Charlie Munger: Whats Wrong With Economics

“Spend each day trying to be a little wiser than you were when you woke up. Discharge your duties faithfully and well. Step-by-step you get ahead, but not necessarily in fast spurts. But you build discipline by preparing for fast spurts. Slug it out one inch at a time, day-by-day, and at the end of the day – if you live long enough – like most people, you will get out of life what you deserve.” – Charlie Munger



[Ed Wexler, Poor Charlie’s Almanack]

Charlie Munger is a brilliant man and I cannot believe how neglected he is in the shadow of Buffett and Berkshire. Charlie gave an insightful lecture titled Academic Economics: Strengths and Faults after Considering Interdisciplinary Needs and gave it on Oct. 3rd, 2003 to the Herb Kay Undergraduates at the University of Santa Barbara Economics Department.

It is the 9th talk in the (Must Read) book, Poor Charlie’s Almanack. Charlie gives much deserved praise to Adam Smith, John Maynard Keynes, Riccardo and Paul Krugman in the beginning of the lecture, although he clearly favored Smith.

Adam Smith was so good a thinker and so good a writer that, in his own time, Emmanuel Kant, then the greatest intellectual in Germany, simply announced there was nobody in Germany to equal Adam Smith. Well, Voltaire, being an even pithier speaker than Kant, immediately said, Oh well, France does not have anybody who can even be compared to Adam Smith.



As Charlie always does, he leaves the apprentice to reach for the answer, explanation, reasoning and judgment. [Hint: Read Wealth of NationsThe Principles of Political Economy and Taxation, and General Theory of Employment, Interest and Money.

  • He explains he has this tendency of leaving questions unanswered because of the way his father taught him, leaving analogies open to interpretation and attribution.



So What’s Wrong With Economics?



Charlie puts forth nine simple ideas to help the economics discipline progress in the years to come and obtain a multidisciplinary attitude along the way.

1) Fatal Un-Connectedness, Leading To “Man With A Hammer Syndrome,” Often Causing Overweighing What Can Be Counted



Simply stated, Overweighing what can be counted, an excessive reliance on quantitative measures leads to and causes fallability. 

As Einstein once said famously “All that can be counted, does not count.”

And Charlie added . . .

[Humans] (1) overweigh the stuff that can be numbered, because it yields to the statistical techniques they’re taught in academia, and (2) doesn’t mix in the hard-to-measure stuff that may be more important. 

One of the most important factors in business cannot be counted. Culture.

Sure you could make up some asinine balanced scorecard, fitting the model to the mood, or you could use your multidisciplinary knowledge in history, biology and psychology to develop an intrinsic model of what has worked and why

What makes a strong culture? What kind of culture does your dream job entail? Why?

Who do you not want to work for? Why? What makes a weak culture? Why? 

2) Failure To Follow The Fundamental Full Attribution Ethos of Hard Science



“What’s wrong with the way Mankiw does economics is that he grabs from other disciplines without attribution. He doesn’t label the grabbed items as physics or biology or psychology, or game theory, or whatever they really are, fully attributing the concept to the basic knowledge from which it came. If you don’t do that, it’s like running a business with a sloppy filing system. It reduces your power to be as good as you can be.”



Attribution helps memory retention through structural recognition of the problem and relates to ones own experience and knowledge for better understanding.

3) Physics Envy



The envy of physics can be simplified into mistaking soft science for hard science and attempting to oversimplify what is dynamically complex. Everything should be made as simple as possible, but no more simple.

Charlie illustrates the point with Washington Post. Washington Post in the early 70s was trading at “a fifth of what an orangutan could figure was the plain value per share by just counting up values and dividing” but because some partner at McKinsey had been educated in capital asset pricing model, beta, efficient market theory and even worse, believed what he was taught, a stock buyback program was neglected.

At the time it was conventional wisdom that companies should not buyback shares on the premise that the market is efficient. This means there is no advantage in buying shares. Luckily for Washington Post shareholders, Warren Buffett (TradesPortfolio) came along and convinced the board to buy 50% of outstanding shares, creating over a billion dollars in value in the process. The rest is history.

