The Quarterly Guidance Trap Bites Apple

“In all of our communications, we try to make sure that no single shareholder gets an edge: We do not follow the usual practice of giving earnings guidance or other information of value to analysts or large shareholders. Our goal is to have all of our owners updated at the same time.”

Warren Buffett, Berkshire Hathaway Owner’s Manual

When Warren Buffett first wrote the Berkshire Hathaway Owner’s Manual in 1983, investors had far fewer options to access corporate information in a timely manner. During the 1980s and well into the early 1990s, it was still common to research investments in a library setting. Readers over forty might even recall reviewing old magazine and newspaper articles using microfiche machines, a practice that would seem ridiculously archaic to the millennial generation. By the mid 1990s, the “information superhighway” was born and investors increasingly had access to all sorts of information online. The past two decades has seen tremendous progress in terms of the volume and velocity of data, but this progress has not necessarily been accompanied by greater understanding; in fact, it seems like market participants are as bewildered as they ever have been and increasingly value “guidance” from experts and insiders.

Apple “Misses” Guidance

The most reported financial story of the first week of 2019 involved coverage of Apple’s “missed” revenue forecast for its fiscal first quarter period which ended on December 29, 2018. Apple CEO Tim Cook kicked off the year on January 2 with a letter to investors describing various difficulties the company experienced during the holiday quarter. The number analysts immediately focused on was the revised revenue guidance which was lowered to $84 billion from a range of $89 to $93 billion given during the last earnings call on November 1. The company also lowered the gross margin estimate to 38 percent from a range of 38 to 38.5 percent.

The reaction of the market on January 3 was swift and severe with the stock price falling nearly 10 percent, although some of that decline has been reversed over the past few days. Interestingly, Berkshire Hathaway’s Class A shares declined 5.6 percent on January 3 which far exceeded the decline in the value of Berkshire’s Apple holdings and appeared to reflect Mr. Market’s skepticism regarding Warren Buffett’s ventures into technology investing.

Apple is probably the most scrutinized company in the United States, or at least in the top five, and I have little of value to add when it comes to judging the intrinsic value of the company or expressing an opinion on its future business prospects. While Tim Cook tried to frame the reduced guidance in the most benign way possible, including blaming much of the situation on macroeconomic factors in China, market participants clearly see more serious trouble ahead, particularly related to Apple’s premium pricing strategy and reports of weak demand for the iPhone XR. The fact that Apple will stop presenting unit sales data for its product lines has only added to investor angst.

The Guidance Addiction

Companies that provide quarterly guidance to the investment community are doing so because the market appears to demand it. Earnings calls typically take place a month into the subsequent quarter so analysts expect executives to not only talk about the prior period but to give a sense of how things are going during the current quarter. Typically, management will furnish either a range or a point estimate for various measures and analysts will plug these numbers into their models and then herd around a “consensus” expectation for the coming quarter.

While this might seem harmless, let’s take a step back and think about exactly what the investment community is asking for. A month into a quarter, analysts are asking management to look at the first third of the quarter and to make projections for the next sixty days. Because investors pay so much attention to guidance, managers spend significant time thinking about these estimates and deciding how aggressive or conservative they should be. Since time is finite, this means that managers are not using this time to run the actual business.

When a large company like Apple makes a prediction on November 1 and then drastically revises the prediction on January 2, a period of only 62 days, this leads investors to believe that management does not have a handle on the business or that events are spiraling out of control. After all, two months is a very short period of time.

When managers provide guidance, this effectively causes analysts to crowd around the mid-point of the range in their own models and the variation of estimates is narrower than would be the case if analysts had to do their own work. This reduces the overall quality of analyst estimates and encourages analysts to do less work and to be more reluctant to make estimates that fall far outside the consensus. When guidance later must be adjusted dramatically, the effect on the stock price is likely to be much greater than would be the case if management provided no guidance whatsoever. The irony is that managers typically give guidance in an effort to reduce volatility in the stock.

Buffett Calls for Ending Guidance

A few months ago, Warren Buffett and Jamie Dimon co-wrote an article in the Wall Street Journal calling for an end to quarterly earnings estimates. The main point of the article is that the act of providing guidance shifts management from thinking about the long term to thinking about the next quarter.

The intrinsic value of a company like Apple will depend on the quality of the decisions Tim Cook makes over the next several years. Shareholders should want Mr. Cook and other executives at Apple to focus on matters such as the optimal price points at which to offer phones for various geographic markets along with R&D that will allow the company to retain its technical and aesthetic edge over time. The last thing shareholders should want is for Mr. Cook to focus his time and energy on providing analysts with estimates of Apple’s revenue and margin over the next ninety days.

If Apple or any closely followed company stops providing all guidance, the market’s reaction is likely to be negative in the short run because it could be perceived as an attempt to hide bad news. However, over time, analysts will come up with their own estimates and a market driven consensus will emerge, probably centered around a wider range of estimates. In time, the market will get used to the lack of spoon-feeding and the actual results delivered over time will drive the value of the stock. This is as it should be and the example of Berkshire Hathaway shows that guidance is unnecessary.

