science. Yet, there are well-understood and timetested methods to reach an accurate picture of value.47 A value investor’s approach to determining value involves three steps—an analysis of the balance sheet, a review of a company’s sustainable earnings power, and an understanding of the future growth potential 48.

Columbia University professors Bruce Greenwald and Stephen Penman deserve credit for outlining this process: Book Value (BV) + Current Earnings + Future Earnings = Intrinsic Value An analyst should start with the most reliable information first: the balance sheet. The balance sheet records a company’s assets and liabilities. The difference between the two can provide us a foundation for determining value. A security that has significant net assets may provide the greatest margin of safety. Graham is famous for looking for net-net securities—the proverbial dollar for 50 cents. A net-net is a security that trades at a discount to its current assets minus all liabilities. In theory, a company with a conservative book value above its market price could be dismantled and sold-off for profit.

After a thorough review of a company’s balance sheet, an analyst will want to review its sustainable earnings power.49 Most value investors define sustainable as average earnings over a complete business cycle, which usually means between five and ten years. In Graham’s words, “The record must be over a number of years, first because a continued or repeated performance is always more impressive than a single occurrence, and secondly because the average of a fairly long period will tend to absorb and equalize the distorting influences of the business cycle.” 50 One reason value investors use an average of historical earnings rather than a point estimate is conservatism. In Graham’s opinion: “What the investor chiefly wants to learn…is the indicated earnings power under the given set of conditions, i.e. what the company might be expected to earn year after year if the business conditions prevailing during the period were to continue unchanged.” 51 The third step in determining value looks at a company’s future growth potential. A value investor is reluctant to assign too much value to growth because the future is uncertain. There are several factors that will impact a company’s future earnings such as the industry dynamics, competition and the business’s economic moat.52 A technology company’s future is typically more uncertain than a consumer products company. It’s the analyst judgment to determine how to account for this uncertainty in the valuation analysis.

INVESTMENT OPPORTUNITIES In broad terms, there are two types of investment opportunities from which determining value should be applied. The first is non-franchise or deep value, sometimes referred to “cigar-butt” investing. There is a saying: “There are no good or bad horses, just correctly and incorrectly priced ones.” These cast-offs can make very profitable investments, but usually require great care and attention. 53 The second type is referred to as franchise opportunities and often are “core” holdings within a value portfolio. Buffett learned that “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful 11

price.” Franchises tend to have strong economic moats often associated with defensible brands that provide for real pricing power.54 There’s a reason Buffett said his favorite holding period is “forever.”

There are occasions when franchises sell at cigar-butt type prices with the Great Depression and the 2008 financial crisis being two that easily come to mind, but situations like these tend to be rare.

Non-franchise and Franchise opportunities require a different level of margin of safety. The first approach popularized by Graham is almost a statistical (purely quantitative) way to uncover mispricing.

A limitation of cigar-butt investing is the once the last few puffs have been exhausted, there is no more value to be gained. The second approach popularized by Philip Fisher and Charlie Munger incorporates more qualitative factors such as management integrity and competence. The key insight into franchise companies is their moats allow for expanding intrinsic value over time. Incidentally, Buffett considers himself 85% Graham and 15% Fisher.

An analyst will do well to keep in mind the first axiom of value investing when determining value: think like a business owner. Although the “numbers” visually represent the difference between value and price, a thorough analysis of the value “drivers” is important. This is another way to say having a good decision-making process is essential to realizing better outcomes. As competitive analysis guru, Michael Porter recently said, it is the person who can “understand what determines the fundamental economic value creation…and how it [may] change [that] gains a huge edge.”55 CYCLES The philosopher Santayana once said: “Those who cannot remember the past are condemned to repeat it.”

Value investors can learn a great deal from past market cycles. Where the economy is in the business cycle56 does influence how aggressive or conservative investors should be with allocating their precious capital. In short, cycles matter.

Oaktree’s Howard Marks has done outstanding practical work in understanding and interpreting cycles and their influence on the market. His chairman’s letters are a must read. 57 An investor needs an awareness of stock market history, in particular the causes and effects of major fluctuations. As Mark Twain was fond of saying, “History doesn’t repeat itself, but it does rhyme.” In other words, the past is not a perfect reproduction of the future, but it does provide a workable template for better decision making. Having this knowledge will greatly help a value investor form a worthwhile judgment on the opportunities and dangers present in the current market.58 Value Investors, then, ignore the market’s current status at their own peril. Even worse are investors’ who feign indifference and somehow believe they can change the conditions of the market. These investors are setting themselves up for disappointment and greater risk of permanent loss of capital. 59 Investors have control over the process, but lack control of market prices and their direction.

Marks systematizes his thought-process on cycles in his book, The Most Important Thing. His checklist, partially reproduced here, is a perfect starting point to analyzing cycles. 60 Is the economy vibrant or sluggish?

Is the outlook positive or negative?

Are lenders acting eager or reticent?

Are the capital markets loose or tight?

Is capital plentiful or scarce?

Are credit terms easy or restrictive?

Are interest rates low or high?

Are interest rates headed higher or lower?

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Are credit spreads narrow or wide?

Are investors acting optimistic or pessimistic?

Are investors eager to buy or uninterested?

Are markets crowded or starved for attention?

Are risk attitudes aggressive or conservative?

