Author: Gísli Eyland

There are just too many interesting things going on

Largest S&P 500 Single Day Drop

One of the things that has preoccupied my mind lately are the underlying differences in approach between active investing and passive investing.

Imagine the two following hypothetical money managers: One of them is an active investor. He performs bottom-up fundamental research of companies, trying to determine their “intrinsic value”.

The other investor is passive. He uses quantitative analysis in order to find factors would have lead to out performance compared to a specific benchmark (these strategies are called “smart-beta” as they are passive in nature, but still aim to outperform the benchmark).

Analytical vs Statistical Approaches

For lack of better terminology, lets say that the active investor has an analytical approach, while the passive investor has a statistical approach.

The active investor is focused on the future cash flows of the company. He is tries to understand the business model of the company he is analyzing how the company creates value. He might try to study historical transaction multiples or how similar public compare in terms of valuation ratios. But primarily, the fundamental investor is trying to analyse future events.

The quantitative investor, however, is looking at a universe of stocks. He mines datasets to find a relationship between factors and performance. He designs different strategies and uses backtesting to see how these strategies would have performed.

The Limits of History

But what is data? Data is history.

Consider the following: Suppose you ask the investors about the largest single day drop in the S&P 500. The quant tells you that the largest single daily drop of the S&P 500 occurred on October 19, 1987, when the index fell by 20.47%.

The fundamental investor, however, tells you that the largest single day drop hasn’t happened yet.

Leverage + Arbitrage

I like reading books on business history and biographies of business people. One thing that I feel is often a common thread in there stories is that substantial wealth creation often seems to stem from some combination of leverage and arbitrage.

I’ll elaborate. Often, the initial businesses are created around some sort of arbitrage. The arbitrage might be that the entrepreneurs have some information or ideas that others don’t. But an arbitrage usually doesn’t sustain. Once the word is out the trade gets crowded, which in turn erodes the profitability.

Some arbitrage are more sustainable than others and cane be ridden for longer. And I suapect that there are plenty of business people out there that found powerful arbitrages to take advantage of and did so for a long time. The reason we never heard about them, is because they were constrained. They were not scalable. They couldn’t not be levered.

If you have an arbitrage, however, that is defensible and has the potential to be leverad to a larger scale, you have the components of substantial wealth creation.

Here are a few examples:

  • Sam Walton realized that by buying cheap and pricing low, he would create operating leverage, by maximizing inventory turns. He realized that the big stores would not go to smaller towns, an opportunity that he was able to arbitrage for a very long time.
  • Kirk Kerkorian built his initial wealth through a unique albeit limited arbitrage. After WWII, Kerkorian borrowed money to bid on surplus bombers which he picked up abroad and flew home. At the time, there was a shortage of jet fuel and Kerkorian was able to sell the remaining fuel in the bombers’ fuel tank. Selling the fuel raised enough money to repay the loans he had taken. He essentially got the planes for free.
  • Sam Zemurray made a fortune in the banana trade. In his early days, he took advantage of a brilliant arbitrage opportunity. When banana cargo came to New Orleans, bananas that were spotted were deemed unfit for the travel to metropolitan locations and were discarded at the port. Zemurray bought the ripe bananas very cheaply and sold them locally to grocers within a day of New Orleans. To get the bananas to grocers fast, he leveraged the train system.

Strawman & Steelman Valuations

A strawman argument is a frequently used tactic in rhetoric and oratory debate. It’s used in business, in politics and Twitter arguments alike. It’s simple and effective. You basically pick an argument of your opponent and rephrase it in a way that makes it easy to refute. Strawman arguments are not real arguments. They don’t even have to be true. 

Peter Thiel argues that for decision making, you should really steelman your opponents arguments. If you try to find the strongest and most compelling reasons for your opponents stand, it allows you to improve your side of the argument or even discover flaws in your own reasoning. 

The same should apply to valuation. You should always try to steelman the potential risk factors that you apply to your investment thesis. 

