The Perils of Too Much Information

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The other day I was flipping through Tim Ferriss’ book “Tribe of Mentors” and came across this great section from Adam Robinson. For those of you not familiar with Adam, he’s a rated chess master, founder of the Princeton Review, and now a global macro advisor to some of the world’s most successful hedge funds and family offices — amongst many other impressive things.

What Adam writes about markets in the book is pure gold. It needs to be read by everybody, printed out and taped above your trading desks and then tattooed across your forearms. It gets at a central truth of markets and what we can do as traders (aka. professional uncertainty managers) to best exploit it.

Without further ado, here’s Adam:

“Virtually all investors have been told when they were younger—or implicitly believe, or have been tacitly encouraged to do so by the cookie-cutter curriculums of the business schools they all attend—that the more they understand the world, the better their investment results. It makes sense, doesn’t it? The more information we acquire and evaluate, the “better informed” we become, the better our decisions. Accumulating information, becoming “better informed,” is certainly an advantage in numerous, if not most, fields. But not in the counterintuitive world of investing, where accumulating information can hurt your investment results.

“In 1974, Paul Slovic—a world-class psychologist, and a peer of Nobel laureate Daniel Kahneman—decided to evaluate the effect of information on decision-making. This study should be taught at every business school in the country. Slovic gathered eight professional horse handicappers and announced, “I want to see how well you predict the winners of horse races.” Now, these handicappers were all seasoned professionals who made their livings solely on their gambling skills. Slovic told them the test would consist of predicting 40 horse races in four consecutive rounds. In the first round, each gambler would be given the five pieces of information he wanted on each horse, which would vary from handicapper to handicapper. One handicapper might want the years of experience the jockey had as one of his top five variables, while another might not care about that at all but want the fastest speed any given horse had achieved in the past year, or whatever.

“Finally, in addition to asking the handicappers to predict the winner of each race, he asked each one also to state how confident he was in his prediction. Now, as it turns out, there were an average of ten horses in each race, so we would expect by blind chance—random guessing—each handicapper would be right 10 percent of the time, and that their confidence with a blind guess to be 10 percent.

“So in round one, with just five pieces of information, the handicappers were 17 percent accurate, which is pretty good, 70 percent better than the 10 percent chance they started with when given zero pieces of information. And interestingly, their confidence was 19 percent—almost exactly as confident as they should have been. They were 17 percent accurate and 19 percent confident in their predictions.

“In round two, they were given ten pieces of information. In round three, 20 pieces of information. And in the fourth and final round, 40 pieces of information. That’s a whole lot more than the five pieces of information they started with. Surprisingly, their accuracy had flatlined at 17 percent; they were no more accurate with the additional 35 pieces of information. Unfortunately, their confidence nearly doubled—to 34 percent! So the additional information made them no more accurate but a whole lot more confident. Which would have led them to increase the size of their bets and lose money as a result.

“Beyond a certain minimum amount, additional information only feeds—leaving aside the considerable cost of and delay occasioned in acquiring it—what psychologists call “confirmation bias.” The information we gain that conflicts with our original assessment or conclusion, we conveniently ignore or dismiss, while the information that confirms our original decision makes us increasingly certain that our conclusion was correct.

“So, to return to investing, the second problem with trying to understand the world is that it is simply far too complex to grasp, and the more dogged our attempts to understand the world, the more we earnestly want to “explain” events and trends in it, the more we become attached to our resulting beliefs—which are always more or less mistaken—blinding us to the financial trends that are actually unfolding. Worse, we think we understand the world, giving investors a false sense of confidence, when in fact we always more or less misunderstand it. You hear it all the time from even the most seasoned investors and financial “experts” that this trend or that “doesn’t make sense.” “It doesn’t make sense that the dollar keeps going lower” or “it makes no sense that stocks keep going higher.” But what’s really going on when investors say that something makes no sense is that they have a dozen or whatever reasons why the trend should be moving in the opposite direction . . . yet it keeps moving in the current direction. So they believe the trend makes no sense. But what makes no sense is their model of the world. That’s what doesn’t make sense. The world always makes sense.

“In fact, because financial trends involve human behavior and human beliefs on a global scale, the most powerful trends won’t make sense until it becomes too late to profit from them. By the time investors formulate an understanding that gives them the confidence to invest, the investment opportunity has already passed.

“So when I hear sophisticated investors or financial commentators say, for example, that it makes no sense how energy stocks keep going lower, I know that energy stocks have a lot lower to go. Because all those investors are on the wrong side of the trade, in denial, probably doubling down on their original decision to buy energy stocks. Eventually, they will throw in the towel and have to sell those energy stocks, driving prices lower still.”

Stanley Druckenmiller’s first mentor Speros Drelles — the man Druck credits with teaching him the art of investing — would always say that “60 million Frenchmen can’t be wrong.

What Drelles meant by that is that the market is smarter than you. It’s smarter than me. It’s smart than all of us. This is why its message should always be heeded. 60 million Frenchmen can’t be wrong…

Markets are incredibly complex which is why there’s a measurable downside to accumulating too much information, as we saw with the horse bettors. It can lead to confirmation bias and overconfidence as Adam points out.

I read a study a couple of years ago. I want to say it was done by the shared research site SumZero. I’ll have to see if I can find the link and add it to this post when I get a chance. But what this study found was that there was a significant difference in performance between short sub-500 word stock pitches and long 10-page+ writeups.

The short and sweet stock pitches outperformed their longer-winded brethren by a country mile.

German psychologist, Gerd Gigerenzer, calls this “The less-is-more Effect”. If you’d like to really dive into this then I highly recommend picking up his book “Gut Feelings”. But, essentially what the less-is-more effect refers to is that heuristic decision strategies can yield more accurate judgments than strategies that utilize large amounts of information. The way I think about this in trading and investing is that if you need 20-pages of notes to convince you to put on a trade then you shouldn’t put on the trade.

Rather, a seasoned trader should have a framework for what constitutes a good trade and a bad one. This framework is focused on the key drivers — the few essential pieces of information needed to make an informed positive expectancy bet. This should be able to fit on the back of a napkin. Literally.

Remember this the next time your scrolling through a 334 slide deck on why Herbalife (HLF) is a zero or reading through a “Macro Strategists” 75-page report on what he thinks the market is going to do over the next 3-months.

Ruthless reductionism and Occam’s Razor may make for cold bedfellows but they’ll help keep you from shooting yourself in the foot. Which, if you can avoid doing, will put you a few steps ahead of your peers.

So remember… Respect the market, seek to get just enough information, and keep things simple but no simpler (to bastardize a popular Einstein quote).

Bill Miller: Lessons From The Legendary Value Investor

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Bill Miller is a melting pot of value investing icons There’s no better description than from Janet Lowe (emphasis mine):

“Like the purist Graham, Miller ignores the fickle moods of the infamous Mr. Market. Like value icon Buffett, Miller looks for franchise value. This is one of the characteristics he likes about Amazon.com. Like John Burr Williams, Miller is willing to forecast when he runs the numbers. At the same time, he believes that numbers aren’t enough to tell you everything you need to know before dialing up your brokerage firm and placing an order to buy a stock. Like Charlie Munger, Miller looks for investment ideas everywhere.”

A combination of Ben Graham, Warren Buffett, John Williams, and Charlie Munger makes for one hell of an investor.

In 2019 Bill Miller turned in one of the best performances in hedge fund history. His fund, Miller Value Partners, generated a 119.50% return. That’s not a typo. This, of course, crushed any benchmark by orders of magnitude. It’s easy to get caught up in recent data, but it wasn’t too long ago Miller’s fund saw declines of over 70% in an 18-month span. Talk about a wild ride.

But at the end of the day, Bill Miller will go down as one of the greatest value investors to have ever live. Bill doesn’t call himself a value investor. And it’s perhaps for that reason why he’s so successful. After all, Bill is the only investor to beat the S&P 500 fifteen consecutive years.

Over the course of this piece, we’ll dive into Bill’s strategy, how he looks at new ideas. His thoughts on margin of safety and intrinsic business value.

The amount of content written, produced and recorded on Miller is astounding. The goal of this piece is to strip everything down. Curate the first principle ideas that make Miller one of value investing’s sharpest practitioners. Then, provide ideas on how to use such ideas in our own process.

There’s three things that distinguish Miller as one of the greatest:

    1. Laser focus on free cash flow
    2. Disregard for Investing Labels
    3. Buying at low expectation inflection points and holding on

Before we can discuss what makes Miller one of the best, we should understand the basics of his investment approach.

Miller’s Investment Process

Bill lays out his approach on his website, which you can find here. The process boils down to five principles:

    1. Valuation
    2. Time Arbitrage
    3. Contrarian
    4. Nontraditional
    5. Flexibility

Some of these things aren’t specific to Miller’s style. Valuation is standard across the board. But remember, Miller doesn’t refer to himself as a value investor. This is why the last two principles make sense (from Miller’s site, emphasis mine):

Nontraditional:Intellectual curiosity, adaptive thinking and creativity are important parts of our investment process. Our team stays current with numerous nontraditional resources, such as academic and literary journals in the sciences. We have also been involved in the Santa Fe Institute for more than 20 years and recently became involved with the London Mathematical Laboratory. Incorporating nontraditional inputs into our research and process allows us to view businesses and situations from perspectives that others may not.

Flexibility –Constraints almost always, by definition, impede solutions to optimization problems. Our strategies are characterized by their unconstrained formats, and each attempts to maximize the long-term risk-adjusted returns for our investors through its primary objective.”

We’ll touch on these in more detail later. Let’s pivot to the foundation of Miller’s investment philosophy: ruthless focus on free cash flow.

It’s Free Cash Flow That Matters

Miller succinctly articulates his views on valuation in a 2016 interview with John Rotoni of Motley Fool (emphasis mine):

The value of any investment is the present value of future free cash flows, so that is ultimately of the most importance to us. It’s important to note that growth does not always create value. A company can grow, but if it doesn’t earn above the cost of capital, that growth destroys value. In order for growth to create value, a company must earn returns above its cost of capital.”

Miller later remarks that free cash flow yield is the most useful metric in determining valuation, saying (emphasis mine):

We try to understand the intrinsic value of any business, which is the present value of the future free cash flows. While we use all of the traditional accounting based-valuation metrics, such as ratios of price to earnings, cash flow, free cash flow, book value, private market values, etc, we go well beyond that by trying to assess the long-term free cash flow potential of the business by analyzing such things as its long-term economic model, the quality of the assets, management, and capital allocation record. We also consider a variety of scenarios. Empirically, free cash flow yield is the most useful metric. If a company is earning above its cost of capital, free cash flow yield plus growth is a good rough proxy for expected annual return.”

According to Miller, a company’s free cash flow yield plus growth provides a guidepost for a stock’s expected return. This makes intuitive sense. A company with positive free cash flow and a beaten-down share price would have a high free cash flow yield (FCF/Market Cap). Because the stock’s down so far, it’s expected annual returns (should the company maintain positive FCF) would be its cash flow yield plus any additional business growth.

What would this look like in your investment process? A quick screen of companies that return at least 6% free cash flow yield. It’s a large list depending on other variables, but it’s a Miller-esque starting point.

At the end of the day, Miller’s goal is simple: Find companies whose free cash flow yield can beat the market’s hurdle of 6%-8% and hold on as long as you’re right.

But that’s not the only reason Miller’s reaped significant profits.

Label Adherence Doesn’t Provide Excess Returns

One of Bill Miller’s greatest qualities is his refusal to conform to investing labels. Many Miller critics try and poke holes in Miller’s success. Saying things like, “he’s not a real value investor.” It’s these types of comments that make true value investors cringe.

Miller doesn’t care if a company trades at 10x P/E or 100x P/E. At the end of the day all he cares about is the future cash flows of the business — and if he can buy those future cash flows for less than they’ll be worth. He lays it out in the book “The Man Who Beats The S&P” saying (emphasis mine):

“Our definition of value comes directly from the finance textbooks, which define value for any investment as the present value of the future free cash flows of that investment. You will not find value defined in terms of low P/E [price-to-earnings] or low price–to–cash flow in the finance literature. What you find is that practicing investors use those metrics as a proxy for potential bargain-priced stocks. Sometimes they are and sometimes they aren’t.”

Here’s the important part of this quote: “Sometimes they are and sometimes they aren’t.” Metrics like P/E and P/FCF should be guideposts for further research, not the end-all-be-all of investment decision-making.

All this goes back to GAAP accounting standards. In his interview on The Investors Podcast. Miller discusses this notion of GAAP accounting. Spoiler, he’s not a GAAP purist (emphasis mine):

“If you earn above your cost of capital then growth equals value creation. We did a regression of over 200 variables to see what was correlated with AMZN’s stock price. And it was gross profit dollars. Makes perfect sense because gross profits after COGs, because all that went to investments where the company would earn well above the cost of capital over the long term. Uses example/comparison of John Malone in the cable biz. The guy never reported a profit over 30yrs but you made 900x your money if you invested with him because he created a lot of value but that doesn’t show up in normal GAAP accounting.”

This is why Miller’s comfortable investing in software/technology companies. Old-school value investors focused on net income, Miller focused on the cash flow.

