“It is the mark of an educated mind to be able to entertain a thought without accepting it.” Aristotle

Introduction

Are you the type of person that has been sitting on the sidelines of investing due to a stream of convoluting advice that is either nonsensical, contradictory, based on pseudoscience or just plain stupid? At the same time, do you consider yourself an entrepreneurial thinker that likes to take matters into your own hands?  If so, keep reading. This article attempts to decipher and demystify investing, by tapping into the mindset of some of the greatest investment thinkers in history. The idea behind the article is for you to become a long-term investor by understanding the frameworks that these guys use so you can make better decisions when analyzing a business or investment opportunity.

First, you will learn why changing your thinking is the building block for all subsequent investment decisions. Consequently, we will talk about specific frameworks that set you up for success, such as asymmetric risk/reward strategies, and finally, we will deconstruct what to focus on before investing in a business and its management team.

1) CHANGE your thinking

Good investments are a result of better and clearer thinking. As an investor you're deciding where to allocate your resources, that's it. You are deploying capital; you are not operating a business, creating a product, or hiring or managing talent.  So how do you become a first-rate thinker?

First, realize the exponential power of knowledge. Then set a strategy to acquire that knowledge and lastly in regards to taking action, stick to your circle of competence.

According to Einstein "compound interest is the eighth wonder of the world. He, who understands it, earns it … he who doesn’t … pays it.” This eighth wonder also applies to knowledge. The fact it compounds over time should be the most important takeaway in the article.

What does Warren Buffet, arguably one of the wealthiest and most prominent investors of all time do all day? He reads and he thinks.

If we quit our jobs and dedicate our time to reading and thinking, will we eventually be as successful as Buffet? Probably not, it will depend on how you "seek worldly wisdom" and your strategy on how to apply that knowledge.

Your learning strategy can make you or break you. You must focus on learning things that change slowly over time; in essence, learn principles. Consequently, these unchanging principles should be applied when evaluating an infinite number of unique scenarios which show up while assessing investment opportunities. Charlie Munger, Buffet's partner, attributes this approach to his success in decision making. He recommends building a “latticework” of mental models. His particular style of learning is mind-blowing and is better explained here: (Article).

Once you study and understand the different mental models and learn how they are interrelated, unearth your circle of competence. Identify where you may develop a unique understanding of the world based on your aptitudes and things that you are naturally drawn to learning.

In the context of investing, this means studying things you have an edge over most people in terms of understanding a particular company or asset class. In my case, I evaluate public companies that have an Advertising Technology (ADTech) component to their business model, and at the same time, I am an avid user. Why? I believe I have a unique perspective over most potential investors in this area. Additionally, I am evaluating the products I use on a regular basis, I have a digital marketing agency that focuses on online advertising. We run hundreds of different ADTech applications with hundreds of different customers.  My job grants me unique insights into this sector, which I in turn leverage that information with investing principles, microeconomics, psychology and other mental models to assess my investing criteria.

To learn more about Circle of Competence click here: (Article).

2) Avoiding Stupidity is Easier than Seeking Brilliance

This is probably Munger's most famous principle in investments and life. For him, “knowing what you don’t know is more useful than being brilliant.” He then elaborates:  “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”

From an investment perspective, this means being obsessive about the downside and outlining the multiple scenarios of what could go wrong; especially knowing the maximum amount of money you can lose within an individual investment. In other words, invert your approach, only look at the potential upside after analyzing the potential downside.

How do we apply this?  

Start by removing and eliminating. Nicholas Taleb, the author of The Black Swan, uses this approach when exploring investment opportunities.

He starts by identifying which companies are not good investments. This process forces our brain to assess risk and look for the fragility in investment opportunities. By eliminating riskier options from the table, you can now evaluate the potential upside of the remaining investment opportunities with a downward risk threshold.

A second recommendation when seeking investment opportunities is to be skeptical about betting on David, and rather lean towards betting on Goliath. David being the underdog company, and Goliath being the company that has stronger competitive advantages.  Sometimes we have a secret urge to be the genius that finds that obscure stock that is overlooked and if we are correct in our investment criteria it will yield enormous returns. Following Charlie's advice, it is better to bet on several Goliath type of stocks, which have proven track records, have greater momentum and have overall better odds, than betting on several David type of stocks.

If you want to dive deep into this concept, I suggest reading this article:  (Article). 

