Author: Chong Ser Jing

Odyssey is an epic ancient Greek poem that is attributed to Homer. It was composed nearly 3,000 years ago, but it can teach us plenty about modern-day investing. 

An ancient epic

Odyssey recounts the tale of Odysseus, a Greek hero and king. After fighting for 10 long years in the Trojan War, Odysseus finally gets to go back to his home in Ithaca. Problem is, the way home for Odysseus was fraught with danger.

One treacherous part of the journey saw Odysseus having to sail past Sirenum Scopuli, a group of rocky small islands. They were home to the Sirens, mythical creatures that had the body of birds and the face of women.

The Sirens were deadly for sailors. They played and sang such enchanting melodies that passing sailors would be mesmerised, steer toward Sirenum Scopuli, and inevitably crash their ships.

Odysseus knew about the threat of the Sirens, but he also wanted to experience their beguiling song. So, he came up with a brilliant two-part plan.

The Greek hero knew for sure that he would fall prey to the seductive music of the Sirens – all mortal men would. So for the first part of his plan, he instructed his men to tie him to the ship’s mast and completely ignore all his orders to steer the ship toward Sirenum Scopuli when they approached the islands. For the second part, he had all his men fill their own ears with beeswax. This way, they couldn’t hear anything, and so would not be seduced by the Sirens when the ship was near Sirenum Scopuli.

The plan succeeded, and Odysseus was released by his men after his ship had sailed far beyond the dark reaches of the Sirens’ call.

A modern tragedy 

One of the great tragedies of modern-day investing is that we, as investors, are self-sabotaging.

Peter Lynch is one of the true investing greats. During his 13-year tenure with the Fidelity Magellan Fund from 1977 to 1990, he produced an annualised return of 29%, turning every $100,000 invested with him into $2.7 million. But the investors in his fund earned a much lower return. In his book Heads I Win, Tails I Win, Spencer Jakab, a financial journalist with The Wall Street Journal, explained why:

“During his tenure Lynch trounced the market overall and beat it in most years, racking up a 29 percent annualized return. But Lynch himself pointed out a fly in the ointment.

He calculated that the average investor in his fund made only around 7 percent during the same period. When he would have a setback, for example, the money would flow out of the fund through redemptions. Then when he got back on track it would flow back in, having missed the recovery.”

A 7% annual return for 13 years turns $100,000 into merely $241,000. Unfortunately, Lynch’s experience is not an isolated case.

In the decade ended 30 November 2009, CGM Focus Fund was the best-performing stock market fund in the US, with an impressive annual gain of 18.2%. But the fund’s investors lost 11% per year on average, over the same period. CGM Focus Fund’s investors committed the same mistake that Lynch’s investors did: They chased performance, and fled at the first whiff of any temporary trouble.

Two data points don’t make a trend, so let’s consider the broader picture. Investment research outfit Morningstar publishes an annual report named Mind The Gap. The report studies the differences between the returns earned by funds and their investors. In the latest 2019 edition of Mind The Gap, Morningstar found that “the average investor lost 45 basis points to timing over five 10-year periods ended December 2018.”

45 basis points equates to a difference of 0.45%, which is significantly lower than the performance-gaps that Lynch (22% gap) and CGM Focus Fund (29% gap) experienced. But the Morningstar study still highlights the chronic problem of investors under-performing their own funds because of self-sabotaging behaviour.

(If you’re wondering about the distinction between a fund’s return and its investors’ returns, my friends at Dr. Wealth have a great article explaining this.)

Tying the tales together

On his journey home, Odysseus knew he would commit self-sabotaging mistakes, so he came up with a clever plan to save himself from his own actions. The yawning chasm between the returns of Magellan Fund and CGM Focus Fund and their respective investors show that the investors would have been far better off if they had taken Odysseus’s lead. 

Having a fantastic ability to analyse the financial markets and find great companies is just one piece of the puzzle – and it’s not even the most important piece. There are two crucial ingredients for investing success.

The first is the ability to stay invested when the going gets tough, temporarily. Even the best long-term winners in the stock market experience sickening declines from time to time. This is why Peter Lynch once said that “in the stock market, the most important organ is the stomach. It’s not the brain.” The second key ingredient is the ability to delay gratification by ignoring the temptation to earn a small gain in order to earn a much higher return in the future. After all, every stock with a 1,000% return first has to jump by 100%, then 200%, then 300%, and so on.

We’re in an age where we’re drowning in information because of the internet. This makes short-term volatility in stock prices similar to the Sirens’ song. The movements – and the constant exposure we have to them – compel us to act, to steer our ship toward the Promised Land by trading actively. Problem is, the Promised Land is Sirenum Scopuli in disguise – active trading destroys our returns. I’ve shared two examples in an earlier article of mine titled 6 Things I’m Certain Will Happen In The Financial Markets In 2020. Here are the relevant excerpts:

“The first is a paper published by finance professors Brad Barber and Terry Odean in 2000. They analysed the trading records of more than 66,000 US households over a five-year period from 1991 to 1996. They found that the most frequent traders generated the lowest returns – and the difference is stark. The average household earned 16.4% per year for the timeframe under study but the active traders only made 11.4% per year.

