Book Review: A Man For All Markets

The team of six, three men and three women, pretended not to know each other and made their way to the baccarat tables at the Dunes casino in Las Vegas.  It was the spring of 1963 and Las Vegas was still controlled by shady characters connected to the mafia.  It was the fourth night at the tables and the pit boss and casino management had taken note of the lead player’s wins and were not happy.  However, on this night, the pit boss was smiling and offered the player coffee with cream and sugar “just the way you like it”.  Shortly into the first round, the player sips his coffee and suddenly couldn’t think! He had been drugged.  A few days later, as the team of six left Las Vegas, their car’s accelerator suddenly stuck as they traveled down a mountain road.  A terrible “accident” was narrowly averted through use of the emergency brakes.

As Nassim Nicholas Taleb points out in the forward to A Man For All MarketsEdward Thorp has written a book that, at times, reads more like a James Bond thriller than the memoir of a mathematician who ventured outside his academic field to beat casinos, both in Las Vegas and on Wall Street.  Conventional wisdom in the 1950s held that it is impossible for players to gain a consistent edge in games such as blackjack, baccarat and roulette.  Driven by an innate sense of curiosity and powered by raw intellect, combined with some help from early computer technology, Ed Thorp demonstrated that players could gain an edge in blackjack through straight forward card counting methods.  After proving the theory through hands-on testing at the casino tables in Reno, Mr. Thorp published his findings in academic journals as well as in Beat the Dealera book that made card counting accessible to the non-technical reader and remains relevant to gamblers today.

While the methods for gaining an edge in baccarat were similar to those used in blackjack and could be pursued through human intellect alone, the challenge facing the roulette player was far more complicated.  The nature of roulette implies a built-in advantage for the casino and casts doubt on the wisdom of participating at all since the expected value of a large number of bets will be negative for the gambler.  However, the fact that many roulette wheels are not perfectly aligned and maintained implies that a gambler could gain an edge by waiting until the wheel and ball is in motion and betting based on minor flaws in the wheel.  Of course, the human eye is not sensitive enough to detect imprecision in the wheel without the aid of technology.  Mr. Thorp, in collaboration with Claude Shannon, developed the first wearable computer which was intended to provide the gambler with an edge in roulette.  The computer was first conceived in 1955 and was tested in Las Vegas in 1961.  It provided the gambler with an expected gain of 44 percent but minor hardware problems prevented serious betting and the technology was unveiled to the public in 1966.

From Casinos to Wall Street

Perhaps the stock market was a natural and inevitable next step for Mr. Thorp after achieving success in casino gambling.  The problem with Mr. Thorp’s methods for beating the dealer is that it attracted attention from unsavory characters associated with the casino industry, as the adventures of 1963 at the baccarat tables of Las Vegas demonstrated.  Surely, the life expectancy of someone gambling in the greatest casino of them all — the stock market — would be far greater than someone confining himself to the smoky casino halls of the 1960s.

In the idealistic view of economics, the stock market is a venue for providers of capital to invest in promising businesses that have the ability to generate attractive returns on capital.  Of course, there is an element of truth in this sentiment since capital is indeed provided to business via the stock market.  However, the volume of trading in the stock market makes it clear that the majority of activity has little to do with providing capital to business or allocating capital to its best and highest use.  Instead, in the short run, the stock market more closely resembles a casino with players who are interested in making quick gains.  The debate over whether the stock market is “efficient” has been raging for decades with academic theorists insisting that there are no systematic ways to outperform market averages without assuming proportionally more “risk”, as defined by the volatility of an individual stock relative to the overall market.

Mr. Thorp naturally was attracted to this giant casino which lacked the shady characters and dangers of Las Vegas, imposed no “table limits” that constrained the capital he could deploy, and had rules that did not change suddenly in the middle of play just as the player was on a winning streak.  Lacking any background related to investing, Mr. Thorp spent the summer of 1964 educating himself, as he had on many other subjects earlier in life.  He included Graham and Dodd’s Security Analysis in his reading but also went further into scores of other books including the study of technical analysis.  Early forays into investing in the silver market produced unsatisfactory results but Mr. Thorp’s self education continued, eventually reaching the subject of common stock warrants.

Warrants and Arbitrage

The value of a warrant on a common stock is derived based the difference between the current stock price and the exercise price of the warrant as well as the amount of time before the warrant expires.  A warrant will always have a positive value prior to expiration even if it cannot be exercised immediately at a profit because the possibility exists that it will become profitable to exercise prior to expiration.  Mr. Thorp came up with the idea of developing mathematical models to determine whether warrants are mispriced relative to the price of the common stock.  By purchasing the relatively underpriced security and shorting the overpriced security, one can exploit the market’s mistake without necessarily expressing an opinion on the merits of investing or shorting the underlying business.

Through collaboration with a colleague in U.C. Irvine’s economics department, Mr. Thorp came up with a system for capitalizing on mispriced warrants and published the results in Beat the Market which was released in 1967.  One might ask why Mr. Thorp was willing to share his discoveries with the public, first with his technique for winning in blackjack and again with warrant mispricing.  Obviously, the more people who are employing a strategy, the less likely it will continue working as envisioned.  The casinos would become aware of card counting and take countermeasures to deal with it, some of which proved to be physically dangerous.  Stock market participants wouldn’t break your legs but would exploit a published strategy.  As underpriced securities are purchased, they become less inexpensive and as overpriced securities are sold, they become less overpriced.  Why give away the secrets?

Mr. Thorp’s ambition early in life was to excel in academia and he appears to have embraced the ethos of viewing scientific research as a public good.  He was also confident that he would have more ideas that could be exploited for monetary gain.  Shortly after publishing Beat the Market, Mr. Thorp independently came up with the formula that would later become known as the Black-Scholes pricing model for options.  Academics Fischer Black and Myron Scholes, who were partly motivated by Beat the Market, came up with their famous formula and published the findings in 1972 and 1973.  It appears that the formula should be known as Thorp-Black-Scholes, if not attributed entirely to Mr. Thorp.

Meeting Warren Buffett

The story takes a very interesting turn when Mr. Thorp is invited to meet Warren Buffett in 1969.  Mr. Thorp had started to manage accounts for clients, one of whom was the dean of the graduate school at U.C. Irvine, Ralph Waldo Gerard.  Mr. Gerard had been a limited partner in the famous Buffett Partnership which was in the process of winding down at the time.  Investors in the Buffett Partnership would be receiving cash plus the option to receive shares in Diversified Retailing and Berkshire Hathaway.  In retrospect, we can say that people who took cash rather than shares were crazy but virtually no one at the time thought that Berkshire would become Mr. Buffett’s investment vehicle for the next half century.

Mr. Gerard was planning to take cash and wanted Mr. Buffett’s opinion regarding Mr. Thorp.  Both men had employed warrant hedging and merger arbitrage strategies and spoke about it during a lunch arranged by Mr. Gerard.  Although Mr. Buffett’s style of investing extended far beyond Mr. Thorp’s activities, he apparently had a positive overall assessment since Mr. Gerard ended up investing additional funds with Mr. Thorp.

Princeton Newport Partners

At the time, Mr. Thorp was managing about $400,000 and the accounts were grossing about 25 percent a year, with 20 percent of profits payable to the general partner.  Mr. Thorp’s $20,000 income from the partnership was equivalent to his salary as a professor and would only accelerate in the coming years as Princeton Newport Partners attracted additional assets and enjoyed steady success.  Mr. Thorp retained his professorship for several years before finally dedicating all of his time toward investing in the early 1980s.