3) Start by minimizing costs

Warren Buffett left a simple but powerful investment strategy for his benefactors. He issued a clear mandate for his family to have only two holdings, a low-cost ETF that mimics the S&P 500 VFIAX |90% of the portfolio) and a 3 month short-term US government bond ETF ( VFIRX |10% of portfolio).  That's it. Consequently, this is what he recommends most people to have. This is not necessarily my recommendation nor is it his if you read between the lines. What's important is to question yourself why, with a plethora of infinite investment possibilities, does Buffet recommend these two particular types of holdings?

First, why the S&P 500 VFIAX? In essence, because equities are the asset class that best perform over time. In this case, we own the top 500 US corporations. If you analyze the index you are not only diversified in terms of industries but also by countries since various US corporations have subsidiaries/revenues all around the globe (Example Coca-Cola and Procter & Gamble).  

Also, as an ETF that mimics the S&P 500, there is no risk of underperforming the index/stock market itself, only the risk that it underperforms another asset class.  Furthermore, being an ETF, it is one of the most cost-effective forms to own a pool of stocks, since they are programmed to trade electronically and automatically to mimic the S&P 500 stocks,  you avoid fees that you would pay an active manager.

Why do active managers still exist today and when does it make sense? Their promise should be to beat the market after fees, yielding a larger return. But beating the VFIAX that mimics the S&P 500 and only charges 0.04% is extremely challenging for an active manager that charges yearly management fees and performance fees. For example, the typical fee structure of a hedge fund (considered the elite of active managers) charges 2% management fees + 20% performance fees.  To simplify we will only account for the 2% flat fee on total assets and not take into account the additional performance fee.

To beat the market, a hedge fund/active manager must trade and take positions that do not mimic the entire market. Therefore, besides the 2% fee, it must account for transactions fees and additional taxes paid for short-term capital gains which you would avoid if you just buy and hold the S&P 500 ETF.  Hence, for a hedge fund to be more profitable than an S&P 500 ETF, it must beat the market by more than it spends on transactions costs, management fees, and taxes. At the same time, by taking concentrated bets and not mimicking the market they also run the risk of underperforming the market which will never happen if you invest in an S&P 500 ETF VFIAX. Here is the catch! 90%+ of active managers underperform the market. Picking a good active manager can be as difficult as picking individual stocks (Article).  If you are not a pro-investor you are probably better off buying and holding the S&P 500 VFIAX.

The other holding Buffett endorses is the short-term US 3-month government bond fund VFIRX, which is basically the cash substitute he recommends. That 10% set aside in cash should be used for rainy days. For younger investors, he encourages us to have 100% of the portfolio in the S&P 500 VFIAX. I would recommend having 10%+ in cash or cash equivalents VFIRX no matter what age or circumstances you are in (For further reading on why he chooses the VFIRX  check the note section below). 

4) Seek Asymmetric Risk/Reward

This is by far my favorite principle. You are looking for investment opportunities that have asymmetric risk/reward ratios. This basically means that you are risking far less than your potential return. This mindset is entirely against the saying, "to win big you need to risk big." Most billionaire investors minimize the downside to risk the least as possible and at the same time bet in situations where the upside potential is disproportionate to the downside.  

There are three variables to take into consideration when analyzing asymmetric investment opportunities, the Risk/Reward Ratio, the timeframe and the expected return per ratio.

Risk/Reward Ratio (Paul Tudor Jones investment Ratio of 1:5)

Start by investing in companies that have a nonsymmetrical risk/reward ratio.

Billionaire Paul Tudor Jones has the following approach “[I’m looking for] 5:1 (risk /reward).  Five to one means I’m risking one dollar to make five.  What five to one does is allow you to have a hit ratio of 20%.  I can actually be a complete imbecile. I can be wrong 80% of the time, and I’m still not going to lose.” (Source).  Warren Buffett has a different way of explaining it: "only swing at the fat pitches." This means pitches that you can identify as having a disproportionate risk/reward ratio, such as undervalued businesses that are in some cases trading below intrinsic value. The positive difference between intrinsic value and market value price is what he calls the "Margin of safety". "Buffett’s greatest investment was the Washington Post. Buffett has said that when he bought his shares, the company was trading at 25% of intrinsic value".  In essence, Buffett had a 4-to-1 investment on his hands (Source).

The trick here is to identify great companies today and wait for that company to start trading at an acceptable price. Seth Klarman states that "margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world." He later states to "give preference to tangible assets over intangibles."

Timeframe

Timeframe gives you context in terms of risk and reward. From a downside perspective, you can't be sure that a company will not lose its value in perpetuity but you can definitely assign a probability of a downside within a constrained time period. If a company has zero debt, a lot of cash on hand and appreciating assets, its downside is limited even in economic downturns, or negligible management. The same applies when calculating the potential upside, set a timeframe.  Take into consideration the average annual revenue growth rate and profit margins. How likely are this company's revenue growth rate and profit margin able to sustain within 5 years or 10 years?  

