Tandy Leather Factory – A Potential Bargain?

Today, shares of Tandy Leather Factory Inc. (AMEX: TLF) took a 30% dive (to close at $4.25) as the company pre-announced the results from a less-than-appetizing third quarter. Since I have a bit of familiarity with the company, I thought I’d provide a few insights.
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Company Overview
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Tandy Leather Factory (TLF), based in Fort Worth, TX, is an international marketer, wholesale distributor, and retailer of a broad line of leather and related products, including leather, leatherworking tools, buckles and adornments for belts, leather dyes and finishes, shoe repair supplies, saddle and tack hardware, and do-it-yourself kits. The company operates in three segments: Wholesale, Retail, and Roberts, Cushman (Other). The Leather Factory (Wholesale) segment sells primarily to wholesale customers through outlet stores located in the United States and Canada. The Tandy Leather segment sells primarily to retail customers through retail stores located in the United States. The Roberts, Cushman segment manufactures decorative hat trims sold directly to hat manufacturers and distributors.
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To make a long story short, the story behind Tandy basically is that it is in the process of shifting from a more wholesale-oriented operation to a more retail-oriented operation. Tandy had previously been a much larger company until the previous management decided to close all the retail stores and try and make this an internet-based business. That didn’t work and the current management was able to take over in 2002 and start opening retail stores again, of which there are now about 70. I believe Tandy had previously had about 300+ locations and had generated enough cash flow to help Charles Tandy launch such businesses as RadioShack and Pier 1. The current plan is to open about 100-120 retail stores this time around.
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Recent Developments
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Sales have slowed and inventory is up. Although sales are still a bit above last year, the infrastructure for growth has continued and so margins have slightly compressed. Although the company and management are experiencing a few growing pains this year, they have shown great prudence in the past and certainly have the ability to right the ship.
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One of the big questions management gets asked is, “how big can you get?” Being the straight shooters they seem to be, they basically say that they don’t know but hint that it is quite a bit bigger than they are now. Wouldn’t it be nice if you could buy this business (which also has good returns on capital) without paying for that growth?
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Another one of the overhanging questions about the company revolves around capital allocation. What will they do with the cash the business generates? Until the purchase, last quarter, of the real estate that will be their new base of operations, the company had built up over $6 million of cash on the balance sheet. Although that has been lessened with the purchase of the property (which was probably a good purchase since 1) they’d been looking for a while and 2) management has historically been good at not wasting money), a time will come again when they may have much more cash than they will even conservatively need. I would love to see TLF take an approach similar to K-Swiss and Timberland and just let cash build until their shares are significantly undervalued and then buy back a bunch of stock (that strategy has worked very well for those companies), but Tandy has yet to decide on any definitive approach in that regard. At any rate, reinvestment and capital allocation are the key questions when/if the business gets back on track.
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What could shares of TLF be worth?
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To get an estimate of what TLF is worth, I used a Discounted Cash Flow plus Excess Capital model that produced the following figures (book value and assets based on end of second quarter balance sheet):
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Book Value: $28,291,889
Goodwill and Other Intang.: $416,530
Capital Assets (PP&E): $1,997,605
Working Capital for Ops.: $1,151,280
Capital Used in Ops.: $3,565,415
Inventory Adjustment (25% cut): $5,044,897

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Excess Capital: $19,681,577
Per Share: $1.77
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Year__Sales__ _ __Net Income_Owners' Earnings
2008__$57,564,000__$3,583,897__$2,933,897
2009__$59,115,840__$4,170,448__$3,502,925
2010__$60,760,790__$4,299,987__$3,613,890
2011__$62,213,830__$4,414,414__$3,711,909
2012__$63,739,521__$4,534,563__$3,814,830
2013__$65,341,497__$4,660,718__$3,922,896
2014__$66,687,157__$4,766,689__$4,013,672
2015__$68,086,644__$4,876,898__$4,108,079
2016__$69,542,109__$4,991,516__$4,206,262
2017__$70,677,373__$5,080,918__$4,282,845
2018__$71,846,694__$5,496,286__$4,685,009
2019__$73,051,095__$5,752,774__$4,927,897
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Using an 8-10% discount rate and a 12.5-14.3 terminal multiple, I get an intrinsic value somewhere between $5.72 and $6.70. Note, my sales growth is less than 3% every year (for a business that still has decent growth prospects and little to no competition) and I think my margins are fairly conservative for the way the business is developing. If management is able to have some success getting things in order (either on the cost or growth side), normalized earnings are probably somewhere closer to the $4-5 million range which could very easily make this business worth $8-10 per share, or more if they buy back their own stock when it is cheap.
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I know I didn’t get into too much detail on things, but it certainly may be a good place for you to start your own research. The company will hold a conference call Thursday afternoon.