Second, finance professor Jeremy Siegel discovered something fascinating in the mid-2000s. In an interview with Wharton, Siegel said:

“If you bought the original S&P 500 stocks, and held them until today—simple buy and hold, reinvesting dividends—you outpaced the S&P 500 index itself, which adds about 20 new stocks every year and has added almost 1,000 new stocks since its inception in 1957.”

Doing nothing beats doing something.”

We should all act like Odysseus. We should have a plan to save us from ourselves – and we should commit to the plan. And there’s something fascinating and wonderful about the human mind that can allow us to all be like Odysseus. In his book Incognito: The Secret Lives of the Brain, David Eagleman writes (emphasis is mine):

“This myth [referring to Odysseus’s adventure with the Sirens] highlights the way in which minds can develop a meta-knowledge about how the short- and long-term parties interact. The amazing consequence is that minds can negotiate with different time points of themselves.”

Some of you may think you’re an even greater hero than Odysseus and can march forth in the investing arena without a plan to save you from yourself. Please reconsider! Nobel-prize winning psychologist Daniel Kahneman wrote in his book, Thinking, Fast and Slow:

“The premise of this book is that it is easier to recognize other people’s mistakes than our own.” 

My Odysseus-plan

So what would our Odysseus-plans look like? Everyone’s psychological makeup is different, so my plan is not going to be the same as yours. But I’m still going to share mine, simply for it to serve as your inspiration:

• I commit to never allow macro-economic concerns (some of the recent worries are the US-China trade war and the unfortunate Wuhan-virus epidemic) to dominate my investment decision making.
• I commit to focus on the performance of the business behind the ticker and never allow stock price movements to have any heavy influence on my decision to buy or sell a share.
• I commit to invest for the long-term with a holding period that’s measured in years, if not decades.
• I commit to not panic when the stock market inevitably declines from time to time (volatility in the financial markets is a feature, not a bug).
• I commit to diversify smartly and not allow a small basket of stocks to make or break my portfolio.

I can’t tie myself to a ship’s mast, but I can keep my plan within easy visual reach so that I can sail safely toward the real Promised Land each time I find myself getting seduced by the Sirens’ song. If you have your own plan, we would love to hear from you – please share it in the comments section below, or email it to us at thegoodinvestors@gmail.com!

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

The excerpt below is from a recent blog post of Tim Ferris, an investor and author. It talks about how we can make better-quality decisions in life (emphasis his):

“How can we create an environment that fosters better, often non-obvious, decisions?

There are many approaches, no doubt. But I realized a few weeks ago that one of the keys appeared twice in conversations from 2019. It wasn’t until New Year’s Eve that I noticed the pattern.

To paraphrase both Greg McKeown and Jim Collins, here it is: look for single decisions that remove hundreds or thousands of other decisions.

This was one of the most important lessons Jim learned from legendary management theorist Peter Drucker. As Jim recounted on the podcast, “Don’t make a hundred decisions when one will do. . . . Peter believed that you tend to think that you’re making a lot of different decisions. But then, actually, if you kind of strip it away, you can begin to realize that a whole lot of decisions that look like different decisions are really part of the same category of a decision.”” 

To me, Ferriss’s thought is entirely applicable to investing too. The more decisions we have to make in investing, the worse-off our results are likely to be. That’s because the odds of getting a decision right in investing is nothing close to 100%. So, the more decisions we have to string together, the lower our chances of success are.

I was also reminded of the story of Edgerton Welch by Ferriss’s blog. There’s very little that is known about Welch. But in 1981, Pensions and Investment Age magazine named him as the best-performing money manager in the US for the past decade, which led to Forbes magazine paying him a visit. In an incredible investing speech, investor Dean Williams recounted what Forbes learnt from Welch:

“You are familiar with the periodic rankings of past investment results published in Pension & Investment Age. You may have missed the news that for the last ten years the best investment record in the country belonged to the Citizens Bank and Trust Company of Chillicothe, Missouri.

Forbes magazine did not miss it, though, and sent a reporter to Chillicothe to find the genius responsible for it. He found a 72 year old man named Edgerton Welsh, who said he’d never heard of Benjamin Graham and didn’t have any idea what modern portfolio theory was. “Well, how did you do it?” the reporter wanted to know.

Mr. Welch showed the report his copy of Value-Line and said he bought all the stocks ranked “1” that Merrill Lynch or E.F. Hutton also liked. And when any one of the three changed their ratings, he sold. Mr. Welch said, “It’s like owning a computer. When you get the printout, use the figures to make a decision–not your own impulse.”

The Forbes reporter finally concluded, “His secret isn’t the system but his own consistency.” EXACTLY. That is what Garfield Drew, the market writer, meant forty years ago when he said, “In fact, simplicity or singleness of approach is a greatly underestimated factor of market success.””

Welch reduced a complicated investing question – “What should I invest in?” – into something simple: Buy the cheap stocks. By doing so, he minimised the chances of errors creeping into his investing process.

My own process for finding investment opportunities in the stock market is radically different from Welch’s. But it can also be boiled down to a simple sentence: Finding companies that can grow at high rates for a long period of time. I focus my efforts on understanding individual companies and effectively ignore interest rates and most other macroeconomic developments when making investment decisions. My process sounds simple, but that’s the whole point – and it has served me well.

