Key Checklist Items

In his review of Atul Gawande's book The Checklist Manifesto a few years ago, John Kay wrote:

Mr Gawande discovered that the good checklist is short but not too short. If the list is long, none of the items on it are taken very seriously. You can easily persuade people to agree to things when you ask them to mechanically click or tick their way through a list of questions. Consider the lack of attention you give to the many privacy questions asked by websites or questions on an immigration form. It turns out you can easily persuade people to declare their involvement in genocide or intention to subvert the constitution of the US by inserting the relevant question in a long list of immigration queries, all of which expect the answer yes. 

So the good checklist is selective – it doesn’t cover mistakes that are rarely made; no one goes on holiday without their suitcase. Or mistakes that don’t matter – toothpaste is available almost everywhere. 

Flying – and surgery – lend themselves to checklists because there is a large element of routine, and because the consequences of an elementary error can be devastating. The first factor makes it possible to compile a useful list, the second encourages people to use it. 

But Mr Gawande’s most important discovery was that the power of the checklist came from a less obvious source. The list empowers members of a team to monitor each other. Adherence to the list allows the nurse to correct the surgeon, the co-pilot to review the captain. The successful travel list is likely to be a family rather than an individual endeavour.

Many investors (myself included) believe checklists can be powerful tools in the investing process. Warren Buffett and Charlie Munger keep it simple and don't use a physical checklist (and didn't even before decades of experience made their process routine), while other investors like Mohnish Pabrai and Guy Spier have discussed their use of a physical checklist. Mr. Buffett's checklist/filter was summed up pretty well in this excerpt from Peter Bevelin's book Seeking Wisdom:

At a press conference in 2001, when Warren Buffett was asked how he evaluated new business ideas, he said he used 4 criteria as filters.

• Can I understand it? If it passes this filter, 
• Does it look like it has some kind of sustainable competitive advantage? If it passes this filter,
• Is the management composed of able and honest people? If it passes this filter,
• Is the price right? If it passes this filter, then we write a check

For my part, I've been experimenting with a combination of the two over the last few years. At first I started just developing a physical list, but it started to become too long because there were many examples I wanted to include, as well as other longer excerpts of things I wanted to include to help me think about a potential investment (examples are things like book passages on the capital cycle or the importance of focusing on expected returns when investing in a business with a moat).

So what I've done is create a document with a bunch of checklist-type questions as well as passages of things I want to review continually over time. I mentioned this at the end of my post on fundamentals, and it has now taken the place as being the thing I review a little bit of almost every day. I still try and read a little bit of all the books mentioned in that post, but now I do that about every week or so instead of doing it as often as before since I've moved many of the key ideas into the compiled document, which now stretches over 100 pages long.

I also continue to practice the routine I described in my post on memortation. This not only helps keep the important things almost always near the top of my mind, but it also provides a nice way for me to get focused in the morning and to get refocused when my mind begins to stray.

And then for practical and idea-specific investment use, I've spent a little time trying to focus on the key ideas to have something that can practically be reviewed and thought about, either by myself or with others before committing capital to an idea. This is an evolving list and will pretty much be different for each individual person to fit one's own preferences and philosophies. And for teams, the checklist may need to be even more simple because I think the best results come from a list that everyone both believes in and is fanatical about executing; which in the case of investing means everyone is fanatical about finding ideas that meet the criteria

Below is a current list I have together that I've found useful for myself. It will likely change a bit over time, and it probably isn't right for you. In fact, it is almost guaranteed not to be right for you. But it may be useful for some, and may give readers of this an idea for their own list, so I decided to post it. 

Key Checklist Items

What’s the downside?

What’s the case for having a reasonable expectation of making a 26% IRR (i.e. a double/100% return in 3 years, or a 2.5x/150% return in 4 years)? While the actual expected return can be less if there is adequate downside, you want there to be a reasonable chance it can produce this IRR.

If I need to get out of this because I am wrong, what will be the likely reason I was wrong on it (i.e. do a pre-mortem)?

Are you sure this is within your circle of competence? What work have you done? Do you understand how the company stands in its industry and versus its key competitors? And remember to never underestimate competition, and that high returns tend to attract competition ‘like a moth to a flame’, and this includes businesses and entrepreneurs that aren’t even competitors yet.

Is my upside 3 times greater than my downside? (And since most investments can be down at least 50% due to the unknown unknowables, you need to really look hard for growing businesses that you think will be worth about 2.5x where you are buying them over a 4-7 year period. And remember that growth can both create and destroy value, so it needs to be economically profitable growth).

“Your goal as an investor should simply be to purchase, at a rational  price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.  Over time, you will find only a few companies that meet these standards - so when you see one that qualifies, you should buy a meaningful amount of stock.  You must also resist the temptation to stray from your guidelines:  If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes.  Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio's market value.” –Warren Buffett (1996 Letter to Shareholders) [emphasis mine]

Is the business a good business?

• Does it earn high returns on capital?
• Does it have a long runway of reinvestment prospects? (Look for businesses that can at least double revenue per share in 10 years, and preferably businesses that can increase revenue per share 3-4x, with profit per share increasing even more.)
• Does it have a moat that protects those returns from competition and allows reinvestment to also occur at a high rate?
• Prefer a business that does not require a lot of capital to grow (i.e. not too capital intensive) where much of the growth will be due to the company’s own actions (instead of relying on things like commodity prices, interest rates, etc.).
• The business needs to be in a Win-Win relationship with all of its constituents to be sustainable over the long term (customers, suppliers, employees, owners, regulators, and communities).
• “A dreamy business offering has at least four characteristics. Customers love it, it can grow to very large size, it has strong returns on capital, and it’s durable in time – with the potential to endure for decades. When you find one of these, don’t just swipe right, get married.” –Jeff Bezos

Does it have a good balance sheet?

