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Investing Archives

June 01, 2004

Vitamin B

Learning to Expect the Unexpected

”We are not made for type-2 randomness. How can humans take into account the role of uncertainty in our lives without moralizing? As Steven Pinker aptly said, our mind is made for fitness, not for truth – but fitness for a different probabilistic structure. Which tricks work? Here is one: avoid the media. We are not rational enough to be exposed to the press. It is a very dangerous thing, because the probabilistic mapping we get from watching television is entirely different from the actual risks that we are exposed to. How can we live in a society in the twenty-first century while at the same time have intuitions made for a hundred million years ago?"

That’s author and mathematical trader Nassim Nicholas Taleb, talking about the problems inherent in the way many people think and act in the face of uncertainty in a recent edition of John Brockman’s ’Edge’. Some readers may be familiar with Taleb’s provocative book Fooled By Randomness: The Hidden Role of Chance in the Markets and in Life, which was published a few years ago and continues to receive enthusiastic reviews from investors all over the world.

Taleb is a professional trader whose views I respect highly. Many financial academics dislike Taleb for his outspoken views on the use of mathematics in finance and economics. Taleb believes that the hard problem of randomness may be insoluble. He argues that many of the mathematical models financial academics use to capture uncertainty work in a casino and gambling environment, but they are not applicable to the complicated social world in which we live.

Much of what happens in financial markets and throughout history, says Taleb, comes from what he calls ‘Black Swan dynamics’ – that is, very large, sudden, and totally unpredictable ‘outliers,’ while much of what investors and analysts usually talk about is almost pure noise (i.e., useless information). He notes that the expert’s track record in predicting black swan-type events is dismal. As Taleb puts it, many investors are drivers looking through the rear view mirror while convinced they are looking ahead.

Taleb believes that one of the reasons people are so bad at understanding Black Swan dynamics or alternatively type-2 randomness, is that part of our brain is designed for the Pleistocene era and not the 21st century. As he points out, our risk machinery is designed to run away from tigers; it is not designed for the information-laden modern world. Indeed, much of the research into humans’ risk-avoidance machinery shows that it is antiquated and unfit for the modern world.

Taleb believes that in order to defend ourselves against black swans we must first acquire general knowledge. His mission today is to aggressively promote his skeptical brand of probabilistic thinking into public intellectual life.

We wish Nassim Taleb all the best in his mission.

Posted by Steve Waite at 10:57 AM | Comments (0) | TrackBack

May 25, 2004

Vitamin B

Google: A Company Warren Buffett Could Love

”Google is not a conventional company. We do not intend to become one. As a private company, we have concentrated on the long term, and this has served us well. As a public company, we will do the same.”

Those are the founders of Google, commenting on the company’s strategy in an S-1 filing with the Securities and Exchange Commission (SEC) ahead of it’s initial public offering (IPO). Google’s IPO has been widely discussed in the financial media over the past month and I will not offer an investment opinion on the company’s stock at this juncture. However, what I will do is offer an opinion on Google’s business strategy, which seems solid and very Buffettesque to me.

In their S-1 filing with the SEC, Google’s founders Sergey Brin and Larry Page note that outside pressures too often tempt companies to sacrifice long-term opportunities to meet quarterly market expectations. Sometimes this pressure has caused companies to manipulate financial results in order to “make their quarter.” Google isn’t going to play the earnings game. If opportunities arise that might cause Google’s management team to sacrifice short-term results but are in the best long-term interest of the company’s shareholders, they will take those opportunities.

Google will make decisions on the business fundamentals, not accounting consideration, and always with the long term welfare of the company and shareholders in mind. The company does not plan to give earnings guidance in the traditional sense. A management team distracted by a series of short-term targets, say the founders, is as pointless as a dieter stepping on a scale every half hour.

In Warren Buffett’s words, “We won’t smooth quarterly or annual results: If earnings figures are lumpy when they reach headquarters, they will be lumpy when they reach you.”

In the S-1 filing, Google’s founders note that they have no intention of being evil. The company is going to strive not to be evil. The management team believes strongly that in the long term, they will be better served—as shareholders and in all other ways—by a company that does good things for the world even if they forgo some short-term gains. This is an important aspect of the culture at Google and is broadly shared within the company.

It remains to be seen if Google not only talks the talk, but walks the walk. Much of the owner’s manual for Google, say the founders, was inspired by Warren Buffett’s essays in his annual reports and his “An Owner’s Manual” to Berkshire Hathaway shareholders.

I am not sure whether Google’s stock is going to make for a great investment over the long run, but I have to admit that their corporate strategy is music to my ears. I suspect it is music to Warren Buffett’s ears as well.

