What is worse in investing: Type 1 or Type 2 errors?

Every investor must answer two questions. The first is whether to buy a business or not. And the second is whether one should continue owning a business after it has been bought.

In answering these questions, one effectively bets on one possible future. The future is inherently unknowable and so mistakes are inevitable. There are two kinds of errors in research: Type 1 and Type 2. Type 1 error is when one incorrectly rejects the null (status quo) hypothesis. Type 2 error is failing to change one’s view when the facts have changed. 

Type 1 error in investing might mean being too quick to buy into a stock (action bias) or wrongly deeming the thesis broken for a portfolio holding in the face of bad news (selling low). Type 2 error might mean being too slow to buy into a stock even when facts suggest it’s a winner (not taking a swing), or engaging in thesis drift and failing to cut one's losses (closed mindedness).

Society seems to focus on minimizing Type 1 errors (judicial system has an innocent until proven guilty approach) but minimizing Type 1 errors (almost always) leads to higher rates of Type 2 errors. This raises a question: “What is worse in investing? Type 1 errors or Type 2 errors?”

I have posed this question to multiple investors and none have given a straight answer. Beyond continuously evaluating (and re-evaluating) one's view, there is one common thread: put risk before reward and try to buy good businesses with a margin of safety. 

This requires discipline and patience but it is worthwhile. The quality hurdle gives you the courage (willingness) - and margin of safety gives the cushion (ability) - to live through periods of subpar business performance. If you do this it is easier to give longer rope when the going gets tough - for inevitably it will.

Social influence makes the best investors blockheads; there is no wisdom of crowds in financial markets.

FTX has dominated my twitter feed recently: the utter collapse of a $32 billion company backed by the venerable VC Sequoia Capital – an unthinkable history. The FTX blowup, did not occur in isolation. The NASDAQ is down 29% year-to-date, with many tech stocks down over 80%. Such boom-busts are not anomalies. The 1630s Tulip-mania, 1930s Great Depression, the dot-com bust, and US housing bubble, are some of the biggest meltdowns in financial history.

This is not supposed to happen. Aren’t markets efficient? Did the present value of the US economy really change so much in the last six months? I won’t concern myself with the well-discussed limitations of the efficient market hypothesis; suffice to say that “investing is more art than a science.” But what about the wisdom of crowds? There is evidence of this in Francis Galton’s Vox Populi experiment. Galton asked 787 attendees at a livestock exhibition to guess his Ox’s weight. Each wrote their guess on a ticket, and the average was 1,197lbs, surprisingly close to the real 1,198lbs. Crowds have been shown to accurately predict elections, sports games, and even the location of a missing submarine.

If crowds are so wise, why do they fail to predict the market? How can they get something so important so horribly wrong? Conventional wisdom explains booms and busts through the primal emotions of greed and fear. Whilst greed and fear are undeniably at work, this explanation is not fully satisfactory to me. All serious investors have studied market cycles and are familiar with Warren Buffett’s famous aphorism “be fearful when others are greedy, and greedy when others are fearful.” How do professional investors (even pre-eminent ones) get sucked into speculative euphoria?

A key, often ignored, criterion in Galton’s experiment was that responses were private. This does not hold in financial markets where we have changing share prices, sell-side analyst predictions, and countless ‘experts’ – who are decidedly un-expert – with weak opinions strongly yelled (on CNBC Squawk Box). This inundation of information facilitates groupthink and conformity, changing perceptions, opinions, and behaviors of people in ways that are consistent with group norms. There are two types of conformity. 

Informational influence is when we use others’ behavior or attitudes as information or evidence about reality. Evidence for this effect is found in Sherif’s Autokinetic Effect Study. In this study, participants were asked to judge how far a bright dot on a dark screen had moved. Subjects first made judgments individually, and then in groups. Over time, estimates converged because participants saw information in others’ guesses. Informational influence underpins financial bubbles. There is, as John Kenneth Galbraith calls it, this “feeling that with so much money involved, the mental resources behind them cannot be less.” This belief that others know something we don’t leads to a lemming-like behavior from investors, bidding up asset values, confirming personal and group wisdom – until the inevitable crash.

The second type is normative influence, when people conform to others’ views or expectations in pursuit of social approval. This is evidenced in Asch’s Line Experiment, wherein subjects viewed a card with a line on it, followed by another with three labelled lines. Students had to say which line matched the length of that on the first card. Other students were in fact actors paid to give incorrect answers, meaning “a group unanimously contradicted the evidence of [subjects’] sense[s].” The pursuit of social approval and fear of being ostracized meant 75% of participants conformed at least once. Professional investors are susceptible to normative influence because they are continually evaluated on their performance by peers and client, whose approval they seek. This means they may buy whatever is in vogue, even if they do not intrinsically believe that is the right decision.

Clearly, social influence undermines the “wisdom of crowds” effect. This is supported by Lorenz et al’s study, wherein subjects were asked to reconsider their responses to factual questions after having received average or full information of others’ responses. Although groups were initially “wise,” knowledge about others’ estimates made them unwise. Social influence diminished the diversity of the crowd and “range reduction” pushed the true answer to peripheral regions of the range of estimates. Ironically, even as the crowd became less accurate, the convergence of their estimates made individuals more confident.

Having just experienced the bang that (likely) marks the end of a speculative episode, one may pause to reflect on investors’ agency. Booms are born out of a kernel of truth relating to innovation – but they escalate into mass insanity. As asset prices go up, people perceive information in these movements: there must be a reason. This drives prices up further. Eventually, irrational herd behavior sets in, and non-believers feel compelled to participate or else look bad in front of clients and peers. In this way, the informational and normative influence that underpins speculation literally “buys up... the intelligence of those involved.” CONFORMITY KILLS.