• Is there a conservative level of debt (and preferably, no debt)?
• Are there any off-balance sheet liabilities that I need to account for?
• Is the balance sheet structured to allow the company to take advantage of unforeseen opportunities or market crises should they present themselves?
• You want a company that can control its own destiny and not depend on the kindness of strangers (for access to capital, debt rollovers, etc.).

Does it have good management?

• Look for “intelligent fanatics” who are owner-operators, and where the ownership was preferably gained through buying in the open market or from founding the company, as opposed to option grants where they got the upside without the corresponding downside risk.
• You want management teams with intelligence, integrity, and energy that pursue excellence in everything they do (products, people, etc.).
• Does management understand capital allocation? Management skill in allocating capital is extremely important.

Is it trading at a good price?

• Is there a significant margin of safety? You need margin for error, because you are bound to make plenty of errors over time. So always consider the question, what if I’m wrong?

Is this a good addition to a portfolio goal of having 6-12 mostly non-correlated positions (where a position may hold more than one stock if there is high correlation among certain ideas and they look about equally attractive to purchase together).

When looking at a potential business, you need to take the mentality of buying the entire business, and retaining management. If you are buying the business as your only family asset and have to keep these people running it, how comfortable are you buying the business at this price? Make sure you are taking a fundamental, entrepreneurial view of the business and NOT an MBA/outside-investor-know-it-all type of view.

What are the 1-3 main things that will drive this business, and what data can I use to track them over time?

If you talk to management, see if you can get answers to the following:

• If you went away for 5 years and could only get updates on 1-3 business metrics to tell you how the business was doing, what would those key metrics be?
• (After assuring them their answer would be kept private…) If you had to buy the stock of any company in your industry, excluding your own, what company would it be, and why?

………………..

"Our strategy remains to own the best companies in worthwhile fields. Our companies retain an abundant potential for growth, an ability to withstand adversity, a lowish valuation, a low likelihood of the business becoming obsolete, and managements that have a record of creating franchises out of thin air. We don't focus excessively on stock prices, because we know that if our companies are gaining on competitors, building up cash and paying off debt, lowering their cost structures, and otherwise better positioning themselves for the next upcycle, we will eventually be pleased with the outcome." -Greg Alexander

Fade rates and the capital cycle...

From Capital Returns (the excerpt below was from a Marathon letter in March 2014):

Marathon looks to invest in two phases of an industry’s capital cycle. From what is misleadingly labelled the “growth” universe, we search for businesses whose high returns are believed to be more sustainable than most investors expect. Here, the good company manages to resist becoming a mediocre one. From the low return, or “value” universe, our aim is to find companies whose improvement potential is generally underestimated. In both cases, the rate at which a company reverts to mediocrity (or “fade rate”) is often miscalculated by stock market participants. Marathon’s own experience suggests that the resultant mispricing is often systematic for behavioural reasons. 

Chart 1.7 illustrates the “fade rate” of corporate returns, an idea developed by Holt Value Associates (now part of Credit Suisse). Holt’s concept of the stock market-implied fade rate chimed well with our focus on competitive conditions within industries and the flow of capital into (and out of) high (and low) return industries. Using this framework, two purchase candidates are identifiable. Purchase Candidate A is a company capable of sustaining high returns beyond the market’s expectation (the upper dotted line) – that is, the company remains above average for longer than average. Candidate B is a company which can improve faster than the market generally expects (the lower dotted line). 

Marathon’s experience suggests that the stock market is often poor at pricing superior fade characteristics. For Purchase Candidate A, mispricing stems from a number of sources. One is the underestimation of the durability of barriers to entry. Another is the underappreciation of the scale and scope of the addressable market. Management’s capital allocation skills are also often overlooked. A recent meeting with the CEO of Bunzl, the leading specialist business-to-business distributor, was instructive in this regard. While sell-side analysts covering the stock have made reasonably accurate forecasts of returns from the core business, they have consistently failed to give management credit for adding value via bolt-on acquisitions, despite 20 years or so of supporting evidence. Investors also appear to be biased against “boring” high return companies, such as Bunzl, which do not offer the prospect of immediate high share price appreciation. 

Chart 1.7 The fade rate  

Source: Marathon, Credit Suisse HOLT. 

The conditions leading to Purchase Candidate B often stem from the market misjudging the beneficial effects of reduced competition as weaker firms disappear, either through consolidation or bankruptcy. Alternately, an unruly oligopoly may tire of excess competition and enjoy an outbreak of peaceful coexistence. The turn in the capital cycle often occurs during periods of maximum pessimism, as the weakest competitor throws in the towel at a point of extreme stress. When the pain of losses coincides with a depressed share price, investors can find wonderful opportunities, particularly if they are willing to take a multiyear view and put up with short-term volatility. 

Management skill at dealing with problems may also be overlooked. This is especially true when a new leader is recruited externally, maximizing the possibility of change. The turnaround achieved at Fiat by Sergio Marchionne in recent years is one outstanding example. Highly competent managers are often attracted by the challenge of turning around a troubled company, not least because of the financial rewards.

More from Phil Fisher on diversification

From Common Stocks and Uncommon Profits and Other Writings:

Usually a very long list of securities is not a sign of the brilliant investor, but of one who is unsure of himself. If the investor owns stock in so many companies that he cannot keep in touch with their managements directly or indirectly, he is rather sure to end up in worse shape than if he had owned stock in too few companies. An investor should always realize that some mistakes are going to be made and that he should have sufficient diversification so that an occasional mistake will not prove crippling. However, beyond this point he should take extreme care to own not the most, but the best. In the field of common stocks, a little bit of a great many can never be more than a poor substitute for a few of the outstanding.

