Interview with Arif Karim of Ensemble Capital

Read as PDF…

I am in my 50ies now, and obviously I read and have read a lot of books. I was late to find interesting things about investing, on Twitter and online in general. But these days I find more and more very high-quality material online, and also a genuine desire to share and educate. As most things online, I stumbled across Ensemble Capital a few years ago, and was immediately struck by the quality of what they produce, and in so many ways and forms. A great blog, twitter & quarterly calls, with detailed discussion on what went wrong and what went right. Regardless if you agree or not with their conclusions, you should learn more about their ideas and their processes. Below you will get a jumpstart, thanks to Arif.

Out of the blue I just sent Ensemble an e-mail, which Arif picked up, and he kindly agreed to answer some very detailed questions. Not many would take the time or be able to answer in this fashion. He shares details about his personal journey in the investing world, which I think are highly inspirational. You are all in for a treat. Enjoy! /Bo

Arif is a senior investment analyst at Ensemble Capital. Before joining Ensemble Capital, he was a senior investment analyst and co-portfolio manager at Kilimanjaro Capital. Positions prior to that included senior equity analyst at Pacific Edge Investment Management and research associate at Robertson Stephens & Co. Arif graduated from the Massachusetts Institute of Technology with a BS in Economics and he is also a CFA charterholder. Follow Ensemble here: or here:

Dear Arif, Thanks for the Q&A opportunity. You, and your firm, is an example of how sharing increases everyone’s knowledge, both your own, your readers and your investors. I am very impressed with the content on your site. So, let's get started.

1. Please tell us something on how you personally found your investment style, and what experiences have formed your investment beliefs over time. If you mention a book or two, we would appreciate it.

First of all, thank you for your kind words and this opportunity to speak with you and all your readers, Bo. We write about and discuss our ideas both to share our perspective based on our experiences and to connect with those with similar investment philosophies, so we can learn from them as well and continue to evolve our collective investment acumen.

As far as my own evolution as an investor, I stumbled into investing after my 10thgrade math teacher roped me into a new investment club she started for a local newspaper competition. That got me hooked on investing and business. Later in college, I read Peter Lynch’s Beating the Streetand it suddenly dawned on me that I could be an investor for a living, which literally felt like an epiphany since I loved my investing side hobby! I had also heard about Buffett as this great genius investor but didn’t really get to reading his writing till after college (I tried to tackle The Intelligent Investor, but it was too dry and unrelatable). 

I moved to the San Francisco Bay Area, both because it was the hotbed of technology and also because I learned Wall Street just took itself too seriously after interning there. I loved the attitude in San Francisco, where people took pride in both working hard but also playing hard in its active, beautiful natural environment – it seemed a lot more of a balanced focus and it was just my style!

I worked at an investment bank in the middle of the Dotcom boom, while I was reading about Buffett – his sensibility and investing style just made sense to me. I think people are drawn to investing styles that resonate with their personalities and value investing certainly suited mine. 

But it was hard to be a value investor at a sell-side research department that pitched technology companies that were very highly valued, justified by very optimistic growth prospects, eyeball metrics, and “GIGO” DCF calculations. While the thematic “thought pieces” discussing grand future did turn out to be generally prescient, the business models would take a decade or two to come to fruition, with most of those early companies sidelined to irrelevance. However, a few of those that survived the cold winter of the Dotcom Bust grew to become vastly more valuable than anyone would have imagined (e.g. Amazon, Booking Holdings). 

I knew I wanted to end up on the buyside like my favorite investors at the time, namely Peter Lynch, Warren Buffett, Bill Miller, and George Soros, but I also loved technology… so I was fortunate to be introduced to a wonderful woman who managed a small cap long/short value tech fund, and we just hit it off. She ticked all my boxes – smart, a genuinely nice person, with a long/short value investment style that resonated with me. And I had a great experience working with her, where she taught me the ropes of investing in small/mid cap tech. It was an especially exciting time when I joined her in 2000… shorting stocks was really fun then! 

But by 2007, I felt like the sandbox we were investing in was getting to be too limiting and my interests had grown beyond tech. In addition, small cap tech investing was mostly about taking advantage of near-term product cycles and I wanted to be able to invest in higher “quality” companies that could sustainably grow (“compound”) profitably over long periods of time. It was a sort of coming of age moment for me.

I took a year off to travel in 2008 to see the world with my wife, a “bucket list” dream we both shared, and came away with an understanding that I had naively never thought about – countries around the world were developing and people all pretty much had similar desires and goals underneath their varied cultures. It just opened the world to me as a human and an investor. 

In addition, I saw the potential of the iPhone and internet connectivity as a power user during my travels. I could do everything with it – take pictures, listen to music, email, call, make hotel and flight bookings. It was a computer in my pocket, and I was able to connect to the internet from the mountains in the Andes to beaches in Thailand and in every major city in the world. It was an incredible realization! And I was convinced that the wealthiest 20% of the world’s population would want one and be willing to pay for one. 

My travels brought that insight of global connectivity, applicability of key preferences across geographies, and the global scale certain types of businesses could achieve.

When I returned in 2009, I started my own investment fund - I had lived in Silicon Valley and, of course, I wanted to try my hand at my own startup! As an investor, I wanted to learn and morph into a generalist, who sought out companies with secular global growth tailwinds and competitively advantaged business models. There was a steep learning curve involved in running a business for the first time, in learning about industries outside of technology, and in managing a portfolio. My partner and I had a lot of fun and learned a ton on how operating businesses actually work and how value creation works in the real world. 

Ensemble Capital Management reached out to me at the right time in 2015, when I was ready to go from a multifaceted role of running and trying to scale my own business back to focusing on investment research on companies, which is my true passion. As I learned more about the firm, I realized Ensemble was the “grown up” version of the firm I had been trying to build, with the right complementary investment philosophy (concentrated portfolio full of “moaty” companies), a disciplined strategy focused on business analysis (it takes conviction and courage to truly be a long term investor), and yet it had the flexibility to evolve its process with new learnings. In Sean Stannard-Stockton, the President and CIO of Ensemble, I found a kindred investor who is also curious, open-minded, and grounded in good judgement. Along with Todd Wenning, we’ve enjoyed working together, uncovering new companies, and continually improving our investment process and acumen.

In summary, my natural inclination towards value investing combined with my intellectual interest in investing, technology, and business value creation led me through a series of learnings that took me from the traditional mold of a value investor of the deep-value Ben Graham cigar-butt style backward-looking investor to a quality, moat-oriented, forward-looking intrinsic value investor. 

As far as books are concerned, I read a lot of different types of books, usually in waves of thematic interest. Some of my favorites related to investing and business are popular/biographical reads like Roger Lowenstein’s and Alice Schroeder’s biographies of Warren Buffett, Peter Kaufman’s Poor Charlie’s AlmanackDamn Right by Janet Lowe, Brad Stone’s The Everything Store, Mark Robichaux’s The Cable Cowboy, Ray Dalio’s Principles, and Jim Collin’s Good to Great and Built to Last. I also like broader concept/history books like Michael Mauboussin’s More Than You Know, Yuval Harrari’s Sapiens, Jared Diamond’s Guns, Germs, and Steel, and Peter Bernstein’s Against the Gods

A couple of influential books outside of business for me were the science fiction book Stranger in a Strange Land by Robert Heinlein, which opened up my view on frame of reference in many ways, and Robert Pirsig’s Zen and the Art of Motorcycle Maintenance, which got me thinking more philosophically on the intersection of my life and my career around personal long term goals.

2. As the core of Ensemble's process you mention that you have “the same essential approach used by many of the truly great investors over the last century” Anyone you would like to mention? Some books you can mention that everyone can learn from.

The obvious one for any value investors are Warren Buffett and Charlie Munger. And there are simple lessons that people have traditionally taken from Buffett on value investing. However, anyone who also is familiar with Buffett’s history also appreciates how flexible he has been over time in adapting his approach from cigar-butt investing in his early partnership learned from Ben Graham, his early mentor, to moat-oriented quality investing from Munger, to most recently stating how Apple, Microsoft, Amazon, Google and Facebook are “ideal businesses” in 2017– that from an investor that traditionally eschewed technology companies because they were hard to value. 

And mind you, I don’t think it’s that he was unable to understand the companies necessarily, but he couldn’t foresee the probabilistic range of outcomes 10-20 years into the future in any comprehensible way that could enable him to assess their intrinsic business values. Because technology changes so fast and companies leap frog one another regularly, they have traditionally been unforecastable. Over time that has changed with certain companies demonstrating network effects, user switching costs, and brand power.

The common thread in all this is that Buffett’s investing success relied on owning competitively-protected, high return on capital businesses over long periods of time for which he could reliably forecast future cash flows. What that business looked like evolved over time and Buffett has too, even in his 9thdecade. It’s no wonder that he’s been so successful an investor over a lifetime!

Then of course there are other investors that we admire that have similar fundamentally based approaches to being patient long term investors in competitively advantaged companies like Chuck Akre, Bill Nygren, and Tom Gayner.

The books mentioned above are great references to these lessons. I’d add to the list 7 Powers by Hamilton Helmer as an interesting lesser known book on frameworks to building moats. 

3. You write that it’s easy to understand your approach but difficult to execute. Why is it difficult to execute, please provide some further color?

We think there are two distinct reasons why our investment approach is difficult to execute – one is temperament and the other is identifying the character and relevance of moats. 

It difficult to execute because there is a temperament required to be able to own shares in companies that exhibit strong competitive advantages when they are down and out, sometimes over long periods of time. It requires you own the company when there are many doubters, both intelligent investors in the market and media reports bombarding you on why the business is broken or obsolete or will face terrible times ahead because of recession, competition - you name it. 

On the other end it’s hard psychologically to become a new or larger owner of a company whose shares have appreciated a lot over a year or five and exhibits what looks like a full valuation based on superficial shortcuts like P/E ratios. Additionally, it’s hard to sell the great businesses you love owning in your portfolio when their valuations become significantly extended beyond the optimistic end of your realistic probabilistic scenarios.

Also, identifying the character and relevance of moats is a very dynamic, subjective, and qualitative thing. While traditional moats have been thought of as sort of static characteristics of companies such as brands, scale, etc., there are many others that don’t fit well into these well established buckets, while some companies with these well-established moats have also seen the relevance of their moats declines. What is now becoming a common example are companies like Procter and Gamble, whose brand and marketing scale advantages have diminished because of social media and e-commerce, while cultural changes are impacting the relevance of Coca Cola’s core product portfolio. Examples of companies we own that don’t fit neatly into traditional moat analysis are First Republic Bank and Netflix.

So, our approach is really about identifying companies that could have strong moats, then doing the fundamental work to understand the nature and dynamics of the moat and the business model and how it creates value for customers and other stakeholders. And then using that fundamental work to build a model that can inform our valuation framework based on future cash flow generation that incorporates a range of realistic scenarios to derive a value for the business. Finally, it’s about having the guts to trust your research, analysis, and framework to filter out the noise outside of the fundamentals that inform your conviction and valuation. All of that is very hard to execute on in our experience and requires a lot of discipline. 

You also have to be flexible enough mentally so that when the facts change, as to either the strength of the competitive advantage or the growth characteristics of a business, you have the wherewithal to adjust your perspective of a company you owned, regardless of it being a big winner or loser to date. You have to have the conviction and discipline to do the appropriate thing on a go forward basis, whether it be to cut the position or buy more based on the changing fundamental factors. 

Filtering the noise from the signal, without ignoring the signal, is one of the biggest challenges that we all face in mitigating our natural biases.

The collection of all this is often seen as the guts to be contrarian and stubborn in buying cheap stocks. However, the opposite also applies when recognizing the market is right on seemingly high valuation stocks at times, and even not enthusiastic enough in certain situations. Classic examples of these would be companies like Google, Mastercard, or Broadridge… all stocks that have outperformed the market over long periods of time because the market was not enthusiastic enough for many years, even during times when they appeared to be “richly valued” on an absolute, relative, or historical P/E basis. 

4.You are in short “business analysts” where you are buying the stocks of these great companies when they are priced at a discount to their intrinsic value. Why do you think that disconnect exists?

The biggest disconnect is the short-term orientation that exists in a lot of the market as far as inputs into valuation for companies based on near term results. It’s hard to stay focused on the character and strength of businesses in the face of near-term headwinds to their financials – in other words this is “Mr. Market”. There are all sorts of incentives that cause many investors to focus within a 6-12 month window for garnering returns, a time horizon when the bulk of stock price performance is based on sentiment changes vs fundamental changes in value that manifest over longer time horizons. 

