Ahhh…the classics

Just as there are classics to be read and re-read in literature, history, philosophy, psychology, etc., there are classics that should be read and re-read in investing.

The most important, in my opinion, is Graham and Dodd’s 1934 classic, Security Analysis.  I just finished re-reading it recently, and found many gems to share here:

“A moment’s thought will show that there can be no such thing as a scientific prediction of economic events under human control.”

Free will makes precise economic predictions a fool’s errand.

“There are no dependable ways of making money easily and quickly, either in Wall Street or anywhere else.”

That seminar you and 40,000 other participants paid for and sat through will make the speakers a fortune, not you.

“Investment theory should recognize that the merits of an issue reflect themselves in the market price not by any automatic response or mathematical relationship but through the minds and decisions of buyers and sellers”

Take that efficient market clods!

“Perhaps [the intelligent student] would be well advised to devote his attention to the field of undervalued securities–issues, whether bonds or stocks, which are selling well below the levels apparently justified by a careful analysis of the relevant facts.”

Value investing…careful analysis of the relevant facts…there it is.

“Analysis connotes the careful study of available facts with the attempt to draw conclusions therefrom based on established principles and sound logic.”

Principles applied logically!

“The value of analysis diminishes as the element of chance increases.”

No, Virginia, everything is not worthy of analysis.

“The analyst must pay respectful attention to the judgment of the market place and to the enterprises which it strongly favors, but he must retain an independent and critical viewpoint.  Nor should he hesitate to condemn the popular and espouse the unpopular when reasons sufficiently weighty and convincing are at hand.”

Lemmings need not apply.

“Analyzing a security involves an analysis of the business.”

It’s shocking how infrequently this is the case.

“In general, the analyst should refrain from elaborate computations or adjustments which are not needed to arrive at the conclusion he is seeking.”

Occam’s razor for investing!

I could go on (and on and on and on, as my wife can tell you), but you get the idea.

It’s amazing how much wisdom can be derived from a book written 77 years ago, and how little can be found in thousands written since….

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Ahhh…the classics

Vacillating when the outcome is clear

Sometimes, the outcome is obvious, but people wish it were otherwise. 

Whether you look at the fiscal situation in Europe, Japan and the United States, or countless examples in world history, you’ll find lots of examples where the proverbial writing is on the wall, but most ignore it. 

It’s not that they don’t grasp it.  They do.  It’s that they don’t want to.  Like a three-year-old having a good temper tantrum, they drop to the floor, close their eyes, and kick and scream that reality is what it is. 

And yet, reality doesn’t change.  It doesn’t care how loud you scream, how much you kick, or how tightly you squeeze your eyes.  At least a three-year-old can make an honest argument that they don’t really understand.

I was really struck by this recently in watching The Teaching Company’s course, “From Yao to Mao: 5000 Years of Chinese History” taught by professor Kenneth Hammond.  In it, I learned that China’s confrontation with the western world in the 19th century was as clear as could be.

First there were the Opium Wars with Britain, then the defeat in the Sino-French War, and then the crushing blow in the first Sino-Japanese War.  In every confrontation of east meets west (for Japan had adopted western ways), east lost–Big Time.

How did China face each of these defeats?  Did they realize they were behind the times and needed to change?  Nope.  Each time, political infighting within China snuffed out any good kind of reform and led to the next defeat. 

The writing was clearly on the wall, and yet the political leaders in China just kept clicking their heels like Dorthy in the Wizard of Oz.  It didn’t work.

Can Greece continue paying public employees huge salaries when not enough taxes are collected?  No.  And yet they riot.

Can German banks afford the losses on the Greek debt they hold?  No.  And yet they dither.

Can Japan’s economy grow when most of its companies show contempt for shareholder interests?  No, sir.  Can an aging population that doesn’t allow much immigration support that aging population by borrowing?  Not really.  But they’d really prefer not to change.

Can Wisconsin, Illinois, New Jersey, New York, San Francisco or California afford its pension promises?  No, and yet they vacillate.

Can the United States pay its current obligations to Social Security and Medicare.  Not at all.  But reform hasn’t occurred. 

Like China confronting the west, the outcome is clear.  And yet, they all vacillate.

Wouldn’t it be easier to face facts, do some math, and make necessary changes?  Without the slightest doubt.  But, on the other hand, most people don’t want to.  I wonder if reality will change for them this time…?

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Vacillating when the outcome is clear

The Virtue of Concentration

If you ask 100 financial planners the most important concept in investing, my guess is 99 of them will say diversification.  I agree with that sentiment for most people, but not for everyone.

Most people, after all, don’t lead the world.  Most are happy to be led, to let someone else take the risks.  Most seek first and foremost to stay out of trouble.  It works, but it’s not a great way to get ahead.

Diversification is protection against ignorance.  If you don’t know what you are doing, diversification allows you to benefit from some of the upside while primarily focusing on protection from the downside. 

If you don’t want to take risks, if you don’t know what you are doing, if you don’t want to stand out, or if you are unsure of yourself, then heavy diversification makes a lot of sense.

If, however, you do want to get ahead, diversification is the wrong way to go.

The facts bear out this contention.  Investors with the best records don’t diversify heavily, they stay focused in the areas they truly understand and they concentrate their bets there.

