What mistakes ordinary investors should avoid in their stock market, How to think about risk & How do we know that we know enough to build a position?
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5 Decent Articles to read and Key Takeaways from them.
How to think about risk
What mistakes ordinary investors should avoid in their stock market (Video Clip)
The power of not making stupid decisions
How do we know that we know enough to build a position? (Mohnish Pabrai)
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Invest Like A Dealmaker: Secrets from a Former Banking Insider (Part-1)
The book you’re about to read is an in-depth guide to understanding Chris Mayer’s investing principles. Before we delve into what they are, let me tell you how he fared during the panic: His 17 open recommendations in Capital & Crisis still averaged gains of close to 40 percent.
Compared to many other portfolios, his sailed through cleanly. Chris’ investment principles come from two distinct places: an earnest desire to learn from the masters and dedication to detail, hard-wrought from his experience as a commercial banker at two prestigious banks: Riggs Bank of Washington, DC, the bank of presidents (since acquired by PNC Financial), and Provident Bank, of Baltimore, MD. During his tenure as a corporate lender, Chris never lost money on a single deal. Even when things didn’t work out, the bank got its money back because of his careful due diligence and insistence on asset quality. Chris became a Vice President while only in his twenties— a rare feat— and he handled high-stake negotiations for hundreds of millions of dollars in loans.
Two markets exist for stocks, says Chris, or more specifically, for businesses. There is the market of public quotations— the prices you see quoted on Yahoo! Finance— which most investors know very well. But, there is also a private market— a market for the control of a company— which is every bit as real. Most investors pay attention only to the first and ignore—if they are even aware of— the second.
What do you think about risk?
Ans: Most investors think risk means the stock price going down. But Chris shows you why that’s a mistake and how the truly great investors never think that way. Why? Because they anchor their valuations in this other private market. They know the real value of a business is not what the stock market says it is. It can be very different. And what do you truly understand about the “principles of wealth creation”? Most investors have a rather myopic view of how businesses create wealth. Mainly, investors think it is all about earnings or perhaps the stock price itself. Invest Like a Dealmaker explores the many ways in which companies create true wealth. Once you realize the full menu of options available, it will change the way you assess whether a stock is attractive or not.
Mayer will guide you to the most fertile hunting grounds for good companies, good stocks; the very places you’re most likely to find winners. At the end of the day, this book should prove to be a deep well of ideas for you to draw from for years to come. Over time, you’ll develop your own favorite variations on these themes and ideas. But that is as it should be. Investing is a fluid process with new ideas adding to the mix all the time.
Chris doesn’t give you their life story. He delivers the meat: their most important insights, the essential takeaways from at least a half-dozen great money managers and investment strategists. You’ll be pleasantly surprised to learn that some of the most important lessons come from names you’ve likely never heard before.
In many ways, investing is not about when to buy, but when to sell. Nearly all investment books, even the good ones, deal with when to sell in a few paragraphs. Selling is never easy. Chris has devoted a chapter to this part of the investing process. You’ll appreciate the results, as he divulges a sound and smart selling strategy— used by some of the greats.
Not to mention a cautionary word about the pitfalls to avoid. There are many. A core tenet of this book is that the secret to successful long-term investing is avoiding serious losers. But by following the principles outlined here, you’ll gain exactly the kind of confidence that you’ll need to prevail when markets get jittery as they did in July and August of 2007, or better yet, to succeed wildly when bull markets prevail.
Stay focused on what you own and why you own it. If your reasons for owning something are still valid, you should hang on.”
“When the market starts selling everything off indiscriminately, there are bound to be opportunities in the aftermath. I think that in the still-warm ashes of a market sell-off there are goodies to be found. I’m committed to finding them. Over the longer term, I’m betting we’ll be happy we held onto many of our stocks.”
A TALE OF TWO MARKETS
Stocks are more than just ticker symbols. They represent companies that exist in the real world of blood and sweat and tears. They have real assets that you can touch and smell and count and, in this case, walk on.
