A Short History of Financial Euphoria, by John Kenneth Galbraith

I first read this book, a perfectly-worded reflection on the most iconic (if I may use such a word!) speculative episodes in human history, after studying the Great Depression and the New Deal at school. I am fascinated by the mass insanity and “the associated financial deprivation and larger devastation” of every speculative episode; the infectious boom, is always accompanied by “desperate and largely unsuccessful efforts to get out”. There is almost no doubt in my mind that “speculative episodes end not with a whimper but with a bang”. In this post I will try to highlight a few insights I picked up from this brief and impactful must-read.

• There is no such thing as financial innovation - only credit. “The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves in one form or another, the creation of debt secured in greater or lesser adequacy by real assets.” This is why Galbraith advises, “when there is a claim of unique opportunity based on special foresight, all sensible people should circle the wagons; it is the time for caution.” 

• Any association of money with intelligence is nothing short of “specious”. People are entranced “by the great financial mind” because there is a “feeling that with so much money involved, the mental resources behind them cannot be less.” This belief leads to the bidding up of asset “values [and] confirms the commitment to personal and group wisdom. And so on to the moment of mass disillusion and the crash”.

• Crowd behaviour and FOMO spread the infection. “Anyone taken as an individual is tolerably sensible and reasonable - as a member of a crowd, he at once becomes a blockhead. - Friedrich Von Schiller, as quoted by Bernard Baruch.” When irrational herd behaviour sets in and a mood of excitement (or god forbid, euphoria!) ripples through the market, speculation (quite literally!) “buys up...the intelligence of those involved.”

• The financial memory is extremely brief. “Dementia comes forward to capture the financial mind” every ten years (rule of thumb?). This “is also the time generally required for a new generation to enter the scene, impressed, as had been its predecessors, with its own innovative genius”.

• As Buffett says, “What the wise do in the beginning, the fool does in the end.” Booms often begin because there is a kernel of truth in the so-called innovation, but they quickly escalate into episodes of mass insanity.

• I am fascinated by the way in which we seek to apportion blame after the inevitable bang that marks the end of a speculative episode. Instead of looking at the way in which market participants were foolish, we instead seek to fault governments, banks, and institutions (to blame the public's mass insanity would be cruel, cold-hearted, and politically incorrect).

The Pretence of Knowledge

This post is based on Friedrich August von Hayek's lecture titled 'The Pretence of Knowledge' to the memory of Alfred Nobel, on December 11, 1974. Adapted quotations may be used without quotation marks.

Key Learnings

Investing, like economics, is essentially complex. This is because outcomes do not depend only on the relative frequency of individual actions or occurrences, but also on the manner in which the individual actions are connected with each other. For this reason we cannot replace information about every individual actor (human being) with statistical information, and require full information about each actor if we wish to derive specific predictions about individual events. 

All of the particular information possessed by every one of the participants in the market drives the value of assets (or goods). This means the price is determined by a sum of facts which in their totality cannot be known to the scientific observer, or to any other single brain. This is the source of the superiority of the market order, and the reason why free markets are the most efficient allocators of resources using information which only exists in dispersed form. 

Our inability to assimilate all of this data means that investing and economics must not be treated as Physical Sciences. In fact, Hayek says that a scientistic attitude is decidedly unscientific in the true sense of the word, since it involves a mechanical and uncritical application of habits of thought to fields different from those in which they have been formed. As mentioned above, we do not have the ability to access (or even measure) all of the necessary data. This is why economists and investors with scientistic attitudes frequently treat the data which happens to be accessible to measurement as important that – not necessarily the best data. We know, for example, that good quality management is essential for a good business to grow sustainably. However, there are shades of grey in measuring the quality of management. This is why a purely numbers-based/scientific approach to investing would only take measurable quantities into account, proceeding on the fiction that the factors which can be measured are the only ones that are relevant.

Without access to all the necessary information, we are confined to making directional predictions – predictions of general attributes, but not containing specific statements. It is possible to say, for example, that a company will be worth substantially more over a long time horizon; however, we must not – or more precisely, cannot – predict the exact value and the time at which this value will be attained.

Implications for Investing

Hayek's paper does not criticise the use of numerical evidence to help put the magnitude and implications of forecasts into a context. However, he cautions against the dangers posed by the false sense of comfort that numbers can give us, and critically aware of the arrogance that (successful) precise predictions can engender. This is why he refers to the "danger [posed] by the exuberant feeling of ever growing power which the advance of the physical sciences has engendered and which tempts man to try, 'dizzy with success', to use a characteristic phrase of early communism, to subject not only our natural but also our human environment to the control of a human will." His speech culminates with a reflection on the importance of humility when dealing with essentially complex phenomena: "The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men’s fatal striving to control society – a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilisation which no brain has designed but which has grown from the free efforts of millions of individuals." All of this means there are a few key things we must remember as investors.