Where do we see such non-GAAP centric ideas today? Software-as-a-Service is a big one. But it goes beyond the SaaS circle. Any business that invests capital today to grow tomorrow won’t look good under GAAP accounting. Short-term profits are exchanged for long-term shareholder value creation. At whose expense? Mr. Market’s short-term bias.

Such companies won’t appear in traditional value investing screens. That’s why it’s important to use metrics like P/E and P/FCF as guides, not absolutes. A perfect example of the dangers of relying on pure quantitative metrics is newspapers. Here’s Miller’s explanation on why buying cheap stocks doesn’t always work (emphasis mine):

“[Value traps happen’] when you get down toward the lower end of these valuations, value people find them attractive. The trap comes in when there’s a secular change, where the fundamental economics of the business are changing or the industry is changing, and the market is slowly incorporating that into the stock price. So that would be the case over the last several years with newspapers. They are a good example of where historical valuation metrics aren’t working.”

An investor focused on sticking to MorningStar’s definition of value wouldn’t be able to invest in technology or software companies. They’d invest in low P/B newspaper-type stocks. Value traps. Miller doesn’t care about labels. He cares about the future cash flows of a business. As it should be. I’ll leave this section with this quote from Miller:

“‘Growth’ and ‘value’ are labels that people use to try to categorize things. If you look at Morningstar’s investment-style grid, we have migrated through the whole spectrum. Yet this fund has invested the same way for 15 years.”

Buy Low (Expectations) and Hold On (For A Long Time)

The final characteristic of Miller’s success is his ability to buy companies at points of low expectations. Maybe it’s one of those Baader-Meinhof phenomenons, but after reading Expectations Investing by Michael Moubouisson I can’t help but see this idea everywhere.

The concept is simple. You buy stocks when the share price implies low expectations of future business performance. If you’re thinking about a reverse DCF, you’re pretty much there. The goal is to use Mr. Market’s price as information about expectations. Does the current stock price imply high or low expectations? What would the company need to do over the next three, five or seven years to justify the current price?

In Miller’s case, he’s looking for low expectation situations (emphasis mine):

The major commonality among our biggest winners is a starting point of low expectations. A stock’s performance depends on fundamentals relative to expectations. For big winners, the gap between how a company actually performs and how it’s expected to perform is the widest. Our biggest winners tend to be companies that continue to compound value over many years as well, like Amazon.”

Low expectations is Miller’s starting point. By being patient, he’s able to take advantage of such low expectation points. When he sees an idea, he buys knowing it’ll continue to drop:

“Lowest average cost wins. It’s rare for us to pay up for anything, and it’s common for us that if the stock goes lower after we buy it — and it always does — we will buy more of it. If we’re not buying more of it, then we’ll be selling it, because it doesn’t make any sense to hold onto a declining position without putting more money into it or changing the weighting in the portfolio.”

If he’s right, he makes a killing. If he’s wrong, his winners make up for the losers. One of Miller’s analysts, Mark Niemann explains this concept (emphasis mine):

“If Miller is investing in four companies, three of them might go to zero. But if the fourth went to 6 times its current price, Miller could end up with a 50 percent return, or a total return on his portfolio that would beat the market. In fact, an analysis of Miller’s portfolio performance would show that he sometimes has a lower frequency of correct picks than other managers do, although his return remains high.

The above scenario can only happen if you do two things:

    1. Buy stocks at points of very low expectations
    2. Hold on longer than others

Not only does Miller buy at low expectation prices, he generally holds positions for over five years. Portfolio turnover averages around 20%, much lower than the 100% turnover average for most managers.

Why is this important?

Two words: Time arbitrage.

If you can look out further than other investors, you can create an edge. As Joel Greenblatt says (about Miller):

Legg Mason’s Bill Miller calls it time arbitrage. That means looking further out than anybody else does. All of these companies have short-term problems, and potentially some of them have long-term problems. But everyone knows what the problems are.

Markets are discounting machines. The short-term is already embedded in the price of the stock. In other words, the only advantage you have as an investor is an ability to look far enough into the future and see a different outcome than the one Mr. Market’s expecting. One way or another it comes back to expectations, as Miller explains:

“The securities we typically analyze are those that reflect the behavioral anomalies arising from largely emotional reactions to events. In the broadest sense, those securities reflect low expectations of future value creation, usually arising from either macroeconomic or microeconomic events or fears. Our research efforts are oriented toward determining whether a large gap exists between those low embedded expectations and the likely intrinsic value of the security. The ideal security is one that exhibits what Sir John Templeton referred to as “the point of maximum pessimism.”

It Boils Down To Three Advantages

Miller’s ability to compound capital is nothing short of spectacular. From the valleys of 70% drawdowns to the peaks of 119.50% annual gains. Miller’s investment style stands the test of time and is one we value investors can learn a great deal from.

As we’ve discussed, Miller’s success boils down to three things:

    1. Ruthless focus on free cash flow
    2. Disregard for investing labels
    3. Buying at low expectations and holding for a long time

Miller consolidates these ideas into three factors: time arbitrage, knowing your competitive edge, and intellectual curiosity.

Are you willing to look further out than most investors? Do you know your edge in the markets? Are you curious about all types of businesses?

If you answered yes to each of those questions, you’re thinking like a value investing legend.

Teachings From Commodities Corp (CC)

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Today I wanted to share a little nugget with you guys and gals that I pulled from our internal library that’s available to members of our Collective.

It’s about Commodities Corp. The training grounds for many of the best traders alive today. Inside, you’ll find some back story on CC along with a host of documents on market theory and practical trading tips that CC published internally and which you almost certainly haven’t seen before. There’s some great stuff in here, so enjoy…

For those of you not familiar with Commodities Corporation, I suggest giving this Fortune article from 1981 a quick read and then pick up a copy of Mallaby’s book More Money Than God, which does a good job detailing the story of this unique outfit, as well as that of many other early pioneers in the hedge fund industry.

CC was a trading operation founded by Helmut Weymar and Amos Hostetter during 1977 in Princeton, N.J. The firm was established to raise money which it would then use to trade in the commodities market and hopefully profit.

In many ways, CC was one of the very first hedge funds. Its story is so incredibly impressive not just because of the unbelievable returns the fund produced (which were astronomical) but even more so because of the long list of legendary traders who came out of it. The CC alumni list reads like a 20th-century trader hall of fame inductee roll. Some of these names include:

Anyways, the other day I was going down the internet rabbit hole and came across some pretty unbelievable finds.

The first one is a short (43 page) internal booklet prepared by another trader named Morry Markovitz at CC that summarizes Hostetter’s teachings and approach to trading. The booklet is titled Amos Hostetter; A Successful Speculators Approach to Commodities Trading. You can find the pdf link here.

The booklet is jam-packed with timeless trading wisdom from one of the greats. Paul Samuelson, Nobel Prize-winning economist and early backer of CC said Hostetter was “the most remarkable investor I know, he made money in commodities 50 years straight.” That’s tall praise coming from a man who was also one of the first investors in a young Buffett.

I suggest you read the booklet in full, but I’m going to share with you one of my favorite takeaways from the piece, which is fantastic in its simplicity and truth. If you were to follow this advice on every trade I guarantee you would see a significant amount of improvement.

To follow are the screenshots of Hostetter’s section on “questions to ask before entering and exiting a trade”:

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

Now here’s the second trading nugget I found in the far-nether regions of the dark web. This one written by an unknown. I don’t think he ever gives his name, but apparently he worked at a broker that filled orders for traders at CC and may have even worked at CC itself for a time.

This one is a 10-page document titled Commodity Corporation: The Michael Marcus Tape. It’s apparently a compilation of some of Marcus’ trading notes along with the author’s commentary; including some of his stories about working with Marcus. The PDF link is here.

For those of you not familiar with Marcus, he was profiled in Schwager’s original Hedge Fund Market Wizards. He’s a legendary commodities trader who is said to have turned his initial $30,000 investment into over $80 million in under 20 years — not bad. He also got his start at CC and is part of the most famous mentor/trader lineage which started with Hostetter, who trained Seykota, who taught Marcus, and who then taught Kovner. Talk about having a mentor advantage — that’s just unfair. And who knows, Hostetter could’ve trained under Livermore and Baruch for all we know.

Again, read the entire document. It’s short and well worth your time. Here are some of my favorite takeaways from the piece (bolding is mine):

Comm. Corp was essentially a trading university where traders learned to trade and perfect their skills. In the course of their employment, the traders were asked to prepare their trading philosophy which was archived. Commodities Corporation also made traders do write-ups when they lost money or “got knocked out-of-the-box.” These “knocked out-of-the-box” papers focused on how they failed and how they were going to correct their problems. All of these were archived and available to read or watch. In my opinion, these were an invaluable resource for all traders to learn from. I just wish they were now available on a website. I will discuss some of these in a later post.    

I think the “knocked out-of-the-box” papers are a great idea and “hot damn!” what I’d give to be able to go through those.

Somebody has to know where those docs are and side note: it’s really strange that a more in-depth book hasn’t been written about CC. I have Schwager’s number — I used to call him years and years ago under the guise that I was writing an interview style book and wanted to learn tips on how to give a proper interview, but I’d just end up pestering him for trading stories (he was cool about it) — I should phone him up and see if he knows anything… But I digress… here’s another one.

Trading has two types of capital that must be managed – financial capital and mental capital. In this case, losing a lot or being unsure of your system drains you of your mental capital. You don’t want to do that. Losing either your financial or mental capital will knock you out of business. So protect both equally well.

So true. Both are equally important and you have to protect one to protect the other. And finally:

Comm. Corp. taught me to see the signal, like the signal, follow the signal. If you follow your system /methodology then over time your edge will kick-in and you’ll end up ahead.

“See the signal, like the signal, follow the signal” was an oft used phrase amongst traders at CC, as well as “ride your winners and sell your losers” which was coined by Hostetter. Simple, yet powerful. There’s also some great stuff in there on adding at “danger points”, something we refer to as inflection points and a good discussion on the importance of developing market feel. Take 10 minutes and read through it.

Lastly, here’s a document (for you more wonkish types) that summarizes and advances Weymar’s original Ph.D. dissertation on forecasting cocoa prices (the theory was the primary reason for CC being created). Here’s the link. I used to have Weymar’s original dissertation, but I seemed to have misplaced it — but this is close enough.

If getting into the weeds of this stuff is your type of thing then I highly recommend you come and check out our Collective (it’s a risk-free highly asymmetric opportunity).

My teammates (Tyler, Chris, Brandon) and I started Macro Ops (MO) with the aim of creating the trading community and research service we always wanted, but which didn’t exist.

Our goal is to build a virtual Commodities Corp. We want a place where traders from all over the world can come together and share ideas, theories, trade approaches, knowledge and so on. A place where those who are committed to mastery and possess a deep respect for the game, can push each other to grow and improve — where iron can sharpen iron. The Collective contains the highest quality trading education, research, and discussion, all of which combine to create spontaneous developmental feedback loops leading to rapid evolution.

This is what we’ve done with The Macro Ops Collective. We’ve created a CC advantage for traders.

Similar to Bridgewater, the Collective is like an “intellectual Navy Seals” for those wanting to reach a deeper understanding of the markets and how to play them. Just click below to find out more.

Special Announcement: The Macro Ops Collective Now Open.

Winter enrollment for the Macro Ops Collective is now open. This enrollment period will end on January 19th at 11:59PM. If you’re interested in joining our community make sure to sign up by this Sunday!

Click here to enroll in the Macro Ops Collective

Every purchase comes with a 60-day money back guarantee no questions asked. That means you have a full two months to immerse yourself in our community, read through our research, see how we trade, and go through a huge library of educational material before committing your money. If the material isn’t a good fit, just send us an email and we will promptly return your funds in full.

Enrollment in the Collective will not open again for another 3-months and we will be raising our prices by 46% this next go around. So if you’re at all interested make sure to take advantage of this opportunity and check it out. Looking forward to seeing you in there.

The Greatest Value Investor You’ve Never Heard Of

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“We can have no finer role model. First and foremost, he was a value investor — a member of that eccentric tribe that believes it’s better to underpay than to overpay.”

Those words by James Grant were in reference to one of the greatest value investors the world has ever seen. It’s not who you think it is. And no, you couldn’t guess him given fifty chances. This investor remains off the beaten path, absent from many investors’ Mt. Rushmore of allocators.

The investor is Floyd Odlum.

Buried somewhere in the junk drawer of investing lore, Odlum’s story remains unknown. A quick Google search reveals his Wikipedia and IMDB pages. Yet in typical deep-value fashion, the last link on the page revealed Odlum’s investing story.

The Holy Financier’s blog post was that last link. The blog proved an excellent springboard for a deeper investigation into Odlum’s early life, initial career and his path to market fortunes. Although Odlum (pictured on the right) and Ben Graham never met, their investment philosophies are one in the same.

We’ll journey through his upbringing, his days as a struggling lawyer and his initial attempt at market speculation. Then we’ll see how Odlum turned $39,000 into $700,000 in two years.

