Interesting Reading – October 24, 2016

Note to readers:  In this series, we suggest worthwhile reading material on a variety of topics, not all of which are directly related to investing.  Some of the articles are behind pay walls.  However, it is often possible to read such articles by going to Google News and searching for the article’s title.  

Warren Buffett Loves This Business — Maybe a Little Too Much — Bloomberg, October 20, 2016.  Reinsurance has long been among the most important businesses for Berkshire Hathaway.  Years of ultra-low interest rates on bonds coupled with capital flowing into the industry have combined to create a difficult competitive landscape.  We should note that Berkshire Hathaway has been through many insurance industry cycles and has demonstrated a willingness to constraint premium volume when faced with inadequate pricing.  The article suggests that Ajit Jain is trying to deal with a “cost problem” at General Re and will be overhauling the company’s compensation strategy.  It will be interesting to observe the balance that is struck between cost containment and ensuring that incentives to reject poorly priced policies are retained.

Buffett’s Three Categories of Returns on Capital — Base Hit Investing, October 18, 2016.  John Huber makes interesting observations regarding how Warren Buffett thinks about businesses in terms of their return on capital profile.  He then provides some thoughts on Chipotle Mexican Grill and Markel Corporation.  Also see The Rational Walk’s recent discussion of Chipotle and earlier coverage of Markel.

Why The Prophets of Buffett Get it Wrong — Financial Times, October 16, 2016.  Countless investors talk about following Warren Buffett’s example but how many actually implement his process in reality?  “There are plenty of people out there who call themselves Buffett acolytes — and as far as I can see they are all phoneys,” says John Hempton, an Australian fund manager.

Wells Fargo’s Former CEO May Have Been Warned of Phony Account Fraud As Early As 2007 — Fortune, October 18, 2016.  John Stumpf’s resignation and daily full page advertisements in The Wall Street Journal have not been enough to contain the crisis at Wells Fargo.  There is increasing evidence to suggest that bank executives knew, or should have known, about fraudulent sales activities well before 2013.  It seems like executives must either confess to being complicit or to being incompetent.  The latter might be a more attractive option from a legal perspective.

Is Bill Ackman Toast? — Vanity Fair, October 17, 2016.  The setbacks experienced by Bill Ackman in recent months have been well documented.  As is the case when a fund manager experiences hard times, people seem to come out of the woodwork to offer critiques and analyses of past mistakes.  An unnamed hedge fund manager is reported to claim that Mr. Ackman’s fund has “returned zero”, which is at odds with others familiar with his record.  But is Bill Ackman Toast?  The article concludes by pointing out that the fund has more than $6.5 billion in permanent capital which perhaps answers the question posed by the title.

The Patients Hurt by Theranos — The Wall Street Journal, October 20, 2016.  This article goes into quite a bit of detail regarding patients who were misdiagnosed by Theranos and the consequences that they faced due to the errors.  These stories are disturbing, to say the least, and highlight the level of ethics required for companies to operate within the health care industry.  Wells Fargo’s scandal is serious but only involves money whereas the Theranos situation is a matter of life and death.

Will Apple Kill Its Own Driverless Car? — Vanity Fair, October 17, 2016.  Rumors have been swirling for quite a while regarding Apple’s ambitions to build an automated vehicle.  Apple seems to have more leaks these days compared to the level of control imposed by the late Steve Jobs when he ran the company.  While perhaps bad for shareholders, these leaks make for interesting reading as we can see from Vanity Fair’s reporting based on “sources within the company”.  Shareholders should continue to question whether these types of initiatives represent a good use of the company’s formidable cash balance and ongoing free cash flow.

Elon Musk’s Empire:  The entrepreneur’s finances are as jaw-dropping, inventive and combustible as his space rockets — The Economist, October 22, 2016.  Elon Musk is widely admired for his propensity to take innovative risks while also often criticized for the financial maneuvering required to fund those risks.  Despite a multi-billion dollar net worth, Mr. Musk has little personal liquidity and his companies require ongoing funding from the investment community.  The Economist explores the financial aspects of Elon Musk’s empire in this article.  Also see Elon Musk’s Wild Ride published by Bloomberg on October 12.

Peter Bevelin on Seeking Wisdom, Mental Models, and Learning — Farnam Street, October 17, 2016.  Peter Bevelin is the author of Seeking Wisdom:  From Darwin to Munger and All I Want to Know is Where I’m Going to Die So I Never Go There (purchase these books from the links provided in the Farnam Street article).  In a wide ranging interview, Mr. Bevelin explains his motivation behind publishing these books and provides more information regarding his background.


Mastering the Art of Pre-Suasion

“The elementary part of psychology—the psychology of misjudgment, as I call it—is a terribly important thing to learn. There are about 20 little principles. And they interact, so it gets slightly complicated. But the guts of it is unbelievably important.” 