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*This is not a recommendation to buy or sell a security. Please do your own research before making an investment decision.

Black Monday and Black Swans

Remarks by John C. Bogle
Founder and former chief executive, The Vanguard Group
before the
Risk Management Association
Boca Raton, Florida
October 11, 2007

Berkshire Hathaway Shareholder Letters - 1973-1976

Whitney Tilson was kind enough to post Mr. Buffett's 1973-1976 shareholder letters here (the link expires in a week!): http://www.yousendit.com/transfer.php?action=download&ufid=8B8FCF4920CF6A98

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The 1977-Present shareholder letters are posted on the Berkshire site here: http://www.berkshirehathaway.com/letters/letters.html

So You Want To Be The Next Warren Buffett? How's Your Writing?

Great speech by Mark Sellers to Harvard MBAs.

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One thing I will tell you right off the bat: I'm not here to teach you how to be a great investor. On the contrary, I'm here to tell you why very few of you can ever hope to achieve this status.

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If you spend enough time studying investors like Charlie Munger, Warren Buffett, Bruce Berkowitz, Bill Miller, Eddie Lampert, Bill Ackman, and people who have been similarly successful in the investment world, you will understand what I mean.

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I know that everyone in this room is exceedingly intelligent and you've all worked hard to get where you are. You are the brightest of the bright. And yet, there's one thing you should remember if you remember nothing else from my talk: You have almost no chance of being a great investor. You have a really, really low probability, like 2% or less. And I'm adjusting for the fact that you all have high IQs and are hard workers and will have an MBA from one of the top business schools in the country soon. If this audience was just a random sample of the population at large, the likelihood of anyone here becoming a great investor later on would be even less, like 1/50th of 1% or something. You all have a lot of advantages over Joe Investor, and yet you have almost no chance of standing out from the crowd over a long period of time.

Warren Buffett Chats with Jack Welch on CNBC's Squawk Box: The Video

This morning on CNBC's Squawk Box, Warren Buffett chatted by telephone with the Squawk team and guest host Jack Welch, the former Chairman and CEO of CNBC parent General Electric.

Oak Value Fund - Investment Adviser’s Review – Third Quarter 2007

Last quarter we dedicated a significant portion of our commentary to the notion of risk and the emotion of “fear.” In a short period of time, Mr. Market has become increasingly focused on this fear. The discipline that defines us requires that we be fearful when others are greedy and greedy when others are fearful. For long-term, disciplined investors interested in owning high quality companies and willing to purchase such at attractive valuations, opportunities abound.

Whitney Tilson Videos

1) On MCD, TGT, the ironies of the banks trying to save SIVs, why declining stock prices are GOOD news for buyers, and why the best course of action is usually to do nothing when others are panicking

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2) On what investors should do during times of market turmoil and why banks are in trouble with SIVs

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3) On Fairfax Financial, Target, Sears and Wal-Mart

Berkshire Hathaway and GEICO: an M&A Case Study

In striking contrast to the problematic M&A track record of many firms, financier Warren Buffett, the Chairman and CEO of Berkshire Hathaway, has been a remarkably successful acquirer. There can be many reasons for this contrast, but a key one is likely Buffett's effective approach to valuation and pricing; in other words, Buffett generally does not overpay for acquisitions. As a student, Buffett received training in valuation at Columbia University from the late Benjamin Graham and has practiced and developed Graham's techniques ever since.

A Storied Name on Sale?

Likewise, Sears' business is getting short shrift, as some of Lampert's restructuring efforts are likely to bear fruit. Too, the retailer's real estate has considerable value that is not reflected in the stock. Add up this real estate, valuable brands like Kenmore and Craftsman, and Sears' huge appliance and home-remodeling business, and the company could have a liquidation value of more than $300 a share.