Goose is Loose!

This year I started a position in Canada Goose. Here is my thesis!

Investment Overview

Canada Goose is a performance-luxury winter wear brand, with 60+ years of history as an expedition parka manufacturer. Management is fantastic. They are long-term oriented brand custodians who are making the right investments to strengthen the company. CG has multiple levers for growth: increasing brand penetration in the US, Asia, and Europe; mix shift to DTC, driven by solid online channel and growing physical presence; plans to monetize brand sensibly by entering adjacent product categories.

Business Overview

History

Canada Goose (originally Metro Sportswear) was first founded by Sam Tick, an immigrant to Toronto, Canada, in 1957. Canada Goose’s products have a long history of being used for Arctic and Antarctic expeditions, stemming from Metro Sportswear’s original specialty in woolen vests, raincoats, and snowmobile suits. Sam Tick was eventually succeeded in 2001 by Dani Reiss, who stimulated growth, committed to the Made in Canada cache, and rebranded the business as Canada Goose. Over time, CG has reduced its dependence on department stores and pivoted towards DTC channels (online is particularly big). In 2016, CG opened its first two flagship stores in Toronto and New York City. They are also in the process of launching a winter footwear product line-up to complement their existing winter jacket and knitwear (started in 2017) business segments.

Business model

Canada Goose operates in a subset of the winter outerwear market, selling parkas costing over $800. Authentic, superior-quality, function (rather than fashion) oriented products are the core of CG’s long- term brand strength. CG’s products, given their bias for function over fashion, are evergreen and so they can follow a strict no-discounting policy which adds to the brand image and maintains the value of their products. Sustainability is also a key consideration that underpins CG’s image. They always use 100% responsibly sourced down and reclaimed fur, are committed to carbon neutrality by 2025, and have launched a new parka, which has a 30% smaller carbon footprint, compared to in-line Expedition Parkas.

More recently, CG has started to monetize its brand sensibly by entering the related product categories including knitwear and footwear. To gain manufacturing expertise to guide the upcoming launch of a CG-branded footwear product, the company acquired Baffin, a specialist brand with Arctic heritage and best-in-class functionality synonymous with CG’s brand, at a cost of USD 32.5 million in 2018. They also recently hired Adam Meek, who has over 20 years of global footwear experience with prominent global brands including Sperry, Nike, and Lacoste Footwear, to head this business line.

Under-penetrated brand

North America

CG’s US operations now generate 30% of revenues, similar to the 35% generated by Canada operations. Given that the US has almost 9x the population that Canada does, there is clearly potential for the US business to grow substantially. CG is strong in Northeast USA but has yet to make entries into the Midwest and Northwest. They should succeed in all markets except LA, which is more fashion oriented.

Europe & Asia (China)

Europe and Asia together account for c. 33% of revenues. Although some countries in this region have milder climates, the brand remains in the early stages of its entry into key geographies. Specifically, future sales growth should be turbocharged by the opening of stores and a growing DTC presence in China. Popularity of CG brand in China is evidenced by the proliferation of fakes. Note also that c.30% of sales in North America and Europe are driven by Asian (primarily Chinese) tourists and travelers.

Key Industry Insights

Outerwear market is large and growing

The global winter wear market is worth USD $290B, of which 50% is jackets and outerwear. The overall winter wear market is expected to grow at just under 5% CAGR between 2020-2025. This is being driven by a fashion trend towards increased casualization as well as increasing business & leisure travel. Key mid-to high-end players in this category include North Face, Arcteryx, Patagonia, Columbia, Marmot, and the like. These players’ products typically cost less than $600.

Luxury outerwear is growing even faster

As mentioned above, Canada Goose operates in a subset of the outerwear market, selling coats costing upwards of $800. This segment has only really become a category in the last ten years and was worth approximately USD 11B in 2019. Luxury outerwear has fast rates of growth, driven by: (i) increasing consumption by young HENRY’s (High Earners, Not Rich Yet), with over USD100,000 in annual income, who account for c.50% of global luxury spending; (ii) an increase in the wealth and number of HNI’s, who’s total wealth has increased by a CAGR of 8.9% since 2011; (iii) the rise of the Chinese luxury consumer.

CG & Moncler lead in fragmented industry

Key players in this new high-end, luxury winter outerwear category include Mackage, Moose Knuckles, PJS, and Moncler. Specifically, Moncler has 16% and CG a 6% share of this USD 11B market. CG and Moncler, which have been growing revenues at 15-20% p.a., are growing faster than the luxury segment and consequently gaining share. This is driven primarily by their DTC efforts.

Moat Sources

Strong performance-luxury brand

CG has 60+ years of history as an expedition parka brand. As mentioned above, authentic, superior-quality, function-over-fashion products are at the core of CG. Brand strength and functional, evergreen products allow CG to operate a strict no-discounting policy which preserves brand equity. For me, brand strength is best evidenced by the strong presence of CG’s trademark Arctic patch at some colleges.

Existing distribution channels

Distribution channels are the second notable entry barrier in the luxury outerwear industry. Most brands start by selling through department stores and then develop the DTC channel, which entails more branding and customer experience management. CG has strong, long-standing relationships with its wholesale partners who extend the brand’s reach and influence. Good sell-in/sell-out helps sustain and cement these relationships.