Covid-19 and Corporate Darwinism

On August 10, 2020, small company in Columbus, Ohio issued a press release announcing its second quarter financial results. There is nothing particularly special about that. Core Molding Technologies, a so-called dark company that trades over the counter, does this every quarter.

In this particular press release, the company disclosed to the world, just like any other public company on the planet, how it was being affected by the Corona-virus Pandemic. So, nothing particularly special about that either.

But what came next was, to me at least, something that caught my attention. The quote, which comes from David Duvall, President and Chief Executive Officer of Core Molding Technologies says “When customers reopened in June and revenues rebounded, to approximately 85% of first quarter’s average monthly revenues, we recorded our highest monthly operating profit of the past five years. It is a clear statement that we have created a stronger company and more resilient organization.”

The underline was added by me.

Darwin’s theory was that the fittest survive. Not the strongest, but the fittest. The fittest for its particular environment. And when the environment changes drastically, the fittest are the ones with the most adaptability.

Every company on this planet has been desperately trying to adapt fast to a new reality. In their struggle to survive, they try to eliminate any excess in their being. Some will go extinct, many will survive.

In many cases, the survivors will have similar things to report as Core Molding. They will be leaner. They will be meaner. And their streamlined costs structures will make them more profitable.

How to Value Your Job

The worst career advice that you get from people is when they say stuff like “you need to take control of your career, you need make sure you get what is coming to you, no one is going to care about you the way you do, so you need to make sure you fight for all of this stuff”, etc, etc. Those are all terrible advises. 

Your job, whatever your job is, is to add value to your employer. It is not your job to try to extract value from your employer and try to get as much of it into your pocket. Rather, your job is to add as much value as you can for the employer and then you can capture some of that value. 

Contrary to what most people think, being underpaid is a very powerful position to be in. Because, if you are adding more value than you are costing then it means also means that you are a very valuable employee. And if your employer is rational, you are going to be treated well.

Nobody has ever gotten fired for creating too much value for their employer. And nobody keeps a job very long if they are getting paid more than they are worth. 

This text was adapted from a podcast interview with legendary investor Bill Miller on Master in Business. The whole podcast is well worth the listen

How to Value a Brand?

The intriguing thing about brands is that they are mostly intangible. You generally won’t find the brand value of a company on its balance sheet. As an example, the $90 billion that Coca-Cola has spent on advertising in its history has no value that is shown on Coca-Cola’s balance sheet. Nonetheless, the brand value clearly is there. The market value of Coca-Cola’s common stock is ten times that of the stated book value of the equity. 

So how do we value a brand? The problem with a task like trying to value a brand is that there will always be some form of circular logic in this kind of exercise.

Is Coca-Cola such a strong business because it is built around such a strong brand, or is Coca-Cola such a strong brand because it is built around such a strong business? 

Where is the boundary where the value from the business model stops and value add from the brand begins? Is it even possible to separate those two things from each other? Brands are contextual. If you could buy the brand out of Coca-Cola, Inc and pivot it to sell Coca-Cola branded furniture, value would most definitely be destroyed. 

Brand Valuation Frameworks

As it turns out, ISO – the International Organization of Standards – has formulated a standard on Brand Valuation. You can even find an old version of the standard online.

Interbrand we the first company to get a certification for standard ISO 10668, the standard for Brand Valuation. Interbrand publishes an annual list of the most valuable brands in the world. You can read more about the Interbrand brand valuation methodology here.

Brand Valuation Resources

Something more to add? Let us know in the comments section!

Repugnant Markets | Alvin Roth on Trading Kidneys

A repugnant transaction is an economic term that describes an exchange between people that is generally perceived as morally or ethically wrong. These transactions fall outside of regular market mechanisms, hence the term repugnant markets. The repugnant nature of these transactions, cause these markets to be structurally inefficient. 

Examples of Repugnant Markets

  • Organ transplants
  • Child surrogacy 
  • Prostitution 
  • Recreational drugs

Whether a market is considered socially repugnant in not a binary definition. At the same time, what people consider to be a repugnant transaction can change over time and across cultures. Some transactions that are considered repugnant, are also illegal. Some are not.