In addition, we’ve written about the market’s focus on growth, which is a fleeting characteristic generally for most companies, instead of return on capital, which is a much more durable characteristic when combined with competitive advantage. Our focus on the latter, and our long term 10-year investment horizon, gives us a better perspective, in our opinion, as to what is an investable business for us and its true intrinsic value. And we can be patient enough to let those results play out (“In the short run, the market is a voting machine but in the long run, it is a weighing machine”). Our experience investing in high quality, moaty companiesso far has generally proven this to be true.

Don’t get us wrong though – we do think that the market is generally right (i.e. efficient) in the way it values high quality business most of the time.  So, we have to be patient and on the lookout for those that we are interested in to fall out of favor for temporary reasons and take advantage of those opportunities or find those companies where the market is not enthusiastic enough at current valuations.

5. You often emphasize the importance for a company to have strong barriers to entry, or wide moats. Can you present some typical signs of moat erosion and how to identify it before it’s already reflected in the price?  And how about widening the moat? How much do you sweat on the competitors and the risk that they may improve even faster?

This is a great question, and it’s a challenge to be honest. It’s generally a qualitative thing evaluating the strength of moats to conclude that it is eroding or strengthening. We are focused business investors, so we begin our research process trying to evaluate if a moat exists in any business we’re interested in. That moat is always forefront in our minds as we study and follow businesses over time. 

Since we are business analysts and we run a concentrated portfolio, we gain a lot of knowledge about the companies we own, their industries, value chains, and competition. We often internally debate significant actions or strategies they employ, to understand the impact those have on the quality of their moats and the impact to their long term business and financial models, positive or negative. The fact that we all share the same investment philosophy in our research team and share a similar vocabulary helps us shape the framework within which we have these debates. 

There’s a huge challenge in identifying the tipping point when we admit that a company’s moat is weakening because some signals can be transitory.  For example, the narrative that Apple’s iPhone is “losing” market share between product cycles when everyone is screaming “Apple can’t innovate” only to then rave about the next great new product no one can live without followed by new revenue and profit records. 

Contrast this with more permanent signals, like watching the trend at Pepsi, where for a number of years its revenue growth was driven primarily by price increases with flat volumes, i.e. its brands losing relevance to new competitors who were the drivers of incremental market volumes. We deemed Pepsi’s challenges as more permanent, which is why we decided to exit that position after owning it for a several years. 

Surprisingly, it’s similar the other way, where one of the members of our team will start to believe that a company’s moat(s) has actually improved, and we need to reevaluate our assumptions behind valuing it (to the upside). The rest of the team members will also need to be convinced that it’s a true permanent change in moat dynamics, which is not always easy either! 

An example of this was Schwab, where our conviction in the moat improved even as the fees on its large AUM business were forecasted to permanently decline towards zero. This seems counterintuitive until one realizes that the AUM fees are both leverageable with scale and are the key decision factor for customers’ competitive evaluations, while its Bank business is the true go forward monetization platform. So, Schwab’s market share and scale grows as customers choose it for the lowexplicit costsacross 85-90% of their assets (and great client service too), while Schwab makes it money on its Bank’s net interest margins (NIM) earned on customers’ cash balances, an implicit opportunity cost to them. This created a unique model that created more overall value for the customer and increased Schwab’s scalability than we had previously understood. You can find more details about our Schwab thesis in our Ensemble Fund letter here.

My colleagues Todd Wenning wrote about the weakening moats in a couple of recent posts here and here, while Sean has discussed the weakening of CPG brands here and here for a deeper discussion on the topic. 

6.Investing is all about expectations. The companies you focus on is therefore 1. Exceptional franchises, but importantly also 2. Where the market forecast a quicker regression to the mean. How much of your time do you spend on analyzing the companies that you deem to be too pricy at the moment but that you would like to own at the right price, compared to existing holdings and potential new companies?

There’s some balance that happens as a result of opportunity and luck. As we’ve discussed, it’s hard to really know beforehand what the outcome of our valuation analysis will be vis a vis the market price that a company’s stock is trading at until we’ve done our own fundamental work. So, there are some years where our work is more immediately fruitful and leads to greater numbers of companies being included in the portfolio, and others where it’s not as much. And of course, there are some portfolios of companies that have a lot more dynamism in their businesses and others that are more stable for extended periods of time where there really isn’t much changing beyond just tracking the execution of the company. So there’s not a great answer for this question, it just varies from year to year depending on opportunities and existing portfolio company dynamics.

7. A key metric for you is ROIC, and you focus on companies that generate high or improving ROIC, as those businesses, all else equal, deliver the greatest shareholder value (your statement).

a. That’s fine, but what valuation metric do you look at? 

We do detailed research and modeling of a business to understand both the level of profitability/growth it can achieve compared to historical base rates and the amount of it is likely to consume in order to grow and sustain its moat. That drives a long-term ROIC that then drives what the fair value multiple should be as an output. This can be restated as we have a diligent DCF methodology that gets us to a value for the business that captures the range of future probabilistic outcomes, which is what we rely upon to make portfolio execution decisions. But we don’t use the short hand valuation metrics commonly talked about in the market like P/E, EBITDA, or book value multiples, though our detailed analysis and cashflow forecasting work will spit out these multiples obviously that we can compare to history. 

But you must keep them in perspective – these multiples reflect the underlying cashflow economics of the businesses, so if ROIC is improving over time or capital intensity is declining, the multiples will deservedly track higher and vice versa. So it’s important to do the modeling work informed by all the qualitative work done to understand business characteristics over time to get a truly informed view of its intrinsic value.

b. When does something become too expensive, or does it?

When the stock price materially surpasses what we’d want to get paid to sell the business if we owned it entirely, i.e. 20% premium over our fair value estimate in our case.

c. How important is the direction & pace of the direction of the ROIC? Maybe you can share an example.

The direction is important but not the end all and be all because again, you must be careful to decipher transitory or cyclical changes vs permanent changes. We don’t pay a lot of attention to the pace so much as the underlying fundamental factors affecting the direction in comparison to our forecasts based on our understanding of the business.  

Ferrari is a great example, where our initial investment relied on the insight that the company had a stronger underlying ROIC potential than historical financial statement analysis indicated, while our continuing investment in the company looks through the depressed ROIC the company will see over the next couple of years of heavy investment in powertrain electrification and model expansion before normalizing at very high long-term rates. For more details on our Ferrari thesis, please see our post here.

8. What is a substantial discount to your estimate of the intrinsic value? Related to this, how do you work with the target over time, i.e. how to handle positive/negative deviations over time? In my view the main risks are holding on to companies getting weaker, and selling great companies getting stronger, vs the initial thesis.

A substantial discount for us is at least a 20% discount from our estimate of a company’s intrinsic value, which generally incorporates a few layers of conservatism. Of course, we’d like to buy companies at even greater discounts to fair value, but a minimum 20% discount to the current intrinsic value translates to a 25% upside from the current price. So if it takes 5 years to close the price gap to intrinsic value (assuming we’re roughly right in our estimate), then the stock will outperform by 4-5% per year over those 5 years.

We then have a sliding scale as that discount widens or contracts in terms of portfolio weight for a particular position relative to others in the portfolio. We cross that to a qualitative conviction scoring framework, which informs the boundaries and pace position size based on our ranking of specific qualities related to the moat, management team, our ability to understand and forecast the business, etc. So, our position sizing is comprised of a matrix that incorporates both quality in terms of our conviction framework and a quantitative discount to our intrinsic value estimate.

Improving/deteriorating qualitative fundamentals will show up in our conviction scoring while improving/deteriorating financial performance will show up in our financial model. The qualitative and quantitative are also interrelated because they inform each other in our forward-looking forecasts, and therefore impact our overall intrinsic value and weight of the position in the portfolio.

9. You mention that there are two key elements of successful portfolio management that are not practiced by the majority of investors. Less diversification & diversify within the client’s portfolio. If we start with the former. Totally agree…but how to choose between and size the best ideas? Mechanic rules on distance to target, adjust for volatility or subjective risk measurement. Rebalance, i.e. increase in loser, sell winners.

You’re correct, we run a fairly concentrated portfolio, typically holding 20-25 companies. We want our resources focused on the best ideas we have, and we want those ideas to count. Having said that, we also recognize all the work that has shown the “free” benefits of diversification from a risk perspective in the construction of a portfolio. However, that incremental benefit basically becomes de minimis beyond that zone of 20-25 stocks. In his classic book A Random Walk Down Wall Street, Burton Malkiel discussed the benefits of diversification and the diminishing benefit of it beyond 25 stocks in a portfolio. We used that data and created this chart to illustrate his point (Source: Malkiel, Burton Gordon. A Random Walk down Wall Street: The Time-Tested Strategy for Successful Investing. New York: W.W. Norton, 2003. Note: The standard deviation is a statistic that measures the dispersion of data relative to their mean. When applied to the annual rate of return of a portfolio, it describes the historical volatility of returns of that portfolio).

It just so happens 20-25 also corresponds with our own intuition based on experience of the level of concentration that we are comfortable on any single position (3-10% portfolio weight). Our highest weighted positions will be those with the highest convictions crossed with the greatest discounts to our estimate of fair value.

As fundamental investors, we do not consider stock price volatility in our portfolio weighting at all, though we do consider fundamental cyclicality or unpredictability or volatility of cashflows in our fundamental conviction scaling.  

Similarly, rebalancing has nothing to do with price performance on its own, but to the extent it impacts thresholds we have on position size vs discount to intrinsic value, that will trigger a rebalancing among certain positions within portfolios.

10. Regarding diversification within the client portfolio, to maintain overall portfolio volatility at a level that fits his or her financial situation and personal outlook. I think this is a great idea. What are the positives and negatives, from your own experience? (I like the idea of the Ulysses pact- is that something you look at doing)

Within the context of our clients’ portfolios, we consider their personal objectives, cash needs, age, and risk tolerance. At that high level we’ll decide with each client what makes sense within the context of these factors as far as mix of equities for long-term growth of capital vs cash needs over the short to medium term. Having their cash needs met in the medium term aligns their cash flow needs with the objectives we jointly agree to for the long term. That long term equity investment portion is then funneled into the equity portfolio strategy we’ve discussed. Studies have shown that the biggest disconnect between clients’ portfolio objectives and actual results happens when they are unable to follow through on a well-thought out investment strategy because their short term needs or fears cause them to take actions that are misaligned with the long term objective and strategy. So we do our best to help them manage through this right from the getgo, by creating a well aligned portfolio structure, while keeping them informed and calm through both exuberant and tumultuous periods in the market. 

Additionally, I’d add that our regular communications informing them about the companies they own also helps them understand the value our portfolio companies create, which makes them more tangible investments than a set of tickers with randomly fluctuating prices. Our companies create real value for their customers every day, and that is important to recognize regardless of the meandering price action of their stock price within any shorter-term context. That value creation and the moats our companies build is what underpins our confidence in their longer-term intrinsic value and that is important for our clients to understand in order to build their confidence in sticking with the portfolio. That is as far as we go towards the Ulysses pact!

In the long term, we believe the intrinsic values and stock prices converge, and that is exactly why the alignment of investment objectives, portfolio structure, and client communication is so important!

11. One of my idols when I was young said – every good long-term investment, starts as a good trade…to what extent do you care about trying to time your entry point? Is it just the distance to the target price that matters? Or a target price range, which in any case has a midpoint. You think in terms of confidence intervals & probabilities at all?

We are of the belief that if you do deep enough work and think through the range of probabilities of outcomes for a specific company with a strong moat, you can pick the midpoint and use that as the best gauge of an expected intrinsic value. We use that point estimate as our north star as far as valuing a company. 

We have guidelines in place that make it so that we have a balance between a realistic view of how fundamentals could play out with a set of guardrails around our long-term assumptions that build in a reasonable level of conservatism in our valuation. We hope that over time, as fundamentals play out, that the margins of safety we have built in lead to better outcomes generally than our midpoint expectation of possible outcomes. 

We don’t really try to time our entry points because we use a disciplined approach to sizing positions based on discounts to fair value and qualitative conviction ratings as we’ve discussed. So, our view is that timing is nothing more than luck rather than a skill we possess in building into a position. We’d rather do the important fundamental work to properly value companies then just let our “automatic” trading system run sizing based on that discount and conviction, however that plays out.