To make better investing decisions, reduce the number of decisions you have to make in your investing process. Simplify!

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

The financial media pays plenty of attention to interest rates. We just have to look at the amount of commentary that pops up whenever central banks around the world make their interest rate decisions.

If you invest in stocks, like us at The Good Investors, there are two things about interest rates and their implications that you should know.

No.1: The reality behind the relationship between interest rates and stock prices

I’ve written about the theory behind how interest rates govern the movement of stock prices in a previous article at The Good Investors titled 6 Things I’m Certain Will Happen In The Financial Markets In 2020. Here’s the relevant excerpt:

“Stocks and other asset classes (bonds, cash, real estate etc.) are constantly competing for capital. In theory, when interest rates are high, the valuation of stocks should be low, since the alternative to stocks – bonds – are providing a good return.

On the other hand, when interest rates are low, the valuation of stocks should be high, since the alternative – again, bonds – are providing a poor return.”

But in the same article, I also pointed out that things are different in real life:

“There’s an amazing free repository of long-term US financial market data that is maintained by Robert Shiller. He is a professor of economics and the winner of a Nobel Prize in economics in 2013.

His data includes long-term interest rates in the US, as well as US stock market valuations, going back to the 1870s. The S&P 500 index is used as the representation for US stocks while the cyclically adjusted price earnings (CAPE) ratio is the valuation measure. The CAPE ratio divides a stock’s price by its inflation-adjusted average earnings over a 10-year period.

The chart below shows US long-term interest rates and the CAPE ratio of the S&P 500 since 1920:

Contrary to theory, there was a 30-plus year period that started in the early 1930s when interest rates and the S&P 500’s CAPE ratio both grew. It was only in the early 1980s when falling interest rates were met with rising valuations.”

No.2: Based on history, interest rates have declined as a country develops

Josh Brown is the CEO of Ritholtz Wealth Management. In a June 2019 blog post, Brown recounted a dinner he had with the polymath investor William Bernstein. During the dinner, Bernstein posed a question that had been in his mind for awhile: What if the cost of capital never rises again? (The cost of capital refers to the cost of money – in other words, interest rates.)

Bernstein’s question is fascinating to think about. That’s because a broad look at history shows us that interest rates have declined as countries mature. Here’s Bernstein on the subject in his book, The Birth of Plenty (I highly recommend it!):

“Interest rates, according to economic historian Richard Sylla, accurately reflect a society’s health. In effect, a plot of interest rates over time is a nation’s “fever curve.” In uncertain times rates rise because there is less sense of public security and trust.

Over the broad sweep of history, all of the major ancient civilisations demonstrated a “U-shaped” pattern of interest rates. There were high rates early in their history, following by slowly falling rates as the civilisations matured and stabilized. This led to low rates at the height of their development, and, finally, as the civilisations decayed, there was a return of rising rates.”

The implications

There are two implications I can draw from the graph on interest rates vs valuation, and Bernstein’s data on how interest rates change with the growth of countries. First, Shiller’s data show that changes in interest rates alone cannot tell us much about how stocks will move. “If A happens, then B will occur” is a line of thinking that is best avoided in finance. The second implication is that it is possible for interest rates in the US and other parts of the world to stay low for a very long period of time. That’s history’s verdict.

In 6 Things I’m Certain Will Happen In The Financial Markets In 2020, I also wrote:

“Time that’s spent watching central banks’ decisions regarding interest rates will be better spent studying business fundamentals. The quality of a company’s business and the growth opportunities it has matter far more to its stock price over the long run than interest rates.

Sears is a case in point. In the 1980s, the US-based company was the dominant retailer in the country…

… US long-term interest rates fell dramatically from around 15% in the early-to-mid 1980s to 3% or so in 2018. But Sears filed for bankruptcy in October 2018, leaving its shareholders with an empty bag. In his blog post mentioned earlier, Housel also wrote:

“Growing income inequality pushed consumers to either bargain or luxury goods, leaving Sears in the shrinking middle. Competition from Wal-Mart and Target – younger and hungrier – took off.

By the late 2000s Sears was a shell of its former self. “YES, WE ARE OPEN” a sign outside my local Sears read – a reminder to customers who had all but written it off.”

Warren Buffett’s Berkshire Hathaway provides an opposite example to Sears. From the start of 1965 to the end of 1984, US long-term interest rates climbed from 4.2% to 11.5%, according to Shiller’s data. But a 23.7% increase per year in Berkshire’s book value per share over the same period resulted in a 27.6% annual jump in the company’s share price. A 23.7% input led to a 27.6% output over nearly 20 years, despite the significant growth in interest rates.

You may also be wondering: What’s going to happen to global financial markets in a world that is awash in cheap credit for a long time?

We can learn something from Japan: The country has already been in a situation like this for decades. The yield for 10-year Japanese government bonds has never exceeded 2% going back to the fourth quarter of 1997, according to data from the Federal Reserve Bank of St Louis. In fact, the yield has fallen from 1.96% to a negative 0.2% in the third quarter of 2019 (see chart below).

Interestingly, Japan’s main stock market index, the Nikkei 225, is just 40% or so higher from October 1997 to today, despite interest rates in the country having declined from an already low base in that time frame.

