Google Talk- The Prejudices of Mr. Market

Google Talk- The Prejudices of Mr. Market

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I would like to talk to you today about empathy which is the ability to step into the shoes of another person, aiming to understand his or her feelings and perspectives and to use that understanding to guide our actions.

Empathy? Normally, you wouldn’t associate empathy with the world of capitalism and investing. And I have to admit I used to think the same way too when I started out as a value investor 21 years ago. But today, I think differently. Today, I think that every value investor should count empathy as one of the key tools in his or her toolkit. Today, I use empathy to really understand a business and it’s market valuation.

Let me tell you how.

I am a value investor who focuses on investing in moated businesses in India. A “moat,” as you know, is a metaphor Warren Buffett uses to illustrate the idea of a competitive advantage.


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According to Mr. Buffett:

What we’re trying to find is a business that for one reason or another .... has this moat around it. And you throw crocodiles and sharks and piranhas in the moat to make it harder and harder for people to swim across and attack the castle.1

It’s quite obvious to me that investing in a business with a moat carries a very low risk of permanent loss of capital. A durable competitive advantage makes a business resilient to economic shocks as well as managerial mistakes. It gives the business what Tom Russo calls the “capacity to suffer.”2

My own experience of more than two decades of value investing has persuaded me that investing in a business with a moat is likely to deliver higher returns with lower risk of permanent loss of capital, than investing in a business without a moat. I am also convinced that buying into scalable businesses with moats at sensible prices, and then holding on to them for long periods of time, is a very profitable, low-stress investment strategy.

But what about empathy? How do I use it for analysing moated businesses? Well, while evaluating a business for a potential investment, I try to empathise with four types of persons. I try to step into their shoes with an aim to understand their feelings and perspectives and to use that understanding to guide my firm’s actions.

Who are these people in whose shoes I try to step into? Well, here is the list:

# 1: THE CUSTOMER: I think it’s terribly important to understand well about the pain of the customer that the business alleviates.

Why does she prefer to buy from the company you are evaluating? What’s so special about the value proposition to customers that will make them want to come back again and again?

#2: THE COMPETITOR: Why would a potential competitor not enter this market? If he tried to, why would it be painful for him? What are the entry barriers? You really have to put yourself in the shoes of a potential competitor to feel the pain that would be created by taking on a moated business.


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#3: THE ENTREPRENEUR: What drives the entrepreneur? Is he an intelligent fanatic? What struggles did he face in making this business a success? What would he do during tough times? What are his shortcomings? Are they so significant that you’d reject partnering with him? Why?

#4: MR. MARKET: Why is the stock market misunderstanding this business? What are its prejudices? What will make them go away?

For the rest of this talk, I will focus on the this fourth person only — Mr. Market. Who is he?

The Semi-Psychotic Mr. Market or a Weighing Machine?

Mr. Buffett likens him to a semi-psychotic creature.

In his classic book, The Intelligent Investor, Ben Graham uses the metaphor of Mr. Market which Mr. Buffett has written and spoken about many times:

“Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.3

Mr. Market has another endearing characteristic: He doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.

But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you


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will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence.”

So, it appears that Mr. Market really is a semi-psychotic creature given to extremes of elation and despair. He is utterly irrational sometimes and whenever that happens, value investors take advantage of his prejudices.

But, here’s the thing: If Mr. Market is irrational, and stays that way, then how will value investors make any money? For them to make money, Mr. Market should mis-price assets only temporarily. And that’s exactly what Ben Graham meant when he said that

Therein lies our opportunity. Once we know (1) the stock market has a tendency of being prejudiced against some business which, in our view, is exceptionally good; (2) such a prejudice produces attractive market valuations for that business; and (3) the market would have a tendency of correcting its prejudice over time, we can really understand how to make intelligent investments.

If we can understand why the market is prejudiced against a business we love and what will make those prejudices go away, then we will have a basis of betting against the market. This is exactly what Seth Klarman meant when he wrote about his need to have “necessary arrogance.”