Princeton Newport employed a true “hedge fund” strategy, meaning that it was designed to be market neutral and profitable regardless of the movement in the overall stock market.  Today, what we call “hedge funds” are usually not market neutral funds of the type Mr. Thorp ran but are instead usually net long or net short, meaning that managers are taking a directional view of their holdings or the market as a whole.  Mr. Thorp focused on identifying opportunities that could be hedged in a way that did not depend on the movements of the overall market.  This resulted in a nearly twenty year track record in which the fund never posted a loss over a single calendar quarter.  From November 1, 1969 through the end of 1988, Princeton Newport Partners posted an annual compound return of 19.1 percent before fees, and 15.1 percent after fees.  This compared favorably to the S&P 500 annual return of 10.2 percent, but more importantly, it was accomplished with a small fraction of the volatility of the overall market.

Princeton Newport ran into trouble in late 1987 when the IRS and FBI raided the firm’s Princeton headquarters which housed the trading operations.  Rudolph Giuliani, who was then a politically ambitious U.S. Attorney, was on a campaign to prosecute suspected Wall Street criminals and was looking for information to bolster his case against Michael Milken at Drexel Burnham and Robert Freeman at Goldman Sachs.  Several employees of the Princeton office ended up facing charges but no one in the Newport office, run by Mr. Thorp, were ever implicated.  However, the damage had been done.  Returns in 1988 were only 4 percent as the firm was distracted by the investigation and Mr. Thorp decided to leave at the end of 1988, after which point the partnership eventually wound down.

Bernie Madoff

Mr. Thorp was already a very wealthy man as Princeton Newport liquidated.  Rather than immediately starting another large fund, he stepped back for a while but still provided consulting services related to hedge fund selection.  It was in this context that he encountered the Bernie Madoff fraud seventeen years before it ultimately collapsed.  The first warning sign was the evasive behavior of Peter Madoff who was filling in for Bernie during Mr. Thorp’s planned office visit.  Peter made it clear that Mr. Thorp would not even be allowed through the front door.

Mr. Thorp was not deterred and went on to examine the accounting records that the Madoff firm had provided to his client.  These records conclusively proved that the Madoff operation was a scam:

“After analyzing about 160 individual options trades, we found that for half of them no trades occurred on the exchange where Madoff said that they supposedly took place.  For many of the remaining half that did trade, the quantity reported by Madoff just for my client’s two accounts exceeded the entire volume reported for everyone.  To check the minority of remaining trades, those that did not conflict with the prices and volumes reported by the exchanges, I asked an official at Bear Stearns to find out in confidence who all the buyers and sellers of the options were.  We could not connect any of them to Madoff’s firm.”

The result of Mr. Thorp’s investigation saved his client from continued participation in the fraud.  The client closed his accounts.  Mr. Thorp made it known within his network that the Madoff operation was a Ponzi scheme.  The establishment at the time would not have believed that Bernie Madoff could be a fraud.  He was a major figure in the securities industry and other attempts to unmask his operation were ignored as well.  It is amazing that the Securities and Exchange Commission never uncovered this fraud.  At the end, Bernie Madoff turned himself in when it became obvious that the game was over in December 2008.

Personal Finance 101

The last few chapters of the book delve into a number of personal finance topics that, while perhaps unexpected in a memoir, provide many good insights for both beginning and experienced investors.  Mr. Thorp goes through the facts and figures associated with wealth in the United States, explains the power of compound growth, examines whether one can beat the market today, looks as indexing strategies as a potential passive approach, and then considers how investors should allocate their wealth between asset classes.

The fact that Mr. Thorp dedicates this much space in his memoir to personal finance indicates that he believes lack of education in this area is a serious impediment to the well being of the public.  He believes that personal finance should be taught in elementary and secondary schools, noting that most people seem to not understand basic probability and statistics.  Clearly, if more Americans understood the power of compound growth when leaving high school, there would be far fewer cases of misery caused by mistaken accumulation of debt and lack of savings.

Although not the focus of the book, many readers will find Mr. Thorp’s treatment of personal finance worthwhile.  The question of whether to attempt to beat the market or not is ultimately a personal decision.  Those who wish to make the attempt must choose between finding managers who can hopefully outperform the market after taking into consideration their fees or must do the work required to personally manage the account.  Indexing seems to be the right choice for the vast majority of people.


Mr. Thorp concludes with a compelling account of the causes and aftermath of the financial crisis.  The follies described may be familiar to most readers but will be an eye opener for some.  Although it would be comforting to believe that a similar crisis will not occur in the future due to wise regulatory changes, Mr. Thorp seems rather pessimistic regarding the efficacy of the reforms put in place after the crisis.  Perhaps his strongest indictment involves the corrupt corporate governance that insulated management at the expense of shareholders and continues to this day.  The incentive structures prevalent in corporate America today are largely unchanged and destined to cause trouble in the future.

Warren Buffett reappears toward the end of the book as Mr. Thorp notes his use of Berkshire Hathaway shares to endow a chair in mathematics at U.C. Irvine.  In a move similar to Warren Buffett’s gift to the Bill and Melinda Gates Foundation (but predating it), Mr. Thorp donated Class A Berkshire stock to the university and directed that shares should be converted to Class B stock and sold slowly in order to fund the endowment.  Like Mr. Buffett’s instructions to the Gates Foundation, Mr. Thorp insisted that his gift would result in funding for additional research that would not otherwise have been funded through existing financial resources of the university.  Unlike Mr. Buffett’s intention for his gift to the Gates Foundation, Mr. Thorp would like his gift to continue to provide funding for the chair in perpetuity.  As such, he limited the annual draw from the endowment to only 2 percent. Since 2003, size of the endowment has more than doubled after accounting for yearly spending.

Mr. Thorp’s memoir is likely to be appreciated by more than one type of reader.  Gamblers and investors will naturally be fascinated by the detail he provides, but those focused on public policy will find his views on the financial crisis compelling and readers less familiar with personal finance will have the bonus of a brief lesson and some actionable advice.  Perhaps the most important lesson to take away from this book is that intellectual curiosity combined with a refusal to blindly accept conventional wisdom is almost always required to advance human knowledge and, in some cases, achieve great wealth.

The Autonomous Vehicle Revolution

It is no accident that the rapid rise in living standards over the past century has coincided with tremendous technological progress throughout the economy.  At a fundamental level, rising living standards require the economy to generate an ever-increasing supply of goods and services through intelligent utilization of the fundamental factors of production:  land, labor, and capital.  Improvements in technology are reflected in the quality of capital goods, the ability of individuals to be more productive through enhancements in human capital, and better uses of limited natural resources.  Progress on a per-capita basis is required for individuals, on average, to see growth in the economy translate into a higher standard of living.

Given the importance of technology in the economy, it is interesting to read Warren Buffett’s frequent statements regarding “not understanding” technology.  He has expressed this sentiment in Berkshire Hathaway annual reports for many years as part of a discussion of the company’s acquisition criteria.  However, what he appears to be saying is that Berkshire does not have a competitive edge when it comes to acquiring technology companies, not that Berkshire itself is somehow immune to technology or does not seek to adapt to technological progress.  This reality seems to have gone unnoticed among some value investors who repeat Mr. Buffett’s assertion regarding technology and take it as a license to totally ignore the impact of technology on the economy in general and on their investments in particular.

The Opportunity

According to the Bureau of Transportation Statistics, there were over 260 million registered vehicles on the road in 2014.  Currently, almost all of these vehicles have no autonomous features and are controlled by human drivers.  The amount of time and energy spent controlling vehicles on the road is obviously very significant.  According to the U.S. Census Bureau, it takes the average worker 26 minutes to commute to and from work which implies that the 139 million workers in the United States collectively spent 29.6 billion hours traveling to and from work, the vast majority in a private automobile controlled by a human driver.

