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.