Guidance vs. Disclosure

An important distinction needs to be made between guidance, or forecasts, from management and the actual disclosures that are made regarding past periods in 10-Q and 10-K reports. Apple recently announced that the company will no longer report unit sales data for its product lines starting in the current fiscal year. Changes in disclosure, as opposed to changes in guidance policy, could very well send an important message to investors. In the case of Apple, investors have reason to view the lack of unit sales disclosure with some skepticism given that it is coinciding with weak sales. A reduction in disclosure at a time of weakness does not send the most bullish signal to investors.

Berkshire Hathaway shareholders have been paying a great deal of attention to Apple in recent quarters. At the end of the third quarter of 2018, Apple represented Berkshire’s largest equity holding and Warren Buffett’s bullishness on Apple’s prospects has been a tailwind for the stock until recently. Apple’s weakness during the fourth quarter could have enticed Mr. Buffett to further increase Berkshire’s Apple holdings. On the other hand, Berkshire’s new repurchase policy opened up the ability for Mr. Buffett to make potentially large buybacks.

We will have to wait until mid-February to learn whether Berkshire’s Apple stake increased during the fourth quarter, and news of any Berkshire repurchases will have to wait until the end of February when the 2018 annual report is released. After all, Berkshire doesn’t provide guidance.

Disclosure: Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway, and by virtue of such ownership, also own shares of Apple on a “look through” basis.

Ten Books Recommendations For The Holidays

Great books represent a terrific value proposition.  For a modest amount of money, or even free of charge at the local library, a reader can gain access to some of the greatest minds in human history.  We take it for granted today that most people can afford to read whatever they want, but this has not always been the case.  Books used to be indulgences available mostly to the wealthy.  Thomas Jefferson, who spent a fortune on his books, would be amazed by the selection and pricing on!

The ten books listed below, in no particular order, include some old classics as well as newer releases.  Most of them are not related to investing.  They are simply books that I have read over the past year and could be interesting selections to read over the holidays or to purchase as gifts.  A previous post provides a list of book recommendations specifically for investors.  All books ever reviewed on this site can be found in the book review archive.

All Quiet on the Western Front

World War I officially ended just over a century ago on November 11, 1918.  Veterans Day this year marked the occasion, although the last American veteran of WWI unfortunately did not live to see it.  The horrors of this war are described in this novel from the perspective of a young German soldier.  The Great War was thought to be “the war to end all wars” due to the extreme misery brought about by modern warfare and the determination of leaders in the post-war period to spare future generations of the same fate.  A century later, we know that these hopes were anything but fulfilled. War remains a constant presence and is more deadly than ever, with the added danger of global annihilation if nuclear war is ever allowed to break out.  This novel, originally published in 1928, tells the story from the perspective of an author not yet aware of the horrors that the coming years would bring.

The Idea Factory

The nature of research and development is that some ideas that seem initially promising may never lead to commercially viable opportunities.  Short term thinking and faulty incentives can lead executives to view R&D as a cost center rather than as a potential driver of future growth.  This book provides a history of Bell Labs, a remarkable institution that spanned six decades during the middle years of the last century and was responsible for numerous important innovations.  The angst over American business “no longer investing” is somewhat overstated given the tremendous success of American technology companies in recent years.  Shareholders with longer term horizons should encourage intelligent long term R&D investments and avoid setting up incentive systems for managers that are excessively short term oriented.

Leonardo da Vinci

If you have ever wandered through an art gallery in awe of what you are looking at but lacking any real understanding, Walter Isaacson’s wonderful biography of Leonardo da Vinci should be required reading.  Even those who normally read books on Kindle should purchase the physical hardbound copy because the book itself and the illustrations are very aesthetically pleasing.  Although the book is quite long, it is structured in such a way that most readers with intellectual curiosity will not be bored.  I read this book prior to a trip to Chicago in late 2017 and I think that it led to a greater appreciation of the art located in the Art Institute of Chicago and the Driehaus Museum.  Leonardo was a remarkable character with diverse interests and a true multidisciplinary mindset and a study of his life is well worth the time spent.

Jefferson and His Time: Volume 1

There are obviously many biographies of Thomas Jefferson but none provide the level of detail in Dumas Malone’s epic six volume biography written over the course of several decades starting with the publication of Jefferson The Virginian in 1948.  Each book covers a specific chronological period in Jefferson’s life and provides much more detail than would be possible in a single volume biography.  Many readers might not desire this level of detail and would be better served with a modern biography.  But those fascinated by the man or a specific period in his life might want to pick up one of Malone’s volumes.  I have read the first three volumes and found all of them to be worthwhile.  However, some readers may find Malone’s treatment to be overly deferential to Jefferson on the slavery issue and the books pre-date the DNA evidence related to Jefferson’s relationship with Sally Hemmings.

Skin in the Game

Nassim Nicholas Taleb despises “book reviews” and heaven help the reviewer who attracts his ire on Twitter. Taleb makes a good point that a book that can be reviewed, or synthesized into some set of basic points, is not one that is worth reading.  A book must stand on its own and not be subject to summarization.  Skin in the Game is the latest volume in Taleb’s Incerto series, described as “a landmark five-book investigation of uncertainty, chance, volatility, risk, and decision-making in a world we don’t understand”.  To get a flavor of the book, read The Intellectual Yet Idiot, a critique of the policy makers who would tell us “what to do, what to eat, how to speak, how to think, and who to vote for”.  Taleb’s style will rub some people the wrong way, but anyone with intellectual curiosity (who is not an IYI) will benefit from a serious consideration of his arguments.