Driving a two ton vehicle on public roads is something that does not lend itself to multitasking, at least not safely.  Fully autonomous vehicles adopted throughout the economy would free up all of this time for other endeavors, including work, and would very likely cut the amount of time spent actually commuting because roads could be optimized more intelligently.  In addition, the number of accidents on the road would theoretically plummet due to the decline of unpredictable human drivers.  This could easily save thousands of lives annually along with significant monetary savings due to decreased frequency of property damage and bodily injury.

Elon Musk’s Tesla Motors is the most visible proponent of automation, although many other manufacturers and technology companies are also investing heavily in research and development.  In 2016, the number of S.E.C. filings mentioning autonomous vehicles surged dramatically.  Many of these filings are from automobile manufacturers but there is also increasing awareness of the benefits and risks of automation in other industries such as automobile insurance.  Is this increased interest just hype or does it reflect reality?

A Question of Timing

If we fast forward fifty years to the mid 2060s, it seems almost inevitable that the United States economy will have fully transitioned to autonomous vehicles and reaped countless productivity benefits.  This might seem like a bold assertion.  Is this science fiction similar to the vision of the future from a 1960s Jetson’s cartoon?  Even George Jetson’s flying car was not fully autonomous, although it did compress to the size of a briefcase.

Warren Buffett recently predicted that autonomous vehicles will eventually dominate the market but was skeptical regarding some of the more aggressive claims on timing.  In particular, he was doubtful that even ten percent of the automobiles in the United States would be self-driving within ten years.  Of course, the timing will be very important for GEICO as well as for other auto insurers.  A much safer fleet of vehicles will reduce the rate of accidents resulting in less damage to property as well as bodily injury.  This will cause insurance rates to fall significantly.

Even if we assume that a fully autonomous vehicle will be released imminently, it could take many years for the technology to become mainstream.  The average age of light vehicles in the United States rose to 11.6 years in 2016.  Furthermore, vehicles sixteen years and older are expected to grow from 62 million units on the road today to 81 million in 2021.  Vehicle reliability has been increasing in recent years allowing consumers to keep older cars on the road without incurring major expenses.

The counterpoint is that perceived vehicle obsolescence will dramatically increase as soon as a fully autonomous vehicle is introduced.  In fact, the comparison between the existing fleet and fully autonomous vehicles might be completely invalid.  While the older vehicles will still get drivers from point A to point B, they will always require human control.  The perceived difference could eventually be as great as the difference between a horse drawn carriage and an early automobile.

Flashback to the 1990s

Anyone who lived through the early days of the internet will recall the lofty predictions regarding how the technology would completely change our lives within a few years.  These predictions were necessary to sustain the dot com bubble in which all sorts of dubious business models attracted capital, both from the unsophisticated and gullible and from those hoping to take advantage of the “greater fool” theory.  Bricks-and-mortar retailing would soon be dead, we would all order products from our living rooms using computers, and everything under the sun would be handled online.  These were just some of the more common predictions.

What ended up happening?  Almost all of these predictions eventually came true!  The only issue is that it took an additional ten to twenty years before technology and infrastructure reached the point where a critical mass arrived and existing business models could be seriously disrupted.

From an infrastructure perspective, we needed much faster internet connections than we had access to in the 1990s. perfected the logistics and infrastructure associated with massive automated warehousing and distribution.  The smartphone revolution put miniature computers in the hands of nearly everyone along with software that increased price transparency and exposed retailers that were not offering good value propositions.  Finally, consumers had to slowly get used to the concept of shifting more and more of their lives online.  We are now at the point where an entire generation has grown up in a connected world and, of course, older generations eventually go along for the ride.

Change is Slow and then Fast

The impact of the dot com bubble on retail took a very long time to fully develop but it seems like we have recently arrived at a tipping point where the predictions of twenty years ago are about to come true.  Malls have been in long-term decline but are now increasingly being razed and redeveloped.  Sears Holdings has been declining for years and recently added “going concern” language to the company’s S.E.C. filings reviving concerns of near-term bankruptcy.  Smaller retailers are often in even worse shape and quarterly earnings disappointments are common.  It is still premature to suggest that bricks and mortar retail is dead but companies without pricing advantages or differentiation seem destined to fall victim to and others operating online.

Could we see a similar outcome for automated vehicle technology?  The hype over vehicle automation is currently reminiscent of the online shopping chatter prevalent in the late 1990s yet we face significant technological and infrastructure challenges that will impede adoption in the near term.  The technology required to safely automate a vehicle is still very much in development and unproven.  The physical infrastructure of the United States is in poor shape, although the Trump administration claims to have plans to significantly boost infrastructure investment.  Perhaps most importantly, people are used to controlling their vehicles directly and most people believe that they are “above average” drivers.  Some people even enjoy driving.

In 2016, a high profile fatality in a Tesla vehicle resulted in a great deal of media coverage.  Even though the ensuing investigation revealed no safety defects in Tesla’s autopilot technology, this incident and similar future incidents will slow down the shift toward automation both from a regulatory and consumer acceptance standpoint.  As flawed as human drivers are, most of us feel like we are “in control” when driving.  Handing over control to technology is a major shift that many people will resist.  There will be a transition period when some vehicles are automated while others are human controlled.  The interaction between autonomous and human drivers will also cause controversy, regulatory review, and impact consumer acceptance.


We have no way of knowing how the shift toward vehicle automation will evolve over time but the end result is easier to forecast.  At some point, all vehicles are likely to be automated and will interact with each other in predictable ways.  This will reduce the rate of accidents and boost human productivity as the time spent driving cars will be redirected to higher value pursuits.  The benefits are likely to be immense but certain industries such as auto insurance will be much smaller as a result.  As is the case with most technological change, there will be clear winners and losers.

What we cannot know at this point is whether the shift to automation will be largely complete by 2030 or if 2050 is a more realistic target.  This has important implications for a business like GEICO or Progressive.  The intrinsic value of a company is the analyst’s best estimate of the present value of all future cash flows from the business.  If the decline of auto insurance is 30 to 40 years in the future, current valuations will be far less impacted than if the decline occurs in 10 to 20 years.

GEICO and Progressive have been growth companies for a long time as they took market share from competitors and benefited from the overall growth of cars on the road.  At some unknown point, this virtuous cycle will reverse.  Premium volume and float will decline.  Companies will compete fiercely over the remaining business.  Auto insurance companies will be valued as melting ice cubes rather than growth companies.  Fifty years from now, we will know how everything turned out.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway, the parent company of GEICO. 

Highlights from Markel’s 2016 Annual Letter

Intelligent investors should be skeptical when reading about companies that could be the “next Berkshire Hathaway” or executives who resemble a “younger Warren Buffett”.  The reality is that very few companies have even a remote chance of replicating Berkshire’s 20.8 percent compound annual gain in per-share market value over past 52 years.  Furthermore, companies that meet or exceed that track record in the future will have to adapt to the conditions that prevail during their time.  Mr. Buffett’s value investing principles are timeless but the application of those principles will not remain static.  The idea that mimicking the style of Berkshire Hathaway’s website or shareholder communications brings one closer to achieving Mr. Buffett’s performance confuses style for substance.

Markel Corporation has been discussed frequently on this website not because the company might be the “next Berkshire Hathaway” but because management has consistently adopted many of Mr. Buffett’s principles in substance while retaining their own unique style of operations.  As the management team notes in the company’s recently released 2016 annual report, the long term record has been strong with compound annual growth in book value per share of 19 percent over the thirty years since the company’s initial public offering.

