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Confronting Behavioral Biases


jschembs
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One of the most difficult problems in investing is adjusting a mindset after you've committed to a certain position - particularly after having spent countless hours supporting your thesis.

 

My point here is to create a punching bag for those of us who could use some counterarguments. I propose posting your "highest conviction" positions for ridicule to the board.

 

I'll start - short CRM, long SODI.

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short CRM: why? are there no other attractive uses for your capital which offer a safer risk/return? it seems like a stock like that has so many non-fundamental issues which may or may not drive the stock price that you open yourself up to a lot of pain while waiting for fundamentals to adjust. additionally, the SAAS business model has very attractive characteristics which you are fighting against.

 

i think the jist of this argument is not whether CRM is a good short candidate or not on an absolute basis, but rather one of relative attractiveness.

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Im always suprised how most investors seem to ignore buffett's advice to not short stocks. You either need to time the market, or you need to large downside risks. You take on additional unnecesairy risks without additional upside.

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Doesn't hurt to think for yourself instead of blindly following Buffett's advice. You can short without timing the market or without taking large downside risks... But I don't think this is the right thread to discuss to pro's en con's of shorting.

 

@jschembs: I'm long SODI as well, but is this really your highest conviction pick? Management is not shareholder friendly, and you probably also have a lot of key man risk (how does the company run without Seraf?). At the same time the business isn't doing that great (and hasn't improved vs a few years ago) while the stock price is up.

 

I'm by the way also short CRM (since 2011... lol).

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Thanks for the comments. I've found shorting to be a helpful tool, although I certainly learned some lessons last year vis-a-vis the chances of silly going to twice silly.

 

I certainly agree on SODI's corporate governance issues, but in this environment I don't see as many opportunities that have the upside from simply reallocating capital. Getting Shevach to listen, however, is another story...

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Doesn't hurt to think for yourself instead of blindly following Buffett's advice. You can short without timing the market or without taking large downside risks... But I don't think this is the right thread to discuss to pro's en con's of shorting.

 

@jschembs: I'm long SODI as well, but is this really your highest conviction pick? Management is not shareholder friendly, and you probably also have a lot of key man risk (how does the company run without Seraf?). At the same time the business isn't doing that great (and hasn't improved vs a few years ago) while the stock price is up.

 

I'm by the way also short CRM (since 2011... lol).

 

Those that are long SODI, I haven't followed it too much, but when I was looking at my first US small cap, I compared it to IEHC. So tell me how is it better than IEHC considering SODI is not shareholder friendly ( I heard about oddballstocks and some others here confronting management at board meetings). I mean if the management is not shareholder friendly, then GET OUT!

 

 

Ok for my highest convinction: WLP. I have owned it for a long time but I increased my position significantly 2 yrs ago. I wrote about my thesis on yahoo boards and I recall I got flak, comments like "total garbage". BTW if you haven't noticed it has almost doubled in that time.  So my high conviction story is something that is working out. But looking back 2 yrs ago, I learned something. When someone on a lousy board like yahoo tells you that your idea is garbage, you are probably on to something good!

 

 

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Thanks for the comments. I've found shorting to be a helpful tool, although I certainly learned some lessons last year vis-a-vis the chances of silly going to twice silly.

 

I certainly agree on SODI's corporate governance issues, but in this environment I don't see as many opportunities that have the upside from simply reallocating capital. Getting Shevach to listen, however, is another story...

How much do you think it's worth?

 

TTM operating income: 575K. Throw a 10x multiple on that (don't have to account for taxes) and you have a value of 5.8 million for the business. They have 6.7 million in cash, so potential value is around 12.7 million. Current market cap is 10 million, so upside is ~25% IF corporate governance can be improved. Must be possible to find a better deal, or not?

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Doesn't hurt to think for yourself instead of blindly following Buffett's advice. You can short without timing the market or without taking large downside risks... But I don't think this is the right thread to discuss to pro's en con's of shorting.

 

@jschembs: I'm long SODI as well, but is this really your highest conviction pick? Management is not shareholder friendly, and you probably also have a lot of key man risk (how does the company run without Seraf?). At the same time the business isn't doing that great (and hasn't improved vs a few years ago) while the stock price is up.

 

I'm by the way also short CRM (since 2011... lol).

I did think for myself, and it seems if you look at risk/reward ratio, shorting seems almost always irrational. Seems you either have to write calls (taking large downside risk vs limited upside) or buy puts (having to time market) , or outright short a stock (large downside risk vs limited upside)? Im talking about outright shorting one stock you don't own, and not pair trades or things like that. Only thing that seems worth it are buying puts if there is a definitive time limit that is not priced well into put options.

