Spotlight

Buying businesses that require constant capital reinvestment and earn lower incremental returns can be disastrous in your wealth creation journey.

In Lewis Carroll’s “Through the Looking Glass”, Alice finds that she has to run faster and faster just to stay in place.

“Well, in our country,” said Alice, still panting a little, “you’d generally get to somewhere else if you run very fast for a long time, as we’ve been doing.”

Here’s the advice Red Queen, an antagonist in the story, offers to Alice…

A slow sort of country!” said the Queen. “Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!

In sum, the Red Queen advises Alice to exert ever more effort just to maintain her current position.

Evolutionary biologist Leigh Van Valen took inspiration from the Red Queen’s words and proposed a principle called the Red Queen Effect in 1973 to explain how, for an evolutionary system, continuing development is needed just in order to maintain its fitness relative to the systems it is co-evolving with.

In biology, this means that animals and plants don’t just disappear because of bad luck in a static and unchanging environment, like a gambler losing it all to a run of bad luck at the casino.
[Read more…] about Spotlight: In Investing, Beware the Red Queen

History has a way of repeating with greater shocks in the financial markets and it shows up in the risk-taking cycle that investors go through.

I tend to collect the best quotes I read on various subjects in print or on the Internet in a document. As I was glancing through that document a few days back, searching for inspiration for my future posts, I found a few on the subject of history and how it repeats itself so often, especially in the financial world.

The philosopher Santayana stressed the penalty for failing to attach sufficient importance to history –

Those who cannot remember the past are condemned to repeat it.

Then, humourist and author Mark Twain talked about the
relevance of the past thus –

History doesn’t repeat itself, but it does rhyme.

And then, economist John Kenneth Galbraith described the shabby way investors treat history and those who consider it important as –

Contributing to…euphoria are two further factors little noted in our time or in past times. The first is the extreme brevity of the financial memory. In consequence, financial disaster is quickly forgotten. In further consequence, when the same or closely similar circumstances occur again, sometimes in only a few years, they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world. There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.

Warren Buffett said –

What we learn from history is that people don’t learn from history.

And here’s Charlie Munger’s version –

There is no better teacher than history in determining the future…

String together these three pearls of wisdom and you get a pretty accurate picture of investment reality. Past patterns tend to recur. If you ignore that fact, you’re likely
to fall prey to those patterns rather than benefit from them. But when markets get euphoric, the lessons of the past are readily dismissed. Investors start to say and believe in the “this time it’s different” theory, and completely forget the pain that such theorizing and subsequent actions had caused people in the past.
[Read more…] about Spotlight: Understanding the Risk-Taking Cycle

When it comes to investing in the stock market, making mistakes is business as usual. But what hurts investors is either trying to avoid all mistakes, or not learn from the past ones.

A life spent making mistakes is not only more honorable but more useful than a life spent doing nothing.~ George Bernard Shaw

IBM and Coke represent two of Berkshire Hathaway’s three biggest investments (the biggest being Wells Fargo). However, disappointing earnings announcements at these companies cost Warren Buffett a few billions last year.

These losses added to a recent rough patch for Buffett, who slashed Berkshire Hathaway’s stake in British retailer Tesco, also last year. He described buying into the stock as a “huge mistake” after the company announced another earnings disappointment and, over that, a £ 250 million accounting scandal.

The media was rife with these big “mistakes”, especially Tesco, and was surprised how the world’s best investor could commit them. But then, Tesco isn’t Buffett first mistake and it won’t be his last mistake either.

He started making mistakes with Berkshire Hathaway, the textile company he bought in the 1960s, and has built up a list over the years. So Buffett has…

• Bought a lousy business (Berkshire’s textile business)
• Bought a stock at the wrong price (ConocoPhillips)
• Confused revenue growth with a successful business (US Air)
• Invested in a company without a sustainable competitive advantage (Dexter Shoes)
• Misjudged the company’s prospects (Energy Future Holdings)
• Trusted the wrong people (Salomon Brothers)

It is easy to get carried away counting the mistakes, questionable decisions and blunders Buffett has made over the decades.
[Read more…] about Spotlight: Making Mistakes in Investing

When it comes to investing in stock market, the power of “the story” is very strong. But unlike the fairy tales, most stories here have an ugly ending.