Bad Blood

If you are looking for a book that will get your blood boiling, pick up a copy of John Carreyrou’s epic reporting on Theranos, the fraudulent blood testing company founded by Elizabeth Holmes.  With the aid of her accomplice, Ramesh “Sunny” Balwani, Holmes managed to deceive a cast of characters operating at the highest levels of venture capital and politics.  Theranos released products that flat out didn’t work or produced unreliable or invalid results for important medical tests that doctors and patients relied on.  This went on for much longer than it should have, in part due to the fact that Holmes managed to assemble a board of directors that knew little about medicine but was well connected in the political and business worlds. It is important for investors to be skeptical about young leaders with new ideas, but not to be unreasonably cynical.  The Theranos saga makes it difficult not to tilt too far toward cynicism.

Reminiscences of a Stock Operator

The more things change, the more they stay the same.  Anyone who has observed the cryptocurrency bubble over the past year might think that we’ve never seen anything that crazy in the past, but that is incorrect.  Originally published in 1923, Edwin Lefèvre presents a fictionalized account of the early life of “Larry Livingstone”, but Livingstone is really a pseudonym for Jesse Livermore. Livermore’s career began as a teenager in the “bucket shops” of the 1890s where he learned to speculate on securities.  What he engaged in was what we could call “day trading” today.  His career spanned several decades and he made and lost fortunes several times.  Livermore was a speculator, not an investor, but his observations and anecdotes are valuable for anyone interested in the mentality behind market madness.  Again and again, the reader comes across statements in the book that would ring as true today as they did a century ago.

Fahrenheit 451

This book might be best paired with 1984, George Orwell’s classic dystopian novel. Both novels deal with societies that have become totalitarian tyrannies barely recognizable to anyone living in a free society today.  In the case of Fahrenheit 451, books are banned and “firemen” are employed to immolate books and any homes in which they are found.  Like in 1984, the protagonist of this novel is just a cog in the totalitarian machine, yet a part of him remains that values freedom and rebels against tyranny.  Americans often take for granted our constitutionally protected rights, but they are under various assaults constantly.  It is worth reading novels dealing with the polar opposite of a free society just to remember that the state of affairs we enjoy is not inevitable and must be vigilantly defended whenever it is threatened.

The Complete Works of Montaigne

Any list of the “great books” of western civilization will inevitably include the essays of Michel de Montaigne.  Montaigne was born in 1533 in the Bordeaux region of France.  As a member of a wealthy Catholic family, Montaigne received a classical education.  Interestingly, his native language was Latin since French was prohibited in his household until the age of six. After a brief career in public service, Montaigne retired to the family estate at the age of 38 to devote himself to various intellectual pursuits.  Despite Montaigne’s elite standing in his society, his essays come across as down-to-earth and are surprisingly accessible to the modern reader, at least in Donald Frame’s translation.  Although lengthy, this book can be read over time since the content is comprised of relatively brief essays on various subjects that stand on their own.  So far, I have completed Book 1 of the essays and look forward to reading Books 2 and 3 along with the included travel journals and letters.

The History of Jazz

Ted Gioia’s book is a comprehensive account of the evolution of jazz.  The story is primarily about the individuals who defined this musical genre over many decades but it is also inextricably linked to the evolution of American cities such as New Orleans, Chicago, Kansas City, and New York.  Gioia spends considerable time providing insight into the social context of the music, especially within the African-American community.  Although at certain points the book delves into more detail than the casual jazz fan might prefer, it is still engaging especially if you listen to YouTube recordings of the various artists he covers.  In fact, it is probably impossible to enjoy this book without pairing it with the actual music.  One sad aspect of this book involves the early deaths of many of the musicians which is an unfortunate trend that extends to the history of rock and roll as well.

Disclosure:  The Rational Walk participates in the Amazon affiliate program and receives a small commission for all products purchased via links on this site.

Berkshire’s Repurchase Policy: Too Little, Too Late?

Berkshire Hathaway acquired $928 million of its own stock during the third quarter of 2018 through a series of purchases of Class A and Class B shares from August 7 to 24.  A repurchase of this size, relative to the company’s cash flow and market capitalization, would normally attract relatively little attention.  However, Berkshire has maintained an unusual policy with respect to return of shareholder capital in general and stock repurchases in particular.

Rational capital allocation is a problem that many companies never adequately resolve because the skill set of management is often more attuned to solving operational problems rather than allocating free cash flow.  However, Berkshire shareholders have benefitted from Warren Buffett’s superior operational and capital allocation skills for decades.  For almost all of Berkshire’s history, there was never any question regarding whether capital should be retained within the company.  Few shareholders would have been better off receiving dividends or selling their shares back to the company and reinvesting the after-tax proceeds elsewhere.  Mr. Buffett’s investment prowess fully justified full retention of all free cash flow generated by the business.