Life Before The Markets

Floyd Bostwick Odlum was born on March 30, 1892 in Union City, Michigan. When Floyd was 16, his father — a Methodist minister — moved the family to Colorado. Floyd stayed close to home, studying law at the University of Colorado. He received his degree in 1914. Floyd bounced around in his first few years after college. After marrying his first wife, Hortense in 1915, Odlum accepted a job as an attorney for the Utah Power and Light company in Salt Lake City, UT.

Three years later, he found himself off the ski slopes and in the throes of New York City. Between 1917 and 1918, Odlum worked for the Simpson, Thatcher and Bartlett law firm, as well as the Electric Bond and Share Company. He settled down with Electric Bond and Share Company long enough to gain the role of vice president.

Dipping His Toes in Speculation

With a decent income from his job as a law clerk, Odlum started trading in the stock market. He initially saw the market as a rich, fertile ground for speculative profits. Far from his cemented legacy as a deep value investor. Yet like most beginning speculators, Odlum too paid his fair share of market tuition.

After losing all his $40,000 starting capital, Odlum retreated from the markets. One newspaper revealed it, “took [Odlum] a while to pay back that sum”. Yet It was this early $40K loss that turned Odlum from speculator to investor. From tape reader to business analysis. Lawyer to Wall Street Legend.

Soon enough, Odlum would be back. The starting capital would be the same. The approach, anything but similar.

The United States Company

Odlum wasn’t just a great investor. He also had a knack for choosing the most generic partnership names, such as his first “The United States Company”. The partnership, formed in 1923, was a couple’s affair. Odlum, George Howard and their wives seeded the partnership with $39,000 ($573K adj. for inflation).

What followed over the next two years was nothing short of incredible. According to Odlum’s biography, The United States Company grew 17x from 1923 – 1925. What started as a small partnership amongst friends turned into a $660,000 behemoth ($9.47M adjusted for inflation).

Odlum’s two-year CAGR is mind-numbing. If that wasn’t impressive enough, he generated these returns while working full-time as a law clerk!

How did he generate such outsized returns?

Well, he was a deep value investor. He searched for fifty-cent dollars and  scoured every corner of the market. According to documents from the Eisenhower Library, Odlum preferred two kinds of investments:

    1. Utility stocks
    2. Special situations

He defined a special situation as “an investment […] involving not only primary financial sponsorship, but usually also responsibility for [the] management of the enterprise.” The former lawyer wasn’t interested in flipping a business for a quick buck, either.

Embedded in Odlum’s strategy was the determination to see a special situation through until success, “[We will] stay with the investment until the essentials of the job have been done, and then move on [to] another special situation”.

Between 1925 – 1928, Odlum steadily grew the partnership. By investing in utilities and special situations, The United States Company AUM grew to $6M (over $88M adjusted for inflation). It was around this time that Odlum began sensing euphoria in the market. He smelled a top and he decided it was time for him to act.

The Formation of Atlas Corporation

In 1929, he rolled his original partnership into a new vehicle, The Atlas Corporation. Wary of a market top, Odlum sold half his assets. He stayed in cash and issued $9M worth of Atlas Corporation securities. With $14M in cash, Floyd sat on his hands. Waiting for the next market crash, which shortly followed.

Odlum was prepared and took full advantage once fear had fully gripped the market and there was blood in the streets… His subsequent operations were chronicled in an old newspaper article (courtesy of NeckarCap on Twitter):

After the crash, Odlum, looking around quietly with more ready money than almost anybody in Wall Street except [a] few of the big banks, noticed that the trend in trusts had reversed.”

Odlum’s 1929 Strategy: Sit. Wait. Attack.

Along with his traditional investments, Odlum dabbled in a number of other industries, including:

    • Mining
    • Oil and gas
    • Motion picture production and distribution
    • Aircraft and airlines
    • Department stores
    • Manufacturing
    • Broadway stage productions
    • Hotels and buildings

But his bread and butter during the Depression was buying investment trusts. His strategy was simple. He found investment trusts that had fallen so much their stock prices were trading less than the value of their marketable securities. A good example of this in today’s markets is Manning & Napier (note: I do not hold shares).

He discovered he could buy these trusts, liquidate their assets, and reap large profits for his stakeholders. He was buying dollar bills for $0.60 and he milked this strategy for all it’s worth. He ended up buying and merging investment trust twenty-two times. The newspaper article profiled these dealings:

“He figured out that by buying all the outstanding shares of a particular trust, he was really buying cash or its equivalent at sixty cents on the dollar.”

When he didn’t have the cash to buy the trusts, he sold shares in his own company, Atlas, to fund the purchases. After exchanging his stock for the trust’s stock, Odlum would merge or dissolved the existing trust, keeping the cash and assets within Atlas Corp.

This strategy helped grow his assets to $150M ($2.2B adjusted for inflation).

Between 1929 and 1935, Odlum invested (and controlled) many diverse businesses. He owned Greyhound Bus, a little motion picture studio named Paramount, Hilton Hotels, three women’s apparel companies, uranium mines, a bank, an office building, and an oil company.

Taking It All In

Odlum started with $40,000 and lost it all speculating in the market. He then pooled together another $39,000 to form his first partnership. That original $39,000 grew to $150M in controlled assets. All that during a span of just twelve years.

The math is incredible. Odlum grew assets 384,515% in a bit over a decade. That’s a 32,042% CAGR for asset growth.

And his early partnership returns are just as impressive. Odlum grew assets from $39,000 to $6M between 1923 – 1929. That’s a cumulative 15,284% return. In other words, Odlum compounded capital at an annual rate of 2,547%.

Life After Markets: A Love of Aviation

Odlum’s life was unique. His extracurriculars sprinkled with high-profile relationships, a pioneer wife and bountiful philanthropy. After his divorce in 1935, Odlum married Jacqueline Cochran. Cochran (pictured below) was a pioneer in the field of women’s aviation. And while Amelia Earnhart garners most aviation lore, Cochran’s track record is nothing to scoff at. Some of her achievements include:

    • Flying solo on the ninth day of flying lessons
    • First woman to complete the Bendix race, a cross-country race from LA to Ohio
    • Set flight duration record in 1937 flying from NY to Miami, FL
    • First woman to make a blind landing (1939)
    • Broke 2,000km international speed record (1940)

The list goes on. At the time of her death, Cochran held more speed, distance and altitude records than any living pilot.

Odlum played a key role in women’s aviation and space flight. He financed a majority of his wife and Earnhart’s flights. He also pumped millions into the US missile development program because, “I think the money could have been spent better otherwise. But it’s too early to tote up the value of its products. My wife thinks the moon shots were terrific.

Health and Retirement

Odlum battled rheumatoid arthritis most of his adult life. The pain got so bad he had to stop working. Yet even in retirement, Odlum conducted business. One section in Odlum’s obituary shines light on his relationship with business:

“He often [took[ telephone calls on a rubberized receiver while floating in his Olympic-sized swimming pool.”

Odlum entertained (and housed) some of America’s most prolific leaders and talents. He dined with General James Doolittle, Bob Hope, Gloria Swanson, Walt Disney, Nelson Rockefeller and Howard Hughs.

But of all these guests, none were more famous than President Dwight D. Eisenhower. He and Eisenhower shared a close relationship. So close, in fact, that Odlum carved out a piece of land for Eisenhower to live during the winters. Eisenhower’s small piece of property on the Odlum Estate was known as Eisenhower Cottage.

Bringing It Back To Investments: Three Takeaways

I want to finish this essay with three takeaways from Floyd Odlum’s investing career:

    1. You don’t need to be 100% invested 24/7
    2. Boring is beautiful
    3. Be a dumpster diver (with standards)

1. You Don’t Have To Be 100% Invested 24/7

Odlum wasn’t a market timer. He was a deep value investor. When value ideas dried up, Odlum went to cash. He didn’t force investments or lower his underwriting standards. He simply sat in cash.

Jesse Livermore, a man whose made (and lost) millions in the markets, praises sitting on cash. Seth Klarman is known for his 40% cash balances during periods of market froth.

If you want to beat the markets you must do things differently. Passive investors are 100% invested, but they’re not worried about beating the market.

2. Boring is Beautiful

The United States Company invested in utility stocks and special situations. These are boring corners of the market. Yet it’s these areas that catapulted Odlum’s returns into the stratosphere. How can we apply this ‘boring is beautiful’ philosophy?

In today’s tech-driven market, many investors forget about the boring, slow-growing cash producers. These companies are toll road operators, electrical component producers, road builders. Boring businesses with not-so-boring returns.

3. Be a Dumpster Diver (with Standards)

The stocks Odlum bought were the ones others hated. These companies traded around 52-week and all-time lows. You wouldn’t find anyone talking about these stocks at cocktail parties. Yet they offered outsized returns simply because nobody bothered to look at the (potential) hidden value. Be a dumpster diver with standards. You’ll find many companies trading around all-time lows that aren’t as bad as Mr. Market thinks.

Sources Used:

https://www.eisenhowerlibrary.gov/sites/default/files/finding-aids/pdf/odlum-floyd-papers.pdf

https://twitter.com/neckarvalue/status/1011583419350945793?lang=en

https://www.advisorperspectives.com/newsletters09/pdfs/James_Grant-A_Positive_Lesson_from_the_Great_Depression.pdf

https://en.wikipedia.org/wiki/Floyd_Odlum

https://pdfs.semanticscholar.org/e85e/5bb20ac461ed6ef05a5fa0590bab214fd3ef.pdf

http://theholyfinancier.com/floyd-odlum-deep-value-investor-never-heard/

Lessons From 24 Years of Operating: Bowl America, Inc. (BWL.A)

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Bowling isn’t a sexy business. In fact, it’s sort of a dying business. Drive by any bowling alley and you’ll find flickering lights and half-filled parking lots. Physical bowling has been replaced by handheld entertainment. Virtual copycat. One might reasonably assume that owning a bowling operator would make for a poor investment.

Yet, what if I told you one of the best public owner-operators ran a bowling business? And what if I told you this same owner-operator never experienced an operating loss in 55 years?

Enter, Leslie H. Goldberg.

Goldberg took over the bowling business from his father after World War II. Luckily for us, he’s left behind over 20 years of shareholder letters. I dug through each one going back to 1995.

The amount of knowledge gained from reading this “simple” bowling operator is astounding. I found gems of wisdom that echoed Buffett’s earlier writings. There are lessons on operating during a war cycle, adapting to changing consumer habits and more.

Goldberg sounds like the brain-child of Warren Buffett and Joel Greenblatt.

As the Internet overdoses on high-profile Silicon-Valley investor letters. It forgets about the little guys. The small, family-owned operators grinding it out year after year. It’s time to give owners like Goldberg their time in the sun.

We have 24 shareholder letters going back to 1995. I want to take you through each one. I’ll highlight a few key insights and apply those lessons to investing in today’s world.

Along with this breakdown, I’ll add some of my own thoughts on the practical application of some of Goldberg’s ideas. Think of it as a reverse-engineered interview. Throughout each letter, I talk to Goldberg, flesh out his concepts and wonder what he’s thinking next.

Bold quotes are my own personal emphasis.

You can find all Goldberg letters here.

Strap on your bowling shoes, it’s time to dive in!

Letters from 1995 – 1999

1995: Switching Costs & Leisure Time

1. “People adjust their recreation activities to accommodate changes in their schedules. They [consumers] do not increase their total recreation expenditures as more options become available; rather they reorder their priorities. They change their total recreation expenditures as their expectations of their earnings change, except in the case of gambling, which often diverts money from other activities.”

The meat of this quote involves the phrase “rather they reorder their priorities”. This is an important distinction. More choices aren’t correlated with increased spending on recreation. Instead, we rank which activities we actually want to do.

This reminds me of the Paradox of Choice theory coined by psychologist Barry Schwartz. The Paradox of Choice states that humans become more anxious with more options. It sounds counter-intuitive, but think about when you order at Chipotle. If Chipotle added five more meat and cheese options, would you feel more enthused? Or would you feel more stress as people behind you wait on you to make a decision?

Goldberg knew this back in 1995, almost 10 years before Schwartz released his famous book. Goldberg also knew bowling would face a tougher time with each incremental new activity.

2. “We will also face the problem that many of our customers will reorder their priorities because of actions beyond our control. In Maryland, for all practical purposes, you can no longer smoke in a bowling center. We have already seen a dramatic decline in league bowling in the centers [affected], as smokers find the restriction limits their enjoyment of the game, and there has been no increase in ‘non-smoking’ traffic.”

This quote about smoking restrictions struck me as ingenious. Marketing guru Rory Sutherland chatted about this concept in a Ted Talk.

Rory jokes (and I’m paraphrasing), “When you’re at a party and you stand off in the corner looking out of a window, alone, you’re a bit of a loser. However, put that same man in the corner, alone, looking out of a window — but this time have him hold a cigarette. Now he’s a fucking philosopher.”

Bowling (like video games and concerts) is more a platform for social interaction and community than a utility good. In other words, people don’t pay for bowling for the actual act of bowling. Rather they pay for the venue and the platform to engage in community with friends. Similar to how video games have shifted from experience to community-based interactions.

It reminds me of Alex Danco’s theory on video games.