The moral of the story being soft sciences are not governed by laws but rather plausible rules or heuristics that are easily broken. The second example of physics envy is of a rustic legislator that attempted to have a law passed to round Pi to 3.2, allowing school children to make computations easier. Luckily the law did not pass, as architects and quantum physics will agree.



4) Too Much Emphasis on Macroeconomics



“There’s too much emphasis on macroeconomics and not enough on microeconomics. I think this is wrong. It’s like trying to master medicine without knowing anatomy and chemistry.”



Charlie gives us a problem to solve to illustrate the lesson at hand.

Business: Tire Chain, Les Schwab

Sales: Hundreds of Millions from zero in 50 years

Founder: No formal education and is now age 80.

How did he do it?

Well, let’s think about it with some microeconomic fluency.

Is there some wave that Schwab could have caught?

The minute you ask the question, the answer pops in. The Japanese had a zero position in tires and they grew rapidly. So this guy must have ridden that wave some in the early times. Then the slow following success has to have some other causes.

“He must have a very clever incentive structure driving his people. And a clever personnel selection system, etc. And he must be pretty good at advertising. Which he is. He is an artist.”



Charlie explains extreme success is likely to be caused by some combination of the following factors, surfing the wave being the most important:

A) Extreme maximization or minimization of one or two variables.

B) Adding success factors so that a bigger combination drives success, often in non-linear fashion, as one is reminded by the concept of breakpoint and the concept of critical mass in physics. Often results are not linear. You get a little bit more mass, and you get a lollapalooza result.

C) An extreme of good performance over many factors.

D) Catching and riding some sort of big wave.

Microeconomics and smaller subconscious cause and effect relationships are the governors of macroeconomics, much like quantum physics governing macrophysics, macrophysics meaning visible and measurable to the naked eye.



5) Too Little Synthesis in Economics



This section can quickly be explained by a problem that Charlie had proposed in combination with the Riccardo comparative advantage and Smiths pin factory observation.


  • Comparative advantage states, it is beneficial for two countries to trade, even though one of them may be able to produce every kind of item more cheaply than others.
  • Adam Smiths pin factory is an observation he made and detailed in the wealth of nations. Smith found that ten workers were able to produce 48,000 pins per day because of the divided and specialized labor. If each worker handled all the steps required to make a pin, he could only make twenty per day. It pays to embrace specialized labor.

Charlie provides an example of a delinquent hotel property, in a bad neighborhood, that had caused nothing but problems and losses in the past. The previous owner (like most of us) encountered the problem of functional fixedness, a problem solving inhibitor. It took a new chap with very little conventional knowledge to turn the ship around. Of all things he needed the hotel as a hub, to store elderly travelers overnight. A shuttle bus picked them up and dropped them off (at Disneyland) so there was no need for the parking lot.

Breaking the functional fixedness of a typical hotel revenue model and turning the parking lot into a putting green solved the problem. Specialization and comparative advantage at its finest.

6) Extreme and Counterproductive Psychological Ignorance



Here I want to give you a very simple problem. I specialize in simple problems.

You own a small casino in Las Vegas. It has fifty standard slot machines. Identical in appearance, they’re identical in the function.

They have exactly the same payout ratios. 

The things that cause the payouts are exactly the same. 

They occur in the same percentages. But there’s one machine in this group of slot machines that, no matter where you put it among the fifty, in fairly short order, when you go to the machines at the end of the day, there will be 25% more winnings from this one machine than from any other machine. What is different about that heavy winning machine? 

Male: More people play it. 

Charles Munger: No, no, I want to know why more people play it. What’s different about that machine is people have used modern electronics to give a higher ratio of near misses. That machine is going bar, bar, lemon. Bar, bar, grapefruit, way more often than normal machines, and that will cause heavier play. How do you get an answer like that? Easy. Obviously, there’s a psychological cause: That machine is doing something to trigger some basic psychological response. 



7) Too Little Attention to Second and Higher Order Effects



This fallability is quite understandable, because the consequences have consequences, and the consequences of the consequences have consequences, and so on. It gets very complicated, very quickly. 



Higher order effects can attributed to cause and effect relationships as well as posterior probabilities. Thinking about the 2nd and 3rd level order effects in a “fish bone” style is a great way to train. 