In 2015, Berkshire marked its 50th anniversary of Mr. Buffett taking full control of the company.  This was a natural time to look back on the history of Berkshire and, more importantly, to take a look at where the company might be a decade in the future:

The implications of Berkshire continuing to retain all earnings over the next decade while growing book value per share at a compound rate of approximately 10 percent are staggering.  If we take Berkshire’s 2015 net earnings of $24 billion as a baseline, reinvestment of all earnings would need to result in enough incremental earnings power to generate approximately $62 billion of net income for Berkshire by 2025.  We would expect retained earnings to increase by about $420 billion over the next decade.  Berkshire’s shareholders’ equity would approximate $675 billion by the end of 2025 based on these assumptions.  With this kind of track record, the market would most likely value Berkshire in excess of $1 trillion.

The idea of a trillion dollar company is no longer as novel today as it was a few years ago, but the numbers are still staggering.  We also pointed out in the article that Berkshire’s repurchase policy may well need to be changed in order to allocate a portion of the massive free cash flow likely to accrue over the coming decade and noted that the novel repurchase policy adopted by Berkshire could make it difficult to deploy cash via repurchases.  Berkshire had, for several years, limited repurchases to times when shares could be repurchased under a fixed price-to-book ratio which had been set at 120% since late 2012 after being established at 110% in 2011.

For critics of Berkshire’s repurchase policy, Berkshire’s updated repurchase policy announced on July 17, 2018 was welcome news.  A fixed price-to-book ratio limit was eliminated in favor of allowing repurchases anytime both Warren Buffett and Charlie Munger believe that the stock is trading “below Berkshire’s intrinsic value, conservatively determined” and when doing so would not reduce Berkshire’s holdings of cash and equivalents below $20 billion.  The news was very surprising to the market with shares closing up over 5 percent on July 18.  One caveat was that repurchases under the new policy would not be permitted until after Berkshire released second quarter earnings.  As a result, the first day that repurchases were permitted under the new policy was August 6.

Let’s take a look at Berkshire’s repurchase activity under the new policy.  Here is an excerpt from the recently released 10-Q report showing repurchase activity during the quarter:

It helps to put these repurchases into proper context by looking at Berkshire’s trading activity during that time.  The charts below, presented separately for Class A and Class B shares, were derived using data from Yahoo Finance:

We can see from the charts that there were two significant bumps in Berkshire’s trading price following the revision to the repurchase policy on July 17.  On July 18, the stock price rose significantly due to market expectations that repurchases were more likely to occur and, on August 6, the stock rose again in response to the release of second quarter earnings.  These price increases did not deter Mr. Buffett from repurchasing close to 9 percent of the company’s trading volume, in aggregate, over the period from August 7 to 24.  This is not to say that he regularly purchased some fixed percentage of volume, although perhaps he did, and repurchases could have been concentrated on specific days.  However, the average price paid of $312,807/A and $207.09/B is pretty typical for that range of dates.

After August 24, the stock price rose to a level where Mr. Buffett decided to halt repurchase activity.  We know that no further shares were repurchased between August 25 and September 30.  However, we can infer that additional shares were repurchased between October 1 and October 25.  We know this because Berkshire is required to release a recent share count along with its 10-Q report.  On the first page of the recently released 10-Q, we see the following:

Given the conversion ratio of 1,500 Class B shares per Class A share, the Class A equivalent share count on October 25 was 1,641,681 shares whereas the Class A equivalent share count was 1,642,269 shares on September 30.  Berkshire typically issues a very small number of shares every year so we cannot simply subtract the October 25 share count from the September 30 share count.  However, we can infer that at least the difference of 588 A equivalents were repurchased between October 1 and October 25.  This is a relatively small deployment of capital – probably around $185 million.  Obviously shares were available during this timeframe well under the levels paid during the August repurchases.

What can we infer from these repurchases regarding what Mr. Buffett and Mr. Munger think of Berkshire’s intrinsic value, “conservatively calculated”?  Since Berkshire’s repurchase policy was based on book value for several years, it is logical to start by considering what price-to-book ratio was paid for the August repurchases.  Mr. Buffett made a point to wait until after second quarter results were released prior to initiating any repurchases.  June 30, 2018 book value per share was $217,677/A and $145.12/B.  The average price paid for the August repurchases was 1.437x book value for the A shares and 1.427x book value for the B shares.  This is substantially higher than the prior 1.2x book value limit and quite surprising.

We do not know the price or timing of the repurchases that took place from October 1 to 25, and there are sometimes “quiet periods” that limit companies from freely repurchasing stock prior to releasing earnings.  However, we know that Berkshire traded below the average level of the August repurchases from October 11 to 25.  Additionally, we know that Berkshire’s book value rose to $228,712/A and $152.47/B as of September 30.  Berkshire’s A class stock price on Friday, November 2 closed at $308,411 which is slightly under 1.35x book value.  With the caveat that the recent stock market correction has put pressure on Berkshire’s book value due to its large holding of marketable securities, it seems like we can still infer that Mr. Buffett and Mr. Munger view Berkshire’s stock to be trading below conservatively calculated intrinsic value.

