Learning from The Great Recession of 2007 to 2008

Bull markets are 

born on pessimism

grow on skepticism,

mature on optimism, and

die on euphoria.

                                                      

               -Sir John Templeton      

The Big Short

I quite liked the "Big Short", which is an entertaining movie about the 2007-8 crisis, and which gives viewers a lens into the euphoria and pessimism which preceded and followed the crisis.

Confidence Game

As a part of my research into Pershing Square Holdings, I have also read Confidence Game by Christine S. Richard of Bloomberg News. Though the details of what caused the crasher too technical for me to understand, this is what I took away from both, the book, Bill Ackman's investment philosophy, and the MBIA crisis in general:

I. Improbable does not equal Impossible.

Bill Ackman says, "One should never risk a business on a situation with a large downside even if it appears that the chance of winning is nearly 100%. Every Once in a while, the roulette wheel comes up green. The unthinkable and unimaginable happens more often than one expects. "

(Basically, just because something is unlikely, doesn't mean it can't happen.) To quote Bill Ackman, "It is an unheard of kind of event - But, it happened."



II. Thorough analysis (and an informational advantage) are key.

i. A great question to ask is, "Why?"


ii. Think about the "Quality of Earnings". "What is it they are trying to do cosmetically?" "Start out by assuming the worst." (-Bill Ackman)

Be critical and look for errors, before you align yourself with a management team. Ask, "WHY?"

iii. Bill Ackman says, "We want to know more than anyone in the world can know based on public information. And usually, by the way, most people don't read the stuff anyway. So you've got a huge edge just by reading, right? And then if you really dig into something, you can really know more than the market."

The Edge: Essentially, it is a question of Second level thinking (Expectations versus Fundamentals); You want to know why the market thinks what it thinks, and see if you think differently. Nowadays, reading doesn't necessarily give you an advantage, BUT not reading certainly puts you at a disadvantage. 

Digging In: To be contrarian and right, you must have some special insight. It is likely that for the vast majority of ideas, you will try to gain an edge by reading, but you won't really dig into it. This is because, it is very rare that you continue to like an idea / like it more, after you have done some thorough research. 

III. Red Flags for collapse.

i. Excessive debt is a red flag.

ii. The "hallmark of every Ponzi scheme" is that "it only works as long as more money [is] put into the scheme."

Always ask, does this constantly need money to keep going, or is it self sufficient. Even for legitimate  businesses, though a very wide moat of capital and infrastructure is desirable, the majority of the best businesses don't require excessive Capital Expenditure.

iii. Does the management deal with problems, or "[shunt] them out of sight"?

Remember, you must align yourself with good managers. Poor managers will be able to destroy a business with even the best underlying economics. Trust is key; as Warren Buffett says, “Honesty is a very expensive gift, Don't expect it from cheap people.”

IV. Poor use of indicators and ridiculous expectations yield catastrophic results.

"Models often rely on historical data to predict what is possible. Unfortunately, the past is not always a reliable guide to the future."

In the Ten attributes of great investors, Mauboussin, too, references extrapolating historic performance into the future as a common and fatal error. The future itself, is probably no longer what you used to think it was. If the past were to keep repeating itself, there would be no uncertainty, and investors would no longer earn an equity risk premium, as they would know what the future held. This is an inherently uncertain exercise, and your opinion of the future must change with facts.

V. Errors (are usually honest).

i. A life lesson, which I would like to keep in my mind at all times (but often fail to remember):

As Warren Buffett says, "Errors will usually be honest, reflecting only the human tendency to take an optimistic view of one's commitments."

ii. ....But a management which consistently conceals errors and "shunts" problems is certainly poor at managing, and, perhaps, should not to be trusted!

VI. Credit (A dangerous gift of finance).

i. Excessive debt is a red flag.

ii. Daniel Webster describes credit as "Man's confidence (trust) in man."

Credit is a powerful resource, and in the opinion of Daniel Webster, "it has done more, a thousand times more, to enrich nations than all the mines of the world." But it is based on trust. Whenever this confidence falters, the system comes close to breaking. The problem comes when we trust cheap people. Remember, "Honesty is a very expensive gift. Don't expect it from cheap people.” It is when there is a lapse in judgement, that you lose money. 

On the stock market, credit yields fantastic results if you are right, but produces equally destructive, leveraged losses if you get it wrong. Leverage should be used in a carefully measured manner, and only if you can negotiate favourable, long-term terms. 

VII. Free Lunches (are very very  very rare)...

...If you think you've found one, think long and hard. Chances are you missed something. If it looks too good to be true, it probably is.