Phil Fisher on diversification

From Common Stocks and Uncommon Profits and Other Writings:

No investment principle is more widely acclaimed than diversification. (Some cynics have hinted that this is because the concept is so simple that even stock brokers can understand it!) Be that as it may, there is very little chance of the average investor being influenced to practice insufficient diversification. The horrors of what can happen to those who “put all their eggs in one basket” are too constantly being expounded.  

Too few people, however, give sufficient thought to the evils of the other extreme. This is the disadvantage of having eggs in so many baskets that a lot of the eggs do not end up in really attractive baskets, and it is impossible to keep watching all the baskets after the eggs get put into them. For example, among investors with common stock holdings having a market value of a quarter to a half million dollars, the percentage who own twenty-five or more different stocks is appalling. It is not this number of twenty-five or more which itself is appalling. Rather it is that in the great majority of instances only a small percentage of such holdings is in attractive stocks about which the investor or his advisor has a high degree of knowledge. Investors have been so oversold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others about which they know nothing at all. It never seems to occur to them, much less to their advisors, that buying a company without having sufficient knowledge of it may be even more dangerous than having inadequate diversification.  

How much diversification is really necessary and how much is dangerous? It is somewhat like infantrymen stacking rifles. A rifleman cannot get as firm a stack by balancing two rifles as he can by using five or six properly placed. However, he can get just as secure a stack with five as he could with fifty. In this matter of diversification, however, there is one big difference between stacking rifles and common stocks. With rifles, the number needed for a firm stack does not usually depend on the kind of rifle used. With stocks, the nature of the stock itself has a tremendous amount to do with the amount of diversification actually needed. 

Some companies, such as most of the major chemical manufacturers, have a considerable degree of diversification within the company itself. While all of their products may be classified as chemicals, many of these chemicals may have most of the attributes found in products from completely different industries. Some may have completely different manufacturing problems. They may be sold against different competition to different types of customers. Furthermore at times when only one type of chemical is involved, the customer group may be such a broad section of industry that a considerable element of internal diversification may still be present.  

The breadth and depth of a company's management personnel—that is, how far a company has progressed away from one-man management—are also important factors in deciding how much diversification protection is intrinsically needed. Finally, holdings in highly cyclical industries—that is, those that fluctuate sharply with changes in the state of the business cycle—also inherently require being balanced by somewhat greater diversification than do shares in lines less subject to this type of intermittent fluctuation.  

This difference between the amount of internal diversification found in stocks makes it impossible to set down hard and fast rules as to the minimum amount of diversification the average investor requires for optimum results. The relationship between the industries involved will also be a factor. For example, an investor with ten stocks in equal amounts, but eight of them bank stocks, may have completely inadequate diversification. In contrast, the same investor with each of his ten stocks in a completely different industry may have far more diversification than he really needs.

Links

Catching up on news and links while doing a bit of traveling...

Tim Ferriss has worked with John Robinson, who narrated a previous selection of Seneca's letters, to do a more complete version of the letters. The early Amazon reviews are a bit mixed on the audio quality, but I enjoyed Robinson's previous narration, so I hope the quality is similar: Volume 1, Volume 2, Volume 3 [You can also listen to a sample, HERE.]

Latticework of Mental Models: Reason Respecting Tendency (LINK)

Seth Klarman's super-secretive and successful hedge fund had its third-losing year ever -- here's what happened [H/T Linc] (LINK)

ValueWalk has also started its usual great coverage of Klarman's year-end letter (LINK)

Horizon Kinetics' Q4 Commentary (LINK)

John Hempton's December 2015 letter (LINK)

Pershing Square's 2015 letter (LINK)

An interview with George Soros - ‘The EU Is on the Verge of Collapse’ (LINK)

Mohamed A. El-Erian on Charlie Rose (video) (LINK)

Related book: The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse

Blythe Masters Firm Raises Cash, Wins Australian Contract (LINK)

How Facebook Squashed Twitter (LINK)

This 60 Minutes segment from a couple of Sundays ago shows what can happen, under worst-case scenarios, with companies that rely on intellectual property (especially software companies): The Great Brain Robbery

A few recent TED Talks look interesting:

Elizabeth Lev: The unheard story of the Sistine Chapel 

Yanis Varoufakis: Capitalism will eat democracy — unless we speak up 

David Gruber: Glow-in-the-dark sharks and other stunning sea creatures

Edge: Remembering Marvin Minsky (LINK)

The question Warren Buffett used to ask every CEO...

From Charlie Munger: The Complete Investor:

Munger is a believer in the investment approaches and ideas of Philip Fisher. Fisher was a successful investor based in California who wrote an influential book entitled Common Stocks and Uncommon Profits, first published in 1958. One of these ideas is that the successful investor is usually inherently interested in business problems. It is precisely for this reason that Ben Graham said that the best approach to investing is to be businesslike. The idea is that, in order to understand the stock, you must understand that the business is fundamental to the Graham value investing system. For this reason, investors like Fisher and Munger developed a “scuttlebutt” network of people who can help them to learn more about a business. What they inevitably find is that people involved in an industry will talk freely about their competitors as long as they believe they will not be quoted. Buffett uses the same approach: 

I would go out and talk to customers, suppliers, and maybe ex-employees in some cases. Everybody. Every time I was interested in an industry, say it was coal, I would go around and see every coal company. I would ask every CEO, “If you could only buy stock in one company that was not your own, which one would it be and why?” You piece those things together, you learn about the business after a while. —WARREN BUFFETT, UNIVERSITY OF FLORIDA, 1998

THE TENETS OF CAPITAL CYCLE ANALYSIS

From Ed Chancellor in his introduction to Capital Returns: Investing Through the Capital Cycle: A Money Manager's Reports 2002-15:

The essence of capital cycle analysis can thus be reduced to the following key tenets:

• Most investors devote more time to thinking about demand than supply. Yet demand is more difficult to forecast than supply. 
• Changes in supply drive industry profitability. Stock prices often fail to anticipate shifts in the supply side. 
• The value/growth dichotomy is false. Companies in industries with a supportive supply side can justify high valuations. 
• Management’s capital allocation skills are paramount, and meetings with management often provide valuable insights. 
• Investment bankers drive the capital cycle, largely to the detriment of investors. 
• When policymakers interfere with the capital cycle, the market-clearing process may be arrested. New technologies can also disrupt the normal operation of the capital cycle. 
• Generalists are better able to adopt the “outside view” necessary for capital cycle analysis. 
• Long-term investors are better suited to applying the capital cycle approach.