Is the popular press bullish or bearish?

According to GMO’s James Montier, “knowing where you are in a cycle and what that implies for the future is different from predicting the timing and shape of the cyclical move.”61 FORECASTS OR PREDICTIONS “Makings predictions is difficult, especially about the future.”—Yogi Berra, New York Yankees Catcher “You can only predict things after they've happened.” —Eugene Ionesco “We may not be able to predict, but we can prepare.” —Howard Marks When asked about what will happen with the economy, Graham would quip, “The future is uncertain.”

There is an important distinction between understanding and appreciating cycles and forecasting and predicting. Value investors resist the temptation to predict the future direction of the market. On the other hand, Klarman said, “Speculators are obsessed with predicting-guessing the direction of stock prices.”62 In his fascinating book, The Signal and the Noise, Nate Silver distinguishes between predictions and forecasts. He defines a prediction as “a definitive and specific statement about when and where something will occur,” and a forecast as “a probabilistic statement, usually over a longer time scale.” A good process incorporates the possibility of a variety of outcomes rather than thinking of the future as a single possible outcome. As Kahneman said in Thinking, Fast and Slow, “The uncritical substitution of plausibility for probability has pernicious effects on judgment when scenarios are used as tools of forecasting.”63 Kahneman, with his training in statistics and psychology, would certainly agree with legendary Canadian value investor, Peter Cudhill, who once remarked, “I think that the financial community devotes far too much time and mental resource to its constant efforts to predict the economic future and consequent stock market behavior using a disparate, and almost certainly incomplete, set of statistical variables.”64 Cudhill went on to conclude the following: “I think that intelligent forecasting (company revenues, earnings, etc.) should not seek to predict what will in fact happen in the future. Its purpose ought to be to illuminate the road, to point out obstacles and potential pitfalls...Forecasting should be used as a device to put both problems and opportunities into perspective… [I]t can never be a substitute for strategy, nor should it ever be used as the primary basis for portfolio investment decisions.”65 INVESTING VS. SPECULATION

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“Speculators…buy and sell securities based on whether they believe those securities will next rise or fall in price. Their judgment regarding future price movements is based, not on fundamentals, but on a prediction of the behavior of others. They regard securities as pieces of paper to be swapped back and forth and are generally ignorant of or indifferent to investment fundamentals. They buy securities because they "act" well and sell when they don't.”66 –Seth Klarman Value investors do not follow fads, confer with charts or succumb to speculation. Speculation is a form of the greater fool’s theory.67 A value investor refuses to play a game where there is equal chance for success as failure. A value investor’s edge is exercising patience by following the value principles with discipline and not deviating from a thoughtful process.

The likes of Buffett and Klarman recognize the foolishness of the institutional imperative 68 and bias toward being active in the market. In Margin of Safety, Seth Klarman wrote that, “most institutional investors…feel compelled...to swing at almost every pitch and forgo batting selectivity for frequency.” 69 A value investor will easily forgo profit opportunities if it means investing in overpriced glamour stocks or the latest hot trend. In investing, you simply cannot create opportunities where they don’t exist.

Warren Buffett famously said there are no called strikes in investing: “Unlike baseball, investing does not have any called strikes...the investor can take pitches all day long and not have to swing because there are no called strikes...”70 Value investors view risk as the permanent loss of capital. Beta and Sharpe ratios are alien concepts that only serve the institutional imperative of sameness, which is another way of saying average performance.

Value investors recognize that the proliferation of real-time information and the twenty-four news cycles are destructive to returns. The more time an investor spends monitoring tickers, the shorter their investment horizon and the less they spend on learning about industries, companies and competition.71 CONCLUSION “The phrases thorough analysis, promises safety, and satisfactory return are all chargeable with indefiniteness, but the important point is that their meaning is clear enough to prevent serious misunderstanding.”72 [italics in original] –Benjamin Graham “Discovery consists in seeing what everyone else has seen and thinking what no one else has thought.”— Albert Szent-Györgyi, 1937 Nobel Prize for Medicine Seth Klarman said a value investor is “a contrarian with a calculator.” Value investors only transact when they think they know something that others don't know, don't care about, or prefer to ignore. Value investors believe that over the long run security prices tend to reflect fundamental developments involving the underlying businesses (reversion to the mean). The greatest challenge a value investor faces is maintaining the required patience and discipline to buy only when prices are attractive (margin of safety) and to sell when they are not, avoiding the short-term performance frenzy that engulfs most market participants.73 How well you do in investing over time will boil down to what you buy and how much you pay for it.

Michael Porter said, “The worst mistake in strategy is for a company to compete with its rivals on all the same things.” The same could be said for successful investing. As Buffett said, 14

“Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.”74 A value investor must enjoy and be good at analyzing business strengths and weaknesses. As it turns out, many investors simply don’t do their homework. After all, “Noah did not start building the Ark when it was raining.”

A value investor must adhere to the principles of value investing and follow a well-defined process that recognizes the cognitive traps that ensnare even the most seasoned of decision makers. By conducting a thorough analysis of the fundamentals and seeking an appropriate margin of safety, a value investor can expect a satisfactory return on their investment. A simple approach is practicing time arbitrage, which avoids the short-term performance derby played by much of the investment community.

