Conflicts of Interest, Biases and Beliefs
A conflict of interest may be defined as any situation in which one party is in a position to exploit a professional or official capacity in some manner for one’s personal benefit. We have worked diligently to mitigate, if not eliminate, conflicts of interest.
A bias may be defined as any internal filter that may influence one’s perceptions of reality. We all have biases. Our experience is the most enjoyable and productive client relationships spring from common biases, beliefs and values.
• The best solutions spring from process, not product.
The omnipresent conflict of interest endemic to the financial services industry revolves about compensation; broker compensation is largely driven by product solutions. Process solutions require sophisticated expertise, labor intensive collaboration, and fiduciary responsibility.
• The stock market represents an opportunity to purchase fractional ownership interests in businesses.
The better the business, purchased at a correct price, the greater the opportunity. Most investors transform the stock market into an electronic casino – and, over time, experience a gambler’s result.
• In this discipline called investing, winning is largely a function of not losing.
In other words, the most successful investors are defensive investors. Warren Buffett once remarked that his best investment ideas have not produced better returns than other people’s best ideas. But, he added, his mistakes were fewer, and of smaller magnitude.
• Always be prepared for bad times and for the bad times to last far longer than anyone anticipates.
We would point out one need never prepare for the good times. They have a way of taking care of themselves. However, a string of bad years, when the emotion of the investment climate transitions to despair, can be unnerving and undermine even the most successful investors.
• The opposite mindset to “always be prepared for a bad time” is “beat the market.”
“Beating the market” is the rallying cry of the ignorant during a bull market. Notice how silent these folks become in periods of adversity. Our portfolios generally keep up in most bull markets even with the considerable burden of periodic large cash positions. This is a noteworthy accomplishment, but one that attracts few enthusiasts. Keeping up with a red-hot, overvalued market, or beating it, implies enormous risk. Our goal is to achieve average performance in the good times and do better when things turn ugly. If we are successful, the result over a full market cycle is an above average experience (and happy clients.)
• There is no better investment, including in an inflationary environment, than a well capitalized, profitable business that enjoys pricing power, purchased at a discount to its intrinsic value.
• Impostor investors will forever be buffeted by the capricious winds of fear, greed and envy.
The foolish behavior resulting from this emotional cycle is predictable. The timing and magnitude are not.
• “The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.”
– Warren Buffett
• Greater risk does not necessarily produce greater returns.
Greater risk increases the probability of loss.
• Risk is not necessarily correlated to return.
Simply stated: the cheaper you buy – the lower the risk; and the cheaper you buy – the greater the return.
• “All intelligent investing is value investing – to acquire more than you are paying for.”
• Risk tolerance is antithetical to successful investing.
When the impostor investor is unafraid of risk, they will assume risk and not get paid for it.
• Buying early (i.e. investing before the crowd) and being wrong look identical.
Selling early (i.e. before the crowd) and being wrong look identical. The most successful investors appear to be wrong most of the time.
• The power of aligned interests is true real world magic.
Most “unsolvable” problems could be transformed by simply aligning interests. For example, imagine the result if a constitutional amendment were enacted stipulating that all sitting representatives, of either house, would be ineligible for re-election for any year that the budget deficit exceeded 2% of GDP.
• Intelligent investors seek absolute returns.
Gamblers seek relative returns. When we speak about absolute returns, we are not applying the conventional definition. For us, the word “absolute” refers to an absolute standard by which to assess value.
• A conservative assessment of intrinsic worth is what illuminates the murky undertaking called “investing.”
We believe an asset is not some ephemeral concept, nor some elusive component in a Nobel Prize winning theory. Assets have value; the assessment of this value facilitates a price/value appraisal, leading to a rational selection process, governed by seasoned judgment.
• What everyone knows about investing is usually worth little
• Achieving average investment performance is easy; above average is exceedingly difficult.
• Modern Portfolio Theory (MPT) and the Efficient Market Hypothesis (EMH) are nonsensical academic notions.
If the stock market was truly efficient security prices would smoothly adjust to reflect changes in enterprise value; volatility would be virtually non-existent.
• Broad diversification is a proxy for ignorance.
Broadly diversified portfolios acknowledge ignorance by saying, in effect, “Because I really do not know, I will spread my risk as much as possible.” Broadly diversified portfolios are the refuge of amateurs.
• Asset Allocation is a first cousin to the misguided notion of Broad Diversification.