More from Ed Chancellor on focusing on industry supply...

From his introduction to Capital Returns: Investing Through the Capital Cycle: A Money Manager's Reports 2002-15:

FOCUS ON SUPPLY RATHER THAN DEMAND 

Given that the future is uncertain, why should Marathon’s approach fare any better? The answer is that most investors spend the bulk of their time trying to forecast future demand for the companies they follow. The aviation analyst will try to answer the question: How many long-haul flights will be taken globally in 2020? A global autos strategist will attempt to forecast China’s demand for passenger cars 15 years hence. No one knows the answers to these questions. Long-range demand projections are likely to result in large forecasting errors. 

Capital cycle analysis, however, focuses on supply rather than demand. Supply prospects are far less uncertain than demand, and thus easier to forecast. In fact, increases in an industry’s aggregate supply are often well flagged and come with varying lags – depending on the industry in question – after changes in the industry’s aggregate capital spending. In certain industries, such as aircraft manufacturing and shipbuilding, the supply pipelines are well-known. Because most investors (and corporate managers) spend more of their time thinking about demand conditions in an industry than changing supply, stock prices often fail to anticipate negative supply shocks [33]. 

ANALYZE COMPETITIVE CONDITIONS WITHIN AN INDUSTRY 

From the investment perspective, the key point is that returns are driven by changes on the supply side. A firm’s profitability comes under threat when the competitive conditions are deteriorating. The negative phase of the capital cycle is characterized by industry fragmentation and increasing supply. The aim of capital cycle analysis is to spot these developments in advance of the market. New entrants noisily trumpet their arrival in an industry. A rash of IPOs concentrated in a hot sector is a red flag; secondary share issuances another, as are increases in debt. Conversely, a focus on competitive conditions should alert investors to opportunities where supply conditions are benign and companies are able to maintain profitability for longer than the market expects. An understanding of competitive conditions and supply side dynamics also helps investors avoid value traps (such as US housing stocks in 2005–06). 

[33] Several accounting based measures provide insights into the capital cycle. As observed above, stocks with the fastest asset growth tend to underperform. When a company’s capital expenditure relative to depreciation rises above its average level it may be a sign that the capital cycle is deteriorating (see 1.4 “Supercycle woes” and Chapter 1, “A capital cycle revolution”). A rising gap between reported earnings and free cash flow is another warning sign (see 1.7 “Major concerns”). The Herfindahl Index provides a statistical measure of industry concentration which may reveal changes in competitive conditions. Anecdotal signs prove just as useful in gauging the capital cycle. It’s generally a bad sign when a company starts building a grandiose new head office (see 4.9 “On the rocks”)

...................

Related previous post: Investors should be thinking 90% about supply...

The advantage of objectivity...

From Howard Marks in his memo "On the Couch":

One of the most significant factors keeping investors from reaching appropriate conclusions is their tendency to assess the world with emotionalism rather than objectivity.  Their failings take two primary forms: selective perception and skewed interpretation.  In other words, sometimes they take note of only positive events and ignore the negative ones, and sometimes the opposite is true.  And sometimes they view events in a positive light, and sometimes it’s negative.  But rarely are their perceptions and interpretations balanced and neutral. 

...investor psychology rarely gives equal weight to both favorable and unfavorable developments.  Likewise, investors’ interpretation of events is usually biased by their emotional reaction to whatever is going on at the moment.  Most developments have both helpful and harmful aspects.  But investors generally obsess about one or the other rather than consider both. 

...It all seems so obvious: investors rarely maintain objective, rational, neutral and stable positions.  First they exhibit high levels of optimism, greed, risk tolerance and credulousness, and their resulting behavior causes asset prices to rise, potential returns to fall and risk to increase.  But then, for some reason – perhaps the arrival of a tipping point – they switch to pessimism, fear, risk aversion and skepticism, and this causes asset prices to fall, prospective returns to rise and risk to decrease.  Notably, each group of phenomena tends to happen in unison, and the swing from one to the other often goes far beyond what reason might call for.

That’s one of the crazy things: in the real world, things generally fluctuate between “pretty good” and “not so hot.”  But in the world of investing, perception often swings from “flawless” to “hopeless.”  The pendulum careens from one extreme to the other, spending almost no time at “the happy medium” and rather little in the range of reasonableness.  First there’s denial, and then there’s capitulation. 

..........

The above reminded me of a quote from Charlie Munger:

“It’s kind of fun to sit there and outthink people who are way smarter than you are because you’ve trained yourself to be more objective and more multidisciplinary. Furthermore, there is a lot of money in it, as I can testify from my own personal experience.”

As well as this excerpt from one of his speeches in Poor Charlie's Almanack:

Engaging in routines that allow you to maintain objectivity are, of course, very helpful to cognition. We all remember that Darwin paid special attention to disconfirming evidence, particularly when it disconfirmed something he believed and loved. Routines like that are required if a life is to maximize correct thinking. And one also needs checklist routines. They prevent a lot of errors, and not just for pilots. You should not only possess wide-ranging elementary wisdom but also go through mental checklist routines in using it. There is no other procedure that will work as well.