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There is also an interesting Value Investors Club write-up on Sears (will need to have or sign up for a free guest account) HERE.

WealthTrack

Robert Hagstrom appeared on WealthTrack this past week:
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Video (10/19/2007): http://www.wealthtrack.com/video_player.html

17th Annual Graham & Dodd Breakfast

GREAT presentation by David Einhorn:
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17th Annual Graham & Dodd Breakfast

a keynote address by:

David Einhorn, President, Greenlight Capital

“Fooling Some of the People All of the Time”

October 19, 2007

Is Your Brain Costing You Money?

In late September, Motley Fool Hidden Gems and Global Gains advisor Bill Mann sat down with renowned financial journalist Jason Zweig. Zweig's new financial book, Your Money and Your Brain, tackles the fascinating topic of neurofinance, the ways that your brain can trick you and cost you money.

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Part 1

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Part 2

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Book: Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich

Morningstar - Picks from the Other Oracle of Omaha

Wally Weitz and Brad Hinton discuss Omaha-based Weitz Funds holdings. (Video)

Interview with Peter Bevelin, author of Seeking Wisdom - from Darwin to Munger

Being such a big fan of Peter Bevelin's book, Seeking Wisdom - from Darwin to Munger, and the Charlie Munger approach to learning, I felt quite lucky when Mr. Bevelin agreed to answer a few questions. If you haven't yet read his book or Poor Charlie's Almanack, you can get them both HERE. Enjoy!

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Interview with Peter Bevelin, author of Seeking Wisdom - from Darwin to Munger
By Joe Koster-

2007 Interview with Peter Bevelin

Q: In the introduction of your book, you mention that you owe a great debt to Warren Buffett and Charlie Munger and that if you had listened to them earlier in your life, you would have avoided many expensive mistakes. Could you elaborate a bit on how you first came across Warren and Charlie, how your process of learning from them began, and maybe even mention a couple of the mistakes that you may have avoided had you come across them earlier?

I first came across the name of Warren Buffett in 1986, when I was on a plane between New York and Miami and picked up Fortune Magazine in the seat in front of me. Back home in Sweden I immediately ordered Berkshire’s annual reports. But I was a slow learner. I didn’t really pick up his and Charlie Munger’s wisdom until I went to my first Berkshire annual meeting in 1994. What did I learn? – How to think about businesses and investing, how to behave in life, the importance of ethics and honesty, how to approach problems but foremost how to reduce the chance of meeting problems. As Munger says: “All I want to know is where I’m going to die so I’ll never go there.” When I hear them at the annual meeting, I am thinking about Einstein’s reply to a student. The student had challenged Einstein’s statement that the laws of physics should be simple by asking: “What if they aren’t simple?” Einstein replied, “Then I would not be interested in them.” 

They have a unique ability to distinguish masses of trivia from what is really important – to filter out situations, and find what’s at their core. They tell the simple, blunt truth rather than say things that sound good.

In the past, I complicated things too much, I put too much trust in people that really shouldn’t be trusted, I wasn’t skeptical enough , I bought into things merely because they were cheap etc. In short, I wasn’t thinking and I was lacking the Munger ability to un-learn my own best-loved ideas. The stock certificates of some of my earlier investments in private businesses are now used as lining in my old overcoat; at least they had a nice color. And is there really any other way to approach investments than their way? Turn it around and ask what are the effects of investing in things we don’t understand, lack advantages and have a dishonest and incompetent management and that can be bought at a high price.

I found that I could increase my chance of making better judgments if I could learn what works and not, if I adapt what I do to my personal situation, and if I could establish some values and preferences. If I then could set up some avoid-rules and filters/tests to judge what make sense or is important or not, life could be improved (even if I still do some mistakes; but hopefully I am less of a fool now). Also remember that all decisions aren’t important. Some people spend more time making a judgment on what TV to buy or where to go on vacation than a life-changing decision like marriage.

Q: Charlie Munger has mentioned that a great way to learn Adam Smith’s ideas is to first learn about Adam Smith. Do you believe that this idea of learning about the “teacher” before the “lesson” is truer in some disciplines than in others and do you have any examples when this method of learning was especially useful to you?

