DIS and DAT-Moving from the game to getting serious-April 2013

Our periodic communication that reminds you to ask, “Should I react to those headlines?”

“ If I can see further it is because I stand on the shoulders of giants”  Isaac Newton

Dear Friends:

In our previous communication we shared how most participants view the investing process as a game of gotcha.  In this piece, we will share with you how a few investors appear to have learned to approach the markets differently.  From these investment legends, we will discover an approach to investing which is different from the popular view.

When Ron Muhlenkamp, manager of Muhlenkamp funds, was asked to summarize his investment philosophy to a client, he wrote a memorandum titled “The Game of the Stock Market versus the Business of Investing”.  In my opinion, reading the entire memorandum would be valuable, but we will just quote a portion of it here.

 “For most people “The Game of the Stock Market” is a distraction that prevents them from making money in “The Business of Investing.” Periodic setbacks and a focus on the game result in their selling stocks when they should be buying, and vice versa. We focus on the long-term “Business of Investing” because we have found it to be more profitable and more reliable.”

Warren Buffett, CEO of Berkshire Hathaway, has been quoted many times on this subject, so we share a few here with you.

"The stock market is a no-called-strike game. You don't have to swing at everything--you can wait for your pitch. The problem when you're a money manager is that your fans keep yelling, 'Swing, you bum!'"

"The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities  that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future  will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands."

“If you're an investor, you're looking on what the asset is going to do, if you're a speculator, you're commonly focusing on what the price of the object is going to do, and that's not our game.”

“Ben [Graham]'s Mr. Market allegory may seem out-of-date in today's investment world, in which most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising "Take two aspirins"?”

“We've long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.”

Mario Gabelli is long-time manager of the Gabelli funds. Here are two quotes on the topic from him.

“Over the past 20 years, our annual macroeconomic and market forecasts haven’t always been right. Fortunately for our clients… our investment methodology is not built upon accurately predicting interest-rate trends or timing the market, but rather on picking stocks, and many of our picks have fared quite well. One reason is that we’ve had a good batting average identifying trends – we call them catalysts – that have unlocked value in selected industry groups.”

“Businesses don’t change in value as quickly as the market.”

Another well known investment manager, Howard Marks, CEO of Oakmark Funds, refers to it as second level thinking in his book “the most important thing”.  Here is a quote from a seeking alpha article about Mr. Marks and this second level thinking.

“Second-level thinking boils down to the ability to ascertain the set of probable outcomes that can occur and to think in probabilistic terms when it comes to weighing the consequences of different scenarios. In contrast, most investors tend to develop working theories about how the future will unfold and then invest as if that outcome will occur, ignoring the broad range of possible outcomes and particularly the “fat tail” outcomes that have been appearing with more frequency than expected in recent years, to say the least. Mr. Marks refers to this flawed approach as “single scenario investing”.

To avoid participating in the game of gotcha these investors have a belief that the underlying value of an investment and its corresponding price are not necessarily the same.  From my knowledge there are two important personal characteristics required in attempting to realize the value of that investment within a world of chaotic prices. They are patience (extreme in some cases) and conviction.  These characteristics are not easy to put into practice, because if your analysis is incorrect, then these qualities can be harmful. For an investor to develop from the “game” mentality into a “serious investor” it requires a change.

Steven Pressfield  is not famous as a  successful investor, instead he became famous as a successful writer.  In his book, “Turning Pro” he describes this transformation, from playing the game (amateur) to getting serious (turning pro). Here are some quotes from him on that topic.

“Turning pro is free, but it’s not easy. You don’t need to take a course or buy a product. All you have to do is change your mind.

Turning pro is free, but it’s not without cost. When we turn pro, we give up a life with which we may have become extremely comfortable. We give up a self that we have come to identify with and to call our own. We may have to give up friends, lovers, even spouses.

Turning pro is free, but it demands sacrifice. The passage is often accompanied by an interior odyssey whose trials are survived only at great cost, emotionally, psychologically, and spiritually. We pass through a membrane when we turn pro. It hurts. It’s messy and it’s scary. We tread in blood when we turn pro.

Turning pro is not for everyone. We have to be a little crazy to do it, or even to want to. In many ways the passage chooses us; we don’t choose it. We simply have no alternative.

What we get when we turn pro is, we find our power. We find our will and our voice and we find our self-respect. We become who we always were but had, until then, been afraid to embrace and to live out.”

Now that we have read the quotes from long-term investment managers and how they think differently about investing, we believe it is important to recall the similarities, to show how it is difficult to determine the difference between the two approaches.

Both approaches have to deal with uncertainty and risk.  Even the greatest investors cannot avoid risk, loss and everything that goes with it. They only attempt to have adequate possible gain for the risk they are taking.

Both approaches have to deal with other people’s opinions.  No matter whom the investor is he or she will run across other people sharing their views on how capital should be allocated.

Both approaches have to deal with constantly changing prices, themes, and environments.

Both approaches have to deal with deception.

Both approaches have to deal with outcomes. Failure and success of their thoughts will occur.

Both approaches have to deal with fear, doubt, and panics.

Both approaches have to deal with hubris, overconfidence and exuberance.

This means that some people playing the game of gotcha on price will win!!!  They will get away with predicting (guessing with conviction), without doing the difficult work of valuing. They will avoid the work of measuring their past failures, adjusting, and taking measurements to see if they matter.  They will instead rely on the randomness of outcomes.  From an outside observer looking at results only; this person is difficult to distinguish from the investor who is avoiding the game.  To reiterate, yes someone playing the game of gotcha will win, it is likely to be fleeting success and the next “winner” will appear as the cycles change.  Warren Buffett says it like this:

“Only when the tide goes out, do you discover whose been swimming with no trunks on”

The point here is that the best investors have not learned how to magically avoid failure. Instead, they have learned how to deal with failure, and how to deal with success.  From our observations, this wasn’t a one-time event, and they are still learning to this day. The process takes continued effort. They did not discover a “set it and forget it” approach. Instead, they discovered a process towards work and self-discovery, which distinguishes them from the amateurs over time.

Hopefully, over the last two versions of “Dis and Dat”, we were able to demonstrate the difference between a game of price predicting, and the serious process of value extraction. This should not leave you with a thought that this is easy, or this is a sure thing. Our intention is to share with you that we believe playing the game of price prediction is a poor way to approach allocating capital which will be needed in the future.

See you next time.

James Pope

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