Although we are still awaiting the release of Berkshire’s 13-F report which will reveal the company’s U.S. equity portfolio as of September 30, astute observers have already inferred from the 10-Q that Berkshire was a heavy buyer of common stocks during the second quarter.  Although an analysis of what Berkshire may have been doing in its equity portfolio during the quarter is beyond the immediate scope of this article, it is worth pointing out that the scale of Berkshire’s repurchases are quite small compared to its overall free cash flow and its allocation of capital into the stock of other companies.  This could be due to a variety of factors.  Mr. Buffett and Mr. Munger could believe that Berkshire is undervalued but not as undervalued as other opportunities in public markets.  It could also be due to the relative lack of trading volume in Berkshire’s stock which could put a cap on how much Berkshire can repurchase without pushing up the price dramatically.

Shareholders who were hoping for very large repurchases relative to Berkshire’s market capitalization or free cash flow will probably be disappointed with the magnitude of actual repurchase activity in the third quarter.  It could be that the peculiarities of Berkshire’s shareholder base and trading volume will make it difficult to execute large repurchases and that activity will be more modest.  However, over long periods of time, a significant reduction of the share count is still a possibility.

One cannot help but wonder how much lower Berkshire’s share count might be today had the present repurchase policy been adopted in 2011 rather than the policy that imposed the 110 percent of book value limit.  We now know that Mr. Buffett and Mr. Munger view a price below 140 percent of book value as a definite bargain.  Although we must note that the ratio between intrinsic value and book value can change over time, we can see that the price-to-book has been below 140 percent for substantial periods since 2011:

Would Berkshire shareholders have been better off with aggressive repurchase activity at various times since 2011 given that the stock price has traded below management’s view of intrinsic value for much of this time?  This is a complicated question to answer because obviously Berkshire has utilized its resources for other purposes during the past several years.  However, the presence of a large amount of undeployed cash on the balance sheet for a long period of time has signaled a dearth of opportunities and, for much of this time, management was unable to capitalize on an undervalued bargain in the form of the company’s own stock due to the constraints imposed by the 2011 and 2012 repurchase authorizations.

The updated repurchase policy is well overdue and hopefully will not be “too little, too late” when it comes to Berkshire’s overall capital allocation over the next decade.  We should, however, note that this new repurchase policy places no more of a “floor” on the stock price than the old policy.  Markets can and will do crazy things and Berkshire’s stock will certainly trade at depressed levels at times in the future.  Now, management has full flexibility to take advantage of such times.  Despite occasional criticism by the uniformed and/or politically motivated, repurchases can be a very intelligent way to deploy capital under the right circumstances.  The key issue is to avoid overpaying and there seems to be little risk of that happening at Berkshire.

It is also worth noting that for many longtime shareholders with a low cost basis, Berkshire represents a particularly tax advantaged way of compounding wealth.  Allocating capital to repurchases rather than dividends, as long as repurchases are below intrinsic value, will have the effect of increasing unrealized capital gains and continue tax efficient compounding for continuing shareholders.  The alternative of receiving dividends would result in immediate tax consequences and interrupt the snowballing tax deferred compounding machine known as Berkshire Hathaway.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.

The Pitfalls of Early Success – A Personal History

“Success makes people think they’re smart.  That’s fine as far as it goes, but there can also be negative ramifications.”

— Howard Marks 

The investing profession tends to attract individuals who, to put it politely, have a healthy sense of self esteem.  After all, anyone who actively invests is essentially saying that their views regarding investments are superior to the collective wisdom of the rest of the market.  Without this underlying belief, it would not be possible to think that one can outperform a passive index and it would make no sense to spend a career pursuing superior performance.  However, investors often get into trouble when they permit a healthy self esteem to evolve into arrogance and hubris that allows no intellectual room for the possibility of being wrong.  There is a huge difference between conviction in one’s skills and delusions of infallibility.

Contrary to what many may wish to believe, random luck plays a major role in one’s life experiences and prospects for overall success.  As Warren Buffett often says, he won the “ovarian lottery” by being born into a successful and prominent family in the United States in 1930.  His unusual numeracy at a young age served him extremely well whereas it would have been of limited value had he been born into a small hunting and gathering tribe in Africa in 3000 BC.  His success is a combination of the circumstances and timing of his birth, his innate intelligence, and hard work.  Only the hard work was under his direct control.

Howard Marks makes many important observations in his latest book, Mastering the Market Cyclebut perhaps the most intriguing points have to do with the role of human nature and emotion.  Chapter 16 deals with the cycle in success, much of which has to do with human nature.  The seeds of failure are often planted during periods of success due to the extent to which our mentality changes when we are doing well.  To the extent that success makes us arrogant, we are more likely to tune out evidence contrary to our own beliefs without a thorough examination of the facts.  We always need to remember that when we make the decision to buy or sell an investment, we are making an affirmative statement that we know more than the market and that even though the market often seems “crazy”, it is made up of thousands of investors just like us who are trying to achieve the same objective – outperformance.  We must always be thinking about what makes our views better than the market consensus – in other words, what is our edge?