 

Anyway to get back on topic, last year I was able to buy little stock as I didnt had acces to most of my money in a brokerage account, and didnt have enough confidence in my abilities. And it seems almost always better to wait a bit to see if something better comes a long. And also better to wait off buying untill you are really familiar with a company. Sometimes you later uncover details that kind of ruin your thesis.

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Doesn't hurt to think for yourself instead of blindly following Buffett's advice. You can short without timing the market or without taking large downside risks... But I don't think this is the right thread to discuss to pro's en con's of shorting.

 

@jschembs: I'm long SODI as well, but is this really your highest conviction pick? Management is not shareholder friendly, and you probably also have a lot of key man risk (how does the company run without Seraf?). At the same time the business isn't doing that great (and hasn't improved vs a few years ago) while the stock price is up.

 

I'm by the way also short CRM (since 2011... lol).

I did think for myself, and it seems if you look at risk/reward ratio, shorting seems almost always irrational. Seems you either have to write calls (taking large downside risk vs limited upside) or buy puts (having to time market) , or outright short a stock (large downside risk vs limited upside)? Im talking about outright shorting one stock you don't own, and not pair trades or things like that. Only thing that seems worth it are buying puts if there is a definitive time limit that is not priced well into put options.

 

The timing aspect should be less of a factor if you buy the longest dated put options. Buying jan '16 now and rolling them over to jan '17 in a few months should give enough time for your thesis to play out given that we would be 8 years into a raging bull market. Sure the market can stay irrational longer than you blabla... Oddly enough some people have no problem buying shorter term bac calls (after a 200% run up) while cloud company put leaps could offer the same returns with the potential to a lot more.

 

Am I nuts? Please confront me! TIA. :)

 

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The timing aspect should be less of a factor if you buy the longest dated put options. Buying jan '16 now and rolling them over to jan '17 in a few months should give enough time for your thesis to play out given that we would be 8 years into a raging bull market. Sure the market can stay irrational longer than you blabla... Oddly enough some people have no problem buying shorter term bac calls (after a 200% run up) while cloud company put leaps could offer the same returns with the potential to a lot more.

 

Am I nuts? Please confront me! TIA. :)

 

After running a lot of numbers i can only agree. In the current market its much easier to find something that is only worth 10-20% of its price than something that is worth 3x. The forward return on some shorts is a lot higher than on most long investments even when you factor in some growth. Most people underestimate how long it takes until growth will bring the value of something that is worth only 20% to its current price.

So its probably a good idea to mix in some shorts. I really changed my mind on this, because the numbers look so compelling. And i think that Prem or Einhorn are not stupid, it looks like this year will be in their favor. And even Schloss has shorted the market in 2000, so its not something a value investor should never do.

 

I think of selling Russel 2000 futures for the summer and going something like 100% long, 80% short because there are some facts like seasonality, the january effect, the presidential cycle and the overvaluation all coming together this year. Only the sentiment is currently not fitting for a crash, perhaps we have one upspike left.

 

Now confront me on that! :)

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Im always suprised how most investors seem to ignore buffett's advice to not short stocks. You either need to time the market, or you need to large downside risks. You take on additional unnecesairy risks without additional upside.

 

Buffett did not get rich by following 80 year old Buffett's advice. In many cases he did the opposite of what he now counsels (short positions, arbitrage, microcaps, activism, etc.)

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Well for one it seems hard to me to find decent liquidity in longer term put options on most stocks. You need really large caps. And even then they don't look v compelling because of the price (in case of CRM).

 

Second is, that most of the aformentioned investors are very large. Most of the cheap names I see are micro or small cap. There might also be institutional reasons, or ideological reasons why einhorn shorts. Maybe his investors want short exposure (for whatever reasons). Maybe he wants to help keep the system honest using his large fund and exposure and also make a buck on it (I kinda got that impression from his book, but i might be wrong).

 

And if you look good you can still find plenty of v compelling risk/reward picks, that are way ahead of even the better shorts out there. I keep seeing how much the edge of being small is underestimated by a lot of people. You really  have a huge edge vs guys like Einhorn just because you have under like 5-10 million$ to invest.

 

Personally I copied over 1/3 of this guys stock picks (I suck at finding good ideas myself):

http://quinzedix.blogspot.de/

 

Read any of those, and study those company's and then show me a short with a more compelling risk/reward ratio with more upside.

