How do you figure out what you don't know in investing?

[CorpRaider]

Often wrong, never in doubt. 

[vinod1]

You can instead take the approach of Buffett. The vast majority of the businesses that Buffett bought, are resilient to all three items you mentioned above. A CEO having an affair or worse do not impact the valuation of most of the businesses in Buffett's portfolio.

 

Sorry, but this is not true. Please read "Snowball". Buffett has fired multiple CEOs because they underperformed. Including 2 CEOs of KO via backroom deals. So CEOs "having and affair or worse" do impact performance of even KO. And KO is not an exception, this has happened with multiple businesses Buffett invested in.

 

I also think that Buffett is deluding himself if he thinks that he knows where IBM will be in 10 years. But that's perhaps different discussion. :)

 

I did read Snowball. In fact, I spent several months (not including reading over the years his annual letters multiple times, etc) diving into his investments and what he said on many aspects of investing and distilled them into a core set of action items and portfolio constraints in developing my own investment approach. So I do at least know a bit about Buffett.

 

When I say "resilient", it means it does not make or break the investment. So instead of getting a 15% return he would end up with 10% return, if the CEO turns out to be a crook or worse. So it does not mean CEO is totally irrelevant, just that the business can carry a poor manager without killing the investment thesis. When he has a chance of course he would want to have a better manager.

 

Vinod

[vinod1]

Let me throw one more Buffett quote on Management:

 

We’ve spent many years buying many things without meeting managements at all. If we buy the entire business, we care very much about management and whether they’ll behave in the future as they have in the past. But in marketable securities, we read the annual reports. In marketable securities, however, we’ve still bought into some extremely good businesses run by people we didn’t care for because we thought they couldn’t screw them up.

 

Vinod

[vinod1]

How do you figure out what you don't know in investing? 

 

I have found over the years that even after a lot of work I can still not understand a key overriding consideration of a business.

I think it was Walter Schloss who said that you have to own a business to really understand it. 

 

Here are 3 types.  I am really interested in type 3, as that is what is more controllable and can cause losses.

 

1.  Unknowns that are identified previously.

2.  Random Unknowns.

3.  Unknowns that are due to ignorance.

 

You can instead take the approach of Buffett. The vast majority of the businesses that Buffett bought, are resilient to all three items you mentioned above. A CEO having an affair or worse do not impact the valuation of most of the businesses in Buffett's portfolio.

 

I do not think Buffett knows the in's and out's of Wells Fargo's or Bank of America's each operation in depth at the division level, and I do not think such knowledge is needed or necessary to invest successfully. Look at his definition of understanding a business and it tells a lot about what he focuses on:

 

"It's a question of being able to identify businesses that you understand and you are very certain about. When I say understand–my definition of understand is that you have to have a pretty good idea of where it's going to be in ten years. I just can't get that conviction with a lot of businesses, whereas I can get them with relatively few. But I only need a few–six or eight, or something like that."

 

or look at his definition of risk

"We think first in terms of business risk. Business risk can arise in various ways. It can arise from the capital structure. When somebody sticks a ton of debt into a business, if there's a hiccup in the business, then the lenders foreclose. It can come about by their nature –there are just certain businesses that are very risky. We tend to go into businesses that are inherently low risk and are capitalized in a way that that low risk of the business is transformed into a low risk for the enterprise. The risk beyond that is that even though you identify such businesses, you pay too much for them. That risk is usually a risk of time rather than principal, unless you get into a really extravagant situation. Then the risk becomes the risk of you yourself –whether you can retain your belief in the real fundamentals of the business and not get too concerned about the stock market."

 

I think it is better for us also to focus on such businesses where we are less exposed to risks you mentioned.

 

Sorry for tossing Buffett quotes, you probably know most of these by heart, but they covey the message better.

 

Vinod

 

I actually didn't know these ones.  The concept of being able to visualize where a business will be in ten years is very valuable, even if you have no intention of holding it ten years.  Would have saved me from botch ups like Yellow pages, sfk, and RIMM.  This seems really important in this era of creative destruction.

