The Value of Luck

Few people are as good at framing ideas as Rory Sutherland. In a talk he gave at the SprintAd-dagen in March of 2019, Rory opened up with the following thoughts on the role of luck and experimentation under capitalism:

You’ve got to leave enough money free and you got to enough eccentric things to give yourself the change to be lucky…

One of the reasons that a lot of people don’t like capitalism is that some of the people who do very well under capitalism are actually total idiots. They happen to stumble into a business at exactly the right industry at the right time. They got lucky.

And even spectacularly intelligent people, I think we can argue…I don’t think there is any argument that Gates and Jobs are hugely intelligent….they were both spectacularly lucky as well as being hugely intelligent…partly by accident of their birth.

If you notice, a lot of those people, Ellison, Gates, Jobs – the giants of the tech industry – were all born within about 18 months of each other. And there was a tiny moment where you had to be young to make it in tech. Five years earlier and they would have ended up working for IBM. Five years later and it would have been to late.

One of the important things about capitalism, interestingly, is that it is a mechanism for rewarding people simply for being lucky. And the strangest thing about that is that it is precisely that, that makes people so angry about capitalism.

But if you don’t have a mechanism that rewards luck, the majority of great discovery don’t get banked.

If you look at the history of science, there is probably as much you can attribute to lucky accidents… Penicillin, Viagra, for example…the two wonder drugs. Those were both a product of completely lucky accidents.

The discovery of vaccination was just one man that happened notice that milk maids didn’t get smallpox. It’s just those tiny things that can have huge effects and we need to leave enough space to actually be lucky.

And the very strength of capitalism is precisely that it rewards ideas that at first make no sense.

Rory’s full talk at SprintAd-dagen

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Drowning in Data

If you agree with the proposition that more information leads to more efficiency in pricing in the markets, that should probably lead to the conclusion that markets have never been as efficient. We’ve simply never had this much data and data has never been as accessible as it is now.

Gone are the days when Warren Buffett could comb through Moody’s manuals to find net-nets. Now, data-rich stock screeners are readily available to anyone. On top of that, there are armies of hedge funds other quantitative investment shops out there, crunching data and trying to advantage of any arbitrage opportunity they can find.

A Valuable Lesson of VAR

Had you argued this to me about a year ago, I would have wholeheartedly agreed. Today I’m not so sure. And here’s the reason why.

You see, I’m a football fan (soccer) and recently they have implemented something called VAR into the game. VAR stands for Video Assistant Referee. It basically means that during a game there is now an additional assistant referee who reviews decisions made by the head referee with the use of video footage and analytical technology in real-time. He is then able to communicate with the head referee during the game.

The objective of the VAR implementation is to minimize human errors causing substantial influence on match results. Previously, the referee had to make split second decisions on incidents. Now he or she can utilize VAR, which means better data. The VAR can analyse incidents by replaying it from different vantage points and use graphics to determine rulings such as offside. Sounds great, doesn’t it.

The Interpretation of Data

The really interesting thing about VAR, is that after its implementation there is still a fair amount of dispute regarding key referee decisions. Even with the additional data provided by VAR, pundits are still arguing whether decisions on offsides, penalties and such where correct or not.

It seems that more accurate data by itself doesn’t necessary lead to better decision making. The data still needs to be interpreted. In that sense, it’s not just a question of decision being subject to human error or not. Sometimes, different people will perceive the same data differently. It is in some way a matter of opinion.

Financial Data and Insights

If we apply this to the investing world, it is safe to say the following:

If you would show two analysts the same financial and operational data two competing companies, it is entirely plausible that the conclusions that those two analysts might draw from the data would be diametrically opposed.

The interpretation of the data will be subject to frameworks the analysts used to draw insights out of the data. Insight, per definition, is the power or act of seeing into a situation. But insight, is in the analyst, not insight the data.

Leverage does not get the Credit it Deserves

First of all: Yes, there is a pun in this title and it is intended. But as with most jokes, there is a truth to it. The use of the term leverage in daily conversation, will usually care a negative connotation. Leverage gets a bad rap, you could say. 

The cause of this, I guess, is because most people will associate leverage with debt. And although debt is definitely a form of debt, not all leverage is debt. In the world of engineering, the term leverage simply means the exertion of force by means of a lever

The Law of the Lever, which was proven by Archimedes using geometric reasoning, shows that if the distance a from a fulcrum to where the input force is applied is greater than the distance from the fulcrum to where the output force is applied, then the lever amplifies the input force. “Give me a place to stand on, and I will move the Earth”, Archimedes is famously quoted. 

Leverage and Investing

When we think about investing and business in general, leverage tends to mean financial leverage. But not all leverage is created equal. There are many types of leverage and those different types of leverage have different kinds of qualitative attributes.  

