We Study Billionaires - The Investor’s Podcast Network - TIP546: The Holy Grail of Long-Term Value Investing

Starting point is 00:00:00 You're listening to TIP. Before we dive into today's episode, I wanted to share something really exciting we've been working on here at the Investors Podcast Network. To give you some background, over the past few months, we've been organizing these TIP meetups for the Berkshire Hathaway Shareholders Meeting in Omaha. Within no time, over 200 people signed up for our TIP meetups, forcing us to close registration due to the limited space we have in Omaha. Then we realize something.

Starting point is 00:00:29 So many people are doing. spending thousands of dollars and taking multiple vacation days to travel to Omaha not only to see Warren and Charlie, but also to meet other like-minded investors. Just skimming through our registration list here, we have people traveling from Singapore, Canada, Australia, Germany, the UK, Bahamas, and all over the U.S. Even with the internet nowadays, it is clear to us that people have trouble connecting with like-minded investors that they can trust. This is why we created the TIP Mastermind Community. In the TIP Mastermind Community, you get access to many of the hosts here at TIP, including myself, and access to a network of high-quality investors. This is a great way to

Starting point is 00:01:12 source ideas, test existing ideas, and meet other investors. With thousands of different stocks and a ton of noise out there, having access to a tight-knit, knowledgeable community that shares ideas is invaluable. Charlie Munger taught us that truly great ideas are rare, and they don't come often. And it's extremely difficult to find these ideas on our own. I think back to the very beginning of how TIP started. Preston and Stig met in an online community that shared ideas. If they hadn't met in that community, then the TIP you know and love today would not exist. Here's the thing, though, with the mastermind community. If we let it get too large and let just anyone in it, then we we'd still have the problem we had before of too much information to sort through.

Starting point is 00:01:58 This is why we are limiting the first cohort to 30 paid members. This is to ensure that the discussions are high quality and the group isn't too overwhelming for you. I'll also be hosting a live discussion with Stig Broderson that will be exclusively available to community members on Monday, April 24, 2023. Stig and I are going to discuss his philosophy on constructing his portfolio, as well as stocks that he is researching today. If you're interested in joining the mastermind community, do so today before spots fill up. You can learn more and join by visiting theinvestorspodcast.com

Starting point is 00:02:34 slash mastermind. That is theinvestorspodcast.com slash mastermind to join today. We want to attract high quality members to the group, so if you happen to know someone who is deeply interested in stock investing and is a fan of TIP, feel free to let them know about the community too. We expect spot to fill up quickly, so be sure to check it out today. All right, without further ado, let's dive right into today's episode. Hey everyone, welcome to the Investors Podcast. I'm your host, Clay Fink, and I'm very excited to bring you today's episode continuing my discussion of Godham Bade's book, The Joys of Compounding. Today's episode is part four of our series covering the book, and this series had been actually quite popular. As I've mentioned before, most of the chapters

Starting point is 00:03:22 in the book are somewhat standalone, so you're able to listen to each and episode separately, but this episode you're currently listening to is part four of my series covering this book. It's been very popular with the audience, and I'm really glad that audience has enjoyed it as much as I've enjoyed covering the book. For those of you who don't yet know Godambade, he is the managing partner and fund manager of Stellar Wealth Partners India Fund. The fund is a Delaware-based investment partnership, which is available to accredited investors in the U.S. The fund is modeled after the Buffett Partnership fee structure, and it invests in listed Indian equities with a long-term, fundamental, and value-oriented approach. Our previous episodes

Starting point is 00:04:01 covering the book are parts 1 through 3, which are episodes 534, 536, and 543. On today's episode, I'll be covering chapters 22 through 25, which are just packed full of investing wisdom. During this episode, you'll learn about the holy grail of long-term value investing, why Goddham prefers investing in high-quality businesses, how we can capitalize on inefficiencies in the markets, how Goddham thinks about portfolio management and position sizing, and why we need to put an immense focus on the preservation of our capital and avoiding ruin. Another interesting piece I've found from reading this book is Goddum's deep interest in the Indian stock market and why it offers ripe opportunities for investors. His fund actually focuses on the Indian market and I plan on

Starting point is 00:04:48 covering India at some point in the future on the show, but there are some parts in this book where he does talk about it, which is also touched on during today's episode. Without further delay, I bring you today's episode continuing our discussion of the joys of compounding. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. diving right into chapter 22 titled The Holy Grail of Long-Term Value Investing. Right away, he shows the Buffett quote I've mentioned multiple times on the show. I quote, leaving the question of price aside, the best business to own is one that over an extended

Starting point is 00:05:42 period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must or will do the opposite, that is, consistently employ ever greater amounts of capital at very low rates of return. What this is really getting at is how fast is the business increasing its intrinsic value over time? Companies that can sustainably invest at high rates of return will grow pretty fast. Companies that invest at low or even negative rates of return are going to grow their intrinsic value either very slowly or maybe even that value is decreasing over time. Buffett also has what's called his $1.00 test. For every dollar,