– New incentives cause expected behavior to deviate because it is based on past incentives (Medicare exuberantly underestimated by over 1000%)

– Investing in textile looms. How much of the proceeds from capital investments will stay at home (in the owners pockets) versus the consumers pocket (in the form of lower prices).

Game theory or dynamical systems are also a great place to start to understand higher order effects.

8) Not Enough Attention to the Concept of Febezzlement



If you have embezzlement that is not known to the embezzled, it has a wonderful Keynesian stimulating effect on the economy because the guy who’s been embezzled thinks he is rich as he always was and spends accordingly, and the guy that has stolen the money gets new purchasing power.

Although anyone with background knowledge in algebra will understand this effect is quickly cancelled out upon discovery of the embezzlement. Essentially a legal, yet unethical, juiced up wealth effect.

Febezzlement = the functional equivalent of embezzlement.


9) Not Enough Attention to Virtue and Vice Effects



The last point Charlie made is best taught with the story he used regarding the differences in attitude, integrity, culture and how social proofing/envy take hold in his speech to Stanford University Law School Address.

“I have a friend who made an industrial product at a plant in Texas not far from the border. He was in a low-margin, tough business. He got massive fraud in the works compensation system – to the point that his premiums reached double-digit percentage of payroll. And it was not that dangerous to produce his product. It’s not like he was a demolition contractor or something.

[The friend wasn’t able to convince the workers to stop the fraud]

So my friend closed his plant and moved the work to Utah among a community of believing Mormons. Well, the Mormons aren’t into workers’ compensation fraud – at least they aren’t in my friend’s plant. And guess what his workers compensation expense is today? It’s two percent of payroll – down from double digits. 

Letting the slop run causes this sort of tragedy. You must stop slop early. It’s very hard to stop slop and moral failure if you let it run a while.”





The last point can be distilled or simplified into four main points.

  • Trust, Virtue, Honesty and Integrity.

Keynes once said: “It’s not bringing in the new ideas that’s so hard. It’s getting rid of the old ones.” And Einstein said it better, attributing his success to “curiosity, concentration, perseverance and self-criticism.

By self-criticism he meant becoming good at destroying your own best-loved and hardest-won ideas. If you can get really good at destroying your own wrong ideas, that is a great gift.

Always look for disconfirming evidence. 

Munger Problem: Achieve Higher Physical Volume By Increasing The Price?

Achieve Higher Physical Volume By Increasing The Price?

Question:

Now tell me several instances when, if you want the physical volume to go up, the correct answer is to raise the price?

“You have studied supply and demand curves. You have learned that when you raise the price, ordinarily the volume you can sell goes down, and when you reduce the price, the volume you can sell goes up. Is that right? That’s what you’ve learned?” They all nod yes. And I say, “Now tell me several instances when, if you want the physical volume to go up, the correct answer is to increase the price?” And there’s this long and ghastly pause. And finally, in each of the two business schools in which I’ve tried this, maybe one person in fifty could name one instance. And nobody has yet to come up with the main answer that I like.”

Answer: There are four categories of answers to this problem. A few people get the first category but rarely any of the others.

  1. Luxury goods: Raising the price can improve the products ability as a “show-off “item, i.e., by raising the price the utility of the goods is improved to someone engaging in conspicuous consumption. Further, people will frequently assume that the high price equates to a better product, and this can sometimes lead to increased sales.
  2. Non-luxury goods: same as factor cited above, i.e., the higher the price conveys information assumed to be correct by the consumer, that the higher prices connotes higher value. This can especially apply to industrial goods where high reliability is an important factor.
  3. Raise the price and use the extra revenue in legal ways to make the product work better or to make the sales system work better.
  4. Raise the price and use the extra revenue in illegal or unethical ways to drive sales by the functional equivalent of bribing purchasing agents or in other ways detrimental to the end consumer, i.e., mutual fund commission practices. [This is the answer Charlie likes most, but never gets]

I found the following problem to be fascinating. From my personal thoughts I was able to come up with the answer luxury goods (I have background experience at Luxottica Retail) as well as an answer that was not provided, although it does relate to number 4. The tactic I thought of (among others) is using stimuli that are addictive, nicotine, etc. to create operant conditioning while slowly raising the price as the social proof factor materializes. If the price is relatively inelastic (determined by observing behavior), the additional funds can be used to market/sell additional product, boosting revenue and creating a lollapalooza effect of marketing, price raises, social proofing, operant conditioning, critical mass, etc. The example is also relatable to pharmaceuticals.

