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.)