Is Markel the “next Berkshire Hathaway”? We would not presume to know the answer, but should management be able to continue compounding book value at 19 percent over the next 22 years and maintains the current price-to-book ratio and share count, the company’s current $13.5 billion market capitalization would rise to over $600 billion.  This is almost certainly far in excess of the results one can reasonably expect but falls into the category of an interesting thought experiment.

Time Frames Guiding Management

One year is not a very long period of time and typically an insufficient time period to measure management’s effectiveness.  Yet how many times do we hear managers make excuses for poor decisions by saying that they should not be judged over one year periods … and similar excuses come up every year?  A series of short-runs eventually becomes the long-run, so it is interesting to see how Markel’s managers view this reality:

“While we necessarily break down our results in the normal pattern of yearly increments, we don’t think about Markel in annual terms.  We think about your company in two distinct yet completely connected time horizons, namely forever and right now.  

These two time frames guide our actions.  We believe that Markel remains unique among most publicly traded companies in emphasizing the forever time horizon as much as we do.  That is an immense competitive advantage for us as we continue to navigate into an always uncertain future that continues to change at faster and faster rates.”

Management seems committed to adapting to rapid changes, especially those brought about by technology, and doing so in a timely fashion rather than using the tired excuse of having a “long term outlook” to explain away short term deficiencies.  With many companies, it seems like there are always short-term excuses for poor performance that tend to recur every year.  However, a moderately long time horizon, such as five years, is obviously made up of a series of five one year periods.  In order to produce good long term outcomes, managers have to show up every day with that goal in mind.

Three Engines of Activity

Management characterizes the company as having three “engines of activity”: Insurance, Investments, and Industrials.  Markel’s roots as an insurance company account for the first two engines.  Insurance underwriting profitability is an essential ingredient for success and provides management with low or no-cost funds to invest in fixed income securities.  Markel historically invested shareholders’ equity in common stocks but over the past decade has increasingly directed funds to majority or wholly controlled companies under the umbrella of Markel Ventures, characterized in the letter as “Industrials”.


The insurance market is characterized as “brutally competitive” in the letter indicating that pricing pressure is significant and that the market is soft, at least in the niche segments in which Markel typically competes.  Nevertheless, total insurance premiums written increased 4 percent to $4.8 billion in 2016 and the combined ratio was 92 percent indicating underwriting profitability:

“Conditions across the insurance market worldwide remained brutally competitive.  That is true in every product across the board.  Despite the ongoing competitive nature of insurance markets we produced an underwriting profit as demonstrated by the combined ratio of 92%.  We’ve been profitable on an underwriting basis in 15 of the 21 years shown on this chart [the letter includes a 21-year summary of financial data] and we hope that provides you with a tangible sense of how much we mean it when we say that we are dedicated to making an underwriting profit.  We will continue to exercise discipline, and walk away from insurance risks that in our opinion carry a likelihood of underwriting losses.”

Anyone who follows the insurance industry knows that, without exception, managers talk about achieving underwriting profitability and rejecting poorly priced business even if that means a loss of market share.  In reality, most managers fall well short of this objective.  We can see Markel’s track graphically in the following exhibit:

The early years on the chart show that no management team is immune from mistakes.  Markel had some trouble initially with the acquisition of Terra Nova which impacted 2000 results and 2001 was impacted by adverse development that required an increase in reserves as well as the September 11 terrorist attacks.  Since then, results have been much more consistently positive.  Although the nature of insurance makes terrible results in some future year nearly inevitable, management has credibility when it comes to underwriting discipline. Credibility is important because sometimes negative results will be surprising as was the case recently with an $85 million reserve increase that will impact Q1 2017.


Markel traditionally invested policyholder float in fixed income securities with a duration intended to match policyholder liabilities while investing shareholders’ equity in common stocks.  In 2016, Markel reported a total return of 4.4 percent from its publicly traded securities portfolio, comprised of a total return of 13.5 percent from equity securities and 2.4 percent from fixed income securities.  Here again, management makes a distinction between the short run and long run when it comes to evaluating results:

“We specifically use the term “reported” for the one year number and “earned” for the 5 year term.  Those words describe two different, yet related things, and we think it is important to conceptually discuss the nuance meant by using those two different words.”

The term “reported” is the simple arithmetic stating the return Markel achieved on securities during the given year but, in the short run, these results might differ from changes in intrinsic value of the securities.  This appears to be the case for both equity and fixed income returns for 2016:

“In our opinion, while the equity portfolio enjoyed a reported return of 13.5% for the year, we believe that the underlying economic performance of the businesses we own in that portfolio was probably slightly less than that reported return.  Some individual companies performed meaningfully better than what the change in stock prices would suggest, and some performed less well than you might think at first glance.  Additionally, the dispersion of economic performance between individual companies, and one industry as compared to another, seems to be getting wider in our opinion.  In aggregate, the overall equity portfolio return of 13.5% remains directionally correct in describing the underlying business performance of our investees, but that number is not precise in describing their aggregate economic progress, and we believe it might be just a touch high.”

Management is more confident that the 15.9 percent annualized five year reported return on the equity portfolio more accurately describes what Markel “earned” in terms of advances in the intrinsic value of the underlying companies.  The passage of time tends to eliminate the differences between what is “earned” and what is “reported” – meaning that in the long run, changes in quoted values reflect underlying intrinsic value.  This is identical in substance to Benjamin Graham’s analogy of the stock market being a voting machine in the short run but a weighing machine in the long run.

The duration of Markel’s fixed income portfolio has been rising in recent years.  Management has stated a goal of keeping a relatively constant duration of between four and five years in the fixed income portfolio in order to match the expected timeframe in which policyholder claims will be paid out.  However, in the short run, the longer duration led to the fixed income portfolio falling in quoted value in the fourth quarter of 2016 as interest rates rose.  The present value of Markel’s insurance liabilities also fell in theory but were not repriced on the balance sheet:

“The rise in interest rates in 2016 means that our “reported” returns from the fixed income portfolio were lower than our economic returns from owning those securities.  U.S. GAAP accounting recognizes that mark to market change of the fixed income portfolio but it doesn’t recognize that the net present value of our insurance liabilities decreased economically by a similar amount.

Over five years, these sorts of timing and reporting differences resolve nearly completely, which is why we pay attention to the 5 year number much more than the annual amounts.”

Overall, Markel’s investment results have been very good in recent years as we summarize in the exhibit below (click on the image for a larger view):

Industrials (Markel Ventures)

Many of the comparisons between Markel and Berkshire Hathaway are driven by Markel’s recent entry into non-insurance businesses which has made the company into something of a mini-conglomerate.  The history of Markel Ventures makes for interesting reading and shows how management has gone about this transformation since 2005.  In addition to diversification, Markel believes that these businesses add resiliency to the overall corporation:

“Markel Ventures continues to grow as a positive factor within your company.  This collection of businesses provides a diversified stream of cash flow for Markel that is not tied completely to the economic fates or regulatory forces affecting our insurance operations.  

As such, these cash flows provide resiliency for the company as a whole and allow us more options to consider when we make capital allocation decisions.  

Resiliency is a much more important concept than diversification.  Diversification is a necessary condition to obtain resiliency, but it is not in and of itself sufficient to achieve that goal.  Resiliency means so much more.  Our goal is to continue to build resiliency at Markel.  Resiliency means that whatever the markets, and technology, and change, throws at us, we’ll be able to rise to those new challenges and circumstances.”