Warren Buffett was born in 1930 and came of age during the post World War II boom and inflation and the subsequent economic expansion of the 1950s.  These early experiences shaped his outlook and also presented him with a set of opportunities.  Would his career have been different if he had been born in 1910 rather than 1930?  He would have come of age right at the tail end of the 1920s boom and his formative experiences would have been in the context of the Great Depression rather than the post-war economic boom.  What if he had been born in 1950 rather than 1930?  He would have come of age during the turbulent late 1960s, possibly have been drafted into the Vietnam War and, from an investing perspective, would have started out in the Nifty Fifty era followed by the dismal 1973-74 bear market.  It is likely that Mr. Buffett would have joined the ranks of the super rich no matter which era in the 20th century he was born into, but being born in 1930 probably was an advantage over being born 20 years earlier or later.  Of course, we will never know for certain.

Clearly, the timing of one’s career plays a big role in the type of opportunities available.  However, the experiences of a particular era probably have an even greater impact on how we see the world.  In the context of the stock market, if we start out in a bull market, we are likely to see the world much differently than starting out in a bear market.  Furthermore, if we have early success in any type of market that was really the product of luck rather than skill, we are almost certain to attribute this success to skill anyway and draw the wrong conclusions from the experience.  Those incorrect conclusions could very well lead to extremely negative consequences.  As Mr. Marks says, “success isn’t good for most people”, especially if that success is due to luck rather than skill.

Would you rather have a string of successful outcomes early in your career, or is it better to be tested with various types of adversity?  Obviously, early success can be much more pleasant.  And certain individuals will just give up if there is too much early failure.  However, we need to keep in mind that from an investing perspective, most individuals have much less to work with early in their career.  Granted, small amounts of money early in life can potentially compound into huge sums later on so decisions at an early age are important.  However, there is also something to be said for making a major mistake with $10,000 of capital rather than $10 million at stake.

As a member of Generation X who was interested in making money from a very early age, I was clearly impacted by the economic boom of the 1980s and, although I had no money invested in stocks during the 1987 crash, I still remember watching Wall Street Week on the Friday after the crash.  Louis Rukeyser’s opening is still worth watching today.  Having no real understanding of stocks, my natural reaction was amazement that so much money could be lost in the blink of an eye and I had no desire to lose my morning paper route and after school job earnings.  However, the crash was fascinating enough to get me to follow stocks and eventually major in finance in college.

My first venture into investing was the Vanguard Wellington fund sometime in the early 1990s.  Wellington was one of the oldest mutual funds in existence which, along with its “balanced” portfolio seemed like an appealing place to put some money.  However, it was boringly conservative by the time I graduated in 1995 armed with what seemed like “all the answers” that I needed to outperform.  I decided to take higher paying work in software with the idea that I would live frugally and invest my savings.  By the mid 1990s, the technology boom was well established but had not yet reached the insanity of the late 1990s, and I was immersed in the technology world since I worked in software in the Silicon Valley.  I sold my mutual funds and went to the library to read Value Line on Saturday mornings, but 60-80 hour weeks in software limited my free time.  Eventually I purchased Intel stock and let it ride for a number of years.  I also purchased real estate and benefited from the late 1990s housing boom in the Silicon Valley.

Having the good fortune to read The Intelligent Investor and Buffett: The Making of an American Capitalist in 1995 made a lasting impression and allowed me to see the bubble of the late 1990s for the insanity that it was.  I was not tempted to purchase dot com stocks and when the value of my Intel stock rose spectacularly, I was not blinded by that success and kept an eye on the valuation.  Through a combination of luck and thanks to Benjamin Graham, I sold my shares of Intel in early 2000.  My reading about Warren Buffett’s career as well as the decline in Berkshire Hathaway stock led me to put the proceeds of my Intel sale into Berkshire in February and March 2000.  My second purchase of Berkshire stock, on March 9, 2000, represented perfect timing.  I had come very close to nailing the bottom tick and had substantial paper gains after the annual report was released shortly after my purchase.  Although I’ve made plenty of subsequent mistakes, I still hold those original shares of Berkshire that were purchased with nearly perfect timing.  I did not nail the timing of the Intel sale quite as well but a year later I felt like a genius for sidestepping the large decline in Intel shares.  The combination of avoiding loss by selling Intel and achieving gains in Berkshire was the mental equivalent of taking drugs:  I viewed myself as an investing genius for many years thereafter.

A heavier workload in my software career put me on the investing sidelines for the most part for several years but I continued to save the majority of my income and opportunistically purchased Berkshire Hathaway shares when they looked attractive, and also sometimes when the shares were not that attractive.  Nevertheless, I posted a respectable overall record during the period leading up to the 2008-09 market crash.  The combination of returns on my investments, new savings and the sale of another real estate property caused my portfolio size to be far larger as I approached the 2008 crash than it had been in 2000.  My success in early 2000 was real, but partly due to luck and only partly due to my insights from reading Graham and Buffett.  But whether due to skill or luck, my capital base was tiny in 2000 compared to 2008.  The “genius” of my moves in 2000 on a small capital base made me feel invincible with a much larger capital base in 2008.