12. When you are wrong, or less right, how do you deal with that? You write like this “However, if our original assessment of a company’s prospects weakens or market prices increase dramatically in the short term, we will adjust our position as necessary”. Fixed signposts? You recently discussed Google in a great way (see below). Maybe an example where you closed a position. Does the stock price matter, i.e. let’s say it starts to weaken, a signal that things are turning or not?

Like any good, rational investor, we incorporate new information into our analysis as quickly as possible, whether positive or negative. And we’ve had our fair share of being wrong on companies in both directions, whether it turned out we exited after a loss or exited too early because we hadn’t understood the full dynamics of growth or profitability.

We don’t use price signals directly for trading per se, but we will reevaluate our thesis on occasions when the price action appears to indicate (positive or negative) that the market is reassessing its view of a stock. We’ll spend some extra time during our “maintenance” period to actively seek out relevant information beyond our normal streams to be sure that we have as accurate a view of the information being ingested by the market that leads to dramatic, unexpected price moves before they trigger a trade to either buy more or sell a portion or all of our position (again based on current conviction and discount/premium to our fair value assessment). More often than not, we find that the market is being driven by something other than our long-term assessment of the company in question and do nothing to change our fair value estimates. However, sometimes we find that there is important new information that changes our opinion on a company’s fundamentals, which then leads to a reassessment of our fair value and position size.

For examples of some of these, please refer to our blog posts where, we’ve discussed many of our positions. The most recent positions where we’ve changed our opinion and exited have been Trupanion (TRUP), explained here, and Apple (AAPL), which we exited after about a decade of ownership because we didn’t think its massive iPhone business could grow much more than a low single digit growth rate going forward after it won the vast majority of its targeted addressable market amidst a mature market and extending replacement cycles. While Apple has created some great adjunct businesses, it will take some time before their scale will offset the slowing iPhone business in our view.

13. Do macro impact your research? I have inserted a quote from your April call below. Do you adjust holdings on the back of a macro view or not? Please elaborate.

“The fact is we are 100% certain that a recession will occur… someday. It is just that neither we nor anyone else knows exactly when. So in thinking about the earnings growth of our portfolio holdings, we focus more on the appropriate growth rate across a full economic cycle that includes a recession while recognizing that the exact timing of that recession is not knowable, but to the extent it becomes more likely to occur sooner rather than later, we will appropriately incorporate this into our company specific forecasts.”

We are bottoms-up fundamental investors, so we don’t generally use short term macro calls as important determinants of our investing strategy. However, changing data will impact our analysis such as changing interest rates for our financial holdings like First Republic Bank (FRC) or Charles Schwab (SCHW), or loads and pricing data on trucking for example in the case of Landstar (LSTR).

Where we do use macro data, is on long-term trends that we think reflect the economic context in which we are assessing a company’s business prospects. Examples of this are long term GDP, inflation, or interest rate trends, population growth, housing demand, internet search trends, digital spending, passenger airline miles, advertising spending, etc. Oftentimes short- or medium-term cyclical variations from the long term underlying trends will lead to a mispricing in the market price of company (positive or negative) relative to our forecast based on a return to trend that will create opportunity for us and we will take advantage of that where it’s applicable. 

Occasionally, either the historical trends may see a permanent break due to a fundamental economic, regulatory, or cultural shift, and sometimes we get that right ahead of time, and sometimes we don’t. The future is always uncertain, but history does tend to “rhyme”, so it’s our belief that it is the most rational way to view the world. Fortunately, our focus on a narrow set of companies often results in us not being surprised when such changes do occur.

Thanks very much for taking the time to have this discussion with us Bo, and we hope that it will be useful to your readers. We’re always happy to take feedback and follow up as we continue our investment journey!

Ensemble on Google:

But in allocating their excess capital we have been less enthusiastic. While Google has been criticized in the past for the M&A they engage in, YouTube and DoubleClick are two hugely successful acquisitions with YouTube ranking as one of the smartest acquisitions in the internet age. But Google has now built such a war chest of cash that they clearly have more than they will ever need, and we think shareholders would be better served if the company began to pay a dividend, bought back stock and used more debt in their capital structure to finance more return of capital. We had hoped that Ruth Porat, the CFO they brought in from Morgan Stanley, would be instrumental in improving capital allocation. But after some initial positive signs, it seems that for whatever reason, Porat is no longer focused on making this happen. The other management issue we’re tracking is the company’s relations with their employee base. For pretty much all of their history, Google has been considered one of the very best places to work. They have pioneered much of what we think of as modern Silicon Valley corporate culture with an employee base that has been raving fans of the company. But last year, employee concerns around the company’s work with the military, and issues of gender equality and sexual harassment became flashpoints between management and its employees. Of particular note to us was the various reports on the company paying large severance packages to key senior employees who were forced out after accusations of sexual harassment. In our view, Google management’s handling of these cases has not been good. We believe for the short-term health of their corporate culture and their long-term ability to attract the best and brightest employees, they must do better. By “do better” we mean behave in a way that satisfies their employee base and preserves the belief that Google is one of the best places to work for the smartest, most technically savvy people in the world. To the extent that the company is not able to manage employee relations constructively, our confidence in the long term success of the business would deteriorate and should we decide to exit our position, something we are not currently contemplating, it would be due to our assessment of the long-term health of the business.

Podcast Series: Housel at Invest Like the Best

Read as PDF…

The Invest Like the Best podcast is hosted by Patrick O’Shaughnessy. In this episode he interviews one of the best writers within the investing space - Morgan Housel.

Housel is a partner at the Collaborative Fund, a Private Equity firm owned by Craig Shapiro. Housel is famous for his great writing both at the Motley Fool where he spent the first nine years of his career and then at his current workplace. In the interview he mentions that he loved his job at the Fool but asked himself the question “If you are 70 years old and you had worked with what you do for your whole life would you feel comfortable?”– and decided to shift gears. He is writing on everything related to investing and I recommend everyone to read his work at the Collaborative Fund. I have summarized the key insights I took with me from the episode. Enjoy!

Public markets vs Private markets

Housel describes how investing in public markets are all about analyzing data while in private markets doing a thorough evaluation of the founder is key. In private markets there is often not enough financial data to make an in-depth analysis and therefore vital to find the right people.

In my view, trusting the right jockey is sometimes a tempting approach also in public markets - evident from books such as The Outsiders and The Intelligent Fanatics (don't miss our interview with the authors of the latter Sean Iddings and Ian Cassel).

Insights into active management

Housel thinks active management is here to stay but that fees for asset managers will continue to go down. “A good asset manager should make as much as a good doctor”. 

I listened to a podcast episode with Ken Fisher recently and his take was that the average fee has gone down due to that more money has gone into passive funds and not necessarily because active managers have lowered their fees. At one end we have index funds charging a few basis points and at the other active funds charging a few hundred basis points.

Housel also discusses financial advisors and thinks they are needed to fill the gap where the information online is not enough. Marrying the two is a recipe for success – which Vanguard has succeeded with.

Reading and writing

Housel describes himself as a late bloomer as he started reading in his early twenties (it is never too late!).  A large chunk of his reading today is to scan Twitter and reading blogs to find new ideas on what to write about. He describes his work as a serendipitous journey where nothing is deliberate, and the best ideas come randomly when he is doing something unrelated.  When taking long walks, he thinks the best and he is relying a lot on the subconscious to bail him out. 

One of my favorite quotes in this regard – of priming yourself to think better - is from Marcus Aurelius “The things you think about determine the quality of your mind, your soul take on the color of your thoughts”.

Personal finance

Housel stresses the importance of understanding that there are two ways to achieve wealth. Either focus on the top-line or bottom-line. The problem is that many focuses on the first and forgets the second. Remember: If you spend all you earn you still end up with a big fat zero. If the large expenses - like tuition, house and car - are kept down you are well on your way to financial safety.

Housel himself focus on the bottom line as it works best for him: Less stuff = More happiness.

The lesson is to find your own way based on your preferences – just make sure that you end each month with something more than nil. Simple but timeless advice.

Learning from history

For those of you who follow Housel knows that he has written a lot about what one can learn from history. I urge you to read his piece about the Wright Brothers. That story and similar stories (for example about how Penicillin was invented and how Scurvy was avoided) are examples of titanic events. But at the time, nobody cared. The lesson: It’s not just about the quality of the idea - timing needs to be right too.

Housel thinks reading old newspapers is great as it makes you appreciate how things were not evident at the time. Some books he recommends in this vain are Benjamin Roth’s: The great depression: A diaryand Frederick Lewis Allen’s three books: Since yesterday, Only yesterday & The big change.

Corporate strategy

Housel thinks centralization has not been a good strategy – and that decentralization is the way to go. This is not new as the trend of decentralization has gone on for some time, however the degree of decentralization has shifted. New firms such as Zappos and Valve have no formal hierarchy but instead operate using self-organizing teams. An example of how good the strategy can be – and also how few individuals can create tremendous wealth - is that of the game Doom.  It was created by 10 developers from Texas. Another one from my country, Sweden, is that of the game Minecraft - a billion-dollar company (Mojang) more or less created by one brilliant developer in Markus "Notch" Persson.

Personal skills

Housel describes how personal skills are hugely important, in addition to technical skills, to become successful. He thinks that is often forgotten. Having worked a lot with complex software development projects I empathize strongly with this - if the customer and the vendor have problems communicating, integrating their systems will be way more difficult. A person who knows both is the most valuable, by far.

Another topic discussed, which is related to the earlier point on history, is the impact of how one will view investing if growing up when the stock market crashed or boomed. Being raised in a crash seems to make people more risk averse and vice versa. Sometimes what makes intuitive sense is actually true.

Blog recommendations from Housel and O’Shaughnessy

In the episode Housel and O'Shaughnessy mentions a couple of the blogs they follow:

The Waiters pad with Mike Deriano 

Slate Star Codex with an anonymous Doctor 

Paul Graham's blog with Paul Graham

Abnormal returns with Tadas Viskanta

Melting Asphalt with Kevin Simler (recommended by Patrick) 

If you liked this brief summary of the episode you will love the whole one. Happy listening!

Niklas Sävås, September 20, 2019


Twenty Lessons from Enron

Read full text as pdf… Link to Amazon

During the summer I read Bethany McLean’s and Peter Elkind’s book about Enron ”The smartest guys in the room”. I found it to be a gem of a book, with tons of lessons for investors - of what not to do... It’s scary how a company (primarily management) can fool regulators, rating agencies, sell-side equity analysts and investors for such a long period. And how auditors – paid by the company – have short-term incentives to be part of the fraud (hopefully the fall of Arthur Andersen acts as a lesson, but I wouldn’t bet on it considering human nature being what it is).

Enron was a darling at the time and the seventh largest company in the US. It had good business areas and bad business areas; the main issue was that management wanted the company to seem better than it was. Without whistleblowers and outstanding work from investigative journalists the fraud would likely have gone on even longer. For long-term investors whose style is to invest in companies with outstanding management teams the lessons from this scandal should act as a reminder. In my view, investors should act as if management is hiding the truth and do the detective work needed to understand if that hypothesis is correct. Here are twenty lessons from the book that may help you with that:

1. Always validate the accounting profits with the reported cash flows

2. Keep tabs on what management do and not what they say

3. Watch out for companies that are re-pricing options

4. Remember that Wall Street extrapolates the results of their darlings (which has met the quarterly forecasts over time)

5. Be wary of investing in companies which are dependent on debt without having stable cash flows

6. If a company puts too much emphasis on the next quarter – stay away!

7. If a company that obsess over their own stock price look elsewhere (Enron had monitors showing the current stock price – everywhere!)

8. Watch out for huge write downs amid management changes

9. If the company continually books non-recurring charges – they are recurring charges

10. Are you anchoring on valuations from sell-side analysts? Don’t!

11. Don’t mix the stock price performance with the performance of the underlying business

12. Don’t rely on reports from rating agencies, sell-side analysts and auditors. Sometimes they are worth much less than zero.

13. Validate your analysis with that from short-sellers – ”invert always invert”

14. Beware of company excesses – Why do you think Buffett called his jet ”The Indefensible”?

15. That the employees are financially rewarded is not a clear sign of a good incentive structure – in fact it tells little about the rewards for the shareholders

16. Don’t trust the predictions from management

17. If a text from a quarterly or annual report is impossible to understand – the company is probably hiding something

18. A cash flow statement is not the holy grail as it can also be tampered with – you need to understand how the cash flow is created.

