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Blowing Up, Walter Schloss, Investing Challenges, & The Coffee Can Edge
Market Talk, Edition 75, June 4th 2023
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Recent Memos: Memos I have shared in the last month.
Comments from Me
To kick things off, Investment Talk recently surpassed 22,000 readers and is slowly approaching the milestone of 100 supporters. Big thanks to everyone for that. I mentioned a few weeks back that I made a career change. Now that it’s official, I can say that I am thrilled to have joined Koyfin; which I am sure many of you are familiar with. For those who are not; Koyfin is the best financial data and analytics platform for researching the fundamentals and technicals of stocks, as well as macro, mutual funds, ETFs, fixed income, currencies, and so much more.
Many describe it as the cleanest alternative to a Bloomberg terminal or CapIQ, without paying tens of thousands of dollars per year. Perfect for individual investors. Because it’s a product I’ve been using daily for years, I felt excited to grab the opportunity and further my personal development. Leaving my old role at Commonstock was bittersweet; I loved working there, the people were great, and I was fortunate enough to have a fantastic mentor; guiding me through the nuances of working in small start-ups. But this new challenge felt right, and so I accepted it.
5x Must Reads
Here are 5 pieces that I found particularly enjoyable or insightful. Note, that these articles are not listed in order of perceived value.
1) Blowing Up
Source: (Malcolm Gladwell)
Authored by Malcolm Gladwell in 2002, this is an excellent profile of Nassim Taleb, author of well-known texts like anti-fragile, fooled by randomness, and the black swan. The article centres around Taleb’s fascination with the roles of luck and success in investment performance, and how he used unorthodox options strategies at his former hedge fund, Empirca. While the majority of the investment world sought out small, consistent profits, Taleb and his eccentric companions, focussed almost exclusively on black swan events. Placing a library of small wagers on outcomes that were deemed unlikely, in the hopes of reaping outsized returns for outcomes that were not ‘priced in’; because nobody likes to believe black swans are real. When describing the black swan that took down LTCM in the 1990s, the Russian default, Taleb recounts; “No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion”.
Empirica was one of the few funds not shying away from black swans and because they actively searched for them every day brought a small but real possibility that it will make a huge win; no chance that it will blow up; and a substantial possibility that it will lose a small amount of money. Or as Taleb put it; “We cannot blow up, we can only bleed to death”. Absorbing small daily losses in pursuit of gargantuan payoffs is exactly what humans are hardwired to avoid. Instead, Taleb believes most investors take substantial tail risk in pursuit of smaller gains.
“Say you’ve got a guy who is long on Russian bonds. He’s making money every day. One day, lightning strikes, and he loses five times what he made. Still, on 364 out of 365 days he was very happily making money. It’s much harder to be the other guy, the guy losing money 364 out of 365 because you start questioning yourself. Am I ever going to make it back? Am I really right? What if it takes ten years? Will I even be sane ten years from now?”
Howard Savery, a former colleague of Nassim Taleb
The profile also examines Taleb’s quirks and early life, and how an unfortunate bout of throat cancer, despite being a non-smoker, made him realise that he, himself, was the victim of a black swan. In keeping with the title of the piece, the story of Victor Niederhoffer, once a prominent money manager in the US, and his eventual ruin is also a recurring theme. Thanks tofor bringing this article to my attention.
2) Walter Schloss Archives
Source: (Elevation Capital)
Walter Schloss has been referred to as the ‘other Buffett’ in the past because of his simple and consistent value-orientated approach to investing. With his no-nonsense strategy, he earned 21% gross annual returns over nearly five decades. But the duo’s styles, despite hailing from the Graham school of thought and working together at Graham Newman, are quite different. Schloss was more of a staunch value investor; often saying he only cared about avoiding debt, buying value, and having downside protection. For instance, while Buffett has said in the past he doesn’t mind paying fair prices for outstanding companies, Schloss was less inclined to care about quality. He only wanted to buy discounted assets, with perceived upside, irrespective of quality.
There is far too much content in the archive for me to comment on; in fact, I am currently in the process of reading most of it myself. Schloss is not an investor I have spent as much time researching, so I am excited to use this resource as a starting point. Two pieces I would recommend starting with to get a flavour of his style are:
3) Confronting Investment Challenges
Source: (Sapient Capital)
How open-minded are you? Tom Morgan believes that being open to new perspectives is an important trait for a successful investor. I wrote about this last week, but on the whole, people tend to be oblivious to reality; only seeing what they want to see. This is because we each have a unique version of reality, based on our acquired knowledge, beliefs, and our brain’s decision to absorb and tune out certain pieces of information. Last summer, I explained this using the cocktail party effect; we tend to purposefully mute the background noise that is not relevant to us and only after we become aware of something do we begin to notice it more frequently in daily life. Tom echoes that sentiment in the below excerpt.
In a recent essay, titled Over the Edge, Morgan revisits the theme to address that closed minds stop growing; and how sometimes we can be forced to adjust our worldview and be enlightened or educated by the circumstances we find ourselves in. The simplest analogy that comes to mind is how travel can layer new perspectives into our frame of thinking. If you remain in one country your entire life, you can only read about the culture of other places. Your opinions, ill-informed as they may be, will be constructed on second-hand evidence. You need to experience these things for yourself. The UK is known as a nation that loves Indian cuisine. So much so, there is a saying that if you want to find the best Indian food, go to the UK. While there are some authentic restaurants floating around the country, this saying is utter nonsense. As I realised over the past few years having visited India on numerous occasions, the best goddamn Indian food is in India! The UK’s version of Indian food, and what most residents perceive to be Indian food, is just that; a perception, and a poor one. Only now, can I appreciate this.
Anyway, read the article, it’s an excellent food for thought.