My results in 2008 were horrific but I still managed to beat the S&P 500 by 8 percent.  Although the magnitude of my losses were great, I was still “winning” relative to the market averages and I finally went into investing full time almost exactly at the early 2009 market lows (which is also the time when I launched The Rational Walk).  I had every reason to believe that I had substantial skill due to my track record and while I was not oblivious to the role of luck, I viewed skill to be the paramount factor in my historical success.

In retrospect, it seems obvious that early 2009 was a time to buy, and it also seems obvious that at that type of inflection point in a market cycle the biggest gains would accrue to those who aggressively purchased leveraged companies that were viewed as being at risk of bankruptcy but subsequently pulled through.  In other words, it paid to be very aggressive at that time.  My decision was to become increasingly conservative.  Part of the reason had to do with becoming a full time investor.  I knew that I would have to live off my investments so my level of risk aversion increased at precisely the time that I should have become more aggressive.  However, I also believed that greater bargains would likely be available later.  I thought that the market had further to fall.

The short story is that I underperformed the S&P 500 by nearly 21 percent in 2009.  I missed one of the greatest buying opportunities of my lifetime and did so with a capital base far greater than I had in 1999-2000.  The experience of 2009 forced me to reassess my strengths and weaknesses and to be more introspective regarding my abilities.  I did not reflexively lose all of my confidence but I had more humility at the end of 2009 than I did at the beginning.  I went back to the basics and re-read Graham, studied Buffett and his letters to shareholders, and fundamentally sought to learn from my experience.  I went on to post respectable performance in subsequent years, but I will never have 2009 back and the drag from the underperformance of that year cannot be undone.

In retrospect, my early success with a small capital base in 1999-2000 resulted in a level of overconfidence and hubris that made me think that I had the ability to time the market in 2008-09.  After all, I had almost perfectly timed my purchase of Berkshire in 2000 so I must have had a “knack” for these things.  The early success on a small capital base played an important role in a major failure in 2009 on a much larger capital base.  Earning returns in 2009 of less than 6 percent when the S&P 500 rose more than 26 percent is a mistake that cannot be undone but one can learn from such experiences and seek to improve in the future.  Ultimately, we are products of our experiences as well as luck.  Sometimes what seems like good fortune, in the form of early success, can actually be worse than the reverse.  Had I encountered more adversity in 1999-2000 with a small capital base, perhaps my results with much more capital in 2009 would have been better.

Book Review: Sapiens – A Brief History of Humankind

There are many aspects of life where the link between cause and effect is very clear.  Humans, as well as many other animals, quickly learn that taking a certain action invariably leads to a predictable and reliable result.  For example, just as other animals, we respond to bodily sensations such as hunger or thirst by finding food and water and consuming it.  We also learn to interpret all sorts of environmental factors in ways that have been conditioned into our minds.  We respond to such stimuli almost automatically.

Daniel Kahneman, in Thinking, Fast and Slow, refers to “system one” thinking as an automatic, fast, and unconscious way of thinking.  When we are crossing the street and we hear the sound of screeching tires behind us, adrenaline and cortisol hormones surge in our bodies to alert us to impending danger and we take action automatically in response.  This response is not that different from the reaction that a squirrel might have when it sees a large bird flying above the telephone wire that it is using to get from one tree to another.  System one thinking has served us well in myriad settings for all of human history but it also can lead us astray in an increasingly complex society.  Human beings, to be successful in our modern world, must increasingly utilize “system two” thinking which is characterized by slow, effortful, conscious, and calculating thought.  Danger awaits humans who respond to situations requiring system two thinking with simplistic “gut responses” driven by system one thinking.  (For more on Daniel Kahneman, see this review of The Undoing Project by Michael Lewis.)

Economics is the study of how human beings produce, distribute, and consume goods and services.  It is considered a social science because the key elements of how an economy works depend on the actions of economic actors rather than laws of nature or the output of a computer algorithm.  The study of how financial markets work is, fundamentally, a subset of the study of economics.  However, academics have long attempted to reduce the study of financial markets to overly precise equations more appropriate for a “hard science” like physics.  In reality, those who are interested in finance would be better off if they devote considerable attention to human psychology.  Popular books on psychology such as Thinking, Fast and Slowhave improved our understanding of human cognitive mistakes.  However, to really understand human beings, we might want to take a step back and survey the fields of evolution and anthropology.  It is in these areas of study that Yuval Noah Harari’s recent book, Sapiens:  A Brief History of Humankind, has made a meaningful contribution to our understanding of what makes humans tick.