Finding those key insights means focusing on things most investors don’t focus on. Heck, most investors would never see the value of IRSA’s land. It doesn’t show up on an earnings statement. There’s no easy way to troll for it with a computer stock screen. To discover the value of IRSA’s land, investors would have to think about stocks and wealth creation in a whole different way. They would need to focus on assets and compare the value of those assets in the stock market to their value in the private market.
Most investors have a habit of selling what’s gone down and buying what’s gone up. The dealmakers of the world almost never do.
The road to Hell is not—contrary to popular opinion— paved with good intentions. It is instead paved with cobblestones, beer and broken promises. That is Wall Street, plain and simple, the place where the faithless mingle, where dreams are shattered and fortunes lost and made.
Charlie Munger, the witty and sometimes bitingly sarcastic— and funny— sidekick to Warren Buffett, likes to say, “There are answers worth billions of dollars in a thirty-dollar history book.”
History may be an abstract teacher, but it teaches profitable lessons nonetheless. “Hindsight enhances foresight,” as James Grant, editor of the well-regarded eponymous newsletter Grant’s, put it.
Munger says this because the old formula still works— buy what’s cheap and hang on. But before you can understand what’s cheap.
In The Intelligent Investor, Graham asserts that a true investor would be better off without market quotations on his stock market holdings. He writes:“[ The investor] would then be spared the mental anguish caused him by other persons’ mistakes of judgment.” What did the great master mean by this? I think he was referring to the concept of two markets, or two prices, for the same stock.
In the investing world, you are either a passenger or a driver. The OPMI is a passenger.
The most important fact I want to establish early— is that there are two markets for stocks. Stock market prices, as quoted in newspapers and online sites, prevail in one market. And that market is tethered to another market normally made up of private and well-informed buyers and sellers.
Marty Whitman is one of my favorite investors, and you’ll hear more from him in the pages that follow. He runs the Third Avenue Value Fund and has been in the business for over 50 years. He’s got a great track record, and his shareholder letters (and books) are loaded with investment insights and wisdom.
On the two-market concept, Whitman writes:
After all, when valuing whole businesses the standards of analysis and the decision considerations tend to be different than when trying to predict open-market stock prices.
Think of it this way: You live in a neighborhood of 300 homes where everyone thinks the value of a house there should be $ 400,000— except one guy, who sells his for $ 375,000. He is the marginal opinion. So guess what price gets recorded on the real estate transactions page of the local paper? Do you panic and sell your house because the guy down the street sold his for less? Of course not.
You have your own feeling about the value of your home and your neighborhood.
Stock prices can rise even though the underlying business is getting weaker. And stock prices can fall even though the underlying business is getting stronger.
In other words, don’t let market prices dictate your actions. It’s for this reason that I oppose the use of stop-losses— investors mechanically selling a stock because it has fallen some prescribed amount.
That is, you’re not really interested in “what the charts say.” I can tell you from over a decade of making business deals as a corporate banker and over a decade as a financial writer that dealmakers don’t consult stock charts. In my personal observation, no one thinks about charts except people who have come into the market first as traders. I can think of no business sale or transaction I’ve ever done or seen that involved people trying to determine when they would buy (or sell) by consulting a chart.
This is important, and unfortunately for many readers, this will be the hardest hurdle to get over because we see charts and chart readers everywhere. They are on the Internet, on the radio, and in magazines and newspapers. They sell books and speak at conferences and have great promotional copy telling you how you can turn a little money into a lot by watching Japanese candlestick patterns or other such tricks and patterns.
For these traders, charts are great. They can have a seemingly intelligent opinion on just about any stock just by running through some of their favorite charts. These people are speculators. They are short-term in-and-out traders. They are playing a whole other game than the people you will read about in this book. The approach I’m encouraging you to adopt is entirely different in its thinking and its
foundations.
You Don’t Care as Much about the Big Picture
Most typical OPM investors love the big picture. They are very interested in what people think about where the economy is going, what interest rates are going to do, or what the price of oil is going to be, among a myriad of other macro variables.
This is often called the top-down approach: an investor tries to think about the big picture (Are we entering a recession? Will consumer spending rise?) and then draws conclusions from that (U.S. stocks should rise; retailers should do well).