Yet, there’s a company in Japan such as Fast Retailing – owner of the popular Uniqlo clothing brand – which has seen its stock price increase by more than 11,000% over the same period because of massive growth in its business. From the year ended 31 August 1998 (FY1998) to FY2019, Fast Retailing’s revenue and profit grew by around 27 times and 56 times, respectively.  

What it all means for stock market investors

So to wrap up everything I’ve shared earlier in this article:

1. Rising interest rates may not hurt stock prices by depressing valuations, as seen from the S&P 500’s CAPE ratio increasing from the 1930s to the 1960s while interest rates were rising.
2. Historically, interest rates have declined and stayed low as countries develop and mature, according to William Bernstein’s book, The Birth of Plenty.  
3. Falling interest rates cannot help a stock if its business is crumbling, as seen in the case of Sears.
4. Rising interest rates also would not necessarily harm a stock if its business is flourishing, as Berkshire Hathaway has demonstrated.
5. The example of Japan’s Nikkei 225 index show that persistently low interest rates don’t always benefit stocks too. 
6. Fast Retailing’s experience highlights how Individual stocks can still be huge winners even in a flat market, if their businesses do well over time. 

And what do all these mean for us as stock market investors? It means that we shouldn’t bother with interest rates. Instead, we should focus on the health and growth of the businesses that are behind the stocks we own or are interested in. In other words, watch business fundamentals, not interest rates.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

In 2011, Jeff Bezos, the founder and CEO of the US online retail giant Amazon.com, was interviewed by Wired. During the interview, he said (emphasis is mine):

“If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people. But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that.

Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue.”

What’s an edge?

I believe Bezos’s quote above applies to stock market investing too. By simply lengthening our time horizon when investing, we can gain an edge and eliminate our competition.

Investor John Huber from Saber Capital Management, who has an excellent – albeit relatively short – track record,  explained in a 2013 presentation that there are only three sources of edge: Informational; analytical; and time. I agree.

A difficult source of lasting edge

The informational edge refers to having access to information that most others do not have. In his 2013 presentation, Huber shared the story of how Buffett uncovered Western Insurance as an investment opportunity in the 1950s.

Western Insurance was a profitable, well-run insurance company and was selling at a price-to-earnings ratio of just 1. Buffett found the company by poring over Moody’s, a print magazine that listed financial statistics of stocks in the US. It would have been painstaking work in those days to look at every stock individually.

With the birth of the internet, the informational edge has mostly disappeared since information is now easily and cheaply available. The Internet – and the growth in software capabilities – have levelled the information playing field tremendously. This makes having access to information difficult to be a lasting investing edge for us.

Another difficult source of lasting edge  

The analytical edge is where you’re able to process information differently and come up with better insights compared to most. I believe, like Huber does, that this is still possible. Give two investors the exact same information about a company and it’s highly likely they will arrive at a different conclusion about its attractiveness as an investment opportunity.

As a great example, we can look at Mastercard and how investors Chuck Akre and Mohnish Pabrai think about the credit card company.

Akre runs the Akre Focus Fund, which has generated an impressive annual return of 16.8% from inception in August 2009 through to 30 September 2019. Over the same period, the S&P 500’s annual return was just 13.5%. Pabrai also has a fantastic long-term record. His fund’s annual return of 13.3% from 1999 to 30 June 2019 is nearly double that of the US market’s 7.0%.

At the end of September 2019, Mastercard made up 10% of the Akre Focus Fund. So clearly, Akre thinks highly of the company. Pabrai, on the other hand, made it very clear in a recent interview that he wouldn’t touch Mastercard with a 10-feet barge pool. In the October 2019 edition of Columbia Business School’s investing newsletter, Graham and Doddsville, Pabrai said:

“Is MasterCard a compounder? Yeah. But what’s the multiple? I can’t even look. Investing is not about buying great businesses, it’s about making great investments. A great compounder may not be a great investment.”

The fact that two highly accomplished stock market investors can have wildly differing views on the same company means that it is possible for us to develop an analytical edge. But it is not easy to achieve. In fact, I have a hunch that the ability to consistently produce differentiated insight may be an innate talent that some investors possess and others don’t.

A simple but lasting edge

Huber’s last source of edge, time, refers to our ability to simply adopt a long time horizon in the way we invest. It sounds simple, but it’s not easy to achieve. Because like Bezos said, not many people are willing or able to be patient. This makes time a lasting edge we can have in the market.

You may be surprised to know just how short-term minded many professional investors can be. A recent article from Huber showed how the hedge fund SAC Capital was predominantly focused on short-term stock price movements (emphasis is mine):

“The firm spent hundreds of millions of dollars they collectively spent on research [sic] was all designed to figure out if a stock was going to go up or down a few dollars in a short period of time, usually after an earnings announcement or some other significant event.

These traders were moving billions of dollars around with no concern for what the company’s long-term prospects were, other than how those prospects might be viewed by other traders in the upcoming days…

… The traders at SAC weren’t even discussing this type of edge [referring to the time-related edge]. It wasn’t even on their radar, because they had no interest in the long game.”