Expected return per scenario

Here is where Ray Dalio makes an emphasis. Once you determine the risk/reward ratios and the timeframe of those ratios, then you should calculate the probability of a negative return vs. positive return. In Buffet's  4-to-1 Washington Post example, how probable was a negative -% return versus 4X return? In this scenario, the idea is that that the probability of a downward scenario should be much less than 4:1 ratio. If the likelihood of a downward event is much less than an upward probability and at the same time the expected returns are higher with a favorable scenario you have a positive asymmetric investment in your hands.

How can you create investment opportunities that limit the downside and have a disproportionate upside potential to its downside?

There is a quote I love by negotiating expert Chester L. Karrass “In business as in life, you don’t get what you deserve, you get what you negotiate.”

Here is a fictitious example: You negotiate to purchase a percentage of a factory that needs cash to expand production. You arrange to pay a price that will yield 10% every year of the total amount you paid for, in other words, your price/valuation is ten times dividends (10X dividends).  Therefore, if the company does not increase its cash flows, in ten years, you will at least receive in dividends the total amount of what you paid for the investment. At the same time, the same owner has another company that owns the land where the factory operates; you can negotiate with the owner to give you as collateral the right to purchase the land at a 50% discount on market value (in the form of warrants)  if the projected cash flows fall below 5% of what you paid within 10 years. In this scenario, you are limiting your downside by having collateral on an appreciating asset class (land) that you can purchase at a discount and by selling it at a market value you will yield more than the 10% of expected cash flows. Simultaneously, you are injecting working capital to expand the business, therefore, increasing the probability that the asset as a whole will appreciate over time and will yield more than 10% in yearly inflows. Does this sound like science fiction? Warren Buffet made a similar deal in  September 2008 when he purchased $5 Billion dollars of preferred Goldman Sachs stock that paid 10% in annual dividends. At the same time, he negotiated warrants which are the right to purchase a set of stocks at a fixed price in the future, in his case he negotiated a strike price at $115 of $43.5 million additional shares. Overall he made a 62% return in a five-year investment period. In cash, he made $1.75 Billion in profits from the 5 Billion preferred shares he sold and $1.35 Billion in stock on March 25, 2013, when he executed the warrants (his profits on the warrants is the difference between $115 vs $146.11 of $43.5 Million shares). As of today June 12, 2018, he still owns about 11 million shares that are trading around $232 dollars which he purchased at $115 in 2013. All this during one of the worst economic meltdowns, chapeaux! Here is an article that better explains the deal (Article). 

5) Diversify & Throw few punches

Diversification is the Holy Grail for most investment firms. Why? Because if done correctly it deludes the risk between different asset classes. Most pro investors diversify for two reasons. The first and most important is that no security in the world is entirely bulletproof, you don't want to have all your eggs in one security. The other is to diminish losses and maximize returns within economic cycles. Ray Dalio is one of the most respected pioneers in asset allocation; he uses the risk parity theory which is a fancy way of saying that he allocates his resources in terms of risk exposure. His portfolios are built to reduce losses during economic cycles. You can see a simplified breakdown of his portfolio here: (Article).

I think Dalio's thinking and investment style is brilliant. I believe his reasoning can only equip you to become a better investor. I don't use his approach because it entails understanding the cause/effect that inflation, deflation, economic decline, and growth have on the assets you own.  It is simply too much information to monitor and analyze. I prefer to invest in an S&P 500 ETF. This will surely be more volatile especially in economic down cycles than Dalio's portfolio but with patience and the stomach to ride the "temporarily losses" in the long run, it will outperform Dalio's all-weather portfolio (Article). To trade off the extra volatility and uncertainty a more significant position in cash equivalents (VFIRX) would be more prudent than the recommended 10% by Buffet. What is important is not what asset allocation strategy you select but why and to be prepared to act accordingly with the different economic cycles.

My Diversification Strategy:

Invest 60% of my liquid assets in an S&P 500 ETF and see this investment as a perpetual endowment fund with no principal withdrawals (I would only withdraw the dividends earned).  20% of my capital would be allocated to throwing few punches and the remaining 20% to keep some powder dry. Sounds like an action-packed civil war? Actually, in the long run, it will be quite boring, most of the time I will sit on my ass and do nothing. Let me explain!

The S&P 500 Endowment Fund? 

I'm just copying Buffet's family investment strategy when he passes away; the only difference is that instead of allocating 90% of my assets in the S&P 500 I'm allocating 60%. 

Throw Few Punches?