• Exceptional investment performance, and safety, springs from concentrated portfolios.
Diluting one’s best investment ideas with inferior investment ideas makes no sense. Our portfolios typically hold between 20 and 40 securities.
• “Risk can be greatly reduced by concentrating on only a few holdings… Risk comes from not knowing what you are doing.”
– Warren Buffett
• The return of your principal is more important than the return on your principal.
• To perform better than average one cannot do what everyone else is doing.
• Investment safety is mostly a function of the balance sheet.
• “… about 90% of the maximum benefit of diversification was derived from portfolios of 12 to 18 stocks.”
Investment Analysis and Portfolio Management by Keith C. Brown, Don M. Chance and Frank K. Reilly. The Dryden Press Series.
• Business cycles will forever be with us.
Business cycles are largely expressions of the natural self-correcting process of the complex adaptive system we call the economy. The ebb and flow of these cycles is as natural as breathing. It is when the politicians, special interest groups, and policy makers monkey around with these cycles that we invite adversity.
• “The market can stay irrational longer than you can stay solvent.”
– John Maynard Keynes
• If it cannot go on forever, it will ultimately end.
• Never confuse genius with a bull market.
• “The dumbest reason in the world to buy a stock is because it’s going up.”
• There has always been, and will remain, an enduring relationship between price and value.
There has never been a time when an asset is so good that it was incapable of becoming a bad investment if purchased at too high a price. Similarly, there are few assets so bad that they could not become excellent investments if purchased cheap enough.
• Unlike the promoters of Modern Portfolio Theory (MPT) would have us believe, there is no asset class entitled to a high return.
Assets are attractive only in relation to price.
• The late John Templeton said,
“To buy when others are despondently selling and sell when others are euphorically buying takes great courage but provides the greatest profit.” Warren Buffett similarly said, “Be fearful when others are greedy and greedy when others are fearful.”
• Professional money managers have strong opinions about all things related to political developments, interest rates, inflation rates, economic trends, etc. and invest according to their beliefs.
These folks are frequently sighted (and cited) on the evening news, sharing their exceedingly valuable insights including their favorite stocks. Does it not strike you as odd that these folks would so magnanimously share such priceless information?
• A correct process will occasionally yield a poor result.
A poor process will occasionally yield a good result. However, an excellent long-term result will always be a result of consistently applying a correct process over time.
• “If we find a company we like, the level of the market will not really impact our decisions.
We will decide company by company. We spend essentially no time thinking about macroeconomic factors. We simply try to focus on businesses that we think we understand and where we like the prices.” Warren Buffett.
• Own what you own.
If you buy a house and pay cash (or tender an “excessive” down payment) you will not tap dance from the closing. However, if you pay cash, or have an insignificant mortgage, you will never experience foreclosure.
• There is enormous virtue in patiently letting value come to you.
Warren Buffett expressed it this way, “Lethargy, bordering on sloth, should remain the cornerstone of an investment style.”
• “If you’re an investor, you’re looking at what the asset is going to do; if you’re a speculator, you’re commonly focusing on what the price of the object is going to do…”
• It takes a lifetime to build a reputation and only minutes to destroy it.
• “The fact that other people agree or disagree with you makes you neither right nor wrong. You will be right if your facts and your reasoning are correct.”
– Benjamin Graham
• The most profitable investments are unconventional, scorned by the crowd.
Sustaining faith in these unpopular commitments requires confidence and conviction – a confidence and conviction that springs from exhaustive research, knowledge, and experience.
• It is impossible for an investment to be cheap and be popular.
Popular investments are dear.
• Markets are largely efficient most of the time.
To suggest that markets are always efficient, all of the time, is to be oblivious to human behavior.
• Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.”
– Warren Buffett
• Leverage will amplify returns when things work out as anticipated.
Leverage also amplifies risk. The next time you hear someone promote the merits of financial leverage remember this: 1. leverage will not enhance the underlying merits of an investment; 2. leverage amplifies prospective gains and losses; 3. leverage does not increase the likelihood of gain, but it does increase the consequences of loss.
• It’s a sad thing. You can have somebody whose aggregate [investment] performance is terrific, but they have a weakness – maybe it’s alcohol, maybe it’s susceptibility to taking a little easy money – it’s the weak link that snaps you. And frequently, in the financial markets, the weak link is borrowed money.”
– Warren Buffett.
• “Compounding is the greatest mathematical discovery of all time”