Another example can be seen in a story that Morgan Housel from the Collaborative Fund shared in a blog post (emphasis is mine):

“BlackRock CEO Larry Fink once told a story about having dinner with the manager of one of the world’s largest sovereign wealth funds.

The fund’s objectives, the manager said, were generational. “So how do you measure performance?” Fink asked. “Quarterly,” said the manager.

There is a difference between time horizon and endurance.”

Since many investors are more concerned with short-term price movements than long-term business value, this creates an opportunity for us if we’re focused on the latter. In the same article on SAC Capital, Huber explained:

“[T]he investor who is willing to look out three or four years will have a lasting edge because the more money that gets allocated for reasons other than a security’s long-term value, the more likely it is that the security’s price becomes disconnected from that long-term value.” 

The curse of patience, and a switch in mindset

Although having time on our side is a simple way for us to gain a lasting edge in the stock market, it is not easy to achieve, since we have to pay a price – of enduring short-term volatility. History bears this out: Even the biggest long-term winners in the stock market have also suffered painful short-term declines. 

Take the US-listed Monster Beverage for instance. I’ve written previously that from 1995 to 2015, Monster Beverage produced an astonishing total return of 105,000% despite its stock price having dropped by 50% or more from a peak on four separate occasions in that timeframe.

But a switch in our mindset can make the sharp swings over the short run easier to manage. “Fees are something you pay for admission to get something worthwhile in return. Fines are punishment for doing something wrong,” Morgan Housel once wrote. Most investors think of short-term volatility in the stock market as a fine, when they should really be thinking of it as a fee for something worthwhile – great long-term returns.

So, fee or fine? I love paying fees. Do you?

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

Walter Schloss is one of my investing heroes. He’s not too well-known, which is a real pity, because he has a tremendous track record. He invested in US stocks for his fund and produced an astonishing annual return of 15.3% for 44 years from 1956 to 2000, far outstripping the US market’s annual gain of 11.5% over the same period.

There’s so much we can learn from Schloss. He never went to college. He was a one-man shop until his son Edwin joined in 1973 – and then they became a two-man shop till the fund was closed in the early 2000s. Schloss typically worked only from 9:30 am to 4:30 pm. Despite running a highly successful investment fund, he led very much a stress-free lifestyle. His office was also simple – it was a closet in a rented corner of a larger office. It seems like there’s no need for a fancy office to do well in investing! Schloss had no use for insider-connections and got his investment ideas mainly by reading the financial statements of companies. He’s a close friend of Warren Buffett, but invested in a completely different way, as we’ll see later.  

Unfortunately, it’s impossible for us now to learn directly from Schloss – he sadly passed away in 2012 at the ripe young age of 95. But the internet has given us the good fortune of being able to freely access a wonderful archive of materials on him. Within the archive is a fantastic investing speech Schloss once gave. 

Here are three great insights from him in that speech, along with my comments:

On investing in commodity-related stocks

Question: “Are you involved with commodities at all and if so…do you see silver as under-valued?”

Schloss: “You know, I have no opinion about any commodity or where it’s going to go and Asarco [a stock Schloss owned at the time of the speech] is a commodity company in copper. I have no idea if copper can keep going longer.

But I just think that the stock is cheap based upon its price, not necessarily because I know what’s going to happen to the price of the copper any more than silver. I have no opinion on any of those things. It saves me a lot of time.”

I love how Schloss had invested in a copper-related company not because he thought he knew where the price of copper’s heading to, but because he thought the stock was cheap. The difference between the two mindsets is very important for two reasons. 

First, the future movement of commodity prices is notoriously hard to pin down. In an article with Fool.com, Morgan Housel shared this fascinating nugget of information (emphasis is mine):

“[Economists Ron Acquits, Lutz Kilian, and Robert Vigfusson] showed that forecasts of the price of oil one year out made by the Energy Information Agency and survey firm Consensus Economics were no more accurate than just assuming whatever oil’s price is today is what it will be next year. Literally, not having any forecast was as accurate as a professional forecast.”

Second, a commodity-related company’s stock may not become a winner even if the price of the associated-commodity rises substantially. Here’s something on the topic that I shared in The Good Investors previously:

“Gold was worth A$620 per ounce at the end of September 2005. The price of gold climbed by 10% per year for nearly 10 years to reach A$1,550 per ounce on 15 September 2015. An index of gold mining stocks in Australia’s market, the S&P / ASX All Ordinaries Gold Index, fell by 4% per year from 3,372 points to 2,245 in the same timeframe.”

A high starting valuation. A weak balance sheet. Poor efficiency in production. Unscrupulous management. These are just some of the obstacles that stand between a positive macro-trend and higher stock prices.

The importance of knowing your own strengths and weaknesses

Question: “Buffett keeps talking about liking a handful of thick bets. It sounds like you don’t do that.”

Schloss: “Oh, no, we can’t. Psychologically I can’t, and Warren as I say, is a brilliant, he’s not only a good analyst, but he’s a very good judge of businesses and he knows, I mean my gosh, he buys a company and the guy’s killing himself working for Warren. I would have thought he’d retire.

But Warren is a very good judge of people and he’s a very good judge of businesses. And what Warren does is fine. It’s just that it’s not our – we just really can’t do it that way and find five businesses that he understands, and most of them are financial businesses, and he’s very good at it. But you’ve got to know your limitations.”