• The market is typically efficient because it is the sum of all of our viewpoints. This is why it is important for investors to ask themselves: Who doesn't know that?
• Trying to be overly scientific, particularly with insufficient data and knowledge, is dangerous.
• Rely on first principles thinking as opposed to blindly using correlations. These correlations are directional – not deterministic – and only work when the ceteris paribus condition holds, till an unexpected event leads people to stop believing in their determinism. In the real world, there are many variables at play, and simple relationships are only useful oversimplifications.
• A great many (important) facts cannot be measured and so, are disregarded. The idea that only facts which can be measured are relevant, is fantastical.
• You must have an understanding of the Narrative and Numbers of the business.
• We must use numbers directionally (as a reality check), and try to avoid being seduced by the false sense of comfort that numbers may offer. 

Is this changing?

To an extent. We are becoming more able to collect data. Not only do firms such as Facebook and Google target advertisements based on our online interactions and search history, but Amazon has a record of our purchases, Netflix a record of what we watch, and Spotify a record of what we listen to. Investors can (or might eventually be able to) analyse traffic in parking lots outside malls, the weight of bags being carried by consumers, lexical choices in transcript, and even the expressions and tones of voice of CEOs to determine their confidence and honesty levels. This is both, good and bad; we will have more data to test hypotheses, but we will also risk becoming more comfortable and more arrogant as we make misleadingly precise predictions.

Whistle while you work (The Economist)

Great article from The Economist about the importance of having happy employees for business performance. Go read my post on Good Corporations Benefit ALL Stakeholders!!!

__________________________________

Article:

Research suggests that happy employees are good for firms and investors. 

THERE IS an old joke about a new arrival in Hell, who is given the choice by Satan of two different working environments. In the first, frazzled workers shovel huge piles of coal into a fiery furnace. In the second, a group of workers stand, waist-deep in sewage, sipping cups of tea. The condemned man opts, on balance, for the second room. As soon as the door closes, the foreman shouts “Right lads, tea break over. Time to stand on your heads again.” 

Terrible working conditions have a long tradition. Early industry was marked by its dirty, dangerous factories (dark, satanic mills) and in the early 20th century, workers were forced into dull, repetitive tasks by the needs of the production line. However, in a service-based economy, it makes sense that focusing on worker morale might be a much more fruitful approach. 

Proving the thesis is more difficult. But that is the aim of a new study which examines the relationship between happiness and productivity for workers at British Telecom. Three academics—Clement Bellet of Erasmus University, Rotterdam, Jan-Emmanuel de Neve of the Saïd Business School, Oxford, and George Ward of MIT—surveyed 1,800 sales workers at 11 British call centres. All each employee had to do was to click on a simple emoji each week to indicate their state of happiness. Those workers were charged with selling customers broadband, telephone and television deals. In total, the authors had adequate responses from 1,161 people over a six-month period. 

The results were striking. Workers made 13% more sales in weeks when they were happy than when they were unhappy. This was not because they were working longer hours; in happy weeks, they made more calls per hour and were more efficient at converting those calls into sales. The tricky part, however, is determining the direction of causation. Workers may be happier when they are selling more because they anticipate a bigger bonus, or because successful sales pitches are less stressful to make than unsuccessful ones. 

The academics tried an ingenious way to get round this causation problem by examining a very British issue—the weather. Workers turned out to be less happy on days when the weather in their local area was bad and this unhappiness converted into lower sales. Since they were making national calls, not local ones, it is unlikely that customer unhappiness with the weather was driving the sales numbers. So it was worker mood driving sales, not the other way round. 

Even if this reasoning proves to be correct, businesses may struggle to find it of comfort. Short of locating all their call centres in California or Hawaii, companies cannot control the weather conditions their workers face. The academics point out that “what we are not able to do, given our data and setting, is adjudicate as to whether investing in schemes to enhance employee happiness makes good business sense”. It is possible that the costs of such schemes might outweigh any gains in productivity. 

More research is clearly needed. But there is evidence that happier workers are good news for shareholders, as well as productivity. Analysts at BofA Merrill Lynch Global Research studied the stocks of firms rated on Glassdoor, a website which allows employees to rate the companies they work for. Those with the highest ratings outperformed those with the lowest by nearly five percentage points a year between 2013 and 2019. The analysts also used software that picked over the text of employee reviews and found that incorporating this approach improved the risk-reward trade-off (as measured by the Sharpe ratio) of the strategy. 

The analysts have now applied the same approach to picking stocks based on particular sectors. Again, the sectors where workers gave the best reviews on Glassdoor over the 2013-2019 period easily outperformed those where employees gave a thumbs down. None of this is unequivocal proof. The history of equity investing is littered with strategies that worked well when back-tested but then disintegrated when applied in the real world. But at the very least, it suggests that companies should consider the merits of a contented workforce. And that might mean giving them harps and ambrosia, rather than devilish treatment.

Superforecasting in Investment Decisions

This post is the second of two based on Shane Parrish's Knowledge Project interview with Philip Tetlock, co-principal investigator of The Good Judgement Project, author of 'Superforecasting: The Art and Science of Prediction', and a professor at the Wharton School.

All investment decisions are based on present expectations of the weighted average of the various futures that could unfold with time. That's a mouthful, but the essence of the issue is that in order to arrive at a future value for a company, we must make assumptions about multiple factors, each of which can materially alter the 'intrinsic' (expected) value of a business. So, investors deal in forecasts. In this post I will discuss briefly three ways in which the quality of our forecasts can be improved, and suggest applications for investment committees. 