Matching Markets

When you think about markets, the first examples that come to mind will be something like stock exchanges, farmers markets or auctions. In all these examples, the transaction is impersonal. If you want to buy a stock on the New Youk Stock Exchange, you simply need to place an order through a stockbroker. In fact, anybody can place a bid. 

Many markets are, however, personal. These markets are called matching markets. In order for a transaction to take place, a buyer and a seller need to be matched. A good example of this is the labour market. If you are in the labour market, you can’t simply choose a job. You need to match with an employer who is looking for someone who matches your skillset. 

Repugnant Transactions

In a matching market, price is not the only mechanism. For a matching market to be repugnant, it means that other people feel that it should not be allowed to engage in the desired transaction. 

Alvin Ross, the economist who coined the phrase, formulated the concept of repugnant transactions when studying kidney transplants. It is against the law almost anywhere in the world, to buy and sell kidneys for transplantation. Yet there is a black market for kidneys, which means that there are instances where individuals are willing to transact in kidneys, while people, in general, feel that it is immoral to do so. 

Alvin Roth on Repugnant Markets and Forbidden Transactions

In the following lecture, Nobel laureate Alvin E. Roth will investigate the nature of and reasons for repugnance with its implications for the design of markets. Why is it forbidden to sell and buy organs? Why is the exchange of kidneys that leads to many successful transplants allowed in some countries such as the US, but not in others like Germany? Which markets or transactions we allow, affects the choices that people have?

Watch the lecture and learn more:

Also on How to Value Stuff

10 Ways to Profit by being Less Logical than Anybody Else

Here at How to Value Stuff, we are all great admirers of Rory Sutherland. Rory is the head Ogilvy Advertising – founded by David Ogilvy, another man we greatly admire. David wrote a legendary book on marketing and sales, called Ogilvy on Advertising – and one of the most influential advertising professionals in the world today.

Rory has a fascinating view of how we perceive the value of the products and services we enjoy. In 2019, Rory published a book called Alchemy: The Surprising Power of Ideas That Don’t Make Sense, which was a follow up on a book he published the year before, Alchemy: The Dark Art and Curious Science of Creating Magic in Brands, Business, and Life.

Here are 10 rules you can adopt which will help you profit by being less logical than everybody else:

1. The Opposite of a Good Idea can be another Good Idea

Nobody can blame you for getting at a single right answer regardless of the materials you used to get there. Conventional logic uses the idea of a single right answer. This is mostly needed where your job is in the line and you need to make everything right.

When it comes to driving at a single right answer, no subjectivity is involved in decision making and what you decide is what you deem right.

2. Don’t Design for Average

Solving a problem with an average person in mind is very difficult. Some models in conventional logic require you to solve a problem for people in aggregate. This can make problems very difficult to solve.

Do not limit yourself to the average person and focus on the fringes. That way, it is easy to find things that will be adopted by extreme consumers.  They can then be ploughed back in the mainstream.

3. It Doesn’t Pay to be Logical if Everybody Else is being Logical

Being logical in business will get you to the same place just like everybody else. In business strategy, it does not pay to be logical because being logical will get you to the same place where your competitors are going. In business, you need to be differentiating yourself away from your competitors.

Find out what your competitors are logically wrong about. If you find out what is wrong with their model, you are in a position to exploit it. Adopt contrarian thinking.

4. Our Attention affects Our Experience

The nature of our attention affects the nature of our experience. Quality is relative. The perception of quality is determined by the difference between expectations and experience. It is more difficult to change how a person experiences something than the expectation of that experience.

Rory gives an example of one of the best hotels he has stayed in. The hotel had previously been a prison or a police station. Everything from the bed and bathroom to the TV and wall hangings was very spartan nature.

Under most circumstances, you normally would have experienced this as a lack of quality. But the hotel was in East Berlin and the experience came across as authentic East Berlin. It fit the circumstances. It met what you would have expected from an authentic East Berlin hotel.

5. If there were a Logical Answer We would have found it Already

If a problem becomes persistent even after discussing it with every person who can relate to it, it means you are giving it a logical explanation. There is a solution somewhere to be found through conventional linear rationality approach.