This happened in the case of my friend Bill Ballhaus. When he was head of Beckman Instruments it produced some complicated product where if it failed it caused enormous damage to the purchaser. It wasn’t a pump at the bottom of an oil well, but that’s a good mental example. And he realized that the reason this thing was selling so poorly, even though it was better than anybody else’s product, was because it was priced lower. It made people think it was a low quality gizmo. So he raised the price by 20% or so and the volume went way up.

But only one in fifty (2%) can come up with this sole instance in a modern business school – one of the business schools being Stanford, which is hard to get into. And nobody has yet come up with the main answer that I like. Suppose you raise that price, and use the extra money to bribe the other guy’s purchasing agent? (Laughter). Is that going to work? And are there functional equivalents in economics – microeconomics – of raising the price and using the extra sales proceeds to drive sales higher? And of course there are zillion, once you’ve made that mental jump. It’s so simple.

Now let us quickly reexamine the problem with the benefit of hindsight bias and frame the questions in such a manner a physicist or algebraist would.

Invert. Always Invert. – Carl Jacobi

 

When can we lower the price and lose sales volume? How?

  • Products associated with reliability or quality, deterioration of social proof and operant conditioning overtime to competitors.

When can’t we raise the price and increase sales volume?

  • Obviously not everyone would be able to exploit such a pricing process or else the government would step in with price controls. The answer is likely to come from non-regulated or minimal regulated industries.

Of course none of these answers are definite and at best are messy and uncertain.

Why did Max Planck, one of the smartest people who ever lived, give up economics?

“It was too hard. The best solution you can get is messy and uncertain at best.”

Conscious Justification: Do We Have Free Will or Free Not?

There has been a rigorous debate for the last 2000 years dating back to the Platonic ages pertaining to free will, consciousness and decision-making. Have you ever asked yourself when making decisions, what are the influences of the decisions? Do I have free will? Is the outcome already determined?

It is beneficial for us as conscious creatures to try to understand the dynamics of the decision-making process and the process the brain uses. I would like to individually examine some of the crucial factors of the decision making process. We can call it the mental model of metacognition, or thinking about how we think.

 The first factor of the decision making process I would like to examine is justificationJustification was chosen first because it is our personal perception of why we made the choice, whether known or not beforehand.

“I think therefore I am” – Rene Descartes

A little contextual backdrop

Our minds work in a hierarchical and linear fashion as a result of billions of neurons and trillions of connections simultaneously firing, strengthening synaptic connections through continuous electrochemical reactions, or as the old saying goes “neurons that wire together, fire together.”

If the electrochemical threshold is not met between synapses, the neuron does not fire. The complexity of the microscopic process is distilled into a simple probabilistically determined answer, with a personal narrative interwoven by our neocortex. The neocortex is the wrinkled and folded external portion of our brain. The probabilities are determined like a hidden Markov model or Bayesian network of prior, conditional, joint and revised probabilities that we can only begin to understand.

Consciousness is defined by Oxford dictionary as:

 “The state of being aware of and responsive to one’s surroundings”

Consciousness cannot be distilled into simple language, as we do not have the words available to describe it in our vocabulary. Think of how you would describe through speech or writing the experience of salty, clear ocean waves splashing rhythmically into your chest. Language, whether written or spoken does not compensate experiencing the waves. For simplicity let us think of unconsciousness/consciousness as perception. Perception is not always deliberate or remembered, like how one perceives their procedural morning commute or what they ate last Tuesday for lunch.

Justification

Now that we have some background information let us start with a mind experiment of choice and justification.

Look at the two pictures below and think about which one you prefer. Before you choose, think about why you prefer that particular picture.

Picture 1 [Abstract Lines]

Picture 2 [House in the Forest]

So which picture did you prefer? Why?

The majority of respondents will have said picture two because of the prime that was used, asking you to justify your choice. In the original experiment, the control group that was not asked to justify their choice usually chose the abstract painting of the colored lines. Only when the group was asked prior to choosing to justify their response was the picture of the forest chosen.

Prior justification single handily changed the outcome.

