Principle 3

The Importance of Comparing Effectively With The - Often Rose-tinted - Past

I am using this opportunity to consider the use of comparisons with historical performance in relation with investing. Following that, I will consider the implications of Hans Rosling's view that we look upon history through a 'rose-tinted' lens.

In investing, an effective comparison with the long term historical track record, serves as a reference point. Similarly, when we think about the world today, we are – often subconsciously – comparing it with the past. For example, when we say that the word is really well connected, we are subconsciously comparing the level of connectivity today, with the level of connectivity in the past. There is one significant difference, however, which is that in investing, a relative comparison with the past -- although it is used as a reference -- is somewhat meaningless; history never exactly repeats itself, and the markets ‘move’ randomly. We are forced to use historical data - cautiously - as they are the only reference points we have. 

Before I proceed to consider how we rose-tint the past, and how we distort it, I must stress that in investing, any attempt to time the market based on historical highs or lows does not work. For example, someone may say, that Company X is a great investment, because of a solid long-term track record, and because the shares are trading at a 52-week low. This would be foolish. Just because a company is trading cheaper than it has for the last year, doesn’t mean it is trading cheap. 

This is because of two reasons. Firstly, changes in price are theoretically supposed to be - although they aren’t necessarily in reality - a result of changes in the economics of a business. So, when you see a company trading at a 52-week low, you should first wonder if there has been any substantial change in the business’ economic position. If the company is now worth less due to the changes in its profitability, then the reduced share price may be correct. In fact, when this happens, the company could even remain slightly overvalued, as people may get anchored to the original price and value of the company. 

Now, to understand the second reason the above thesis for investing in X is incorrect, let us assume there has been no change in the business’ economics. Then you must consider whether it was previously over-valued; just because the price is lower than it used to be, it doesn’t mean it is low enough. Indeed, the business may now – finally – be valued fairly, or might still be overvalued, depending on the previous price and the percentage change. To exemplify this, let us say Company X’s shares – which we believe are worth $9.40 each - were trading in a range between $9.90 and $9.70 per share for a period of 364 days. Now, on the 365^th, they are trading at $9.60 per share. That is a 52-week ‘low’, but is not really a low price. If you buy shares in company X, you will be overpaying, and as the price slowly converges with the value, you will make a loss. So, the best way of making a good investment is determining how much a company is worth, and buying a part of it for less than this value.

This is not to say that a 52-week low is not a useful way of looking for companies which may well be undervalued due to short-term ‘turbulence’. However, it is a useful - and simple (and arguably superficial) - way of finding out where to look for a bargain. Treating it as any more than one of many screening processes you could use to identify potentially undervalued companies would result in traumatic failure.


...and finally...the principle and one its implications

The above paragraphs about the misuse of a comparison with the past are very important. There is, however, another noteworthy instinct, which one must be aware of. This is what Hans Rosling refers to as the human tendency to reflect upon the past through a ‘rose-tinted’ lens. Essentially, this human instinct is the “good old days-attitude”. On the non-investing side of things, this instinct causes us to underestimate progress, and not recognize how the world is slowly improving. In investing, the “rose-tint” may lead people to forget how horrifying and frightening a stock market crash can be. This ability to forget the cyclical, boom-bust nature of the stock market leads to an irrational euphoric epidemic of exuberance, as the stock market booms. Remembering how bad things can be will probably encourage a more cautious investing approach during ‘bubbles’.

Principle 2

"Stories about gradual improvements rarely make the front page" 

This means that significant but slow changes in the world sometimes get missed - and are rarely acted upon.

As an investor, you need to identify these significant but slow shifts in the world, because they provide opportunities; noticing and acting upon fundamental changes in consumer behaviour or structural changes in the world, is difficult, but - if done correctly - will result in profits. For example, if someone had noticed the potential for e-retail as Amazon began delivering books, they may have invested early - long before Amazon became a FAANG and a household name. At the very least, someone who had noticed these changes could have avoided losses, by exiting positions in brick and mortar retailers. Similarly, if someone had noticed the trend of moving away from cotton to synthetics before others, they could have invested heavily in companies which were involved in the  manufacture of synthetic garments - or at the very least, avoided losses by exiting positions in textile manufacturers. Another example is the disruption of the TV industry, which has moved from cable to on-demand streaming; this change is discussed a lot nowadays. But, if someone had noticed the change early enough, they could have benefitted greatly from the shift - or at the very least avoided losses, by exiting positions in cable companies.