Exposing everything to logic and the problem persists, it indicates that logic is not the answer to that problem. Gather some courage and test less rational solutions. Context is a marketing superweapon.

6. The problem with Logic is it Kills off Magic

Logic and magic cannot coexist. There is no magic where logic is involved. The rules of logic demand that there can be no magic.

Logic requires that you change your product instead of improving the perception of the product in order to enhance the customer experience. This confines you into doing exclusively objective things because you think that people perceive the world objectively.

7. A Good Guess which stands up to Empirical Observation is still Science

You should not let methodological purity restrict your capability of coming up with multiple solutions. It is good to allow solutions that come in randomly rather than being restricted to explainable solutions. The latter will hold you captive and will monopolize your progress.

8. Test Counterintuitive Things because Nobody Else will

Since you do not want to put your source of livelihood on the line, create a space in your business where you can test things that do not make sense. This will be an advantage to win over your competitor because your experiment will land you in a lucrative business idea that will make you outdo your competitors.

9. Don’t Solve Problems using only Rationality

Solving problems using only rationality is like playing golf using only one club. Using rationality as the only way of solving a problem will get your solution based on a very narrow path.

Solving problems by using only rationality will generate solutions that restrict themselves to a very narrow definition of human motivation and how they think, act and decide.

10. Dare to be Trivial

Sometimes big problems do not require huge intervention. On the contrary, a small thing can have an enormous effect. You do not have to do things in the correct order simply because it is the way they should be done. Small changes, such as alternating the order of options or changing relative scales, can yield an order of magnitude in results.

 

 

This is the biggest mistake value investors make

Value Investing is seductively easy. Summarized into one sentence, Value Investing is the art of picking stocks that are undervalued, a.k.a. buying a dollar for 50 cents.

Tempting, right?

The big problem – paraphrasing what Johan Cruyff said about football – Value Investing is a simple concept, but it is extremely hard to invest with simplicity.

How Value Investors Buy Books

Consider the following analogy:

Put yourself in the shoes of a Value Investor in a book store. Having a natural inclination to buy stuff that is undervalued, you will automatically be drawn to the table with a big sign saying:

  • Books 50-80% OFF! 

…and therein lies the problem.

Buying a book is a bet with an asymmetric outcome. The downside is that you will buy a book and it might turn out to be a waste of your time, plus the $10 to $30 it cost to purchase it. The upside, however, is close to infinite. A good book can fundamentally alter your life.

Coffee consumption is another good example. If you could only drink one cup of coffee a day, you would probably not drink the first cup of joe available to you. You would be more selective. You might even be willing to pay more for the right one.

Mistakes of Omission

Most of the books on the discount table are crap. They are there for a reason.

The Value Investor, focused on the table of discounted books, might end up finding a book that is good enough to be worth the purchase.

At the same time, his attention is turned away from the books that can truly alter his life.

https://youtube.com/watch?v=GtfYRY3rYVY%3Ffeature%3Dplayer_embedded

Do you disagree? Let us know in the comments below!

Diversification | What it really means

According to Wikipedia, “diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk.”

Investopedia has a slightly different take, saying that “[d]iversification is a risk management strategy that mixes a wide variety of investments within a portfolio.”

To many, diversification means investing in the market in general. You can do that by investing in a broad market index, such as an ETF that tracks the S&P500 index. There are also the Russel indexes. Basically, if you own the market, you get the market return.

The Contrarian View on Diversification

But diversity does not necessarily have to mean more. The goal of diversification is not to get the market return but to reduce exposure to a particular event.

What you are trying to achieve by being diversified is to make sure not everything you are investing in moves in tandem. By doing so, you embed optionality into your portfolio.

If you accept this reasoning, you will also agree that a portfolio of 5 stocks can be seen as being diversified if those 5 positions are not affected by the same factors.

Think about it this way: Which of the two portfolios is the safer investment strategy?

  • Portfolio A: A basket of common stock of the 20 biggest financial institutions in the U.S.
  • Portfolio B: A basket of 5 stocks each in a separate industry.