CG also has a notable DTC presence. Brands typically maintain an online and brick-and-mortar presence. Early recognition of the potential of ecommerce and a subsequent willingness to make strategic investments means that CG over-indexes on ecommerce and has 51 national ecommerce markets. The company also has a small but expanding physical presence with 28 stores vs. Moncler which has 282 stores. Although smaller brands will undoubtedly try to move into the DTC channel, they may struggle to successfully grow DTC as CG already has.

Investing in moat asset

In-house manufacturing strengthens brand

CG has doubled down on the “Made in Canada” cache and is increasingly taking manufacturing in-house. They have gone from 33% in-house in 2018 to c. 50% today and are targeting 70% in-house. The “Made in Canada” cache assures consumers of authenticity and in-house manufacturing allows for greater quality controls. As a result, their commitments bolster their image as a superior-quality specialist brand with Arctic heritage and best-in-class functionality. As a testament to management’s long-term orientation, CG will reinvest savings from bringing manufacturing in-house to keep strengthening the brand.

DTC strengthens brand and improves unit economics

CG sells its winter apparel through (i) DTC and (ii) Wholesale channels. Consistently faster DTC growth (double wholesale growth) means there has been an ongoing mix-shift towards DTC. This is being catalyzed by CG’s rationalizing its wholesale presence and expanding its physical presence. DTC went from zero in 2015, to being a roughly equal revenue contributor pre-covid. Covid-19 resulted in a big drop in wholesale sales and an acceleration of DTC growth. In Q4 2020, 80% of sales were from online DTC channel alone. For FY21, 70% of sales are expected to be through the DTC channel (Moncler stands at c. 75% DTC).

CG has a two-pronged DTC strategy, combining an ecommerce-first business with a strategic brick-and-mortar presence. The company’s physical presence has been increasing. Having opened their first two stores in 2016, CG now has 28 stores, and plans to have 40-50 stores, with a particular emphasis on China going forward. Going DTC allows for a superior customer experience and more careful brand management; fewer clearances help preserve brand equity.

Note also that DTC is a higher margin channel. Luxury winter wear segment is a high margin category with COGS being approximately 25% of the retail price of goods. In the traditional department store channel, brands sold to department stores for half the retail value and so made a 50% GPM. Meanwhile, in the DTC channel, revenues are double, and GPM rises to 75%, meaning gross profits can be 3x normal. Indeed, in the most recent period CG’s wholesale GPM was 35.3%, about half of its DTC margin of 72.8%. There are, of course, higher SG&A costs associated with running stores, advertising, and maintaining an online presence. Nevertheless, this channel mix shift has boosted CG’s operating margins.

Building an emotional link b/w products & customer

Historically, CG struggled to build an emotional link with customers. In fact, they received flak for their use of real fur, with some falsely stating that ‘they trap and kill wildlife for an unnecessary, decorative fur trim.’ There have been significant positive developments on this front, with several non-fur products being launched (fake fur would be contrary to brand image). I believe this brand-image issue is mostly in the past as CG announced it would stop purchasing fur by 2021 and stop manufacturing using fur by 2022. CG is also a pioneer in its promise to source 100% RDS-certified (responsibly sourced) down by 2021. Note also that CG’s DTC push gives them more control over the customer journey and allows them to build a deeper emotional relationship with buyers.

Goose Black Label makes the brand more aspirational

Given high demand, CG can comfortably increase prices slightly when they bring new products to market. They are also using Goose Black Label to serve a slightly more premium ($1200+ vs. 800+), more fashion-oriented customer. These moves create interest in CG, make it more aspirational, and boost profitability.

Entry into adjacent verticals to monetize brand

CG’s transcendental parka brand is being leveraged to enter new adjacent product categories. The company has been expanding its offering of related products to include lightweight down-jackets, knitwear, and rainwear, to sensibly monetize their brand and reduce seasonal fluctuations in their sales. Most importantly, even as they seek to enter new categories, the company is careful to stay true to its DNA. This approach is, for me, epitomized by the way in which CG acquired Baffin – a specialist brand with Arctic heritage and best-in-class functionality synonymous with CG’s brand – for its manufacturing expertise to prepare for the upcoming launch of its new winter footwear line. 

Stewardship

Great brand custodians

CG is a family run business. Dani Reiss and team are great brand custodians. They understand that authentic, superior quality winter wear is at the core of CG. Given the company’s manufacturing roots, they place outsized importance on product quality. Additionally, they abide by a strict no-discounting policy. It is hopefully evident that management has a long-term mindset towards preserving the brand and growing sustainably through small, deliberate investments which can be scaled as things work. Incentives of common stockholders are well-aligned as promoter Dani Reiss has 18% ownership.

Innovation (but not newness)

CG is not a fashion company and does not launch new products at a rapid pace. Instead, they innovate whilst staying true to their DNA. New concepts are typically rolled out slowly and allowed to scale as they show signs of success. Therefore, it can take multiple seasons for concepts to become significant. That said, the pace for products in new categories has accelerated slightly, and there has been a greater attention to making sure products are aesthetically pleasing, in addition to being functional. One new initiative that stands out to me is the cold room (five currently exist) where customers can try on a parka in a store and go into a virtual Arctic experience in a giant refrigerator room.

Key Risk

CG is a fad. Company has over-invested and expanded. Growth runs out of steam. Poor profitability ensues. Although this has the appearance of a fad, I believe it is not. CG’s products are at their core function-oriented, as any CG parka-owner who has endured a Chicago winter will attest.