Remember the story of Cinderella? And how she seemed plain and peasantly? With the help of her fairy godmother, Cinderella was able to turn her pumpkin, mice, rat, and lizards into her coach, horses, coachman, and footmen.

You know how that turned out. Cinderella became a princess, even though her step-mother and step-sisters thought she was destined to scrub floors till the end of her days.

I can relate this story of Cinderella to the stock market. To find a stock worth investing in, you’ve got to search for your own Cinderella – a story worth believing in, but which is ignored or looked down upon by most other people.

The problem is, most investors end up stumbling onto story stocks that have ugly endings. A large part of this is because the hottest selling stories in the stock market are often those where the storytellers are looking for bigger fools to offload their own junk before the stories turn sour. And they often manage to find a lot of such believers (often small, gullible investors) for their stories You see, as investors, we all are on the receiving end of sales pitches from brokers, friends, investment advisors, fellow investors, and bloggers in media, stock forums, and social media about stocks that they claim will deliver spectacular returns. These stories not only sound persuasive and reasonable but are also backed up by evidence – anecdotal, in some cases, and statistical, in others – that the strategies work. I am sure you have often read stuff like these in media –

• Small-cap stock backed by famous investors like ABC and XYZ has “tremendous potential”
• 5 multibagger stocks picked by ABC are set to soar
• XYZ multibagger stock is set to multiply 10x in next 3 years
• 5 Indian stocks Warren Buffett would buy and why

These are nothing but stories that are hyped under the pretext of “what has worked in the past will surely work in the future.”
[Read more…] about Spotlight: Investing and The Power of Story

Investing is a loser’s game and not anyone else but the investor, with his unforced errors, beats himself all the time. That’s why even an average performer can win this game by being consistent in avoiding mistakes. Focusing on what can go wrong has long been a hallmark of sound investing.

An investor needs to do very few things right as long as he avoids big mistakes. ~ Warren Buffett

If you don’t lose money, most of the remaining alternatives are good ones! ~ Joel Greenblatt

We are big fans of fear, and in investing it is clearly better to be scared than sorry.~ Seth Klarman

Superior returns are mostly earned through minimizing mistakes than through stretching for yield. ~ Howard Marks

Warren Buffett isn’t particularly prone to superlatives, so it’s high praise indeed that he calls two chapters in Benjamin Graham’s The Intelligent Investor – one on stock market fluctuations (chapter 8) and the other on margin of safety (chapter 20) – “the two most important essays ever written on investing.”

In the first, Graham introduces the concept of a manic-depressive “Mr. Market,” whose mood swings can lead to equity mispricing. In the second he describes how to manage risk by investing only when there is “a favorable difference between price on the one hand and appraised value on the other.” This margin of safety, Graham writes, “is available for absorbing the effect of miscalculations or worse-than-average luck.”

Focusing on what can go wrong has long been a hallmark of sound investing. Baupost Group’s Seth Klarman put it succinctly in an investor letter –

We are big fans of fear, and in investing it is clearly better to be scared than sorry.

But chances are that even the most avowed pessimists can have their attention to risk dulled by long periods of generally favorable market conditions and low volatility – becoming oblivious, as Klarman writes, to “off-the-radar events and worst-case scenarios.”

Many fund managers have unimpressive careers, not because they haven’t had any multi-baggers. They might have quite a few 10, 20, even-50 baggers, but along with those home runs they also have too many losers which end their careers too soon.

And yet they don’t learn from each other because you can still find many of them swinging for fences with every bet they make.
[Read more…] about Spotlight: What Could Go Wrong