Experiments have shown that we learn better if information is tied to a vivid story. So, I would say, it depends. In some cases the “Smith-model” is superior and in other cases I may learn better in some other fashion. For example, I learnt a lot from reading The Autobiography of Charles Darwin. But I also learnt a lot of Einstein’s ideas by reading Mr. Tompkins in Paperback by George Gamow. See also what I wrote about Reason-respecting (20 in the book). On the other hand, when reading, we must constantly watch out for the sensemaking trap (19 in my book) since we are so easily influenced when we are told stories or given information in a “story-format.”

Q: As you state in the introduction, “This book is for those who love the constant search for knowledge. I have focused on explaining timeless ideas. The number of pages I have devoted to each idea does not reflect on its importance. My goal is to lay the foundation.” Once readers acquire the foundation they receive by reading Seeking Wisdom, where should they go next? Specifically, what is the first thing that you would recommend they should pick up to start learning more about the big ideas in the discipline of Math? Psychology? Physics? Biology? Chemistry? Economics? Engineering? Philosophy?

Look around you – observe reality. What can explain this? Learn some core concepts that account for reality. Start from the basics for each discipline and emphasize the understanding of general principles and use simple real-life examples to illustrate principles. Read, read and think about what you have read. Look for understanding. What is going on here? What is the core idea? What is the evidence that it is right? Also remember what Richard Feynman once asked someone who remarked that he had read a book. “But, did you learn anything?” Understand an idea’s meaning and applications. Focus on useful and obviously important and correct general ideas, concepts and principles. What does it mean? What happens? What is the effect?

Q: As many value investors have been taught, it is more important to focus on the process of doing something instead of solely focusing on the outcome of that process. Do you have any tips that may help people along the process of “seeking wisdom?” Should someone focus their attention on learning many ideas from one or two disciplines at a time, or by learning many disciplines one or two big ideas at a time?

There are principles, which apply to all different kind of phenomena. For example, JB Williams’s definition of value is applicable for all financial assets. Personally, I started with biology and psychology since knowing some human constraints and “brain traps” I could avoid some things by for example using some “avoid-rules.” Why can’t we all be nice, honest and rational? (And why can’t we all have wings and thus eliminate department store escalators?). I favor ideas that explain a whole range of phenomena. For example, biology (evolution and natural selection) explains why people: fear losses but take big risks when threatened, fear strangers, trust similar people, cooperate, imitate, fear social disapproval, make fast judgments, and overreact to vivid information.

Also, some disciplines are more reliable than others. For example, disciplines describing experimentally tested ideas, concepts and principles.

Some other examples on disciplines and ideas that explain a lot: Mathematics (scaling) explain how living things are shaped and constrained by basic mathematical principles. For example, why: no giants exist, a mouse can survive a big fall but not a human, some animals have short and thick legs, larger plants have leaves, small animals can’t live in cold countries, ants can lift such a big load, and grasshoppers can jump so high relative to their body sizes. Mathematics (combinatorics) and Physics (systems theory) explain why: we can’t predict the economy, it is hard to make money on new ventures, most projects take more time and money than we anticipate, nuclear accidents happen, we will have more electrical black-outs, coincidences occur, and some mutual funds beat the index.

Q: Are there any books in which you believe the models presented within those books are so important that you make it a habit to re-read them every year or every couple of years?

All of Charles Munger’s speeches. Most of them can be found in Peter Kaufman’s Poor Charlie’s Almanack. I also re-read Hardin’s Filters Against Folly.

Q: Charlie Munger once said that he can’t afford ($) to have too many friends like Peter Bevelin because when you recommend a book to him, it is so good that Charlie feels compelled to buy a copy for all of his friends and family. So, have you made any recommendations to Charlie or read any of those “need-to-send-everyone” kinds of books recently?

No comments.

Q: Can you give a Top 10 list of books that really changed the way you view the world?

Some books that I really learnt a lot from (in no order of preference):

Cialdini Robert B., Influence: The Psychology of Persuasion 

Darwin Francis (editor), The Autobiography of Charles Darwin and Selected Letters

Dawes Robyn M., Everyday Irrationality: How Pseudo-Scientists,Lunatics, and the Rest of Us Systematically Fail to Think Rationally (it really introduced me to the value of always asking: Why should I believe this? – Show me the evidence + Compared to what?)