One of the most crucial skills we have to master as investors is knowing the limits of our knowledge and staying clear of the boundaries is. A failure to do so can be disastrous when investing. That’s because we may end up using strategies that are ill-suited to our psyche, and thus potentially result in us commiting stupid mistakes frequently.

Schloss understood this well, and invested in a manner that was well-suited to his own strengths and weaknesses. In his seminal 1984 essay on investing, The Superinvestors of Graham and Doddsville, Buffett shared the following about Schloss (emphasis is his):

“Walter has diversified enormously, owning well over 100 stocks currently. He knows how to identify securities that sell at considerably less than their value to a private owner. And that’s all he does.

He doesn’t worry about whether it’s January, he doesn’t worry about whether it’s Monday, he doesn’t worry about whether it’s an election year. He simply says, if a business is worth a dollar and I can buy it for 40 cents, something good may happen to me. And he does it over and over and over again.

He owns many more stocks than I do – and is far less interested in the underlying nature of the business; I don’t seem to have very much influence on Walter. That’s one of his strengths: no one has much influence on him.”

We need to evolve with the ever-changing market

Question: “Has your approach changed significantly?”

Schloss: “Yes, it’s changed because the market’s changed. I can’t buy any working capital stocks anymore so instead of saying well I can’t buy ‘em, I’m not going to play the game, you have to decide what you want to do.

And so we’ve decided that we want to buy stocks if we can that are depressed and are some book value and are not too, selling near to their lows instead of their highs and nobody likes them.

Well why don’t they like them? And then you might say there may be reasons why. It may simply be they don’t have any earnings and people love earnings. I mean that’s, you know, the next quarter that’s the big thing and of course we don’t think the net quarter is so important.”

I published an article recently in The Good Investors titled Sometimes, This Time Really Is Different. In the article, I shared that “it’s important for us to acknowledge that conditions in financial markets can change in permanent or near-permanent ways to severely blunt the usefulness of historical experience.”

Schloss was well aware of the need to keep up with the times, and he changed his investing approach when there was a paradigm shift. I think this is a severely underrated reason for his longevity in investing. 

But crucially, Schloss also knew what to retain. He continued (1) seeing stocks as partial ownership stakes in businesses, (2) to purchase stocks that were selling for far less than what their underlying businesses were worth, and (3) to be aware of his own limitations.

There are things about investing that are timeless. But markets do change, and so should we.

I highly recommend you to check out Schloss’s speech. It will be well worth your time. Here it is again.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

News broke earlier today that Iran has fired missiles at US troops stationed in Iraq, in retaliation for the death of a top Iraninan general at the hands of the US military. 

Could Iran’s latest move escalate into a full-blown war between itself and the US? I have no idea. My heart sinks at the thought of the human lives that could be painfully ended or maimed because of any potential large-scale armed conflict. May a war not happen. The human costs are too tragic. 

But what if tensions between Iran and the US erupt and a huge battle develops? What happens to the financial markets? In this uncertain time, it’s worth remembering that:

• The US experienced a recession in July 1990
• The US entered into war in the Middle East in August 1990. 
• The price of oil spiked in August 1990. 
• Ray Dalio said in early 1992 that “unfortunately… the current economic climate of low inflation and historically slow growth means that bonds will actually prove to be the better long-term performers.”

But from the start of 1990 to today, the US stock market is up nearly 800% in price alone (the chart below shows the price-change for the S&P 500 from the start of 1990 to early December 2019):

Every time I’m confronted with uncertainty in the markets, I turn to one of my favourite investing passages. It’s written by Warren Buffett in his Berkshire Hathaway 1994 shareholders’ letter:

“We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen.

Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%.

But, surprise – none of these blockbuster events made the slightest dent in Ben Graham’s investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices.

Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.

A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results.”

This too, shall pass. But again, may war not happen.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

In 2010, the US government interviewed Warren Buffett as part of its investigation on the causes of the 2007-09 financial crisis. 

The 103-page transcript of Buffett’s interview was released by the US government in March 2016, along with many other documents created during the investigation. The documents are a wonderful resource if you’re interested in gaining a deeper understanding of the worst economic meltdown seen in generations.

The transcript of Buffett’s interview is a fascinating treasure-trove of valuable insights from one of the best investors in the world today. Here are my favourite Buffett quotes from the transcript:

Spotting a great investment:

“And basically, the single-most important decision in evaluating a business is pricing power.

If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you’ve got a terrible business. I’ve been in both, and I know the difference.”

Causes of a bubble:

“[T]he only way you get a bubble is when basically a very high percentage of the population buys into some originally sound premise and – it’s quite interesting how that develops – originally sound premise that becomes distorted as time passes and people forget the original sound premise and start focusing solely on the price action.”

More on the causes of a bubble (emphasis mine):

“[W]hat my former boss, Ben Graham, made an observation, 50 or so years ago to me that it really stuck in my mind and now I’ve seen evidence of it. He said, “You can get in a whole lot more trouble in investing with a sound premise than with a false premise.”