Why Necessary Arrogance and Hostile Stereotyping Can Make You Rich


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Klarman writes:

“At the root of value investing is the belief, first espoused by Benjamin Graham, that the market is a voting machine and not a weighing machine. Thus an investor must have more confidence in his or her own opinion than in the combined weight of all other opinions. This borders on arrogance, the necessary arrogance that is required to make investment decisions. This arrogance must be tempered with extreme caution, giving due respect to the opinions of others, many of whom are very intelligent and hard working. Their sale of shares to you at a seeming bargain price may be the result of ignorance, emotion or various institutional constraints, or it may be that the apparent bargain is in fact flawed, that it is actually fairly priced or even overvalued and that sellers know more than you do. This is a serious risk, but one that can be mitigated first by extensive fundamental analysis and second by knowing not only that something is bargain-priced but, as best you can, also why it is so. You never know for certain why sellers are getting out but you may be able to reasonably surmise a rationale.”4

Klarman makes a very important point about the need to know the prejudices of Mr. Market. And many of those prejudices arise out of a shortcut called the representativeness heuristic which means that we look for similar past experiences to make judgments about the probability of future events. So, for example, if you run an insurance operation, you’d have vast amounts of customer data that allows you to determine future likely behaviour of a potential buyers of insurance. You determine that probability (and accordingly determine the insurance quotation) based on “categories.” A potential buyer of insurance might, in your judgement belong to a “high risk” category because he is male, 20-year old young, alcohol consuming, college-going student who has never owned a car before. For such a buyer, your quotation for selling car insurance would be higher than that for a “low risk” category comprising of, say, 35-year old mother of 2 children, who has never had an accident in the 10 years of car driving experience.

Such type of categorization or stereotyping is essential for making quick judgements in any domain. Indeed, the very word “stereotyping” has an unnecessary negative connotation, as Daniel Kahneman writes in his book, Thinking Fast and Slow:

“Stereotyping is a bad word in our culture, but in my usage it is neutral. One of the basic characteristics of System 1 is that it represents categories as norms and prototypical exemplars. This is how we think of horses, refrigerators, and New York police officers; we hold in memory a representation of one or more “normal” members of each of these categories. When the categories are social, these representations are called stereotypes. Some stereotypes are perniciously wrong, and hostile stereotyping can have dreadful consequences, but the psychological facts cannot be avoided: stereotypes, both correct and false, are how we think of categories.”5

When Kahneman writes that “some stereotypes are perniciously wrong,” he is referring to


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such stereotyping as a key source of prejudice. In his wonderful book, Mistakes Were Made But Not By Me, Elliot Aronson writes:

Prejudices emerge from the disposition of the human mind to perceive and process information in categories. “Categories” is a nicer, more neutral word than “stereotypes,” but it’s the same thing. Stereotypes are energy-saving devices that allow us to make efficient decisions on the basis of past experience; help us quickly process new information and retrieve memories; make sense of real differences between groups; and predict, often with considerable accuracy, how others will behave or how they think. We wisely rely on stereotypes and the quick information they give us to avoid danger, approach possible new friends, choose one school or job over another, or decide that that person across this crowded room will be the love of our lives.6

But when Kahneman also writes that “hostile stereotyping can have dreadful consequences,” he is referring to sensitive social contexts such as hiring and racial profiling and not investing. In the world of investing, hostile stereotyping by Mr. Market can have wonderful consequences for the value investor.

Take the case of the airline industry. Anyone who has read Mr. Buffett’s letters knows just how bad the economics of the airline industry is.

Source: https://youtu.be/5D6znniUbyY

Mr. Buffett, of course, is taking about the idea of insensitivity towards base rates. He is telling us that before we invest in the airline industry, we should be aware that the odds of making money in that industry are bleak. That’s because the overall economics of the airline industry sucks. But that does not have to mean that we put every airline in the “crappy business” category in our mind. If we do that, then we will never invest in a Ryanair or a


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Southwest both of which are solid businesses which have beaten market indices handsomely over the long run.