Now what if you were told it is harder to make a choice without justification and then went a little further, explaining that the majority of people will actually pay money to postpone the decision if there is not justification for it to be made?

Well that is exactly what Tversky and Shafir did in 1992 with the following experiment.

Imagine that you have just taken a tough qualifiying examination. It is the end of the semester, you feel tired and run-down, and you find out that [(pass group) you passed the exam; (fail group) you failed the exam and will have to take it again in a couple of months – after Christmas holidays]. You now have the opportunity to buy a very attractive 5-day Christmas vacation package to Hawaii at an exceptionally low price. The special offer expires tomorrow. Would you

  • Buy the vacation package?
  • Not buy the vacation package?
  • Pay a $5 nonrefundable fee in order to retain the right to buy the vacation package at the same exceptionally low price the day after tomorrow?

    Passed Failed Result in 2 Days
         
Buy   54% 57% 32%
 

Don’t Buy

  16 12 7%
 

Pay $5 to Keep Option

30 31 61%

The interesting results to note are in the column “result in 2 days” as those students were told they would not receive their exam marks for two more days. Almost two thirds of students could not make the decision without their exam mark, opting to pay $5 to retain the option until they could justify making the decision.

Tversky and Shafir suggest that students who passed reward themselves for passing while students who failed use the trip as recuperation. There are other interpellations one could arrive at from the results but it does provide some intrinsic evidence that justification if a factor in the decision making process.

Why Does It Matter and What Can We Do?

 Our brains our naturally hardwired to be lazy, pursue the road of least resistance (availability bias) and think in linear hierarchies in fractions of a second. The confluence of factors leads to heuristics and mental short cuts, some of which are very helpful, others inhibit rational thought and action. Unfortunately there is likely nothing we can do as the process begins before we are even aware of it, deep inside the unconscious controlled by constantly changing implicit and procedural algorithms.

Vilayanur Subramanian “Rama” Ramachandran explains the situation differently stating there is always a lot going on inside of our minds and that we are consciously aware of very little of it. Decisions of all magnitudes are continuously being processed with proposed solutions arriving at our consciousness. Rama suggests instead of focusing on “free will” of the decisions, we should focus on “free won’t” – the power to reject solutions proposed by our unconscious.

Consider the analogy (borrowed from Ray Kurzweil) of a military campaign. Army officials prepare a recommendation to the president. Prior to receiving the president’s approval, they preform prep work that will enable the president to make the decision. The proposed decision is presented to the president who approves it or disproves it. If the decision is approved the mission is undertaken.

We can argue how much or how little influence is exerted on the president but the structure of the analogy remains the same, the decision making process begins (and is usually presented) before we become consciously aware of it.

As investors let us think about the justification prior to making the decision and to attempt to inhibit the profound availability bias. Do not settle for surface justification but rather look for the structural ones and above all, never be afraid to answer:

I… Don’t … know.

The Brain – is wider than the Sky –

For – put them side by side –

The one the other will contain

With ease – and You – beside –

The Brain is deeper than the sea –

For – hold them – Blue to Blue –

The one the other will absorb –

As Sponges – Buckets – do –

The Brain is just the weight of God –

For – Heft them – Pound for Pound –

And they will differ – if they do –

As Syllable from Sound

– Emily Dickinson

A Diamond In The Rough: Warren Buffett Talks Jewellery

Warren Buffett (TradesPortfolio) detailed in a written letter what you should know about the business economics of the jewelry industry in general and specifically Borsheim’s. The letter was written shortly after the acquisition was made in 1989. Emphasis is my own with additional comments added throughout original excerpts. 

First WB explains very simply the economics of the existing jewelry industry.

1) high overhead

2) average margins

3) high fixed costs.

The high overhead is based on low inventory turns, a small majority (25-30%) likely coming from inventory holding costs, insurance and shrink. Another direct result of low inventory turns is the amount of capital that is “tied-up” in working capital, essentially diluting returns on capital as it sits idle in inventory.

 To begin with, all jewelers turn their inventory very slowly, and that ties up a lot of capital. A once-a-year turn is par for the course. The reason is simple: People buy jewelry infrequently, and when they do, they are making both a major and very individual purchase. Therefore, they want to view a wide selection of pieces before zeroing in on a single item.