Many investors use leverage and there are probably more types and forms of leverage at your disposal than you can imagine. Savvy investors and entrepreneurs excel when it comes to creative use of leverage. 

Different Types of Leverage 

Once you start looking for leverage, you will start seeing it everywhere. Operating leverage, for example, is a generally under-appreciated form of leverage. Many of the most successful businesses in the world have been able to use operational leverage on favourable terms. Operational leverage is a necessary ingredient in any venture trying to scale fast. 

When we think of Financial Leverage, we tend to think about loans. But there are other forms of financial leverage, such as derivative instruments. 

Operational leverage

  • Other People’s Assets (think marketplaces and aggregators)
  • Other People’s Money (think asset management companies) 
  • Negative Working Capital (think insurance float) 
  • User-base leverage (think new products to your existing user base)

Financial Leverage

  • Debt
  • Unsecured Notes
  • Margin Loans
  • Options
  • Futures
  • Forwards
  • Warrants 

The Beauty of Non-Recourse Leverage

Determining whether leverage is recourse or non-recourse is crucial to any reward/reward assessment. The beauty of non-recourse leverage is that it is asymmetric. If you invest in a stock, the most you can lose is the money you put up. The upside, however, is infinite, theoretically speaking. If you start a limited liability company, your theoretical upside is infinite, but you can only lose the equity you put up (unless you are providing personal collateral). 

Non-recourse leverage often comes at a price. If you buy a call option, you have to pay for it. The further out-the-money it is, the cheaper the price. Unsecured loans are more expensive than secured loans. Etc, etc.

Finding a mispriced, perpetual, non-recourse option on something is the holy grail of fundamental investing. This is how the best investors and most savvy business people create wealth for themselves.

Read more on Leverage and Optionality

Real Value | A Dan Ariely Documentary

Real Value, a economics documentary by the legendary Behavioral Economist, Dan Ariely, is a available in full length on YouTube. Ariely is know for his ground breaking work on experimental economics, covering fascinating and unconventional economic topics such as pain, attraction and cheating.

Why is Chuck Royce such a Good Investor?

The title of this post is a question posed by Tobias Carlisle to his guest Micheal Green of the Logica Fund, on his The Acquirers Podcast. Micheal’s answer to this question was pretty interesting, to say the least, and beautifully formulates the investment framework of Chuck Royce and the Royce Funds.

Michael Green: “First of all, Chuck has just an incredible mind and an incredible awareness of the embedded optionality in securities. And so, his philosophy as it relates to securities selection at Royce [Funds] was that he focused on small cap stocks, but he required that they have very low levels of leverage. And the reason why he did that…I think he intuitively knew this but I don’t think certainly he was explicitly modelling it in the same way I would be forced to do.

When he recognized this, that they had option-like characteristics, right, owning a portfolio that has small cap names in it is the greatest potential to exhibit that lottery-like winner capability. And he was very agnostic between value and growth from that standpoint. Always looking for that option-like characteristic. But his simple rule was that the company couldn’t have enough leverage that would lead to aggregation or a shortening of that option duration.

So he was effectively trying to pick infinitely lived option-like assets. And he just did it extraordinary well. I mean, he had seen so many management teams and he had seen so much. I met him in 2003 for the first time and he had been running Penn Mutual Fund which was the core of the Royce universe. Which he acquired for $1 in 1974. People forget how bad things got.

There is maybe a little bit of this feeling in the active manager community today. But he was able to buy Penn Mutual Fund for $1 dollar. Because the owner, it had assets, and it had a bit of a track record. But the owner was incapable of paying directors salaries, registration fees etc. So he bought it for a dollar and then it proceeded to lose money for some time as he paid directors and others. But it turned into this extraordinary vehicle on the back of his talent. 

Tobias Carlisle: My interpretation of the Royce firm is that they seem to have a holding in every single stock I ever look at. A tiny holding. 

Michael Green: So, I think that’s true. I think that is again a reflection of Chuck’s philosophy that each of his securities represents this option like characteristics. A typical portfolio of Royce would have somewhere in the neighborhood of 160 to 300 stocks. There would be multiple portfolios.

Portfolios would typically be launched in a new fund when we thought it was a peak of a market. Which sounds counter-intuitive. Until you realize that what this actually means is that you have launched a vehicle that has an excess of cash in an environment of high valuations. And so as the markets sell off, that cash creates actually an out-performance characteristic.

So when the next cycle emerges, not only did you have cash to deploy at more attractive valuations, but you benefited from the cash component. And I mean, that type of insight. And again, I highly doubt that Chuck modeled it, but he just knew it intuitively. And that’s part of what I referred to with my respect to Chuck. I think he is probably the single finest investor I have encountered.