It is useful to take a step back and consider human history in the context of some very large numbers (the following is a condensed re-statement of the “Timeline of History” included in the book):

Years Before Present    Event                                                    
13,500,000,000          Matter and energy appear
 4,500,000,000          Formation of Earth
 3,800,000,000          Emergence of organisms
     6,000,000          Last common ancestor of humans and chimpanzees
     2,500,000          Evolution of the genus Homo in Africa
       500,000          Neanderthals evolve in Europe and Middle East
       300,000          Daily usage of fire
       200,000          Homo sapiens evolves in East Africa
        70,000          Cognitive revolution and emergence of fictive language
        30,000          Extinction of Neanderthals
        13,000          Extinction of Homo floresiensis
        12,000          Agricultural revolution
         5,000          First kingdoms, money, and polytheistic religions
         2,000          Christianity
         1,400          Islam
           500          Scientific revolution
           200          Industrial revolution

What we often perceive to be “long periods of time” are, in fact, nothing but tiny blips on the radar when it comes to overall history.  Until 70,000 years ago, human beings were “animals of no significance” according to the author.  It isn’t that human beings did not exist prior to 70,000 years ago.  Creatures that were very similar to modern humans first appeared about 2,500,000 years ago but they did not stand out from the other animals that shared their habitat.  Humans went along, generation after generation, without distinguishing themselves in any particular way and were just part of the overall food chain.  However, humans did many of the same things they do today.  While humans played, formed various relationships and competed within their social groups, the same was true for other primates such as chimpanzees and baboons, as well as elephants and many other creatures.

Amazing advances took place about 70,000 years ago that allowed Homo sapiens to shoot ahead of other human species and other animals.  Prior to that point, sapiens did not have a capability called fictive language.  Humans, as well as other animals, had long had the ability to communicate factual information about the here and now.  Studies have been done that show that certain monkeys have specific calls that warn about various dangers in surprising detail.  For example, there are specific calls that warn about lions and eagles since the necessary response is different in each case.  Humans had the capability to communicate about the present but could not conceive of the concept of fiction.

Fictive language involves the ability to use imagination to describe things that are entirely abstract.  The concept of religion*, for example, describes a set of beliefs that cannot be observed by ordinary human beings but, nonetheless, allows humans to form a common set of beliefs and customs.  Without fictive language, it is difficult for groups larger than about 150 individuals to form a cohesive society because they lack the ability to develop “fictions” that bind together larger populations.  The development of the notion of religion and nationality allowed much larger groups of humans to form social bonds.  Two humans who meet each other for the first time cannot know how to interact without a common set of underlying beliefs.  Just as two Roman Catholics or two Germans meeting for the first time today will already share a lot in common, humans after the cognitive revolution had the ability to understand each other much more fully after the emergence of fictive language.

Until the agricultural revolution, which took place about 12,000 years ago, humans were primarily hunters and gatherers who lived a nomadic lifestyle and did not generally settle in permanent villages or cities.  The development and use of “system one” thinking and “fight or flight” instinct was necessary for survival.  You and your family or tribe would eat, or not eat, based on the success of your hunting and gathering activities in the very near term.  The development of agriculture fundamentally changed human society by making it possible to settle in permanent villages and for some members of a society to engage in activities other than those needed for immediate survival.  Agriculture also made it necessary to analyze and plan for the future.  In other words, the development of agriculture made it necessary to utilize “system two” thinking – slow, effortful, calculating, and long range in nature.

Take another look at the table above showing key developments in history.  12,000 years seems like a long time to us, but it is less than one-half of one percent of the time since the first humans appeared in Africa 2.5 million years ago and only six percent of the time since Homo sapiens first appeared 200,000 years ago.  The vast majority of our time as a species has been spent in hunter/gathered mode where “system one” thinking was paramount for survival.  Not only was a refinement of “system two” thinking unnecessary for survival but it would have been a liability.  When you see a predator on the horizon, taking immediate action is required and analysis is a liability.

A major problem with the way that most of our minds work is that, in evolutionary terms, we are still basically designed to optimize for conditions that our hunter/gatherer ancestors faced but are largely irrelevant to our modern lives.  The acceleration of human advancement through the scientific and industrial revolutions has been remarkable for such a short period of time and change seems to be accelerating even more rapidly than ever before.

Charlie Munger often talks about the psychology of human misjudgment.  The study of psychology can help us better understand how human beings think which, in turn, helps us understand how complex social systems operate.  The study of economics and financial markets, if done without an underlying understanding of psychology, is destined to be superficial and prone to misunderstanding.  As Mr. Munger might say, without an understanding of psychology, you would be like a “one legged man in an ass kicking competition”, compared to those who do have a better understanding.

By reading books such as Sapiensthe reader comes away with an enhanced understanding of how humanity developed over a very long period of time, puts that development into an evolutionary context, and can help to answer why humans tend to think the way they do.  It would be folly, however, to think that we ourselves have somehow ascended to a higher intellectual plane simply by understanding these topics.  The best we can do is to understand where we came from, what we have evolved to do well, and how we might be prone to making errors.  Immunity from such errors is beyond our reach.  Some think that we can develop artificial intelligence that is super-rational and reaches an intellectual and decision making plane that surpasses our own.  If this ends up being the case, artificial intelligence may end up surpassing humanity and result in our extinction. The author’s new book, Homo Deus, apparently delves further into the question of where we go from here.


* The author comes across as somewhat insensitive to religious people when repeatedly describing their beliefs as “fictional”.  It seems unnecessary since we can arrive at similar conclusions regarding the development of humanity without dismissing the possibility of humans who had special insights or divine inspiration.  Rather than “fictional”, one might prefer to think of language capable of describing abstract, or unobservable, things that cannot be perceived by ordinary humans.  The conclusions drawn by the author need not preclude the possibility of religion. 


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