Play your own game

I recently read Morgan Housel's short and insightful article titled Play your own game. I think this article is a must read for all investment professionals and asset allocators.

Every trade has a counter-party and consequently involves an implicit declaration: "I'm right you're wrong." This declaration of one's superior insight is frequently stretched beyond individual decisions to encompass investment strategies. Deep value investors might shit on quality growth ones and vice versa. 

Such arrogance pervades through investment business. This is wrong.

Housel explains that just as athletes competing in different sports must train differently, equally smart and talented people invest very differently depending on what game they’re playing. His key messages are:

1. Judge less.

At least half the people doing things with money that you disagree with are playing a different game than you are. You probably look just as crazy in their eyes. 

2. Figure out what game you’re playing, then play it (and only it).

So few investors do this. Maybe they have a vague idea of their game, but they haven’t clearly defined it. And when they don’t know what game they’re playing, they’re at risk of taking their cues and advice from people playing different games, which can lead to risks they didn’t intend and outcomes they didn’t imagine. 

“That’s how I played the game,” Jordan said. “If you don’t want to play that way, don’t play that way.”

Moats as assets

I was incredibly lucky to be a summer research analyst at WCM Investment Management this summer. At WCM, there is a belief that a company’s moat trajectory is more important than its existing moat. This post, inspired by WCM’s concept of moat trajectory, will reflect on how a moat may be thought of as an asset. 

Before I apply the language of assets onto WCM’s framework, I want to outline first the origin story of moat trajectory. 

A moat, in common parlance, is a deep, wide water-filled ditch surrounding a castle. In investor-speak, a moat refers to a business’ ability to protect its long-term profits by maintaining its competitive advantages. A business’ economic moat, a term popularized by Buffett, works just like a medieval moat, which protects those inside the castle from attack. Following in Munger and Buffett’s footsteps, fundamental investors have gravitated towards investing in fairly valued businesses with large economic moats. 

However, in keeping with one of the foundational tenets of microeconomics, competition, drawn by the potential for supernormal profits, often erodes away the competitive advantages enjoyed by such superior companies. The result is that business’ moats may shrink over time. Once great businesses become simply good ones. Returns in such cases are less than spectacular. The WCM team’s key realization was that it is not just the existing but the future moat that really matters. Enter moat trajectory.

Having explained the importance of investigating the moat trajectory of a business, I will now make the case that the language of assets can be used in relation to moats. 

An asset, broadly defined, is something of value which can be converted into cash. As a company generates cashflows, a part of this asset may be used up. Take for example a luxury brand which overexposes itself and so generates outsize profits today. Here, the extra cash generated is really from the sale of an asset: the brand equity or intangible moat. In other words, the company divested an asset.

 
Just as companies can divest part of the moat, they can also invest to create and grow it. For example, a luxury brand may forego some cashflows today by hiring the best designers, spending on brand advertising, and curbing sales to maintain scarcity. These moves may be thought of as investments in the intangible moat. Preserving brand equity will lead to sustainable, strong performance and vice versa.

 
It may be said, then, that the future moat drives future cashflows, which ultimately determine how much a business is worth. Thus I believe the moat is an asset. Thinking like this will help us (i) reduce the risk of buying optically cheap businesses which are selling assets to generate outsize profits today, but will have less future cashflow; and (ii) identify companies which, although they might appear expensive, are really great businesses that are under-earning because they are constantly investing in their moat-asset.

To end I will return to the image of a medieval castle, one that is constantly under attack. As enemies fill the moat with dirt in a bid to make it crossable, one must spend on digging to maintain and grow it. Similarly, companies too must invest to create and expand their economic moats.

The Art of Worrying Productively

Worrying is an often unproductive activity. I certainly am guilty of worrying about tasks for longer than it eventually takes to complete them. In investing, too, worrying can breed doubt and become paralyzing (for no company is perfect).

But, worrying is not all bad. Worrying can induce a desirable level of stress which is, in fact, conducive to productivity. Similarly, in investing, too, worrying can be an incredibly productive activity — perhaps even more so than in any other field. Worrying is doubly useful. First, worrying about all the ways you might be wrong allows you to discover what you don’t know. Secondly, worrying in this way leads one to work harder, dig deeper, and become more vigilant, enabling a more thoughtful view on the range of potential futures a business might face. 

Long-term investment success probably relies on a mastery of the art of worrying productively.

Decline and Fall

So far in my journey as a student of investing, I have gravitated towards the strategy of buying stakes in good businesses at reasonable prices. Execution of this strategy often involves investing in these great businesses when they are going through a period short term turmoil. This sounds simple enough. 

Although it sounds simple, it is quite challenging in practice. Investor's typically study a business' history and forecast its future. Evaluating historical track records is undoubtably a crucial part of analyzing  a business and is helpful for developing conviction in investment ideas. However, historical greatness does not imply future success. So, when great businesses sell-off, you run the risk of buying optically cheap businesses where the silent creep of impending doom has set in and the sell-off is, in fact, appropriate.

To learn how to avoid making such mistakes, I have read Jim Collins' How The Mighty Fall, which presents institutional decline as a staged disease. Collins develops a framework for identifying great companies, which are on the path of decline and fall. Here are my notes on Collins' framework.

Stage 1: Hubris Born of Success

For Collins, this stage is characterized by a change in the internal orientation of the company from an emphasis on understanding why you adhere to certain practices, to simply insisting that they are best. This in turn might mean that management stops focussing on the core business, failing to renew obsessively. Thus, the primary flywheel is neglected. 