"A game in which you win without putting up any money and lose nothing when you lose is a no-loss illusion."

You are always being compensated for many risks (which may be obvious or obscure). The risk may seem improbable, but improbability and impossibility are worlds apart. 

A risk-free upside is rarely found! When you find one, though, you ought to pounce, and capitalise on it.

VIII. Quality over volume.

It is better to take a smaller profit if the additional profit comes with ridiculous exposure. Remember, investing and insurance are both, about risk adjusted returns.



IX. Serve the customer.

No one likes tax. If your business has no value for a consumer/ the consumer doesn't get anything (product, brand, information) from you, you are essentially levying a tax on your customers. This can never go on for ever. The best businesses create value for the shareholders, and provide something of use (as overpriced as it may be) to the customer. If you don't offer anything of use to your clients, they will just stop coming.



X. Irrational exuberance.

i. Anyone who says, "this time is different," is probably wrong.

ii. As Buffett says, "be fearful when others are greedy, And be greedy when others are fearful."

iii. The average person's investment cycle:

 (Of course, no model can predict the random walk down Wall St., but well, it is an interesting model showing how people are greedy/buy at the wrong time, and sell during an even worse time.)

Notes on Berkshire Hathaway Shareholder letter 1983

1. "Think of shareholders (investors) as owner-partners."

2.  "We eat our own cooking." All managers and directors should ideally have a stake in the business and benefit from the company's success.

3. The "goal  is to maximize the average annual rate of gain in intrinsic business value on a per-share basis." You want to invest "businesses that generate cash and consistently earn above-average returns on capital".

4. You should "rarely use much debt and, when you do,  attempt to structure it on a long-term fixed rate basis. One should reject interesting opportunities rather than over-leverage our balance sheet." (Leverage magnifies BOTH, gains and losses. That is not to say, by any means, that small amounts of debt on GOOD TERMS are to be entirely shunned.)

5. "We react with great caution to suggestions that our poor businesses can be restored to satisfactory profitability by major capital expenditures. (The projections will be dazzling - the advocates will be sincere - but, in the end, major additional investment in a terrible industry usually is about as rewarding as struggling in quicksand.)"

Recall that "Turnarounds seldom turn (W. E. Buffett)," and there is usually a tendency to compare incorrectly (M. Mauboussin). If the industry is struggling, it is unlikely managerial magic will ever be able to turn a business with poor underlying economics into a successful company.

6. "We also believe candor benefits us as managers: the CEO who misleads others in public may eventually mislead himself in private."

7. "One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it." This gives you a measure of the company's market share, moat, and the nature of competition in this industry.

8. The "ideal business" is one that is "built upon exceptional value to the customer that in turn translates into exceptional economics for  its owners." Consumer trends matter, and at the end of the day, businesses are designed to serve customers. Amazon, for example, owes some of its success to its goal of being the "most customer-centric company" in the world.

9. "We never take the one-year figure very seriously. After all, why should the time required for a planet to circle the sun synchronize precisely with the time required for business actions to pay off? Instead, we recommend not less than a five-year test as a rough yardstick of economic performance." 

Long-term views are best - it is nearly impossible to predict what will happen in the next year (indeed, any forecasts will say more about the forecaster than the future). By contrast, it is easier to see what the situation may be like in 5 to 10 years. This requires imagination, and the acceptance that there is no surety. You can only speculate - But you must speculate with an edge.

10. "So, also, do businesses having equal financial input end up with wide variations in value." What (money) you put in (Book Value) doesn't necessarily have a specific output (Intrinsic Value).

11. "The difficulty lies not in the new ideas but in escaping from the old ones." "Be actively open-minded," and change your opinions when the facts change. This is difficult- that is what makes it essential.

12. "Some (investments) will disappoint us, others will deliver pleasant surprises." Remember this is an uncertain business, and that you can only attempt to find good quality companies which have a share price below your estimation of intrinsic value. After that, its (largely) out of your control. You must be prepared to lose money to make money.

13. "In candy, as in stocks, price and value can differ; price is what you give, value is what you get." As Vinod Nair and Arun Agarwal at Altavista Capital say, you are looking for simple, "good quality businesses with a margin of safety." (Think about expectations versus fundamentals, or second level thinking.)

14. Market Activity:

"Brokers, using terms such as 'marketability' and 
'liquidity', sing the praises of companies with high share 
turnover (those who cannot fill your pocket will confidently fill 
your ear).  But investors should understand that what is good for 
the croupier is not good for the customer. A hyperactive stock 
market is the pickpocket of enterprise."