3. “Male and female bowlers skills overlap to such an extent that leagues can be organized without regard to gender. Almost anyone can be taught to bowl. And over 95% of adults do not currently bowl in a league. That’s a great potential for a great game whose importance to the community is being recognized anew.”

Goldberg hints at the low barriers to entry for a sport like bowling. Bowling is unique in that its a sport that any able-bodied person can pick up. Most times with ease.

Another unique aspect of bowling is the lack of gender difference in skill level. Other sports (basketball and football) have clear differences in skill level between genders.

1996: Capital Allocation & Forecasting

1. “The number of times that companies with enormous financial resources and stables of previously successful executives ‘get it wrong’ when it comes to predicting the public taste is a measure of the difficulty of the task.

Forecasting is hard with quantitative measurements. Forecasting human emotions, tastes and preferences is damn near impossible. It’s difficult to know what the consumer wants. Why? Most times the consumer herself doesn’t even know what she wants.

2. “This uncertainty about recreation spending led Bowl America to develop its approach to the allocation of our resources.”

3. “People often react to a strong balance sheet the way they do to an insurance premium for a catastrophe that didn’t happen. In our case, we paid little for our security and flexibility for expansion and modernization because of the earnings received over the years from the investment of our reserves.”

Goldberg begins fleshing out his capital allocation theories in his 1996 letter. He prefers a strong balance sheet with loads of cash and no debt. He views a cash-loaded balance sheet as an insurance vehicle.

We’ve seen this before from a man in Omaha, NE. A strong balance sheet protects a business during a major downturn in the business cycle. Yet Goldberg reminds investors that the cash generates returns. So it’s not completely idle.

4. “Our focus remains on building a profitable company from which the owners receive continuing income. We have never viewed Bowl America as a trading vehicle and those of you who have read these reports will know that we distinguish between profiting from a business and profiting from trading paper.”

If I took out the words “Bowl America”, you would think this were Joel Greenblatt. Goldberg makes it clear to investors that BWL.A is in it for the long-term. Families depend on the income from this small company.

That’s also why I love diving into small and micro-caps. These are businesses that feed families in a more direct way than larger firms.

1997: Operational Improvements & Marketing Ideas

1. “One such effort that shows promise is glow-in-the-dark bowling. We now have 12 centers in operation or scheduled for equipment. In addition to higher revenues, we’re seeing increased traffic from young adults, a group we had not been regularly reaching.”

One way to spur youth involvement is to create something new. Something like glow-in-the-dark bowling. It works because it’s a visually drastic change, but isn’t a major capital expense.

Yet it shifts how young people view the activity. It goes from being an “old person’s game” into the hip, cool thing to do on a Friday night.

Goldberg reached the younger population by offering another marketing incentive: good grade rewards.

2. “We also worked closely with local school systems to reward academic achievements. Students were offered a free bowling game at a Bowl America center for every ‘A’ on their final report cards.”

Although simple in practice, this marketing technique is genius. Incentivizing students with free bowling games does two things. First, it creates an image that Bowl America wants students to succeed. This increases people’s affinity for the company.

Second, the company knows that these students can’t drive. This means for every one free game of bowling a student receives, their parent(s) pay for an equal game. Moreover, if the student has siblings, they will most likely bring them along for a game.

This is a perfect example of Rory Sutherland’s “1+1=3”.

3. “This conversion [owning amusement games vs. third-party operators], installation of glow-in-the-dark, our expansion at Dranesville, and the closing of two unprofitable centers created extra expense in the last quarter of 1997, but has improved profitability at the start of fiscal 1998.

If there’s one sign that management’s focused on the long-term, it’s this: creating short-term expenses for longer-term increased profitability. Short-term operators wouldn’t close down stores, add glow-in-the-dark capabilities and buy-out third party concession operators. At least not all in one year.

Yet Goldberg’s able to look beyond the next quarter or next year. He’s setting his business up for success five, ten, even twenty years from now.

1998: Thinking about Revenues & Working Staff

1. “League bowlers provide the steady base to support our operations by showing up every week. The casual or non-organized bowlers provide a less predictable but increasingly important contribution to our earnings.

This is a great way to think about the bowling business. You have two customers you’re trying to reach. One is the league bowler. This is your “fanatic”. They’ll show up every week, pay their dues and bowl for hours.

The next customer is the casual fan. The one that shows up with a date or a couple buddies. They don’t normally bowl, but given the rainy weather outside, they decide to shake things up.

Goldberg knows he has to focus on the fanatic bowlers. These bowlers keep the lights on. But the real money at the end of the year comes from the casual bowlers. These, while infrequent, have the potential to increase returns ten-fold. These are your casual bowlers.

2. “But two of our best performing centers could not accommodate much of the new equipment, and still significantly improved their results, mostly by working harder at giving good service.

We see in the 1998 letter a focus on customer service. Later he remarks, “More and more, when observing our staff solve a problem, I find myself wishing I had thought of their response.” Great leaders commend their employees.

3. “But there is little we can do about the weather. Continuing to adapt to the shift to casual bowling while not discouraging the heaviest users, our league bowlers, remains our biggest challenge. Our biggest asset in managing the process remains our capable and experienced staff.

What I like about this quote is Goldberg’s focus on what he can control, and his disregard for what he can’t control. He mentions earlier in the letter that “weather does not recognize a fiscal calendar.”

This quote doubles as the business model for Bowl America. A succinct, one sentence model.

1999: Stock Buybacks and Customer Retention

1. “When a bowling center is filled with leagues, potential open play customers become discouraged and may not even try to bowl. This provides a shrinking pool of replacement bowlers for existing leagues. It is only when league play has contracted enough that people feel they can drop into a bowling center on a weeknight and get a lane that we can begin to build back our customer base.

2. “Our challenge is to make sure that those customers enjoy themselves enough to participate regularly and to talk about the fun they had to their friends, neighbors and fellow workers.”

Repeat customers are the lifeblood of any company. The casual fan needs to enjoy herself enough to come back. Goldberg knows that if he can convince each customer to revisit the bowling center at least twice, he’s won their business.

Goldberg even mentions an analysis of a competing recreation center that went bankrupt. When reviewing the insolvent firm, the analyst noted, “[the business] needed only to get customers to come back a second time to survive.”

Goldberg trained his staff to get customers to come back 35 times a year. Talk about margin of safety.

3. “It is superior customer service that has made Bowl America the bowling centers for people who love to bowl.”

4. “Also, the greater the number of recreation events a person tries, the greater the bargain bowling seems. Therefore, we should get the advantage of better pricing to support all of our locations.”

Goldberg’s business has two things going for it:

1. excellent customer service

2. substitution effects.

Goldberg mentions many times the level of customer service. He attributes much of each center’s success to the employees that work everyday. This reminds me a lot of Jeff Bezos’ obsession with the customer.

Goldberg also benefits from substitution effects.

How does substitution effect work in Bowl America’s favor? Comparatively, bowling is a lower-cost option for fun. It’s one of the few date ideas that won’t wring you out of $50. So, with every new form of recreation a person tries, bowling will likely appear the cheapest option.

Letters from 2000 – 2004

2000: What Makes a Strong Financial Position

1. “I am enclosing the press release from our nine-month earnings report, which shows that we have completed our eleventh consecutive year-to-year quarterly profit improvement.”

2. “Bowl America has increased its dividend for 28 consecutive years and twice in the last twelve months.”

The year 2000 marked 11 straight quarterly profit improvements. The company also increased its dividend for the 28th straight year. Credit that to Goldberg’s fiscal responsibility and fortress-like balance sheet.

3. “Bowl America has no debt. In addition, we have substantial reserves to adapt to changes in public taste, both now and in the future. Casino operators (among other masters of statistics) are quick to tell you that you have to have the cash to outlast a bad run so that you can capitalize on the good run that inevitably follows.”

No debt, large cash reserves and an optimistic outlook. That seems to be the recipe for Goldberg’s financial success. During the time of this letter, many bowling operations closed shop due to debt. Goldberg’s avoidance of debt is so strong it’s as if he’s scared of it.

4. “Timing the market is beyond me. But a dividend that increases faster than prices provides real income in any market and downside protection in a poor market. It gives us a chance to share our success four times a year, something I hope we can do for many years in the future.”

Goldberg reiterates the benefits of real income BWL.A produces for its shareholders. Why do I keep going back to this saying? Because the purpose of this business is to generate income for shareholders.

Goldberg doesn’t mention capital gains or trading profits. He mentions real income. It’s this distinction that infects his letters with a sense of true ownership.

2001: Simple Business Models & Ownership in Business

1. “Bowling is easy to understand, simple to learn and allows people of various skill levels to compete with each other. Add to that Bowl America’s policies of locating sites near our customers, moderate pricing and emphasizing friendly service and you have a foundation for earnings longevity.

There’s nothing confusing about what Bowl America wants to do. They want to bring bowling to where the people are. At an affordable price. With excellent service. Prioritizing the customer.

2. “Bowl America is one of the leading companies in providing its owners with these annual [dividend] increases. At the end of 2000, according to Mergent’s Dividend Achievers, only 73 companies of the 10,000 they surveyed had longer consecutive dividend increase records.

This is an impressive feat for any company. Let alone a micro-cap stock. Once again we see a focus on ownership and being owners of BWL.A, not owners of paper.

3. “However, we were able to use the money we might have used for a new location to buy in more of our stock, increasing each shareholder’s stake in the remaining bowling centers. The combination of reduced shares outstanding, the strength of our balance sheet and the relatively higher valuation granted by the market to dividend-paying stocks combined to enable us to reach an all-time high for Bowl America stock.

Goldberg again portrays his knowledge of capital allocation philosophy. He understood that higher returns were possible if he bought back stock. This is also the first time he mentions BWL.A’s stock price. And as we’ll see he’s quick to note why he mentioned it.

4. “That [share price increase] often gives rise to a temptation to sell one’s interest in a successful company in order to find another more successful company … We prefer to continue to emphasize the benefits of ownership of a business as opposed to ownership of stock certificates.

Read that again and tell me it doesn’t sound exactly like the doctrine Joel Greenblatt preaches. Goldberg is a value investor through and through. He knows that share prices are blips on a screen and not a reflection of the true underlying value of a business.

2002: Thoughts on The Double Tax of Dividends

1. “I have always held that our objective should be to help our shareholders prosper through their ownership of Bowl America … Dividends have the benefit of being paid in cash, not accounting fantasy. The disadvantage is that they are subject to double taxation.

Double taxation.

My biggest gripe when it comes to dividends. The first tax is the tax on operating earnings of the company. Then, if a company issues a dividend, the shareholders pay income tax on that dividend. Ouch.

This is why I prefer buybacks. When companies buy back stock, they don’t inflict the double taxation rule. Yet at the same time increase the value of each shareholder’s stock.

2003: Opportunity Cost and Board Dependence

1. “The current panacea is control of companies by “independent” directors. I favor “dependent” control of boards … My preference is, however, related to the fact that the “dependent” directors will be more likely to share in any loss caused by their decision making. If a director shares with other owners the risk of loss from the collapse of the enterprise, he or she is more likely to focus on the company’s survival.

I’ve never understood “independent” board members. If you think about it, board members should have a vested interest in the future success of a company. It never made sense to have a board of directors, paid for showing up four times a year, without skin in the game.

Goldberg nails the reason why. A dependent board, one with skin in the game, must think long-term if they want to reap financial success.

2004: Longevity, Building New Stores and Short-Term Thinking

1. “For the first time in ten years, we are building a new bowling center from scratch … It will add to our standing as the best and oldest continually operating bowling company in the Richmond [VA] area.”

After failing to find bowling centers to buy, Goldberg took matters into his own hands. The company had the cash on hand to build the bowling center without debt. Even with building a new facility, the company kept its promise of dividend increases. Good for 32 consecutive years.

2. “Location in any retail business is important, but we have always felt that longevity flows from great customer service and great customer service flows from people who enjoy what they do. I have always been pleased that so many of our employees are bowling enthusiasts.”

Goldberg’s recipe is simple: Focus on the customer. Make sure they have the best experience possible. Word-of-mouth experiences are binary. You either had such a great time that you must tell others. Or you had such a bad time that you need to let others know so they avoid your experience.

3. “Another group shares the need for price increases, but has an even shorter horizon. These are the so-called money managers, whether they be mutual funds, pension funds or insurance companies that are threatened with investor defection if they didn’t ‘match market performance.’

Letters from 2005 – 2009

2005: The Changing Consumer

1. “As our business shifts from the committed week-after-week bowler to what we call the casual bowler, it will become even more important to vary our entertainment, communication and control capabilities.”

We see the beginnings of a tectonic shift in their core business model. A few letters back, Goldberg referred to his league bowlers as the earnings driver. Casual bowlers, in contrast, provided hefty (albeit lumpy) returns.

Instead of burying his head in the sand and sticking to the “old way” of doing things, Goldberg adapted.

2. “League bowling is not dead. Only this week I heard a report that sociologists have discovered that many of the declining neighborhood institutions are showing turnarounds. The reason given is the growth in the immigrant population, which is looking to community groups as a way to participate with their neighbors.

Goldberg believes in the league bowler, but not as his main source of revenue. Yet the most important piece of this quote revolves around the community group. With each incremental advance in technology we lose that shared, human connection.