Stage 2: Undisciplined Pursuit of More

Contrary to popular belief, not a lack of innovation, but overreach is the more common cause of decline, particularly for great businesses. This is for two reasons. First, when hubris kicks in, bravado (not insight and understanding) starts to drive decisions. Second, when businesses start to pursue new projects outside their circle of competence without the right people, they are forced to institute bureaucratic processes. Collins would say a culture of bureaucratic mediocrity replaces a culture of disciplined excellence.

Stage 3: Denial of Risk and Peril

This follows from stages 1 & 2. Management starts to "discount negative data, amplify positive data, and put a positive spin on ambiguous data". The last of these three is perhaps most dangerous. In stage 2, businesses take undisciplined risks. In stage 3, leaders fail (i) to cut losses when the facts change and (ii) to maintain a sharp focus on customer loyalty and stakeholder engagement.

Stage 4: Grasping for Salvation

Companies may stumble towards the end in stops-and-starts. Along the way, there are always moments of exuberant hope. A charismatic visionary, bold and revolutionary bets, that much-mentioned hoped-for-blockbuster. People become so desperate to avoid the worst outcome that they cling to the few straws (frayed as they may be) of hope. However, as is the case with a critical patient, the next speed bump is only too often around right around the corner. As goes the discerning Buffetism, turnarounds seldom turn. 

Stage 5: Capitulation to Irrelevance or Death

In Stages 1-4 organizations burn through cash. By stage 5 they are mere shadows of their former selves.

I find this this framework super useful. But, as a rookie, small investor who is not privy to the internal workings of a business and cannot meet management, I am faced with a practical issue: how do I determine if the silent creep of impending doom has set in? Collins' book suggests the following markers which one can look out for in company presentations and transcripts.

• Good decisions are attributed primarily to skill, and bad ones to luck
• Management exudes a know-it-all attitude
• M&A inconsistent with core business and values
• Personal interests are placed above organizational interests
• Management bets the ranch on grand visions and complete overhauls as opposed to taking a build, test and grow approach. 
• Hype about the future and insufficient focus on risks
• Constant reorganization and chronic restructuring
• Leadership churn
• ALSO: Watch out after a legendary leader steps away

Simple things matter

No one wanted the pandemic. It is, nevertheless, an opportunity to learn. In this post, I will reflect on one of my most important learnings from this experience: simple things matter.

There is a lot of angst around covid. Some simply seem not to care; others have fully holed themselves in. My approach is simple. We must endeavor to lead near-normal lives whilst doing simple things (following good hygiene and some social distancing) to contain the spread. Indeed, having spent a quarter on the UChicago campus, I can say with some degree of conviction that small measures can go a long way. If people wear masks, use hand sanitizer, and form well-defined social bubbles, we can not only contain covid, but can also lead fairly, albeit not entirely, normal lives while we are at it!

I see parallels to this in investing, which too is all about responsible risk-taking. Doing seemingly simple things like focusing on the long term, limiting oneself to one's sphere of knowledge, and emphasizing management quality can help avoid blowups, the equivalent of a covid outbreak perhaps. This is a lot of the job done! Indeed, as Howard Marks says, "If we avoid the losers, the winners take care of themselves." The reverse of this logic also holds true: if we fail to do the small things right, we are more likely to have a covid outbreak, or make a terrible investment. And a single blowup can negate the effects of several good decisions.

It's all about the little big things!

Betting on humankind

As the 2020 saga is coming to a close, I want to take a quick look at the world's scorecard:

Deaths? MILLIONS extra

GDP? DOWN

Mental health? SCREWED 

World? SHUT the hell DOWN

2020 was a bummer year for the world. Full stop!—no ifs, no buts. 

As the 2020-saga comes to a close, however, it seems the covid-saga is, at long last, near the beginning of its end too. I think the world is ready (almost!) to let out a muted "Phew": the economy has not been decimated, mortality has fallen, vaccines are being rolled out...there is light at the end of this dark tunnel. 

In March, fear engulfed the world. Now, our lips are poised, tongues are ready for that collective sigh of relief and sense of having made it out of the woods. We have shown great resilience and displayed a capacity to cope with and adapt to unforeseen and highly undesirable situations. Perhaps the age-old adage "this too shall pass" is indeed accurate. Humankind has survived two pandemics, two world wars, and a great deal more. The full weight of human history points in one direction: Betting on humankind is wise.

Time has a way...

To use the title of Aswath Damodaran's book on corporate valuation, investment decisions should be based on a combination of "Narrative and Numbers". In order to start developing an understanding of the numbers side, I recently took a super interesting Coursera course on financial accounting!

Near the start of the course I realized that non-cash items such as depreciation, amortization, and bad debt expense add artistic elements into accounting. Managers can legally get creative with accounting? What? My reaction exactly: the thought that the numbers published in an annual report present a twist on reality (and not reality itself) worries me.

But as I went through the course, I realized that this is partly because the future reality is unknowable till it happens. More importantly, I learned that provided the books are not cooked, time has a way of revealing and ironing out adventurous, aggressive accounting; if you don't account for non-cash items sufficiently, you will have to take write downs on assets in the future. (And similarly if you are too conservative, the expenses booked today will reduce future expenses.) Time just has a way...

So what did I take away? There are three things that were reinforced for me: 

• Time has a way of setting things right.
• One must carefully evaluate a long term track record. 
• You have to trust that the managers' interest is aligned with yours.