If you’ve seen one financial crisis, you’ve seen one financial crisis

The title of this post is a quote from former Fed governor Kevin Warsh. It’s reminiscent of the line from Tolstoy’s Anna Karenina that says happy families are all alike but every unhappy family is unhappy in its own way.

At the same time, our behavior is highly mimetic. Not only do we base most of our learning on imitation, but we are constantly searching for clues by comparing the current to the historic. I do this myself, literally all the time. 

When I’m looking at potential investments or trying to value stuff, I find myself searching for historical comparisons. When looking at XL Media, I immediately connected it with American Express and the famous Salad Oil Scandal. When I looked at CentralNic, I started drawing comparisons between the domain industry and cable industry in its early days.

Performing these mental model checks and looking for similar histories, is the default setting, in my experience. It seems to happen almost automatically. I need to force myself to not do it. It is in our nature. It’s a survival thing (see, I just looked for a comparable mental model and found evolutionary theory…).  

What’s obvious is obviously priced in…

The title of this post is a quote from a famous bond investor Jeffrey Gundlach. Gundlach is the manager of DoubleLine Capital, a huge bond fund, which has earned him the nickname the Bond King. 

It is clear to me that information that is obvious, should be priced into the market price of a public asset. This is logical. But if you abide by this logic, you should also agree with the statement that everything that is not obvious, is not priced in. 

By this logic, you would also have to assume that, unless every possible event is inherently obvious to market participants, the price of a public security is inevitably always wrong, since it does not account for the obvious. 

In the same vein, being a contrarian is a valuable stance, but only if there is an non-obvious truth that the market isn’t accounting for. Successful contrarians, try to approach the world from a different perspective. But they only act on it when they feel they have discovered an under appreciated possibility. 

The key is that thinking contrarian is a process, being contrarian is an action. You don’t always think contrarian, but only sometimes be contrarian.

Peter Lynch: “I Love Volatility”

There is this great short clip on YouTube with the legendary former mutual fund manager Peter Lynch (of Magellan Funds). In the video, Lynch declares his love for volatility and explains how he approached it: 

Volatility will occur. The markets will continue to have these ups and downs. I think that is a great opportunity, if people can understand what they own. If they don’t understand what they own mutual funds. And keep adding to it. Basically, corporate profits have grown about 8% per year, historically. So corporate profits double every nine year. The stock market ought to double every nine years.

The operative phrase here is “if people can understand what they own”. We can also invert what Lynch is saying in the video and ask ourselves what value we can provide by understanding the assets that have a volatile price?  

The Social Value of Active Investing

There’s a fantastic podcast interview with Micheal Mauboussin on the Invest with the Best Podcast, where he talks about the value that active investors bring to the market. Mauboussin says the following: 

Now, one of the things we’ve talked about quite a bit is, is there a role for indexing? And the answer is, absolutely yes. And I think for many people, that’s a very sensible solution. But that does not mean that the active management industry can go away. It’s not going to go away, because there are two things that it does that are still really important. One is price discovery, and again, indexing benefits from that positive externality, I think we can never lose that.” 

Essentially the fees paid to active management subsidize the indexing industry. And the other is liquidity. And even in these environments, we see that index people don’t trade that much. And so we need liquidity if you have it. I think those are public goods, those are vital, and those will continue to play a role. So the debate should be, what percent of the assets should be active versus passive?” 

By this logic, you could also posit that as an active investor the best way for you to add value is to find areas where you can add value by pricing the securities in question (research, know-how, etc), especially in securities where (or time when) liquidity is scarce.

How to Invest like Warren Buffett?

If you are asking yourself this question, you are asking yourself the wrong question. At the very least, I would propose you implement a minor tweak to it: How would Warren Buffett be investing if he were in your shoes? 

The thing is that the investing style of Warren Buffett has changed immensely over time. That’s just because he is extremely smart and extremely adaptable. And you wouldn’t want to mimic Buffett’s investments today, for the simple reason that he is severely disadvantaged compared to yourself. 

If Buffett were in your shoes, he most definitely wouldn’t be looking at Berkshire Hathaway for copycat ideas. You see, one of the things that is not talked enough about, when people are discussing Buffett is that he has been extremely adaptable. 

There are assets worth a total of $788 billion on the Berkshire Hathaway balance sheet. If the company would want to deploy 1% of its assets base to one investment, that investment would have to be valued at $7.8 billion. By comparison, the smallest company in the S&P 500 index has a market cap of $1.5 billion.

Therefore, if Buffett wants to make an investment that actually moves the needle today, his universe of available investment opportunities is actually tiny. 