19. Read stories about the company from investigative journalists – then re-evaluate your story

20. You are always susceptible to be fooled

Niklas Sävås, August 19 2019


Interview with Gautam Baid - author of The Joys of Compounding: The Passionate Pursuit of Lifelong Learning.

Link to pdf version…

Gautam Baid is Portfolio Manager at Summit Global Investments, an SEC-registered investment advisor based out of Salt Lake City, Utah. Previously, he served at the Mumbai, London, and Hong Kong offices of Citigroup and Deutsche Bank as Senior Analyst in their healthcare investment banking teams. Gautam is a CFA charterholder and member of CFA Institute, USA; an MBA in Finance from Nirma University, India; and an MS in Finance from ICFAI University, India. He is a strong believer in the virtues of compounding, good karma, and lifelong learning. Gautam is the author of The Joys Of Compounding: The Passionate Pursuit Of Lifelong Learning.

The book has received wide critical acclaim from readers globally and it was the #1 new release on Amazon USA in Investment Portfolio Management and Investing Analysis & Strategy categories.

Gautam's views and opinions have been published on various forums in print, digital, and social media. In 2018, he was profiled in Morningstar's Learn From The Masters series. Learn more at and Connect with Gautam on Twitter @Gautam_Baid


Dear Gautam, thanks for agreeing to do this Q&A session. We are delighted. Everyone else, please enjoy.


IBB: You have read so much, in so many forms & ways. And at the same time, you have written a masterpiece. Quite an achievement, and you are still so young!  Please keep it up. Could you please recommend some online sources that you think are worth following, to track new ideas or get overall inspiration? Twitter, blogs, fund quarterly reports etc.

GB: Thank you for your kind words of appreciation Bo. The pursuit of lifelong learning greatly enriched my life in many aspects, and I have endeavored to share its virtues with our dear community.

I enjoy learning from the blog articles published by Morgan Housel, Safal Niveshak, Fundoo Professor, Janav Wordpress, Base Hit Investing, and Microcap Club among others. Also, I believe that Twitter is the best learning and networking university in the internet age. It is a great medium to attract like-minded people into your fold by sharing content that you find personally meaningful. At the same time, it is important not to spread yourself too thin by following every Twitter account that interests you. You need to set a very high bar and follow only those accounts which add very high value to you. As regards the fund quarterly reports, I do not have a pre-decided list. I simply select the ones I come across that grab my interest and start reading them. To me it feels like an intellectual treasure hunt, you never know what hidden gems or new insights you will stumble upon when you begin reading a new book, a new blog post, a new research report, a new white paper, or a new investment newsletter and start flipping through the pages.

IBB: Is it possible to highlight 3 books, and maybe even chapters in those books, that have formed you as an investor.  And it doesn't have to be a financial book.


  • Poor Charlie's Almanack - A life-changing book for investors and non-investors alike

  • Seeking wisdom by Peter Bevelin - The finest book I have ever read on multidisciplinary thinking

  • All I Want To Know Is Where I'm Going To Die So I'll Never Go There by Peter Bevelin - The best book ever written on the theme of inversion

And I would print out the Buffett Partnership letters, and the Berkshire Hathaway letters and owner's manual separately.

It is difficult to point out specific chapters from these supertexts which have benefited me the most in my journey. Every single page in them contains a great deal of wisdom.

IBB: You have a lot of examples from the Indian stock market, which probably non-Indians are not so familiar with. Long term performance has been very good, in real terms it seems to be in same magnitude as USA & Sweden which over time tend to be among the best of markets, be it much more volatile. (Elroy Dimson has data since 1952, annual real return in USD 5.8%) Looking ahead would you agree with that there is a major tailwind for the Indian stock market, for example due to the very long potential runway of high GDP growth & political reforms that will ease to do business?

GB: There is a saying that goes "No force on earth can stop an idea whose time has come." And India's time has arrived. It took India almost sixty years to reach its first trillion dollars in GDP but only seven years to reach the second trillion. And the next consecutive trillions are expected to be reached in faster succession. Even if market cap to GDP remains around parity in the long run, one can envision the kind of wealth creation that lies in store for investors in great Indian businesses. Trillions of dollars. And this, in turn, will have a positive multiplier effect on the prosperity of the nation.

IBB: Indian stock market vs the US? Any difference in how to find good stocks? And how the market behaves?

GB: If you had asked me this question a decade ago, I would have probably stated that the price discovery, liquidity, and depth in the US market is superior. However, with the advent of vastly improved technology, those differences seem to have narrowed considerably. The principles of sound investing remain the same across all the markets in the world. But each market is peculiar in its own way and has its set of specific industries and companies which lead it. For instance, private financials and consumer stocks are usually the most favored industries among investors in India, while high-growth tech stocks catch the fancy of many investors in the US markets. Over the long run, individual markets track their economic fundamentals, but in the short run, the US markets are the primary driver of sentiment in global markets.

IBB: Any good sources/sites etc. you can recommend for foreigners to invest in the Indian market and to know more about interesting ideas in India? We did an interview recently with Rahul Saraogi, and he clearly suggested not to try to invest in single names…but still…. might be some of us that still have an interest to try.

GB: ValuePickr, Alpha Ideas, and Alpha Invesco blogs are some great resources to develop expertise about investing in the Indian market and study promising ideas.


IBB; Now that we have warmed you up a bit, let’s get into some detailed question about your wonderful new book, "The Joys Of Compounding". First congrats to the name of the book, it immediately grabbed my attention and I ordered it promptly. Secondly, very impressive to find s much content and to make it such pleasure to read. I recognized a lot of it, but there were gems everywhere, not the least Warrens talk in 2007 in Florida on how leverage causes smart guys to go broke (LTCM), which I never had come across before. (Roger Lowensteins book on the subject is a mandatory read for every investor, I think). The chapter I will reread often are 18, 27 and 31-32. They get better every time. I suggest that everyone that will read your book or have read it, read those chapter and have this Q&A at hand, which will further deepen your knowledge. And mine.

Chapter 18. The Market is efficient most of the time, but not all the time.

An important chapter for the overall message, so it's one we all should reread. But I would like to ask about the confusion investors getting confused between risk and uncertainty which can lead to bug mispricing's. You mention that is boils down to price, I totally agree and later in the book, on the subject you mention(p416), Richard Zeckhausers essay as well. Your example of Piramal is great, and very clear, but would you consider investing in a cyclical company with negative momentum, and no sign of turnaround in demand/supply for years at some price, or stay clear? Is there a price, if so, when and why?

GB: It's a good question and let me answer it with a live example from the Indian markets. The Indian auto industry is currently experiencing its most severe slowdown in many years and there is a well-run 2-wheeler financier with a ROE of 18% and a price to book valuation which is now approaching 1x as against its peak valuation of 3x early last year. At 1x book, we would be factoring in zero future growth for this business even though 2-wheeler financing penetration in India today is barely 35% and clearly has a long runway for growth. It should be noted that 2 wheelers typically are the first to recover during an auto industry recovery, ahead of passenger cars and commercial vehicles. Additionally, with the increasing adoption of food-delivery apps in India (e.g. Zomato, Swiggy), the long-term fundamentals of the 2-wheeler industry in India appear to be structurally attractive. For developing a sound understanding of investing in cyclicals and commodity stocks, one should study Edward Chancellor's book, Capital Returns.

IBB: On a different subject, but on the same page, about missing out on serial acquirers. You have any examples in the US or India, that you find interesting? Any story you can share?

GB: In general, M&As have a higher chance of creating value when they are a core element of strategy and management has a track record of disciplined and value-accretive M&A. Firms in this category are rare. Think Berkshire Hathaway, Fairfax Financial, Markel Corporation, Constellation Software, and Piramal Enterprises.

Above all, the truly exemplary capital allocators act as a trustee for shareholders and demonstrate rationality and complete emotional detachment when making decisions. In an interview with the Hindustan Times in June 2012, Ajay Piramal said:

“I have an obligation to my shareholders, to create maximum value for whatever they have invested and that's what my job is and that's what I am here to deliver. I don't carry an egoistic or emotional attachment to the businesses. We did a calculation to justify the value that Abbott paid- I would have had to grow the business for 15 years at 20% CAGR with an operating margin in excess of 35%. Now that's not possible and therefore, the choice was should I leave aside my ego that it is my business and I created it, or should I do what is in the best interest of shareholders. If you look at it like that, that's what a leader ought to do, in my view. Job of a leader is to act like a trustee.”

Chapter 27 Investing in commodities and cyclicals is all about the capital cycle.

A very interesting chapter in many aspects. The significance of empathy in investing. Do you look at daily/weekly charts of singles names, industries, ETF:s to get some input? Or look at a list of 52 week high/lows? Any good source of this kind of information.

GB: If a group of stocks from a single industry are all rapidly going up together at the same time for a few successive days in a row, then that is a very strong signal that the fortunes of that industry may be turning around and should be investigated further. It is even more significant if this happens amid overly negative sentiment for the sector in question. This is one of the best ways to identify inflection points in a sectoral trend during the early days of an industry's fortunes turning around. Most of the time we will observe that the stocks that are going up together so rapidly do not have any current earnings to support their valuations, but we generally get to realize only in hindsight that the market was an extremely smart discounting machine. It is why Gerald Loeb said, "The market is better at predicting the news than the news is at predicting the market." Always respect the wisdom of the collective. If a particular stock displays a price volume breakout to fifty-two-week/ multiyear/all-time highs on very large volumes, then that stock is a strong candidate to start researching on.

I obtain my desired information on the above group of stocks in the Indian markets from moneycontrol website (

IBB: "Techno-Funda" investors. I have never come across that name, but after reading William ONeils book, "How to make money in stocks", in the early 90ies I see that as a more modern version. When I googled it, seems to be big in India? To what extent do you act on T.F investors key principles of strong growth and industry fundamentals? Any site you can recommend on the subject? Personally, I think it’s important to look at this, as an antidote, if you for example are in too much love with cigar butts, which I used to be.

GB: Techno-Funda investors tend to believe in two key principles, in addition to strong earnings growth and industry fundamentals, when analyzing potential buys: first, stocks that show relative strength, that is, that go sideways or consolidate during significant market pullbacks, tend to become the leaders of the next rally; and  second, the first stocks that break out to new fifty-two-week highs after a major market correction, or during the correction itself, tend to outperform significantly during the subsequent market recovery. I do follow these principles to identify promising ideas, especially during a bear market like the one we are experiencing in India. This is because new trends always emerge during a bear market-that's the period during which most investors are either waiting for their original purchase price to come back or are busy committing fresh sins by averaging the winning leader stocks bought during the previous bull market.

Some very good books on the subject of techno-funda investing are The Next Apple by Ivaylo Ivanov, How To Make Money In Stocks by William J. O'Neil, Trade Like A Stock Market Wizard by Mark Minervini and Insider Buy Superstocks by Jesse Stine.

IBB: Tryst with commodity investing. One of the best parts of the book, from a "sugar low" to a "graphite high" so to say. Here you show how to learn, and the process behind it. Have you found a way to track interesting commodity's, or do you do it case by case? For example, right now Gold has started to break out from a 5-year consolidation, does that matter? Time to look for interesting gold equities. Silver has lagged. Any interest?

GB: I get my requisite information for tracking the fundamental developments in various commodities from S&P Global Platts website ( I do not track silver very closely. Gold looks promising at the current juncture, especially in the backdrop of the Chinese Government buying gold instead of dollars to diversify the composition of their reserves. In addition, the technical setup of gold looks very positive. Your point about gold breaking out from a 5-year consolidation range has important implications. Let me share an excerpt from my book to illustrate why:

“Time frame is important. All else being equal, a stock that has broken out of a multiyear trading range is more promising than one that has broken out of a one-year trading range. In the case of the former, many individuals who bought the stock years ago may have sold a long time previously, out of frustration, and there would be fewer people waiting to get back to break-even and to sell the stock at higher levels. It is important to note that prices don't break out of a long-term range unless investors' expectations have changed. Someone is willing to pay a price that no one else has paid for a long time, and this is usually a sign that something major has changed in the underlying fundamentals of the company.”

“The underlying psychology of market participants doesn't really differ much across asset classes, and the above behavioral phenomenon applies to commodities as well.”