Value investors are most likely to error in one of two ways.75 The first is in their estimation of value. For this reason, Benjamin Graham gave us the central concept in value investing: margin of safety. The second is an error of judgment. For this reason, a value investor must have a process.

In investing, a common question is what is your edge and why is it sustainable? If I have done my job, this paper has answered that question. It seems appropriate that the last word be given to the man most credited with laying the groundwork for future generations of value investors, Ben Graham, “If you believe that the value approach is inherently sound then devote yourself to that principle.

Stick to it, and don’t be led astray by Wall Street’s fashions, illusions and its constant chase after the fast dollar. Let me emphasize that it does not take genius to be a successful value analyst, what it needs is, first, reasonably good intelligence; second, sound principles of operation; and third, and most important, firmness of character.”76

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NOTES 1. Academic research has shown consistently that value investing, typically defined by low price-toearnings, low price-to-book or low price-to cash flow, outperforms other investment styles. See, for example, Athanassakos [2011]; Chan and Lakonishok [2004]; Fama and French [1998]. And see the following link: http://www8.gsb.columbia.edu/ideas-at-work/publication/764/what-do-financialeconomists-have-to-say-about-value. According to Columbia business school professor, Tano Santos, “using monthly data stretching back more than four decades, we find that the average (annualized) monthly return of the extreme growth portfolio is about 3.8 percent. Instead the average (annualized) monthly return of the extreme value portfolio is a whopping 10.9 percent.”

2. Warren Buffett. Chairman’s Letter to the Shareholders of Berkshire Hathaway Inc., 1992.

3. Seth Klarman, Margin of Safety: Risk-Adverse Value Investing Strategies for the Thoughtful Investor (New York, NY: HarperBusiness, 1991).

4. For example, a business owner would not look to sell their business because it lost money in a single quarter, lost a key customer, or if there was a shift in interest rates. Business owners tend to think about strategy, operational excellence and execution. They tend to make investment decisions based on returns (ROIC) and think long-term. Buffett said thinking like an owner “gives you an entirely different view than most people who are in the market.”

5. Seth Klarman, Margin of Safety: Risk-Adverse Value Investing Strategies for the Thoughtful Investor (New York, NY: HarperBusiness, 1991).

6. Benjamin Graham, The Intelligent Investor, Fourth Revised Edition (New York, NY: Harbor & Row, 1973). Graham introduced value investors to the concept of “Mr. Market” in his 1949 text of the Intelligent Investor, but the idea that price quotations are based more on psychological factors than business fundamentals has a long history. In fact, G.C. Selden, a fellow at Columbia University, wrote a book called Psychology of the Stock Market that described a “they” theory of the market, which is quite similar to Graham’s Mr. Market. It is Mr. Market’s mood swings from euphoria to despondence that create the very opportunities for value investors to take advantage of.

7. Graham recognized that the market “in the short run is a voting machine, but in the long run, it is a weighing machine” (The Intelligent Investor). In The Warren Buffett Way, Robert Hagstrom says his “research shows the greatest opportunity to bag excess returns occurs after three years.”

8. “Fama and French [2000] found that profitability (measured as earnings found over total assets) was mean reverting at the rate of 40% per annum. They also found ‘that the rate of mean reversion is higher when the profitability is far from its mean, in either direction.’ James Montier, Value Investing (Hoboken, NJ: John Wiley & Sons, 2009), Pages 100-101.

9. Michael Mauboussin, The Success Equation: Untangling Skill and Luck in Business, Sports and Investing (Boston, MA: Harvard Business Review Press, 2012); “Any activity that combines skill and luck will eventually revert to the mean.” Michael Mauboussin, More Than You know (New York, NY: Columbia University Press, 2006), Page 27.

10. Short-term is defined differently by different people and in different context. One month is short in comparison to one year; one year is short in comparison to ten years; and ten years is the short-term in comparison to one hundred years.

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11. The phrase “short-term performance derby” should be credited to either strategist James Montier or Seth Klarman. Incredibly, the 1960 annualized value-weighted NYSE/AMEX turnover was < 10%, whereas today the ratio is > 300% (Hagstrom). An investor has a real “edge” by exploiting time arbitrage. An investor who thinks and acts long-term will avoid competing with the vast majority of Wall Street pros.

12. Professional investors worry that acting boldly—taking contrarian, non-consensus points of view will expose themselves to the risk of being fired by their employers or terminated by their clients. As a result, many “agents” moderate their actions to uncontroversial (consensus) ideas. Many professional investors feel compelled to take action in order to justify their high fees. Unfortunately for their clients, this is often detrimental to performance. A Morningstar report reviewing 3,650 domestic equity funds found that over a ten-year period those funds with < 20% turnover ratios had 14% higher returns than those funds with turnover ratios > 100%.

13. Warren Buffett in one of Chairman’s Letters to Berkshire Shareholders 14. John Burr Williams in his 1938 book, The Theory of Investment Value, describes the discounted cash flow (DCF) method to valuing stocks. He said, “The value of any stock, bond or business today is determined by the cash inflows and outflows—discounted at an appropriate interest rate—that can be expected to occur during the remaining life of the asset.” This has become the standard approach to valuing any financial asset. It seems simple enough to understand an asset is worth the sum of its future cash flows discounted back to the present, but then it’s not easy to accurately estimate the future or decide on a fair discount rate.