This is why companies such as Nextdoor and Discord are Silicon successes. These businesses thrive on creating a sense of community within a neighborhood. In the case of Nextdoor, a community as small as your zip code.

2006: The Pitfalls of Earnings & Not Selling Shares

1. “Also, some of our best business is done in locations that have been actively used for almost 50 years. This year, some of the oldest buildings required expensive and unpredicted repairs. These buildings, however, are well located for future growth.”

Businesses aren’t linear entities. They’re living, breathing, volatile organisms. Thus, earnings should not grow in a linear fashion over the long-term. If they do, it might be a sign of earnings manipulation. But I digress …

2. “We have long argued that shareholders are best served if they can share in their companies’ success without having to sell their stock.”

Here we see Goldberg (again) push the doctrine of thinking of stocks as pieces of businesses.

3. “Future success won’t simply flow from bricks and mortar. It will be determined by the skills of our people and customs we have developed over the years.”

Goldberg emphasizes the importance of his employees whenever he gets the chance. That’s a sign of a great leader. That’s a sign of someone you want to work with.

2007: Bowling People, Not Stock People

1. “Three hundred thousand shares of the new Bowl America stock were sold to the public at $2.00 [at founding]. In addition to the current fiscal year being a birthday for the bowling center, it will also mark the year in which the cumulative dividends on that single $2.00 share will exceed $100.00. Those original investors who were smart enough not to sell their original shares now have 11.3 shares of Bowl America stock.

This is a testament to the power of compounding. Investors received 11.3 shares for every one share owned — all through dividends. Granted that was over the course of 50 years, but that’s the point. You bought and you held it. You participated in the business rather than traded its shares.

Goldberg made no mistake about what he wanted the company to be: A conservative enterprise that generates income for shareholders.

2. “We were bowling people, not stock market people, and our objective was to create a secure, profitable bowling company to generate income for our families’ futures. We, therefore, valued survival of the company as our top priority. We proudly reported paying off each mortgage.

Now contrast this approach with today’s public companies. We live in a time where money is cheap, revenue growth is the gauge of success and fiscal responsibility is low.

How much better would public companies be, micro-caps in particular, if they ran their businesses like Goldberg? A business that focused on preservation of capital. An obsession with its employees and its customers. Would we see such pessimism permeate through the micro-cap space if that happened?

2008: Strong Balance Sheets & Business Reform Ideas

1. “As of today, we own 17 of our 19 bowling centers. None has a mortgage. In fact, we have no long-term debt. Our payrolls and trade bills are current … We, therefore, expect that we have deep protection for our ability to finance our center operations and to support possible expansion. Further, unless there is a runaway panic, we believe that our healthy balance sheet would enable us to borrow if a promising option became available.”

And so we’ve arrived. The Great Financial Crisis. Yet before reading the 2008 letter, one would assume that the company would survive — and even thrive.

Emphasizing a strong balance sheet, little to no debt and a focus on creating value pays off. It’s obvious in times like the GFC.

Businesses with great balance sheets and zero debt relish opportunities like 2008. During recessions, responsible businesses can scoop up competitors for pennies on the dollar.

Goldberg reminds shareholders of this idea, saying, “I hope you will take comfort as we work through the problems and opportunities of the near term, that we share common objectives.”

2009: Bad Politics and Long Term Capital Management

1. “I was recently asked if I could recall a scarier time for business … ‘How about December 7, 1941?’

If that doesn’t put things into perspective for shareholders I don’t know what will. Think bigger (and farther out) than the last few quarters.

Letters from 2010 – 2014

2010:  Matching Expenses and Long-Term Investing

1. “We have, therefore, devoted our efforts during the past year to bringing our expenditures as closely in line as possible to our traffic, continuing to promote the business and providing a service that, when economic conditions change, will enable us to accommodate the upswing in our business.”

2010 marked BWL.A’s first league bowling season under Virginia’s “no indoor smoking” policy. We saw the negative effects of a smoking ban in earlier letters.

Why do people have such a hard time quitting the devil stick? There’s the nicotine, yes. But is that it? I stumbled upon an article from Psychology Today (written by Romeo Vitelli, Ph.D) addressing this very issue.

The article reveals that, “Not only did study participants describe themselves as being friendlier, more extroverted, and less socially anxious after ingesting nicotine, but nicotine use helped improve awareness of social and facial cues compared to participants who had abstained from nicotine use for 24 hours or longer.”

Now it’s clear why a smoking ban hits bowling sales. Bowling was the outlet, the catalyst for social smoking.

2. “Perhaps someday people will view stock purchases as an opportunity to own part of a business and not simply a piece of paper. We will continue to run this company as though we represent people who prefer the former.”

I love this. There’s nothing to add.

2011: Skin in The Game & Operating Leverage

1. “As you may have noted over the years our Board shares the risks and rewards of ownership of Bowl America with all of you. Our ladder has been designed to protect as well as possible every owner of the Company.”

Goldberg’s 2011 letter brings back the notion that Board members should have skin in the game. That they should own a part of the business they’re running. While such a common sense idea, it amazes me how few boards install this philosophy.

2. “Debt can create the risk of bankruptcy. We have no debt. It has been over 20 years since we paid off our last mortgage. Rent in a troubled economy can be as dangerous as debt.

Many investors underestimate the cost of obligations. We see this especially in retail businesses. Why is that? Under GAAP accounting, operating leases count as an operating expense. This makes sense at first glance. You need the building/space to do normal business activities.

Yet valuation guru Aswath Damodaran disagrees. He suggests, in his 2009 whitepaper, that operating leases should count as a financing expense. According to Damodaran, leaving leases as an operating expense, “results in a skewed estimate of profitability, leverage and value.”

What does he mean by that?

Damodaran argues that operating leases look, smell and feel like regular debt. The type of debt you would see on a balance sheet. It makes sense. Leases meet all the requirements of debt:

    • length agreements
    • contract terms
    • specified payments
    • use of building as collateral if payment is not received.

Yet for some reason, these payments don’t receive capital expense status.

This designation results in higher than actual operating income, returns on equity and lower debt to equity ratios. All these things matter when valuing a business.

Goldberg drives this point home later in the letter, saying, “We own the land and buildings at 17 of our 19 bowling centers. In addition to the security that provides, the cost savings when compared with rent are significant.”

2012: Hoarding Cash & Staying Profitable

1. “We are not pleased with our results but we are pleased that we have done better than many companies in keeping the doors open and employment levels high and in operating profitability during every year of this downturn.

Staying profitable during the Great Financial Crisis is applause-worthy on its own. Doing so in a recreation dominant business? Even more impressive.

Bowling, like most recreational activities, isn’t an inelastic good. We engage in recreation in tandem to our level of leisure time and discretionary income.

There wasn’t much of either between 2007-2009.

2. “We are probably the oldest firm in the bowling business which has the operation of bowling centers as its primary activity. Over the years our interaction with you, with our customers, and with our employees has convinced us that all prefer a more predictable outcome to an adventure.

Goldberg wants to be the tortoise, not the hare. In a business where the board, the employees and the CEO owns most of the company’s stock, this makes sense.

There’s a skewed preference among value investors around distribution of returns. Most value investors prefer a lumpy, but excess return. Meanwhile, Goldberg prefers a steady, predictable income stream. After all, this business feeds his family, and his employees’ families.

2013: Employee Ownership & Inflation Benefits

1. “Survival of the employer is the cornerstone of employee security. But benefits must be personal for employees to commit to a career. Our full-time employees, without cost to them, participate in our stock ownership plan which now owns 7% of Bowl America stock.”

Employee stock ownership makes sense. You want your employees to care about the long-term future of the business. What better way to inject that sense of long-term thinking than via direct ownership?

Investors relish large, C-suite level ownership. But it’s employee ownership that matters more. The reason for this hypothesis lies in scuttle-butt research. When managers engage in scuttle-but, where do they find the most valuable information?

It lies inside the trenches.

Erik Forsblom and Ludwig Smedberg dove deeper in their whitepaper, Stock-based Compensation and Shareholder Value. Their results were, well, predictable.

Companies with more generous (or presence of) employee stock ownership programs generated almost double the return over the five-year period. The study also found that the use of warrants resulted in even higher shareholder return.

This isn’t to say that employee stock programs were the sole reason for excess return. The companies that offered such programs could be better companies in general. But it is something to think about.

2014: Digging Out From Recession & Social Capital

1. “Our results continue to disappoint despite the fact that this was the 51st consecutive year of profitable operations … You have perhaps noticed in the news the pattern is the same for golf rounds played, movie attendance and even some football stadiums. People simply have more choice for recreation and for shrinking budgets.”

We first saw this instance of Paradox of Choice in Goldberg’s 1995 letter. A decade later, it resurfaces. It shows how challenging it was for businesses to get back to Square 1 after the GFC.

BWL.A’s stock recovered in swift motion — less than three years — but the underlying business failed to grow. Imagine how difficult things would’ve been if they had excessive leverage.

Goldberg ends the 2014 letter giving his elevator pitch for bowling:

2. “Bowling is the most gender-neutral major popular pastime. Bowling is safer and more age inclusive than almost any sport. Our game is economical (the price of a game actually declined in the last year). Bowling is an important contributor to social capital.

Social capital. The term first coined by Robert Putnam in his book Bowling Alone (imagine that). In Putnam’s words, social capital “refers to features of social organization such as networks, norms, and social trust that facilitate coordination and cooperation for mutual benefit.”

Goldberg runs with the idea. Each Bowl America building is the hub for social capital. People come in, bowl, and grow their social capital. That social capital then spreads throughout their community. The community grows closer together, prompting more group-level engagement. These groups then choose to bowl together … And the beat goes on.

Letters from 2015 – 2018

2015: Light at The End of The Tunnel

1. “If you acquired one of the original shares at $2.00 and still held today, you would have 11.4 shares and would have received dividends of $164. The market value of those 11-plus shares roughly equals the dividends received, suggesting a balanced return as rewards of our ownership.

Ben Graham liked to say that in the short-term, markets are voting machines. It doesn’t matter the fundamentals of a business or strong financial position. In the short-term, anything’s possible.

That’s the beauty of an auction-driven market. We can take advantage of these mechanisms.

Yet in the long-run, Graham believed markets become weighing machines. In contrast to voting machines, weighing machines balance price and value. In this time-frame, fundamentals do matter. Strong balance sheets matter. Exceptional (and aligned) management matters. Over time, the market will get it right.

But not on your time.

2. “Overbuilding in the industry in the early ‘60s required the founders to guarantee additional borrowing to save the company. From that experience the directors decided that it would be wise to own property rather than lease locations so that if business turned down again it would not be faced with closing good locations or paying inflated rents.”

The rise of Amazon reveals a crucial error in most brick-and-mortar business models. Death via operating lease. We discussed operating leases a few pages back, but it’s worth bringing up again. Why? Because operating leases are value destructive in times of slow-down.

A lease is a fixed cost. Whether a company generates ample or pitiful sales, the lease must get paid. Goldberg mentions one way to ease the lease overhead: buy the building.

But what if you can’t do that? How can brick-and-mortar operators protect their solvency when forced to lease? Here’s two ideas:

Idea #1: Figure out a “worst-case” scenario for profitability, earnings and revenues. If you can still make your lease payment in a worst-case scenario, sign the agreement.

Idea #2: Downsize, downsize, downsize.

In this scenario, less is more. Everybody wants the larger house. Yet nobody wants the added responsibility of owning a larger house.

Therein lies the key: unit margins. The higher the margin, the more sensible it is to expand. The lower the margin, the riskier it is to expand.

2016: Nothing New Under The Sun (and Profitability Factors)

1. “It would seem that the old pattern of consumer preferences changing is in fact accelerating … However the particular impact of in-home entertainment is not new. Our predecessor company went into business two months before World War II. We were exposed to behavioral changes brought about by new TV technology. VCRs, DVDs, high definition, cable, 3-D and, of course, streaming TV. Each of these events had an impact that was noticeable on the bowling business and from each of them Bowl America recovered.

Ecclesiastes recognized this thousands of years ago. There is nothing new under the sun. The reason for this is simple, yet important. Technology changes and improves quicker than ever before. Meanwhile, our human brain — evolutionarily speaking — remain in the hunter-gatherer stage of development.

There’s an element of genius in Goldberg’s decision not to change bowling as quickly as technology. Throughout each technological change, Goldberg’s business remained profitable. In fact, 2016 marked the 53rd consecutive year of profitability. Wars, recessions, massive inflation, you name it. The company adapted.

Goldberg offers two reasons for the company’s enduring success:

    • Incentivized and aligned employees
    • No mortgages

Goldberg reminds shareholders of these two factors. His letters sound like a broken record. But then again, so does 53 consecutive years of profitability.

2. “We think two factors have helped us. Most important is our view that an enlightened policy towards our employees has produced an experienced staff able to deal with the changing bowling customer … Over 700 Bowl America employees are owners of the stock … [Bowl America] has no mortgages. This stability is a key to the development of long-term employment opportunities.