Guesstimating
A good place to begin forecasting is guesstimating. Making guesstimates allows us to identify gaps in our knowledge, clearing up the zone of ignorance. Making guesstimates also enables us to review our assumptions when evaluating the quality of a forecast.

Forecasting teams
Some investors swear by a committee-based approach to asset allocation. The idea is this will result in ideas being challenged and hypotheses being questioned, reducing the impact of biases and the potential for errors. There is some merit to this approach, but often organisational hierarchy and homogenous information limit its benefits. Forecasting teams can be made more effective if individuals' success rates are tracked, and a weighted average of forecasts, which gives more weight to individuals with stronger track records in the relevant industry, is used. Forecasting teams can be made even more effective if they have access to distinct pools of information because decisions made when different pools of data point in the same direction, are likely to be more accurate. In the investing world, this is very difficult to achieve, but could still be partially achieved by splitting sources (annual reports, sell-side reports, company management meetings, and data analytics) encouraging team members to research each company independently and arrive at a conclusion before a discussion.

History rarely repeats itself...
...but it does rhyme. Mark Twain's eloquent quotation is often used to emphasise the importance of using past data and patterns in investment decision making. Tetlock's work cautions against over-learning patterns in history. Perhaps we should pay equal attention to both parts of Twain's wise words, as we continue to rely on the only truly concrete information available to us.

Superforecasting

This post is based on Shane Parrish's Knowledge Project interview with Philip Tetlock, co-principal investigator of The Good Judgement Project, author of 'Superforecasting: The Art and Science of Prediction', and a professor at the Wharton School.

7 Billion Forecasters
We make implicit forecasts on a daily basis. Whenever we choose to cross the road, whenever we buy a good, whenever we say something, we make an implicit forecast; we forecast the likelihood of being hit by a vehicle as we cross the road, we forecast our future use of the good and ascribe a present value to it, and we forecast the response we expect to elicit.

Implicit forecasts are convenient and serve us well when we are crossing roads, buying certain goods, and talking to people. Of course, you wouldn't want to spend hours by the roadside calculating the probability of death should you choose to cross the road at a certain moment. However, implicit forecasts are less useful when we are dealing with complex, nuanced situations (or making important investment decisions). 

Explicit Forecasts
Implicit forecasts made with words are vague and can't be falsified. Explicit forecasts (with specific probabilities attached), by contrast, are easier to fault. This is why they enable us to hold ourselves accountable and evaluate past investment decisions. This evaluation is important because both luck and skill are involved in forecasting, and it is important to be able to consider alternative histories and attempt to distinguish lucky winners from good decisions, and unlucky losses from mistakes.

Good Forecasting
Forecasting is roughly 70% skill and 30% luck according to Tetlock's research. And, good forecasters are made not born. Good forecasters have specific knowledge in their field, are open-minded, and believe that it is worth estimating probabilities of real world events. We can make good forecasts by reading about our subject (in the case of investing, this may be the relevant company), and cultivate the necessary qualities for consistent outperformance by encouraging debate in our organisations and adding probabilistic thinking to our decision-making process. Most importantly, by second-guessing successes and evaluating failures, we can become better forecasters.

Leave it to the Experts (Don't)

Experts are experienced individuals with a good track record (have a good reputation and are widely trusted) and reliable authority of knowledge relative to the audience. They usually have formal training (are generally highly educated from accredited institutions), regularly share their opinions, and are valued by society (generally earn a high income and have developed a cult following).

As an investor, one must use expert's opinions. This is because talking to an industry expert or ex-CEO of a company, for example, allows you to gain access to specific knowledge and develop specific insight about the industry and the specific company.

However, expert-opinion must be treated with a healthy dose of skepticism. Firstly, one must acknowledge that experts are often overconfident. Furthermore, they are often in an ivory tower (this is particularly true for academic experts), and out of touch with reality. Moreover, one must remember that expertise is perceived to exist. This is the most important point, because charismatic pseudo experts can lead one to make ill-informed decisions.

So, we must use expert opinion - with a grain of salt.

Change is not always for the best

I am creature of change and variety. A change of furniture, a change in layout, a change in almost anything is exciting. I even get uncomfortable with the status quo. Being excited is great. Needing change is less so; often times, the status quo works best! This need for change is an important world issue which receives insufficient attention. 

In the political sphere more than any other, people are always looking for change. A large part of this is driven by media which makes the current system look broken. I am not saying that the existing systems are flawless (because nothing ever is). I am simply saying that a lot of the systems are in employment because they work.

In the corporate sphere, management change is often followed by grand strategy overhauls. It is true that management changes are often the result of extended periods of sagging performance, but continuously taking two steps forward and three steps back does not lead to progress. Instead of an overhaul, a better strategy is often to fine tune existing processes, and selectively plant a few seeds that can grow into trees.