15. Benjamin Graham, The Intelligent Investor, Fourth Revised Edition (New York, NY: Harbor & Row, 1973).

16. Psychologists have divided our cognitive process into two parts—System 1 and System 2. Our System 1 thinking is intuitive, meaning it’s “quick and associative.” This type of thinking is simple and straightforward as it takes little time and not much intellectual work to retrieve answers.

Unfortunately, System 1 will often answer a different question than the one being asked due to its associative, quick process. Our System 2 thinking is governed by reason, meaning it’s “slow and rule-governed.” This type of thinking is reflective and operates in a controlled manner that requires a fair amount of real effort. System 2 can monitor System 1; however, it has a poor record of this.

Studies show most individuals are not accustomed to thinking hard and instead rush to the most plausible answer that comes to mind. As Keynes said, “It’s not thinking about new ideas that is difficult, it’s escaping the old ones.” For System 2 thinking to work, a decision maker must allocate time for deliberation and meditation. Buffett once said, “I insist on a lot of time being spent, almost every day, to just sit and think. That is very uncommon in American business. I read and think. So I do more reading and thinking, and make less impulse decisions than most people in business. I do it because I like this kind of life." Gary Klein in Sources of Power lists the parameters when System 2 is most likely to fail to overrule System 1. Here is that list: When the problem is ill structured and complex. When information is incomplete, ambiguous and changing. When the goals are ill defined, shifting or competing. When the stress is high, because of either time constraints and/or high stakes involved. When decisions rely upon an interaction with others. For more on System 1 and System 2, an investor will do well to read Daniel Kahneman’s Thinking, Fast and Slow.

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17. Klarman, Seth A. Margin of Safety: Risk-Adverse Value Investing Strategies for the Thoughtful Investor. New York, NY: HarperBusiness, 1991.

18. Warren Buffett. Chairman’s Letter to the Shareholders of Berkshire Hathaway, Inc., 1998.

19. A person who wants to make consistently good decisions cannot underestimate the importance of process. Phil Rosenweig’s The Halo Effect addresses several important questions that can improve decision making. These questions are: Has the right information been gathered or has some important data been overlooked? Are the assumptions reasonable and conservative? Or have they been flawed? Were the calculations accurate or has there been errors? Has a full set of eventualities been identified and their impact estimated? And had the overall risk portfolio been considered? In addition, Chip and Dan Heath’s Decisive also addresses important questions a decision maker should answer before coming to an intelligent conclusion: Am I gathering information or simply fishing for support of my decision? What would have to be true for this option to be the best option? What could go wrong and why? In Decisive, the authors tell of a study conducted by Dan Lovallo, a professor at the University of Sydney and Olivier Sibony, a director at McKinsey. The two researchers investigated over 1,000 business decisions over a period of five years tracking both the process and the outcomes in terms of revenues, profits and market share. The researchers found that in most cases rigorous analysis was conducted. In addition, they asked the teams about their decision making process: “Had the team explicitly discussed what was still uncertain about the decision? Did they include perspectives that contradicted the senior executive’s point of view? Did they elicit participation from a range of people who had different views of the decision?” When they compared whether the process or analysis was more important in producing good decisions—those that increased the above—found that process mattered more than analysis—by a factor of six. [italics mine] 20. Heath, Chip, Dan Heath. Decisive: How to Make Better Choices in Life and Work. New York, NY: Crown Business, 2013.

21. Keith Stanovich, a professor of human development and applied psychology at the University of Toronto said, “Humans are cognitive misers because our basic tendency is to default to the processing mechanisms that require less computational effort, even if they are less accurate.”

22. See Appendix A for a list of the many heuristics that psychologists have identified as causing serious problems with our logical reasoning process including the five mentioned here: narrow framing, availability bias, confirmation bias, overconfidence and hindsight bias.

23. Kahneman, Daniel. Thinking, Fast and Slow. New York, NY: Farrar, Straus and Giroux, 2011.

24. Research demonstrates that to reach an expert level in any activity takes “deliberate practice.”

Deliberate practice requires an unusual amount of concentration and a feedback loop that accurately reflects cause and effect. Two examples where this works well are the game of chess and learning to play an instrument. In these activities experience serves intuition. However, the stock market has reflexive properties. Since outcomes reflect controllable and non-controllable variables, the feedback loop is often broken. Therefore, intuition should not be relied upon with any amount of confidence.

It becomes a form of System 1 thinking; a short cut that shortchanges our rational thinking mind.

25. Russo, Edward J. and Paul J.H. Schoemaker. Winning Decisions: Getting it Right the First Time.

New York, NY: Doubleday, 2002.

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26. A good example is asking an interviewer his/her perception of the company’s work/life balance. This question is likely to receive an answer short on the real details the interviewee is really searching for.

Instead, the interviewee should ask how many days per week do you arrive home to have dinner with your family, which is likely to provide a much better idea of the balance between work and life.

27. Russo, Edward J. and Paul J.H. Schoemaker. Winning Decisions: Getting it Right the First Time.

New York, NY: Doubleday, 2002.

28. Mauboussin, Michael J. More than You Know: Finding Financial Wisdom in Unconventional Places.

New York, NY: Columbia University Press, 2006.

29. Russo, Edward J. and Paul J.H. Schoemaker. Winning Decisions: Getting it Right the First Time.

New York, NY: Doubleday, 2002.