Links

Oaktree Insights: Investing in Real Estate [H/T ValueWalk] (LINK)

In this Oaktree Insights paper, John Brady (Real Estate Portfolio Manager) explores the introductory concepts of real estate investing and provides an overview of Oaktree's investment strategy and our perspective on the asset class.

Ray Dalio on CNBC (Video 1, Video 2, Video 3)

Lagarde, Fang, Dalio Discuss China Outlook at Davos (video) (LINK)

Bloomberg Debate on Future of Finance at WEF in Davos (video) (LINK)

Yale's Shiller: Markets Over-focused on China, Oil (video) (LINK)

Raghuram Rajan: China, Oil Trigger for Market Volatility (video) (LINK)

The FANG Playbook (LINK)

Latticework of Mental Models: Matthew Effect (LINK)

Stephen Hawking: Humans at risk of lethal 'own goal' [H/T Will] (LINK)

More (and Best Yet) Evidence That Another Planet Lurks in the Dark Depths of Our Solar System (LINK)

Howard Marks Memo: What Does the Market Know?

Link to Memo: What Does the Market Know?

My buddy Sandy was an airline pilot.  When asked to describe his job, he always answers, “hours of boredom punctuated by moments of terror.”  The same can be true for investment managers, for whom the last few weeks have been an example of the latter.  We’ve seen bad news and prices cascading downward.  Investors who thought stocks were priced right 20% ago and oil $70 ago now wonder if they aren’t risky at their new reduced prices. 

In Thursday’s memo, “On the Couch,” I mentioned the two questions I’d been getting most often: “What are the implications for the U.S. and the rest of the world of China’s weakness, and are we moving toward a new crisis of the magnitude of what we saw in 2008?”  Bloomberg invited me on the air Friday morning to discuss the memo, and the anchors mostly asked one version or another of a third question: “does the market’s decline worry you?”  That prompted this memo in response.

Links

James Montier: Market Macro Myths: Debts, Deficits, and Delusions [free registration may be required] (LINK)

In this white paper James Montier attempts to show why the proponents of sound finance are mistaken by defining and unpacking a series of “myths” that are foundational to, or at least helpful to, convincing us that sound finance requires that governments run a balanced budget.

Greenlight Capital's Q4 2015 letter to partners (LINK)

Brookfield CEO Bruce Flatt on Bloomberg (video) [H/T Santangel's Review] (LINK)

I've only watched one of the videos below so far, but here are some others that stood out as potentially interesting after a quick scan through more of the Conversations with History shows:

Conversations with History: Joseph Tussman (January 2000) (video) (LINK) [Related book which I have not read but looks interesting: Habits of Mind: The Experimental College Program at Berkeley]

Conversations with History: Paul Ekman (April 2004) (video) (LINK)

Conversations with History: John Kenneth Galbraith (video) (LINK)

Conversations with History: Sebastian Mallaby (video) (LINK)

Conversations with History: Amy Chua (April 2008) (video) (LINK)

Conversations with History: Daniel Kahneman (April 2007) (video) (LINK)

Links

How to Feel Safe in Stocks When the Market Seems Dangerous - by Jason Zweig (LINK)

Long-term Thinking and Back to Basics - by John Huber (LINK)

More than A Dozen Reasons Why Investing in Airlines Belongs in the Too Hard Pile - by Tren Griffin (LINK)

Michael Lewis: the scourge of Wall Street [H/T Linc] (LINK)

Related book: The Big Short

Barrron's thinks Colfax is a tempting long-term buy (LINK)

Amazon is cutting out middlemen to stop bleeding billions in shipping costs [H/T @activiststocks] (LINK)

Hussman Weekly Market Comment: An Imminent Likelihood of Recession (LINK)

Since October, the economic evidence has shifted from supporting a growing risk of recession, to a guarded expectation of recession, to the present conclusion that a U.S. recession is not only a risk but an imminent likelihood, awaiting confirmation that typically only emerges after a recession is actually in progress. The reason the consensus of economists has never anticipated a recession is that so few distinguish between leading and lagging data, so they incorrectly interpret the information available at the start of a recession as “mixed” when, placed in proper sequence, the evidence forms a single, coherent freight train. 

While I’m among the only observers that anticipated oncoming recessions and market collapses in 2000 and 2007 (shifting to a constructive outlook in-between), I also admittedly anticipated a recession in 2011-2012 that did not emerge. Understand my error, so you don’t incorrectly dismiss the current evidence.

Paul Graham essay: Life is Short (LINK)

Yuval Noah Harari on Why Humans Dominate the Earth: Myth-Making (LINK)

Related book (one of my favorites): Sapiens: A Brief History of Humankind

Brightest-ever supernova still baffles astronomers (LINK)

I’m STILL Not Sayin’ Aliens. But This Star Is Really Weird. (LINK)

The tendency to overlook negatives...

From Howard Marks in his memo "On the Couch":

One of the most notable behavioral traits among investors is their tendency to overlook negatives or understate their significance for a while, and then eventually to capitulate and overreact to them on the downside.  I attribute a lot of this to psychological failings and the rest to the inability to appreciate the true significance of events. 

 

As negatives accumulate – whether they surface for the first time or just are finally recognized as significant – eventually a time comes when they can no longer be ignored, and instead they come to be treated as being of overwhelming importance.