2017: Buying Assets For Pennies on The Dollar

54 consecutive years of profitability. I’m beginning to wonder if they even have red pens in their corporate office. In this letter, Goldberg looks back on what he thinks the most pivotal year in the company’s history: 1974.

During that year, the company won a lawsuit, received a hefty cash payment and invested in a new center. This center, located in Richmond, VA remains one of their best-performing assets. It also marked the shift from leasing to owning property.

Meanwhile, the bowling business in Japan crumbled …

1. “Many high-quality bowling lanes and pin setting equipment were for sale [in Japan]. We began to buy and store [the equipment] for future use. Our skilled employees handled much of the installation and maintenance of this equipment themselves, developing skills which continue to benefit us.”

Goldberg is, in fact, a deep value investor. He bought good quality Japanese bowling equipment for pennies on the dollar. And he bought from forced sellers.

2. “Once our original investment in the new centers was paid off, we had a cost basis that could not be duplicated. In addition, when we made a mistake we were able to sell the resulting real estate at a profit.

Two things jumped out at me:

    • Bowl America’s competitive advantage — its moat — comes from buying great equipment at cheap prices.
    • Goldberg builds in a margin of safety into each new center.

One decision changed BWL.A’s trajectory forever. Those Japanese assets provided the company a low cost-basis. So low, in fact, competitors couldn’t achieve similar margins and remain profitable. In turn, the low cost-basis offers a low hurdle should Goldberg sell the bowling center.

Heads I win, tails I don’t lose much.

2018: Have Your Cake & Eat It Too

Here we are, Goldberg’s most recent letter. We’ve journeyed over two decades to this point. We’ve seen the dot-com bubble, the Great Financial Crisis and advancing technology.

Yet despite the above factors, one thing remains unchanged: profitability. 2018 marked the 55th consecutive year of profitability. An incredible feat of any company, let alone a consumer behavior-driven, micro-cap business.

Goldberg book-ends these 24 years the same way he started them. By focusing on employees, customers and no debt. He’s owned BWL.A stock for 60 years and hasn’t sold a share. He’s got skin in the game and longevity.

1. “Every full time employee of Bowl America has a piece of the same cake. The Company’s non-contributory stock ownership plan holds 391,000 shares, with employees fully vested after 6 years of plan service.”

Many BWL.A directors sport 30, 40 even 50 year tenures with the company. The most common cause of employee turnover seems to be death. Goldberg hints at why that’s the case, saying, “We are of the opinion that this plan has contributed to the feeling of security held by our employees.”

Skin in the game throughout all levels of employment.

2. “Ours is a service business and attitude is important in providing service. In addition, the experience of our staff guarantees competence to our customers who are rarely faced with ‘that’s not my job’ when asking for assistance.”

Bowl America is the Chick-Fil-A of bowling centers. Excellent customer service is a large competitive advantage. It’s also one of the hardest to achieve. Top-notch customer service requires employees to buy-in to the company’s long-term vision.

Not only that, employees must enjoy working for the company. Reward your employees and they’ll reward the business.

Concluding Thoughts

Leslie Goldberg is an incredible operator. Unfortunately he passed away on October 14th, 2019. Yet he left behind an incredible legacy. 55 consecutive years of profitability is a feat few business owners can tout.

I hope these letters and Goldberg’s thoughts  inspire you to think about durability in business. About investing through economic cycles and the power of long-term ownership.

We now live in a world where it costs nothing to buy or sell securities. The barrier to entry for short-term minded traders has never been lower.

Where will the advantage be over the next 24 years? It will rest in the hands of those willing to look beyond the next quarter or year. The advantage goes to the one with a long-term mindset. The mind-set of an owner. One that views stocks as ownership in actual businesses. Not pieces of paper or blips on a Bloomberg screen.

Think like an owner. Think like Leslie.

“Good service, happy customers and a fun game is the way to bake a great cake.” – Leslie H. Goldberg

Plato’s Cave and How I Lost $127,562.06

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Are you familiar with Plato’s allegory of the man in the cave?

It’s about a man deep in a cave who’s been chained to a wall his entire life. He’s never seen the light of day and doesn’t know there’s an outside world.

In this cave, out of the man’s purview, there’s a fire with people moving statues in front of it, casting shadows on the wall which the man sees.

The man believes these shadows are real things. He sees shadows of lions and thinks they’re real lions, he sees shadows of people and thinks they’re real people… you get the idea. The shadows are his reality.

This story is meant to show the natural state of ignorance man is born into and in which most live — where they spend their days looking at shadows thinking they’re real…

This is exactly how my trading career started out. I was that ignorant bastard chained to a wall ogling shadows. I didn’t know jack. But because of my professional background and my previous successes, I thought I was pretty smart. I was even a bit arrogant.

This arrogance, mixed with my ignorance, cost me a LOT of money. $127,562.06 to be exact.

Here’s the quick story of how it happened. This is how I hit rock bottom, plunging to the darkest depths of the cave of ignorance… and how this painful failure pushed me to discover the key to beating markets going forward.

Let’s go back in time to two years before I lost the $127,562.06 gambling in markets.

I had been trading for a number of years by that point. I worked a full-time job in an unrelated field but spent nearly every minute outside of work on markets. I was hooked. I read all the classic trading books you’re supposed to and scoured the farthest reaches of the internet for anything that would give me an edge.

Through all this work and study, I became decent… or at least I thought so. I only lost a little bit of money while occasionally hitting winners when I got lucky. But like I said, I was arrogant. Every win, no matter how small and infrequent, sparked grand visions of me soon being praised as the next George Soros… but with Ed Thorpe’s quantitative know-how and Dan Loeb’s jawline.

I’m not joking. I really believed Market Wizard status was right around the corner, even though I had barely made a penny trading and was by no means consistent.

I figured the only thing holding me back from becoming a trading legend was the size of my stake. I needed a real bankroll. I mean who can be expected to do anything amazing when they’re piking around with $15K. That’s play money. If I could get a six-figure line, then I would really buckle down and make a killing.

So I went to the Middle East. A war zone in the Middle East to be exact. Not a normal place to build a trading stake, but with my background, it made sense.

To quote Liam Neeson, I have “a very particular set of skills. Skills I have acquired over a very long career. Skills that make me a nightmare…” You get the point.

Certain companies are willing to pay people with my skill sets buku bucks to operate in a warzone (all perfectly legal, above board, and in support of the US of course).

So I packed my backpack along with a 120-pound trunk full of trading books (Kindles weren’t really a thing yet) and set off to the other side of the world.

I spent a year working 12+ hours a day, 7 days a week, in a hot and shitty desert, only to go back to my trailer and study/trade markets for another 4-6 hours. I was dead set on becoming the next PTJ.

After the year was finally up, I came back with the six-figure trading line I always wanted. I was 100% ready to fulfill my “destiny”. It was finally time to become the next Market Wizard

And then the absolutely worst f*cking thing happened to me.

I started winning. And I mean A LOT.

I was minting money on nearly every trade.

It was ridiculous. I made more than my previous annual salary in just a few months. And in less than six months, I had more than tripled my money. I was like the guy from that old E-Trade commercial getting wheeled into the ER with money coming outta my wazoo!

It was the worst…

Now you’re probably wondering why the hell this is a bad thing.

Well… remember those visions of grandeur I had before? They multiplied 100 fold.

I began believing I was the love child of Livermore and Buffett… the living, breathing trading Jesus born to bless markets with his divine mouse click and great hair. Every time the phone rang I fully expected it to be Jack Schwager asking for an interview.

Maybe you can see where this is headed…

Anyway, after all that winning, the tide eventually began to turn (as it always does in markets) and I started losing.

At first, it was just a little bit. But then it became alotta bit.

It just didn’t make sense. Trading Jesus didn’t lose… how was this possible? So, of course, like a jackass I upped my risk and started trading more. I NEEDED to make back the money I lost and do it fast.

This is when I began my journey to traders’ hell, where I visited all of Dante’s eight circles, enjoying each as much as the original protagonist. Every day I woke up to my P&L bleeding red. And as the losses kept piling up, I felt more and more physically sick.

After my legendary year, it took me just THREE MONTHS to give back $127,562.06 in profits.

This was no small beans for me. I was a 20-something at the time and this was by far the most money I’d ever had.

The fact that I felt like a market god after my astounding year made this fall all the more painful. That’s why I said winning like I did was the worst thing that could’ve happened to me.

At some point, I finally hit rock bottom — total utter despair. I realized my Market Wizard year was just a lucky streak and that I was still a shoddy trader. I can’t remember exactly what did it, but I eventually called my broker and had him send my remaining balance back to my bank account. I was done.

This experience was more than humbling, it was downright brutalI mean it was knees-to-the-mat-delusion-busting-4am-wakeup-call kind of brutal. The emotional rollercoaster rocked me. And I don’t get rocked easily. I’ve been in some pretty sticky situations overseas and have been trained to handle my emotions. But this was something completely different. I was honestly shocked by the effect it had on me.

And that’s when it hit me.

Markets are nothing more than a bunch of people like me, trying to manage their emotions. And these emotions are really just a result of their beliefs. Together, these beliefs and subsequent emotions make up the pricing mechanism we call the “market”.

So really, if I wanted to succeed in markets, I didn’t need to worry about finding the “correct” price of an asset. I just needed to understand the other emotional sons of bitches I was trading against!

It was so damn obvious once I realized it.

The majority of my professional training, whether as a spec ops sniper, military interrogator, or government counterintelligence specialist, all focused on psychology over everything else. It wasn’t just about managing my own psychology, but understanding the psychology of my opponent as well. The goal was always playing the player.

Hell, even outside my military experience, anything I ever strived for, whether it be a new job, a lovely lady, or even a discount at the car dealership… it was all about playing the player. And if the market is just a giant version of these one-on-one interactions, with beliefs and emotions all mixed in, then what was the difference?

It was this realization that helped me finally break the chains keeping me inside Plato’s cave of ignorance.

I finally learned what it meant to be a contrarian. And not a twittering holier than thou trend fighting finger missing knife catching “contrarian”… But an actual Keynes’ ‘Beauty Contest’ fourth-degree playing patient salmon type contrarian — you know, the kind that actually makes money.

I had to earn this realization, with plenty of blood, sweat, and tears — on top of a pile of lost money.

But it was necessary. Necessary because that is part of the Trader’s Journey. The trader’s journey is a lot like Joseph Campbell’s Hero’s Journey. We go out into the world and venture into the unknown, accept challenges and stare into the abyss, make discoveries, learn from our mistakes and return a better person with newfound knowledge and skills.

That’s what the Macro Ops Collective is all about, facilitating this Trader’s Journey.

If you choose to embark on this journey and do it well. You have to step off knowing there is no there there. It’s an endless spiral of growth and evolution. There are always new challenges to tackle, problems to solve, mistakes to be made, and goals to strive for.

This is why the MO Collective is not just another newsletter giving stock picks. Yeah, sure, we provide regular research from Brandon (value investing focused), ChrisD (systems+technicals), and myself (a bit of everything). But that’s just a small bit of our value proposition, to be honest.

I mean, show me one person who’s become rich after signing up to a newsletter? Exactly… Do you want to know why that is? It’s not just that most newsletters are really disguised investo-tainment. Services that spin good yarns but are only as valuable as monkeys throwing darts when it comes to  your P&L.

The bigger reason is that newsletters are all — and I mean all — focused on the wrong thing. Wanna know what that is?

Stock picks and market predictions — the same damn thing that every other trader and investor focuses on.

The funny thing is if you talk to any pro – and I mean a real pro, not some guy who wears a necktie and regularly appears on CNBC but somebody who actually consistently carves out profits from the market for a living. They all say the same thing: “trade picks are maybe 10% of the game, predictions are detrimental to your bottom line, and trade management is EVERYTHING”.

Trade management is about having a watertight process. One that you follow day in and day out. It’s position sizing, risk management, and entries/exits — and more position sizing. That’s it. Nothing flashy or glamorous. The truth is successful trading and investing is fairly mundane. At least it is if you’re doing it right.

And that’s why we not only give you fish but teach you how to do so yourself.

If you want to join us on the journey, learn to fish, and hopefully catch a few whoppers along the way. Then go ahead and click this link and sign up. You can come in and try us out for 60-days risk-free. If you realize it’s not for you, no hard feelings, we’ll give you a refund in full and hope you continue to enjoy our publicly available work. Simple as that. No downside, life-changing upside potential = a very asymmetric trade.

I hope you enjoy the rest of your Sunday.


If you’re interested in joining our group of macro traders and investors then sign up for
The Macro Ops Collective before this Sunday, October 13th at 11:59PM!

Ditch the Predictions and Play the Odds

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We are in the business of making mistakes. The only difference between the winners and the losers is that the winners make small mistakes, while the losers make big mistakes. ~ Ned Davis

When I became a winner, I said, “I figured it out, but if I’m wrong, I’m getting the hell out, because I want to save my money and go on to the next trade.” ~ Marty Schwartz

When I see or hear of someone pushing a gigantic market call, talking as if they know exactly what’s going to happen in some well-extended time frame, my inner skeptic has a field day.

There is a HUGE difference between odds-based scenarios and needlessly gaudy predictions… and I tend to trust gaudy predictions about as far as I can throw them.