Results at Markel Ventures continue to require additional explanations beyond the raw numbers.  This is primarily due to the impact of accounting conventions, specifically the manner in which goodwill is evaluated on an annual basis.  When an acquisition is made, the consideration paid to the seller in excess of identifiable assets is recorded as goodwill.  The goodwill of each individual business unit is evaluated for impairment each year and written down if needed.  However, because this is done at each individual business unit rather than in aggregate, the overall economic goodwill of the Ventures businesses could be rising even as a goodwill write-down is taken at one unit.  Management believes that the $18.7 million write-down in 2016 does not reflect fundamental impairment of the goodwill of Ventures as a whole:

“Neither we nor anyone else knows when or if energy prices will rise or to what degree.  That said, the carrying value of this cyclical business has been reduced substantially through this particular goodwill charge.  This creates an asymmetric financial reporting outcome.  The process creates a one way street where only negative events get highlighted and charged off in lumps.  Future good news of better earnings, and the implication of a business that is worth more economically, will never show up in the balance sheet.  You’ll just see those earnings anonymously comingled with all of the other earnings streams in the income statement.”

Of course, there is nothing to prevent management from highlighting these positive developments in the annual letters when warranted or providing more granularity in financial reporting.  Currently, Markel Ventures subsidiaries are presented in a non-granular manner which could partly be due to a desire to conceal information from the competitors of individual subsidiaries but also makes it more difficult for shareholders to evaluate results.

Capital Allocation

Markel restated the principles of capital allocation that were presented a few years ago in the 2013 annual report:

“We will continue to use our capital with the same priorities.  As we wrote in the 2013 annual report, “Our first and favorite option is to fund organic growth opportunities within our proven, existing line up of insurance and non-insurance businesses.  Our next choice is to buy new businesses. Our third choice is to allocate capital to publicly traded equity and fixed income securities, and our final choice is to repurchase shares of our own stock when it is attractively priced and increases the value of each remaining outstanding share.”

It is interesting that repurchases are listed as the last choice in the list, but perhaps not surprising given that Markel has not historically repurchased a meaningful number of shares.  Repurchase activity in recent years seems more related to a desire to keep the share count constant as new shares are issued as part of the company’s stock incentive programs and has not varied much based on Markel’s valuation.  As an example, Markel’s stock price traded at only a modest premium to book value for much of 2013 yet repurchases for the year were only $57 million, as compared to $51 million in 2016 when shares traded at a much more significant premium.

Overall, however, management should be evaluated based on progress in intrinsic value per share and Markel has posted good results in recent years with compound growth in book value per share of 11.5 percent over the past five years and 10.2 percent over the past decade.  Management has reason to be confident in their ability to compound intrinsic value at satisfactory rates far into the future and shareholders seem willing to allow for retention of capital in order to fund that growth.


The exhibit below shows Markel’s track record from the turn of the century through earlier this month, with the top chart showing the movement of the company’s stock price, book value, and tangible book value per share and the bottom chart showing the company’s price-to-book ratio:

As Markel’s stock price advances to near the psychologically meaningful (but substantively meaningless) $1,000 per share level, it is notable that the price-to-book ratio is only now reaching levels that prevailed before the financial crisis.  Markel is still primarily an insurance company, albeit with a growing collection of non-insurance subsidiaries, so price-to-book remains a meaningful but understated measure of intrinsic value.

The bottom line is that we have no way of knowing whether Markel is the “next Berkshire Hathaway” but the track record since the company’s IPO thirty years ago gives us reason to at least watch closely in the coming years.  Substance matters much more than style.  Markel’s management is very different from Berkshire’s in style but has adopted much of the substance that resulted in Berkshire’s unusual success.

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

Sharing Ideas? Beware of Negative Lollapalooza Effects

“Good investment ideas are rare, valuable and subject to competitive appropriation just as good product or business acquisition ideas are. Therefore we normally will not talk about our investment ideas.”

— Warren Buffett, Berkshire Hathaway Owner’s Manual

One of the interesting aspects of investing is the fact that there are so many people who are willing to discuss ideas in public forums.  As Warren Buffett points out, truly valuable investment ideas are extremely rare and discussing them in public could very well hurt an investor’s results.  As more people become aware of an attractive opportunity, it is obvious that their actions in the market will erode the price advantage and eventually eliminate it entirely.  So why do people feel compelled to go public with their ideas?

There are obviously some benefits associated with publishing investment insights, many of which we discussed several years ago.  The ability to test an investment thesis by subjecting it to the scrutiny of other intelligent investors can be quite helpful in terms of “killing an idea”, an approach advocated by Bruce Berkowitz, among many others.  Warren Buffett often turns to Charlie Munger as a sounding board for his investment ideas.  Even the best investors can benefit from seeking out the opinions of others.  The need to clarify one’s thinking to the point where it is intelligible and coherent to someone who is not familiar with a topic can be extremely valuable.  However, Warren Buffett and Charlie Munger are on the same “team”.  Mr. Buffett does not seek input by exposing his ideas to the potential competition of strangers.

There are obviously many nefarious reasons to discuss ideas as well.  An investor can build a position in a company and then write about it in a manner that is designed to increase investor interest.  The stock price might then advance allowing the promoter to cash out at a profit.  Of course, this is very common on the internet especially when it comes to thinly traded securities, but it is not an unknown phenomenon even in larger capitalization stocks.  For this article, however, we put aside the question of nefarious intent and focus only on risks facing someone discussing ideas in good faith.

Less Obvious Risks

It should be obvious that publicly discussing a company that you find attractive and are still planning to buy can only make it more expensive to purchase shares.  This is clearly true if Mr. Buffett talks about a company on CNBC but it is also true for small blogs, including The Rational Walk, especially when the company in question is small.  However, let us put aside the direct and obvious risks associated with discussing investment ideas and consider some less obvious psychological factors.

Charlie Munger has long been fascinated with the role of standard thinking errors associated with human misjudgment.  Mr. Munger’s Psychology of Human Misjudgment provides us with an extensive list of pitfalls to be aware of as we go through life.  Human beings have evolved over millennia to make many decisions based on heuristics that can be expected to work reasonably well most of the time, but pose enormous stumbling blocks in certain situations.

When we publicly discuss ideas, we should be aware of the fact that we are most certainly opening ourselves up to the negative effects of several psychological tendencies.  These tendencies work against us in many ways and, to make matters worse, we are usually unaware of the fact that we are affected.  In this article, we examine just a few of the more important psychological tendencies that could be triggered through a public discussion of investment ideas.

Inconsistency-Avoidance Tendency

For most people, the state of mind characterized by cognitive dissonance is extremely uncomfortable.  We seek to maintain consistent thoughts, beliefs, and attitudes throughout life and when circumstances occur that require us to re-examine a long-held belief, the process of re-examination is often delayed or avoided entirely.  Taking public stands on issues in a way that results in a person being identified with a particular idea pounds in that idea in one’s mind to the point where any re-examination becomes even more difficult.  The saying that “science advances one funeral at a time” is a manifestation of this tendency.

Consider what happens mentally when one publishes a write-up on a company or gives a presentation in a public setting.  The individual becomes associated with the idea to a degree that would not have been the case previously.  There is a strong desire to be proven correct, not only in terms of profiting from the investment, but also to gain approval from others.  In addition, if other investors have acted on the idea, there is a desire to not let them down even if there is no fiduciary responsibility involved.

After going public with an idea, will it be easier or harder to be open to emerging data or circumstances that conflict with the idea?  Obviously, there will be mental resistance and a tendency to interpret new developments in a way that forces consistency with the investment thesis that was presented.  This does not mean that it is impossible to reconsider the idea in light of new evidence, but a mental stumbling block has been put up that must be overcome.  There are probably many investors who can overcome this without too much difficulty.  What they are likely to have in common is full awareness of this psychological tendency and enough self confidence to be able to reassess and discard old beliefs.