I understand that we must focus on issues and solutions if things are to improve. But before we seek to improve everything, we must improve our “factfulness”, for things often work better than we think. So, I would be weary of grand presentations in which management proposes strategy overhauls: running an existing company is (almost always) about understanding the mechanics of the vessel, and precision-setting the course of a ship; it is rarely about turning the ship in an entirely different direction, and (almost) never about rebuilding the entire vessel. 
___________________
N.B: If an executive finds themselves trying to rebuild the vessel, they probably failed to see potential sources of disruption, and didn't set the course carefully enough. And, the chances are they will fail to rebuild the vessel in time (before it fills with water and sinks!!).

Go with the flow

Twenty-four people, six families of four arrive at a hotel over a two hour period; before the arrival of the next group, the party that has already arrived congregates in the foyer. You might think this is a tour group, but it is not. You might think they are travelling separately, but they are not. They are not even the same family, yet they are closer than most families truly are. 

This is the my family’s “gang” of friends — it has been the same since I can remember. My parents have an unusually special group of friends; the “gang” spends time together every year, regardless of geographic boundaries, logistical complexities, or a paucity of time. Moving to the UK allowed me to realise the unique, precious dynamic of this group, which had been - and always will be - a large part of my life. 

I was curious. If this group had so much fun together that we couldn’t imagine going on a holiday without each other, why didn’t more people have friend groups like this? What was stopping them? On a recent trip, I posed the question to some of my parents’ friends: “Why do you think groups like this are so rare?”

They responded in similar fashion — there may well be some truth in that age old adage “birds of the same feather flock together”. They each felt that the group was willing to “go with the flow”, and nobody attempted to unilaterally drive the agenda; simply put, people were flexible.

This is rare, because people (me included) love doing exactly what they want to do: siblings bicker over which show to play on Netflix, and friends debate which restaurant they should go to. In the process, people miss out on what they actually wanted. The goal was to spend quality time with one another, whilst engaging in a fun, entertaining activity.

I first tried going with the flow in Summer 2018. I spent three weeks at Columbia University, and in my free time, I tagged along with my roommate and a friend of his. I was walking blind, following and not leading, and I had some of the most fun I have ever had in my life!

That is not to say you should never drive the agenda. I believe it is important to stand up where it counts. Stand up for ideas, values, beliefs, colleagues, friends, family, and yourself. It is also important to lead and to carry your share (if not more). But, when someone else is taking charge, and one doesn’t really have a problem with the direction they are heading in, one must learn to go with the flow and be a passenger.

I think the same principles apply when investing in companies; although it may be tempting to get management to do what you want, it is far better to identify managements with expertise in the relevant field who have a value system you can back, and let them execute their strategy. Don't try to influence every management decision. Don't react to every management decision. Asses the big picture and if you like the overall direction they are heading in, "go with the flow".

Key Things I Learned at First State (FSSA)

This summer, I spent more time with First State Investments: one week at FSSA's Singapore office, and two weeks at their Hong Kong office. Attending internal meetings and company meetings during these three weeks allowed me to gain exposure to several sectors and markets, including Chinese FMCG and manufacturing, Japanese IT services, and Sri Lankan telecommunications. 

In addition to attending meetings, I conducted research and wrote a company report on Nissin Foods, the HK listed subsidiary of Nissan Japan (a instant noodle company). My report was then discussed by the entire FSSA team. This experience has allowed me to learn a great deal about the investment research process.


I am very grateful to the entire FSSA team, and look forward to more experiences like this in the future. Here are a few Key Things I Learned at FSSA:

• It is important to look for good quality, risk aware management who are frank about mistakes and determined to improve and grow the business strategically in the long term. Their interests must be aligned with minority shareholders’ and you have to be able to trust them.

• There is a big opportunity with formalization and premiumisation of consumer goods in developing countries.

• If the overall industry is not a good industry, even the best operators will struggle to be successful.

• You have to put down your thoughts and look back over what you were thinking. Otherwise, it is very easy to fool yourself and think you “knew it all along”. 

• It is a mistake to buy optically cheap businesses. Businesses that look cheap often deserve to be cheap because they are bad businesses, and good businesses are often expensive because they deserve to be. If you want to invest in good businesses either find those that are fundamentally undervalued due to short term challenges, or be willing to pay up for good businesses.

• You have to be somewhat contrarian to make high returns. i.e, it is important to have a view that is different to the consensus. However, you should not be contrarian for the sake of being different.

• It is very important to have a good investment process. A focus on process will drive returns over the longer term.

• Try to invest in companies that don’t need your money, and have the ability to grow organically.

Write a note

Whilst we can debate whether thought precedes language or language precedes thought, we cannot deny that language and thought are intertwined; the way you think influences what you say and how you say it, which again influences the way you think. Clearly, language is powerful, and we must be mindful of the way we use it.

Often, we unknowingly misuse language. We use words such as "like", "problematic", and "good", which add ambiguity to our statements. We also establish non-links between sentences to make arguments seem more bullet-proof. I have unconsciously included an example of the latter in the first paragraph, when I suggest that my preceding statements make it "clear" that language is powerful. This is unclear communication. This unclarity in language may lead to unclarity of thought. This could in turn be a self-reinforcing loop. This is dangerous.