I mention this in light of three “big calls” that, though not exactly new, have garnered fresh media attention in recent weeks.

I’ll avoid naming names here, as specifics aren’t so important.

Let’s just say one of these guys is a well known perma-bear who’s been screaming about a recession over the last 10-years and now sees — can you guess? — a catastrophic recession around the corner. Another is a popular perma-bull who hasn’t seen a dip that shouldn’t be bought since he first opened his etrade account in 2000… the third is a media-hungry academic who thinks now is a “great time” to be a buy and hold investor.

Useless. All of ‘em.

It’s Not About Being “Right”

As a general rule of thumb, I could care less what media-hungry attention seekers think. The manufactured certainty is more than a bit off-putting, as is the cozying up to quote-hungry news outlets. In the swirling sea of uncertainty, here are a few things the MO trader knows to be true:

    • The vast majority of “big calls” are an annoying waste of time.
    • Being “right” or “getting a big call right” has little to do with real trading.
    • Great traders have balls, but they sure as hell ain’t crystal.
    • Being right and making money are two completely different things.

Why are table-pounding market calls – especially ones spoon-fed to the media for the sake of garnering attention – more often than not a waste of time?

Aside from rampant cherry-picking – step right up and pick an opinion! – one big reason is because successful trading is NOT about prediction (i.e. being “right”). Instead, it’s about seeing the markets as an odds game, and understanding the full implications of what that means.

First and foremost, seeing the markets as an odds game means constantly putting the odds in your favor.

Always acting pragmatically… always in concert with the dictates of observation and experience… always aligned with the twin goals of maximizing profits and minimizing risk (as applied over the full spectrum of trades).

In actual, real-world, day to day execution – something far too many pundits have far too little knowledge of! – this means cultivating a ruthless focus on making money, with being “right” so far down on the trading priority list it’s practically an afterthought.

Because, think about it – if you’re emotionally and intellectually focused on being “right,” then you aren’t truly focused on making money, are you?

Or, if you’re captivated by all the dough you’re going to make by being “right,” then you are probably hopelessly enmeshed in confirmation bias and grossly neglecting the downside risk.

P&L First!

On the other hand, let’s say your primary trading focus is indeed on making money (as it should be). Let’s further say a handful of new trades are not acting right (or that the market script is otherwise going off-kilter).

Well, if P&L (i.e. making money) is the ruthless focus, what are you going to tell yourself when things get iffy? That you should stick to your guns and keep those funky-smelling positions on because, dammit, you are “right” and the market is wrong?

No way José. A truly good trader will act in the best interests of P&L first… even if that means admitting being “wrong” in one’s initial assessment of a trade. For discretionary traders, i.e. those forced to make a steady stream of decisions as part of their discipline, this kind of thing happens all the time.

In other words, being “right” takes a backseat to making or preserving $$$ every time a market shift behooves a change of mind. (And yet, the table-pounding types NEVER seem to change their minds. Notice that?)

There is simply no way around it: Being right and making money are competing priorities… and a focus on one greatly diminishes the other.

Prediction versus Conviction

Something else: It’s important to distinguish between flashy calls and high-conviction probabilistic assessments based on accumulated evidence and a clear read of market conditions. The first is an ego trip; the second is betting with the odds in your favor.

A damn good trade is like a damn good poker hand. You rarely if ever have 100% certainty (and you certainly don’t pretend that you do)… but you can most definitely know, based on the situational dynamics of the hand, when it’s time to bet big.

John Hussman explains the conditional probability concept well (I know, Hussman? The irony doesn’t escape me but that doesn’t detract from this explanation it just means he can’t follow his own advice):

From a Bayesian standpoint, if you always observe a certain combination of information when X occurs, and never observe that same data when X is not present, then even if X is hidden under a hat, you would conclude that X is most likely there. If I see clowns walking around the grocery store buying peanuts, and there’s a big top tent with two unicycles in front of it in the middle of what is usually an open field, I’m sorry, I’m going to conclude that the circus is in town.

Cutting Through the Crap

One final thing. Let’s say there are two opposing scenarios, both of them plausible (a fairly regular phenomenon in markets). Plausible scenario A says market “Up.” Plausible scenario B says market “Down.” Which do you choose?

Easy – you don’t worry about it. You watch and wait… and let price action be your guide.

One of the great things about price action is the way it cleaves through “analysis paralysis” like a hot knife through butter.

Simply put, price action cuts through the bullshit. It’s a lamp unto our feet (or rather, our P&L).

We can make the most of price action signals, you see, because as MO Traders we are nimble and liquid. We are speedboats, not aircraft carriers. Not for us the problems of the hidebound pension fund, the mammoth Fidelity manager who has to buy $200 million worth of stock just to move the needle, or the glacier-slow advisory board that takes three months to make a decision. Being small and fast, we can turn on a dime in real-time… and thus bypass the lumbering constraints that plague the big and slow.

So, forget prediction – and tune out anyone who tries hard to get your attention by making one. Focus on odds and gaming out the various scenarios instead, and be wary of anyone who “knows” what’s going to happen.

If you want to be consistently successful as a trader – to carve out large chunks of profit in the MO style – here is how it’s done:

You invest time and energy developing a flexible forecast – be it for an industry, a commodity, a currency, or even the broad market itself.

You digest info from high-quality sources, but with the intent of getting in tune with the market, not embracing some iron-clad far-off prediction that can’t possibly account for the dynamic nature of markets in the first place.

You do your fundamental homework and your due diligence legwork, gathering useful data to give you a sense of conditional probabilities and odds-based assessments. You work with probabilities, not certainties, in mapping out your potential trade setups.

You make it your primary focus to get a handle on the scenarios – to synch up with the ‘market script’ – as opposed to consulting a crystal ball. You regularly consult the charts and maintain a general awareness of how other market participants are positioned. You overlay all such activities with a ruthless focus on MAKING MONEY as opposed to being “right.”

And then, when your trading vehicle of choice approaches an actionable juncture, you watch and you wait… and you let the price action tell you what to do.

A favorite trading quote of mine comes from Bruce Kovner of Market Wizards fame. He put the job of a trader as this.

One of the jobs of a good trader is to imagine alternative scenarios. I try to form many different mental pictures of what the world should be like and wait for one of them to be confirmed. You keep trying them on one at a time. Inevitably, most of these pictures will turn out to be wrong — that is, only a few elements of the picture may prove correct. But then, all of a sudden, you will find that in one picture, nine out of ten elements click. That scenario then becomes your image of the world reality.

Another Wizard profiled in Schwagger’s iconic series is Stan Weinstein (he authored an excellent trading book titled “Secrets for Profiting in Bull and Bear Makrets”). Anyways, Stan who’s motto was “The tape tells all” was an incredible market timer — he made a LOT of money playing the big swings in the market.

He didn’t do this by being an ideologue, having an opinion on the market’s direction and then seeking out confirming data. He looked at what he called the “weight of the evidence”, which for him was a dashboard of 48 technical market indicators that looked at everything from margin debt levels to credit spreads, call-put ratios, odd-lot short sales, and more.

These indicators never gave him a “sure bet”. They were just data points that added up to odds in a constantly evolving continuum where the tape was the final arbiter.

Quite a different process than the one practiced by those who’ve been confidently predicting a recession since the last one, isn’t it?

In the following series of posts, we’re going to imagine alternate scenarios and evaluate the weight of the evidence by going through our process for pulling signal out from all the noise.

Stay tuned…

The Evolution of Political Regimes

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Plato, using Socrates as his mouthpiece, wrote the following condemnation of Athenian democracy in his Republic:

[The citizens] contemptuously rejected temperance as unmanliness… Insolence they term breeding, and anarchy liberty, and waste magnificence, and impudence courage… The father gets accustomed to descend to the level of his sons and to fear them, and the son to be on a level with his father, having no shame or fear of his parents… The teacher fears and flatters his scholars, and the scholars despise their masters and tutors… The old do not like to be thought morose and authoritative, and therefore they imitate the young… Nor must I forget to tell of the liberty and equality of the two sexes in relation to each other… The citizens chafe impatiently at the least touch of authority, and at length…. They cease to care even for the laws, written or unwritten… And this is the fair and glorious beginning out of which springs dictatorship… The excessive increase of anything causes a reaction in the opposite direction;… dictatorship naturally arises out of democracy, and the most aggravated form of tyranny and slavery out of the most extreme form of liberty.

Plato reduced the evolution of political regimes to a sequence of monarchy, aristocracy, democracy, and dictatorship. In the excerpt above he’s commenting on the fraying democracy in Athens that was driven by a widening gap between the rich and poor… sound familiar?

The wealth disparity drove the poor to try and enlarge their cut of the pie through legislation, taxation, and revolution. The rich banded together to protect themselves and their money. This division fractured Athenian society and opened the door for Philip of Macedon to invade and conquer Greece.

Greeks had grown so despondent with their political system that many actually welcomed his conquest. Greek democracy transitioned to dictatorship.

Nearly 300 years later we saw a similar sequence play out in Rome. The Roman Republic created enormous amounts of wealth through its vast control and exploitation of foreign lands. The new aristocrats curried favor with the leaders on Palatine Hill through bribes and political support. Over time, the government began to work for the special interest of the few.

In response, the commoners supported Julius Caesar who seized power and established a popular dictatorship. He was then stabbed in the back (literally) by the aristocrats and replaced by another dictator, Gaius Octavius. Democracy became a dictatorship which then became a monarchy.

Political regimes like much of nature seem to oscillate between extremes (democracy and autocracy), where each extreme sets the conditions for the inevitable transition towards the other. How a nation’s wealth is divided amongst its people is one of the biggest drivers of this constant pendulum.

In Will and Ariel Durant’s The Lessons of History they write that “inequality is not only natural and inborn, it grows with the complexity of civilization. Hereditary inequalities breed social and artificial inequalities: every invention or discovery is made or seized by the exceptional individual, and makes the strong stronger, the weak relatively weaker.”

This fact keeps the political system in oscillation between extremes. Where — again quoting both Durants—  “…freedom and equality are sworn and everlasting enemies, and when one prevails the other dies. Leave men free, and their natural inequalities will multiply almost geometrically, as in England and America in the nineteenth century under laissez-faire. To check the growth of inequality, liberty must be sacrificed, as in Russia after 1917. Even when repressed, inequality grows; only the man who is below the average in economic ability desires equality; those who are conscious of superior ability desire freedom; and in the end superior ability has its way.”

When economic prosperity is relegated to a few, society’s desire for political freedom becomes merely a conciliatory afterthought. This arises not so much through the wealthy’s direct exploitation of the poor but rather due to the increasing complexity of the economy and government. This complexity puts an additional premium upon one’s superior ability to navigate it, which further amplifies the concentration of wealth and political power.

Running under all of this is the Bridgewater style long-term debt cycle. The wealthy are the creditors that hold the assets, the poor the debtors who suffer under the liabilities. The larger the balance sheet grows, the more complex the economy and the more enriched the wealthy and the more financially strangled the masses become. Until of course, a natural limit is hit… equality pushes back at freedom… and democracy inches towards autocracy.

The Durant’s note that when “our economy of freedom fails to distribute wealth as ably as it has created it, the road to dictatorship will be open to any man who can persuasively promise security to all; and a martial government, under whatever charming phrases, will engulf the democratic world.”

The interesting political events of late (ie, Brexit, Trump, the rise of nationalist parties in Europe etc) are not causes but rather effects of the debt cycle and the natural evolution of the political sequence as described by Plato some 2,400 years ago.

That is not to say we are going to see a shift to dictatorship or anything of the kind in the near future (we aren’t)… nor am I saying that is what Trump in any way represents (he doesn’t). Rather, I’m talking about the large tidal forces at work; the historical cogs that are turning and driving the current rise in populist sentiment and which will play out for many years to come.

We are witnessing the battle between two opposing forces of political and economic nature unfold. Neither is good or bad, they both simply are. Each is embedded in the evolution of our natural system where equilibrium is merely a concept and constant change a reality.

It is with that understanding that we must judge and assess things to come. Taken in this context, the current insanity of the world begins to make a lot more sense.

The course we are on now is not a sustainable one.

I fear the rise in populist politics is only just beginning. Let’s hope we don’t swing too far back in the other direction…

Trader Vic’s Market Methods

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I first came across Trader Vic over a decade ago while meandering through an old book store. My dog eared and excessively highlighted copy still sits on the bookshelf next to my desk. It’s one of the few trading books I regularly turn to for a reread. The book covers everything from trade management to market psychology, to technicals and fundamentals, and even some economics.

Below are a few of my notes from the book.


On Thinking in Essentials

“If I had to reduce all the components of my methods to a single phrase, it would be thinking in essentials.

It’s not necessarily how much you know, but the truth and quality of what you know that counts. Every week in Barron’s there are dozens of pages of fine print summarizing the week’s activities in stocks, bonds, commodities, options, and so forth. There is so much information that to process all of it, and make sense out of it, is a task beyond any genius’s mental capacity.

One way to narrow down the data is to specialize in one or two areas. Another way is to use computers to do a lot of the sorting out for you. But no matter how you reduce the data, the key to processing information is the ability to abstract the essential information from the bounty of data produced each day.