Starting point is 00:06:22 that's retained within the business, it should create at least $1 of market value for the company. Then Gottem shows one of my very favorite quotes of all time, which is a quote from Munger. It essentially boils down to the long-term returns of the business or the stock trend towards the return on capital within that business. So if a company is reinvesting at, say, 18% per year, then the stock's annual return will trend towards that 18%. If the company earns 6%, then the returns will trend towards 6% over time. This is Munger's way of saying that it's better to own a great business at a potentially

Starting point is 00:06:57 expensive looking price than a fair business at what we'd consider a great price. This is why Munger loves Costco so much. They're able to earn high and stable returns on capital that are likely to persist over time. Easy enough to do, right? Not so much. It's a simple concept, invest in a business with a durable competitive advantage that can earn high rates of return over time, but it's not easy to do in pre-term. practice. Determining the competitive advantage of a business, as well as the durability and the

Starting point is 00:07:28 longevity, is one of the most difficult parts of investing. Dotum defines a competitive advantage as a company's ability to generate what's called excess returns. Excess returns is a return on invested capital minus the company's cost of capital. A sustainable competitive advantage requires barriers to entry to prevent competitors from entering the market and eroding those excess returns. In a 1999 interview with Fortune, Buffett highlighted moats as the main pillar of his investing strategy. Buffett stated, the products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors. Then Goddham states that, great businesses are those with an ever-increasing stream of earnings with virtually no major capital

Starting point is 00:08:15 requirements. They produce extraordinarily high returns on incremental invested capital. The truly great businesses are literally drowning in cash all the time. They tend to earn infinitely high returns on capital as they require little tangible capital to grow and are driven by intangible assets such as a strong brand name with quote, share of mind. They tend to earn infinitely high return on capital as they require little tangible capital to grow and are driven by intangible assets such as a strong brand name with shared mind, intellectual property, or proprietary technology. Great businesses are typically characterized by negative working capital, low fixed asset intensity, and real pricing power. Now, negative working capital is essentially when a business is

Starting point is 00:09:01 paid upfront while the actual product or service is delivered at a later date. For a business that's growing, this is just fantastic because it's like the company is receiving a 0% interest rate loan to help fund the future growth of the company. Negative working capital is common in subscription-based businesses. If you think about a company like, say, Adobe, I'll pay up front for one year of their various products, but the product or service isn't actually delivered at the time that I make that payment. Within the competitive advantage or the mo, Buffett also wants a business with pricing power, or a business that is able to increase prices at or above the rate of inflation without losing business to their competitors. The market places a heavy

Starting point is 00:09:45 emphasis on the certainty and the longevity of the business. Goddham writes that the longevity of growth is always given a greater weight by the market than the absolute rate of growth. So you often will notice that stocks with 12 to 15% increases in their earnings over the next 10 to 15 years, they're going to have current PE multiples of, say, 40 to 50. The phenomenon perplexes most new investors, but with experience, they come to appreciate the finer nuances of the market and respect its wisdom. The expensive, high-quality, secular growth stocks tend to remain at elevated valuations for extended periods of time because investors in such stocks generally are willing to sit out periods of high valuation until those earnings catch up. Markets provide

Starting point is 00:10:32 disproportionate rewards to companies that can promise years of sustainable earnings growth, end quote. We should also be mindful of those who pitch an investment just because an industry is growing. A high return on capital within a business is much more important than a high growth rate within the industry. The airlines industry has changed the world over the last century, but very few airline companies were good investments. In Buffett's 2007 letter, he uses the analogy of three different types of savings accounts. The great one pays an extraordinarily high interest rate that will rise as the years pass.

Starting point is 00:11:08 The good ones pay an attractive interest rate that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and it requires you to keep adding more money at disappointing returns. Munger says that he loves businesses that are drowning in cash because they're so profitable. These businesses can consistently reinvest back into the business at high rates, as well as deliver capital back to shareholders through repurchases and dividends. Godham tweaks this idea and says that the holy grail of long-term value investing is when a business can reinvest a large portion of its earnings at high rates of return, and it doesn't have to send a check to shareholders because its investment opportunities are so great.

Starting point is 00:11:52 Then Gottem makes this really important distinction. You not only want high return on invested capital, but he rightly points out that you also want high return on incremental invested capital, which is the return a company can earn on the incremental capital invested over time. He states, investors tend to confuse return on incremental invested capital with the return on invested capital. It's the return on incremental invested capital minus the cost of capital that drives value creation. Even though the legacy moat businesses with established franchises with low or no growth opportunities may have high return on invested capital, if you purchase the stock today

Starting point is 00:12:33 and own it for 10 years, it is unlikely that you will achieve exceptional returns. In this case, the company's high ROIC reflects returns on prior invested capital rather than the incremental capital of the company is investing today. In other words, a 20% reported ROIC today is not worth as much to an investor if no more of those opportunities are available to reinvest profits. Mature legacy moat businesses with good dividend yields may preserve one's capital, but they are not great at compounding wealth." Then he uses an example of two companies, say Company A and Company B.

