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."
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".)
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".)
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