"By market activity, investors can 
impose upon themselves the equivalent of such a tax."

Essentially, you don't want to trade. Would you rather buy a company's shares and hold them as they rise from 10 to 40, pay 2 for your transactions, and make 28, or buy at 10, sell at 20, then buy at 30, and sell at 40, and then pay 4 for the trades, making only 16? Indeed, if you are just to buy and sell, you are being taxed-by the brokers instead of the government.

You want to buy good companies' shares cheap, and hold on to them for as long as possible. 

My Reflections on the "Ten Attributes of Great Investors by Michael Mauboussin "

1. "The single greatest error in the investment business is a failure to distinguish between the knowledge of a company's fundamentals and the expectations implied by market price."
Essentially, even if a company seems to be great, and is primed for growth, it won't perform well as an investment, if people are expecting it to do better than it does. Always ask, "Is it baked into the price?" (I find points 1, 16, 27, and 28 to be most interesting. This is because acquiring second-level thinking is extremely challenging. It is also more important than everything else. You must always consider WHY the stock is priced the way it is, and WHY the crowd has got it wrong.)

2. An important thing to learn is "what you are bad at."

3. "Constant learning and teaching, and diverse input combined with rigour can lead to insight."

THE TEN ATTRIBUTES

I. BE NUMERATE (and understand accounting):

4. You must assign a "present value to the future free cash flow."

5. "Growth in earnings and growth in value are distinct." Growing earnings is great, but only if it can be achieved with a superior return on capital expenditure, to the investor investing earnings themselves. Companies are obliged to ensure that they only reinvest earnings, if the ROCE will be relatively high.


II. UNDERSTAND VALUE (the present value of free cash flow):

6. "The present value of the future free cash flow determines the value of an asset."

7. "The average half-life of a company is about a decade."

8. Brilliant questions to ask are:
"Where is the industry in its life cycle?"  (Industry)
How is the "company's competitive position" ?  (Competition)
What are the "barriers to entry"?  (A MOAT that protects the business from competition.)
How are "the economics of the business"?  (Profit margins, Scalability)
How skilled is "management at allocating capital"?  (ROCE, Trustworthy Management)

9. Never forget the "blind spots".  Risk comes from not knowing what it is you don't know.


III. PROPERLY ASSESS STRATEGY (or how a business makes money):

10. Understand the business, "Gain a grasp of its sustainable competitive advantage", Consider "threats from disruptive innovation", and Analyse the Returns On Capital Expenditure.

11. "Strategy is about being deliberately different", whereas "operational effectiveness relates to what all businesses need to do." You must have good OE, and a good Strategy, in order to create a thriving business. OE is the way the business is streamlined, whilst strategy is about making trade-offs with regards to location, differentiated merchandise, differentiated pricing, etc.

12. You must have an "economic moat".


IV. COMPARE EFFECTIVELY (expectations versus fundamentals):

13. To make money, you must "have a point of view that is different than what the current price suggests." (Contrarianism and Second-Level Thinking)

14. "Fundamentals is what captures a sense of the company's future performance." Essentially, you give a present value to the future free cash-flow, while ensuring that there is a margin of safety. (Valuation = present Value of future free cash flow)

15. The stock price is a brilliant indicator of the expected financial performance.
 (Valuation = Expectation)

16. When you bet in horse racing, "the goal is not to figure out which horse will win, but rather which horse has odds that misplaced relative to how it will likely race." This is Second Level Thinking: Everyone thinks that the company is going to have a brilliant future, but the future is less bright and more unlikely than people think - Short. Or, everyone thinks that company is doomed, but it is just experiencing temporary issues - Long.

17. Comparing incorrectly can be disastrous. An example from Mauboussin is, "Rather than asking whether this turnaround is similar to a prior turnaround, it is useful to ask the base rate of success for all turnarounds." (N.B.: 'Turnarounds seldom turn!')

18. "What you are looking for dictates what you see." This is the Confirmation Bias. "We see similarities when we focus on similarities and see differences when we focus on differences." I have noticed, that the opportunist in me always find a way of thinking that a company could be a great investment.

19. "To learn from History you need to understand Causality." The issue is correlations (in timing) are easily mistaken as being causal.


V. Think probabilistically (there are few sure things):

20. "Seek an edge"

21. "Focus on the process of making decisions", and tweak this as you go along. In the investing world, "good decisions sometimes lead to bad outcomes, and bad decisions sometimes lead to good outcomes" Over a very long time-period though, good decisions will result in good outcomes.