Posted by Steve Waite at 11:17 AM | Comments (0) | TrackBack

April 27, 2004

Vitamin B

Remembering Philip A. Fisher -- My Hero

Great investors are a rare breed. Recently, one of my heroes – the legendary Philip A. Fisher – passed away. He was 96 years old. Fisher’s brilliant career spanned 74 years. He was a pioneer in the “growth stock” school of investing – a school that has had a huge influence on the thinking of Warren Buffett and Charlie Munger over the past couple of decades. Buffett and Munger were extremely fond of Fisher’s book Common Stocks and Uncommon Profits which was the first investment book ever to make the New York Times bestseller list. The book has since become an investment classic, and in my view, required reading for all investors.

Phil Fisher was more diverse than the traditional “growth stock” investor. He did venture capital and private equity, advised chief executives, wrote articles and books and taught. Fisher was one of only three people ever to teach the investment course at Stanford’s Graduate School of Business. He had an ability for getting great minds to think their own thoughts, but bigger than they would have conceived otherwise on their own.

When it comes to investing, Phil Fisher had several strong beliefs. Perhaps first and foremost is to always think long term. A short-term horizon, if it is relevant at all in investing, is a tactical tool to get to your long-term future. Thinking long term usually goes hand in hand with a portfolio that has low turnover. Fisher was one of the early investors in Motorola back in 1955 when the companies main business was radio systems. He still owned the stock at the time of his death.

Secondly, Fisher believed that it’s important to have faith in capitalism and its basic ability – despite recessions, depressions and scandals – to better the human condition. Based upon that belief, Fisher concluded that investing in stocks works over the long term. Third, Fisher emphasized that investors should buy what they understand. Astute readers know that Buffett preaches this as well. However, unlike Buffett, Fisher did not exclude technology stocks from his portfolio.

In fact, Phil Fisher was a great technology investor. He believed that technology offered society a bounty in the decades ahead that is vastly underestimated even by expert technologists. Fisher noted that it is as powerful to invest in companies adopting technology as those creating it. With either, he urged buying stocks of firms he called “fundamental” (think IBM, Microsoft and E-Bay).

In short, Fisher believed that you don’t buy assets or earnings, but rather the overall endeavor.

Philip A. Fisher was a great man and a great investor. He may no longer be with us, but his ideas and books will live on for a long, long time. If you are an investor and haven’t read his book, Common Stocks and Uncommon Profits, I highly recommend it. It’s one of my all-time favorite books on investing -- a real gem.

Posted by Steve Waite at 10:52 AM | Comments (0) | TrackBack

November 18, 2003

Vitamin B

Bet With The Best

”The issue is not which horse in the race is the most likely winner, but which horse or horses are offering odds that exceed their actual chances of victory.”

That’s Steve Crist, one of America’s leading handicappers, commenting on a fundamental truth when it comes to horse betting. Crist describes his views on horse wagering in the excellent book, “Bet With The Best.” In our view, his insights on betting have a great deal of relevance for investors in financial markets.

Crist believes we have all been conditioned to think that betting is all about finding the winner and placing the bet. But this is wrong. The relevant issue, says Crist, is finding a horse or horses offering odds that exceed their actual chances of victory.

This may sound elementary, but few people actually have this mindset. For those who do adopt this mindset, everything but the odds fades from view. As Crist points out, there is no such thing as “liking” a horse to win a race. The only thing that matters is whether there is an attractive discrepancy between the horses’ chances of winning the race and his price.

In order to bet with the best, you must have a clear sense of what price every horse should be, and be prepared to discard your plans and seize new opportunities depending solely on the tote board. If you begin espousing this approach, says Crist, you are sure to suffer abuse from your fellow horseplayers, but this is the only way to win in the long run.

The horseplayer who wants to show a profit must adopt a cold-blooded and unsentimental approach to the game that is at variance with both the “sporting” impulse to be loyal to your favorite horses and the egotistical impulse to stick with your initial selection at any price. This approach, says Crist, requires the confidence and Zen-like temperament to endure watching victories at unacceptable low prices by such horses.

A horseplayer cannot remind himself/herself too often of a simple truth: value equals probability multiplied by price. A horse with a very high likelihood of winning can be either a very good or a very bad bet, and the difference between the two is determined by only one thing: the odds. Crist points out that what defines sucker money is not the horse selected, but the acceptance of odds on that horse that are substantially out of line with its chances of winning.

There is no shame in passing a race because you just don’t see any value in it. Nor should you force yourself to play a race in which you have no confidence in your own odds line. The name of the game, says Crist, is to look for discrepancies between your odds and those set by your opponents.

Crist’s approach to betting on horses is very similar to the investment process discussed by Michael Mauboussin and Alfred Rappaport in their terrific book, “Expectations Investing.” Stock prices, like the odds appearing on a tote board at a horse racing track, are a gift – a gift of information about how other investors with money on the line are estimating the value of future cash flows (or in the case of a horse, the likelihood of winning a race).

Mauboussin and Rappaport point out that what distinguishes winning investors from losers is how well they interpret the information in the marketplace. Different investors interpret the same information differently, and some interpretations are much better than others. This is very similar to the approach endorsed by Crist: Look for discrepancies between your odds and those set by your opponents and bet accordingly.