30. Mauboussin, Michael J. The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing. Boston, MA: Harvard Business School Press, 2012.

31. Michael Mauboussin in his very entertaining book, The Success Equation, addresses the role of skill and luck in determining outcomes. A quick way to tell the role of skill and luck in outcomes, Mauboussin writes, is to ask if you can lose on purpose. If you can, then skill plays a more significant role. If you can’t, then luck is involved in the outcome.

32. Mauboussin, Michael J. More than You Know: Finding Financial Wisdom in Unconventional Places.

New York, NY: Columbia University Press, 2006. Page 10 33. Michael Mauboussin deserves much of the credit for this story.

34. See Appendix B for a sample investment checklist 35. Gawande, Atul. The Checklist Manifesto: How to Get Things Right. New York, NY: Metropolitan Books, 2009.

36. Klein, Gary. The Power of Intuition. New York: NY: Doubleday, 2004.

37. Perhaps the most seductive of all the mental mistakes we are likely to make is the narrative fallacy— the telling of a good story. Humans are social animals and have a long history of communicating through storytelling. As such we are poor at seeing statistical realities: we abandon evidence in favor of plausibility. Nassim Taleb writes, “The fallacy is associated with our vulnerability to overinterpret and our predilection for compact stores over raw truths.” Kahneman writes in Thinking, Fast and Slow that humans are pattern seeking and therefore desire explanations even for unexplainable events. We distrust chaos and disorder…we demand answers. And in the absence of certainty/truth, we are willing to accept anything plausible…we are acutely uncomfortable and anxious in the face of uncertainty, so much so that we are willing to listen to those who promise to alleviate that anxiety. Investors must be attuned to the slippery slope of narratives. Storytelling inadvertently increases our confidence in propositions as the story itself becomes its own proof. The illusion of understanding is hard to overcome—flawed stories of the past shape our views of the world and our expectations of the future. Taleb writes, “narrative fallacies arise inevitably from our continuous attempt to make sense of the world.” Kahneman said, “The ultimate test of an explanation is whether it would have made the event predictable in advance. The human mind does not dell well with nonevents." The core of the illusion is that we believe we understand the past, which implies that 19

the future also should be knowable, but in fact we understand the past less than we believe we do.

38. Graham, Benjamin. The Intelligent Investor, Fourth Revised Edition. New York, NY: Harbor & Row, 1973.

39. Philip Tetlock’s Expert Political Judgment: How Good is it? How can we Know? Provides the clearest evidence that overconfidence affects all of us, none more so than experts. Experts are great at providing historical information, but terrible at predicting.

40. Klarman, Seth A. Margin of Safety: Risk-Adverse Value Investing Strategies for the Thoughtful Investor. New York, NY: HarperBusiness, 1991.

41. Graham, Benjamin and David Dodd. Security Analysis: The Classic 1934 Edition. New York, NY: The McGraw-Hill Companies, Inc., 1934.

42. Graham, Benjamin and David Dodd. Security Analysis: The Classic 1934 Edition. New York, NY: The McGraw-Hill Companies, Inc., 1934.

43. http://www.businessinsider.com/jim-chanos-best-quotes-2013-11 44. http://www.businessinsider.com/jim-chanos-best-quotes-2013-11. Chanos process is not too different from Buffett’s own. In providing a few tips on how to conductive effective research, Buffett said, “review annual reports from a few years back, paying particular attention about strategies for the future then compare those plans to today's results, how fully were they realized, how has their thinking changed? Then compare to other companies in the industry/sector.”

45. Kahneman, Daniel. Thinking, Fast and Slow. New York, NY: Farrar, Straus and Giroux, 2011.

46. Buffett deserves credit for this analogy 47. The most recognized and accepted method for determining value is the Discounted Cash Flow (DCF) analysis. There are several shortcomings, however, of using a DCF. First, it does not incorporate the balance sheet. Second, it uses a weighted sum of future cash flows, thus mixing better information (near cash flows) with worse information (far cash flows). And third, calculating the discount rate typically requires the use of CAPM or WACC, both of which have not been proven to be accurate representations of real-world risk factors. (Bruce Greenwald deserves much credit for writing about these shortcomings.) Value investors tend to pay particular attention to Return on Invested Capital (ROIC) and Return on Equity (ROE) metrics. A company can increase earnings without actually increasing value due to accounting rules. For this reason, most value investors look upon earnings with skepticism and prefer Free Cash Flow (FCF) metrics (CFFO – CapEx). Alfred Rappoport and Michael Mauboussin’s Expectations Investing provides a clear example of how to reverse engineer a DCF. This is an interesting exercise to gauge the market’s current expectations relative to growth rates and margins.

48. Columbia business school professors Bruce Greenwald and Stephen Penman deserve credit for this approach; however, it is really another example of “standing on the shoulder of giants.” This value approach to determining value has been in use for a very long time.

49. Value investors start with the balance sheet because it presents the most reliable and concrete picture of a firm’s net assets. However, as value investing has evolved, there has been a recognition a 20

company’s value is not just these net real assets, but also the value of earnings that these assets can produce.

50. Graham, Benjamin and David Dodd. Security Analysis: The Classic 1934 Edition. New York, NY: The McGraw-Hill Companies, Inc., 1934.