VI. Update your views effectively (beliefs are hypotheses to be tested, not treasures to be protected):

22. "Beliefs are hypotheses to be tested, not treasures to be protected"

23. "You must avoid confirmation bias, by being 'actively open-minded', because good thinking requires maintaining as accurate a view of the world as possible."

24. "Seek information or views that are different than your own and update your beliefs when the evidence suggests you should." It is very important to be humble - particularly when you are betting against the crowd. If you are unwilling to change when the facts change, you are doomed.


VII. Beware of behavioural biases (minimizing constraints to good thinking):

25. Rationality and Intelligence Quotients: "A lot of people start out with 400-horsepower motors but only get a hundred horsepower of output. Its way better to have a 200-horsepower motor and get it all into output." In essence, you don't need to be the smartest person in the room- you just need to be efficient and dedicated.

26. Loss Aversion: You have to be willing to lose money to be willing to make money. Mauboussin says, "Loss aversion, which says that individuals tend to suffer more from losses than comparable gains, is not good for money management". I would like to make a slight alteration to this statement. Gains and Losses should be measured relative to expectations, because people should be disappointed when something does differently than they had expected. Let's say you expected to make a 10% return, but instead, you made a 30% return. The extra 10% should make you as happy, as you would be disappointed if you had made a 10% loss. This is usually not the case, because a positive outcome tastes sweeter than it really is, and loss is often the bitterest of all medicines.


VIII. Know the difference between information and influence:

27. "Stock prices provide an indication about the expectations for future financial performance."

28. "Great investors are adapting at translating between expectations and fundamentals, and keep them separate in decision making." (What does the market think, VS. Reality!)

29. A very valuable skill is a blatant disregard for the views of others. The crowd is often right nut when it is wrong you need the psychological fortitude to go against the grain. A great example is Bill Ackman's short position on bond insurer, MBIA, which he held against a "vortex of influence," before the 2008/9 Wall Street Crash.


IX. Position sizing (maximising the payoff from edge):

30. Position sizing is very complicated.

31. You want to consider the potential for upside, the probability of losing capital, the extent to which the company's shares may be mispriced, and a way in which you have an information advantage.


X. Read (and keep an open mind):

31. "Success comes from curiosity, concentration, perseverance, and self-criticism. And by self-criticism, he meant the ability to change one's mind so that one is able to destroy one's own best-loved ideas." Be your greatest critic, and relish mistakes.

32. "Being actively open-minded involves reading material you do not necessarily agree with."




What next?

33. "In the long run, investing is a game of skill. However, as more people have skill, luck is beginning to become more important in determining outcomes." There is a degree to which this is true. But, everything is cyclical - When people think it is hard to make money on the market, fewer try to, and so more mispricings can be found. By contrast, when everyone is getting into the field, it becomes more competitive. I believe (and HOPE) that if you really love investing, and keep doing a good job, you will probably fare well.

34. "Before figuring out how you will win the game figure out which game to play." Howard Marks did this in his distressed debt investing strategy; since institutional investors do not invest in below investment grade bonds, Oaktree is able to find and monetise a larger number of mispricings.




A concluding thought:

"If you compete against a computer, you are highly likely to lose. If you compete with a computer to augment your performance, you are more likely to win." (I recommend looking at the blogpost about Investing, "A learning business".)

Market timing

Making macroeconomic forecasts for the near future is a task which is easily done - easily done wrong.

-Adit Agarwal

This is an amazing video by Ray Dalio, one of the most Principled and succesful investors, and someone I admire!

I have now watched this video multiple times, and can't help but wonder where the world is today, with regards to the economic cycle. This stems from a desire to 'time the market'. Indeed, during the February correction earlier this year, I wanted the stock market to 'crash', so that I could make some investments. However, that entire episode, led me to realise that timing the market is impossible. Indeed, any predictions will tell you more about the forecaster than they do about the future.  A great example which depicts the difficulty of making macroeconomic forecasts, is Ray Dalio's statement (at Davos in 2018), just a few weeks before the February correction, that anyone sitting on cash was going to feel very stupid - After the correction, Mr. Dalio said that the economy was in fact further on in the cycle than he had initially imagined. It cannot be denied that the stock market is not a metric to be entirely ignored; it is a fantastic indicator of people's expectations, and when valuations become high, it is important to exercise caution. Similarly, when fear-driven crashes occur, we must be greedy, to paraphrase Warren Buffet.

The more important things to consider are: 1. Intrinsic Value, 2. Market Value, 3. Growth Opportunities, 4. Risk, 5. Management, and 6. Business model, before making an investment. This is because you want to invest in good quality companies that are trading cheap.