Links

Nice graphic showing the performance of stocks in the S&P 500 [H/T Linc] (LINK)

Howard Marks on Bloomberg (Video 1, Video 2)

Five Good Questions for Victor Ricciardi about his book Investor Behavior (video) (LINK)

Hoisington Quarterly Review and Outlook, Fourth Quarter 2015 [H/T ValueWalk] (LINK)

Bitcoin Is Dead, Long Live Bitcoin (LINK)

TED Talk - Jill Heinerth: The mysterious world of underwater caves (LINK)

Howard Marks Memo: On the Couch

Link to Memo: On the Couch

I woke up early on Saturday, December 12 – the morning after a day of significant declines in stocks, credit and crude oil – with enough thoughts going through my mind to keep me from going back to sleep.  Thus I moved to my desk to start a memo that would pull them together.  I knew it might be a long time between inception and eventual issuance, since every time I dealt with one thought, two more popped into my head.  In the end, it took a month to get it done.

 

Professor Richard Thaler of the University of Chicago is a leading expert on behavioral economics and decision-making (in fact, he’s such a significant figure in the field that he was given a cameo role in the movie The Big Short).  He opens his new book, Misbehaving, with Vilfredo Pareto’s assertion that “the foundation of political economy and, in general, of every social science, is evidently psychology.”  I’d apply that equally to the not-so-scientific field of investing.

 

It has been one of my constant refrains – dating back all the way to “Random Thoughts on the Identification of Investment Opportunities” (January 1994) – that in order to be successful, an investor has to understand not just finance, accounting and economics, but also psychology.  A thorough understanding of how investors’ minds work is essential if one is to figure out where a market is in its cycle, why, and what to do about it.  For me, the markets’ recent behavior – certainly on December 11, but also at other points in 2015 – reinforces that observation. 

 

This memo is my attempt to send the markets to the psychiatrist’s couch, and an exploration of what might be learned there.

Links

Latticework of Mental Models: Social Proof (LINK)

Kevin Plank Is Betting Almost $1 Billion That Under Armour Can Beat Nike [H/T @iancassel] (LINK)

Former Apple CEO John Sculley shares the most important thing he learned from Steve Jobs [H/T @BaseHitInvestor] (LINK)

Related book: Moonshot!: Game-Changing Strategies to Build Billion-Dollar Businesses

Investing book of the day: Quality Investing: Owning the best companies for the long term

Charlie Munger on being fair

From the Berkshire 2011 Annual Meeting (as quoted in Charlie Munger: The Complete Investor):

Generally speaking, where Berkshire has the power, we try to be more than fair to the minority who don’t have the power and who depend on us. You can say, “Aren’t they wonderful, moral people?” I’m not sure we get credit for a lot of morality because we early knew how advantageous that would be to get a reputation for doing the right thing and it’s worked out well for us. And my friend Peter Kaufman said, “If the rascals really knew how well honor worked, they would come to it.” It really has worked well. People make contracts with Berkshire all the time because they trust us to behave well where we have the power and they don’t. There’s an old expression on this subject, which is really an expression on moral theory: “How nice it is to have a tyrant’s strength and how wrong it is to use it like a tyrant.” It’s such a simple idea but it’s a correct idea. 

Links

TED Talk - Tim Harford: How messy problems can inspire creativity (video) (LINK)

The $500 Million Battle Over Disney’s Princesses: How Hasbro grabbed the lucrative Disney doll business from Mattel (LINK) [H/T @ChrisPavese] (LINK)

Greg Ip on EconTalk discussing his book Foolproof: Why Safety Can Be Dangerous and How Danger Makes Us Safe (LINK)

Book of the day: Birdseye: The Adventures of a Curious Man

Given the areas of the market that are getting hit especially hard right now, maybe one or more of the documentaries below will be of interest to some:

Crude - The Incredible Journey Of Oil

Offshore Oil Drilling Industry

World's Marvelous Oil Tankers

Super Tanker: LNG Carrier

The Biggest SHIP in the World 2015

Links

Today's Audible Daily Deal ($3.95) is a worthwhile listen: The Hard Thing About Hard Things: Building a Business When There Are No Easy Answers - by Ben Horowitz

Broyhill Book Club 2015 - by Chris Pavese (LINK)

In Silicon Valley Now, It’s Almost Always Winner Takes All [H/T @BrattleStCap] (LINK)

Apollo Asia Fund's Q4 report: Upheaval and new perspectives (LINK)

The First Million - by Ian Cassel (LINK)

What made Charles Darwin an Effective Thinker? Follow the Golden Rule (LINK)

Links

A Dozen Things Learned about Investing from Jim Chanos (LINK)

A New Year Message from Horizon Kinetics (LINK)

In 2015, we continued to observe evidence of the impact of indexation as the primary investment modality. At the risk of sounding like a broken record, we can’t help but share yet another data point illustrating the valuation dichotomy created by the ETF divide, which to our knowledge is unprecedented, at least in our three-plus decades of investing experience. The largest 15 companies in the S&P 500 Index have an aggregate market capitalization of $4.7 trillion dollars. That is also the total market capitalization of the smallest 346 companies in the S&P 500. Looked at in another way, the 15 highest-contributing stocks, with an average aggregate weight of 13%, produced about 280% of the S&P’s return. That’s the extent of bifurcation which investors face. Mindboggling as it is, this is reality. 

Of course, our ongoing study on the subject of indexation begs the question: how does it all end? Fee competition continues to trend toward a dead end: the iShares Total Market ETF (ITOT), which purports to include every possible subset that is buyable in the stock market, just lowered its expense ratio to three basis points, which is three 100ths of 1%. We believe that this is a seminal moment in indexation mass-investing. As the profitability is squeezed out of it, so too will be the incentive of the manufacturers and promoters to practice it. This change will have completely unpredictable consequences for equities at large, because ETF asset flows have been dominating valuations with no regard whatsoever for the fundamental properties of the underlying securities they comprise.