For an investor, clarity of thought is of utmost importance: it is necessary to have a specific thesis, which you can constantly test and evaluate. This is because if one is unclear about the investment case, one is more likely to make decisions influenced by emotion. For example, one might hold on to an investment even as the company's thesis story fails to play out. Alternatively, one might sell when a risk we were previously aware of - and comfortable with - actually materialises. In both scenarios, the action may actually be right; the long term story may be intact in the former case, or the risk may be bigger than one perceived it to be in the latter. However, if an investor's decision is driven by emotion, it is a bad decision - regardless of the outcome.

In order to have clarity in thought, an investor must have clarity of language. This clarity of language can be achieved by writing. When we are forced to put concrete thoughts down on paper, we are forced to clarify what it is we mean, and be more precise in our thesis. This results in greater clarity of thought.

So, I urge you to "write a note".

______________________________________


This post was inspired by my attendance of a seminar titled "Am I Helping Tyrants When I Say 'Like'? George Orwell and Alexis de Tocqueville on How Political Language Manipulates and Liberates" at Yale Young Global Scholars, PLE II, 2019. The following was the provided description of the Seminar:

Terry Smith's Investment Philosophy

Terry Smith is the founder and chief executive Fundsmith. This post will summarise his investment philosophy as presented in the above video.

Invest in good quality businesses

1. High Return on Capital Employed: Charlie Munger says that "Over the long term, its hard for a stock to earn a higher return than the business which underlies it earns."  This is because companies with a high ROCE (above their cost of capital) are increasing in value over time; meanwhile, businesses with a low ROCE are like melting ice cubes, whose value is being eroded. Thus, instead of investing in companies which seek EPS growth at the expense of ROCE, it is far better to invest in businesses that target high ROCE. The idea is that in the long-term, the company's capital allocation decisions are the only thing that will really matter. Franchisee businesses are great in this respect, as they rely on someone else's capital.

2. Sustainable Growth Resulting from Secular Trends: Companies which are growing can retain earnings and reinvest them at high ROIC. This allows investments to compound in value over time. Smith says that one must invest in businesses with compounding value instead of investing for dividend income. This is why he seeks to invest in businesses which are in sectors experiencing secular growth that results from consumerisation of people in the developing world, or premiumisation of consumers in developed markets. Alternatively, seeking to invest in businesses which can expand into white space, or which will benefit from demographic shifts is also likely to result in compounding value creation.

3. Moat: The high ROCE of a business should revert - eventually - to the mean. A moat (entry barriers), in the form of brand loyalty/trust, distribution and supply chains, and software helps protect the high ROCE of a good quality business. Businesses that make differentiated goods, whose consumption is a legal requirement, are also likely to survive. That being said, some moats are more easily crossed than others: patents expire, tangible moats comprising land or factories, for example, can be overcome easily with debt or cash, and businesses in rapidly changing sectors, are unlikely to have any moat at all. Companies that have operated in a sector for very long periods of time, and have never had to raise money often have sizeable moats.

4. Mr. Smith never invests in a company that needs his money. He looks for big private companies operating in the sector, which have never had to list; this gives him comfort about the profitability of the business.

Try not to overpay.

For Mr. Smith, this is a secondary consideration. He subscribes to the belief that “If a business earns a very high ROCE, even if you pay an expensive looking price, you'll end up with one hell of a result.” This is because a good company, which is growing in value will dig you out with time; meanwhile, a bad company with low ROCE, and negative growth will shrinks in value, burying you over time, even if you pay a seemingly low price. That being said, you still don't want to pay too much as you want a high rate of return. In addition, it is worth remembering that if you overpay for a great business you could lose money, and if you buy a declining business very cheap, you could make a lot of money.

Do Nothing.

It is important for investors to remember that you don’t need activity, you need results. This is because, inactivity often gets the best results, and “it’s awfully hard work doing nothing”.

Don’t try to time the market.

Mr. Smith says that there are two types of people: those who can’t time the market, and those who don’t know they can’t time it. Market timing is a futile exercise. It is better to identify good companies and then make long-term investments at attractive valuations.

Seek long-term returns.

The Tour de France has never been won by someone who won every stage. In fact, it is often won by people who never won a single stage. Investing is like the Tour de France. You are not trying to have the highest return in a given year, but the best return over a lifetime.

Good Corporations Benefit ALL Stakeholders

I have just completed a summer program at Yale University. At the Yale Young Global Scholars' Politics, Law, and Economics session, I had several discussions about the role of corporations in society. A number of individuals expressed strong views against corporations, and the profit motive. A common sentiment was that in order to seek profits for shareholders, corporations must abuse their workers' rights, and the environment they operate in.

Unfortunately, it is true that some corporations do mistreat their workers and their environment. However, I believe it is wrong to think that this benefits shareholders. Mistreating workers leads to dissatisfaction, poor customer service, and high worker turnover. Similarly, a company which destroys the local environment may face backlash from workers and customers in the community.  Over time, dissatisfaction and backlash kill a company.

Thus, seeking sustainable, long-term profits for shareholders and caring for other stakeholders aren't mutually exclusive - to me, the two are synonymous.

What is ESG investing? Does it work?

ESG refers to the Environmental, Social and Corporate Governance. ESG investors often evaluate companies solely on a range of ESG metrics, and allocate capital to companies with "high ESG scores". Over the last few years, "ESG funds" have outperformed "non-ESG" ones. Consequently, they have gained popularity, with ESG-focussed asset managers receiving record inflows of capital in 2018, and Q1 2019.