Perhaps the analyst who did invest in either of these two businesses thought differently from the market without falling for the prejudice of applying the “crappy business” label to them. Perhaps she dug deeper and found that both businesses had durable competitive advantage and were run by entrepreneurs whom Charlie Munger would call as intelligent fanatics. Perhaps she had reliable and persuasive evidence specific to those businesses which would go against the conclusion in the base rate that airlines are crappy businesses. Perhaps, these were exceptional businesses which defied the rule. Perhaps she had the necessary arrogance based on facts that she was right and Mr. Market was wrong.

Exactly this type of thinking produces exceptional returns. When Mr. Market is deeply prejudiced against what you know to be a wonderful business, that very prejudice creates a fabulous investment opportunity.

And so, let’s empathise with Mr. Market and understand it’s prejudices in the pricing of moated businesses. Before I do that, however, some words of caution. First, these are the prejudices I have found and exploited which means that there may be others I have not found yet. Second, I only refer to prejudices in the pricing of moated businesses. To be sure, there are many ways of practicing value investing and moat investing is just one of them. Finally, there will be overlaps in the sense that sometimes you will find multiple prejudices in a single situation and when that happens, you can expect what Charlie Munger calls as a “lollapalooza outcome.”


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Prejudice # 1: Marshmallow

Here, I want to talk about the tendency of investors to categorize stocks of businesses as “cheap” or “expensive” based on their reported P/E multiples. For example, many of my value investors friends wouldn’t want to buy into a business selling at a P/E multiple of 25. That’s a prejudice in my view for two reasons.

First, there’s plenty of evidence which disconfirms the notion that businesses selling at P/E multiples of more than 25 are expensive. By definition, a business that’s expensive, if purchased at that expensive price, should deliver poor investment returns over the long term. But there’s plenty of research which shows that’s not the case. While the average business may well be over-priced at 25x, that doesn’t mean that exceptional ones are also expensive at that market valuation. The following observation of Charlie Munger applies.

Second, in moated businesses, reported earnings often understate true economic earnings. That’s because money spent on successful moat expansion activities is charged off to P&L but should be treated as an expenditure with benefits spanning more than a year.

They is a key point that Mr. Buffett has made in his letters and one which, in my view, is often not fully understood by investors. Charlie Munger's observation that “almost all good businesses engage in ‘pain today, gain tomorrow’ activities” also means that after making the necessary adjustments, one would find that the multiple of their economic earnings — the ones that really matter — are sometimes significantly lower than P/E multiples based on


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reported earnings. And so, what looks optically expensive is really not that expensive.

In my view, the market’s tendency to categorize a business as expensive simply because it’s stock is trading at 25 times earnings is an exploitable prejudice. Mr. Buffett agrees.

The term “value investing” typically connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics — a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield — are in no way inconsistent with a “value” purchase.7

At this point, you must be wondering why did I title this part of the talk as “marshmallows.” The answer to that question lies in a famous experiment which I am sure many of you’ve heard about: The Marshmallow Experiment conducted by the psychologist Walter Michel at Stanford University in the late 1960s. The experiment is beautifully described in this video.

Source: http://www.youtube.com/watch?v=g75lwNUpUQg

Why did most kids not wait? Well, if you think about it, they were implicitly using DCF to make their choice. The kid who could not wait for 15 minutes for another marshmallow was implicitly, at the subconscious level, using a very high discount rate to determine the present value of that second marshmallow. To her, two marshmallows 15 minutes later, were not worth as much as one marshmallow now. And the only way that can happen is if she was using a very high discount rate.

If kids can be myopic and overweigh instant gratification and under weigh delayed gratification, then why not Mr. Market? Indeed, Mr. Buffett offers clues about how he thinks about discount rates for valuing a business.

When we look at the future of businesses we look at riskiness as being sort of a go/no-go valve. In other words, if we think that we simply don’t know what’s going to happen in the future, that doesn’t mean it’s risky for everyone. It means we don’t know – that it’s risky for us. It may not be risky for someone else who understands the business. However, in that case, we just give up. We don’t try to predict those things. We don’t say, “Well, we don’t know what’s going to happen.” Therefore, we’ll discount some cash flows that we don’t even know at 9% instead of 7%. That is not our way to approach it.