Hussman Weekly Market Comment: Complex Systems, Feedback Loops, and the Bubble-Crash Cycle (LINK)

In any complex system, there are typically two types of feedback loops at work. Some feedback loops are balancing, so that deviations from some desired target are followed by actions to push the system back to that target. Your body has lots of these, which keep your temperature, blood sugar, and other vital processes in check. Other feedback loops are self-reinforcing, so that deviations from some starting point are followed by changes that push the system even further from that point. Cancer and viral replication are among those self-reinforcing feedback loops, and can be fatal if left unchecked by a balancing loop. 

Any system that rewards the winner of one competition with the means to win the next competition also contains a self-reinforcing feedback loop. Many internet and social media companies benefit from this dynamic, because new users tend to gravitate toward the platforms chosen by existing users. Even if these companies operate with little profit, speculative financial markets may provide them with a war chest of cash through overvalued public offerings, which can then be used to acquire other businesses. The U.S. income distribution has featured a similar feedback loop in recent decades because repeated cycles of capital misallocation have resulted in a scarcity of productive investment. The irony is that as productive capital becomes scarce, the pie becomes smaller, but a larger share goes to the owners of existing capital. Fed policymakers then respond to economic weakness with actions that amplify the misallocation of capital. Instead of continuing these monetary distortions, the best way to improve the distribution of income in the U.S. would be to encourage productive investment at every level - government (productive infrastructure, clean energy), industry (investment and R&D incentives), and individuals (education, job training). This would contribute both to a larger pie and a more equitable income distribution. 

Most complex systems contain both balancing and self-reinforcing feedback loops, and the behavior of the overall system can change dramatically depending on which loop becomes dominant at any point in time

BRIEF HISTORY & INTRODUCTION OF RUBBER (LINK)

Book of the day: Cod: A Biography of the Fish that Changed the World

While I've had the book Cod on my list for a while, it was brought back to my attention from this paragraph in the book Capital Returns:

Thoughtful investment managers probably packed Capital: The Story of Long-Term Investment Excellence by Charles Ellis for their beach reading this year. Instead, our pick of the holiday reading this year is Cod by Mark Kurlansky. In this wonderful book, Kurlansky describes the rise and fall of the cod fishing and processing industry from the perspective of a social historian and gastronome, and the book takes the form of a culinary travelogue peppered with recipes. The recipes look appealing, but our advice is to read the book from the perspective of the capital cycle; then the industry’s rise and fall becomes even more interesting.

Links

Sanjay Bakshi: NO HEDONIC TREADMILL FOR MR. CHANDRAN (LINK)

Latticework of Mental Models: Game Theory (LINK)

Five Good Questions for Gareth Jones about his book Why Should Anyone Work Here? (LINK)

a16z Podcast: Blockchain vs./and Bitcoin (LINK) [This was from November, but I just got to it, and it provided some hints as to how the Blockchain may find its way into financial markets that I thought were worthwhile things to think about.]

Links

Last night, I finished watching the first two segments from the last 60 Minutes episode, on the sinking of the El Faro (LINK) and the Agromafia (LINK), and I thought both were interesting.

Buffett Nears Buyback Threshold as Shares Extend Slump (LINK)

PayPal Co-Founder Max Levchin's Bet on Cryptography (video) (LINK)

Audible's latest sale goes until January 10th, and includes some good titles (I think you have to be a member, and if you aren't you can get a free trial HERE). Some that stood out to me:

The Most Important Thing ($3.99)

Common Sense on Mutual Funds ($4.95)

Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist ($4.95)

Law 101: Everything You Need to Know About American Law ($4.95)

The Primal Blueprint ($4.95)

Good Calories, Bad Calories ($4.95)

The 48 Laws of Power ($4.95)

On the Path to Enlightenment: Heart Advice From the Great Tibetan Masters (4.95)

Links, and a few comments

The Motley Fool interviews Sanjay Bakshi (LINK)

Focusing on the Investment Process (LINK)

Economic Inequality: The Simplified Version - by Paul Graham (LINK)

Nassim Nicholas Taleb on the Real Financial Risks of 2016 (LINK)

Teams of foxes make the best forecasts, but expert hedgehogs can help - by John Kay (LINK)

Related book: Superforecasting

Horizon Kinetics - What's in Your Index? The Beta Game - Part II (LINK)

The Ghosts of Baha Mar: How a $3.5 Billion Paradise Went Bust (LINK)

Book of the day (just released): Deep Work: Rules for Focused Success in a Distracted World

*****

On the topic of forecasts (which seems relevant given a couple of links above)...

I occasionally take pictures of forecasts I see people make online and then use Google's Inbox email service to have those pictures re-sent to me at some point in the future. It serves as a good example to ignore nearly every forecast, especially about the future, and especially if they have anything to do with the price of something over a short period of time. The one that showed up today was from an oil 'expert' whom I like and whose work I respect. In July of last year, he was predicting that "for a variety of fundamental reasons" oil was likely to end 2015 above $75 per barrel. It was a post he made on Twitter which it appears he has since deleted. I won't mention his name here, but just wanted to point out that you need to even be careful when finding useful people to pay attention to because they can selectively craft their prediction record to look better that it actually might be. As hard, or impossible, as it is for people to predict the future, it's also hard to predict who may have been correct in the past because you may not see the entire paper trail (and this is before even taking the extreme role of luck into consideration). I think it was probably a worthless exercise to try and predict something like the price of oil a few months out in the first place. But since he used the word "likely" in his prediction, maybe he was even right, and that the less likely event is what happened. But given that this particular prediction was deleted, probably because it didn't look so good when the end of the year was approaching, the historical narrative when trying to judge his future comments is now distorted, though most who read this blog probably don't pay much attention to such forecasts anyway.