I have attended two lectures - one at Columbia University, and another at Yale - about ESG investing in order to understand the reasons for its rise. I frequently hear people saying that being ESG-investing generates better returns. I partly disagree with this statement.

Just because you invest based on ESG scores does not mean you will necessarily generate better returns; ultimately, all that counts is that you buy businesses for less than they are worth. That being said, I do not believe that an evaluation of a company's ESG standards is futile. Indeed, I advocate considering how a company thinks of Corporate Social and Environmental Responsibility; a company which is fulfilling its responsibility to its employees, and attempting to reduce the negative effects of its operation is likely to be better managed. And, a better management is likely to create more long-term value for shareholders.

Thus, I wish to suggest that ESG should be one of many factors that drives a capital allocation decision. Having tweaked the layman's definition of "ESG investing", I can say that there is no such thing as ESG vs. non-ESG investing: all investors must consider ESG standards when evaluating a company. 

Insider ownership is great, insider control is less so.

As an investor, one feels comfortable when founders/executives have a significant portion of their net-worth in their company’s stock. This is because it indicates that they believe in the company’s future success. This also ensures that their interests are aligned with those of minority stakeholders. Indeed, the fact that Mr. Howard Marks’ income was entirely from his stock holding in Oaktree Capital Management was a source of comfort for me when I invested in the company.

However, in some companies (generally tech companies, and nowadays in other newly listed companies) founders are not only personally invested, but they control the company through controlling stakes, or shares with supervoting rights. This has its positives. Firms with such ownership can take a longer-term view and not succumb to the short-term performance pressures exerted by the capital markets, which tend to have shorter investment horizons than those required by businesses investing for the long term. However, total control is a double edged sword and can also be dangerous. This is because when one/few individual(s) has complete control over a company they cannot be held accountable. Thus, their decisions receive less scrutiny and less challenge. Furthermore, the controlling shareholders could act to serve their personal interest at the expense of minority shareholders. For example, they could engage in related party transactions that may destroy value, or even sell the company at low valuations, whilst securing a better deal for themselves. The latter may well have occurred in Oaktree’s sale to Brookfield, in which I feel that minority investors received less than intrinsic value, while the management team will be bought out over a longer time period, and appears to have a potentially more favourable deal. It was frustrating to have trusted the alignment of my interests with Mr. Marks’, only to realise that super voting shares meant interests were not completely aligned after all.

My conclusion is that controlling founder ownership by visionary entrepreneurs is often a positive attribute of an investment. However, we must be keenly aware of the risks as interests are not completely aligned. 

Never Settle

Never settling results in better decision making, increased openness to opportunities and ultimately a better outcome. For me, 'never settle' has a few particularly significant meanings. 

Firstly, never settling is about constantly striving. That is seeking to develop or improve one's skills in - and a knowledge and understanding of - a particular field. This may range from working to improve one's written communication skills and develop a better understanding of Physics, to attempting to increase the distance one can run. Often, this will involve repeatedly seeking out and attempting to resolve personal shortcomings. This will not only lead you to become better at something, but will also reinforce the importance of hard work and industry. 

Secondly, never settling is about being openminded - and not fixed in one's views. In the investing world, where you must have a strong view before you act, never settling is about having "strong views, which are loosely held". This is essential if one wants to be able to evaluate facts objectively and make good decisions.

Thirdly, never settling is about constantly seeking opportunities, and embracing change, instead of becoming increasingly comfortable with the status quo. This may be about being willing to move countries if a better opportunity presents itself, and being willing to seek mentors from different fields, or about choosing to be an early adopter, or even an innovator. This will lead to personal growth.

The 'never settle' mindset is very powerful. Thus, I encourage you to ask yourself what 'never settling' means for you, and I urge you to subscribe to this philosophy.

A note on inequality and the case for inheritance tax

The most toxic form of social inequality is unequal access to opportunity. Inequality of opportunity compounds the issue of inequitable distribution of wealth. This is very dangerous, because it reduces social mobility, and extended periods of low social mobility can result in disillusionment, which could culminate in radical revolutions.

Warren Buffett once said, "Someone is sitting in the shade today because someone planted a tree a long time ago". This is true. The efforts of a generation can - and often do - bear fruits for several generations. Well educated, wealthy individuals are likely to ensure that their children receive an excellent education, and are likely to be able to facilitate their offspring's extracurricular pursuits. In effect, the offspring of wealthy individuals have more capital invested into them to try to ensure their future success. So, they are more likely to be (financially) successful. Hence, their success compounds from one generation to the next. Meanwhile, parents who are struggling financially often do not have the means to allow their offspring to pursue passions, let alone the time to look after their offspring's physical and mental wellbeing. Thus, their families may become victims of the poverty trap. As if this were not enough, wealthy individuals are also able to bequeath more assets. As a consequence, the gap between the wealthy and the ‘less-privileged’ widens over time.

So, financial inequality is the most important driver of unequal distribution of opportunities, as the inequality of outcome for one generation affects the outcomes of the next generation.