Starting point is 00:13:12 Both companies may very well have high returns on capital on paper, say 20%, but if Company A reinvests twice as much money as Company B, then over time, Company A is going to create significantly more value. As time progresses, the gap in the investment results between Company A and Company B are going to continue to widen. This is why over the long run, the quality of the businesses you purchase matter much more than the valuations at which you purchase them at. In the short run, your returns will largely be affected by the valuation of which you purchase. Over the long run, your returns will largely

Starting point is 00:13:47 be affected by the quality of the business you purchase. Remember, as Munger said, your stock returns over the long run will tend to trend towards the internal returns of the business. One of my favorite Buffett quotes is that Time is the friend of a wonderful company and the enemy of a mediocre company. Because the market tends to recognize high-quality businesses, the best businesses almost always seem overpriced to a majority of investors. They look at the PE ratio and immediately dismiss it. What's hiding in plain sight is the enormous reinvestment opportunities ahead for many of these companies, as well as the potential for these earnings to be overstated because of

Starting point is 00:14:27 the shortcomings of things like GAAP accounting. Then there's this interesting piece that explores why Gautom is optimistic on the Indian in stock market in particular. He says, investing is part art, part science, but over the long term, investing in businesses that earn high return on incremental capital significantly improves the probability of achieving above average returns. I have a simple, overarching belief that makes me joyfully average upward in the great businesses that I own. Over the coming decades, trillions of dollars are going to be added to India's GDP. The nation's best management companies, with proved ability to scale up operations, will capture the bulk of this upcoming

Starting point is 00:15:10 wealth creation boom in India's stock market. This is all assuming that the market cap to GDP ratio, also known as the Buffett indicator, approximates 100% over time. Then he touches on why you don't always need the tailwind of the overall stock market like he expects in India in the years to come. Even if the overall stock market doesn't move, there's still room for individual investors to buy great companies and profit from them. From 1964 through 1981, the Dow was flat. At the end of 1964, the Dow was trading at around $874, and then at the end of 1981, 17 years later, it was $875, so practically flat. It went nowhere during that 17-year period. Meanwhile, Buffett managed to compound his capital at 20% annually. Investing is all about identifying great

Starting point is 00:16:02 businesses with high-quality earnings growth and capital allocators and firmly holding onto them as long as they exhibit these characteristics. The difficulty is that capitalism is just brutal, and excess returns attract competition and go out to eat their lunch. Only a few businesses are able to enjoy excess returns for many years by creating structural competitive advantages or economic modes. That competitive advantage can come from a variety of things. from intangible assets such as a brand, you can come from high switching costs, network effects, or having a low-cost advantage. The topic of competitive advantages can be a podcast of its own. I discussed moats and competitive advantages back on episode 524. I discussed the sources of competitive

Starting point is 00:16:51 advantages, and then I expanded on four examples, which were Alphabet, Amazon, S&P Global, and Sherwin Williams. One more underappreciated source of a moat is a difficult to replicate culture. Goddham writes that culture is best epitomized by companies like Berkshire Hathaway, Amazon, Costco, Kewaq Corporation, Constellation Software, and Mark L Corporation, to name a few. Strong cultures are focused on delivering a strong value proposition to customers relative to their competitors. Quote, as investors, we look for those companies that are fanatically obsessed with the well-being of their customers and that empathize with them more than their competitors do. Culture matters to long-term investors because it empowers the company's employees

Starting point is 00:17:38 to do their day-to-day tasks slightly better than their competitors do. Over time, these little advantages compound into much larger advantages, which can persist far longer than conventional wisdom expects. He says, when assessing the moat of any business, simply ask yourself how quickly a smart competitor with unlimited financial resources could replicate it. If your competitors know your secrets to success and they still can't copy it, you have a strong moat. Not only is a moat important in assessing a company, but capital allocation is important as well. If a company has high return on investment opportunities, then the management should reinvest heavily back into the business, as we all know. Share buyback should only be performed when the shares are

Starting point is 00:18:23 purchased below their intrinsic value. Oftentimes management will conduct share repurchases simply to offset the dilution via stock options. talks a little bit about mergers and acquisitions. A simple rule of thumb regarding mergers and acquisitions is that the larger the deal size and the less similarity between the buyer and the target, the more likely the deal is to destroy shareholder value. Mergers and acquisitions have a low base rate of success, whereas smaller Bolton acquisitions have higher rates of success. Gautum states in general, mergers and acquisitions have a higher chance of creating value when they represent a core element of strategy and when management has a track record of disciplined

Starting point is 00:19:05 and value-acreative M&A. Think Berkshire Hathaway, Fairfax Financial, Markell Corporation, and Consolation Software. Above all, the truly exemplary capital allocators act as trustees for shareholders. These individuals demonstrate rationality and complete emotional detachment when making decisions, end quote. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is. From June 1st through the 3rd, 2026, the Oslo Freedom Forum is entering its 18th year, bringing together activists, technologists, journalists, investors, and builders from all over the world. many of them operating on the front lines of history. This is where you hear firsthand stories from people using Bitcoin to survive currency collapse, using AI to expose human rights abuses, and building technology under censorship and authoritarian pressures.