Feynman Richard, The Character of Physical Law and The Meaning of it All: Thoughts of a Citizen Scientist

Hardin Garrett, Filters Against Folly: How to Survive Despite Economists, Ecologists, and the Merely Eloquent

Lowenstein Roger, Buffett: The Making of an American Capitalist

Montaigne Michel de, The Complete Essays

Nassim Nicholas Taleb, The Black Swan 

Q: Can you talk a little about the process of writing your book? I think you did a magnificent job of pulling things together into a logical and understandable order and I imagine it was quite the experience organizing all the models that you have acquired over the years from your mind down on to paper.

Gene Fowler once said: “Writing is easy. All you do is stare at a blank sheet of paper until drops of blood form on your forehead.” Most people can do what I did. I am not especially smart or talented. It just takes curiosity and real interest. After being inspired by Charles Munger’s lectures on worldly wisdom (from Outstanding Investor Digest), and after reading Darwin, I took some time off business and started reading books in biology, neuroscience, psychology, and physics. As Warren Buffett once said: “I think you can learn a lot from other people. In fact, I think if you learn basically from other people, you don’t have to get too many ideas on your own. You can just apply the best of what you see.” Then I wrote down what I learned – I put together some key thoughts as a crude working model (what I found was that I couldn’t really synthesize things sitting in front of the computer. Like Arthur Schopenhauer said: “Thoughts die the moment they are embodied by words.” I could only see various connections between things and the big picture when I was out walking thinking about something else). Since sorrow feels worse than happiness feels good, I concentrated on learning causes of what I wanted to avoid – things with huge consequences.

I also spent some time visiting the Neurosciences Institute in La Jolla where I got some real understanding of how our anatomy, physiology and biochemistry constraints our behavior. I also interacted with a lot of science people via the Internet. Remember, I did this not to write a book, but to improve my own thinking and as a kind of memorandum to my children. I had no time constraints. And I loved it! Exploring and learning new things give me great satisfaction. When I started to read and write some of my friends said: what’s that good for? Why do you waste time studying that? How can that help you make money? Usually I don’t like to answer these questions, not because I don’t believe that the basic insight into how things work will not pay off at some time, but because I believe that acquiring insight is in itself a worthwhile effort. As Benjamin Franklin said: “ If a man empties his purse into his head, no one can take it away from him. An investment in knowledge always pays the best interest.”

Q: Finally, is there anything people may be surprised to know about you? Any unique interests?

People immediately assume that merely because I have written a book containing a lot of science, I must be a professor or an academic. I am not. Regarding any unique interests – nothing that would interest your readers.

I wish you and your readers a happy day – Everyday!

Street Smarts: Value Plays

Finding opportunity in stocks under stress, with Bruce Berkowitz, president of Fairholme Capital Management, and CNBC's Maria Bartiromo

Greg Mankiw - How to Write Well

This is directed toward writing about Economics, but the tips relate to writing about any subject, especially when you likely have more knowledge about that subject than the reader.

ERP Writing Guidelines

• Stay focused. Remember the take-away points you want the reader to remember. If some material is irrelevant to these points, it should probably be cut.
• Keep sentences short. Short words are better than long words. Monosyllabic words are best.
• The passive voice is avoided by good writers.
• Positive statements are more persuasive than normative statements.
• Use adverbs sparingly.
• Avoid jargon. Any word you don’t read regularly in a newspaper is suspect.
• Never make up your own acronyms.
• Avoid unnecessary words. For instance, in most cases, change: “in order to” to “to”; “whether or not” to “whether”; “is equal to” to “equals”
• Avoid “of course, “clearly,” and “obviously.” Clearly, if something is obvious, that fact will, of course, be obvious to the reader.
• The word “very” is very often very unnecessary.
• Keep your writing self-contained. Frequent references to other works, or to things that have come before or will come later, can be distracting.
• Put details and digressions in footnotes. Then delete the footnotes.
• To mere mortals, a graphic metaphor, a compelling anecdote, or a striking fact is worth a thousand articles in Econometrica.
• Keep your writing personal. Remind readers how economics affects their lives.
• Remember two basic rules of economic usage: 1. “Long run” (without a hyphen) is a noun. “Long-run” (with a hyphen) is an adjective. Same with “short(-)run.” 2. “Saving” (without a terminal s) is a flow. “Savings” (with a terminal s) is a stock.
• Buy a copy of Strunk and White’s Elements of Style. Also, William Zinsser’s On Writing Well. Read them—again and again and again.
• Keep it simple. Think of your reader as being your college roommate who majored in English literature. Assume he has never taken an economics course, or if he did, he used the wrong textbook.