Yet, we must not abandon the idea of unequal outcomes, as this would serve as disincentive for hard work. Indeed, we must embrace inequality of outcome with open arms. Those who have consistently worked hard see themselves benefit from these efforts, whilst those who have worked less hard enjoy fewer benefits; whilst there is luck involved, I am inclined to believe that in aggregate, and over a long period of time, the impacts of luck are insignificant in comparison with the impacts of persistent hard work. So, an unequal distribution is largely equitable.

Furthermore, it is not right to close a gap by pulling people back. Instead, we must pull people forward. So, the real cause of this problem lies in our inability and unwillingness to try to close the opportunity gap. In order to achieve this, governments must attempt to offer a high quality of universal healthcare and education. Collectively, these services would unleash people from the shackles of the poverty trap.

Thus, the question arises, “how will governments fund such extensive public services?” To me the answer is blindingly obvious: raise inheritance taxes. In addition to paying for the universal services, this would encourage people to spend money, and so would allow money to trickle through the economy. It would also force each generation to start afresh.

Unfortunately, this is an unpopular solution; people are strongly opposed to the ‘death’ tax. Thus, one significant cause of the multifaceted problem - unequal opportunity - is people's unwillingness to forgo the right to bequeath their wealth.

Stronger for Longer

"The Tortoise and the Hare" is a famed fable, which is most commonly associated with the dictum slow and steady wins the race. This dictum has given rise to my new philosophy: stronger for longer. In this post, I will explain why investors should always have this at the forefront of their minds. 

In a recent gym session, I pushed myself particularly hard. Consequently, my left quadricep froze, causing inflammation around my knee. A few days later, my lower back muscles went into spasm. I am now using compression, a foam roller and ice-packs to help my leg and back heal. This is the second time my knees have become irritated, and the third time my back has gone into spasm. Clearly, I have injured myself far too frequently in the gym. Thus, I have decided that I must be more careful in the gym, and dedicate more time to post-workout stretching. 

My repeated experiences in the gym have finally reminded me of "The Tortoise and the Hare"; I have concluded there is no point attempting to go too far too fast, only to suffer from an injury. It is better to make slow and steady progress.

So, why should all this matter to an investor? Amongst athletes and active-types, making gains is a colloquialism used to refer to getting stronger, and building muscle mass. Too many people are in a rush to make such gains. Too many people get injured in this rush.

Investors are in the business of seeking gains - albeit of a different kind. And, surprisingly - or unsurprisingly - investors too are in a rush to make gains. Thus, it is important for investors to remember that the race is won through patience, and disciplined capital allocation - not by chasing quick money; it is always better to avoid an injury that will land you back at square one. Let us all seek to be stronger for longer.

Howard Marks on Investing

In my previous post, I criticised the decision of the Oaktree management Company to sell itself to Brookfield. I continue to believe that Mr. Marks did not act in the best interest of the minority shareholders. However, I have decided that it is still worth continuing to learn from Marks' investment approach. Thus, in this post, I have collected my thoughts relating to the following Howard Marks Investor Series Interview at Wharton. I have added my thoughts to Mr. Marks' comments. 

                                                   Source: Wharton School Youtube

What makes money?

Uncertainty is a money machine. As Wilbur Ross puts it, "Investors often find themselves running into burning buildings", or as Howard Marks puts it, in the investing world, you "have to be willing to catch a falling knife". Given that as an investor one is usually being bold in distressed situations, one must search for two things: A margin of safety and conviction. 

"The margin for error comes primarily from being able to use conservative assumptions and then still be looking at a generous rate of return; But, I must say that it it's not true that the the more conservative the better, because you can get to the point where you can make assumptions that are so conservative that you'll never lose money, but it will give you a target buying price which is so low that you'll never buy anything."

To be comfortable making a decision, you have to have a good idea about what a company is worth - come up with a conservative estimate - and buy it for less. The discount to valuation despite conservative estimates should provide you with a margin of safety. However, as with all things in life, moderation is key. This is because if you are excessively conservative, then you will simply be rationalizing inaction. 

Emotions are a roadblock to harnessing the power of uncertainty. This is partly what Warren Buffett may mean when he says that we must be greedy when others are fearful, and fearful when others are feeling greedy. In effect, when every one is greedy, they become less conservative - often without realising it - and when everyone is fearful, they become too conservative. Instead of thinking about it in black-and-white terms, perhaps it would be more appropriate to say that one must approach investing with a healthy balance of optimism and caution. What I understand from Mr. Buffett's statement is that when everyone is optimistic, it is important to tread cautiously, and when everyone is scared, it is important to be optimistic - whilst still remaining cautious.

"The knife falls until the dust has settled, until all the uncertainty has been resolved. But, the trouble is that once that happens then the price will have rebounded. So, we want to buy at a time of upset and while the knife is still falling, and I think that the refusal to catch a falling knife is a rationalization for inaction. It's our job to catch falling knives; that's how you get bargains; but, you have to do it carefully."

In effect, a big downmarket is when one is required to be bold. But, one must be eternally cautious. This can be emotionally difficult. In an environment in which it is instinctive to be scared, one must become emboldened; as an investor you must always be rational!