Once it passes a threshold test of being something about which we feel quite certain we tend to apply the same discount factor to everything. And we try to only buy businesses about which we’re quite certain. And as for the capital asset pricing

http://www.youtube.com/watch?v=g75lwNUpUQg


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model type reasoning with its different rates of risk adjusted returns and the like, we tend to think of it – well, we don’t tend to think of it. We consider, it nonsense.

But we think it’s also nonsense to get into situations – or to try and evaluate situations – where we don’t have any conviction to speak of as to what the future is going to look-like. I don’t think that you can compensate for that by having a higher discount rate and saying, “Well, it’s riskier. And I don’t really know what’s going to happen. Therefore, I’ll apply a higher discount rate.”8

Clearly, Mr. Buffett does not use an equity risk premium in the discount rate. He does not heavily discount distant cashflows (delayed gratification) like the children in the marshmallow experiment. And that gives him an edge over competition because he can pay up for quality, without actually overpaying for it.

Prejudice # 2: Hidden Champions

In his book, Hidden Champions of the Twenty-First Century, Hermann Simon writes about extremely successful businesses which remain below the radar for long periods of time.

Large corporations are the subject of close and constant scrutiny by academic researchers, analysts, shareholders, and journalists. Hidden champions, on the other hand, remain a virtually unexplored source of knowledge. Scattered across the globe, thousands of these highly successful companies are concealed behind a curtain of inconspicuousness, invisibility and, in some cases, deliberate secrecy.

This applies to the products these companies make, how they beat the competition or—even more difficult to research—how they are managed internally. Even their names are known to only a handful of experts, consultants, journalists, and researchers. This secretiveness contrasts starkly with the dominant positions the hidden champions enjoy in their markets. Many of them have global market shares of over 50%, and some even hold shares in their relevant markets of 70%–90%. On average, they are more than twice the size of their strongest competitors. Only a few large multinationals achieve comparable market positions.

Why have these outstanding companies, all of which occupy leading positions in their markets worldwide, remained hidden? There are many reasons, but the most obvious is that a large number of the products offered by hidden champions go unnoticed by consumers. Many of these companies operate in the “hinterland” of the value chain, supplying machinery, components or processes that are no longer discernible in the final product or service. As a result, the products lose their distinct identity or autonomy.

[Their low profile] does not mean that the hidden champions are not well known to their direct customers. The opposite is true. Most hidden champions have extremely strong brand names in their markets. Their brand awareness is high, they enjoy outstanding reputations, and competitors often see them as benchmarks.9


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The most interesting part of this quote is:

The products offered by hidden champions go unnoticed by consumers. Many of these companies operate in the “hinterland” of the value chain, supplying machinery, components or processes that are no longer discernible in the final product or service.

Such businesses not only go unnoticed by consumers. Often, they also go unnoticed by investors.

A related tendency of the market is to categorize all businesses in a commodity industry as “crappy businesses” — something I described earlier in the context of the airline industry.

Some of the best ideas in which my colleagues and I have invested have exploited these prejudices of Mr. Market — mis-priced B2B businesses which have business models as good as or even better than some exceptional B2C businesses, as well as profitable niches hiding inside commodity industries. Indeed Mr. Buffett and Mr. Munger love the idea of investing in profitable niche businesses operating in industries with commodity characteristics. For example, Berkshire Hathaway owns several profitable niche insurance operations and Mr. Buffett has written about occupying niches in that industry.

The insurance industry is cursed with a set of dismal economic characteristics that make for a poor long-term outlook: hundreds of competitors, ease of entry, and a product that cannot be differentiated in any meaningful way. In such a commodity- like business, only a very low-cost operator or someone operating in a protected, and usually small, niche can sustain high profitability levels.10

In another lecture, Munger said:

In nature and in business, specialization is key. Just as in an ecosystem, people who narrowly specialize can get terribly good at occupying some little niche. Just as animals flourish in niches, similarly, people who specialize in the business world — and get very good because they specialize — frequently find good economics that they wouldn't get any other way.11


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Prejudice # 3: Learning Machines

You live in that part of the world where making mistakes and encountering failures is celebrated and is often is a pre-condition for getting funding from VC’s or even a job. The world out there is very different from all this.

