Below are a couple of sections (slightly edited for public
viewing) from a letter just sent to the investors of the fund I help manage.
Disclosure: I am a portfolio manager at Boyles Asset Management, LLC
("Boyles") and the fund managed by Boyles may in the future buy or sell shares of the stocks mentioned below and we are under no obligation to update our activities. This is for
information purposes only and is not a recommendation to buy or sell a
security. Please do your own research before making an investment decision.
***
Reasonable Imagination
“I am enough of the artist to draw freely upon my
imagination. Imagination is more
important than knowledge. Knowledge
is limited. Imagination encircles
the world.”
– Albert Einstein, The Saturday Evening Post
Interview (October 26, 1929)
There is no
doubt that an appropriate temperament, a strong analytical mind, robust
research process and experience are key determinants of investment success, but
it is imagination that doesn’t seem to get much attention. It is likely that the word imagination
is more often associated with artists than investors, but we’ve come to
appreciate the role a “reasonable imagination” plays in the investment
process. Perhaps even Mr. Buffett
alludes to this in his work, often comparing his effort over the years at Berkshire
Hathaway to painting his masterpiece. It certainly took his imagination to build an investment
group not seen before and, more importantly, it took an imagination to
conceptualize, in potential investments, the opportunities beyond mere numbers
on paper.
Defined by
Merriam-Webster as, “the act or power of forming a mental image of something
not present to the senses or never before wholly perceived in reality,” the
noun begins to take the shape of a concept important to the investment
process. As we know, investing is
about laying out cash today for something to be received in the future and so
an investor had better be able to visualize as well as articulate what he or
she expects to receive. That takes
more than just examining what is before one’s eyes—it takes imagination.
A properly calibrated
imagination plays a role in such things as:
§ conceiving of potential risks not immediately
evident
§ hypothesizing about management and board of
directors’ motivations
§ appreciating that earnings or cash flow might be
markedly different in more or less optimum conditions
§ picturing competitive dynamics and responses over
time
§ appreciating competitive strengths of businesses
§ seeing a future for a business that is different
from general consensus
§ thinking about future regulatory issues
§ identifying potential catalysts for an investment
§ conceiving of potential future capital investment
opportunities (how long is the runway)
§ identifying investment opportunities in a
competitive market
§ improving the investment process
§ developing mental models
As can be inferred
from the list above, we must be careful to regulate our imaginations, lest we
forget that it is a “reasonable imagination,” rather than an “unreasonable imagination,”
that counts. And it certainly is
not only about imagining what might be on the upside. Equally important is an imagination about what might lurk on
the downside. In addition, it is
vital to have a reasonable imagination when panic starts to impact markets or
individual stocks. Often it is
investors’ imagination that gets the better of them in these situations.
Investors aren’t
able to look up the answers or easily crunch some numbers to address these
parts of the investment process.
They are not “present to the senses.” For our part, we’ll continue to work on our investment imagination.
Side-Note 1
Just before we “went
to press” with the letter, one of your managers happened to be reading 100
to 1 In the Stock Market, by Thomas Phelps (incidentally, we recommend the
book). Two-thirds of the way
through, he came across the passage below that debunks the idea that we are the
only ones thinking about the importance of a “reasonable imagination”:
To make a sensible choice we investors must make
or accept some assumptions about the future…To make intelligent assumptions
about the future we must try to perceive the tendency of events… It all boils
down to practical imagination – the ability to see what is not there but will be
soon enough to matter to you.
Side-Note 2
If you happen to
know a modern art collector willing to pay top dollar for a Miller or Koster,
please let us know.
Inefficient Markets
“Two markets are inefficient: very small ones
(which are not much use to Berkshire, with its $120 billion), and ones where
crazy people are doing crazy things, especially if they’re selling. From time to time, the big markets have
some crazily mispriced securities in them. But there’s no question that in small markets there’s a lot
of opportunity to find mispricings.”
–Charlie Munger (2007 Wesco Financial Annual
Meeting)
The above quote
from Charlie Munger is about the best summary we’ve seen to explain what we do,
and how we believe we can generate good returns over time. Our main focus has been on trying to
find small, underfollowed, and mispriced companies. We’re willing to look all over the world and have a
particular focus on countries that speak and report in English so that we can
perform the necessary due diligence we believe needs to be done when managing a
concentrated portfolio. And while
our focus has been on smaller companies in the past and remains so today, we
have the flexibility to venture into larger companies when opportunities
present themselves, which they occasionally will just as they have before, as
was evidenced during the depths of the financial crisis about five years ago.
In 2008, during
the week that spanned from November 13th to November 20th, Class A shares of
Berkshire Hathaway dropped from $103,600 to $74,100, a decline of almost 30%
from the high to the low, on rumors that it was having troubles with some of
the derivatives contracts it had written on four stock indices. Those contracts still had between 10 and
20 years before Berkshire would be required to pay out a penny, though there
was some worry that mark-to-market losses could force Berkshire to be at risk
of falling short of the capital it is required to hold as part of its insurance
business. The rumors turned out to
be false, and Berkshire’s stock recovered the full amount of the initial drop
one week later, and continued its march upward over the next few years to close
2013 at $177,900 per share.
Berkshire is but
one example of what can occasionally happen with the shares of larger companies
when fear takes hold and you get to a point where “crazy people are doing crazy
things.” Of the roughly 400
companies with market capitalizations north of $5 billion at the start of 2007,
about 15% of them had stock returns greater than 300% for the 5 years to the
end of 2013. Some well-known
companies such as Whole Foods, Starbucks, and American Express are all up over
8 times where they traded during the crisis lows. While we did not participate in the rise of those stocks, our
hindsight points out one of the more difficult effects one’s psyche must face in
investing: regret.
When looking
back, you always find things you wish you had done (or not done), and it is
important not to let the feeling that comes with knowing the past affect the
way you invest in the present. When
crises strike and Mr. Market panics, the competitive advantages one can have
over other market participants are largely psychological. One must be greedy when others are
fearful and be willing to look stupid (since no alarm bell rings at the bottom)
and look beyond short-term troubles, which can be quite real, in order to focus
on long-term values.