 

Agree completely. This is probably one of the best filters to avoid "value traps".

 

Vinod

[Jurgis]

When I say "resilient", it means it does not make or break the investment. So instead of getting a 15% return he would end up with 10% return, if the CEO turns out to be a crook or worse. So it does not mean CEO is totally irrelevant, just that the business can carry a poor manager without killing the investment thesis. When he has a chance of course he would want to have a better manager.

 

I don't think KO produced 10% return with bad CEOs. I think pretty much any business can be killed by bad CEO. Of course, if Buffett owns a large chunk of such business, he's likely to can the CEO faster than the business loses 50% of its value.

 

I will agree that there are some businesses that are likely to be resilient to some "unknowns". So your idea to buy businesses resilient to most "unknowns" might be good one. I just don't believe that any businesses are resilient to bad CEO. And in "bad" I don't necessarily mean corrupt or stupid. They might be just not fit the business and the context the business finds itself in.

 

Edit: if you want another example, take JNJ. I don't know if we can blame CEO on this one, but this is an example where Buffett business was hit hard by "unknowns". Of course, it recovered - after CEO change and Buffett selling... :)

[randomep]

 

 

Your spoiling my fun....  I have spent my life razzing engineers and their models.  I once sat in a construction trailer for hours with a group of engineers who were debating the operation and construction of a unit 50 feet away.  Eventually, a pipe fitter/plumber suggested they go out and actually look at the process.

 

I agree on the academics though.  Black-Scholes is an abomination but others use it, therefore understanding it helps us get better deals.  Same with technical analysis.

 

On the topic of academics, back 15yrs ago in grad school the stochastic department personel was in demand by finance industry because of the ability to do whatever they do with derivatives. My opinion is that their work was for the most part useless except to give the people pushing the buttons an air of authority: look we got phd's calculating this data. Same for Merton, Scholes at Long term capital....

 

 

[vinod1]

When I say "resilient", it means it does not make or break the investment. So instead of getting a 15% return he would end up with 10% return, if the CEO turns out to be a crook or worse. So it does not mean CEO is totally irrelevant, just that the business can carry a poor manager without killing the investment thesis. When he has a chance of course he would want to have a better manager.

 

I don't think KO produced 10% return with bad CEOs. I think pretty much any business can be killed by bad CEO. Of course, if Buffett owns a large chunk of such business, he's likely to can the CEO faster than the business loses 50% of its value.

 

I will agree that there are some businesses that are likely to be resilient to some "unknowns". So your idea to buy businesses resilient to most "unknowns" might be good one. I just don't believe that any businesses are resilient to bad CEO. And in "bad" I don't necessarily mean corrupt or stupid. They might be just not fit the business and the context the business finds itself in.

 

Edit: if you want another example, take JNJ. I don't know if we can blame CEO on this one, but this is an example where Buffett business was hit hard by "unknowns". Of course, it recovered - after CEO change and Buffett selling... :)

 

Well the bad CEO you are referring to must be Paul Austin, who is the CEO from 1966 to 1981. He increased earnings about 10 times during this period from $47 million to $420 million. Even if you include some dilution that is pretty good.

 

Let us look at the bad patch where he did indeed diworsify. This is the period from 1973 till his retirement in 1981. Earnings increased from $215 million to $447 million or about 10% per share. Add in around 1 1/2 to 2% in dividend yield over this period, you are looking at an intrinsic value growth of around 10%. I do not have per share figures and I am sure there is dilution and I am sure it is helped by the high inflation of the 1970s but you get the picture. Here we have a CEO who is hell bent on value destruction and still the result is not so bad.

 

I am not talking about share performance, as it is a different matter as it is impacted by compression of PE multiples across the market.

 

Yes, any business can be killed by a bad CEO, just as any business can go bankrupt. But when we are investing we are looking at probabilities. How many very high quality businesses got killed by a bad CEO?