Books:

1. The Elements of Style
2. On Writing Well

Whitney Tilson on Fast Money

On air he recommended getting long EMC Corp (EMC) and shorting VMWare (VMW) which he says gives investors one of the world's premiere technology companies for 8 times cash earnings.

WealthTrack - Bill Gross, Jean-Marie Eveillard, Robert Shearer

Jean-Marie Eveillard, one of the all time great value investors, appeared on WealthTrack this past week with Consuelo Mack:

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Video - http://www.wealthtrack.com/video_player.html

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The transcript (October 12, 2007) should be available soon.

Buffett predicts a long flight for loonie

At an invitation-only Toronto dinner Thursday for about 140 prominent investors, billionaire investor Warren Buffett said he expects the Canadian dollar to continue rising beyond the parity it recently reached with the U.S. dollar.

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Buffett, who has made substantial resource investments this decade, after a history of avoiding them, is now interested in the Alberta oil sands. His rationale is that it is a known resource, says Hull, who manages money for clients of Berkshire Securities Inc., recently acquired by Manulife Financial Corp.

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In contrast to speculative drilling, oil-sands projects are mining operations where the size of the reserves is known. One can calculate with relative certainty the breakeven requirements over 10 years. And production costs tend to drop as the extraction and processing technology improves.

Cashing In On Corporate Restructuring

Companies use mergers, acquisitions and spinoffs to increase their profits. Strategic mergers and acquisitions can help a company become more competitive in its field and improve its bottom line, while spinoffs are a way to get rid of underperforming or non-core business divisions that can drag down profits. While mergers, acquisitions and spinoffs can be great moves for companies, they can be even better for the enterprising investor willing to do a little research! If you do your homework, you can find profitable opportunities in these corporate actions - we'll take you through this process step by step.

The Pleasure of Finding Things Out

Link

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For more on Richard Feynman, visit Feynman Online.

Bill Miller: What's luck got to do with it?

This interview is from July of this year and since I don't believe I posted it before now, here it is.

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Bill Miller on poker and investing
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Question: Right. Who's Puggy Pearson, and why should anybody care?

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Answer: Well, the late Puggy Pearson was a professional gambler, lived in Las Vegas, had a 5th grade education, but nonetheless became legendary in poker, and really in other gambling circles, because of his undeniable skill at a game that involves a high degree of chance.

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And he won the World Series of Poker, I think in 1973. He also told me he actually won it one other time, but they awarded it to somebody else, because they didn't want him to win it twice. (Laughter) Back in the early years.

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Question: In the old days.

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Answer: I didn't know whether to believe him or not, but that's what he said. But in any case, he summed up the skills required for successful poker in a pithy way. And those skills, in my view, are also the skills necessary for successful investment.

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Somebody once asked Bill Ruane [the late manager of the legendary Sequoia Fund], and I happened to be in the audience that day, "How do you learn about investing?"

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And Bill said, "Well, if you read Ben Graham's Security Analysis and The Intelligent Investor you'll be well versed in it. And then if you read Warren Buffett's shareholder letters and understand them too, you'll know everything there is to know about investing. And you will become a successful investor."

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And I think Bill was right, but it takes a lot of time to do that. Puggy Pearson made it a little pithier when he said, his line was, "There ain't only three things to gambling. Knowing the 60/40 end of a proposition, money management, and knowing yourself."

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And if you translate that into investing, knowing the 60/40 end of a proposition means knowing when you have some competitive advantage over somebody else. And you don't bet, you don't gamble, you don't invest, unless you have some competitive advantage. I'll come back to what that means in a second.

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Second, money management means well, okay, if I've got a competitive advantage, how much do I invest? Do I invest 10 percent? 20 percent? 50 percent? Three percent? So knowing the proper money-management strategy, the proper amount of money to invest is the second thing.