They start at the top and work their way down until they find investments that fit with their big-picture view. Relying on this kind of analysis is fraught with risk. You have to get many parts right for it to work consistently well.
The investment approach in this book has fewer moving parts and a built-in margin of safety that is simply missing from the big-picture approach.
Klarman says it best: There is no margin of safety in top-down investing. The top-down investors are not buying based on value; they are buying based on a concept, theme or trend. There is no definable limit to the price they should pay since the value is not part of their purchase decision.
we were acutely aware of the difference between earnings and cash flow. We had a saying:
“Earnings don’t repay loans— cash flow does.
It was a reminder to always look beyond earnings and figure out the cash flow— the cycle of collections and disbursements. At times those cycles can vary widely in fact, a company that otherwise appears profitable can suddenly find itself in a cash crunch. Worse, you could end up like Lucent Technologies. Lucent made lots of sales and gave generous terms so it could keep booking those profits for WallStreet’s benefit. It kept meeting earnings targets and showing nice growth, but meanwhile its accounts receivable were ballooning. Lucent wasn’t collecting the cash nearly so well as it was booking sales! So what happens? At some point you have to write off the uncollectible receivables. Lucent’s customers started to get in trouble themselves and stopped paying their bills. Some went out of business entirely. All those pretty earnings had to be reversed out. That means the company reported losses. Suddenly, those earnings per share targets went out the window. The market took down the stock. It went from over $ 80 to under $ 5.
A company that borrows money to meet its dividend payment is probably not making a wise decision. Dividends are best paid with surplus cash flow that the business cannot put to good economic use.
Charlie Munger likes to use a schematic that includes no-brainers, gold mines, cash cows, and cash traps. A no-brainer is an investment you must make if you are to have any chance at success. This kind of investment includes the usually basic investments you must make to keep your business running smoothly.
Sometimes the patience needed may appear quite considerable.” He related his experience in holding a net-net for three and a half years and making 165 percent— a 47 percent annual return. But almost the entire gain occurred in the fourth year.
THE DEALMAKER S TOOLBOX
Success comes from repeatedly making good risk-reward decisions: betting when the odds favor you, and holding back when they do not.
When many forces are working in your favor, amplifying and reinforcing each other, you get what Munger calls a“ lollapalooza effect.” Forces combine, and the result is more than simple addition.
Some investors obsess over numbers. Over the years I’ve found that understanding what the numbers are is less important than understanding what they mean. In other words, you’re better off focusing on why the number is what it is— drawing the connection to the real world
Enterprise Value (EV)
Think of when you buy a house. You don’t ask, “What’s the value of the equity in the house?” Nobody cares about that. You want to make an offer based on what you think the house is worth and on what you are willing to pay. Normally, the seller will take the proceeds, pay off his mortgage completely, and keep the rest (after expenses). So the price of the house has two components: the value of the equity and the value of the debt. You pay off the debt first. Equity is the residual. It’s the same with companies. You have two components: equity and debt. The quoted stock price is only the equity component.
Let’s say the business has a $ 300 million mortgage. If you’re buying the stock, you’d probably like to know that, wouldn’t you? You’d want to factor that in. So when you see that the company made a profit of $ 40 million, you want to compare that to the value of the equity and the debt. A profit of $ 40 million may look cheap on an equity value of $ 250 million. It looks different against a value of $ 550 million (the $ 250 million plus the $ 300 million in debt). The $ 550 million is the value of the whole business.
Okay, now you’re halfway to understanding the concept of enterprise value, which you can think of as a theoretical price to pay for the entire company— equity plus debt.
But there’s another component we have to think about: excess or surplus cash. Again, let’s consider the example of buying a house. You have two houses to choose from. Each is selling for $ 500,000, but one house has a drawer stuffed with $ 200,000 in cash— and the drawer and its contents “ convey,” that is, you get to keep it. You’d want to know which house that was, wouldn’t you? And all
things being equal, you’d prefer the house with money stuffed in it.