The Buffett Partnership

So, how did Buffett invest early in his career, when he was a much smaller fish in a much bigger pond? This question brings you to the the Buffett Partnership, which Buffett managed from 1956 to 1969. When Buffett dissolved the Partnership in 1970, he kept his stake in Berkshire Hathaway, which the Partnership had had a controlling shareholder in. The rest is history, I guess.

First of all, during the Partnership years, Buffett invested in smaller, less liquid companies. Secondly, Buffett was a relatively concentrated investor, focusing on a few high conviction ideas. Nonetheless, this does not mean he didn’t try to diversify the Buffett Partnership Portfolio. The way he did it was not through quantity of exposure, but through the quality of exposure. 

By quality, I don’t mean that the stocks he chose were of higher quality than the stocks in the general market. But rather that he managed the stock portfolio by allocating its capital into three buckets that each had exposure to qualitatively different factors. 

The Three Arrows of Buffett’s Capital Allocation

His objective, as I understand it, was to be able to keep his options open and be flexible under different market conditions. For example, if the overall market went up, he would be able to allocate capital to the bucket of stocks that were not driven by the overall market, and vice versa if market sentiment was overly pessimistic. 

But you don’t have to take my word for it. Here is Buffett’s explanation of the three qualitative areas that he allocated capital to. The following is taken from the 1961 Buffet Partnership Letter Shareholders:

Our Method of Operation 

Our avenues of investment break down into three categories. These categories have different behavior characteristics, and the way our money is divided among them will have an important effect on our results, relative to the Dow in any given year. The actual percentage division among categories is to some degree planned, but to a great extent, accidental, based upon availability factors. 

The first section consists of generally undervalued securities (hereinafter called “generals”) where we have nothing to say about corporate policies and no timetable as to when the undervaluation may correct itself. Over the years, this has been our largest category of investment, and more money has been made here than in either of the other categories. We usually have fairly large positions (5% to 10% of our total assets) in each of five or six generals, with smaller positions in another ten or fifteen. 

Sometimes these work out very fast; many times they take years. It is difficult at the time of purchase to know any specific reason why they should appreciate in price. However, because of this lack of glamour or anything pending which might create immediate favorable market action, they are available at very cheap prices. A lot of value can be obtained for the price paid. This substantial excess of value creates a comfortable margin of safety in each transaction. This individual margin of safety, coupled with a diversity of commitments creates a most attractive package of safety and appreciation potential. Over the years our timing of purchases has been considerably better than our timing of sales. We do not go into these generals with the idea of getting the last nickel, but are usually quite content selling out at some intermediate level between our purchase price and what we regard as fair value to a private owner. 

The generals tend to behave market-wise very much in sympathy with the Dow. Just because something is cheap does not mean it is not going to go down. During abrupt downward movements in the market, this segment may very well go down percentage-wise just as much as the Dow. Over a period of years, I believe the generals will outperform the Dow, and during sharply advancing years like 1961, this is the section of our portfolio that turns in the best results. It is, of course, also the most vulnerable in a declining market. 

Our second category consists of “work-outs.” These are securities whose financial results depend on corporate action rather than supply and demand factors created by buyers and sellers of securities. In other words, they are securities with a timetable where we can predict, within reasonable error limits, when we will get how much and what might upset the applecart. Corporate events such as mergers, liquidations, reorganizations, spin-offs, etc., lead to work-outs. An important source in recent years has been sell-outs by oil producers to major integrated oil companies. 

This category will produce reasonably stable earnings from year to year, to a large extent irrespective of the course of the Dow. Obviously, if we operate throughout a year with a large portion of our portfolio in workouts, we will look extremely good if it turns out to be a declining year for the Dow or quite bad if it is a strongly advancing year. Over the years, work-outs have provided our second largest category. At any given time, we may be in ten to fifteen of these; some just beginning and others in the late stage of their development.

I believe in using borrowed money to offset a portion of our work-out portfolio since there is a high degree of safety in this category in terms of both eventual results and intermediate market behavior. Results, excluding the benefits derived from the use of borrowed money, usually fall in the 10% to 20% range. My self-imposed limit regarding borrowing is 25% of partnership net worth. Oftentimes we owe no money and when we do borrow, it is only as an offset against work-outs. 

The final category is “control” situations where we either control the company or take a very large position and attempt to influence policies of the company. Such operations should definitely be measured on the basis of several years. In a given year, they may produce nothing as it is usually to our advantage to have the stock be stagnant market-wise for a long period while we are acquiring it.

These situations, too, have relatively little in common with the behavior of the Dow. Sometimes, of course, we buy into a general with the thought in mind that it might develop into a control situation. If the price remains low enough for a long period, this might very well happen. If it moves up before we have a substantial percentage of the company’s stock, we sell at higher levels and complete a successful general operation. We are presently acquiring stock in what may turn out to be control situations several years hence.