 

I seem to be in the mood for Buffett quotes so let me answer my own question with another quote:

 

It has an incredible distribution system. Tell me how you'd attack that business? You wouldn't want to anyway, as the market's not big enough. Larson-Juhl has a HUGE moat. I always ask myself how much it would cost to compete effectively with a business. With businesses like these, nothing's going to go wrong. If you bought 20 of them, 19 of them would work out well.

 

All I am saying is if you stick to these kinds of businesses you are much less likely to be exposed to bad kinds of unknowns.

 

Vinod

[vinod1]

When I say "resilient", it means it does not make or break the investment. So instead of getting a 15% return he would end up with 10% return, if the CEO turns out to be a crook or worse. So it does not mean CEO is totally irrelevant, just that the business can carry a poor manager without killing the investment thesis. When he has a chance of course he would want to have a better manager.

 

Edit: if you want another example, take JNJ. I don't know if we can blame CEO on this one, but this is an example where Buffett business was hit hard by "unknowns". Of course, it recovered - after CEO change and Buffett selling... :)

 

This again makes my point. Even with all the unknowns what happened? At most value is stagnant for a few years and it is up and running again. I did not follow JNJ for a while so just looking at operating earnings, it is growing pretty well after a couple of years of stagnation.

 

I also do not think the CEO is to blame for this and even if he not changed I think JNJ would pretty much be in the same position it is today.

 

Vinod

[LongHaul]

A lot of wonderful posts.  Thanks everybody.  That was a great article netnet, especially the 1st part.

 

I agree with Vinod.  I think Vinod has studied Buffett well.  Buffett generally invests in understandable/predictable businesses with a big margin of safety minimizing the damage from unknowns.

 

A quote I found yesterday on Buffett,  "Warren Stays away from the gray areas with almost all of his investments, keeping to what he knows and what is sure of."

 

Munger Quotes

“I think we have had a temperamental advantage: Warren and I know better than most people what we know and what we don’t know. That’s even better than having a lot of extra IQ points.”

 

Mr. Munger continued: “People chronically misappraise the limits of their own knowledge; that’s one of the most basic parts of human nature. Knowing the edge of your circle of competence is one of the most difficult things for a human being to do. Knowing what you don’t know is much more useful in life and business than being brilliant.” 

 

I think Munger and Buffett have enough humility to admit that they can't understand certain things. 

 

I would add a few things about what I have found helpful about limiting the unknowns and risk.

 

1.  Checklists.  Business and psychological checklists.  I am just not smart enough to remember every risk off the top of my head or be aware what might be driving my subconscious mind.

 

2.  Keep learning and grinding it out. 

 

3.  Keep an open mind.  Exploratory thought is an "evenhanded consideration of alternative points of view."  Change your views when you are wrong. 

 

4.  Explore a lot of business failures. 

 

5.  Listen to your gut - to an extent.  Does something not feel fully right about the situation and makes one uncomfortable?  I have had a gnawing feeling in my stomach that some situations were very risky and then they did badly.  I choose to ignore them and paid the price.  Sometimes your gut or subconscious mind is alerting you to inherent high risk in an investment may be best to avoid.

 

 

Great topic, very thoughtful responses as well.

 

I've been thinking about the topic generally (called the Dunning Krugger effect, the unknown unknown, great article here http://opinionator.blogs.nytimes.com/2010/06/20/the-anosognosics-dilemma-1/?_r=0  (Wherein the more experienced admit to their ignorance and the less,  well I won't spoil the punch line.)

 

As long as humans with emotions work at companies there will be risks.

So true.

 

As is this:

Most discussion even on this board does not go into "Outcome X has Y% chance, outcome Z has W% chance, so your return will be approximately U%". People will rather say "Oil will go down,

 

  Now, I deliberately try to hold onto those I have held because I have some basic understanding of the company, and some comfort with management (really critical). 

and you get the power of compounding!

 

nothing can replace good old fashion experience

I would add temperament.