Mr. Market has a prejudice against people who make mistakes. For a while, it is unable to distinguish between people who make mistakes and who will continue to make them and people who Charlie Munger would call “learning machines.” In other words, it has a tendency of categorising all mistaken entrepreneurs as dumb people. This tendency doesn’t last forever of course but sometimes it last long enough to make it exploitable.

A few years ago I invested in a business which at one time was in bankruptcy but is today one of India’s most profitable listed businesses as measured by return on invested capital. The chief cause of bankruptcy was a series of mistakes made by the founder. Unlike many other entrepreneurs, however, this one was not only candid about his mistakes, he was also determined not to make them again. And he didn’t. He got out of a lot of businesses that destroyed value and became really good at doing one thing very well. He outsourced manufacturing operations to eight vendors which dramatically boosted returns on capital. He got out of debt and now have a liquid balance sheet with surplus cash. He made a very wise acquisition at a ridiculously low price which not only gave him access to important patented technology, it also opened up a new big market for him.

And there was this period of time, when the market pretty much ignored all the lessons he had learnt and the stock continued to languish even though during that time, his company became the world’s most dominant player in the industry. But, as Graham says, in the long-run the stock market is a weighing machine and that’s how it treated this business too. Today it is far more appropriately valued and it’s obvious that Mr. Market has overcome it’s prejudice against this particular learning machine.

There’s a pattern here of course. I think value investors should consciously look out for learning machines which haven’t yet been forgiven for their past mistakes. That’s a prejudice worth exploiting.


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Prejudice # 4: Serial Acquirers

It’s a well known fact that most acquisitions don’t create value. That’s because the acquirers become over-optimistic about the prospects of the targets and over-estimate the synergies of the acquisition. So statistically speaking, the stock market is absolutely right to view serial acquirers with a great deal of skepticism. But this does not have to mean that all serial acquirers will destroy value. There are a few exceptions and sometimes the market is prejudiced against them. The market’s tendency to categorize all serial acquirers as value destroyers is an exploitable prejudice in my view.

Now, let’s example the common factors in those serial acquirers which do create value. There are a few examples. Henry Singleton was one. Warren Buffett is one. Prem Watsa of Fairfax Financial is another one.

The common factors are: (1) extreme financial discipline i.e. willingness to walk away from a deal that doesn’t make economic sense; (2) providing a permanent home to a promising business; (3) preserving the successful culture of the acquired business; and (4) providing growth capital for inorganic growth though “bolt-on” acquisitions.

For value investors, making an investment in such a business, when the market is prejudiced against it, makes a lot of economic sense because of the option value embedded in such a situation. Successful serial acquirers like Berkshire Hathaway carve out a niche for themselves to become a preferred owner of wonderful businesses. This competitive advantage — of sourcing deals not available to others — has significant option value over time.

The investor is, in effect, making to borrow a term coined by Richard Zeckhauser in his wonderful paper titled Investing in the Unknown and the Unknowable — a “sidecar investment” with an individual who has exceptional sourcing skills and a track record of value creation through inorganic growth.


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Zeckhauser writes:

The investor rides along in a sidecar pulled by a powerful motorcycle. The more the investor is distinctively positioned to have confidence in the driver’s integrity and his motorcycle’s capabilities, the more attractive the investment.12

Prejudice # 5: Freaks and Misfits

I am almost sure you’ve seen this. A few months ago someone asked a question on Quora:

And Elon Musk’s ex-wife, Justine gave an answer which went viral and ended up being quoted by The New York Times, Vox, CNBC, CNN, The Huffington Post and Time.

Here’s an excerpt:

Extreme success results from an extreme personality and comes at the cost of many other things. Extreme success is different from what I suppose you could just consider ‘success,’ so know that you don’t have to be Richard or Elon to be affluent and accomplished and maintain a great lifestyle. Your odds of happiness are better that way. But if you’re extreme, you must be what you are, which means that happiness is more or less beside the point. These people tend to be freaks and misfits who were forced to experience the world in an unusually challenging way. They developed strategies to survive, and as they grow older they find ways to apply these strategies to other things, and create for themselves a distinct and powerful advantage. They don’t think the way other people think. They see things from angles that unlock new ideas and insights. Other people consider them to be somewhat insane.13

The term “freaks and misfits” which might rings a bell with you was taken from Justine.