Invest with the Dao

I recently took a course on Daoist Thoughts. Daoism, for those who don't know, is a thought-process which emphasizes the importance of leading a simple life in harmony with nature, and not resisting the dao (the way of nature). The concept at the heart of Daoism is wuwei: action in inaction. This is somewhat like the idea of Going with the flow and involves taking only those actions, which are suited to the circumstances.

With the summary out of the way, I can get to the connection between Daoism and investing, which I wished to highlight. In the manuals on wisdom produced by Daoists, we are repeatedly told that rather than impose a plan or model on a situation, we should let others act frantically, and then lightly adjust ourselves as we see the direction that matters have evolved in. Investing is, above all, a test of our equanimity. So, it seems to me, that we investors must master the art of wuwei; the idea of achieving the greatest effects by a wise strategic passivity is at the heart of long-term investing. Hence the Mungerism: The big money is not in the buying and selling, but in the waiting. 

Dead Companies Walking

In Fortress Balance Sheets I said that I had exited my investment in Aston Martin at a 42.5% loss and I quoted one of my favourite adages: "When you don't get what you want, you get experience." Back then I had - and I still have - every intention of making this experience count. My Aston Martin foray made me very curious about business failure so I kept asking myself: why do some corporations seem to last forever, whilst others struggle to stay alive?

If we avoid the losers, the winners will take care of themselves.  -H. Marks 

In that spirit, I went on to read Scott Fearon's Dead Companies Walking, which is chock-full with anecdotes and insights acquired over an investment career spanning more than three decades. Fearon identifies six company leadership mistakes, which help him spot losers. In this post I want to touch on each of these fatal management errors:

1. They learned only from the recent past. 

We frequently - usually unwittingly - learn from the recent past rather than the entirety of history. This is somewhat analogous to relying on anecdotes in lieu of base rates (if you know the first thing about probability, you know that this is a recipe for disaster!). Business leaders, as well as investors, must guard against myopic vision, for it leads to error. Fearon also applies this to individuals': A successful track record and a degree from a good school...can create a kind of historical myopia, a mistaken belief that one's past successes guarantee similar results in the future. 

2. They relied too heavily on a formula for success.

Using a formula without thoughtfully considering its limitations and relevance to the situation at hand is a fool's errand. Maslow explained the law of the golden hammer best: I suppose it is tempting, if the only tool you have is a hammer, to treat everything as if it were a nail. It is also important to remember that a formula can be plain wrong even if it appears to have worked for a period of time. In fact, a formula is most dangerous when it has worked for a long time, because we have a tendency to forget that it is not gospelspeak. I would love to have a foolproof formula for success (who wouldn't!!!), but I'm not sure one exists.

3. They misread or alienated their customers.

The classic product-market-fit problem has wrecked countless companies. There is at least one of two key things at work in almost every case: (i) the product is targeted at the management, instead of the consumer; (ii) management failed to account for the way in which people in the real world actually behave. REMEMBER: A truly valuable company is one that provides a product or service, which possesses significant value in the eyes of its target customer.

4. They fell victim to mania.

Largely self explanatory... If management bets the ranch on the latest cool thing, they will almost certainly lose the ranch. Instead of bold bets, you want companies to invest in new initiatives and ideas by making small, calculated bets, which can be scaled up if and when they yield promising results. If this is done well and the organisation learns from past mistakes, this will allow the company to go from strength to strength and move forward (with caution!).

5. They failed to adapt to tectonic shifts in their industries.

When the entire industry changes and a business fails to adapt, the entity must die. This is because no business can outlive its utility; fewer customers will inevitably (at least eventually) mean that the corporation will be deprived of the lifeblood of any business: revenue growth. I would go so far as to say that tectonic shifts in their industries, which materially alter the economics of doing business can undo even the most nimble, well run company. Hence the sage Buffetism: turnarounds seldom turn.

6. They were physically or emotionally removed from their companies' operations.

This post is all about leaders' mistakes which can destroy a business. To me it is blindingly obvious that management matters!!! It is no surprise then, that this error rounds-off Fearon's list of fatal mistakes. If management is not actively engaged with trying to understand the business and getting a feel for its pulse, how can they steer the company in the right direction? In case you didn't realise, that was a rhetorical question: they can't!

For me, Fearon's book is a guide for becoming better at avoiding disastrous losers and maybe benefiting from their often self-inflicted and predictable deaths. I would unreservedly recommend this book to all other aspiring investors!

"Firefighting" by Ben Bernanke, Timothy Geithner, and Henry Paulson

JFK once said "The Chinese use two brush strokes to write the word 'crisis.' One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger - but recognize the opportunity." For an investor, crises are an opportunity to buy into good businesses at reasonable - or at least not ridiculous - prices. That is why, after three years of struggling to find opportunities, I made more investments over the last month than I had made over the last five years. Vladimir Lenin supposedly said that there are some decades when nothing happens, and some weeks when decades happen. From my experience with this crisis, the first of my still-short investment journey, I have learned that in times of crisis, lots happens - or at least, for an investor, a lot (of buying) should happen! 

When you are choosing to invest at a time of crisis, you are catching a falling knife. You do this because you believe the world will bounce back, because it always does. Indeed, human inventiveness, solidarity, and our sheer will to 'live to fight another day' have always come to the rescue. But, it is important to note that this recovery is aided by the tireless work of policymakers, who seek to limit the damage caused by the fire (crisis) at hand. It is important to understand this damage control aspect of crises.

