Thoughts on Investment Process
There are many ways to be an investor. In my opinion, there are only 2 ways in the equity markets–you could either buy dirt cheap assets in dark crevices or you could invest in great assets that compound capital at a satisfactory rate over time. Any other way belongs to the speculator. (Investing in an index fund is essentially the latter way–buying into a country that on a net basis compounds rather than consumes capital over time)
Both ways share many similarities, however, there is one distinctive difference that justify their demarcation. That is, the former makes no distinction between a good enterprise and a bad one, whereas the latter requires-by definition-a good business. Where they converge is the importance of the price paid.
As an aspiring investor, one must not just learn the logic behind both methods, but also consider which path to specialize in as it will determine the materials you read and learn from in your efforts to further your intellect. How should one think about it? I offer my thoughts in the following paragraphs.
I believe that the markets are semi-strong form efficient and the traditional Graham and Dodd method of looking for cigar butts-even in emerging markets–is getting highly competitive as more brilliant graduates enter the investment industry. One must not forget that the increasing ease of access to financial information makes Graham’s statistical process of winnowing through companies simpler. The logic goes: if most people can do it, it ain’t gonna work.
In the Postscript of the revised edition of The Intelligent Investor, Ben Graham spoke about an opportunity that was offered to his fund’s partners to purchase half-interest in a growing enterprise that sparked my interest (The entity in question is GEICO):
“For some reason the industry did not have Wall Street appeal at the time and the deal had been turned down by quite a few important houses. But the pair (referring to himself and his partner, Jerome Newman) were impressed by the company’s possibilities; what was decisive for them was that the price was moderate in relation to current earnings and asset value. The partners went ahead with the acquisition, amounting in dollars to about one-fifth of their fund. They became closely identified with the new business interest, which prospered.
… Ironically enough, the aggregate of profits accruing from this single investment decision far exceeded the sum of all the others realized through 20 years of wide-ranging operations in the partners’ specialized fields, involving much investigation, endless pondering, and countless individual decisions.”
The key points extracted from the passage above are important. First, GEICO was invested not at a ridiculously cheap price, but at a moderate price. This implies the existence of some margin of safety built into the enterprise itself and not just the price. Second, Graham and Newman invested 20% of their fund’s capital into one issue. Note that Graham does not encourage concentrated investments, but he acknowledges that concentration is key to building wealth if you know what you are doing. Third, I assume “closely identifying” as semi-actively managing the operations of the enterprise as they are half owners of the business. This is not something small investors can do, but perhaps a collective of small investors could pool voting power to drive change. Finally, the results of this form of investment can have a significant long-term impact on wealth.
Graham, however, never once taught people how to pick great businesses like GEICO. In fact, this investment went against what was truly taught in the book–the price was reasonable, not cheap, and investing 20% of a portfolio into one issue is not prudent diversification as it initially seems. The reason is a personal one; Graham was more interested in helping educate the masses and stuck to a method of investing that would be easy for many to practice, i.e. his statistical method of picking stocks for a highly diversified portfolio. (Of course, it isn’t that easy anymore given the changing conditions due to massive adoption of his technique.) In addition, he is cautious about teaching something that only happened once and is wise to acknowledge that it could simply be the result of luck:
“Another, not so obvious, is that one lucky break, or one supremely shrewd decision–can we tell them apart?”
Graham definitely understood the power of capital compounders albeit his paucity of mentioning it in his teachings. For students interested in investing in capital compounders like GEICO, the road is miles off the beaten path and there is no consolidated guide or book to learn from (which can be a good thing). Graham did, however, left us with a clue, pointing us to a possible direction right at the end of the book:
“But behind the luck, or the crucial decision, there must usually exist a background of preparation and disciplined capacity. One needs to be sufficiently established and recognized so that these opportunities will knock at his particular door. One must have the means, the judgement, and the courage to take advantage of them.”
So as a young aspiring investor, what path should we pick? There is no one right method. Obviously, there are many ways we can invest and make money. The key is to stick to what interests you because life is short and you are likely to spend a large chunk of your life reading and thinking in a certain way. Personally, I lean towards investing in good enterprises that compound capital sustainably over time at a satisfactory rate.
Given my decision, the obvious path forward is to study all past capital compounders and expose myself to a broad range of knowledge from various disciplines in order to build a sustainable and coherent web of mental models. This is important, because finding capital compounders isn’t as easy (and by easy, I mean “tangible”) as Graham’s statistical techniques. Instead, it requires a boiling pot of seemingly uncorrelated insights that form a critical mass of sorts (Munger has an eloquent word for that–”Lollapalooza”). Of course, one must also be very conscious of the element of luck in order to not fool oneself.