51. Graham, Benjamin and David Dodd. Security Analysis: The Classic 1934 Edition. New York, NY: The McGraw-Hill Companies, Inc., 1934.

52. Bruce Greenwald and Michael Porter are two luminaries in the field of competitive strategy and how it relates to investment decisions.

53. By 1965 through the influence of Philip Fisher and Charlie Munger, Buffett was becoming aware of the strategy limitation of Graham’s cigar butt investment approach. In particular, Buffett recognized for this approach to work required a “liquidator” or someone to see the value he saw and a willingness to pay for it in a timely fashion. The cigar butt approach also required a greater degree of diversification for this reason and more turnover. Buffett saw advantages in finding a few, highquality franchises that he could pay a “fair” price, but hold indefinitely allowing the compounding effect of value creation to generate long-term results.

54. See's candies, which was trading at 3x book value when Buffett purchased the company was Buffett’s first major move away from Graham's strict philosophy of buying only when underpriced on the “facts.” Munger said, "It was the first time we paid for quality." Buffett saw the value in looking beyond the numbers and learning about a company’s moat. Graham was interested in purchasing cheap stocks without regard to future prospects whereas Fisher was interested in companies that have potential to increase their intrinsic value over a long term. The best example of this idea is Buffett’s investment in Coca-Cola. By the time Buffett made his investment in Coke in 1988-89, KO had already been an outstanding performer. The Company’s stock had risen more than five-fold in the prior six years and over five-hundredfold in the previous sixty years. Buffett’s KO investment is a perfect example of a franchise investment. Coke has wonderful brand, a product that is accessible to any consumer and consumption patterns that are highly repeatable. These characteristics were generally recognized by the market—Coke’s stock was trading at 5x book value, 15x earnings (then a 30% premium to the market) and 12x cash flow (then a 50% premium to the market). In the prior five years before his investment, KO returned 18% annualized. Yet Buffett decided to commit approximately one-third of Berkshire’s assets to the purchase of Coke’s stock (his single largest investment at the time). KO did not disappoint rising ten-fold over the next ten years and outperforming the S&P 500 by sevenfold. Interestingly, however, the ten year performance actually had a negative emotional utility since in four of those ten years, the stock underperformed the market.

Yet again another example of Buffett’s incredible patience paying off in a big way. Buffett has said, “Inactivity strikes us an intelligent behavior.”

55. Interview in Value Investor Newsletter from Dec 2013 56. Ray Dalio, founder and chairman of Bridgewater Associates has created a wonderful short video on the business cycle: http://www.economicprinciples.org/ 57. Howard Marks, Oaktree Capital’s chairman’s letter can be found here: http://www.oaktreecapital.com/memo.aspx

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58. Marks, Howard. The Most Important Thing Illuminate: Uncommon Sense for the Thoughtful Investor.

New York, NY: Columbia University Press, 2012. Also see: http://www.oaktreecapital.com/memo.aspx 59. The surest way to avoid a permanent loss of value is to only buy when there is a substantial margin of safety.

60. Marks, Howard. The Most Important Thing Illuminate: Uncommon Sense for the Thoughtful Investor.

New York, NY: Columbia University Press, 2012.

61. Montier, James. The Little Book of Behavior Investing: How Not to Be Your Own Worst Enemy.

Hoboken, NJ: John Wiley & Sons, 2010.

62. Klarman, Seth A. Margin of Safety: Risk-Adverse Value Investing Strategies for the Thoughtful Investor. New York, NY: HarperBusiness, 1991.

63. Kahneman, Daniel. Thinking, Fast and Slow. New York, NY: Farrar, Straus and Giroux, 2011.

64. Risso-Gill, Christopher. There’s Always Something to Do: The Peter Cundill Investment Approach.

Montreal, CN: McGill-Queen’s University Press, 2011.

65. Risso-Gill, Christopher. There’s Always Something to Do: The Peter Cundill Investment Approach.

Montreal, CN: McGill-Queen’s University Press, 2011.

66. Klarman, Seth A. Margin of Safety: Risk-Adverse Value Investing Strategies for the Thoughtful Investor. New York, NY: HarperBusiness, 1991.

67. In his 1985 Chairmen’s Letter to Berkshire Shareholders, Buffett shared one his favorite Graham stories about an oil prospector meeting St. Peter at the gates of heaven. “You're qualified for residence" says St. Peter, "but as you can see, the compound for oilmen is packed. There's no way to squeeze you in.” The prospector after thinking for moment asks if he can say just four words to the occupants. St. Peter grants the request. The prospector yells, “oil discovered in hell." Immediately there is a rush for the gates and St. Peter invites the prospector in. "No,” he says "I think I'll go along with the rest of the boys. There may be some truth to that rumor after all."

68. There is an institutional imperative to grow for growth’s sake. Managers ignore their most important role—that of capital allocator. There are five ways a manager can allocate capital—invest in the business, acquire assets, issue dividends, pay down debt, and buy back shares. How a manager makes these decisions will have a big impact on returns to shareholders over time.

69. Klarman, Seth A. Margin of Safety: Risk-Adverse Value Investing Strategies for the Thoughtful Investor. New York, NY: HarperBusiness, 1991.