— Charlie Munger in a speech to the USC Business School in 1994.

Charlie Munger has long been a strong advocate of viewing the world through a multi-disciplinary mindset.  Many readers are familiar with Poor Charlie’s Almanack which is the best way to get acquainted with Mr. Munger’s life and philosophy.  On a number of occasions, Mr. Munger has recommended that those who wish to become more familiar with psychology should read the work of Robert Cialdini.  Dr. Cialdini is best known for Influence:  The Psychology of Persuasion, a landmark book that has become standard reading for marketing professionals in recent decades.  Mr. Munger has been known to give copies of this book to friends and relatives and felt so strongly about the value the book has brought to the world that he gave Dr. Cialdini a gift of one Berkshire Class A share in appreciation.

The attraction of Influence for Charlie Munger was not primarily related to applying the techniques in a marketing setting.  Instead, Mr. Munger valued the book because it provided deep insights into the psychology of human misjudgment.  One of the very first articles to ever appear on The Rational Walk applied a few of Dr. Cialdini’s insights to the mystery of how Bernard Madoff was somehow able to use his weapons of influence to steal money from so many intelligent people for many decades.

Pre-SuasionIn Dr. Cialdini’s new book, Pre-Suasion:  A Revolutionary Way to Influence and Persuade, a key insight is provided that could change how marketing professionals approach persuasion.  Dr. Cialdini reveals that the major factor that separates extraordinary persuaders from average ones involves the key moment before a message is delivered.  By setting up a “privileged moment” prior to delivering a message, a persuader can materially increase the odds of a positive outcome.  What is a “privileged moment”?  Dr. Cialdini describes an approach called channeled attention that does not require the persuader to actually alter a person’s beliefs but only to alter what is prominent in a person’s mind at the time they are making a decision.  This is a major departure from the traditional view that it is necessary to change a person’s beliefs by persuading them regarding the merits of a proposal.  Instead, one must only pre-suade through channeled attention.

Human beings typically assume that whatever we are focusing on at a given moment deserves heightened attention.  Dr. Cialdini contends that the human mind can only really hold one thing in conscious awareness at any given point in time and that the cost of that heightened attention is a momentary loss of focused attention on everything else.  One striking example in the book involves a study of consumers who were in the market for a new sofa and were reviewing choices online.  Prior to viewing the sofas, individuals were either shown a background of fluffy white clouds or images of pennies.  Controlling for other factors, the individuals who were subliminally led to focus on clouds placed a higher priority on comfort while those who saw the pennies were more concerned with price.

The implications of this basic thesis are both fascinating and terrifying.  The individuals involved in the sofa study refused to believe that the background images of clouds or pennies had any influence whatsoever but their behavior said otherwise.  Essentially, persuaders – whether they are salespeople, politicians, or journalists – have the power to dramatically influence the actions of their targets merely by directing people’s attention toward what they want them to think about.  These techniques have also been used by police interrogators to persuade individuals to confess to crimes that they did not commit typically leading to convictions even when the individuals later renounce the false confession.

Assuming we buy into the primary thesis of “pre-suasion” via focused attention and channeling, the question naturally flows to the nuts and bolts of how one might command attention and direct it toward the desired objective.  Once the attention has been directed to the right place, it must be held there for long enough to produce the desired decision.  Dr. Cialdini provides a number of guidelines and potential roadmaps to follow.  As one reads through these concepts, it is tempting to think of these techniques as ones that would only work on “other people” – we cannot believe that we are subject to such persuasive techniques but, of course, almost all of us are!

What does this have to do with investing?  Well, perhaps it has a great deal to do with it when we look at our research process objectively.  Although Dr. Cialdini does not discuss the influence CEOs have on shareholders, surely the same principles of pre-suasion apply.  CEOs can focus our attention to certain facts and figures or even use subliminal suggestions in presentations to get us to focus on certain metrics while overlooking others.  For this reason, it seems prudent to immunize ourselves against this risk by avoiding any contact with management prior to an objective review of documents that are more fact based.

Although investors will vary in their research process, ideas typically flow from many initial sources – newspapers, magazines, blogs, newsletters, and more.  What is the first step one should take when investigating further?  Should we dive into the 10-K directly or perhaps review the latest quarterly conference call and slide deck?  Which would be less of a mental challenge?  Well, obviously it would be a lot easier to listen to the conference call while flipping through a slide deck.  However, by doing so, we are allowing management to pre-suade us!  The material that is presented, the order in which it is presented, and even the subtle hints in the presenter’s language can all have an influence on us whether we accept it or not.