IBB: Cyclicals, early beginnings. You write that you have started to expand into infrastructure as well as construction. Is that mostly due to the expected tailwind from the huge government projects that you mention in the book? Is that the way you think of cyclicals, find a big tailwind (also discussed in chapter 31, p419, and then get the best exposure to it? (your list on p350-354, is brilliant & spot on, from my experience as well).  When I have looked at cyclicals in the past, say sectors like steel, pulp, semis, staffing etc., I have tried to use various types of trough multiples to estimate the downside risk, have you any experience on these types of situations? Or is your idea not to "bottom fish" and rather play the long game, with the help of a tailwind?

Both the approaches work. The temperament and personal preferences of the individual investor determine which of these approaches is ultimately adopted. In my view, mediocre businesses like infrastructure necessarily require a tailwind in order to thrive. One should keep in mind that these are never meant to be long-term holdings. One should buy them during depressed times for the industry when they are trading at historical trough valuations. If you are unsure about this aspect, then look to the market for guidance - many times, even after a big miss on earnings and a sharp cut in analyst estimates, a cyclical stock actually goes up after bad earnings. It is a typical sign of a company or industry bottoming out-when the stocks no longer go down after companies report bad news.

Chapter 32. The Education of a value investor.

Key chapter. Easy to read & borrow ideas, but everyone needs to develop ones owns convictions. To do that, there is a shortcut, keep a journal (chapter 26 and update your beliefs chapter 22) learn about yourself. But it’s easier said than done. Is it possible for you to share an example how you have improved your process? What’s the danger of reading too much vs learnings about yourself, by investing and keeping a journal etc, to find a strategy that fits you, rather than someone else's?

GB: I spent ten dollars on purchasing a journal in late 2014, and I consider it to be one of the best value investments I have ever made. Since that day, I have been keeping track of my investing decisions and subsequent developments in a journal. This has helped me a lot in learning about my thinking process at the time of making my past decisions. I receive a lot of valuable feedback and use it to correct my biases. I also have maintained a personal archive of the media commentary and investor behavior during various episodes of market panic from early 2015 till date, and I find it highly beneficial to refer to it whenever the market undergoes its periodic steep corrections. Human behavior in the markets has never really changed much over time. For instance, currently there is a lot of gloom and doom prevalent among many investors in India owing to the bear market that has been in vogue since January 2018. Recency bias is all pervasive. People tend to extrapolate recent trends into infinity as they assume them to be the "new normal." Until it isn't, in a cyclical world.

Reading and vicarious learning is very important and beneficial, but there is no substitute for real-world experience in the markets and putting your hard-earned money on the line. The real learnings for life take place only when skin in the game is involved. One should always be mindful of the fact that an investor's investment philosophy is highly personal, and it cannot be borrowed from someone else. It is something that is gradually built over time through direct and vicarious experience.

IBB: So many different forms of biases, which do you think are the worst for investors? What tricks do you have to mitigate them? Do you have any emotional states, you are in "tilt", you have some cues that trigger yourself? For example, you write about cool down periods.

GB: One of the most harmful biases for investors is the bias from consistency and commitment tendency, i.e. being consistent with our prior commitments and ideas, even in the face of disconfirming evidence. It includes confirmation bias- looking for evidence that confirms our beliefs and ignoring or distorting disconfirming evidence to reduce the stress from cognitive dissonance. When we have made an investment, we tend to seek out evidence confirming that it was the right decision and to ignore information that shows that it was wrong. As Buffett has said, "What the human being is best at doing is interpreting all new information so that their prior conclusions remain intact."

The more public a decision is, the less likely it is that we will change it. Rigid convictions are more dangerous enemies of truth than lies. In order to minimize this bias, I have consciously stopped discussing stock recommendations or my personal holdings on social media since early last year and now I discuss my fundamental ideas only with a few close friends in my personal circle. At the same time, one should be mindful of the fact that you can't really learn anything new if you're always surrounded by people who agree with you. As investors, we often have our personal group of intellectual peers with whom we discuss our ideas. But we should be careful that our sounding board does not turn into an "echo chamber," for that would be harmful for our decision-making process. Amay Hattangadi and Swanand Kelkar wrote about this issue in a December 2016 report for Morgan Stanley titled "Connecting the Dots": "We tend to be surrounded by people who are like us and share our world view. Social media accentuates this by tailoring our news and opinion feeds to match our pre-set views. To avoid falling into this homogeneity trap, one needs to seek out and dispassionately engage with people whose views differ from your own and that's true not just for current affairs but your favorite stocks as well."

IBB: When we are wrong, how to deal with it, especially when stock is down, and we are at loss? Compare with initial fundamental thesis? Sell regardless of price, normally stock is down same amount as the size of new problems, i.e the new adjusted estimates suggest that we have the same upside as before…I would like to add some discussion on the use of stops, could be on PRICE (some % of the holding) or TIME. I know some value guys look at time, say if dead money for 2-3 years, they give up and move on. Price is more for traders, but I have been inspired by Lee Freemans book. Any discussion on this subject would be highly interesting, since you have practiced stop losses, but in the book you only mention the mistakes using it. Whats your thoughts around this?

GB: A money manager must have the resilience to suffer through periodic bouts of underperformance. During 1999, Tom Russo was invested in high-quality businesses like Nestlé, Heineken, and Unilever, among others. They were terribly out of favor relative to the speculative forces that were driving the market at the time. Russo's fund was down 2% for the year and the Dow was up 27%. During the early part of the following year, he was down 15% and the market was up by 30%. Russo was able to stay the course because he had the capacity to suffer. The same can be said of his investors at the time.

Equity investing is like growing a Chinese bamboo tree. One should have passion for the journey as well as patience and deep conviction after planting the seeds. The Chinese bamboo tree takes more than five years to start growing, but once it starts, it grows rapidly to eighty feet in less than six weeks. Peter Lynch's investing experiences share a symbolic resemblance to the inspiring bamboo tree story: "The stocks that have been most rewarding to me have made their greatest gains in the third or fourth year I owned them." Stocks can stay cheap for longer than we expect and then can become repriced much more quickly than we expect. We should judge our businesses based on their operating results, not on the downside volatility of their stock prices. The stock market is focused on the latter, but investing success is based on the former. If the management team executes, the stock eventually follows. In fact, not getting immediate returns on our existing high-quality growth stocks builds antifragility. Patience plays a critical role during such times.

The only time you should take a proactive sell action upon encountering downside volatility in a stock is when you realize that you are inside a "value trap." Value traps are abundant and all-pervasive. In the stock market, prices usually move first, and the reported fundamentals follow. A plummeting stock price (in an otherwise steady market) often turns out to be an accurate harbinger of deteriorating fundamentals for a company. Think about it before you jump in to buy. What "appears" cheap or relatively inexpensive can continue becoming cheaper if industry headwinds intensify. When you see one of your deep value stocks suddenly break down on high volumes with no "visible" explanation, take notice. You are likely inside a value trap. Value traps are businesses which "look" cheap but are very expensive in reality. This could happen for a variety of reasons: a cyclical business operating at near peak margins; potential "app risk" leading to technological obsolescence; bad capital allocation; and/or corporate governance issues, including misreporting of earnings.

Disclaimer: The views and opinions expressed by Gautam Baid are solely his own and do not reflect the views of Summit Global Investments. Any recommendations, examples, or other mentions of specific investments or investment opportunities of any kind are strictly provided for informational and educational purposes and do NOT constitute an offering or solicitation, nor should any material herein be construed as investment advice.

Podcast Series: Katsenelson at Planet MicroCap

Read full text as pdf…

The Planet Micro Cap Podcast is hosted by Robert Kraft. The podcast’s main topic is interviewing though-leaders in the micro-cap space but from time to time other guests take part. This time I was thrilled to see that Kraft had interviewed Vitaliy Katsenelson.

For those of you who are avid readers of InvestingByTheBooks will know what we think of Katsenelson and his books. Both his first book Active Value Investing and his second The Little Book of Sideways Markets  are top-rated at the site.

For those who have read Katsenelsons books this episode is partly a repetition of how he views investing, but it also gives another angle as he discusses his own views of his books, how the last years have shaped him as an investor, his current view of the market, and his advice for young investors. He also mentions a 15-page article he hasn’t published yet about the pain and suffering he has experienced as an investor…

The Importance of Finding a James Montier

Read as pdf (with pictures)… Link one to Amazon… Link two to Amazon…

A Recent Dinner

Yesterday a number of friends gathered at a seaside restaurant in sunny Stockholm for a pleasant dinner. This specific party consisted of persons from the financial sector that usually gather once a quarter to eat, drink a few beers and discuss financial literature. The theme for this specific occasion was books that had a decisive impact of how one looked at investing going forward, those books that in a major way changed how we think about our occupation.

For me a number of potential authors could have been viable choices: Philip Fisher, Ben Graham, Edwin Levère, Nassim Taleb and in later days Howard Marks. Still, in the end there were only two real contenders and they were Michael Mauboussin and James Montier, of which - at least in those early days – the latter became my largest inspiration. In all honesty, the time when they were the most influential was actually before they published the books that today make it to the top half of our site’s top list of the best investment books of all time. This is because, similarly to Marks’ brilliant The Most Important Thing, both Mauboussin and Montier later published books that consisted of a number of research notes that previously had a profound effect on my view of how investing functioned.

The Crash

The books that you appreciate the most are often those that inspire you at important junctions of your life – just as the best music of all times is always for some reason released in one’s youth. To understand the impact Montier had, we have to take a step back to the 1990’s and early 2000’s. I had gone to business school, picked up some of the practical tools of the trade through working in corporate finance and in fund management and then almost exactly at the peak of the TMT-bubble I joined one of Sweden’s largest asset managers as a global telecom operator, telecom equipment and media analyst. And then the downturn started.

This asset manager had been early in into technology and telecom stocks and also prudent enough to gradually scale down holdings in the more aggressive Internet-stocks as the craze continued and valuations became more and more detached from reality. Still we didn’t fully appreciate how much of the growth within telecom – which we saw as something much more tangible – was dependent on a temporary investment boom. I was too young to have a full systems understanding and we lost tons of money. That is, in reality we outperformed the market but we still lost our shirt and mostly so in my sectors. At one time our seasoned and very well known head of equities in frustration burst out saying “We will never own one single bloody telecom stock again!” Not what you want to hear as an aspiring young analyst.

As a side note, this head of equities quite early got us/me out of one of the positions I had inherited, namely a holding in Worldcom. I had met Bernie Ebbers and although he left a very questionable impression the stock was dirt cheep. It’s hard to argue against a PE-ratio of 7, but the stock just kept going down. At one point my boss told me, “There is something we don’t understand here. Get out.” What we didn’t understand at the time was of course that much of the earnings were fabricated to start with. Ebbers would end up in jail and the influential cheerleading telecoms analyst Jack Grubman at Salomon Smith Barney was to be banned from the profession for life. In this instance we saved most of our money but there were other positions were we weren’t as lucky.

As the saying goes, victory has a hundred fathers, but defeat is an orphan. It wasn’t at all that anyone at the firm I worked for blamed me for what was happening, but I still felt quite a bit disillusioned. The sell side hade 95% buy recommendations and kept those for most of the downturn so there wasn’t much help to be had from that direction. In retrospect I probably over-compensated my absent overview of events by digging even deeper into the intricacies of which equipment vendor that had the best DWDM-technology, which mobile operator price plan that was most competitive and so on.

On top of things I lacked a clear path to develop and take my game to the next level. I wanted to work with more than just a few sectors and it was also clear to me that what I knew about markets wasn’t sufficient. Obviously the stock market wasn’t the rational equilibrium that I had read about in school or the hysterical joyride I had participated in during the late 1990’s.

And Then Enters

At this time James Montier of Dresdner Kleinwort steps through our door. Today, he’s got thick hair and a knack for wearing Hawaii shirts, but by then he mostly looked like a football hooligan – albeit a fairly cultured one. This was definitely the regular sell side analyst.

The timing for someone to try to market the concept of behavioural finance as Montier did couldn’t have been more opportune. It was so obvious to many of us in the asset management industry that investment psychology played a huge part of how markets functioned.