It’s the same with investing, and it’s the same way in thinking about these companies. Sometimes you will find companies that are stuffed with cash. If you pay $ 25 per share, the cash works out to $ 5 to $ 10 or more per share. That’s a significant source of value that most investors never consider. Excess cash in effect lowers the price you pay for the company. If you buy the house with cash, for example, then your purchase price is really only $ 300,000 ($ 500,000 less the $ 200,000 cash you get right back). It’s the same with companies. If you pay $ 15 per share for a stock, and it has $ 5 per share in cash, then your real price, for purposes of valuing the business, is only $ 10 per share.
If that company earned $ 1 per share in profits, you can safely say that it is trading for a multiple of 10 times earnings, as opposed to 15. The stock is cheaper than it first appears.
Of course, analyzing cash takes more than just looking at the cash itself. If the company is not profitable and instead is burning through its cash, then you have to factor that in. But if the company is healthy and profitable and even adding to its cash pile over time— well, that’s something to look at. My experience has been that these are good companies to own because that cash gives the company a lot of options to add value to the business (and thus to your shares). There’s more on the ways to create wealth in the next chapter.
Now you have the elements to calculate enterprise value (EV): market cap plus debt minus cash.
EV-to-EBITDA ratio
Some investors have a bias against companies or businesses that require high levels of capital expenditures and don’t want to own “capital-intensive” businesses. I think this bias is not wise. What is more important is whether the business is making— or is reasonably likely to make— a good return on its investments.
EBITDA got a bad name. But as long as you understand its limitations, it is useful in comparing companies and looking for bargains. Why you may wonder, do you add back interest expense when calculating EBIDTA? Well, you add back interest expense because you are going to use it to compare firms based on enterprise value. Remember, in the EV calculation you’ve included net debt. Some firms have debt and some don’t. If you don’t also add back interest expense to get EBITDA, you’ll get a distorted view. You have to add back interest expense to earnings so that you are comparing apples to apples. For the same reason, you add back taxes, primarily because debt levels have an impact on taxes since interest is tax-deductible. By adding these two things back, you can reasonably compare different businesses in the same industry without allowing financing decisions— such as how much debt to carry— to color the basic profitability comparison.
it is with EBTIDA to get a quick snapshot on value. I call this EV-to-EBITDA ratio the dealmaker’s ratio because dealmakers often target companies with low EV-to EBITDA ratios.
The margin of safety concept is the idea that you want to buy an investment at a price that gives you room for uncertainties and errors.
Let me again borrow from Klarman, who writes in his book:
Tangible assets . . . are more precisely valued and therefore provide investors with greater protection from loss. Tangible assets usually have value in alternate uses, thereby providing a margin of safety. If a chain of retail stores becomes unprofitable, for example, the inventories can be liquidated, leases transferred, and real estate sold.
Conversely, when it comes to buying a well-known soft-drink company like Dr. Pepper, you will probably wind up paying a high price relative to its underlying book value, because the market gives a lot of value to— or credit for— the Dr. Pepper brand. But, as Klarman says,“ if consumers lose their taste for Dr. Pepper, by contrast, tangible assets will not meaningfully cushion investors’ losses.”
So now you have three important concepts introduced in this chapter:
1. Think about whole companies.
2. Think about cash flows.
3. Think about asset values.
A HIDDEN FOURTH BIG IDEA: HOW TO THINK ABOUT RISK
Most investors think about risk in terms of price. They buy a stock, and risk means the probability that the stock price will go down.
I hope you see that this is not a good conception of risk. You understand now that stock prices are judgments of value that you should not rely on. The public market quotations are going to change in ways that seem irrational.
So how should you think about risk?
There are market risks and there are business risks. Market risk is the risk of the stock price moving against you in the short term. We don’t worry about this risk, which is the risk of unrealized losses or a reduction in unrealized profits. Market risk is a risk you should ignore.
What we are most interested in is the business risk— a specific risk to the particular business we are looking at. It might be the risk of a big customer leaving or the risk of losing a key contract. It might be the risk of a costly development project not panning out. Business risks can be lots of specific things. What we don’t want is a lot of risks that something bad will happen to the business itself. The great risk we try very hard to avoid is the risk of a permanent capital impairment. This is a fancy phrase that captures the idea of a business losing a material amount of money, suffering a severe drop in asset prices, or losing its credit standing. Basically, it is a real material loss that affects what the business can achieve in the long run. A permanent capital impairment shrinks the possibilities of what a business can achieve.