70. Warren Buffet in one of his famous Chairman’s Letters to the Shareholders of Berkshire 71. See the work of Greenwald, Porter, Christensen and others 72. Graham, Benjamin and David Dodd. Security Analysis: The Classic 1934 Edition. New York, NY: The McGraw-Hill Companies, Inc., 1934.

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73. Klarman, Seth A. Margin of Safety: Risk-Adverse Value Investing Strategies for the Thoughtful Investor. New York, NY: HarperBusiness, 1991.

74. Warren Buffett. Also see Mauboussin’s The Success Equation’s discussion of the paradox of skill 75. Other prominent value investors have recognized three possible mistakes—the price you pay, the management you join or a miscalculation of the future economics of the business.

76. Graham, Benjamin. The Intelligent Investor, Fourth Revised Edition. New York, NY: Harbor & Row, 1973.

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APPENDIX A Common Behavioral Pitfalls The affect heuristic occurs when our judgments and decisions are guided directly by feelings of liking and disliking with little deliberation or reasoning.

Anchoring bias describes our tendency to rely too heavily on one piece of information when making decisions. Anchoring occurs when people consider a particular value for an unknown quantity before estimating that quantity. This can have a significant impact on investing. System 1 tries its best to construct a world in which the anchor is the true number. This is one of the manifestations of associative coherence (Thinking, Fast and Slow). Investors need to be diligent in seeking information from various sources.

Anchoring-and-adjusting: an example of this heuristic is jotting down your phone number and then attempting to estimate the number of doctors in New York. The first, unrelated number has been demonstrated to affect the answer to the real question. In short, it leads to insufficient consideration of alternatives, sometime referred to as tunnel vision. We tend to reason from a set of premises and only consider compatible possibilities partly because we begin to disregard non-confirming evidence. Most people stop adjusting once they reach a value deemed plausible or acceptable (System 1 thinking). In order to avoid tunnel vision, a decision maker should explicitly consider alternatives (seek dissent) and keep track of pervious decisions (keep a journal).

Availability Bias is the tendency to weigh more heavily information that easily comes to mind or to give unwarranted importance to memories that are vivid to use at the expense of information that is â&#x20AC;&#x153;just off stage.â&#x20AC;? It encourages us to ignore alternatives.

A bias is the inclination to present or hold a partial perspective at the expense of possibly equally valid alternatives.

The illusion of control is the belief that we can influence (overrate our abilities) the outcome of uncontrollable events. As a result, people often mistake randomness for control.

Causal relationships: System 1 is highly adept in one form of thinking: it automatically and effortlessly identifies causal connections between events, sometimes even when the connection is spurious.

Confirmation Bias occurs when an individual seeks information that confirms a prior belief or view and disregards or disconfirms evidence that counters it. Most people see and hear what they want and tune out everything else. This has two negative consequences. First, it permits us to stop thinking about an issue. Second, it frees use from the consequence of reason, namely, changing our behavior. Our normal habit is to develop a quick belief and then seek out confirming evidence to support it. Studies show that we are more than twice as likely to favor confirming information than disconfirming information (Decisive). Confirmation bias increases the more time and effort a person has invested in a given issue.

A direct violation of Karl Popper who argued the only way to test a hypothesis was to look for all the information that disagreed with itâ&#x20AC;&#x201D;a process known as falsification.

Creeping Determinism is the propensity of individuals to perceive reported outcomes as having been relatively inevitable. Once we know the outcome, we have a tendency to forget (dismiss) the influence of luck.

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Empathy gap is the inability to predict our own future behavior under emotional strain. In short, we are not good at knowing how we will feel in the future. A particularly effective solution is “precommitting”—doing your homework with a cool, rational head ahead of time. Pre-commitment is one way to deal with empathy gaps and procrastination and in studies has proved to work effectively (Dan Ariely and Klaus Wertenbroch, “Procrastination, Deadlines, and Performance: Self-Control by PreCommitment,” Psychological Science 13 (2002): 219-224.) The very definition of empathy gap is swimming against the tide.

The endowment effect: once you own something, you start to place a higher value on it than others would.

Groupthink is a mode of thinking that happens when the desire for harmony in a decision-making group overrides a realistic appraisal of options. The evidence casts serious doubt on people’s ability to maintain their independence in the face of pressure. See: S. Asch, “Effects of Group Pressure upon the Modification and Distortion of Judgment,” in Groups, Leadership and Men, ed. H. Guetzkow (New York: Carnegie Press, 1951). Psychologists have found people conform to the group’s incorrect majority view about 1/3 of the time. More recent studies using brain scans show that going against the crowd triggers the area of the brain responsible for fear and pain.

The halo Effect is the human proclivity to make specific inferences based on general impressions. It is the tendency to like (or dislike) everything about a person--including things you have not observed.

Sequence matters because the halo effect increases the weight of first impressions. The standard practice of open discussion gives too much weight to the opinions of those who speak early and assertively, causing others to line up behind them.

Hindsight bias – refers to the idea that once we know the outcome we tend to think we knew it all the time. Research shows people are unreliable in recalling how an uncertain situation appeared to them before finding out the results. Soren Kierkegaard said, “Life must be understood backwards, but it must be lived-forwards.” By writing down the rationale behind our decisions can lead to reducing its impact.