To do this, you have to relate the information to principles — to fundamental concepts that define the nature fo the financial markets. A principle is a broad generalization that describes an unlimited number of specific events and correlates vast amounts of data. It is with principles that you can take complex market data and make it relatively simple and manageable.”

This is why we at MO practice Ruthless Reductionism. Einstein said, “Everything should be made as simple as possible, but not simpler”. Your information intake is a key part of your process. Strip away the fat, know what you consume and why you consume it, search for key principles and let them guide your way.


A Business Philosophy for Consistent Success

“I base my business philosophy on three principles, listed here in order of importance: preservation of capital, consistent profitability, and the pursuit of superior returns. These principals are basic in the sense that they underlie and guide all of my market decisions. Each principle carries a different weight in my speculative strategy, and they evolve from one to the other. That is, preservation of capital leads to consistent profits, which makes pursuit of superior returns possible.”


Preservation of Capital

“Preservation of capital is the cornerstone of my business philosophy. This means that, in considering any potential market involvement, risk is my prime concern. Before asking, “What personal profit can I realize?”, I first ask, “What potential loss can I suffer?”

… In my terms, money isn’t green… it’s either black or white. Black and white have come to be associated with false or true, wrong or right, bad or good. In ethical terms, most of society has been taught that ‘there are no blacks and whites — there is only gray’: gray — the mixed and contradictory — the lack of absolutes. But on a ledger sheet, htere are nothing but absolutes: 2+2 is always 4, and 2-6 is always -4! Yet, in a subtle way, the modern investor has been taught to accept gray by the money management community. He is encouraged to rejoice if his account goes down only 10% when the averages are down 20% — after all, he has outperformed the averages by 10%! This is B.S., plain and simple.

There is one, and only one, valid question for an investor to ask: “Have I made money?” The best insurance that the answer will always be “Yes!” is to consistently speculate or invest only when the odds are decidedly in your favor, which means keeping risk at a minimum.”


Consistent Profitability

Obviously, the markets aren’t always at or near tops or bottoms. Generally speaking, a good speculator or investor should be able to capture between 60 and 80% of the long-term price trend (whether up or down) between bull market tops and bear market bottoms in any market. This is the period when the focus should be on making consistent profits with low risk.

Consistent profitability is a corollary of the preservation of capital. Now what do I mean by a corollary? A corollary is an idea or a principle. IN this case, consistent profitability is a corollary of the preservation of capital because capital isn’t a static quantity — it is either gained or lost. To gain capital, you have to be consistently profitable; but to be consistently profitable, you have to preserve gains and minimize losses. Therefore, you must constantly balance the risks and rewards of each decision, scaling your risk according to accumulated profits or losses, thereby increasing the odds of consistent success.

…Anyone who enters the financial markets expecting to be right on most of their trades is in for a rude awakening. If you think about it, it’s a lot like hitting a baseball — the best players only get hits 30 to 40% of the time. But a good player knows that the hits usually help a lot more than the strikeouts hurt. The reward is greater than the risk.


Pursuit of Superior Returns

As profits accrue, I apply the same reasoning but take the process a step further to the pursuit of superior returns. If, and only if, a level of profits exists to justify aggressive risk, then I will take on a higher risk to produce greater percentage returns on capital. This does not mean that I change my risk/reward criteria; it means that I increase the size of my positions.

Trading is a business and should be treated as such. Know your edge, play the game of making money versus trying to be right, and don’t take unwarranted risks.

Arlington Value Investor Letters: Five Invaluable Lessons On Value Investing

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There aren’t many investors compounding capital at double digits over the course of decades and those that do are already well known (i.e., that guy from Omaha). However, in a small office above a taco shop, there’s a man running a hedge fund called Arlington Value who has demonstrated the advantage in simplicity, long-term thinking, and the power of compounding.

Arlington Value doesn’t have a large team of analysts. They don’t run advanced machine-learning algorithms or exploit esoteric satellite data and there’s not a single distinguished diploma on their walls.

Yet, Arlington Value has returned 18.36% CAGR over 11.5 years and its main fund, AVM Ranger Fund, has returned a mind-boggling 37.9% return since 2008. The man behind these numbers is Allan Mecham.

I spent all of last weekend pouring over his letters (s/o to Focused Compounding for the post) and there is plenty of nuggets to share. I’ve gone ahead and whittled down Mecham’s insights into five recurring lessons from his letters (spanning from 2008 – 2017) that are worth reviewing. Let’s get started!

1. Less (Not More) Information is Better — Avoid Noise

“I disagree with the notion that more information is always better.” – 2008 Letter

This may sound tongue-in-cheek as you’re reading this from an “information source” on investing, but bear with me. Mecham is old school. He reads print newspapers and avoids the sensationalist financial news media found on TV and the internet. Warren Buffett, Walter Schloss and countless other value investors follow similar practices (i.e., Buffett doesn’t have a computer in his office).

We know successful investors practice the art of “less is more”, but why exactly do they do it? What’s the edge?

The edge is found in clear thinking and an uncluttered mind. Our brains only have so much decision making power capacity each day. Disposing that energy into numerous outlets — reading too many blogs, following too many investors, watching Mad Money — reduces our brain’s capacity to make full-powered decisions on important questions. Mecham addresses these issues in his 2010 annual letter, saying (emphasis mine),

The steady surge of information coupled with short-term performance pressures can push rational long-term investing to the brink of extinction. The easy access to information, and the snack-bar nature of consuming it, suggests that disciplining one’s temperament rivals the need for energy and action.

The less information you consume the more time you have to ponder the few critical bits that really matter.

2. Selling Great Businesses Is Almost Always a Mistake

“Selling is difficult, and my track record suggests it’s usually a mistake.” – 2010 Letter

In a perfect world, we find businesses we love with management teams that know how to allocate capital well, and then we sit. Unfortunately, a small fraction of public companies meet that criteria, and even then, it’s tremendously difficult to sit and hold. In his 2010 Letter, Mecham addressed the issue of selling, saying (emphasis mine):

My view on selling is akin to the old sports adage, ‘the best defense is a good offense’; the best sell discipline is a stingy buy discipline — which couples proper analysis with a bargain price.

Mecham highlights his disdain for selling via his example of selling Autozone in 2010 — sale he admits was a mistake.

At the time, Autozone (AZO) comprised 18% of the Fund’s portfolio (something we’ll touch on later). Mecham sold at an average price of $155.67/share. Had Mecham held his shares till year end he would’ve seen share prices climb to $272.59/share (that’s good for a 75% increase in price). Hindsight is 20/20, so it’s not the share price increase I want to highlight, but Mecham’s post-mortem analysis on AZO:

We’ve followed and owned AZO for years and admire the intrinsic qualities of the business — a leading market position, durable and counter-cyclical characteristics, strong growth prospects, and an impressive managerial record of capital allocation.

Mecham sold a business with all of these characterisitcs (albeit for another great business in BRKB) and regretted doing so. Hold on to great businesses.

3. Inactivity Is The Key To Success — Learn To Do Nothing

We favor infrequent action (and commentary), patiently waiting for exceptional opportunities. – 2010 Letter

Takeaway #3 is a corollary to the cousin above as you cannot have one without the other.

If you don’t have an ability to be patient, do nothing and wait for opportunities, you’ll never be able to hold on to great businesses. In order to achieve the powerful effects of compounding, inactivity isn’t a preferred skill, it’s a must-have.

Although value investors talk about the necessity for long periods of inactivity, the reasons for doing so are not always clear. Mecham (like most successful value managers) buys only at deeply discounted prices — normally expressed during bouts of extreme pessimism. In his 2014 Letter, Mecham discusses his important practice of sitting on his hands (emphasis mine):

Our office feels more like an abandoned library with a couple of bums loitering around. We have yet to be swayed by the virtues of analyst teams and investment meetings. We’re old school. We mostly just sit around reading, thinking, and waiting. A quip by Stanley Druckenmiller describes our process best: ‘I like to be very patient and then when I see something, go a little bit crazy.

Not only does frequent activity result in reduced performance, but it also translates into higher costs of doing business (i.e., commissions and taxes). But why is inactivity so hard? =Two major reasons come to mind: job security and measurement barometer.

There’s an aura of legitimacy around seeing someone (or a group of people) frantically engaged in work. If you’re paying someone to do a job, your mind will more likely be at ease seeing that person at work. This plays into the first reason why it’s so hard to stay inactive: job security. Most money managers are closet indexers. In other words, they hug the index as close as possible to keep clients’ assets flowing in. And if you put yourself in the shoes of the average money manager — this makes sense. It’s a much easier conversation to have with a client if their assets move in line with the index (going up or down). It’s a much harder talk to have when the market is going up and your portfolio is stagnant (or God forbid down) during the same time frame.

Along with this crutch of job security, most managers — whether through their own blight or from their clients — measure themselves on too short of a time frame. For example, if clients expect you to outperform quarterly or monthly, how will the manager base his/her decisions on investments? Quarterly or monthly measurements leads to overtrading, selling too soon and getting into riskier positions to chase incrementally higher returns over a short time frame. This third takeaway is best surmised with the following quote from Phil Carret:

Turnover usually indicates a failure of judgement. It’s extremely difficult to figure out when to sell anything.

4. Focus On The Long Term — Play For Keeps

Our ideas and policies are all structured with one goal in mind: to cultivate a culture that encourages rational decision making that ultimately leads to solid risk-adjusted returns. – 2012 Letter

If there’s one takeaway that was mentioned the most throughout Mecham’s letters, it was Number 4. Playing for keeps.

Mecham routinely stresses the importance of an owner-like mindset and its impact on long-term investing success. Not only does an owner-like mindset change the time frame as an investor, it forces you to change what you care about when looking at businesses. Focusing on long-term investing (i.e., holding businesses for decades not decimal seconds) leads to a natural decline in the level of importance you place on quarterly results (earnings “beats”), short-term headwinds and temporary compressions in earnings and margins. When you think long-term, all of that doesn’t really matter. More than that, if you keep thinking like this, you’ll start to question why others even ask for quarterly guidance.

Mecham makes this crystal clear when he discusses the long-term mind-set in his 2014 letter, writing (emphasis mine):

First and foremost, we adopt the mentality of a business owner buying for keeps. To us this means thinking about staying power, competitive threats, economics, and  comparing price to value … We don’t think quarterly “beats” are germane to intrinsic value.

In other words, changing the time frame in which you think about investments leads you to spend most of your time thinking about the above items instead of the quarterly metrics that everybody else is so focused on. Mecham drives this point home a couple pages later, claiming:

I believe the biggest difference (and our main advantage) between Arlington and the average fund is our ability to implement a framework of analyzing businesses like long-term owners.

5. Concentration (Not Diversification) Is Vital To Outperformance

The result is a concentrated portfolio that tends to be more volatile than the indices — a situation that’s not well tolerated by lay people and Wall Street alike. – 2010 Letter

The fifth and final takeaway is (arguably) the most important for investors looking to outperform the market over the long-term.

Concentration of assets is as counter-consensus as it gets within the investing community. As I’ve mentioned before, most money managers hug the index, investing in 30, 40 or 100 stocks. This is the recipe for average, something Allan recognized early on in his Fund’s existence.

Mecham keeps a concentrated portfolio of around 12 – 15 businesses. He isn’t afraid to allocate a large percentage of his Fund’s capital to a few select names. For example, we saw earlier where Mecham allocated 18% of his funds to Autozone. Even 18% pales in comparison to Mechem’s largest investment during the course of his letters. In 2011, Mecham made Berkshire Hathaway a 50% position in his Fund. That’s a five zero % position. In fact, Mecham went so far as to go on margin to purchase more shares of Berkshire Hathaway (1.5% margin cost) — leveraging up in his largest Fund position. Most run-of-the-mill managers would be on career suicide watch after a move like that. But, like Mecham illustrates, it made logical sense (emphasis mine):

Conventional fund management holds dogmatic disdain for highly concentrated positions. Needless to say, we hold a different view. To us, as a BRK owner, the contempt for concentration is acutely illogical as BRK provides ample diversity, with exposure to disparate businesses, sectors, and asset allocations.

This logic falls in line with Buffett’s old adage of adequate diversification in which he describes owning a few local businesses in your town as proper diversification. If you own a few of the best operations in town, wouldn’t that be considered properly diversified? Of course. Somehow when venturing into financial markets that same philosophy flies out the window. A portfolio of 10 – 15 strenuously researched companies bought at bargain-bin prices is as low of a risk investment strategy as they come. Mecham stresses this to his LP’s when he pens (emphasis mine):

While our focused portfolio is sometimes criticized by the financial mainstream, we think the judgements lack substance. We are a risk-averse fund looking for low-risk layup-type investments while other funds are akin to a run-and-gun offense that routinely takes a smattering of low-percentage shots.

If you want to beat the market over the long-term, you need to make concentrated bets in companies you believe will earn higher returns on their capital than the general market. Couple these concentrated bets with a long-term time horizon and steadfast determination to do nothing and you’re almost on your way to cloning Allan Mecham.

Here’s the link to all of Arlington Value’s Letters via Focused Compounding.