I especially wanted to mention the above because there are a number of companies that have been bought at much higher prices by respected value investors that have been correlated with the price of oil (and other commodities) that have taken another leg down lately. The question now becomes whether or not the current prices provide enough downside protection where the commodity prices are less relevant to making an investment decision because the risk/reward equations have become so favorable. A few names that come to mind that are big enough for me to mention here are things like Subsea 7, TGS Nopec, SEACOR, and Colfax. Many investors don't even consider names like this, and I think that's fair enough. But given that it is an area that has gotten as beaten down as it has, I am reminded of the Howard Marks quote:

Skepticism is usually thought to consist of saying, “no, that’s too good to be true” at the right times. But I realized in 2008—and in retrospect it seems so obvious—that sometimes skepticism requires us to say, “no, that’s too bad to be true.”

If anyone happens to have any on-the-ground type of scuttlebutt on these names (i.e. not just the stuff that can be found in filings or online), I'd love to hear what you might be willing to share. Thanks.

Links

How To Find Intelligent Fanatic CEOs Early (LINK)

Culture Eats Strategy: Nucor’s Ken Iverson on Building a Different Kind of Company (LINK)

Related book: Plain Talk: Lessons from a Business Maverick 

Related previous post: The importance of culture

Mohnish Pabrai: Bubbles - Past, Present and Future (video) [H/T ValueWalk] (LINK)

The Absolute Return Letter - January 2016 (LINK)

When tarantulas grow blue hair (LINK)

Investing book of the day: The Zulu Principle

Investing quote of the day: "...once an outstanding management has proven itself and fundamental conditions have not changed, shares should never be sold just because the stock has had a huge rise and may seem temporarily high priced." -Phil Fisher (Common Stocks and Uncommon Profits and Other Writings)

Links

Bill Gates on Books and Blogging (LINK)

The latest essays from Paul Graham: 1) The Refragmentation; and 2) Economic Inequality

Energy Equities Are Cheap? Define That, Please (LINK)

Book of the day: The Personal MBA

Links

Kyle Bass on Wall Street Week (video) (LINK)

Mutual Fund Observer, January 2016 (LINK)

Hussman Weekly Market Comment: The Next Big Short: The Third Crest of a Rolling Tsunami (LINK)

Over the holiday, we went with a group of friends to see The Big Short, based on the book by Michael Lewis about the global financial crisis. The film is deeply critical of Wall Street and weak banking regulation, most of which I see as valid. The one thing missing was that the film didn’t clarify why the mortgage bubble emerged in the first place, which I would have liked Margot Robbie to have mentioned while she was explaining mortgage-backed securities in the bubble bath. 

The answer is straightforward: as the bubble expanded toward its inevitable collapse, the role of Wall Street was to create a massive supply of new “product” in the form of sketchy mortgage-backed securities, but the demand for that product was the result of the Federal Reserve’s insistence on holding interest rates down after the tech bubble crashed, starving investors of safe Treasury returns, and driving them to seek higher yields elsewhere. 

See, the Fed reacted to the collapse of the tech bubble and the accompanying recession holding short-term rates to just 1%, provoking yield-seeking by income-starved investors. They found that extra yield in seemingly “safe” mortgage securities. But as the demand outstripped the available supply, Wall Street rushed to create more product, and generate associated fees, by lending to anyone with a pulse (hence "teaser" loans offering zero interest payments for the first 2 years, and ads on TV and radio hawking “No income documentation needed! We’ll get you approved fast!”; “No credit? No problem! You have a loan!”; “Own millions of dollars in real estate with no money down!”). The loans were then “financially engineered” to make the resulting mortgage bonds appear safer than the underlying credits were. The housing bubble was essentially a massive, poorly regulated speculative response to Federal Reserve actions. 

The current, obscenely overvalued QE-bubble is simply the next reckless response to Federal Reserve actions, which followed the global financial crisis, which resulted when the housing bubble collapsed, which was driven by excessively activist Federal Reserve policy, which followed the collapse of the tech bubble. As my wife Terri put it “It’s like a rolling tsunami.”

Richard Duncan warns of weak credit growth ahead for 2016 and 2017 (LINK)

Between 1952 and 2008, every time US credit growth (adjusted for inflation) fell below 2%, the United States went into recession. During that period, the ratio of total credit to GDP rose from 150% to 380%. In other words, credit growth drove economic growth; and when credit did not grow, neither did the economy. 

...Credit growth looks likely to fall back below the 2% recession threshold next year. If the Fed’s inflation forecasts are correct, then credit growth (adjusted for inflation) could fall to 1.6% next year and to only 1.0% in 2017.

[And if you want to subscribe to Richard Duncan's Macro Watch newsletter, you should also still be able to use the coupon code 'valueinvestingworld' to get 50% off.]

Links

The Edge Annual Question 2016: WHAT DO YOU CONSIDER THE MOST INTERESTING RECENT [SCIENTIFIC] NEWS? WHAT MAKES IT IMPORTANT? (LINK)

Warren Buffett Arrives in Europe: Seeking Quality Companies to Preserve and Protect (LINK)

Related book:  Berkshire Beyond Buffett

Hayman's Bass Sees Energy as Investment Opportunity as Glut Ends (LINK)

John Malone 1994 interview [H/T @Find_Me_Value] (LINK)

Other People’s Yachts: Churchill and his Money, or Lack of It [H/T @ChrisMayerAgora] (LINK)

Related book: No More Champagne: Churchill and His Money

Five Good Questions for Arthur Benjamin about his book The Magic of Math (video) (LINK)

Clips of a number of famous founders on how they got started (Bezos, Jobs, Oprah, Branson, Page, Zuckerberg) (video) [H/T @iancassel] (LINK)

Comedians In Cars Getting Coffee: President Barack Obama (video) (LINK)

Book of the day: How to Talk to Anyone: 92 Little Tricks for Big Success in Relationships