As an aside, you should realize that your goal as an investor should not be to eliminate risk entirely. Every investment brings an element of risk. There is always something that can go wrong.
Great investments “take time to develop and mature.”
But above all, Tisch felt that it is most important to focus on your downside. If that’s covered, then you know you can wait.
In business school, everyone is taught that risk and reward go together. When you take bigger risks, you make more money. And when you take smaller dosages of risk, you get less return. This is often taught as a law. The reality though doesn’t work that way. In fact, you will find value-rich opportunities in profitable companies that are in rock-solid financial condition. These are low-risk situations, and yet they will make you a lot of money.
You won’t worry about daily changes in stock prices. This investing stuff is actually a lot of fun. You don’t have to rush it. It’s like a great big puzzle you can assemble at your leisure. You’ll learn lots about the companies you own, and this knowledge will just build up over time. Before you know it, you’ll surprise yourself with what you know.
Excerpts and Learning from Articles/Blogs
1) Reflections on Life, Investing (Safal Niveshak)
Q - “Why are you telling us all these things you know if we need to not know them for you to make money?”
Howard Marks :
knowing them is not enough. You also have to implement them. I think we do a superior job of implementing them. This is fun for me. And I’ve gotten such a great reward from sharing these things with people.
The people that I share these things with are not my competitors. They’re people. And I get these letters saying, you know, you made something complicated clear. Or I get letters that say you changed my life because I had a — there was a prominent economist from the ’70s who called me up a few years ago. He said, “You changed my life.” I said, “How?” He says, “I don’t think forecasts anymore. I tell people what I think is going on. And I tell them what I think the implications are.” That’s so gratifying.
Insights From Michael Mauboussin’s latest Interview:
Great investors do two things that most of us do not. They seek information or views that are different than their own and they update their beliefs when the evidence suggests they should. Neither task is easy.”
On common mistakes among analysts. “There was a letter from Seth Klarman at Baupost to his shareholders. He said, we aspire to the idea that if you lifted the roof off our organization and peered in and saw our investors operating, that they would be doing precisely what you thought they would be doing, given what we’ve said, we’re going to do. It’s this idea of congruence.”
What has he changed his mind on? “When you start to understand the fundamental components of complex adaptive systems, there’s no way to look at the stock market the same way again, personally.”
On being an effective teacher. “To be a great teacher, an effective teacher, it’s about being a great student, be a great learner yourself. And I think that comes through if you’re doing it well.”
2) Brookfield Asset Management Q2 Letter
Price and Value are rarely the same; this often creates an opportunity
At junctures where stock markets trade off significantly, it is worth repeating why value investing is a proven way to achieve long-term success. Buying, building, and holding great businesses, with great people, in great places, for long periods of time, is the source of long-term investment success.
Value investing is, in essence, the arbitrage between “Price” and “Value”. The goal of the value investor is to arbitrage price differentials between the Price for assets, whether that be in the public or private markets, and the true intrinsic value of those assets. And while it’s simple to understand in concept, it takes years to develop the discipline, patience, and judgment required to successfully implement a value investing strategy.
In the short term, for many reasons, Price often does not equal Value. Investors in the stock market, of course, have a daily mechanism allowing them to know the quoted Price of each asset. Price is more difficult to ascertain in the private markets—particularly during periods of the market volatility—and it can be well above or well below the long-term Value.
Asset prices are usually dependent on the supply of and demand for capital, which in turn is heavily influenced by investor sentiment. In robust markets, there is generally more capital than there are assets. This forces the price higher, even to the point where it far exceeds Value. There is no doubt that, in hindsight, this described many technology and “growth” stocks in 2020/2021. On the other hand, in stressed markets, if a sale has to be made, the Price received for an asset can be far below its Value.
In summary, Price is often influenced by the news of the day, market sentiment, the availability of capital, and other factors that may or may not have any relevance to the Value of a specific security.