Montier wasn’t alone in this at Dresdner Kleinwort. Around him he had the idiosyncratic economist Albert Edwards, the quant Andrew Lapthorne and sometimes the fellow strategist Dylan Grice - all distinctly different from each other and as a collective from other firms. They were slightly outlandish, thought like their customers and quite often criticized both how their clients and how the banks and sell side acted. I’m sure that the management at DrKW often must have thought of cutting these renegades loose at several times. But the clients loved it so they stayed on – money talks. Most of that crew later moved on to Societé Generale and today Montier is a strategist at GMO where he has worked with amongst others Jeremy Grantham, Ben Inker and Edward Chancellor.

The papers that Montier and Mauboussin wrote during the early 2000’s became one of the first stepping-stones for me to up my game, to take the next step in my intellectual development. It would be a stretch to say that the two of them were the reason for me becoming such a voracious reader of investment literature from then on; it was rather a parallel development in re-igniting my thinking in how to become a better investor. The self-improvement efforts actually some years later lead to an ambitious book manuscript in Swedish called Edge that no-one wanted to publish as it was “too advanced for the small Swedish private market and not academic enough to become a text book”. Honestly, it didn’t bother me too much as I by then was well on the way to the next level in a still ongoing process of constant learning.

The Next Level

The topics that Montier covered were behavioural finance but extended broader to psychology, neurology and sociology – combining to cool sounding areas like neurofinance. That’s all very fine but the real trick was that he, with a lot of help from the quant team, turned these topics into practical processes and strategies for investors. I was handed investment tools that not all appreciated and that were applicable to a broad set of investment opportunities.

At times the texts presented some stock recommendations but their practicality really didn’t consist of bottom up stock picking. Rather the practical part was how to construct processes, investment methodologies, screens etc. and thereby either avoid falling into the behavioural traps described or instead benefit from others’ mistakes. The biases could be individual or based in crowd psychology and the bubbles that those create. Often the pieces took a psychological bias and connected it to a top down value investing strategy that the quant team a DrKW or Societé Generale then brought to life. It was using investment processes as a behavioural defense. As such Montier brought up topics that were supposed to help their clients to create tools that they themselves could use to sharpen their ability to manage money.

Today quant investors continuously scour academic research for new potential ways to get an upper hand but 15-20 years ago quants weren’t as prevalent as today and few ordinary portfolio managers read many books and certainly not many read academic research. What they do read is sell side research. James Montier read all the academic material and packaged it into a format that investors were used to read. In this way he was instrumental in introducing behavioural finance very early to a large part of the European investment community. With the interest sparked we could all then dig further and when Richard Thaler and Bob Shiller in later years received their Nobel prizes (as did Daniel Kahneman) I and many others could boost that we met those guys years ago.

Montier had a somewhat cynical style and the texts had a typical understated British humor that I grew very fond of. In my opinion Montier’s texts benefitted hugely from the fact that he continually had to meet investors and discuss what he had published. It was applied academia but it had to be packaged in an understandable way and above all, it had to be useful. The scarcest resource for a portfolio manager is his own time. Since the target audience was Europe’s largest institutional investors the language and the expected background knowledge suited me perfect.

The research pieces often had eye catching titles like Placebos, Booze and Glamour Stocks; CAPM is Crap (or, The Dead Parrot Lives!); Keep it Simple, Stupid; Spock or McCoy?; Part Man, Part Monkey; Brain Damage, Addicts and Pigeons; The Folly of Forecasting; Abu Graib: Lessons from Behavioural Finance and for Corporate Governance; ADHD, Time Horizons and Underperformance or Why Waste Your Time Listening to Company Management? Perhaps the most read analysis was called Seven Sins of Fund Management, banning his clients for making seven different stupid types of investment mistakes and then offering his take on alternative approaches.

Still, it might be that the sins text was beaten in popularity by a text called If It Makes You Happy. In it Montier draws on psychological research on happiness and presents his top 10 suggestions for improving this. The motivation being that “some of the most miserable people in the world seem to work in finance”. Most of the time I have been happy to work in finance – but then again I read Montier’s advice early on.

The Books

To date Montier has authored four books. The first called Behavioural Finance published in 2002 builds on a number of lectures that he held as a visiting professor at university. As I had grown used to the research pieces I at the time found it academic, dry and ultimately a disappointment. The second book called Behavioural Investing from 2007 and the third named Value Investing published in 2009 consist of most of the research pieces written by Montier at his time at Dresdner Kleinwort and Societé Generale. The texts are loosely grouped after subject. Then the quartet is finalized by The Little Book of Behavioural Investing from 2010 that summarizes the earlier work in a condensed and readable format.

Although the last book is probably more coherent and fluent than the others and certainly better edited it in my view lacks some of the sprawling energy of books number two and three. During those early years Montier was on a mission. When Behavioural Investing and Value Investing were released I had obviously already read all of the texts and they were rather like old friends but I still reread them and it had the added bonus that I could throw out a ton of research hard copies that I had saved. However, I still have a signed hard copy of Seven Sins of Fund Management saved somewhere in the attic.

During a period I wrote columns for one of the two dominating weekly Swedish business and investment magazines. It is probably true that half of these columns were based on concepts, ideas and examples that originated with either Montier or Mauboussin. Since the topics they had covered were largely timeless and universal a different geography, language and some water under the bridge made no difference - the ideas were as relevant as ever. I would argue that this goes for Montier’s books as well.

Role Models

Now, I’m sure that Montier would have a blast being called a role model or perhaps even more outrageous - virtuous. But, stay with me: in virtue ethics, as famously advocated by Aristotle, we should all be on a path towards our virtuous best selves that will do good deeds. Virtue ethics concentrates on how to become a better person. In this pursuit the truly virtuous persons are hugely important as role models and standard setters for what is good.

Being prosperous as an investor is also down to constant improvement. Charlie Munger and Warren Buffett have always stressed how important positive role models are for the improvement that is required for deserved success. Benjamin Franklin, Ben Graham and Lee Kuan Yew are some of their favorites. To me James Montier brought new insights and perspectives when I needed them to become a better investor. Hence, an intellectual role model at the right place and the right time for me. We can all benefit from one of those.

Kudos, James!

Mats Larsson, June 25, 2019

The Liquidity of a Plasma Market

Read full text as pdf… Link one to Amazon… Link two to Amazon…

Focus on the Abnormal

In a classic 1999 paper called A Framework for Understanding Market Crisis financial risk manager Richard Bookstaber argued that we are analyzing financial risk in the wrong way. Financial risk models often remove the most extreme statistical outliers to create mathematically tidy and statistically convenient representations of risk arising from movements in asset prices.

Unfortunately this creates a risk management approach that works really well when no risk management is needed but doesn’t work at all when risks are rampant, i.e. in a market crisis. Hence, financial risk models should throw out everything but the outliers and look to the structure of financial crises. It’s like markets can take two forms, one where the normal rules apply and another when there seems to be no rules.

Since 1999 a number of tail risk measures has been brought forward such as kurtosis and skew, maximum drawdown and a number of VaR-varieties. With about a decade passed since the great financial crisis the meaning of these figures is however gradually fading in the mind of people in financial markets. Many that have entered the industry the last few years have only seen good times. The VaR-number is nothing abstract; it’s the pain of watching your firm being shamed in media, the desperate outcry from customers over the phone line and the fear of loosing one’s job.

Much has changed in financial markets over the last two decades but unfortunately not allways to the better. Bookstaber’s understanding of how financial crises function is still highly relevant. In this text we will try to learn from one of the most experienced financial risk managers there is to see what can be said about today’s market situation.

 Apart from the already mentioned paper we draw on Bookstaber’s books A Demon of Our Own Design from 2007 and The End of Theory from 2017. The author is the Chief Risk Officer at the pension fund University of California Board of Regents. Earlier he has been both a PM and a risk manager at numerous leading hedge funds and investment banks. Few have longer experience of financial risk than Bookstaber.

Bipolar Markets

According to the traditional academic theory of financial markets, changes in market prices are caused by new information. The market price discounts all available information and only when there is an addition to this bank of data will the price adjust to a new equilibrium. Apart from the trading from a handful of dim witted, to the theory later added ‘noise traders’, that is it.

Obviously this bears little resemblance with how we see market prices behaving. Prices move around most of the time – sometimes violently. And often without any obvious new relevant news being released. Bookstaber brings forward the view that it is actually the market participants’ need for liquidity that dominates the trading of financial markets and subsequently the price movements. An investment bank needs to hedge a swap position, a mortgage desk needs to hedge its mortgage position and a fund manager who sells to meet liabilities are examples given by the author. It’s (mostly) a liquidity driven market, not an informational market.

Bookstaber’s market is a place where liquidity demanders meet liquidity suppliers. Liquidity demanders are demanders of immediacy - to them time is more important than price. Price levels are relevant but do not trump immediacy. Liquidity suppliers meet the liquidity demand and for them price matters more than time. They have a view of the market and take a position when prices deviate too much from what the liquidity suppler thinks the value is. By keeping capital available for investment at the right price and exposing himself to the risks of doing investments the liquidity supplier provides a valuable economic function that is rewarded by a financial return.

Between the two sits the market maker, the transaction intermediary who’s facilitating the trading. Market makers don’t want to take risk and trade with a very short horizon to make money on the bid-ask spread. The market price clears where the immediacy of liquidity demanders balance the price sensitivity of liquidity suppliers. If the immediacy of demanders increases and prices drop, suppliers step in with larger volumes. Liquidity suppliers and demanders serve each other well. In normal markets that is. Suddenly the behavior changes.

To describe how the market changes into something very different Bookstaber uses a magnificent metaphor from physics. In normal times mater is solid and clearly distinguished. “As energy increases, the constituents of matter blur. At low energy levels – room temperature – molecules and atoms are distinct and differentiated. As energy goes up, the molecules break apart and what is left are the basic building blocks of matter, the elements. As energy goes up even more, the atoms break apart and plasma is left. Everything is a defused blob of matter.” Matter is now an undifferentiated soup.

In normal times investors for example compare the PE-ratio of this stock to that stock, the credit risk of that bond to this bond, the potential future profitability of one company from another. Investors develop niches where they are comfortable to compete and sharpen their skill within their circle of competence. However, when the energy of the market goes up there is no time to look to the little things. It’s time to ditch broader segments like cyclical stocks and high yield bonds etc.

When the energy level goes up further all risk assets look the same, correlations go to one and there is a rush for cash, gold and government bonds. All risk assets go down together offering no normal diversification. What matters isn’t what characters assets used to have but who owns them and their immediate demand for liquidity. Risk assets are now an undifferentiated soup.

Critically, in this plasma market liquidity suppliers turn counter-economic. Normally, a lower price entice larger volumes, a larger supply of liquidity. Now a falling price triggers a flood of selling and despite the record low prices buyers are on strike – if they haven’t turned sellers themselves. The buyers might already have lost more than their board can stomach, they have gone through their stop-loss levels, they are busy denying media claims of their firm defaulting, some might have already lost their jobs and all their customers are withdrawing their money. The market maker is flooded with sell orders with no one to take the other side of the trade at almost any price.

Hence, there is an in advance unknowable tipping point where lower prices suddenly counter-economically entice even lower prices in a death spiral of escalating velocity. These tipping points are obvious in retrospect but always missed and misunderstood in real time. Somehow markets and their complexity seem to be beyond our ability to comprehend.

For me reading the chapter on the 1987 crisis in A Demon of Our Own Design was a revelation. Why are researchers still debating what triggered the downturn? It’s written out in black and white from someone who had the doubtful benefit of both a front row seat and the oversight and understanding to make sense of the event.

In short it was a combination of investor psychology, a mismatch in liquidity between the futures market and the cash equities market to act as a trigger and the widespread usage of portfolio insurance that created a self-enforcing negative loop of selling from liquidity demanders while the liquidity suppliers backed away. In his books Bookstaber gives his accounts of all the large market crises of the last three decades to try to make sense of the market dynamics.


Even though the volatility of the real economy has been declining for decades, as measured in the variability of economic growth, inflation and the like, the total risk of financial markets has instead increased. In can be argued that both the 2000/02 and the 2007/09 crises were generated from within the financial system and only later spread to the real economy. Shouldn’t behavior of financial prices and markets reflect the behavior of underlying assets?

Bookstaber describes how a combination of financial innovation, complexity and tight coupling creates unforeseen events that often cascade through the financial system as a crisis. The complexity arises as the agents in the system change their behavior depending on other’s behavior and events are often triggered by the use of derivatives. Due to the constant need for liquidity when using derivatives - and the often-high leverage - agents in the financial system are critically interdependent and the speed of the market trading gives little room for error or time for adjustment when things go wrong.