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Starting point is 00:23:35 This brings us to chapter 23 covering the efficiency of markets. He starts out this discussion with Benjamin Graham's idea of Mr. Market and how we shouldn't be affected by the market's mood swings that are irrational at times. He writes, don't let the exuberant markets get to your head. Don't let pessimistic markets get to your heart. Volatility of the mind is far riskier than volatility of the stock price, and an objective mind is key to investing success. Remember, disruptions may be accelerating, but human nature and investor psychology have not changed in centuries. Be an ardent student of the history of human behavior during times of utter panic, as well as periods of extreme exuberance.

Starting point is 00:24:17 This approach will enable you to stay the course during such times and adhere to Napoleon's definition of a military genius, the man who can do the average thing when all those around him are going crazy. Your lifetime achievement as an investor will be determined primarily by how you conduct yourself during the occasional periods of extreme market behavior. Benjamin Graham has stated, basically, price fluctuations have only one significant meeting for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times, he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.

Starting point is 00:25:01 The crowd is almost always wrong when it comes to the markets. As Buffett says, we should be greedy when others are fearful and fearful when others are greedy. Even the world's largest companies have massive swings in their stock prices, despite them being very well-known and very well researched. Meta declined by over 75% in just one year, and then it rallied to increase by over 100%. The largest and most widely known companies still see their values shift dramatically during some years. As investors who are able to remain calm during the chaos, these investors can find opportunities to buy great companies at a discount. Peter Lynch talked about this in his book One Up on Wall Street, the idea of buying stalwarts or more mature

Starting point is 00:25:44 businesses, buying stalwarts when their valuations become cheap relative to its recent history. Back on episode 508, I had shared Aswath Demotaran's Doomsday analysis on Meta, essentially sharing that Aswath believed that this stock was significantly undervalued. Using the EV-to-Ebit, just as a general example for Meta, I used this website called Ticker, T-T-I-K-R to see what the EV-2-E-Ebit is for a company. Historically, Meta's EV-2-E-E-E-Bet has traded around 20. In early November, 2022, the EV to EBIT hit 6, which was the point of Max Fear for the stock. Now it's trading at a multiple of 16, so just off of that multiple expansion, investors who bought around the time

Starting point is 00:26:26 of Max Fear saw their investment increased by over 100%. Turning to a stock I do own, Alphabet historically has traded in the 16 to 25 range, and recently it's hung around the lower end of that multiple. As I'm recording, the stock is trading around $100 and $1,000. and EV to EBIT around 15 to 16. So if the market ends up being too pessimistic about the company today and the multiple re-rates to 20, then just off of that multiple expansion, you could see a 30% upside on Alphabet. On the flip side, if the advertising market contracts during a recession, then Alphabet may be appropriately priced as the Ebit portion of that multiple contracts downwards.

Starting point is 00:27:08 And that's not considering whether the earnings end up increasing over the years ahead as well. Anyways, that is one way in which we can recognize and take advantage of Mr. Markets' mood swings. They need transitions to talk about the economy so we can better understand market cycles and market conditions. He says, bull markets are typically fueled by cheap liquidity and usually come to an end with a sharp spike in interest rates. As we know, Buffett equates interest rates to gravity. As interest rates rise, asset prices tend to fall.

Starting point is 00:27:38 To be honest, to see the 10-year treasury go from as low as 1.1 percent, you know, in 2021 to over 4% in 2023, I'm quite surprised that the market hasn't decreased more than it has at this point, given Buffett's comment on how interest rates affect valuations, but overall liquidity in the market can also play a major role in asset prices as well. Stanley Drunken Miller stated, the major thing we look at is liquidity. Contrary to what a lot of the financial press has stated, looking at the great bull markets of the last century, the best environment for stocks is a very dull, slow economy that the Federal Reserve is trying to get going, end quote. John Templeton described bull market cycles as the following. Bull markets are born on pessimism,

Starting point is 00:28:24 grow on skepticism, mature on optimism, and die on euphoria. What has surprised me most about the recent bear market is the drastic differences in how different companies are affected in terms of their stock price. The high growth, high flyers got absolutely crushed, companies like shop, Spotify, Square, Peloton, etc. The blue chip companies like the Fangs had a decent pullback for the most part, but if you look at the chart of some of the higher quality companies, you find that some of them are still hitting all-time highs or at least near their all-time high. Companies like what Chris Mayer owns, who I just recently had on the podcast, companies like Constellation Software, HICO, or Copart. Costco is another name that comes to mind. Andy Grove said that

Starting point is 00:29:06 bad companies are destroyed by a crisis, good companies survive them, and great companies survive them, and Great companies are improved by them. All the definitions you'll read of what a bull market is are totally subjective as we don't really know how far human greed is going to take a bull market. A bull market doesn't have to end just because we hit some certain valuation level. As Buffett says, the market can stay irrational longer than any of us can stay solvent. Gottem writes, the best investors are willing to humbly admit that market cycles do not exhibit any certainty or predictability.