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Why is it important for us to understand Justine’s perspective?

Harvard Business School professor, Joseph Badaracco offers an explanation. Here’s a professor who uses literary fiction to teach leadership to his students at Harvard Business School. In his book, Questions of Character: Illuminating the Heart of Leadership Through Learning, Badaracco writes:

How does serious fiction help us understand leadership? The answer is simple but extraordinarily powerful: serious fiction gives us a unique, inside view of leadership. In real life, most people see the leaders of their organisations only occasionally and get only fleeting glimpses of what these leaders are thinking and feeling. Even interviews with executives have their limits. Executives say only so much, even when they want to be candid: sensitivities have to be observed, memory fades and sometimes distorts, and successes crowd out failures.”

In contrast, serious literature offers a view from the inside. It opens doors to world rarely seen — except, on occasion, by leaders’ spouses and closest friends. It lets us watch leaders as they think, work, hope, hesitate, commit, exult, regret, and reflect. We see their characters tested, reshaped, strengthened, or weakened.14

The reason why Justine’s perspective is important for us is because — as Badaracco puts it — “it opens doors to world rarely seen — except, on occasion, by leaders’ spouses and closest friends.”

In my view, when it comes to evaluating the quality of extremely successful entrepreneurs in the early part of their journey, the market displays a prejudice. The prejudice is derived from not only the complex personalties that some of these entrepreneurs have — many of whom are definitely not likeable people — but also from the limited view about the individual in question that investors get.

I have seen this prejudice play out over and over again. Market participants are just too judgemental about such people. Instead of focusing on the track record of entrepreneur, they draw pre-mature and incorrect conclusions by looking at incomplete fragments of data about his character.


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Source: http://youtu.be/tx-mQZqXaKo

Source: http://youtu.be/t3EVM_x63Go

But the reality is that by riding on the coattails of such extraordinary human beings is a key source of compounding capital for public market investors. Charlie Munger agrees:

In an interview with with Miguel Barbosa of Simoleon Sense, successful value investor Paul Lountzis says:

http://youtu.be/tx-mQZqXaKo

http://youtu.be/t3EVM_x63Go


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The ability to identify a young Phil Knight, a young Howard [Schultz] from Starbucks, a young, John Mackey from Whole Foods is becoming ever more important…

I’m typically attracted to a company because of the numbers. But what can make you enormously successful for your clients is when you identify qualitative features that have yet to appear in the quantitative results.

The key is to identify these situations early. You still have those opportunities when the companies are small but it’s getting harder because there are many smart people looking. For example if you see Progressive generating an 82 combined ratio and making $0.18 of every dollar on their underwriting before investment income and you might say, “My God, State Farm’s at 110. How are these guys so profitable?”

It is really hard to identify these unique teams and cultures but if can do it or get lucky, then you can do very well for your clients. By having this edge you will avoid overpaying. You are protected on the downside and you have enormous upside because you are piggybacking on a visionary who’s building an extraordinary culture with a long run way and because of this “mispricing” you can stay with them for 20 years.

Furthermore, because you have done your research you understand how this visionary is building the business and you have the confidence to survive all the vicissitudes of the market. So when they go through tough times, you recognize they have a stable competitive advantage. They’ve got better people. They’re tenacious and they’re likely to come out of this stronger. It’s an important distinction that I’m trying to make that the qualitative is becoming more important. I still think qualitative features are subordinate to the business model and valuation but the business model is infinitely more impacted by management (and culture) than it was in the past.15

I think it’s terribly important for value investors to recognize that a key source of investment success is to become long-term, passive partners with extraordinary human beings whom many would regard as “freaks” or “misfits.” When George Bernard Shaw said:

… was he talking about “freaks and misfits?” Shouldn’t the label of “freaks and misfits” not sometimes be relabelled as “intelligent fanatics?”

One of my key learnings from studying such people is that as an investor I have to teach myself to overlook many of these personality traits, some of which are not admirable. Indeed, I think these traits are a consequence of their fanatic focus on their work. I have been consciously training myself to empathise with such extraordinary human beings.

http://fundooprofessor.wordpress.com/2015/07/10/intelligent-fanatics/


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In Defence of Mr. Market.