How about skipping the presentations but diving right into an annual report?  That’s probably not a great idea if management provides a glossy annual report with a lot of marketing material in it.  It seems much more prudent to focus on the 10-K.  Obviously, even a 10-K can pre-suade us in various ways based on how the company is described and the areas that are emphasized, but we probably stand a better chance of remaining objective if we are in a text based format without visual imagery to exert any influence.  Then, by documenting what we, as investors, view to be the critical factors, it will be possible to resist potential attempts at redirecting our attention when we later review the conference calls, presentations, and glossy annual reports.

The applicability of Dr. Cialdini’s insights are endless and span multiple disciplines.  This is no doubt why Mr. Munger has given away so many copies of Influence over the years and felt strongly enough to give Dr. Cialdini one Berkshire Class A share to thank him.  There is some evidence that the influence has gone in both directions.  Dr. Cialdini thanks Mr. Munger for reviewing the manuscript prior to publication and there are several pages describing how Warren Buffett uses the concept of unity as a persuasive tool that has contributed to the unique loyalty Berkshire shareholders feel toward management.

Readers may wonder whether they should read Influence before Pre-Suasion.  It seems like doing so will increase comprehension of the topics discussed in the new book although each book can stand alone in terms of providing value.  It should be noted that both books come with extensive end notes.  In Pre-Suasion in particular, it is important to read the end notes along with the text.  In some cases, quite a bit would be lost without consulting the notes.

Click on these links to purchase a copy of Influence:  The Psychology of Persuasion and Pre-Suasion:  A Revolutionary Way to Influence and Persuade. Dr. Cialdini refers to Daniel Kahneman’s book, Thinking, Fast and Slow, which is an excellent resource for those who are interested in a more extensive tour of the mind.

Disclosure:  The Rational Walk LLC was not provided with a review copy of Pre-Suasion and purchased a copy of the book.

The Virtue of Being Merely Average

Are you merely average?

MediocreIf you are reading this article, chances are that you will instinctively recoil when asked this question.  People do not like to think of themselves as merely average and this is even more true for individuals who have selected careers in business.  We live in a hyper-competitive world where professional identity and self esteem depends on having above average insights and achieving superior results. The cognitive bias known as illusory superiority is behind the tendency of individuals to overestimate their ranking relative to peers.  This phenomenon has been shown to be true in ordinary activities like driving and it certainly seems to extend to investing.

Active investing requires the recognition of certain fundamental realities.  The world is full of intelligent people who have access to the same information at the same time, and this has only been accentuated by the internet.  Additionally, there are plenty of people who might have special insights due to longtime involvement in an industry or familiarity with key decision makers at a company.  This doesn’t necessarily imply illegal inside information although it would be naive to think that one isn’t competing against people with access to such information and willingness to act on it.  If we are going to rationally choose to be active investors, we must believe that we have some type of edge over other market participants.  Merely reading SEC filings and newspapers is not enough to provide such an edge.

The Rise of Passive Investing

The Wall Street Journal is running a series this week exploring the rise of passive investing.  Passive investing has been a viable option for the past four decades ever since Jack Bogle created the first index fund accessible to ordinary investors.  The idea of indexing is to match the performance of the broad stock market (or whatever sector is being indexed) rather than to make any attempt whatsoever to pick winners and avoid losers.  This could be done at much lower cost even in the 1970s and the advantage of passive indexing has only grown more pronounced over the years as assets under management increased dramatically allowing for progressively lower management fees.  The Vanguard Group, which became the dominant player in indexing under Mr. Bogle’s leadership, has been joined by many other firms eager to capitalize on this trend.  Indexing has become the default choice in many company retirement plans.  As the following graph from The Wall Street Journal illustrates, indexing has outperformed the vast majority of active fund managers.

Indexing Advantage

Index funds incur low fees and index fund managers have no psychological impulses to deal with.  They simply own all stocks in a given index in an effort to be average.  Obviously, some actively managed funds have demonstrated that they can outperform but outperformance during a period in the past does not necessarily allow us to predict whether such returns will continue into the future.

But none of this applies to most of us, right?  As value investors following the principles of Benjamin Graham, Warren Buffett, and Charlie Munger, aren’t we immune to the folly that makes the majority of active managers fail?  Unfortunately, this is not necessarily the case.  For one thing, the number of “value investors” competing for ideas is hardly small.  Mr. Buffett’s record and the simplicity that seems to underpin his success leads many people to seek to emulate the approach.  Few will come anywhere close to succeeding both because the actual process is not simple and because the temperament required to succeed is rare.

As we argued last year, individual investors have many important advantages over professional investors.  In particular, with no outside constituency to manage, individuals can exploit timeframe arbitrage to their advantage provided that they themselves have the temperament required to do so.  However, it is worth questioning whether the typical individual investor should attempt to outperform even if he or she has the skills and temperament required to do so.

Settle For Average?