Starting point is 00:29:40 On this topic, you should completely ignore the so-called market experts, talking heads, and macro forecasters. It is impossible to know when a market cycle will end because the pendulum can swing too far in either direction. The challenging aspect of risk management in the stock market is that you can only approximately and qualitatively evaluate the extent of risk, but can never precisely time the trigger that will cause this risk to play out. Former Federal Reserve Chair Alan Greenspan's highly publicized, irrational exuberance comments

Starting point is 00:30:12 were made in 1996, but the tech bubble didn't pop until March of 2000. For every data point on stock ownership or investor sentiment that shows stocks are overvalued or undervalued, a logical sounding corresponding counterargument exists. Anytime you see a dataset or a single data point attempting to define the current stage of the stock market, treat it with skepticism. Markets are driven by emotion. Sentiment existing in the minds of human beings is subject to abrupt change without any notice. Trillions of moving parts are involved in the economy, so it's simply impossible for a single

Starting point is 00:30:50 variable or even a handful of variables to tell us exactly when the good or bad times will end. So Gottem is very straightforward saying markets are just unpredictable, so we shouldn't bother trying to time the end of a bull market or the end of a bear market. There are just too many moving pieces to make any meaningful predictions and human emotions are always a really key driver. The good news about market timing is that it really doesn't matter. As long as you are invested in great businesses and continue to buy them over the long term, we know we're going to turn out just fine as investors.

Starting point is 00:31:24 The longer your time horizon, the lower your risk is. Peter Lynch says that the real key to making money in stocks is not to get scared out of them. In helping us better understand the boom and bust nature of markets, Scottham reminds us of what Daniel Conman calls availability heuristic, which is one of the most insidious and dangerous cognitive biases. Essentially, this means that people tend to overweight the importance of certain issues based on what's most available to them. If the media is constantly talking about self-driving cars, then the general public is likely to believe that self-driving cars are just around the corner, whether that is actually true or not. Thus,

Starting point is 00:32:03 When stocks are booming, everyone's bullish, and it becomes a self-reinforcing cycle. Greed feeds on greed, and on the flip side, fear feeds on fear. When all you hear is bad news and stocks are just getting crushed, we tend to naturally believe that more bad news is to come and stocks will fall further. This is just totally subconscious and it's just our availability bias at play. He then lists a number of notable examples of Mr. Market frequently giving patient investors many opportunities, a number of which I will list here. First of which is the market grossly undervaluing high-quality businesses because of the focus on the PE, which uses accounting

Starting point is 00:32:42 earnings. Accounting earnings are oftentimes understated, which makes the PE look optically high. What investors should put more focus on is owner's earnings, which are a more accurate reflection of how much a business earns and how much is attributable to shareholders. Another example is not giving enough credit to an entrepreneur who is a learning machine, even after he has rectified his past mistakes and has taken a series of value-creating initiatives. Then he lists another one here that I've recently discovered myself, he writes, totally bypassing serial acquirers as a broad category, even though a few companies have a proven track record of successful value-acreative M&A deals.

Starting point is 00:33:24 If you're interested in learning more about one serial acquirer, I actually purchased just this year, you can check out Episode 531 where I talk about Constellation Software and do a deep dive on their business. The 7th 1E list is talking about lacking the ability to delay gratification and end up heavily discounting the distant future free cash flows, while the free cash flows today are low because the company is reinvesting back into the business. So this would be a quality company that is still in the early stages of their growth cycle. The last one I wanted to mention here is confusing risk.

Starting point is 00:33:57 and uncertainty. Risk is the potential for permanent capital loss or the risk of losing money. Uncertainty refers to the unpredictable range of potential outcomes. A profitable investment opportunity could be highly uncertain, but also could have very little risk, so we don't want to confuse the terms risk and uncertainty. Gottem writes, some of the best investment opportunities are highly uncertain, but have minimal risk of permanent capital loss. To round out the chapter on the efficient market hypothesis, he talked about the wisdom of the crowds and the power of the market being a brilliant mechanism for bringing in efficient prices for most of the time. Knowing when the market is being brilliantly rational or ludicrously irrational is learned from experience

Starting point is 00:34:44 in an extensive study of financial history. Ironically, it's the efficient market hypothesis which keeps many investors from even trying to find inefficiencies, which potentially gives us as individual value investors the opportunity to pounce when the market overreacts in either direction. This brings us to Chapter 24 covering the dynamic art of portfolio management and individual position sizing. Most people would recommend that you have a widely diversified portfolio in order to reduce your risk. But Gautom points out that by being widely diversified, it actually just transfers your risk. You are exchanging company-specific risks, which might actually be quite low, depending on the company, and you're exchanging that for market

Starting point is 00:35:28 risk, otherwise known as systematic risk. He writes, risk hasn't been reduced. It has simply been transferred from one form to another. Diversification is touted as reducing both risk and volatility. Although a diversified portfolio indeed may reduce your overall level of risk, it also may correspondingly reduce your potential level of reward. Buffett has always said that risk is not knowing what you're doing. If you don't know how to analyze individual companies, then you should just purchase something like a market index for the long term. Munger has stated that academics have done a terrible disservice to intelligent investors by glorifying the idea of diversification. Because I just think the whole concept is literally almost insane. It emphasizes

Starting point is 00:36:14 feeling good about not having your investment results depart much from average investment results. So Munger is essentially saying that if you want to have a shot at beating the market by a substantial margin, then you're going to have to deviate from the market to a large degree. If a fund holds 50 or more large-cap companies, then you're probably not going to vary that much from the market. Munger in his partnership and even in his portfolio today is highly, highly concentrated. He has been quoted as saying that a well-diversified portfolio for him includes just four stocks. Four, the world's wealthiest people became wealthy through concentration. Think about Jeff