So during the ongoing COVID-19 crisis, I decided to read Firefighting, a page-turner which tells the story of the 2007-2009 Great Financial Crisis from the perspective of the three fire-chiefs who spearheaded the United States government's response. As something of a neo-classicist myself, I found it tempting to cry moral hazard on many instances while I was reading the book; however, I am nevertheless fascinated by the success of the unprecedented measures taken (and arguably needed) to contain the crisis and right the economy. 

I am fascinated by the way in which greed and fear, and exuberance and panic result in credit cycles. That is why I have thoroughly enjoyed reading Galbraith's A Short History of Financial Euphoria and Krugman's The Return of Depression Economics, and watching HBO's Panic: The Untold Story of the 2008 Financial Crisis. And that is also why I have loved learning from Firefighting. Buffett said "[Firefighting's] cautions for the future should be required reading for all policy makers". They should be required reading for all investors too!

When I read, I like to pick out nuggets of wisdom, quotations that beautifully state or explain a seemingly basic, but in fact profound truth. So, here are a few of my favourite quotations from Firefighting (I promise you being this selective was far from easy - in fact it was pretty damn tough):

Financial Crises will never be a thing of the past. Long periods of stability can create overconfidence that breeds instability. We are later told: The enemy is forgetting. 

Risk, like love, tends to find a way. 

Bad news about one segment of the housing market [created] the E.coli effect, where rumours about a few incidents of tainted hamburger frighten consumers into abandoning all meat rather than trying to figure out which meat...is actually tainted. So, as the authors later note, investors began to shun entire classes of financial products, whether they were contaminated with subprime or not, which depressed prices and made them even more toxic. It was as if avoiding meat caused E.coli to spread. 

Every banker knows that if he has to prove that he is worthy of credit, however good may be his arguments, in fact his credit is gone. 

If you've got a squirt gun in your pocket, you may have to take it out. If you've got a bazooka, and people know you've got it, you may not have to take it out. 

Capitalism without bankruptcy is like Christianity without hell. 

Capital cushions can seem safe and adequate until suddenly they aren't. 

We spend a lot of time looking for systemic risk, but it tends to find us.

Learnings from Robert Caro's "Working"

Robert Caro is known for his biographies of political figures such as Robert Moses and Lyndon Johnson. Caro's epic biographies are renowned because of his forensic research process and relentless pursuit of facts. Caro's latest book, 'Working', is an autobiographical text that allows us to gain insight into the methodology of the world's greatest biographer. As an aspiring investor, who is just beginning to realise the importance of meticulous research, I wish to reflect on how some of my key learnings from 'Working' can be applied in the investing world.

Make sure to be thorough
Caro received one piece of advice when he became an investigative journalist: "Turn every page. Never assume anything. Turn every goddamned page." Ever since, this philosophy has been the cornerstone of his research process; a relentless pursuit of the truth underpins Caro's writing.

The more facts you accumulate, the closer you come to whatever the truth is. And finding facts...takes time. Truth takes time. 

A relentless pursuit of facts is of immense importance in investing because it can enable better decisions. However, I must add a caveat. While the past is undoubtably important, investing is less about the past and more about the inherently uncertain future. Thus, it is necessary to accept some uncertainty, provided you understand the limitations of what you know. This is because if you spend your whole life researching, continuously deferring action, you will never make a single investment.

Thought precedes communication
Caro's Princeton professor once told him to "Stop thinking with [his] fingers". I would want to supplement that phrase with another: Stop thinking with your lips. I am targeting both learnings mostly at myself (the lord knows I need to hear them on repeat!).

I can't start writing a book until I've thought it through and can see it whole in my mind. So before I start writing, I boil the book down into three paragraphs, or two, or one - that's when it comes into view.

You only have to watch CNBC's Squawk Box or Closing Bell to know that these tenets would be applicable in the investing world too. Indeed, we seem to suffer from an irresistible urge to quickly publicise our baseless, speculative thinking on the direction in which the market will move next, and to offer instant, frequently-dubious explanations for recent market movements. I know from experience how tempting it is to write without due consideration and speak without proper reflection. This is why I intend to learn from Caro's rigorous process in which thought precedes communication.

Talk to the people that matter
Caro's research relied heavily on being able to speak to people for long periods of time. During these interviews, Caro always asked questions like "What did you see? What did you hear?" They are unusual questions, but they are useful ones; they allow you to learn more about the atmosphere and setting in which an event occurred. In addition, he urges the interviewers to let the interviewees (and not themselves!) fill moments of silence. That way, you might just "find out things from them that maybe they didn't even realise they knew". 

You have to keep going back to important people - people who were important not necessarily because of their status but because of what they saw.

When you become a stockholder in a business, you make the active choice to own a part of it. Before making such a big decision, you have to be sure that you understand the business you are buying into. Therefore, it is important to speak with managers and employees - particularly those employees who are on the frontline - because they are important people. They should know the business better than anyone else, and speaking with them should allow an investor to have a deeper understanding of said business.

'Working' is undoubtably one of my new favourite books. For me, it is the ultimate guidebook on effective research. It should be required reading for all researchers.

Learnings from Stephen Schwarzman's "What it Takes"

Stephen Schwarzman's autobiography details his extraordinary journey of building one of the world's largest asset-management companies. His anecdotes, insights, and values are deeply inspiring for an aspiring investor like me, and I have really enjoyed reading this book. In this post I will briefly note some of my most important learnings, which I hope to take forward with me.

• Entrepreneurship is psychologically and financially demanding. Even when you have a unique idea and are blessed with fortuitous timing, you have to "bludgeon it into existence". If you are dedicating your life to something, it better be worth it: go big or go home.