Excessive Self-Regard Tendency

The field of investing tends to attract individuals who have, at a minimum, a healthy degree of self-confidence.  After all, attempting to outperform market indices that the vast majority of active investors fail to match is the same thing as making a statement that you have greater insight and skill than most other investors.  The danger, as with many other vices in life, comes when healthy self-confidence morphs into an uncontrolled ego accompanied by excessive self-regard.

Charlie Munger advises us to counter excessive self-regard by forcing ourselves to be “more objective when you are thinking about yourself, your family and friends, your property, and the value of your past and future activity.” Is it easier to be more objective when one publicly discusses investment ideas?  And isn’t the act of making a presentation regarding an investment something that is likely to pound in additional doses of self-regard, particularly when a presentation is well received?

For investors who are well known, a presentation will usually result in a reaction of the price of the investment in question, whether it is an advance due to a bullish outlook or a decline in the case of a short thesis.  Knowing that intelligent individuals (presumably) with large sums of money have acted in response to your idea can no doubt be intoxicating and will only add to an already healthy degree of self-confidence.

The flip side comes when negative information calls into question the initial idea.  Schadenfreude is probably one of the least attractive reactions when observing the misfortune of others, yet it is exceedingly common in the investment world.  Every time a high profile investor has a serious setback, social media erupts in a flurry of sarcastic commentary.  An individual with a high degree of self-regard is likely to react to such a development by lapsing into pain-avoiding psychological denial.

Social Proof Tendency

Investing can be a solitary endeavor.  The best opportunities are, almost by definition, the ones that the rest of the market has overlooked.  Irrational pessimism and short-term thinking have the power to cause market prices to detach from any reasonable assessment of intrinsic value.  When this occurs, the intelligent investor has to be willing to act quickly and forcefully to take advantage of the opportunity.  In other words, it is important to discard the notion of requiring social proof prior to acting on an investment opportunity.

The ability to go against the crowd might be obvious, but many of us are more comfortable taking action when others agree that our idea makes sense.  In order to obtain this approval, one can present ideas in a way that is designed to persuade.  The applause at the end of a presentation, positive comments on an article, or a spike in a stock price might be enough for a relatively insecure individual to redouble belief in his or her idea.  Of course, by requiring this type of approval from others, the investor has not only potentially eliminated the opportunity but also unleashed the other negative psychological forces we are discussing.

The Lollapalooza Effect

The combined effect of several psychological tendencies is not usually merely additive in nature and can behave more like an exponential function.  The tendencies discussed in this article, combined with several other tendencies discussed by Mr. Munger, have the potential to create extreme outcomes in which rational decision making is almost impossible.  The act of publicly discussing investment ideas has benefits but also poses very serious risks and this must be explicitly understood and accepted.

There is no doubt that some investors are more likely to be affected by psychological pitfalls than others.  However, to some degree, we are all subject to human misjudgment and should strive to stack the decks in our favor whenever possible.

Personal Examples

Intellectual honesty requires some degree of self examination regarding how these forces have impacted the psychology of the writer.  I will consider two separate cases where I wrote a great deal about a company on The Rational Walk and the impact the writing had on my results from an investment perspective.

Berkshire Hathaway

Over the past eight years, Berkshire Hathaway has been a frequent topic on The Rational Walk in the form of many articles and two lengthy publications.  There is no doubt that writing about Berkshire Hathaway has clarified many aspects of the company in my mind and opened up interactions with a number of Berkshire shareholders.

For the most part, my outlook for Berkshire has been proven correct over time, although obviously the journey was not at all smooth.  There were times, such as the summer of 2011, when the general premise of Berkshire being worth far in excess of book value was called into serious question.  Although it is doubtful that I would have sold shares at those levels, the public stance that I took probably had a positive effect due to the inconsistency-avoidance tendency.

About a year ago, I published an article that attempts to analyze what Berkshire might look like in 2026.  What would happen if circumstances change and Berkshire’s outlook diminishes greatly, possibly due to some problem associated with management succession?  Would I have the ability to dispassionately change my mind regarding Berkshire’s prospects in the future?  Or would I be too attached to the idea based on my public writing about the company?  The truth is that I cannot answer that question today.  I would hope that objectivity will prevail over the desire to be proven “correct” in my outlook.  But I do not know whether that is the case.  If I allow my writing on Berkshire to impact my assessment of Berkshire’s future prospects, it could prove to be a very costly mistake.

Contango Oil & Gas

A better case study of the psychological pitfalls associated with writing about ideas might be Contango Oil & Gas which I owned from 2009 to 2013.  Contango was run by a CEO who, in many ways, looked like “the Warren Buffett of oil exploration” and I wrote about the company several times starting in early 2010. However, I did not present a full write-up on the company until September 2012 when the stock price had taken a hit following an announcement that the CEO would take a medical leave of absence.

Bad news associated with the company’s operations was revealed in October 2012 but I mostly explained them away in a follow-up article.  In May 2013, the longtime CEO passed away and the company announced a merger with Crimson Exploration, which was covered in another article where I revealed that I had reversed my assessment and sold all shares.  Although I took a significant loss on the overall position, the timing of the sale was fortuitous in retrospect as shares have declined over 80 percent since then.

To what degree did writing about Contango Oil & Gas impact my financial results?  Taking public stands on Contango over the years pounded in the notion that the company was unique in the exploration and production industry, particularly in terms of the risk management approach of the company’s founder and longtime CEO.  The company was a significant percentage of my portfolio and in mid-September 2012, I purchased additional shares shortly before publishing the full write-up on September 22 (this was fully disclosed).

In October 2012, I increased my position and again wrote about Contango (again, fully disclosing the position).  I made further purchases in November 2012.  Contango, at this point, had grown into a very large position.  The company was in a volatile industry and the longtime CEO who was responsible for the differentiation of the company’s approach was on medical leave with a serious illness.  There is no doubt that writing about Contango resulted in inconsistency-avoidance.  I did not want to be wrong.

On a positive note, when the deal with Crimson was announced, I almost immediately came to the conclusion that management of the combined company would not have any of the attributes that I thought differentiated Contango’s operations and risk profile so I liquidated the entire position at a substantial loss.  I published a “mea culpa” article which was very unpleasant to think about and write.  Contango remains the largest investment mistake, in dollar terms, of my investment career.


There are plenty of valid reasons to discuss investment ideas in public forums or to make presentations in public.  Investors may be seeking out other opinions that can be valuable as part of their investment process.  Those who are seeking capital to manage must find a way to get the attention of potential investors.  Some people might just enjoy the interaction with other investors.  However, we must keep in mind the risks that are being taken when ideas are discussed in public.  The risks are not intuitively evident but they are very real.  We are all subject to the pitfalls associated with human psychology.  The dawning of wisdom is the realization that you too are subject to the tendencies that we might wish only affect “other people”.

The obvious policy is to only discuss investment ideas in public to the extent that doing so is expected to result in some form of net gain, whether it is monetary or intangible.  In recent years, The Rational Walk has not published as frequently as in the past and most companies under discussion have not been ones likely to result in a personal commitment of capital.  This has been mostly by design and is likely to continue in the future with the possible exception of Berkshire Hathaway.

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

Book Review: There’s Always Something to Do

“There is always something to do.  You just need to look harder, be creative and a little flexible.”