4) The Coffee Can Edge
Source: (Saber Capital)
I had a conversation this week that felt like one I’d had or seen take place numerous times before. When we open investment accounts for our young children, we tend not to employ the same strategies we do in our own portfolios. Most often, I find, the parent employs more of a coffee can or ETF-centric approach. Something which is lower maintenance, and seeks to capitalise on the child’s outsized time horizon; if you start these accounts from birth, the child has eighteen years before they can access the funds. That’s a minimum of eighteen years for compounding to do its magic. The prospect is exciting, because, for most young parents, that’s longer than they have been in the market themselves.
“In the end, what counts is buying a good business at a decent price, and then forgetting about it for a long, long, long time”.
Of course, the missing context from Buffett’s comments about “forgetting” your investments is that one should continue to stay familiar with those stocks, but in a way that allows them to sidestep noise. It interests me, then, that you can have a parent who disregards the style of coffee can investing in their own pursuit of wealth, but feel it’s an appropriate strategy for their youngsters. Perhaps, as John Huber says, it’s because the conditions for patience are more apparent. Eighteen years is a forgiving stretch of time in the stock market.
In a true coffee can approach, there will be numerous losers in the portfolio, but the idea is that a handful of winners will pay the tab, and then some. The problem for most is the temptation to meddle in the midst of that process playing out; they may begin to reallocate capital from winners to losers for instance. Whatever they do, it interrupts the core tenants of the coffee can. If a strategy ought to be deployed, it ought to be deployed correctly to maximise the chances of it working. However, we are not bound to one style of investing either. For most, they operate multiple portfolios; some taxable, others tax-exempt. It may be that pension accounts or other long-term tax-exempt accounts (like the UK ISA, or the US IRA) are controlled under a different mandate than a taxable account.
This is something I can relate to. In my UK ISA, an account which allows an investor to contribute £20,000 (~$25,000) per year and be exempt from capital gains and income tax, I tend to be more forgiving as my mental time horizon is significantly longer. This is also the environment where I am somewhat of a closeted indexer. In another account, my typical time horizon begins at 3-5 years. Is this efficient? Probably not, but that’s another story. As I reflect on the idea of coffee canning, and how we can variate our style for different means, I thought this essay on the coffee can edge by John Huber would be an interesting read for you all.
5) Seth Klarman: Theory Doesn’t Bear Resemblance to the Real World
“A country full of well-trained investors would make the same kind Of mistakes that investors have been making forever”. That was the title of Seth Klarman’s rebuttal to Louis Lowenstein’s 2004 paper on searching for rational investors in a perfect storm; in which he examines the performance of ten value managers throughout the tumultuous 1999 to 2003 period. So what was Klarman talking about? In Lowenstein’s words, the late 90s was a perfect storm; as a “rare coincidence of forces - caused huge waves in our financial markets, as the NASDAQ index soared, collapsed, and bounced part way back”. He concluded that for managers hugging in the indexes, it was difficult to avoid calamities of the era like Enron and Oracle. But the ten managers he examined, managed to stay far away from these disasters.
“Instead, they owned highly selective portfolios, mostly 34 stocks or less, vs. the 160 in the average equity fund. They turned their portfolios at one-sixth the rate of the average fund. Bottom line: every one of the ten outperformed the index over the five-year period, and as a group they did so by an average of 11% per year, the financial equivalent of back-to-back no-hitters”.
The paper is an interesting read in itself, but Klarman’s five-page response outlines some notable flaws in the study; the largest being that these managers were selected ex-post (in hindsight). Klarman’s response also stands as a critique of the efficient market hypothesis (which I touched upon last year, number 3). He recommends rehashing the study but with an ex-ante (before the fact) approach and further dissects the falsehoods of Lowenstein’s paper.
“The challenge for academics is simple. Select in advance a group of investors to be studied. Verify with a panel of value investing experts that the individuals to be studied are, in fact, value investors (and not simply those who call themselves value investors). Determine in advance a sufficiently long period over which they will be studied (but not so long that most of them will be retired by the end of the period). Perhaps choose a group of “growth stock” investors to also be examined over the same period. Finally, establish criteria in advance for an analysis of risk, illiquidity, and other considerations which academics are prone to using after the fact to explain away any market outperformance. Then, let the investing begin”.
Here is some other great stuff worthy of your time.
• Neckar: A Simple Framework for Wealth
• MicroCapClub: A Beginner’s Guide to Researching Microcap Stocks
• MicroCapClub: Conquer Your Fears
• Of Dollars & Data: Why Down & Sideways Markets are Bullish
• Ensemble Capital: The Future of Growth Companies
• Investing 101: VC Contagion, Is Venture Capital Killing Itself?
Company Related Write-Ups
• Invariant (META): The Foundation
• Stratechery (MSFT): Windows and the AI Platform Shift
• Platformer (AAPL): Apple prepares for a platform shift
• Invariant (BTI): British American Tobacco, A Great Divergence
• Fallacy Alarm (ABNB): Defying the Disruptor's Deflation Dilemma
• Arda Capital (GOOG): I/O, Bard, and Implications for Search
• Librarian Cap (MA): Still Attractive Despite Recent 52-Week High
• Vest Rule (DSGR): Distribution Solutions Group
• WSG (AZO): AutoZone, Hundred Bagger
• Holland Advisors (SCHW): Schwab, Stormy Weather
• British Investing (RMV:LON): Rightmove write up
• Apricitas: Americans' Excess Savings Are Mostly Spent
• Last Bear Standing: Nvidia and the Return to Normal
• Investor Amnesia: A History Of Debt Limits & Defaults
• Verdad: Optimal Duration
• Rational Walk: Warren Buffett's Advice on Stocks vs. Bonds
Please be sure to visit the publications of the mentioned writers!