Time after time new financial products are launched without any real understanding of unintended consequences that can shock the system. Sometimes the risks are even deliberately ignored as the gains will fall to the banks’ personnel but they will not face the losses. Combine our normal-times-based risk models with the non-linear effects of a constant stream of newly invented derivatives plus complex organizations with plenty of politics’ aggravating decisions and you have an accident waiting to happen. That accidents occur in such a system is according to the author to be expected – they are so-called normal accidents that arise by the system’s design.

If we are to understand the market we should according to Bookstaber look beyond traditional economics and instead understand its four building blocks: 1) computational irreducibility – it is a system without mathematical shortcuts to describe it, 2) emergent phenomena – that the overall effect is different from the sum of the individual actions (nobody caused the economic crisis of 2007/09, but it still happened), 3) non-ergodicity – the concept that actions of one agent depend on and are shaped by history, context and the actions of other agents and 4) radical uncertainty – the fact that the system cannot be modeled by using historical events. The really important future developments will be unprecedented.

In effect Bookstaber is describing what others have called a complex adaptive system. When in time such a system reaches a tipping point, hurling it from one energy state to another, simply isn’t knowable in advance.

The key point if we want to understand how such a complex adaptive system behaves during a crisis is the state of the agents in the markets such as the liquidity providers and demanders; “what are their decision cycles; how much are they affected by market dislocations; and how critical is the market stress to their portfolio adjustments?”

Further with regards to the market makers; “what is their capacity for taking on inventory; and how long are they willing to hold these positions? And of the cycle of feedback: how are these answers affected by market dislocations; and how do they in turn further affect funding, leverage and balance sheets?” Some agents will be under more pressure than others. Which assets will they hold and are those who are under stress holding the same type of assets?

In the end the market reaction is determined by the volume of liquidity driven selling, the ability of market makers to take on inventory and the time and price level required for liquidity suppliers to take the other side of the trade.

What About Now?

Since we always regulate the previous crisis the leverage of the banking system is much lower today than in 2007. According to Bookstabber the next crisis will instead be one primarily concerned with liquidity. As a matter of fact, many of the rules that were designed to lower leverage risks have increased the liquidity risks of the financial system. Leverage is observable for those who know where to look but the liquidity of good times is not the same as that of bad times. Hence, the problem we might be facing in the next crisis is less observable.

Looking at today’s situation I would say that there are quite a few potential causes for economic misfortunes that come from outside the financial system. These are the things we tend to read about in the papers; the debt levels of some economically very significant states like Italy, Japan or China could cause problems in times of lower growth; the liquidity effects of quantitative tightening can turn out to be hard to manage; the more populist tendencies in global politics exemplified by events like Brexit and the flow of trade policy changes in the US-China battle for world supremacy; the monetary policy induced low growth caused by economic resources being locked in the many zombie companies that really should have been the subject of creative destruction long ago; or perhaps all the commentators are wrong and economic bull markets actually can die of old age.

Then there are the causes of trouble that hide inside the financial system. I’m bound to forget most of them and in reality what triggers a financial crisis tends to come from a direction where you are not looking. Still, a pair of distress candidates of mine would be firstly the fact that within corporate bonds the BBB-segment has ballooned to encompass half the investment grade market. Hence, the bonds with the highest credit risk have reached unprecedented size and the leverage of BBB-bonds in the US is also at historic record levels. If only parts of these securities would be downgraded this could totally dwarf the high yield market.

Further, even though the leverage of banks has moved in one direction – down – this doesn’t mean that leverage hasn’t moved elsewhere. The private debt market has seen a huge expansion the last decade. Not that this must lead to trouble, but booms in largely unregulated means to take on leverage has at least historically been good contenders for follow-on busts.

Irrespective of where the next crisis will originate there are also a number of factors present that can amplify the effects. The first category relates to Bookstaber’s liquidity demanders. Not unlike the portfolio insurance in the 1987 drawdown, the number of portfolio strategies and market functions that today sell when prices goes down are abundant. There are all the risk-parity and trend following strategies, there are the strategies that scale down position sizes as volatility goes up and the massive selling from delta hedging of derivatives when there are larger price movements. On top of this private clients usually run for the hills at the same time.

The second category of amplifiers has to do with the market making function of today. New regulation has made it forbiddingly expensive for bank market makers to hold inventory that would aid the provision of liquidity. Further the Volcker rule has almost made banks’ proprietary trading obsolete.

The order making is lightning fast and automated making the ‘coupling tighter’ than ever when it comes to market trading. Without much discussion on consequences a huge part of market trading has moved from underlying cash based markets, such as buying and selling stocks, to trading in ETF-units one layer up from the cash based markets. The effect of this is that the liquidity of normal trading of for example a credit-ETF can be great despite that the underlying securities – the corporate bonds - are hugely illiquid. Still, if the liquidity of the top layer would be exhausted in a crisis, the buying and selling drops down to the lower level where the size of the fire exit is made for ants, not a stampede of elephants.

Last of the potential amplifiers, is the category of liquidity suppliers that range from those with minimal time horizons to those that measure their horizon in multiple years. A large part of today’s market liquidity is provided by high frequency traders. In normal times this helps boost liquidity. In more troubled times the evidence shows that the algorithms governing the high frequency trading simply make the HFT-funds exit the market. It’s like the old story of the banker lending you an umbrella…

Related, but working on a different time scale, is that due to the lengthy underperformance the assets under management in active value investing portfolios have been dwindling. Value investors are the quintessential liquidity providers that buy when prices have gone down too far and by this prevent the drawdown from being too severe. Now they are clearly decimated and quant based value ETFs will probably not be of much help as I would guess that they are held by end investors who will try to exit the market in times of trouble.

Much institutional money has the last decade been allocated to so-called alternative assets like unlisted real estate, private equity, hedge funds, and infrastructure. The good thing is that these assets don’t have daily pricing and therefore, at least on paper, are relatively unaffected by the first turbulent stages of a market crisis. The flip side of the coin is that with more funds in illiquid assets the forced selling of institutions due to for example cash calls related to collateral in currency hedging, the selling in what remains among liquid assets can turn out to be more indiscriminate and risk causing forced selling of assets that you really want to buy at the time. The Harvard and Yale endowments experienced this in 2008/09.

Now, private equity is also a potential liquidity supplier so more funds in PE could be of benefit. The problem here is the time lag, the period from the point that a PE-firm becomes interested is something to the time where a public stock company is bought out and taken private is several months. Hardly the liquidity provider to call on to stem an immediate market drawdown.

Nobody can predict when and from where the next large financial crisis will come, nor how it will spread through the financial system and the real economy. Despite this Bookstaber has made an important contribution in articulating and analyzing market functionality in a crisis situation and we are thanks to this at least in a position to clear away some of the fog in front of us.

Mats Larsson, March 5, 2019

Economic moats - A recipe for long-term outperformance

Read full text as pdf…

“In business, I look for economic castles protected by unbreachable ‘moats’.”  - Warren Buffett

The greatest investor of all time - Warren Buffett -breaks down his investment criteria into the following four areas:

1. Circle of competence

2. Great long-term prospects

3. Competent management

4. A fair price

This text deals with the second point but also touches upon the third. In order for a business to have…

Kent Janér

Read as pdf… Link to Amazon…

Investor profile at InvestingByTheBooks: The book The World’s 99 Greatest Investors: The Secret of Success provides a unique opportunity to learn form the most prominent investors globally. In the book they generously share their experiences, advice and insights and we are proud to present these excerpts. Magnus Angenfelt, previously a top ranked sell side analyst and hedge fund manager, will be presenting one investor per month. For those who cannot wait for the monthly columns, we strongly recommend you to buy the book. The investor himself writes the first section below and then Angenfelt describes the background of the investor and comments on his investment philosophy. Enjoy.

Successful investors have two important abilities. One is the ability to identify interesting and potentially profitable investments. This is grounded in a well thought-out analysis of macroeconomic developments, a stock, or some other investment. If the market valuation is too high or too low in relation to what the analysis indicates is correct, things become interesting. The probability of finding a good deal increases if you also understand the reasons for this disparity. If, on the other hand, there is no apparent reason for the disparity, there is a greater risk that the market is right, and you have missed something in your own evaluation. Financial prices assume predictions about the future, but predictions are considerably more uncertain that most of us would like to believe. Accepting and locking yourself into a particular scenario that appears to be reasonable right now is not a good way of handling insecurity. It is better to think in terms of a variety of possible future scenarios, weighing up the possibility of them occurring. The market price should then reflect a reasonably balanced assessment of these scenarios. Because new information is forever becoming available, you should adjust your weightings over time, and therefore also what you think a reasonable market price.

The other ability of successful investors is to identify and handle risk, which is mostly aimed at reducing the chances of catastrophic results from your investments. The worst possible result is so bad that you no longer can, may, or wish to make new investments. Rule number one is to never risk ending up in this situation. Further, it is important to understand which risks you are exposed to, and actively decide whether they are the ones you wish to carry, or if there are particular risks that should be insured or protected against. In many cases it can be wise, for the right price, to have a general insurance against unexpected events or macroeconomic shocks. Mathematical models can be very useful for measuring risk, but they should be combined with practical experience of financial markets. Excessive belief in models, which are of course simplifications of reality, can be downright dangerous. Good judgement and common sense are required, both of which are often underappreciated qualities.


If you as an investor want high riskadjusted returns over a long period of time in a changeable world, you will need to know about financial theory and understand macroeconomic structures and relationships, not to mention politics, including central bank policy-making. Without a certain understanding of these topics (which does not necessarily mean expert knowledge) there is a risk of becoming a one-trick pony, and making the same investment over and over again, despite the fact that reality has changed so that the factors and relationships which ensured success in the past are no longer valid.

Hard work and a passion for what you do are definitely important factors in success!

BORN Laisvall, Sweden 1961.

EDUCATION Janér graduated from the Stockholm School of Economics in 1984.

CAREER His first job after graduating was as a market maker in government bonds for Svenska Handelsbanken. After two years he switched to a similar role at Citicorp in London, working with British gilts. In 1989, Janér started working for the Swedish bank JP Bank with responsibility for bonds and the bank’s investment strategy. In 1998 he founded the hedge fund Nektar Asset Management, where he has been head of investments from the start, and is now also chairman of the board.

INVESTMENT PHILOSOPHY Janér runs Nektar, one of the decade’s most successful hedge funds in Europe. The fund is market neutral and looks for misvaluations between various financial instruments, which are advantageous from a risk perspective. The positions can also be based upon a macroeconomic theme (lower growth, higher inflation, higher volatility, etc.). The emphasis is on interest rate market. The fund usually holds several hundred positions and is characterized by relatively low risk.

OTHER Janér made his name by being one of the most successful investors to take positions on the falling Swedish krona in 1992. Today, Nektar manages over $4 billion. Among the large number of international awards received over the years, for three years in a row Hedge Funds Reviews named Nektar the best market-neutral fund in Europe over the previous ten years. He is a member of the scientific advisory board of the Stockholm Institute for Financial Research, and his hobby is deep-sea fishing.

Source: Kent Janér; Nektar Asset Management.

Real Estate Primer: Part II

Read full text as pdf…

Similarly to other financial companies like banks and insurance companies, but in contrast to most other companies, the layout of the financial accounts for real estate companies deviates from the standard company. We will exemplify by looking at the 2016 financial reports for Klövern and as…

Part I of this Real Estate Primer was published December 2, 2018

Stanley Druckenmiller

One of the "masters of universe" is Stanley Druckenmiller, who here is interviewed by Kirik Sokoloff in late september.

Its a great view/listen in many aspects, I am highlighting a few.


first 10 minutes is about private life

ca 10 min: Some history and background to his trackrecord, 30% cagr.

ca 16 min: Why algos is making his old system of using the markets price signals to make money

ca 22 min: On how he made money, build a thesis and make a small bet, and wait for price confirmation

ca 29 min: On FED

ca 37 min: On big tech

ca 41 min: On big bets & capital preservation

ca 50 min: Your most important job, is to know when you are hot or cold

ca 54 min: View of the us equity market

ca 1 hour 2 min: The rise of populism, wealth inequality

ca 1 hour 6 min: Stanleys book recommendation =>  Charles Murray, Coming Apart

ca 1 hour 8 min: US in the world

ca 1 hour 16 min: His philanthropy


Real Estate Primer: Part I

Read full text as pdf…

Real estate is property consisting of land and buildings on it. Real estate companies are firms that engage in the acquisition, management, development and selling of real estate, generally for a commercial purpose. The ownership of a piece of real estate is by definition a very local undertaking and real estate companies are often classified by the regions where their properties…

Part II will be published within short!