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And then knowing yourself, that means knowing how you react to stress, how you react to adverse outcomes, how you react when things go well. Do you get giddy and overconfident when things are going well? Do you get morose and difficult when things go badly? Do you make bad decisions at both extremes? Just understanding your own psychology, what your weaknesses and strengths may be, as it comes down to evaluating decisions when the markets are at extremes.

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Those three things are really all that successful investing involves.

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Let's go back to the first one, though, and the 60/40 end of a proposition. There's three sources of competitive advantage in investing: informational, analytical and behavioral.

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Informational is - well, let's say you manage money for a Middle Eastern government, and you go over there and the oil minister tells you that they're going to double oil production in the next three months, you know something other people don't know.

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But informational advantages are very difficult to get. They're difficult for two independent reasons. Number one, the [U.S.] government tries to keep you from getting them, because they want a level playing field. There are rules against inside information and acting on it. People know when companies are going to release their earnings, and there's supposed to be equal access to that information. And then the hedge funds are the other independent reason. Many of them are trying to get an informational advantage. With so many of them out there doing this full time, it's very difficult for people to get an informational advantage - even other professionals such as ourselves.

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The second category is analytical advantages. This is where you know the same things that other people know, but you weight them differently, you give them different probabilities. And that can happen a lot. If you've owned the company over a long period of time, you can get a sense of how their business is evolving, how their capital allocation is going to work, that other people aren't thinking about. And you might have a different sense of their risk, the risk in assessing the investment. So the analytical advantage involves different probabilistic weights on the same information that other people have.

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And then the third one is behavioral. And that's the most enduring, because behavioral advantages arise out of the manifest tendencies of large numbers of people to react in predictable ways to certain kinds of situations. So we know that people are risk averse. We know that their coefficient of loss is about two to one - which means that they feel the pain of losing a dollar twice as intensely as they feel the pleasure of gaining a dollar.

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Question: Correct.

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Answer: People overweight the most recent information. They overreact to dramatic information, or dramatic circumstances. They tend to have what's called outcome bias, which is they judge things on their outcome, and not on their process. So a lot of these behavioral elements are things that you can actually identify and exploit to your advantage if you are aware of them - and aware also that no matter how much you're aware of them, you're not immune to them yourself. You really have to have a sense of discipline and patience, and understanding in that.

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Question: Okay.

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Answer: That was a very long explication of Puggy's very short, pithy remark.

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Question: All explanations of short pithy remarks are long.

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Answer: I think so, yes.

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Question: What's the Kelly criterion?

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Answer: The Kelly criterion is named after J.L. Kelly, Jr., who in 1956 wrote a paper for The Bell System Technical Journal called "A New Interpretation of the Information Rate," drawing on work by Claude Shannon, the father of information theory.

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What Kelly did was to take an aspect of Shannon's work and derive a formula that had broad applicability outside of information theory. What it enabled you to do was to maximize the growth rate of anything, if you used this formula. So gamblers quickly used it to adopt money management strategies.

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It's known as a fixed fraction strategy. So what it tells you is what fraction of your bank roll you should commit to any particular probabilistic endeavor, whether it be a gambling debt, or an investing debt, if you know the probabilities that pertain to it. And if you know those preconditions, you will either maximize your bankroll at the fastest possible rate, or you'll minimize your loss at the slowest possible rate.

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The rough formula, in a grossly oversimplified form just for the purposes of discussion, is:

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2p - 1

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where p is the probability [converted from percentage to decimal form]. So, to make it easy, if you were 100% certain that a particular investment would pay off at your expected rate, then 2 times that p is 2.0, minus 1, yields 1. That means 100% of your bankroll should go into that investment.

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Now if you were only 60% sure, then it would be two times .60, which is 1.20, minus 1, equals .20. So 20% of your bankroll should go into that proposition.

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What the Kelly criterion does is it gets you to focus on the probability that you are correct in your assessment, and then to understand that the amount of money you should commit is directly related to the probability that you are correct. It also shows that if you have less than a 50/50 proposition, you shouldn't bet at all. Which again, makes perfect sense.

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Question: Let's boil all that down for people who can't do 2p - 1, because it's too much math.

