Thursday, February 20, 2014

Humility and knowledge

In most companies the person who knows the most is seated in a corner and quickly approaching retirement.  They've accumulated their knowledge through years of experience.  To an outsider their experience and knowledge might not mean much.  A handful of procedure codes, or special procedures and approaches to solve specific problems.  Their knowledge is stored in their mind and scattered amongst hundreds of emails.  Something like this might sound preposterous to an outsider, but every company has someone like this.

I'm convinced that as we get older instead of knowledge increasing our knowledge of what we don't know increases.  There is great power in understanding what we don't know.

My soon to be four year old son recently proclaimed that he "knew everything about airplanes."  He proceeded to tell his grandmother that if she ever had any questions about airplanes she should ask him.  The punchline is that his grandmother has worked for various airlines for a significant portion of her career.

This seems like a silly story, of course a child doesn't know everything about airplanes, how could he?  The problem is many investors act like my son.  He watches a few shows about airplanes and suddenly he's an expert.  Investors read a few books about an industry and suddenly they're experts.  Both are blinded by what they don't know.

What we need is more humility and less arm chair experts.  As investors we're looking at companies from the outside.  Our interface to operations are financial filings, and whatever other industry information we can gleam.  Investors who consider themselves experts might only have the knowledge equivalent of an average industry practitioner.

Humility is needed to recognize that we don't know as much as we think we do, and that we're wrong more than we'd like to be.

I think it was Charlie Munger, or John Templeton who said that investors only need to be right 60% of the time.  If that's true that means 40% of our decisions will be wrong.  Not slightly wrong, or off by a hair, but completely wrong.  In school answering questions correctly 60% of the time resulted in the lowest passing grade possible.  Yet in the investing world it signifies considerable success.

Value investing is successful because it is a system that attempts to handicap unknown risks related to an investment.  We might want to be experts, or think we're experts, but we need to recognize we're not.  Once we realize we're not experts we can start to take advantage of the handicaping system built into value investing.  Is a company facing a lawsuit, and the liability a wide range of outcomes?  Seek a bigger discount.  Does the company's management leave much to be desired?  Seek a bigger discount when purchasing.  Are the quality of assets questionable?  Seek a bigger discount.

Unlike some aclaimed value investors most of my investments have a bit of hair on them.  I'm not in the business of buying good companies at great prices.  Because of this many of my potential investments are trading at low multiples.  The only protection I have when I purchase is the discount to intrinsic value.  The larger the discount the more protected I am from negative outcomes.  It's likely that something negative will happen to a holding, but I am protected because I purchased so cheap.  If a company with a 2x earnings multiple reports that earnings fell 50% I now hold a company at 4x earnings, not a terrible position to be in.  

We need humility to recognize that we're not experts in our holdings.  When we're not experts we need a larger handicap against bad situations.  The more unknowns and the more unknowables the larger the discount.  One of the biggest mistakes we can make is thinking that we are more knowledgable than others, and because of that we don't need as large a discount to intrinsic value.  Investors playing this game are taunting the odds.  For that to work out investors need to be right, and as noted above being right only happens about 60% of the time for the best of us.

It's alright to admit we don't know everything about an investment.  It's alright to have a simple investment thesis.  Understanding our own psychology and working with it is better than fooling ourselves into losses.


4 comments:

  1. Nice post Nate. This is why I'm skeptical when investors (Ackman, Sham Gad, etc) think they know how to run a business just because they run a hedge fund. Any retailer could have told Ackman that eliminating markdowns at JCP was a foolish thing to do (I'm not sure why Johnson didn't know that...he was probably blinded by his time at AAPL).

    I spent a couple years working as the controller/CFO of a brewpub, and I learned more in those 2 years than I could have learned in 10 years of just analyzing restaurant financial statements. I think too many people go directly into asset management...their lack of experience working or running a business harms them in the long run. Spend a couple years actually running a business (no matter how small) and you'll learn far more than you will by reading 10-ks or books. To paraphrase Buffett, Rose Blumkin (not sure she even had a high school education) knew far more about accruals and inventory management than any financial analyst out there.

    ReplyDelete
  2. I agree with above. Admitting that we do not know everything also should prevent us from overconcentration or thinking that any investment could be. "No brainer".

    Kevin, i have read analyst reports about the company i work for and the analyst conclusions can almost be comical. It is obvious, that their knowledge is completely artificial and second hand. I presume this happens, when you hire someone for an analyst job right out if college.

    ReplyDelete
  3. I embrace my ignorance! By admitting that I don't really understand ANY industry, it leads me to buy only securities that I am highly certain cannot lose money. This means I rarely buy common stocks as you usually need to be higher up in the capital structure to be sure you won't lose money. So I end up with a concentrated portfolio of mostly illiquid preferred stocks and bonds. It is definitely not a portfolio for someone who wants to see "action" or follow news on the portfolio on a regular basis, but it has done quite well for me. My lack of knowledge is made up for by patience and the value investor mindset

    ReplyDelete
  4. This article has reminded me why I like to diversify adequatly instead trying to hold 10 stocks at a time. I can't possibly know everything.

    ReplyDelete