— Irving Kahn

One of the interesting aspects of the stock market involves the peculiar attitude many investors have when it comes to reacting to market advances.  If the price of groceries, gasoline, or clothing rises, most individuals are going to feel poorer rather than euphoric because each dollar will have less purchasing power than before.  The same is not true when it comes to stocks.  Investors typically are more excited about buying stocks as prices rise.  Why is this the case?  Human psychology seems to lead many of us astray.  We assume continuation of a trend and it is easy to feel “left behind” when looking at other people who are getting rich, at least on paper.  The opposite is true in market declines as investors abandon stocks due to fear of further declines even as each dollar invested is purchasing a greater ownership interest than before.

The stock market has been on a generally upward trajectory for many years and has rallied strongly since Donald Trump won the presidential election in November 2016, which incidentally was the exact opposite of market expectations at the time.  It seems like many individuals took notice when the Dow Jones Industrial Average reached the 20,000 milestone and then quickly broke through 21,000.  The Dow might be a highly flawed benchmark but it is one that people seem to follow.  Of course, a record high does not necessarily indicate overvaluation, but the recent rally has coincided with the highest Shiller PE Ratio since the dot com bubble.  The Shiller PE is based on the average inflation-adjusted earnings from the prior ten years.  As we can see from the chart below, the Shiller PE has rarely been higher than it is today:

What does this really mean?  The honest answer is that we have no way of knowing what the stock market is going to do in the short run.  As Howard Marks has pointed out, one can view investor sentiment as a “pendulum” swinging between fear and greed.  We cannot know when the pendulum has reached the furthest point and is about to swing back, but we should be able to tell when the pendulum is on the upswing toward greed.  Individual investors are again piling into stocks, Snap Inc. just went public and rallied sharply despite serious questions regarding corporate governance, and market rumors are swirling regarding potential IPOs for hot stocks such as Uber and Airbnb.

It would be arrogant and ill advised to “call” a market top, but it would be foolish to not at least note that the pendulum is firmly in an upswing.  Besides, as value investors, we should not make decisions based on market indices and instead look at individual companies.  Obviously, the market for individual companies is impacted by overall sentiment and we aren’t likely to find many companies selling below net current asset value these days.  Nevertheless, there should always be something to do for an enterprising investor.

The Story of Peter Cundill

Peter Cundill’s value investing odyssey began when he experienced a “road to Damascus” moment in late 1973 as he read Security Analysis and, like Warren Buffett and many others, was immediately struck by the power of Benjamin Graham’s logical approach.  The Cundill Value Fund, starting in 1975, established one of the strongest track records in the industry with a 15.2 percent annualized return over 33 years.

Was this excellent record due to skill or random luck?  As Warren Buffett pointed out in his classic essay, The Superinvestors of Graham and Doddsvillea certain number of investors from a large population could very well outperform over many years due to random factors.  However, the examples Mr. Buffett presented had something in common:  they were all from a “zoo in Omaha” that had been “fed the same diet”.  That is, they had operated based on the principles developed by Benjamin Graham and David Dodd starting in the 1930s.  Importantly, these investors achieved their records in very different stocks rather than piling into the same ideas.  The foundational concepts were shared by these investors but how they applied the concepts varied widely.

Peter Cundill kept a daily journal from 1963 to 2007 in which he recorded a variety of thoughts ranging from his personal life to business and investing.  Christopher Risso-Gill was a director of the Cundill Value Fund for ten years and had exclusive access to Mr. Cundill’s journals.  This positioned Mr. Risso-Gill perfectly to write There’s Always Something to Do, a book about Mr. Cundill’s life and the evolution of his investment philosophy over more than three decades.  Journals allow us to view a contemporaneous account of an individual’s life and thought process.  Mr. Cundill was diagnosed with Fragile X Syndrome, a rare and untreatable neurological condition, in 2006 and passed away in 2011.  We are fortunate that Mr. Cundill kept a detailed journal that allowed Mr. Risso-Gill to document his investment philosophy and many case studies applying his approach.

A Whiff of Bad Breath

Most arguments against insider trading appeal to our sense of fair play and ethics.  It seems dishonorable to trade based on information that is not available to others because the deck is stacked against your counterparty.  However, there are other valid reasons in favor of keeping away from inside information out of pure self interest.  By getting close to management, we can pollute our minds and compromise our reasoning process, as Mr. Cundill points out in his journal:

I will never use inside information or seek it out.  I do implicitly believe in Sir Sigmund Warburg’s adage, “All you get from inside information is a whiff of bad breath.”  In fact it is worse than that because it can actually paralyze reasoning powers; imperiling the cold detached judgement required so that the hard facts can shape decisions.  Intuition, whether positive or negative, is quite another matter.  It is a vital component of my art.  

Stock manipulations only have a limited and temporary effect on markets.  In the end it is always the economic facts and the values which are the determining factors.  Actually value in an investment is similar to character in an individual — it stands up better in adversity which it overcomes more readily.

So we should certainly avoid inside information for ethical reasons, not to mention the risk of going to prison, but also because it simply is not a great way to improve our results over long periods of time.  Our logical reasoning powers and ability to dispassionately assess facts and come to valid judgments is how we can make money investing for the long run.  The temptation to take shortcuts might always exist but should be resisted out of pure self interest.  Appealing to self interest is often a better way to achieve socially desirable outcomes compared to appealing to a sense of ethics.

When to Buy

How do we know when to purchase a security?  Do we rely on our own analysis or allow others to impact our decision making process? This can be a very important question when buying into distressed situations which, by definition, are usually hated by the vast majority of our peers:

As I proceed with this specialization into buying cheap securities I have reached two conclusions.  Firstly, very few people really do their homework properly, so now I always check for myself.  Secondly, if you have confidence in your own work, you have to take the initiative without waiting around for someone else to take the first plunge.  

Does this sound familiar?  It might to those who were actively investing in the aftermath of the 2008-09 financial crisis when pessimism was rampant and stocks had declined over fifty percent in a short period of time.  Mr. Cundill wrote the preceding words in the midst of the 1973-74 bear market which was a similar time of pessimism in the stock market.  Pessimism can be a virtue and can also lead to opportunities for investors who do their own work and have the courage to act on their convictions.

When to Sell (and associated frustrations)

Mr. Risso-Gill provides a fascinating case study of Mr. Cundill’s investment in Tiffany during the 1973-74 bear market, a time when the stock sold for less than the value of fixed assets on the balance sheet including the company’s Fifth Avenue flagship store in New York City as well as the Tiffany Diamond.  The iconic brand was effectively being given away for free so Mr. Cundill started buying the stock.  At the time, Tiffany was controlled by Walter Hoving, the company’s CEO, who clearly stated that he had no intention of ever selling his controlling stake. Mr. Cundill assured Mr. Hoving that he was “quite content to be patient and await the inevitable recognition of the fact that Tiffany shares were fundamentally undervalued.”  The two men became good friends.

After accumulating 3 percent of the company at an average cost of $8 per share, Mr. Cundill quickly declared victory and sold his entire position within a year at $19 and was able to “rub his hands contentedly.”  It appears that Mr. Cundill was content with his decision to sell because he assumed that Mr. Hoving was serious about “never selling” his controlling stake, thereby discounting the possibility that the entire company would be acquired at a control premium.  But this turned out to not be the case:

“Peter’s assessment had turned out to be entirely accurate and within a year he was able to sell his entire position at $19.00 and rub his hands contentedly.  But six months later there was a “sting” when Avon Products made an all share offer for Tiffany worth $50.00 per share and Hoving unhesitatingly accepted it.  Peter’s comment was that he ought to have asked Hoving, “Never, ever – at any price?”  