Albert Frère

Read as pdf… Link to Amazon…

Investor profile at InvestingByTheBooks: The book The World’s 99 Greatest Investors: The Secret of Success provides a unique opportunity to learn form the most prominent investors globally. In the book they generously share their experiences, advice and insights and we are proud to present these excerpts. Magnus Angenfelt, previously a top ranked sell side analyst and hedge fund manager, will be presenting one investor per month. For those who cannot wait for the monthly columns, we strongly recommend you to buy the book. The investor himself writes the first section below and then Angenfelt describes the background of the investor and comments on his investment philosophy. Enjoy.

·       Perform only those investments that you understand.

·       I suffer from insomnia when I am in debt.

·       Amat victoria curam – Victory favors those who take pains.

·       In every danger, an opportunity.

BORN Charleroi, Belgium 1926.

EDUCATION Dropped out of secondary school.

CAREER Aged 17, after his father died, he took over the running of the family’s nail merchant business. Aged 30 he began investing in steel factories which, when he sold them in late 1970s, became the foundation for his wealth. He continued to buy and sell, mainly Belgian national companies, and has today an empire of media, oil, and utilities.

INVESTMENT PHILOSOPHY Frère has displayed impeccable timing in his dealings. His strength and strategy predicting changes is business structure, political impact, and long evolutionary trends in industries. He was, for example, the pioneer in Europe on cross-border deals. He foresaw the single European market and the consolidation that would be one consequence of the EU. The valuation is not always the crucial point for him in making decisions, and he invests in both public and private companies. This investment strategy demands specific skills and contacts, and is not easy to apply. He is described by making money by exercising stone cold patience in a serene manner in connection to being a workaholic.

OTHER Frère keeps himself well out of the limelight. He rarely gives interviews (I thank him for granting me one!) or speaks in public. According to Forbes his wealth is an estimated $3.7 billion in 2013, which makes him the richest individual in Belgium. He is nicknamed The Warren Buffett of Belgium. At the age of 85 he made one of his biggest deals so far taking the investment conglomerate CNP private. He is a hunter, athlete, and lover of fine wine. Frère took up golf in his seventies.

 Sources: Albert Frère; Wikipedia; Forbes.

The Knowledge Project Podcast with Shane Parrish: Annie Duke

I am new to podcasts. But beeing a runner sometimes means knee problems, and you need to live life differently, or in my case, sit on a stationary bike.


But if you listen to a great podcast, you don’t mind.

This is a great interview by Shane Parris, and a nice written summary in the link as well.

It two hours long, which is very entertaining, and you soon forget that you are on a stationary bike.

Happy listening & have some skin in the game:

Stop reading and play some football!

So since you are at the investingbythebooks site, I guess you have read a few books. But besides reading books ... What else can you do to become a better investor, and not to read another book about value investing?

Lets compare with something else, for example football.  “A huge football fan that knows every tiny detail about the game. He knows exactly what is going on, what the players are doing right, what they are doing wrong. But if you put him on the field, he can't throw the ball because he never did it in his life before.”  It is one thing to know what you need to do, but it is another to execute. Only way to learn how to execute is to actually play the game, or in this case, actually invest your own money”

 Below is a text who is heavily inspired from Geoff Gannon, original here,


1) Have Skin in the Game 

Buy stocks you pick yourself. Stocks you can only blame yourself for if they lose you money. The hard work isn’t just analyzing a company and handicapping the situation. It’s putting your own money — and your own ego — on the line.

2) You have to have skin in the game.

You have to risk taking a self-inflicted blow to your money and your mind.  The most important part of investing is trying, failing, experimenting, and adapting on your own. Watch yourself work under real world stress. And be brutally honest about what you see.

3) Keep an Investment Diary

Take some time every day or at the least once a week and just write down whatever thoughts you have. Stocks you are looking at. Months from now and years from now, your memory of what you were feeling and what you read in that journal won't match. And you may not recognize the person who wrote those things. You'll have changed as an investor without realizing it.

4) Keep an Investment Bucket List

If you had to put your family’s money into five stocks before you died, which five stocks would they be? Study companies regardless of their stock price. Keep a list of your favorite companies. Imagine the following limitations:

· You have to invest all of your family's net worth in stocks.

· You can never sell a stock once you buy it.

· You can only buy five stocks between now and the day you die.

It’s amazing how quickly this exercise will force you to distill your thinking.

5) Work more

When authors list Warren Buffett's investing secrets they don't mention that he read every book on investing in the Omaha public library by the age of 11. That he owned stocks in high school. That he took a train down to Washington and knocked on GEICO's door. That he went to annual meetings of companies he knew Graham owned stock in even though he was only a student and Graham himself wasn’t going. Which brings me to the Buffett did that you can do too: 1. Work an absurd amount. 2. Become an expert .

6) Become an expert

Become an expert. You've studied some different stocks now. You've had a taste of Indian stocks, U.S. stocks, Japanese stocks, micro caps, big caps, net-nets, hidden champions, etc. What interested you? What stock was the most fun to research? What did you think you really "got"?  Think about what area you might want to learn more about.  Then become an expert in that area. Pretty soon, you'll develop your own investing style.

7) Invest with Style

Do you buy turnarounds? Hidden champions?  Wide moats?  Brands?  Companies with surplus cash? Family controlled companies? Food and beverage companies? Companies with mind share?  With cutting edge tech?  With a lack of change?  Young companies?  Old companies? Low cost operators? Stocks in industries with little price competition?  Stocks with an activist banging at the gates?

8) One example – of someone with an investment style…

One example of  investment style”, watch an interview — any interview — with Tom Russo, for example he gave three lectures at Columbia. He is a buy and hold investor. He is a global investor. He likes brands. He likes food and beverage companies. And he likes family controlled companies. He wants a high return on capital and the ability to reinvest that capital for many, many years to come. He cares about price. But he’s a lot more flexible on price than most value investors. Just Google him.

To summarize, grow your own style, and play some football!

Selling and Selling Short

Read the full text as pdf…

“Almost all of the really big trouble that you’re going to experience in the next year is in your portfolio right now; if you could reduce some of those really big problems, you would come out as a winner […].” /Charles Ellis

When it comes to investing in portfolios of individual stocks, it doesn’t matter if your benchmark is an index or an absolute return number; there are still two basic ways to beat that target…

Insurance Primer

Read full text as pdf…

Life presents us all with a wide variety of risks. This gives us a choice to either accept the consequences of those risks, should they materialize, or to try to protect ourselves from these consequences and by this reduce the exposure to various perils. Insurance companies protect against the financial risks of both retail customers and those of corporations. Those who…

Warren Buffett’s only public investment thesis

Although Warren Buffett is open and transparent about most things he never discusses the details of his investment theses. That is too bad since that is probably what most of us investors are interested in. But there is actually one investment case that he has described publicly. And it is not any investment, but his favourite and probably most important investment, Geico.

Warren wrote the article when he was 21 years old and working as a security broker at his father’s investment firm Buffett-Falk & Co. He had just received his degree from Columbia where he studied under his mentor Benjamin Graham.

What struck me is that, contrary to public perception about his old strategy, Warren was investing in a fast growing company with competitive advantages. Although he paid a value multiple of 8 times earnings, Geico was clearly not a cigar-butt or liquidation play. On the contrary, Warren discusses the advantages the company has compared to its competitors. Another thing that struck me is that he only mentions management and insider ownership briefly. That is a factor that he has focused more on as he has developed. That said, the quality of the analysis is high and impressive given his young age. Already at 21, he was good at making difficult things sound simple.

Enjoy the read: The Security I Like Best

Carl Icahn

Read as pdf… Link to Amazon…

Investor profile at InvestingByTheBooks: The book The World’s 99 Greatest Investors: The Secret of Success provides a unique opportunity to learn form the most prominent investors globally. In the book they generously share their experiences, advice and insights and we are proud to present these excerpts. Magnus Angenfelt, previously a top ranked sell side analyst and hedge fund manager, will be presenting one investor per month. For those who cannot wait for the monthly columns, we strongly recommend you to buy the book. The investor himself writes the first section below and then Angenfelt describes the background of the investor and comments on his investment philosophy. Enjoy.

There are no words in our vocabulary that define the common quality that all very successful people share, but the closest words would be ‘passion’ or ‘obsession’ relating to what they do. A second quality these people share is a lack of hubris when achieving a great victory in a game or investment. When they are victorious they do not believe they are geniuses, rather they understand how much luck is involved. As Rudyard Kipling put it, ‘if you can meet with Triumph and Disaster and treat those two impostors just the same’.

A third quality that I believe all great investors share is the ability to recognize the difference between a ‘secular’ and ‘cyclical’ change in companies they have carefully studied. If a company they have studied and believe in is down because of a cyclical change, successful investors use the opportunity to purchase as much as they can as quickly as they can. They do not care and are not influenced or frightened by market conditions, etc. However, if a company is in trouble due to ‘secular’ change, successful investors will take their losses and back away.

The ability to recognize secular and cyclical cycles cannot be taught, in my opinion. Rather, it is an instinct or talent that has been honed over many years of arduous work. In other words, the great investors, just like the great champions in other fields, can divorce themselves from their emotions and just play the game.

BORN New York, USA 1936.

EDUCATION He studied philosophy at Princeton University in 1957 and at the New York University School of Medicine, but he left without graduating.

CAREER Icahn began his career on Wall Street in 1961 as a registered representative with Dreyfus & Company. Aged 32 he bought a seat on the New York Stock Exchange and started Icahn & Co. Inc., a brokerage firm that focused on risk arbitrage and options trading. In 1978, he began taking substantial controlling positions in individual companies. Today, he is chairman of Icahn Enterprises, a diversified publicly listed holding company engaged in a variety of businesses, including investments, metals, real estate, and consumer goods.

INVESTMENT PHILOSOPHY Icahn is the most successful and famous stock market activist in the world, but his roots are in contrarian value investing. His strategy is to invest in beaten-down assets that nobody else wants, usually out of bankruptcy, then fix them up and sell them when they are back in favour. When studying a firm’s structure and operations to explore the reasons for any disconnect between the company’s stock price and the true value of its assets, ‘for the most part the reason for this disconnect is management’, as he explains it. To take the steps necessary to seek to unlock value he uses tender offers, proxy contests, and demands for management accountability. When valuing companies, he looks at replacement cost, break-up value, cash flow and earnings power, and also liquidation value.

He operates with almost all market instruments – including long and short equities and bonds, bank debt and other corporate obligations, options, swaps, etc. He regards consensus thinking as generally wrong. ‘If you go with a trend, the momentum always falls apart on you’ says Icahn. In contrast to the general view about activists, he is more of a long-term investor. The focus is on capital structure, management, and finding the best long-term owner for the assets.

OTHER Icahn Enterprices has revenues around $20billion and almost $30 billion in assets. In 2008, Icahn launched the Icahn Report, which campaigns for shareholder rights and encourages them to shake up the management and boards of underperforming companies. He has through his different vehicles taken positions in various corporations over the years and very seldom failed to wring out changes and higher valuation. Some of the most famous battles were RJR Nabisco, Texaco, TWA, Phillips Petroleum, Western Union, Gulf & Western, Viacom, Blockbuster, Time Warner, Yahoo, Motorola and recently Dell. In the fight over Time Warner, where he owned about 3.3 %, he unveiled a 343-page proposal calling for the break-up of the company. In 2013 his net worth was estimated by Forbes to be $20.3 billion, making him the eighteen richest man in the world. He has been an active participant in a variety of philanthropic endeavors through Icahn Charitable Foundation, which mainly focuses on child welfare, education, and medicine. 

Sources: Carl Icahn; Icahn Enterprises L.P.; Icahn Enterprises; the Icahn Report; Wikipedia.

The Market and Corporate Governance

Read full text as pdf…

Who is “the Market”? Or rather, how does the stock market work? Why does it react as it does? Why is our stock valued as it is? What do investors really want out of us? Board directors and executive managers at times have a strained relation to a stock market they view as short-sighted, moody and that infringes on their valuable time. Many are genuinely unsure of what makes this unruly monster tick and others…