In fact, the firms with the best records tend to hold only 5-10 positions per analyst.  As any financial planner will tell you, that’s not diversification.

It makes sense, too, if you think about it.  If an investor works 250 days a year and 10 hour days, he has 2,500 hours a year to work.  If he owns 500 stocks, that’s a mere 5 hours a year to understand each stock.  If he owns 100 stocks, that’s 25 hour per stock per year. 

How well can an analyst really know a company he studies for 5 to 25 hours a year in a dynamic, rapidly changing economy?  Not very well.

Now, suppose his competition only follows 25 or 10 stocks.  That’s 100 or 250 hours a year to follow each business.  Who do you think knows each business better, understands its competition and economics, evaluates management more thoroughly?  The guy who spends 5 to 25 hours per year, or the guy who spends 100 to 250 hours per year?

It’s really no contest.

And that’s why I’m a concentrated investor and consider it a virtue.  I’m seeking to lead, to get better than average results, to get ahead. 

I know I can’t compete with investors who spend 20 to 50 times more hours understanding each business, and I take great comfort knowing most of my competitors are less focused than I am.

Don’t get me wrong–concentrated investing is not for everyone.  It’s almost guaranteed to be more volatile, look more risky, and suffer the criticisms of financial planners. 

Those who don’t want to stand out, take intelligent risks, or be criticized won’t enjoy being concentrated.  But, for those who do, the rewards are great.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The Virtue of Concentration

Economics rap

(If you’d like to skip my set-up to two amusing and excellent economics rap video’s, please zip to the bottom for the links)

After graduating from the Air Force Academy in 1992, I went on a knowledge-gathering binge.  I read philosophy, pop science, great quotes and great literature.  I was eager to put my 17 years of learning to work, but I realized I still had much more still to learn.

After graduating from pilot training, I got back to work in my knowledge-gathering project, this time filling huge gaps in my knowledge of history, politics and economics.  In that journey, I found out about the Austrian economists.

In college, I took Economics 101 and 201, which focused on micro-economics–the economics of supply and demand in individual markets–and macro-economics–economics at the aggregate level (national, regional, world). 

Little did I know that an intellectual battle had been fought long ago, and that the Austrian economists had been essentially stricken from the record of academia.  In almost any college in the nation, the focus of macro-economics courses was on Keynes and the Monetarists (Milton Friedman being the most prominent of the latter).

My problem, before reading the Austrians, was that Keynes and the Monetarists didn’t seem to very well describe reality as I saw it.  Keynes, a British economist, saw the government having an active roll in the economy, smoothing out the bumps of free markets.  But, my reading of history clearly showed this always ended in tears.  The Monetarists, based especially out of Chicago and MIT, constructed complex mathematical models based on assumptions that were clearly false, so they too seemed off the mark.

When I read the Austrian economists, especially Carl Menger, everything seemed to fall into place.  I felt like a physicist reading Newton for the first time–this was clearly a better description of reality.  So, I was stunned that my college classes never mentioned the Austrians and that they were basically relegated to the back-woods of academia (much like Aristotle during the Dark Ages).

As time went by (I first read the Austrians 16 years ago), I realized the Austrians weren’t and wouldn’t get a hearing any time soon.  The Austrians, including Hayek and Mises, were considered to be cranks and irrelevant (like those who believe in the gold standard–oh wait, that’s becoming fashionable again, too!).

The Austrians showed that economics was best left to individuals freely choosing their own economic destiny.  Interest rates, prices, quantities produced, etc. set by the free market would fluctuate, but this would be infinitely better than bureaucrats setting them more disastrously. 

In particular, they showed that bureaucrats setting interest rates would lead to gross mis-allocation of capital over time, leading to worse booms and busts than occur in free markets.

This discussion may seem academic, but it became clear to me that the Great Depression could be clearly understood in this framework.  The Federal Reserve was created in 1913 to prevent financial panics.  In the mid 1920’s, the Fed held interest rates artificially low so France and Britain could pay back their debts from World War I.  This led first to a real estate and then a stock market bubble that crashed (sound familiar?).

The mis-allocation of capital for years before 1929 had caused the Great Depression, not animal spirits (Keynes) or inadequate money supply (the Monetarists).  This seemed a more accurate description of reality than anything else I had read.

Not surprisingly, this meant the Austrians clearly saw the dot-com and housing bubbles building and bursting more recently–because they were focused on the mis-allocation of capital due to the Fed fiddling with interest rates!  Keynes and the monetarists were oblivious and even responsible for the busts! 

Despite all this supporting evidence, I still expected the Austrian economists to remain in the backwoods during my lifetime.  I didn’t think they’d get their hearing. 

I must admit, I was short-sighted and wrong.  The Austrian economists are coming back.  As proof, here are two links (Keynes and Hayek round 1, Keynes and Hayek round 2) to rap video’s featuring none other than Keynes and Hayek (not the real people–they are both dead–but actors playing economist rappers).

Perhaps the Austrians will get their hearing.  Perhaps people will start demanding economic policies that conform to the facts of reality and human nature.  I must admit, I would be all too happy to be wrong on this.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Economics rap