Starting point is 00:36:54 Bezos and Amazon or Bill Gates through Microsoft and Mark Zuckerberg through Facebook. All these people became wealthy through concentration. Joel Greenblatt has stated that two things should be remembered. After purchasing six to eight stocks in different industries, the benefit of adding even more stocks to your portfolio in an effort to decrease risk is small. And overall market risk will not be eliminated merely by adding more stocks to your portfolio. Another reason you need to concentrate your portfolio to vastly outperform the market is because great ideas are rare. Once someone like Munger finds that rare opportunity to purchase, he acts in size. Munger will sift through hundreds of different companies and he says no to almost all of them. Phil Fisher, as stated,

Starting point is 00:37:41 any individual holding over 20 different stocks is a sign of financial incompetence. I think the big idea behind this is that you want to know your individual holdings really well. It's better to hold a handful of individual stocks you know really well and you're really confident than to own 20 stocks you know just somewhat well. The approach I personally take is to have a larger portion of my portfolio in something like index funds. So some portion of my wealth will be directly correlated to the overall market. And then I have a handful of individual stocks that I have been adding to over time as

Starting point is 00:38:17 long-term holdings in my own portfolio. Goddham has a section here titled The Babe Ruth Effect. He writes, according to the late management guru, Peter Drucker, Efficiency is doing things right, effectiveness is doing the right things. In investing, the latter refers to picking the right stock and the former refers to appropriate allocation. Anyone can identify a winning stock, But the great investors differentiate themselves through superior individual position sizing. Given that the average success rate of an investment idea is less than 50%, even for the best investors, it really does matter that when you win, you make it count. When you find a great idea, buy enough of it to make a meaningful difference to your life.

Starting point is 00:39:04 Successful investing is not only about being right per se, far from it. Success in investing boils down to how the great ideas are executed, that is, initial allocation and subsequent pyramiding. It is not the frequency of winning that matters, but the frequency times the magnitude of the payoff. Michael Mobison calls this the Babe Ruth effect. It is what George Soros was referring to when he said, it's not whether you're right or wrong that's important, but how much money you make when you're right and how much you lose when you're wrong. Now we can apply this to portfolio concentration. The key is to purchase stocks that are mispriced by the market, which means that we have to consistently evaluate better

Starting point is 00:39:44 than other investors the probabilities that the market assigns to future outcomes. Gottem writes, investing is all about expectations, and the outcomes are driven by revisions and expectations which trigger changes in the stock price. Therefore, the ability to properly read market expectations and anticipate revisions of those expectations is the springboard for superior returns. To do this successfully, an investor needs to have variant perception, that is, one must hold a well-founded view that is meaningfully different than the market consensus. One of the most satisfying moments in investing is when the world looks at a business the same

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Starting point is 00:43:47 All right. Back to the show. Gottem also mentions the Kelly formula, which I talked about during my episode covering Monish Pabarai strategy back on episode five. The Kelly formula can be used to determine the optimal bet size for a given set of probabilities and payoffs. The Kelly formula to determine the optimal portion of your portfolio to allocate to a bet includes both the probability of both winning and losing the bet, as well as how much you win if you're right and how much you lose if you're wrong.

Starting point is 00:44:19 Essentially the better the odds are and the more you win when you're right, the more you should allocate towards that position. A word of caution when using this formula, it's essentially intended to be used in games where you know the probabilities, which is practically impossible to know for sure in the investing world. Also, it's intended for games where you make frequent bets, like Blackjack, for example. The formula should be used with caution in the investment world because investments are typically made much less frequently. When I spoke with Chris Mayer on the podcast, for example, he said he made one buy and one sell in 2022. That's it, just one buy and one sell. So the best investors

Starting point is 00:44:57 are not making big decisions frequently. But Gottem does use the Kelly formula to help guide his own investing process. His largest holdings have the lowest likelihood of permanent loss of capital coupled with above average potential returns. New positions are given a minimum 5% weighting and he adds to those positions if the management team executes above his initial expectations. If a position gets too large for his comfort, then he isn't opposed from trimming his winners to avoid them from getting disproportionately large. He also wants to have bigger weightings to businesses with high longevity, solid growth prospects, and disciplined capital allocators.

Starting point is 00:45:37 One item I really love about this book is that you can sense the optimistic and the positive energy that Gautom has, and he really displays it in his book. I quote, our constant focus as investors should be on increasing the intrinsic value of our portfolio and letting the market give us gains according to its own schedule. If we are patient, we will eventually get rewarded because financial markets ultimately take money away from mediocre and stagnant businesses and redirect it towards growing profitable ones. Money never sleeps. Every crisis brings opportunity. We have a better way to look at the world and to think deeply about our investments. This is the glass-half-full approach, and it comes from a

Starting point is 00:46:20 basic understanding of how capitalism functions. Every bust in one area of the market establishes the foundations for a boom in another. Every company's rising cost is another company's rising revenue. Every company's declining revenue is another company's declining cost. The best part is that the stock market usually does an excellent job of recognizing the beneficiaries in each situation by sending their stocks to new highs. Money has a metaphysical-like attraction to places of its best possible use. This is one of the most powerful correcting forces of capitalism. Take advantage of it.