Given that their turnover is low, a jeweler must obtain a relatively wide profit margin on sales in order to achieve even a mediocre return on their investment. In this respect, the jewelry business is just the opposite of the grocery business, in which rapid turnover of inventory allows good returns on investment though profit margins are low.



In order to establish a selling price for their merchandise, a jeweler must add to the price they pay for that merchandise, both their operating costs and desired profit margin. Operating costs seldom run less than 40% of sales and often exceed that level. This fact requires most jewelers to price their merchandise at double its cost to them or even more.



The math is simple: Jewelers charge $1 for merchandise that has cost them 50 cents. Then, from their gross profit of 50 cents they typically pay 40 cents for operating costs, which leave 10 cents of pre-tax earnings for every $1 of sales. Taking into account the massive investment in inventory, the 10-cent profit is adequate but far from exciting.”



Now let us think…

If we were in charge of running the businesses and tossed in as the CEO tomorrow, whatchanges would we implement, what would we leave the same?

Seriously….

What would be the optimal strategy to pursue?

At first glance, we would likely come to the conclusion we need to turn our inventory quicker, we need lower fixed costs and we need higher gross margins. What we need is a higher capital turnover ratio. (Sales / Invested Capital)

But how can a higher capital turnover be achieved?

We need to either increase the numerator (Sales) or decrease the denominator (Invested Capital), or a combination of both.

“ At Borsheim’s the equation is far different from what I have just described. Because of oursingle location and the huge volume we generate, our operating expense ratio is usually around 20% of sales. As a percentage of sales, our rent costs alone are fully five points below those of our typical competitor. Therefore, we can, and do, price our goods far below the prices charged by other jewelers. In fact, if they priced to match us, they would operate at very substantial losses. Moreover, in a virtuous circle, our low prices generate ever-increasing sales, further driving down our expense ratio, which allows us to reduce prices still more.



How much difference does our cost advantage make? It varies by competitor but, by my calculation, what costs you $1,000 at Borsheim’s will, on average, cost you about $1,350 elsewhere. This is called the “Borsheim’s Price”. There are very few instances where we are unable to offer you those great savings due to restrictions, but you will always know upfront if an item is non-discountable.



Borsheim’s charges roughly 26% less for merchandise than competitors. They are enabled to do so because of the low fixed costs (rent, property tax, insurance etc.) and huge volume (higher inventory turns, lower overhead in the form of lower inventories on hand, lower variable costs due to scalability) created through direct selling.

 Our “shop-at-home” program brings Borsheim’s to our qualified customers. Simply contact Borsheim’s to describe what you’re looking for – to any degree of detail. We will assemble selections that best reflect your wishes and send them to you. Then, in the comfort of your own home or office, you can conveniently and leisurely select the item(s) you most prefer, or return the entire selection. Our results from this “shop-at-home” program have been amazing. Customers have loved it and keep coming back for more. Each year, we send out several thousand packages, ranging in value from $100 to $500,000.”



The business economics described above are not new and can be seen when examining Nebraska Furniture Mart (1983 acquisition) and the famous Dell business model that everyone seems to relate it to. Because of the single location, roughly 5% mark-up can be forgone by the product vendor and passed onto the consumer in the form of price savings. I like to call these feedback loops or cycles, “the ratchet up effect”, essentially leading to a virtuous cycle or prosperity for the low cost producer or leader. 

 I can remember well how helpless I used to feel in a Fifth Avenue or Rodeo Drive jewelry store, where the only thing I knew for sure was that the operator had extraordinarily high overhead – and that they had to cover it in their sales priceI was also wary of the “upstairs” solo operator who operated on consignment merchandise, since that would have cost them more than merchandise bought outright, and would necessarily haveinflated their retail price.”



Key Take Away

    • In a commodity business, high inventory turns are crucial

 

    • The lower the business overhead, the better

 

    • More units sold and spread across a smaller base of fixed costs results in a higher return on capital

 

    • Selling on consignment is not usually beneficial in a commodity type business

 

    • Direct selling reduces fixed costs and increases inventory turns, if done correctly

 

    • Capital turnover ratio signifies how much $1 invested can produce in revenue.