If you are looking for a good read for the holidays, pick up a copy of “Bet With The Best.” It may well be one of the wisest investments you’ll make this year.

Steve Waite

Posted by jhudock at 08:48 AM | Comments (0) | TrackBack

September 29, 2003

Gov. Gray Davis explained

At last, we have an explanation as to why Gray Davis grew up to be such a dangerous nerd who has almost destroyed the great state of California. Dave Broder in the WaPo reports that "State Senate President Pro Tem John Burton (D), a liberal San Franciscan, said he received a phone call recently from actor Warren Beatty, asking him to be more supportive of Davis. 'You have to cut him some slack,' Burton quoted Beatty as saying. 'He had an abusive, alcoholic father and it affected him.'" (courtesy Lucianne.com)

Posted by Jerry Scharf at 03:34 PM | Comments (2) | TrackBack

September 19, 2003

Close the NYSE

John Bogle has an op-ed in the WSJ today, taking on the NYSE specialist system.

Every security traded on the NYSE is assigned exclusively to a specialist firm. The specialist ultimately sees every order in its assigned stocks submitted to the exchange either electronically or through brokers on the floor. But while the NYSE grants specialists a privileged position in order to maintain a "fair and orderly market" (which, curiously, is nowhere defined), the specialist is also permitted to simultaneously trade for his own account -- an obvious conflict of interest.

NYSE rules attempt to limit the specialist's ability to improperly use inside information by limiting specialists to trading only when there is a temporary disparity between supply and demand, buying when there are no other buyers and selling when there are no other sellers. Yet if specialists really traded only when there is an absence of buyers or sellers, one would think they would lose money.

The fact is that specialists are profitable, in Samuel Johnson's words, "beyond the dreams of avarice." A forthcoming study by Precision Economics will reveal that publicly traded firms with specialist units last year enjoyed pre-tax profit margins ranging from 35% to 60%. Labranche, the largest NYSE specialist, generated more than a quarter of a billion dollars in revenues, almost entirely from trading for its own account on the floor. Pretty profitable for trading only when nobody else wants to!

Since trading is a zero-sum game, these profits come at the direct expense of investors such as large institutions, which desperately want competitive alternatives to the NYSE but are reluctant to publicly complain about the fundamental unfairness of the NYSE model. After all, institutions have to do business with the NYSE because there are no real competitive alternatives.

I complete agree. While in pre-computer days there may have been some argument in favor of specialists, it seems to me a complete anachronism (as does the open outcry still practiced at various commodity exchanges). A transfer of all trading activities to an open-book Nasdaq type system would be fairer and less expensive for all trading parties except the specialists and floor brokers.

Posted by jhudock at 10:09 AM | Comments (1) | TrackBack

September 16, 2003

Insider trading

Michael McMenamin has a very thorough article at Reason this month on the idiocy and nebulousness of current insider trading laws and why the charges against Martha Stewart are nothing more than a publicity campaign by the SEC.

Posted by jhudock at 11:25 AM | Comments (0) | TrackBack

July 15, 2003

Vitamin B

Wither The Dow?: Wisdom from the QI Hive

A few months ago, we created a place on our website www.quantuminvesting.net, for people to register their opinion on companies that are likely to remain in the Dow Jones Industrial Average index by 2025. Many people have participated in the survey and new members continue to chime in with their views on a weekly basis.

Although it is still very early, we thought it would be interesting to share some of the wisdom from the QI Hive. Of course, we expect the overall opinion of the QI Hive to evolve over time. Nevertheless, there are some opinions that we find fascinating.

For example, based on the tally to date, there are only 2 companies out of the 30 DJIA companies that the QI Hive expects to remain in the index: Coca-Cola and General Electric. Not one voter questioned the long term viability of these companies in the Dow. The other companies with odds favoring inclusion in the DJIA by 2025 are IBM, Wal-Mart and Walt Disney (Mickey Mouse shows signs of immortality).

Interestingly, the QI Hive is less convinced about the longer-term viability of tech giants Microsoft and Intel. Both companies are given slightly better than even odds of remaining in the Dow Jones Industrial Average over the next two decades.

Who are the companies that are destined to be removed from the index? Well, according to the QI Hive, SBC Communications, Philip Morris (now known as the Altria Group, Inc), JP Morgan, Eastman Kodak, American Express and AT&T; are companies with low odds of surviving the Dow in coming years.

Other companies where the jury is still out include Hewlett-Packard, International Paper, Honeywell and Procter and Gamble.

We encourage readers and their colleagues and friends to become a member of the QI Hive (it?s free!) and vote regularly. We will provide another update before year-end. In the meantime, we thank you all for your wisdom and support.

Steve Waite

Posted by jhudock at 08:11 AM | Comments (0) | TrackBack