Starting point is 00:46:58 We should not aim for the highest possible returns in the shortest period of time, but rather we should seek above average returns over a long period of time with the lowest possible risk, end quote. In order to achieve this, we must develop a sound investment process that we can stick to through thick and thin. The best long-term performers in any probabilistic field always emphasize process over outcome. An investment process is a set of guidelines that governs the behavior of investors in a way that allows them to remain faithful to the tenants of their personal investment philosophies. A process is what will help us stay through the course through periods

Starting point is 00:47:39 of underperformance. In the short term, anything can happen, including bad luck. So we need to stick to focusing on our process and know that over the long run, we tend to get what we deserve. He writes, Deserved success comes when a sound process results in a favorable outcome. Poetic justice is served when a bad process is accompanied by an unfavorable outcome. Luck is a major contributor in the short term. To sustain high returns, it requires more than luck. And over the long term, skill becomes the dominant factor.

Starting point is 00:48:12 I keep quoting the book because what he writes is just things I just find so, so valuable, and I just really want to share it with the audience. An investment philosophy is something that is gradually built over time. We cannot control the movement of the markets any more than we can control the returns. We can, however, always derive a great deal of intellectual satisfaction from following a sound process and staying true to our personal investment philosophy. To make money, we need luck. To create wealth, we need consistency. Compounding is a lifelong journey and an individual's

Starting point is 00:48:47 impatience with his or her investment process could lead to a fatal decision and bring the journey to an abrupt end. Stay the course and remain faithful to your personal investment philosophy in your individual process. Focus is the key to success. Successful investors identify their niches and stick to them, gradually evolving them over time as they learn and adapt. As munger says, all intelligent investing is value investing, and value investors do not equate risk with random fluctuations of stock prices, nor do they equate high risk with high returns. Instead, they always think in terms of the positive relationship between intelligent effort and returns, end quote. Then he closes out the chapter with a Benjamin Graham quote that states,

Starting point is 00:49:32 It has been an old and sound principle that those who cannot afford to take risks should be content with a relatively low return on their invested funds. From this, there has developed the great notion that the rate of return which an investor should aim for is more or less proportionate to the degree of risk he is ready to run. Our view is different. The rate of return sought should be dependent rather on the amount of intelligent effort the investor is willing and able to bring to bear on his task. This brings us to chapter 25 covering the importance of avoiding ruin as the chapter is titled,

Starting point is 00:50:07 To Finish First, You Must Finish. Naseem Teleb writes, the worst case is far more consequential than the forecast itself. This is particularly true if the bad scenario is not acceptable. Warren Buffett has often cautioned against the use of leverage, which magnifies our gains, but also magnifies our losses. Tells us that those who utilize leverage too often end up broke, even for those that are very, very smart. Leverage is also dangerous for companies as well.

Starting point is 00:50:40 Buffett has said that credit or debt is like oxygen. When it's abundant, its presence goes unnoticed. When it's missing, that's all that is noticed. Even a short absence of credit can bring a company to its knees. Buffett has often said that if you are smart, you don't need leverage. And if you're dumb, you have no business using it. Gottem writes that cash is a call option on opportunity. Having ample liquid cash puts a valuable optionality in the hands of investors to make bargain

Starting point is 00:51:11 purchases when opportunities arise and it also makes them anti-fragile. Cash is a much underappreciated asset. It's one of the only price-stable assets that is simultaneously highly value elastic. Cash increases in value as other asset prices drop. The more they drop, the more valuable cash becomes. So you never want to put yourself in a position where you potentially become a forced seller of assets. I talked about this earlier during my episode covering spinoffs, where oftentimes during

Starting point is 00:51:42 spinoffs funds are being forced to sell their shares. Goddham recommends having ample amounts of cash so that you aren't forced to sell assets during a period of market turbulence and sharp drawdowns. Quote, nothing is worse for an investor than selling an asset at rock bottom prices to get cash for essential purchases. End quote. Holding a lot of cash is one way of decreasing our risk, but extending our time horizon

Starting point is 00:52:07 also decreases our risk as well. Holding something like the S&P 500 for one year is somewhat risky because there's a lot of downside risk during a one year period. But holding the S&P 500 for more than 10 or 20 years, years, historically has not really been that risky. Nick Majuli shared an equation on his blog that the ability to take risk equals assets minus liabilities plus time. So your ability to take risk increases with your amount of assets, decreases with your amount of liabilities, and increases with your time horizon. This is an enormous opportunity for younger investors because they have time

Starting point is 00:52:46 on their side. In order to avoid any catastrophes, Goddum also puts immense focus on the downside risk. He writes, always be aware of the potential downside. If the consequence of an action is not acceptable to us, then no matter how low the probability, we must avoid that action. If bankruptcy, death, or less of a reputation are one of the potential downside risks, then it doesn't really matter what the various upside possibilities are because they become totally irrelevant. Certain bets in life, regardless of how asymmetric they may appear, should be avoided by any prudent individual. The key to long-term survival is planning your life to prepare for the odds of bad luck, which in turn requires a strategic focus on diversification, room for error, and avoiding single points of failure and non-insurable risks.