Most readers will be able to relate to the experience of selling too early.  It can really sting to sell at what we consider to be “full value” only to watch the stock price continue to ascend.  Sometimes the ascent might be for fundamental reasons that were not adequately considered.  At other times, speculative factors could come into play.  But it must especially sting when one feels misled about the intentions of a controlling shareholder and misses out on a massive control premium.  The Cundill Value Fund board members were concerned about this situation and debated the question of when to sell:

“In the end the solution turned out to be something of a compromise:  the fund would automatically sell half of any given position when it had doubled, in effect thereby writing down the cost of the remainder to zero with the fund manager then left with the full discretion as to when to sell the balance.”

Strictly speaking, this compromise is not logical.  If a manager finds a security trading at 25 percent of intrinsic value, why should he be forced to sell half of the position when it doubles in price and is still selling at 50 percent of intrinsic value?  Nevertheless, the solution is quite common among investors.  Mentally thinking of the remaining half of a position that has doubled as a “free position” has some pitfalls but could mentally make a scenario like Tiffany’s more palatable in the end.  It is somewhat refreshing to see that even an investor of Mr. Cundill’s caliber had to deal with these sorts of questions and ultimately came up with a compromise that all could live with even if it was not completely optimal.

Much later in his career, Mr. Cundill made the following observation about selling too early:

“This is a recurring problem for most value investors — that tendency to buy and to sell too early.  The virtues of patience are severely tested and you get to thinking it’s never going to work and then finally your ship comes home and you’re so relieved that you sell before it’s time.  What we ought to do is go off to Bali or some such place and sit in the sun to avoid the temptation to sell too early.”

This is reminiscent of Charlie Munger’s famous quip about “sit on your ass investing”, as discussed in Poor Charlie’s Almanack.  Sometimes we are our worst enemy when it comes to investing, and value investors can really be their own worst enemy when it comes to selling far too soon.  This is why one of the most important metrics to track each year is the result of an investor’s “do nothing portfolio” – that is, the performance of your portfolio had you done absolutely nothing all year long.  Did your trading activity add or detract value during a given year?  One way to know is to compare your results to Charlie Munger’s “sit on your ass” method of investing.

1987 Crash

It is easy to look back at any crash and fool ourselves into thinking that it was “obvious” that it would happen to those operating in the markets at the time.  Of course, this is absurd because if everyone expects a crash to occur in the future, the crash would occur immediately as everyone would sell immediately.  The same is true of post-crash bottoms.  It is never “obvious” that the market will sharply rebound.  This is why it is so valuable to keep a journal (or a blog) documenting our thoughts at the time.  For example, this article from early March 2009 on The Rational Walk makes it pretty clear that it was far from “obvious” that the market was close to a bottom.

Getting back to Mr. Cundill’s journal, we have the ability to see what he was thinking in the months leading up to the 1987 crash.  This excerpt from his journal from March 1987 documents his meeting with Jean-Francois Canton of the Caisse des Depots, the largest investment institution in Paris at the time:

“He is as bearish as I am.  He told me that Soros has gone short Japan, not something that Soros himself mentioned at our recent meeting but definitely in harmony with my instincts.  Canton and I had an excellent exchange — he understands value investment thoroughly.  As I see it, with money being recklessly printed, higher inflation and higher interest rates must be just around the corner and so much the likelihood of a real and possibly violent stock market collapse.  I have an unpleasant feeling that a tidal wave is preparing to overwhelm the financial system, so in the midst of the euphoria around I’m just planning for survival.”

How did Mr. Cundill plan for survival?  By the time the crash took place in October 1987, the Cundill Value Fund was holding over 40 percent of its assets in short term money market instruments.  Was Mr. Cundill a market timer?  Mr. Risso-Gill does not think so:

“… This positioning was not the result of a deliberate decision to build up cash because, although he had anticipated a crash, he could not have predicted its exact timing.  The enlarged cash position was actually the result of the increasing number of securities in the portfolio that had been attaining prices considerably in excess of book value, consequently qualifying them for an automatic sale unless there were overriding reasons to hold on to them.”

Due to the fact that he had ample liquidity in the days after the crash, Mr. Cundill was able to repurchase some of the positions he sold earlier in the year and the fund ended 1987 up by 13 percent.  Unfortunately, shareholders of the Cundill Value Fund redeemed shares in the wake of the crash and the fund’s capital actually declined for the year in spite of the excellent results.  Mr. Cundill was disappointed, as must be the case for any manager of an open-ended mutual fund who might wish to have permanent capital to work with.

Smart People Failing, Dictatorship, and Committees

As Warren Buffett often says, a sky high IQ is not necessary to be very successful in the field of investing.  What is required is a strong temperament coupled with the basic concepts outlined by Graham and Dodd.  Mr. Cundill makes the following observation in a journal entry on New Year’s Day 1990:

“Just as many smart people fail in the investment business as stupid ones.  Intellectually active people are particularly attracted to elegant concepts, which can have the effect of distracting them from the simpler, more fundamental, truths.”

This effect can be even worse when you get a large number of very smart people in the same room and attempt to manage by committee.  In another journal entry, Mr. Cundill reveals his views on committees versus dictatorship in the business world:

“To my knowledge there are no good records that have been built by institutions run by committee.  In almost all cases the great records are the product of individuals, perhaps working together, but always within a clearly defined framework.  Their names are on the door and they are quite visible to the investing public.  In reality outstanding records are made by dictators, hopefully benevolent, but nonetheless dictators.  And another thing, most top managers really do exchange ideas without fear or ego.  They always will.  I don’t think I’ve ever walking into an excellent investor’s office who hasn’t openly said “Yeah sure, here’s what I’m doing.” or, “What did you do about that one?  I blew it.”  We all know we aren’t always going to get it right and it’s an invaluable thing to be able to talk to others who understand.”

Warren Buffett has said that he usually learns about the actions of Todd Combs and Ted Weschler through their monthly trading reports, not by walking down the hallway at Berkshire Hathaway and interrogating his subordinates regarding their current investment moves.  Each investor is a “dictator” within the area of responsibility he has been assigned and that is how it should be.  Does this mean that no discussions take place regarding investments?  Obviously not.  Mr. Buffett’s recent purchase of Apple for the portfolio he manages for Berkshire followed the Apple investment of either Mr. Combs or Mr. Weschler.  They obviously talk about investments and mull over shared ideas, but at the end of the day, decisions are each investor’s to make and there are no committees.

Something to Do Today

As the stock market continues to levitate, we all have to figure out what actions to take, if any, in order to capitalize on opportunities and mitigate risk.  Perhaps the best approach is to emulate Charlie Munger and “sit on your ass” if you already own excellent companies and intend to own them for decades or, perhaps, even for the remainder of your life.  Or the best approach might involve selling securities as they reach or exceed prices at which any margin of safety exists.  There might even be remaining opportunities to purchase investments well below intrinsic value for those willing to look.  The answer regarding what to do today is one for each individual to answer.

Perhaps the most productive endeavor during times like this is to look for businesses that you find interesting regardless of the current valuation of the companies in question.  The key to being able to take advantage of opportunities in the future is to have a prepared mind and a list of companies that you would like to own if available at the right price.  A market crash offers few opportunities and mainly fear to those who do not have any idea what to do.  Those of us who build up an inventory of ideas far in advance of a crash are better equipped to take advantage of opportunities when they arise.  In many cases, rebounds can be as quick as a crash and those who prepare in advance might be able to capitalize.

The story of Mr. Cundill’s life and his investment track record is well worth careful study.  He is not a household name in the same way as Warren Buffett or Charlie Munger, nor does he have quite the same track record, but this is part of the attraction.  After all, there are many ways to win in the field of investing.


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