 

Another bias I see is that people think they are not nearly as good as buffett so they believe they don't  deserve high returns. So I think if you tell yourself that, then subsonciously you will settle for ideas with less upside. Because a lot of investors probably still have the notion in their head that the market is quite efficient. So if they see something that looks really cheap, they subsconsciously assume they are not good enough to see every risk and dismiss it too easily. And i think once you fall for this type of thinking and you reach a certain level of returns, you stop learning. Because your not as good as buffett, einhorn etc right? So you are putting a cap on what you can achieve basicly. I saw this all the time with other poker players. They reached a certain winrate, and then just stopped improving because they believed that is all they could do and were satisfied with that rate. Intelligence seems rarely to be the issue.

 

I mean before buffett made the dumb mistake to buy a textile mill and an airliner. he made over 50% a year in his twenty's. So obviously he wasn't that good back then and he did it. We now have a huge edge over him because we have the  internet.

 

Just imagine if you want to learn something about an industry and how it works back then.  You couldnt look up quick articles or research reports on roughly how an industry works, and how certain players get an edge. Couldnt quickly look up product reviews. You didnt have enourmous amounts of blogs and websites writing up some really good and hidden value ideas like you have now. No online forums with industry experts discussing products in that industry. You didnt have all the books written on investing and moats (he basicly had to invent it). There was a reason why he basicly begged graham to teach him all that stuff.

 

It just seems so much easier now to do what buffett did back then. You can get all the basic information on an industry at your finger tips now. In the 60's that might have taken you months to do it. And only if you knew the right people. And the market is still very irrational at times and very short term oriented.

 

But ill stop ranting now :D

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Well for one it seems hard to me to find decent liquidity in longer term put options on most stocks. You need really large caps. And even then they don't look v compelling because of the price (in case of CRM).

 

Second is, that most of the aformentioned investors are very large. Most of the cheap names I see are micro or small cap. There might also be institutional reasons, or ideological reasons why einhorn shorts. Maybe his investors want short exposure (for whatever reasons). Maybe he wants to help keep the system honest using his large fund and exposure and also make a buck on it (I kinda got that impression from his book, but i might be wrong).

 

And if you look good you can still find plenty of v compelling risk/reward picks, that are way ahead of even the better shorts out there. I keep seeing how much the edge of being small is underestimated by a lot of people. You really  have a huge edge vs guys like Einhorn just because you have under like 5-10 million$ to invest.

 

Personally I copied over 1/3 of this guys stock picks (I suck at finding good ideas myself):

http://quinzedix.blogspot.de/

 

Read any of those, and study those company's and then show me a short with a more compelling risk/reward ratio with more upside.

 

Another bias I see is that people think they are not nearly as good as buffett so they believe they don't  deserve high returns. So I think if you tell yourself that, then subsonciously you will settle for ideas with less upside. Because a lot of investors probably still have the notion in their head that the market is quite efficient. So if they see something that looks really cheap, they subsconsciously assume they are not good enough to see every risk and dismiss it too easily. And i think once you fall for this type of thinking and you reach a certain level of returns, you stop learning. Because your not as good as buffett, einhorn etc right? So you are putting a cap on what you can achieve basicly. I saw this all the time with other poker players. They reached a certain winrate, and then just stopped improving because they believed that is all they could do and were satisfied with that rate. Intelligence seems rarely to be the issue.

 

I mean before buffett made the dumb mistake to buy a textile mill and an airliner. he made over 50% a year in his twenty's. So obviously he wasn't that good back then and he did it. We now have a huge edge over him because we have the  internet.

 

Just imagine if you want to learn something about an industry and how it works back then.  You couldnt look up quick articles or research reports on roughly how an industry works, and how certain players get an edge. Couldnt quickly look up product reviews. You didnt have enourmous amounts of blogs and websites writing up some really good and hidden value ideas like you have now. No online forums with industry experts discussing products in that industry. You didnt have all the books written on investing and moats (he basicly had to invent it). There was a reason why he basicly begged graham to teach him all that stuff.

 

It just seems so much easier now to do what buffett did back then. You can get all the basic information on an industry at your finger tips now. In the 60's that might have taken you months to do it. And only if you knew the right people. And the market is still very irrational at times and very short term oriented.