If you have some premise that the moon is made of green cheese or something, it’s ridiculous on its face. If you come out with a premise that common stocks have done better than bonds — and I wrote about this in Fortune article in 2001 – because there was a famous little book in 2001 by Edgar Lawrence Smith – in 1924 by Edgar Lawrence Smith that made a study of common stocks versus bonds.

And it showed – he started out with the idea that bonds would over-perform during deflation and common stocks would over-perform during inflation. He went back and studied a whole bunch of periods and, lo and behold, his original hypothesis was wrong.  He found that common stock always over-performed. And he started thinking about that and why was that.

Well, it was because there was a retained earnings factor. They sold – the dividend yield on stocks was the same as the yield on bonds, and on top of it, you had retained earnings.  So they over-performed. That became the underlying bulwark for the ‘29 bubble. People thought stocks were starting to be wonderful and they forgot the limitations of the original premise, which was that if stocks were yielding the same as bonds, that they had this going…

…So after a while, the original premise, which becomes sort of the impetus for what later turns out to be a bubble is forgotten and the price action takes over.”

Even more on the causes of a bubble:

“It’s a totally sound premise that houses will become worth more over time because the dollar becomes worth less. It isn’t because – you know, construction costs go up.  So it isn’t because houses are so wonderful, it’s because the dollar becomes worth less, and that a house that was bought 40 years ago is worth more today than it was then.

And since 66 or 67 percent of the people want to own their own home and because you can borrow money on it and you’re dreaming of buying a home, if you really believe that houses are going to go up in value, you buy one as soon as you can. And that’s a very sound premise.  It’s related, of course, though, to houses selling at something like replacement price and not far outstripping inflation.

So this sound premise that it’s a good idea to buy a house this year because it’s probably going to cost more next year and you’re going to want a home, and the fact that you can finance it gets distorted over time if housing prices are going up 10 percent a year and inflation is a couple percent a year.

Soon the price action – or at some point the price action takes over, and you want to buy three houses and five houses and you want to buy it with nothing down and you want to agree to payments that you can’t make and all of that sort of thing, because it doesn’t make any difference: It’s going to be worth more next year.

And lender feels the same way. It really doesn’t make a difference if it’s a liar’s loan or you know what I mean? …because even if they have to take it over, it’s going to be worth more next year. And once that gathers momentum and it gets reinforced by price action and the original premise is forgotten, which it was in 1929.” 

Detecting danger in financial institutions:

“Well, I didn’t know that they weren’t going to be good investments, but I was concerned about the management at both Freddie Mac and Fannie Mae, although our holdings were concentrated in Fannie Mac.

They were trying to – and proclaiming that they could increase earnings per share in some low double-digit range or something of the sort. And any time a large financial institution starts promising regular earnings increases, you’re going to have trouble, you know?

I mean, it isn’t given to man to be able to run a financial institution where different interest-rate scenarios will prevail on all of that so as to produce kind of smooth, regular earnings from a very large base to start with; and so if people are thinking that way, they are going to do things, maybe in accounting – as it turns out to be the case in both Freddie and Fannie – but also in operations that I would regard as unsound.”

There’s never just one problem:

“And, you know, there is seldom just one cockroach in the kitchen. You know, you turn on the light and, all of sudden, they all start scurrying around. And I wasn’t – I couldn’t find the light switch, but I had seen one.“

Having faith in the system:

“I was, in my own mind, I – there was only way both the financial world and the economy was going to come out of this situation of paralysis in September of 2008, and that was – I made the fundamental decision that we had really the right people in Bernanke and Paulson in there, where the President would back them up. That we had a government that would take the action and only the government could take the action to get an economic machine that had become stalled, basically, back into action.

And I didn’t know what they would do. I didn’t know what Congress would go – it really didn’t make much difference. The important thing was that the American public would come to believe that our government would do whatever it took. And I felt it would – it would have been suicide not to, but it hadn’t been done in the early ‘30s.

And therefore, I felt companies like General Electric or Goldman Sachs were going to be fine over time. But it was a bet essentially on the fact that the government would not really shirk its responsibility at the time like that, to leverage up when the rest of the world was trying to de-leverage and panicked.”

Understanding moral hazard:

Question to Buffett: “Would the American economy have been better off in the long run if there had been no exceptional government assistance to financial institutions? In other words, do you think we’ve increased the likelihood of moral hazard in the long run?”

Buffett’s response: “No, I think the moral hazard has been misunderstood in a big way. There is no moral hazard existing with shareholders of Citigroup, with Freddie Mac, with Fannie Mae, with WaMu, with Wachovia – you just go up and down the line. I mean, those people lost anywhere from 90 percent to 100 percent of their money, and the idea that they will walk away and think, “Ah, I’ve been saved by the federal government.”

I think just the companies that I’ve named there’s at least a half a trillion dollars of loss to common shareholders. Now, there’s another question with management, which we might get into later, but in terms of moral hazard, I don’t even understand why people talk about that in terms of equity holders.”

The difference between investing and speculating:

“It’s a tricky definition. You know, it’s like pornography, and that famous quote on that.

But I look at it in terms of the intent of the person engaging in the transaction, and an investment operation – though, it’s not the way Graham defines it in his book, but investment operation in my view is one where you look to the asset itself to determine your decision to lay out some money now to get some more money back later on.