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Answer: (Laughter) Well, what Kelly says is the same thing Puggy Pearson says, which is you have to know the 60/40 end of the proposition. You have to be confident that you have an edge, that you have some positive probability of an expected positive gain, before you commit any amount of money. And if you can't identify that edge, you probably don't have it. And if you can't identify it, you probably shouldn't commit the capital to it.

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Question: Right. And how much capital you commit -

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Answer: - depends crucially on your assessment of how big your edge is. And that's why the government punishes inside information. Right? If you have a tip that comes from somebody that knows Company X is bidding for Company Y, then you would commit large amounts of your personal capital to that, following perfect Kelly fashion.

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Question: Right, because your P is 100.

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Answer: Exactly. Your P is 100.

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Question: But doesn't this bring us to a really difficult problem which is that since humans have an incorrigible tendency to be overconfident, how do you calibrate your P so that it's correctly less than 100?

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Answer: Well, I wouldn't advise people to go so far as to try to do calibrations on it. I would advise them basically to understand, A) people are overconfident, and B) that therefore whatever probability you think you have of being right, it's probably less than you think.

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So if you think you have a small edge, you probably don't have any edge at all.

Benjamin Franklin - "The Way to Wealth"

One of my favorite literary pieces. I also recommend buying this short work in book form. If you read The Way to Wealth and The Richest Man in Babylon, you'll know the best secrets to gaining wealth. The rest is up to you.

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Benjamin Franklin - "The Way to Wealth"

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When there is so much to be done for yourself, your family, your country, and your gracious king, be up by peep of day; let not the sun look down and say, inglorious here he lies. Handle your tools without mittens; remember that the cat in gloves catches no mice, as Poor Richard says. 'Tis true there is much to be done, and perhaps you are weak handed, but stick to it steadily, and you will see great effects, for constant dropping wears away stones, and by diligence and patience the mouse ate in two the cable; and little strokes fell great oaks, as Poor Richard says in his almanac, the year I cannot just now remember.

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"Methinks I hear some of you say, must a man afford himself no leisure? I will tell thee, my friend, what Poor Richard says, employ thy time well if thou meanest to gain leisure; and, since thou art not sure of a minute, throw not away an hour. Leisure is time for doing something useful; this leisure the diligent man will obtain, but the lazy man never; so that, as Poor Richard says, a life of leisure and a life of laziness are two things. Do you imagine that sloth will afford you more comfort than labor? No, for as Poor Richard says, trouble springs from idleness, and grievous toil from needless ease. Many without labor would live by their wits only, but they break for want of stock. Whereas industry gives comfort, and plenty, and respect: fly pleasures, and they'll follow you. The diligent spinner has a large shift, and now I have a sheep and a cow, everybody bids me good morrow, all which is well said by Poor Richard.

Joe Bradley at Investors Hotline interviews Whitney Tilson

http://www.investorshotline.com/t2partners/

Casting for Value:Where do Professional Investors Get Their Ideas?

Everyone’s goals, risk tolerance and timeframes are different, and individual portfolios should reflect this. People should be learning to fish, but instead they ask (and sometimes pay) others to throw fish at them. This is a good way to get smacked in the face with a fish, end up with a foul-smelling pile of carcasses, and learn absolutely nothing about where, when and how to catch fish on one’s own.

A SHORT COURSE IN THINKING ABOUT THINKING - A "Master Class" By Danny Kahneman

While Kahneman has a wide following among people who study risk, decision-making, and other aspects of human judgment, he is not exactly a household name. Yet among many of the top thinkers in psychology, he ranks at the top of the field.

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Harvard psychologist Daniel Gilbert (Stumbling on Happiness) writes: "Danny Kahneman is simply the most distinguished living psychologist in the world, bar none. Trying to say something smart about Danny's contributions to science is like trying to say something smart about water: It is everywhere, in everything, and a world without it would be a world unimaginably different than this one." And according to Harvard's Steven Pinker (The Stuff of Thought): "It's not an exaggeration to say that Kahneman is one of the most influential psychologists in history and certainly the most important psychologist alive today. He has made seminal contributions over a wide range of fields including social psychology, cognitive science, reasoning and thinking, and behavioral economics, a field he and his partner Amos Tversky invented."