• Ask for help and seek advice. Don't hesitate to knock on the doors of the people you admire. The odds are that they will be happy to guide you - and maybe, just maybe, you'll find a lifelong friend.

• Relationships and reputations are invaluable. Do whatever it takes to build and maintain them.

• Help others by solving their problems. All acts of kindness (big or small, random or not) go a long way. When you help someone, they remember. This is why listening to others' problems, and trying to solve them is a great way to win friends.

• Information is money. This was why Schwarzman once told an interviewer "I want to be a telephone switchboard, taking information from countless feeds, sorting it, and sending it back out into the world."

• "The harder the problem, the more limited the competition." If you can build a reputation for solving tough problems, people will actively seek you out - and pay you handsomely.

• Work in a team. Scwarzman puts it best: No one person, however smart, can solve every problem. But an army of smart people talking candidly with one another will.

• "There are no brave, old people in finance." As you learn from your mistakes and failures you have to develop a healthy dose of skepticism along the way; otherwise, you won't survive in finance.

• Take a moment. "Take a breath, slow it down, and relax [your] shoulders until [your] breaths [are] long and deep." This works particularly well because "people [are] always happy to let [you] have that extra moment". It "even reassures them" and makes them "more eager to hear what [you have] to say once [you are] ready."

Hail Cash, for Cash is King!

In Fortress Balance Sheets, I talked about how my Aston Martin adventure has taught me that leverage is "the most dangerous gift in finance". In this unusual crisis, however, I am learning not only about the perils of leverage, but also the importance of cash. 

I now realise that it is valuable to have what may, in the normal course, be considered an obscene amount of excess cash. Several companies (e.g. Booking Holdings, which owns OTA Booking.com) are likely to see their revenues hit zero (note that this did not happen even in GFC). Such firms will still incur fixed costs as well as those variable costs, which cannot be cut quickly. So, firms will lose a lot of money. A strong net-cash balance sheet position allows a firm to comfortably weather this storm, without being forced to permanently dilute equity holders. And, perhaps most importantly, having an abundance of cash heading into a downturn can allow a firm to invest aggressively for the long-term at a time when a lot of other firms are fighting for survival. This is why, Facebook's USD 50 billion cash pile no longer seems excessive when you consider that the firm could potentially lose 25 billion this year alone.

Cash piles that seemed ridiculous only three months ago now seem anything but; so-called "excess" cash is now evidence of management's prudence. 

Fortress Balance Sheets

The most dangerous gift in finance is leverage. Over the last five years, I have frequently read, heard, or written words to the following effect: 

Excessive debt is a red flag. On the stock market, credit yields fantastic results if you are right, but produces equally destructive, leveraged losses if you get it wrong. So, leverage magnifies upside; BUT, it also magnifies downside.

Amidst the coronavirus turmoil, I have finally learned this from a first-hand experience as I have exited my investment in Aston Martin (at a notable 42.5% loss). One of my favourite adages says "When you don't get what you want, you get experience". And I have every intention of making this experience count. So, in this post, I will detail my experience and reflect on what I have learned.

Aston Martin Lagonda - the journey

My investment thesis was simple and I still believe each of the following is true.

- AML is a heritage brand with a notable following.
- Company has invested in good products, and is launching one new car per year.

- Exclusive specials, F1 participation, and mid-engine cars will elevate the brand.

- SUV (the DBX) broadens appeal, and should increase volumes.

Then why exit? One word: LEVERAGE. 

Aston Martin is a highly levered company (even after factoring in a recent rescue investment by Lawrence Stroll and the upcoming rights issue). When I invested in AML, I was aware that leverage magnifies the upside and the downside; but, I was mostly focussed on the upside, because the stock had been cratering, and the company looked incredibly attractive. 

However, despite believing in the long-term story, I am unsure whether Aston can survive amidst the challenging climate of the covid-19 induced economic disruption. As it shuts factories, revenues will fall, losses will grow, and the business will be pushed closer to the brink of default and bankruptcy. Equity holders can potentially get wiped in such a scenario. This is why I chose to sell my shares in AML and invest the proceeds in a compelling business with a far stronger balance sheet.

So what lesson did I learn from this experience?

You need a FORTRESS BALANCE SHEET, because it can allow a firm to weather a storm. I have taken an edited excerpt from a previous post to explain my thinking in more detail.

Risk = (Hazard x Vulnerability)/Capacity to Cope. This allows us to distinguish between a hazard or bad event and the factors that determine the level of risk posed by this event. A strong company, by which I mean one that is not using performance enhancing drugs (leverage), has a higher capacity to cope with a bad event, and may even be less vulnerable to a bad financial event. And, because bad things happen to good companies (all the time) a fortress balance sheet is non-negotiable.

I once said, "Predicting rain doesn't count, but carrying a coat does". To me, maintaining a fortress balance sheet is the equivalent of carrying a coat. In fact, a strong balance sheet is more than just a protective coat; it is also a weapon. A company which has a strong balance sheet will likely outlast a levered competitor and so will benefit from the levered company's demise. Furthermore, having cash on hand (or at least favourable access to capital markets) can allow firms to strategically acquire businesses that are on sale. So, a fortress balance sheet allows companies to bounce back stronger than they were before the crisis.

As a result of this experience, I am particularly sensitive to the importance of a solid balance sheet. I hope never to repeat my mistake of investing in a highly levered business. In good times I might end up seeming a stubborn fool; but, when the tide goes out (for it inevitably will), I don't want to be caught swimming naked.