So you look to the apartment house, you look to the stock, you look to the farm, in terms of what that will produce. And you don’t really care whether there is a quote on it at all. You are basically committing some funds now to get more funds later on, through the operation of the asset.

Speculation, I would define as much more focused on the price action of the stock, particularly that you, or the index future, or something of the sort. Because you are not really you are counting on for whatever factors, because you think quarterly earnings are going to be up or it’s going to split, or whatever it may be, or increase the dividend but you are not looking to the asset itself.” 

The dangers of using borrowed money:

“Anything that increased leverage significantly tends to make – it can’t even create a crisis, but it would tend to accentuate any crisis that occurs.

I think you that if Lehman had been less leveraged, there would have been less problem in the way of problems. And part of that leverage arose from the use of derivatives, and part of the – part of the dislocation that took place afterwards arose from that.

And there’s some interesting material, if you look at – if you look at – I don’t know exactly what Lehman material I was looking at – but they had a netting arrangement with the Bank of America, as I remember.

And, you know, the day before they went broke – and just are very, very, very rough figures, from memory – but as I remember, the day before they went broke, Bank of America was in a minus position of $600 million, or something like that, they had deposited with, I think, JPMorgan in relation to Lehman. And I think the day they went broke, it reversed to a billion and a half in the other direction. And those are big numbers. And I think the numbers – I think I’m right on just order of magnitude.

So when things like that exist in the system, you know, it’s under stress for other reasons, it becomes a magnifying factor how big of a one, you don’t know. But Lehman – Lehman would have had less impact on the system if they had not had the derivative book that they had. Now, they probably had bad real estate investments and a whole bunch of other things as well.” 

More on the dangers of using borrowed money:

“But it gets down to leverage overall. I mean, if you don’t have leverage, you don’t get in trouble.  That’s the only way a smart person can go broke, basically. And I’ve always said, “If you’re smart, you don’t need it; and if you’re dumb, you shouldn’t be using it.”” 

The risks of financial derivatives:

“I think it’s a terribly difficult problem because – well, it was so difficult a problem, I didn’t think I could solve it.

We bought Gen Re, which had 23,000 derivative contracts. I could have hired 15 of the smartest people – math majors, Ph.D.s, and I could have given them carte blanche to devise any reporting system to me, that would enable me to get my mind around what exposures I had, and it wouldn’t have worked. The only answer was to get out of it.

Can you imagine, 23,000 contracts with 900 institutions all over the world, probably 200 of them with names I can’t pronounce, you know? And all of these contracts extending years in the future, multiple variables. You know, all of these – you can’t – you can’t manage them, in my view. You know, I wouldn’t be able to manage something like that.

And if I read a 10K that’s 300 pages long and it describes notional values and all this – not to impugn anybody because probably one of the best managed, really large institutions around – but if I look at JPMorgan, I see two trillion of receivables, two trillion of payables, a trillion seven netted off on each side; of the 300 billion remaining, maybe 200 billion collateralized.

But that’s all fine, but I don’t know what these continuities are going to do to those numbers overnight. If there’s a major nuclear, chemical, or biological terrorist action that really is disruptive of the whole financial system here, who the hell knows what happens to those numbers on both sides or thousands of counterparties around?

So I don’t think it’s – I think it’s virtually unmanageable. It certainly is – it would be for me.” 

The causes of the housing crisis that led to the financial crisis:

“Well, I think the primary cause was an almost universal belief, among everybody and I don’t ascribe particular blame to any part of it – whether it’s Congress, media, regulators, homeowners, mortgage bankers, Wall Street — everybody — that houses prices would go up.  And you apply that to a $22 trillion asset class, that’s leveraged up, in many cases. And when that goes wrong, you’re going to have all kinds of consequences.

And it’s going to hit not only the people that did the unsound things, but to some extent the people that did the semi sound, and then finally the sound things, even, if it is allowed to gather enough momentum of its own on the downside, the same kind of momentum it had on the upside.

I think contributing to that — or causing the bubble to pop even louder, and maybe even to blow it up some, was improper incentives — systems and leverage. I mean, those — but they will contribute to almost any bubble that you have, you know, whether it’s the Internet or anything else.

The incentive systems during the Internet, you know, were terrible. I mean, you just — you formed a company, and you said, “I’m going to somehow deliver a billion eyeballs,” and somebody says, “Well, that’s $50 apiece,” or something. I mean, you get craziness that goes on there.

Leverage was not as much a factor in a bubble. But I think in this particular bubble, because leverage is so much a part of real estate, that once you loosened up on that, you’ve provided fuel that caused that bubble to get even bigger, and you made the pop even bigger, when it finally did pop.”

Accepting but not condoning fraud:

“Well, I mean, there was, obviously, a lot of fraud. There was fraud on the parts of the borrowers and there was frauds on the part of the intermediaries, in some cases. But you’d better not have a system that is dependent on the absence of fraud. I mean, it will be with us.”  

Here’s the link to download the transcript of Buffett’s interview. Take a look. Trust me – you’ll thoroughly enjoy it.

Photo source: Modified from Warren Buffett Caricature by DonkeyHotey under Creative Commons 2.0.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.