Value, on the other hand, is the net present value of the future cash flows of a business or asset, based on assumptions for future growth and discounted at the appropriate rate for that particular investment strategy. The difficulty in ascertaining Value is that there is no absolute value for anything, so there will always be a wide range of views over an asset’s growth profile, profitability, and the appropriate discount rate.
3) Rare Skills {End-up highlighting almost the entire write-up :) Worth reading the full blog}
Few Most Favourite Lines:
Just accepting that everyone wants easy and comforting answers in a complex and painful world is a rare skill.
The temptation to exploit every drop of opportunity leads many people to push relentlessly for more, more, more. They only discover the limits of what’s possible when they’ve gone too far and when the momentum of decline is often unstoppable.
People on social media push relentlessly for more likes and retweets until their audience is sick of them.
4) Timeframe Matters
A model might show you some risks, but not the risks of using it. Moreover, models are built on a finite set of parameters, while reality affords us infinite sources of risks.
Nassim Taleb
Much of the behavior gap we talk about in Investing happens in my opinion because of time frame mismatch. Its easy to talk about long term investing, but how do we react to short term blips and how do we react to long term blips matters.
Time frame of our investments need to be inline with our requirements as also our ability to go through painful periods when all seems lost.
5) Charlie Munger: The power of not making stupid decisions
Know your competencies
The circle of competence is simple — each of us, through experience or study, has built up useful knowledge on certain areas of the world. Some areas are understood by most of us, while some areas require a lot more technical knowledge to evaluate. The economics of running a restaurant might be easy to understand but it takes a lot more to understand a biotech company at the same level.
It takes a lot of courage to admit and acknowledge one’s limitations, especially when one holds such a high office. Hence the folk saying: it’s the strong swimmers who drown.
A loser’s game
If you’re an amateur, your main focus should be on avoiding stupidity. One can get ahead in such circumstances by just playing conservatively and outlasting his competition.
The problem? Most of us are amateurs but refuse to believe and play like one. It is here where Munger truly excels.
Utilizing mental models
Munger may have gone to top schools for his education, but most of his wisdom wasn’t derived from textbooks. He never took a course in business, economics or accounting, yet thrived in his role as vice chairman of Berkshire Hathaway.
By accumulating knowledge and stringing them together in a pattern, Munger has built models that have allowed him to navigate through any obstacle through rational thinking. To him, there are big ideas you can pick up that can be applied to every facet of life.
Constant renewal
Munger realizes that the only way to overcome the problem of false knowledge is to keep adding new ideas and models to one’s repository. It is only when there is disconfirming evidence — evidence that runs contrary to what one knows — that the best model emerge. The best model is the model that works.
You have to have a temperament to grab ideas and do sensible things. Most people don’t grab the right ideas or don’t know what to do with them.”
Continuous learning is how Munger has avoided making stupid decisions.
The long game
Each stupid decision he hasn’t made adds up, and that’s taken him to places most will never reach.
All it requires is patience and the ability to play the long game.
Small Video Clips
Investors' main purpose should be to enjoy long-term benefits and not do Market Timing | Howard Marks (9:16 To 10:45)
What mistakes ordinary investors should avoid in their stock market journey to enjoy long-term benefits | EA Sundaram (13:56 to 18:10/29:55)
What gives investing an advantage | Mohnish Pabrai (18:02 to 20:10)
Criteria to sell stocks | EA Sundaram (37:19 to 39:37)
Why do we overreact to Negative News? And how did Warren Buffett and Bill Miller overcome this? | Daniel Goleman (35:20 To 38:54)
How to select fund managers/ what to look for while selecting fund manager for you | Mohnish Pabrai (29:16 to 31:28)
How to deal with information overload without losing your focus | Daniel Goleman (51:31 To 57:00)
How Mohnish Pabrai invested in a high secular inflationary country | Mohnish Pabrai (47:29 to 53:55)
How do we know that we know enough to build a position? | Mohnish Pabrai (1:07:58 to 1:09:29)
Thanks for reading.
- Dhaval (Investment Books)
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One of your best issues yet!! Amazed at the power-packed info I processed here (at 4:00 am 🙂)!! 🙌🙏
Superb one..