When Warren lectures at business schools, he says, "I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches ‑ representing all the investments that you got to make in a lifetime. And once you'd punched through the card, you couldn't make any more investments at all."

This is what I intend to do with 20% of my portfolio. Pick 5 to 6 companies with the idea of holding on to them for 20 to 30 plus years.

Keep some Powder Dry:

Here is where the real magic happens. Buffet and seasoned investors have cash-on-hand not necessarily to diversify risk but as gunpowder to strike at the most appropriate time. A down cycle for an investor is the equivalent of Black Friday and Cyber Monday put together. In their eyes its when stocks are on sale. Yes, the economy slows down, people lose their jobs, and a lot of things suck. They are not celebrating because of that. But the overall exuberance makes some companies cheap. Some stock prices can be down -50% but if this -50% loss is not proportional to the decline in income or other measures of value, it's a great time to purchase more stock of the companies you have been following closely. This article highlights some investment techniques/criteria he uses when picking stocks: (Article)

6) Business First, Management Second

Can a corporate superhero turn around a failing business into a prosperous one? The idealist within us wants to believe that, but some business/industries have inherent structural constraints that hinder their ability to grow. Purely managerial improvements over time will not outperform other companies that have structural advantages. Concerning investing, betting on a better business will yield better returns, even if you pay a higher price.  Munger illustrates this point in numbers:

"Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result". Charlie Munger

Structural competitive advantages:

1. Exclusive governmental licenses.

2. Consumer (demand) preferences such as strong brands.

3. A cost (supply) position based on long-lived patents or durable superiorities.

4. Combination of economies of scale thanks to a leading share in the relevant market with consumer preference. 

This article goes into detail on how you can differentiate a business from a business-franchise, the later being Buffet's preferential bet. It also expands on each structural competitive advantage: (Article). 

7) Watch for Skin in the Game

This is probably my favorite insight. Businesses are still designed by people and are run by them. When purchasing stock, look for skin in the game. Analyze upper management's compensation structure, which "should be based on the long-term health of the company, and management should personally face the risk of loss if things go wrong" (Source). It is important to "research their stock options and track record".

In a nutshell, we need to understand how aligned are the incentives of upper management with their shareholders. 

What to look for in compensation:

1) The proportion of base salary to stock that upper management holds.

2) How are the stock options vested and what are their restrictions? I would go as far as having lockup periods where management can't sell all their stock when they leave a company. They can sell all their stocks 10 years after they leave the company. This will guarantee that they are making structural improvements that will last and that they leave behind a more equipped management team.

Conclusion:

At the beginning of the movie "Pulp Fiction", the actor Samuel Jackson interpreted as "Jules" holds the character "Brett" at gunpoint and quotes:

“Ezekiel 25:17. The path of the righteous man is beset on all sides by the inequities of the selfish and the tyranny of evil men. Blessed is he who, in the name of charity and good will, shepherds the weak through the valley of the darkness, for he is truly his brother’s keeper and the finder of lost children.”

Besides a crazy line to use before shooting someone (in a movie), what does this quote mean? In essence, the "shepherd" or the true "brother's keeper" is the righteous man who helps the weak navigate between the temptations of good and evil. My invitation is for us to become sublime thinkers that distinguish what is true from what is false, not necessarily what is right from what is wrong. It is a petition to become our own shepherds that navigate through reality, help others or better yet put truth before our own ego, ergo enabling learning.  To be open to debate and to seek the principles. A great quote from Ayn Rand is “When I disagree with a rational man, I let reality be our final arbiter; if I am right, he will learn; if I am wrong, I will; one of us will win, but both will profit.” Both will profit since the one who suppresses his EGO in order to gain a new level of understanding will make better decisions in a world we all share.

Special thanks to: Luis Cisneros, Diego Cisneros, Andres Navia, Eugenia Machado, Ana Sofía Kowalenko and Corina Ayala for reading drafts of this article.

Notes:

VFIRX: Why does Buffet choose short-term T-Bills as his cash equivalent (VFIRX)? The 3-month T-Bill, in general, yields better returns than Money Markets and CDs (In some cases it also has a better tax incentive). Since their maturity periods are only 3 months, they tend to fluctuate less in price than long-term T-Bills. If you wish to sell your T-Bill before the expiration date to use the cash to purchase a stock when the bond market is down, a 6-month T-Bill will probably be more discounted than a 3-month T-Bill that day. In others words, it is less risky to trade short-term T-Bills then long-term T-Bills before maturity since they vary less in price.

If you liked this article I recommend reading:  8 Timeless Lessons on Entrepreneurship

This article was originally posted here:  Link