Be contrarian - and right - to "make the really big money". Catching a falling knife, requires you to go against the herd. You must be contrarian, and right to really generate a substantial return. 

"You make the really big money in this world by unhooking from the market when everybody's happy, and nobody could think of anything that could ever go wrong, and everybody thinks that the trees are going to grow to the sky, and so you should sell up here. And then, the market collapses and nobody can think of anything that could ever go right again, and every stock price is devoid of any optimism at all, and that's a great time to buy. But to be [able to do] that you have to be a contrarian, and you have to be able to diverge from the crowd."

Being contrarian requires you to use what Howard Marks frequently refers to as "second-level thinking." In today's world, where information is instantaneously and universally available, second-level thinking means interpreting facts differently, thinking differently, and reacting differently.

"Everybody receives the same inputs. We [all] read the same newspaper [...] but some of us see the news and the prices as a buy signal, just when most people see the news and the prices as a sell signal, and vice versa. And you want to be in the minority. [You know,] there are three stages of a bull market. The first stage is when only a few unusually perceptive people believe that there could be some improvement. The second stage is when most people accept that improvement is actually taking place, and the third stage is when everybody and his brother believes that things can only get better. You make a lot of money if you buy in the first stage. You lose a lot of money if you buy in the last stage. You buy the same things as everyone else, but what matters is when you buy them and at what price."

We have said that contrarianism is an indispensable ingredient for investing success. However, we must not be contrarian just for the sake of it. There are thousands of investment professionals, who are usually - on average - right; thus, if we are to hold a contrarian view point with conviction, we must question our interpretation and views to make sure we are right. There is, after all, no prize for being contrarian and wrong - indeed, being contrarian and wrong yields nothing but punishment.

The past, the present and the future.

The past is a good indicator for the future. Cycles repeat themselves, and learning from past experiences is a good way to prepare yourself for future experiences; being able to effectively compare and contrast the present with the past enables us to make better decisions. 

Mark Twain once said, "History doesn't repeat itself but it often rhymes".

As is almost always the case in the investment world, we must tread cautiously when we compare with the past. This is because our comparisons are often flawed. Firstly, the past can be viewed through an array of lenses, which makes it difficult to determine what really constitutes the past. Moreover, history only rhymes, and cycles cannot be counted upon; there is no such thing as market timing! Marks also makes a point of reminding new entrants into the investing world, that it has not been boom-crash all the way through; there may well be periods of low, steady growth, or even just stagnation.

Yet, there is little doubt, that a detailed, far-reaching study of the history of financial markets is likely to make everyone a better investor. It is also likely that past management decisions of a company are an indicator of forthcoming decisions.

Today is on the way to tomorrow. Businesses must survive this year before making it to the next. Thus, it is important to consider the ability of a business to navigate the present business environment; this may require financial ability, technological ability, or execution skills. Moreover, decisions today will affect the company's future; indeed, Jeff Bezos says that "[a quarter's results were] baked three years ago," so surely what a company is doing today could also be a pretty good indicator of where it might be three years later!

Investors can't escape dealing with the future. This is because what you are willing to pay for a business today is a function of what you think its earnings will be in the future. However, the future is inherently uncertain, and so people's opinions of the future change continuously. These changes are reflected in asset prices. This is what allows contrarian investors to generate returns.

Building an investment team.

In Pioneering Portfolio Management, David Swenson says that investing requires “a rich understanding of human psychology, a reasonable appreciation of financial theory, a deep awareness of history, and a broad exposure to current events”. Thus, investing is a challenging, interdisciplinary field.

"Hire rational grown-ups with a long-term orientation. [As a contrarian investor] you only really make money in downturns. That is less than 20% of the time." 

Consequently you need partners who possess integrity, and an ability to "[grind] it out". You need people who are curious, investigative, and contrarian. And of course, you need people who are extremely patient and humble. 

The future of the investing world

Passive Investing dominates. In recent years, low cost ETFs have gained in popularity. This is likely the result of three things. Firstly, these funds have low costs. Second, actively managed funds can be mismanaged. And, third, during the long economic recovery after the financial crisis, alternative asset managers have struggled to generate alpha. This  has two particularly significant implications. Firstly, asset managers are being forced to be more competitive on price. Secondly, asset managers with poor performance are being eliminated from the industry. Thus, this is a relatively 'tough' time for asset managers, who previously received extremely high compensation. Whilst it is unlikely that the active asset management industry will return to its glory days, I believe it is possible that alternative strategies will come back into favour following a downturn.

Investing requires skill - but also luck. As larger numbers of skilled asset managers have entered the field, the market has become more efficient. This - coupled with the low interest rate environment [in the US] - has produced a low return world. In addition, owing to the paradox of skill (Success Equation, Micael Mauboussin), luck has become a more important determinant of returns. 

Fear not for there is hope. Whilst asset management is harder, and perhaps not as financially rewarding as it used to be, it remains an intellectually stimulating field, which continues to reward its successful players handsomely. Indeed, it is also possible that in light of the aforementioned challenges, people will seek alternative opportunities and careers. This will only increase the opportunity available to those who continue to seek stakes in high quality, well run businesses which are available at a (discount to) fair value.