 

But ill stop ranting now :D

 

+1 constant self-improvement/self-confidence

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@yada you bring on some good points. But shorting is about down side protection for the overall portfolio. I wouldn`t need that when i have only netnets @50% of cash value in my portfolio. But i have only found one that was investable in the last 6 month and that trades now at netcash value. And i could never put more than 2-3% of my hard earned and saved cash into such ideas. So i need a lot of them. I am pretty sure that Buffet had a lot more investable net nets in his time, but nowadays everybody finds them with one mouseclick. But maybe i complain too much and should work harder.

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I'll extend my list for further ridicule - short Z, long AIRT and JCTCF

 

Air T, I see the appeal of a profitable unleveraged company trading at a low multiple to sales and barely above book value. But with margins declining, it is not increasing in value very quickly. Hopefully there is a near term catalyst for the business or the valuation? What is it?

 

I ask myself, do I want to own this company 5 years from now? If not, I demand a cheaper price.

 

Is this cheaper and a better business than other small companies with similar financial metrics, for example KTCC, NTWK, CMT, WILC or VSR?

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CRM has a wonderful business and makes amazing software.  It is arguably overvalued.  (Let's assume it is overvalued.)

 

(A) If you put in more elbow grease, you can find overvalued companies where the underlying business is really awful (or will be).

(B) Or, you can find frauds.

© Or, you can find frauds that don't report insider selling.  (e.g. like the pump and dumps that Jordan Belfort of The Wolf of Wall Street did.)

 

I shorted CRM in the past.  To me, it is a mistake because I could be doing A, B, and/or C.  I have 20+ short positions doing A/B/C.  B is the easiest for me to find, then A, then C.

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DirecTV has grown to be my second largest position. Anyone want to make the case for selling shares ahead of a potential bid by AT&T?

 

Obviously, negotiations could go nowhere if there's a wide gap between the price AT&T is willing to pay and the price DirecTV demands. DTV management can be pretty hard-nosed on price, having walked away from several acquisitions in the past few years.

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Well for one it seems hard to me to find decent liquidity in longer term put options on most stocks. You need really large caps. And even then they don't look v compelling because of the price (in case of CRM).

 

Second is, that most of the aformentioned investors are very large. Most of the cheap names I see are micro or small cap. There might also be institutional reasons, or ideological reasons why einhorn shorts. Maybe his investors want short exposure (for whatever reasons). Maybe he wants to help keep the system honest using his large fund and exposure and also make a buck on it (I kinda got that impression from his book, but i might be wrong).

 

And if you look good you can still find plenty of v compelling risk/reward picks, that are way ahead of even the better shorts out there. I keep seeing how much the edge of being small is underestimated by a lot of people. You really  have a huge edge vs guys like Einhorn just because you have under like 5-10 million$ to invest.

 

Personally I copied over 1/3 of this guys stock picks (I suck at finding good ideas myself):

http://quinzedix.blogspot.de/

 

Read any of those, and study those company's and then show me a short with a more compelling risk/reward ratio with more upside.

 

Another bias I see is that people think they are not nearly as good as buffett so they believe they don't  deserve high returns. So I think if you tell yourself that, then subsonciously you will settle for ideas with less upside. Because a lot of investors probably still have the notion in their head that the market is quite efficient. So if they see something that looks really cheap, they subsconsciously assume they are not good enough to see every risk and dismiss it too easily. And i think once you fall for this type of thinking and you reach a certain level of returns, you stop learning. Because your not as good as buffett, einhorn etc right? So you are putting a cap on what you can achieve basicly. I saw this all the time with other poker players. They reached a certain winrate, and then just stopped improving because they believed that is all they could do and were satisfied with that rate. Intelligence seems rarely to be the issue.

 

I mean before buffett made the dumb mistake to buy a textile mill and an airliner. he made over 50% a year in his twenty's. So obviously he wasn't that good back then and he did it. We now have a huge edge over him because we have the  internet.

 

Just imagine if you want to learn something about an industry and how it works back then.  You couldnt look up quick articles or research reports on roughly how an industry works, and how certain players get an edge. Couldnt quickly look up product reviews. You didnt have enourmous amounts of blogs and websites writing up some really good and hidden value ideas like you have now. No online forums with industry experts discussing products in that industry. You didnt have all the books written on investing and moats (he basicly had to invent it). There was a reason why he basicly begged graham to teach him all that stuff.

 

It just seems so much easier now to do what buffett did back then. You can get all the basic information on an industry at your finger tips now. In the 60's that might have taken you months to do it. And only if you knew the right people. And the market is still very irrational at times and very short term oriented.