Recognising these structural shifts is even more important for companies than investors. Incumbents, which resist change and ignore slow changes are inevitably faced with problems. A large number of retailers, and several cable companies did not change their business models till it was too late. This was despite the fact that Netflix and Amazon have been spoken about on all media outlets. Today, they are undertaking radical re-structuring just to stay afloat.

Warren Buffett says, "chains of habit are too light to be felt until they are too heavy to be broken". Similarly, structural changes are too insignificant to be noticed until they have already taken place and hindsight enables us to realise that they have occurred.

Principle 1

The Bell Curve and the Gap Instinct - Beauty and the Beast.

The gap instinct is our tendency to - often incorrectly- separate everything into two groups. Groups such as rich & poor, developing & developed, left wing & right wing, good & bad, and "short" & "long", or "sell" & "buy". This stems from a human need to differentiate between things. In investing, such categories can be dangerous, and will result in traumatic failure. This is because such categories encourage you to act. If a company can only be a "buy" or "sell", then you will inevitably hold a strong opinion, and concurrently a position; being either a buyer, or a seller - or even a short seller. This will lead you to put companies in one group or the other, when in reality, there are both, factors which make each company a "buy", and factors which make it a "sell". Hence, if for example you are clubbing a company as a "buy", you will likely be ignoring the reasons it is a "sell", and focusing on the reasons it is a "buy", or vice versa. Of course, any action taken without facts, is unlikely to be successful. 

This is where the bell-curve comes to the rescue. If we consider that everything lies on a range, and identify where the majority lie, we can be better judges of everything. We would find, that most people are on middling incomes, that most countries are quite developed but still developing in tandem, that most people lie about the centre of the political spectrum, that mot things are  simply, "okay", that most companies are neither "longs" nor "shorts", and that most companies are neither "buys", nor "sells"! In investing, such a thought process would lead you to act less frequently. Indeed,  it encourages you to be more cautious, and will probably result in you having a much more concentrated portfolio. 

Indeed, the caution and selectivity induced by the bell curve into portfolio management is crucial. Howard Marks says, "If we avoid the losers, the winners will take care of themselves". Similarly, Warren Buffett recommends a 20-slot rule, where you make only 20 investments in your entire lifetime, and punch a hole in a card each time. Both of there principles recommend a more selective, cautious approach to investing. In brief, the bell curve is great, because it - like the 20 slot rule - encourages us to be more selective - and cautious - and recognise that very, very few companies are actually "good" companies to invest in - most are just "okay"!!

Applying the Principles of "Factfulness" to Investing.

Factfulness: Ten Reasons We're Wrong About the World - and Why Things Are Better Than You Think

The book is an eye-opening, marvellous work of art. The book symbolises the late Hans Rosling's final attempt to change the way we view the world. The book is a guide to existence in a busy world, where we have an unprecedented level of access to information. 

In the next few posts, I will attempt - sometimes at a stretch - to apply some of the principles recommended by Hans Rosling to investing. In my view, this is important, because investing requires you to use information, and decide whether or not you want to act based upon the aforementioned information. 

If you do not have the curiosity and energy to read Factfulness, I recommend that you should - at the very least - watch one of the talks given by Hans (below), and visit Gapminder.

Bill Ackman on Investing

'Everything' You Need To Know About Finance And Investing In Under An Hour

Key Learnings:

1. Start investing early, in order to benefit fully from the power of compounding.

2. Higher returns are usually compensating you for higher risk. You should be able to find bargains where people are overestimating the likelihood, and potency of risk, as this usually results in undervaluation. Conversely, if you are planning to short a company (this is arguably much harder to do in a successful manner over a very long period of time), you must believe the opposite. i.e You must believe the people have underestimated risks.

3. William Ackman's "Keys to Successful Investing":

• Understand how the company makes money.
• Is it a reasonable-or bargain-price?
• Invest in a company that could last forever.
• Find a company with limited debt.
• Look for high Barriers to entry, and consider how these barriers are changing.
• Invest in a company immune to extrinsic factors.
• Invest in a company with low reinvestment costs.
• Avoid Businesses with controlling Shareholders