From a purely mathematical standpoint, it takes a relatively large portfolio and/or a significant degree of outperformance to logically induce an individual investor to seek to outperform an index fund.  Let’s consider a simple example.  A 50 year old marketing executive has a $1 million 401(k) account accumulated through diligent payroll deductions and compounded investment returns over a period of 20 years.  The money has been invested in a selection of the mutual funds offered by his employer and individual security selections were not permitted.  Let’s say that this investor leaves his company for a better opportunity within the field of marketing and rolls the 401(k) into a self directed IRA.  He will not need to draw any funds from this account until reaching the age of 70.  Should he actively manage that $1 million portfolio or index it?

Obviously the answer to this question is not simple.  Does this individual have a special circle of competence in one or more areas that could provide a discernible edge over other market participants?  Does he have adequate time to devote to research and the inclination to spend his time on research outside of his normal day job?  Does he have the appropriate psychological temperament to view his investments as long term commitments or will he start to actively trade at precisely the wrong time?  If all goes well, what is the margin of outperformance that he expects to achieve?

For one thing, it is probably not possible to answer many of these questions unless the individual has an existing track record outside his $1 million self directed IRA.  If he does not, he almost certainly should index. However, let’s assume that the investor has managed a smaller account successfully over the past decade and has achieved returns 1.5 percent greater than the S&P 500 index.  Let’s further assume that he read Poor Charlie’s Almanack in 2006, started attending Berkshire Hathaway annual meetings, and has ever since made an effort to expand his circle of competence through a multi-disciplinary framework.  He enjoys reading and is eager to spend around 500 hours per year on intellectual pursuits including the selection of investments for his portfolio.

The Temptation

Our investor appears to be a candidate for active investing but is it worthwhile?  Let us assume that the S&P 500 will average 6 percent total returns over the next two decades given the fact that valuations are hardly at bargain levels today.  If an investor expects a 1.5 percent outperformance, then that would imply returns of 7.5 percent.  Keep in mind that this small margin is actually a very significant difference that few professionals can hope to achieve even working on a full time basis.  However, our investor feels confident that he can achieve this margin by devoting 500 hours per year to the endeavor.

Based on these assumptions, and with the obviously incorrect assumption that returns will be smooth, the expected result would look something like this:

Active vs. Passive

If you look at the expected account value in the early years, the difference is fairly small but eventually compounding does its magic and the end result of active management, given our oversimplified assumptions, will be about $1 million over what is delivered by the index fund.  Looking at the difference in early years shows that the effort expended in achieving the outperformance might be questionable:  In year one, for example, the 1.5 percent margin of outperformance results in a dollar difference of only $15,000 in exchange for 500 hours of effort which works out to $30 per hour, far below the value our investor attaches to his time, both in his day job and for leisure.  However, a sustained effort will eventually lead to a material difference in the final account value.

Simple Assumptions Are NOT Reality

The rather naive assumptions and smooth curve of outperformance shown above is far from reality.  Instead of a smooth curve, the natural volatility of the stock market will result in a much more variable picture from year to year.  The chart below shows exactly the same endpoint for the active and passive strategies but with a more plausible variation of annual returns:

Active vs Passive Realistic

So our hypothetical investor begins by falling short of the index for four years before pulling ahead until year fourteen when his investments are suddenly viewed unfavorably by Mr. Market.  Diligence and a steady temperament pays off in the subsequent years, however, and we end up with the same $1 million margin over the index at the end of the twenty year period.

How many investors, in reality, would stick with this more realistic scenario for the first four years?  How many would still stick with it after posting cumulative underperformance after fourteen years?  Would most people begin to question whether their circle of competence is real when faced with a brutal verdict from Mr. Market so many years into the process?

Ultimately, investors need to assess their ability to outperform, the level of effort required if one chooses to make the attempt, and the very real psychological pressures that could cause the effort to be abandoned during difficult times.  Anyone who cannot confidently claim to have the ability based on an actual track record should index.  Anyone who does not want to put in the level of effort required should index.  And unless one has been through difficult times in the past and acted with a steady hand, it is probably best to index.

We end up with something of a chicken vs. egg conundrum:  How can anyone know whether they have the ability to succeed without trying?  And how can we know how we will truly react to adversity without putting ourselves in situations that test our resolve?  The answer is that we cannot know the answers to these questions without putting ourselves out there in some way and making the attempt.  If there is a desire to engage in the process, which many investors truly enjoy, it seems prudent to enter the competition with a meaningful enough amount of money to test one’s ability and psychological tendencies, but to start out by indexing the rest.  It isn’t possible to test ourselves using a “paper account”.  We have to have actual “skin in the game” to see how we will react to the many psychological pressures that conspire to make even those with above average aptitude achieve only average results.

Ultimately, there is no shame in being merely “average” when it comes to investing but there would be cause for regret if one posts consistently inferior returns due to an overly optimistic self-assessment of skill or psychological makeup.