 

It's why you MUST have a margin of safety.

 

And as Munger says, you have to be a learning machine.

[alwaysinvert]

5.  Listen to your gut - to an extent.  Does something not feel fully right about the situation and makes one uncomfortable?  I have had a gnawing feeling in my stomach that some situations were very risky and then they did badly.  I choose to ignore them and paid the price.  Sometimes your gut or subconscious mind is alerting you to inherent high risk in an investment may be best to avoid.

 

I've had this feeling with investments that have done well too. Maybe you attribute it to some kind of deep insight only when things turn sour and forget about it if everything works out. I can hardly recall a single stock which wasn't uncomfortable to hold at one point or another.

 

On another note, I think maybe some people systematize a bit too much. I see people post checklists with 150 items on them. To me that's just silly. You aren't going to learn about the salient features of a business from going through 150 checkboxes, I promise.

 

And combining this with an approach of owning 5 or so stocks seems just weird to me. You can't keep up with a handful of companies without an elaborate system? It would be one thing with a more mechanical approach and more holdings. Trying to quantify the art aspect of investing strays dangerously close to scientism, physics envy etc. 

[ni-co]

How do you figure out what you don't know in investing? 

 

I have found over the years that even after a lot of work I can still not understand a key overriding consideration of a business.

I think it was Walter Schloss who said that you have to own a business to really understand it. 

 

Here are 3 types.  I am really interested in type 3, as that is what is more controllable and can cause losses.

 

1.  Unknowns that are identified previously.

2.  Random Unknowns.

3.  Unknowns that are due to ignorance.

 

You can instead take the approach of Buffett. The vast majority of the businesses that Buffett bought, are resilient to all three items you mentioned above. A CEO having an affair or worse do not impact the valuation of most of the businesses in Buffett's portfolio.

 

I do not think Buffett knows the in's and out's of Wells Fargo's or Bank of America's each operation in depth at the division level, and I do not think such knowledge is needed or necessary to invest successfully. Look at his definition of understanding a business and it tells a lot about what he focuses on:

 

"It's a question of being able to identify businesses that you understand and you are very certain about. When I say understand–my definition of understand is that you have to have a pretty good idea of where it's going to be in ten years. I just can't get that conviction with a lot of businesses, whereas I can get them with relatively few. But I only need a few–six or eight, or something like that."

 

or look at his definition of risk

"We think first in terms of business risk. Business risk can arise in various ways. It can arise from the capital structure. When somebody sticks a ton of debt into a business, if there's a hiccup in the business, then the lenders foreclose. It can come about by their nature –there are just certain businesses that are very risky. We tend to go into businesses that are inherently low risk and are capitalized in a way that that low risk of the business is transformed into a low risk for the enterprise. The risk beyond that is that even though you identify such businesses, you pay too much for them. That risk is usually a risk of time rather than principal, unless you get into a really extravagant situation. Then the risk becomes the risk of you yourself –whether you can retain your belief in the real fundamentals of the business and not get too concerned about the stock market."

 

I think it is better for us also to focus on such businesses where we are less exposed to risks you mentioned.

 

Sorry for tossing Buffett quotes, you probably know most of these by heart, but they covey the message better.

 

Vinod

 

I actually didn't know these ones.  The concept of being able to visualize where a business will be in ten years is very valuable, even if you have no intention of holding it ten years.  Would have saved me from botch ups like Yellow pages, sfk, and RIMM.  This seems really important in this era of creative destruction.

 

Agree completely. This is probably one of the best filters to avoid "value traps".

 

Vinod

 

I agree. Buffett's saying "understanding the business" is often misunderstood and confused with "understanding every aspect of a company". I don't think that he's talking about that. What he means is that you have to take an entrepreneurial point of view: How ist this business earning its money? What are the key aspects/drivers for it? Can you foresee their development with reasonable clarity over the next 5, 10, 20 years?

 

With regard to the "unknown unknowns": I discovered last year that I have been thinking far too little about global macro.