 

But ill stop ranting now :D

 

I would disagree, because while information is easily accessible, it's easily accessible for everyone. Back when Buffett was doing his special situations investing, you can actually have an informational edge if you dug deep enough. With the internet, any new techniques, situations, events are quickly distributed, so it's so much harder to get an edge or keep an edge for an extended period of time.

 

Also, I don't think it's a bias that people think they're not as good as Buffett. In most cases, it's probably true. I don't think I'm biased when I say I can't run as fast as Usain Bolt, I think it's the same when I think that I can't invest as well as Buffett.

 

I remember Buffett mentioned this in an interview something along the lines of "no one thinks they can do what Bill Gates does, but everyone thinks they can do what I do." I almost think the bias is that too many people think they can have an edge in the markets or beat the market like Buffett does.

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I did think for myself, and it seems if you look at risk/reward ratio, shorting seems almost always irrational.

 

I think you might underestimate the importance of correlation in portfolio construction, especially the value of negative correlation.

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I think you might underestimate the importance of correlation in portfolio construction, especially the value of negative correlation.

 

+1! I don`t want to propose asset allocation, but when you study the permanent portfolio construction of Harry Browne you understand how powerful this can be.

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CRM has a wonderful business and makes amazing software.  It is arguably overvalued.  (Let's assume it is overvalued.)

 

(A) If you put in more elbow grease, you can find overvalued companies where the underlying business is really awful (or will be).

(B) Or, you can find frauds.

© Or, you can find frauds that don't report insider selling.  (e.g. like the pump and dumps that Jordan Belfort of The Wolf of Wall Street did.)

 

I shorted CRM in the past.  To me, it is a mistake because I could be doing A, B, and/or C.  I have 20+ short positions doing A/B/C.  B is the easiest for me to find, then A, then C.

 

I can understand if you don't short based on valuation alone anymore, to each their own. :)

 

But if CRM has such a wonderful business with amazing software, why is it so hard to make a profit to go along with that amazing growth?

 

(To add to my CRM rant:)

That amazing growth is also slowing down as they get bigger and I don't see this changing with competitors stepping up their game.

 

Take this piece from today on seeking alpha: http://seekingalpha.com/article/2209263-why-salesforce-coms-future-growth-is-already-factored-in#comments_header

 

Valuation Analysis

 

Our discounted cash flow model indicates that Salesforce.com's shares are worth between $43.00 - $65.00 each. The estimated fair value of $54 per share is roughly in-line with where the company is currently trading (about $50 at the time of this writing). Though the ValueRisk rating is not as high as other volatile equities, we wouldn't think much of a 10%+ decline from current levels in the context of the fair value range. We think this is a fair assessment at this juncture. Our model reflects a compound annual revenue growth rate of 24.8% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 34.9%. This is simply fantastic growth that we're building in, and the decline is more a reflection of the law of large numbers than any fundamental impediments to continued expansion. Our model reflects a 5-year projected average operating margin of 12.2%, which is above Salesforce.com's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 15.5% for the next 15 years and 3% in perpetuity. The phase II growth is among the best in our coverage universe, and its resulting fair value is in-line with the market price. Investors should take this to mean that future growth is largely priced in. For Salesforce.com, we use a 10.7% weighted average cost of capital to discount future free cash flows.

 

So to come at a valuation between $43 and $65/share, they have to compound revenue growth at almost 25% for 5 years and then grow FCF 15.5% for the next 15 years (we are talking about 2034 here..). Average operating margin will somehow have to pop up to 12.2%. Maybe that will come from scale benefits that you can't have at $4-5B but suddenly appear at $10B? I don't know, just guessing what they are hoping for here... Among other things, I don't see them accounting for future stock dilution either. With organic revenue growth at only 25.7% excluding ExactTarget for financial year 2014, I'm simply not seeing how this is even remotely likely.

 

Seems like a classic case of tweaking the valuation to match the stock price in order to run with the pack. Well, at least they don't assume it's worth even more!

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  • 4 months later...

Hi guys,

 

I've been reading up a lot of behavioral biases and forecasting errors recently and I came across a bit of information that appears contradictory.

 

In Thinking Fast and Slow it's stated that investors that watch their positions every day are more likely to be risk averse at the regular bad news that comes out and more likely to trade on it. In general, this decreases financial performance and the suggestion is to commit to holding onto a position for a minimum timeframe

 

I've also read elsewhere that investors don't like to lock losses in and are more likely to sell winners too soon and hold onto losers too long.

 

I understand that more than one bias can affect you at a time and these aren't exactly opposites, but seem irreconcilable enough that they both couldn't be generally true. What am I missing?

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