 

    • A cost advantage is a competitive advantage susceptible to “the ratchet up effect”

 



I will write up something in more detail later in the week regarding the cost of capital, the return on capital, growth and how they are all interrelated. Thinking deeply about capital invested and the return on that capital as well as their relationship to growth is something I would encourage all investors to do routinely. Look for reasons why the ROIC is above or below average (9% is the median according to “Valuation” by Mckinsey & Company) and how the advantage is created or lost. 



“Constantly think about how you could be doing things better and keep questioning yourself” – Elon Musk


Howard Marks Memo: Dare to be Great I & II

A new memo from Howard Marks is out and is it ever great. The original post “Dare to be Great” is provided here. I would definitely suggest reading both, preferably the one from 2006 first, as it serves as an appropriate backdrop on the context in which Marks writes today. Either way, Howard provides some key excerpts from 2006 in the 2nd part, published April 8th, 2014 and provided below.

In September 2006, I wrote a memo entitled Dare to Be Great, with suggestions on how institutional investors might approach the goal of achieving superior investment results. I’ve had some additional thoughts on the matter since then, meaning it’s time to return to it. Since fewer people were reading my memos in those days, I’m going to start off repeating a bit of its content and go on from there.

About a year ago, a sovereign wealth fund that’s an Oaktree client asked me to speak to their leadership group on the subject of what makes for a superior investing organization. I welcomed the opportunity. The first thing you have to do, I told them, is formulate an explicit investing creed. What do you believe in? What principles will underpin your process? The investing team and the people who review their performance have to be in agreement on questions like these:

  • Is the efficient market hypothesis relevant? Do efficient markets exist? Is it possible to “beat the market”? Which markets? To what extent?
  • Will you emphasize risk control or return maximization as the primary route to success (or do you think it’s possible to achieve both simultaneously)?
  • Will you put your faith in macro forecasts and adjust your portfolio based on what they say?
  • How do you think about risk? Is it volatility or the probability of permanent loss? Can it be predicted and quantified a priori? What’s the best way to manage it?
  •  How reliably do you believe a disciplined process will produce the desired results? That is, how do you view the question of determinism versus randomness?
  •  Most importantly for the purposes of this memo, how will you define success, and what risks will you take to achieve it? In short, in trying to be right, are you willing to bear the inescapable risk of being wrong?

    Passive investors, benchmark huggers and herd followers have a high probability of achieving average performance and little risk of falling far short. But in exchange for safety from being much below average, they surrender their chance of being much above average. All investors have to decide whether that’s okay. And, if not, what they’ll do about it.

    The more I think about it, the more angles I see in the title Dare to Be Great. Who wouldn’t dare to be great? No one. Everyone would love to have outstanding performance. The real question is whether you dare to do the things that are necessary in order to be great. Are you willing to be different, and are you willing to be wrong? In order to have a chance at great results, you have to be open to being both. 

    Dare to Be Different
    Here’s a line from Dare to Be Great: “This just in: you can’t take the same actions as

    everyone else and expect to outperform.” Simple, but still appropriate.

    For years I’ve posed the following riddle: Suppose I hire you as a portfolio manager and we agree you will get no compensation next year if your return is in the bottom nine deciles of the investor universe but $10 million if you’re in the top decile. What’s the first thing you have to do – the absolute prerequisite – in order to have a chance at the big money? No one has ever answered it right.

    The answer may not be obvious, but it’s imperative: you have to assemble a portfolio that’s different from those held by most other investors. If your portfolio looks like everyone else’s, you may do well, or you may do poorly, but you can’t do different. And being different is absolutely essential if you want a chance at being superior. In order to get into the top of the performance distribution, you have to escape from the crowd. There are many ways to try. They include being active in unusual market niches; buying things others haven’t found, don’t like or consider too risky to touch; avoiding market darlings that the crowd thinks can’t lose; engaging in contrarian cycle timing; and concentrating heavily in a small number of things you think will deliver exceptional performance.

    Dare to Be Great included the two-by-two matrix and paragraph below. Several people told me the matrix was helpful.

    Of course it’s not that easy and clear-cut, but I think that’s the general situation. If your behavior and that of your managers is conventional, you’re likely to get conventional results – either good or bad. Only if your behavior is unconventional is your performance likely to be unconventional . . . and only if your judgments are superior is your performance likely to be above average.

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