Starting point is 00:53:38 A peaceful night's sleep and assured survival is much more important than higher relative returns for one's overall well-being." During market mayhem, you want to own high-quality businesses. The prices of most stocks are going to fall in a correction, but quality businesses always recover because they're well-run and they don't put themselves in precarious situations. I quote, a market always exists for the best of anything because people who appreciate quality always seem to have the money. Once you reach financial independence, it is important to realign your portfolio to have the majority of your weight in high-quality businesses. Owners of outstanding

Starting point is 00:54:20 businesses sleep better at night. Quality of the business and the integrity of the management matter the most in creating and much more importantly in retaining the hard-earned long-term wealth. This is precisely why the handful of high-quality secular growth businesses in any stock market, deservedly enjoy a scarcity premium, and they tend to trade at rich valuations for long periods of time. I limit second-line stocks to less than 20% of my portfolio. Having been around the markets for more than a decade, I have seen plenty of rising stars vanish without a trace. The returns from tried and tested frontline stocks may not be spectacular, but over longer periods of time, they tend to be more consistent and more reliable. The key to a lifetime of investment success,

Starting point is 00:55:08 is not to make brilliant or complex decisions, but to avoid doing foolish things." Definitely reminds me of Charlie Munger, and he's picked a lot up from Munger, as I can definitely tell from reading this book. This ties into Munger's clever point of not trying to be the smartest, but by being the least foolish he can possibly be. We also need to remember that Black Swan events are always a risk. Black swans are essentially a major tail risk that really can't be foreseen by anyone, yet they can really happen at any moment.

Starting point is 00:55:40 Nobody foresaw a global pandemic going into 2020. This is why we need to have the humility to understand just how difficult it is to make predictions and make forecasts into the future, and just how complex and interdependent our world really is. And because of this interdependence, risk can happen really, really fast. As Vladimir Lenin stated, there are decades where nothing happens, and there are weeks where decades happen. Because of this unforeseen tail risk and these risks of a black swan, we shouldn't concentrate into

Starting point is 00:56:12 one single stock or one single industry. Howard Marks once shared a story that there was a gambler who bet everything on a race when only one horse was in the race and he was thinking there was no way he could really lose on this bet. Halfway around the track, the horse jumped over the fence and it ran away. And that's just a funny story that Howard tells with regards to risks and thinking, oh, oh, there's no way I can lose. Many people think about the worst case scenarios, but they may end up being biased about how

Starting point is 00:56:42 worst case scenarios played out in the past or what are the worst case scenarios they've seen in their own lifetimes. But that doesn't mean that the future can't be even worse than what we've experienced in the past. The biggest risks for us as investors are those that we can't foresee. To round out this chapter, Godham discusses owning companies with staying power to help mitigate the risk of ruin. Nassim Teleb is written,

Starting point is 00:57:06 Time is the best test of fragility. It encompasses higher doses of disorder, and nature is the only system that has been stamped as robust by time. Time is an eraser rather than a builder, and a good one at breaking the fragile buildings and fragile ideas. In his 2014 letter, Buffett shared the characteristics of companies with staying power. I quote, financial staying power requires a company to maintain three strengths

Starting point is 00:57:33 under all circumstances. First is a large and reliable stream of earnings. Second is massive liquid assets. And third is no significant near-term cash requirements. Ignoring that last necessity is what usually leads companies to experience unexpected problems. Too often, CEOs of profitable companies feel they will always be able to refund maturing obligations, however large those might be. In 2008 and 2009, many management teams learned how perilous that mindset can be.

Starting point is 00:58:08 Then Goddham follows it up by writing, Businesses with staying power have stable product characteristics, a strong competitive advantage, a fragmented customer and supplier base, prudent capital allocation, a growth mindset with a razor-sharp focus on long-term profitability and sustainability, a corporate culture of intelligent and measured risk-taking, a cash-rich promoter family or parent company that can infuse capital during periods of high stress,

Starting point is 00:58:36 a highly liquid balance sheet, and both the willingness and the capacity to suffer by investing for the long term at the expense of short-term earnings. These companies thus have higher longevity, higher duration of cash flows, and thus a higher intrinsic value, end quote. This all ties into focusing on high-quality businesses that have long durations and they have that staying power that Buffett and Gotham have talked about. That's all I had for today's episode. To continue following our discussion of Goddham's book next week, I will be starting with Chapter 26, which discusses why we should read more history and study fewer forecasts. If you're enjoying

Starting point is 00:59:16 this series, consider sharing it with one of your friends. We really appreciate you supporting the show, and wouldn't be able to do this without loyal listeners like yourself. With that, thank you so much for tuning in. If you have one minute, please share this episode with one friend if you did end up enjoying it. I hope to see you again next week for part five covering the joys of compounding. Thanks for tuning in. Thank you for listening to TIP. Make sure to subscribe to millennial investing by the Investors Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts or courses, go to The Investorspodcast.com. This show is for entertainment purposes only, before making any decision

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