In-attentional blindness: we don’t expect to see what we are not looking for. The classic example is the short video clip of teams playing basketball as a monkey crosses the screen. D.J. Simons and C.F. Chabris, “Gorillas in Our Midst: Sustained Inattentional Blindness for Dynamic Events,” Perception 29 (1999): 1059-1074). The experiment shows that about 60% of people fail to spot the gorilla. Investors can get caught up in the details and distracted by the noise thereby losing sight of the big picture.

Illusion of knowledge: Daniel J. Boorstein said, “The greatest obstacle to discovery is not ignorance—it is the illusion of knowledge.” P. Slovic, “Behavioral Problems Adhering to a Decision Policy” (Unpublished paper, 1973). The study of bookmakers’ conclusion: with five pieces of information, accuracy and confidence were quite closely related. But perhaps surprisingly, the more information made available, two things happened. First, accuracy did not improve. Second, the degree of confidence expressed in the forecast massively increased. (Little Book of Behavioral Investing) Most studies actually suggest information has diminishing returns where after a certain point it no longer creates knowledge, but only confidence.

Loss aversion: Losses are two to two-and-one-half times as painful as gains. Studies show that golfers make their birdie putts 2-3% less than their par putts of comparable lengths.

The overconfidence bias leads humans to put more weight on our own judgment than is objectively warranted. It suggests that our sources of information are as important as the information itself.

Overconfidence bias is another manifestation of Kahneman’s “What you see is all there is.”

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The outcome bias is judging a past decision by its ultimate success or failure only, not on how the decision was made. This is especially troublesome for institutional investors because it creates unintended consequences such as buying stocks that are more easily justifiable to clients than those that truly represent the best opportunity to exploit the value price gap.

Over-optimism: Ben Graham said, “Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions. The purchasers view the current good earnings as equivalent to ‘earnings power’ and assume that prosperity is synonymous with safety.”

The reductive bias is the tendency for people to treat and interpret complex circumstances and topics as simpler than they really are leading to misconceptions.

The illusion of safety is the belief that providing an explanation is the same as truth. Precision should not be a proxy for accuracy. Precision often gives the false sense of security. One way to overcome this illusion is to think probabilistically.

Self-attribution bias is the propensity to ascribe our successes to our skill and blame our failures on bad luck.

Substitution – when faced with complexity, humans tend to resort to simpler, more intuitive modes of thinking. The target question is the assessment you intend to produce. The heuristic question is the simpler question that you answer instead.

The illusion of validity: Subjective confidence in a judgment is not a reasoned evaluation of the probability that this judgment is correct. Confidence is a feeling, which reflects the coherence of the information and the cognitive ease of processing it. It is wise to take admissions of uncertainty seriously, because declarations of high confidence mainly tell you that an individual has constructed a coherent story in his mind, not necessarily that the story is true (Thinking, Fast and Slow).

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APPENDIX B A Sample Checklist Business A) Is the business simple and easy to understand?

B) Does the business have favorable long-term prospects?

C) Does the company have a sustainable competitive advantage? If so, what is the source of this advantage?

D) What is the company’s source of growth? What are the probabilities and possibilities the company continues this growth for the next decade?

E) Does the company have stable and/or high margins? Check the progression of historical margins for cyclicality and sustainability.

F) What are the sources of the company’s earnings over the past five years? The next five years?

Industry Dynamics A) What is the industry structure? What are the possible challenges and opportunities?

B) What are the industry dynamics?

C) Perform a Porter “Five Forces” analysis.

Valuation A) Approximately how much is the company worth? a. Can the business be purchased at a significant discount to its value? i. BV + Owners Earnings + Future growth opportunities B) Is there a conservative investment case that 2-3 years out the current valuation will look attractive?

C) What expectations are priced into the company’s shares (reverse engineer)?

D) If I could purchase the entire company (think like a business owner) how much would I pay?

E) Does the company have attractive return characteristics such as ROE/ROIC. What have been the trends over time?

Balance Sheet & Cash Flows A) Is inventory build-up occurring faster than sales? Watch for inventory write-downs.

B) Is accounts receivable increasing faster than sales?

C) Is the cash flow from operations increasing in line with net income?

D) Is the balance sheet a source of strength or weakness for the business?

Management A) Is management rational?

B) Is management candid with its shareholders?

C) Is management accountable? Has the company achieved its goals/objectives it laid out in public announcements? If not, are the shortfalls well explained?

D) Is management compensation and incentives aligned with shareholder interest? Check proxy statements.

E) Has management allocated capital successfully in the past?

F) Does management focus on the short-term earnings or long-term business trends?

Risk Factors (Financial and Operational) A) Is There Too Much Leverage? Check credit metrics.

B) Have I checked the covenant levels of the debt? How much cushion does the company have under its maintenance covenants in the largest agreements? What is the likelihood that it can meet its future obligations?

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C) Does the business have a consistent operating history? Does the company have operating leverage?

D) What are the two-four most important factors that drive the business?

Cycles A) Is the market expense or cheap?

B) Our investors greedy or fearful?

C) Are most economic indicators improving or deteriorating?

Behavior Pitfalls A) Do the facts support my decision or am I falling into cognitive traps?

B) Have I thoroughly tested the bear thesis?

C) What could go wrong and why? a. Imagine in a couple years the company has not performed, write down why.

D) What assumptions have to be true for my bull/bear thesis to work in a reasonable time frame?

E) Did I seek out dis-confirming information?

F) How confident am I in the decision?

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