In his wonderful book, The Social Animal,16 Elliot Aronson talks about the insidious nature of prejudice. He quotes a fictional dialogue from Gordon Allport’s classic book, The Nature of Prejudice:

The dialogue illustrates the insidious nature of prejudice far better than a mountain of definitions. In effect, the prejudiced Mr. X is saying, “Don’t trouble me with the facts; my mind is made up.” He makes no attempt to dispute the data presented by Mr. Y. He either distorts the facts in order to make them support his hatred if Jews or he bounces off them, undaunted, to a new area of attach. A deeply prejudiced person is virtually immune to information at variance with his or her cherished stereotypes. As famed jurist Oliver Wendell Holmes, Jr., once said, “Trying to educate a bigot is like shining light into the pupil of an eye—it constricts.”17

While Aronson’s words — a deeply prejudiced person is virtually immune to information at variance with his or her cherished stereotypes — apply to many prejudiced human beings, they do not apply to Mr. Market. That’s because Mr. Market is a learning machine. He corrects his prejudices over time. While the five patterns of prejudice I described keep repeating, the prejudice against specific examples conforming to those patterns tend to disappear over time. We have a name for that and we call it re-rating.

I think there are two lessons here. The first one I have already told you about. The second one is that we should look at Mr. Market with some respect. After all, he is far less prejudiced than us. Why couldn’t we learn to get rid of our own prejudices from him?

Sanjay BakshiAugust 31, 2015Googleplex, Mountain ViewCalifornia

Ends

1 Warren Buffett on Franchise Value: http://youtu.be/plw8luDu8Tg2 Tom Russo’s Interview: http://youtu.be/GSNBTaPYAng3 Warren Buffett’s letter to the shareholders of Berkshire Hathaway Inc.: http://

www.berkshirehathaway.com/letters/1987.html


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4 Seth Klarman quoted: http://www.valuewalk.com/2015/05/seth-klarman-on-the-arrogance-of-value-investing-barrons-1999/

5 Thinking Fast and Slow: http://www.amazon.com/Thinking-Fast-Slow-Daniel-Kahneman/dp/0374533555/

6 Mistakes Were Made But Not By Me: http://www.amazon.com/Mistakes-Were-Made-But-Not/dp/0151010986/

7 Warren Buffett’s letter to the shareholders of Berkshire Hathaway Inc. http://www.berkshirehathaway.com/letters/1992.html

8 Warren Buffett speaking at 1998 AGM of Berkshire Hathaway Inc.9 Hidden Champions of the 21st Century: http://www.amazon.com/Hidden-

Champions-Twenty-First-Century-Strategies/dp/0387981462/10 Warren Buffett’s letter to the shareholders of Berkshire Hathaway Inc.: http://

www.berkshirehathaway.com/letters/1987.html11 Charlie Munger on Elementary Worldly Wisdom: http://csinvesting.org/wp-content/

uploads/2014/05/Worldly-Wisdom-by-Munger.pdf12 Investing in the Unknown and the Unknowable by Richard Zeckhauser: http://

www.hks.harvard.edu/fs/rzeckhau/InvestinginUnknownandUnknowable.pdf13 Justine Musk’s reply to a question on Quora: https://www.quora.com/How-can-I-

be-as-great-as-Bill-Gates-Steve-Jobs-Elon-Musk-and-Richard-Branson/answer/Justine-Musk

14 Questions of Character: Illuminating the Heart of Leadership Through Learning http://www.amazon.com/Questions-Character-Illuminating-Leadership-Literature/dp/1591399688/

15 Paul Lountzis Interview: http://www.simoleonsense.com/conversation-with-paul-lountzis-investing-scuttlebutt-research/

16 The Social Animal: http://www.amazon.com/Social-Animal-Elliot-Aronson/dp/1429233419/

17 The Nature of Prejudice: http://www.amazon.com/Nature-Prejudice-25th-Anniversary/dp/0201001799/

Documents

Google Talk- The Prejudices of Mr. Market