On the (Long) Education of a Value Investor
In recent years, we were tickled pink to read about how intangibles had rendered accounting irrelevant1 and to learn how young analysts at investment firms were outsourcing “low-value-added” model building in order to deploy capital based on “creatively imagining the futures of businesses that are unprovable.”2 It has also been en vogue to pour scorn on the Ben Graham-style value investing that emphasizes scrubbing balance sheets, reconciling income statements to cash flow statements, and carefully reading footnotes to understand capitalization and depreciation/ amortization policies, revenue recognition, one-time adjustments, and acquisition/merger/ divestment accounting.
In fact, we believe that good value investors must pass through Ben Graham in their journey as investors. In one’s 20s and early 30s, one is often reaching the height of one’s raw analytical horsepower, when one can “see” (with the mind’s eye) and recall tremendous amounts of data about businesses. At this stage, young analysts develop a fluency in accounting — the language of investing — by working to understand the financial mechanics of businesses. In the process, young analysts begin to develop pattern recognition for good businesses with resilient balance sheets, high capital efficiency, high cash conversion, flexible cost structures, etc., and bad businesses with vulnerable balance sheets and fragile business models.
As analysts continue to progress in their development, they begin to appreciate that not all valuable assets of a business are reported on accounting balance sheets. For example, the brand recognition, habitual consumption and global distribution reach of Coca-Cola are worth a lot more than its property, plant, and equipment. These analysts also begin to understand that accounting earnings do not always reflect the true economics of a business model. For example, The Berkshire Hathaway Reinsurance Group produces more cash flow than it produces earnings because of the float it generates.
Over time, analysts that do the work begin to appreciate the power of intangible moats. Such analysts begin to recognize the true outliers, that is, exceptional businesses that buck the trend of particular industries; for example, the rare retailer that sustainably makes supernormal profits, the atypical industrial supplier that sustainably commands high margins, or the uncommon software company that benefits from low industry clock speeds. As analysts continue to mature and as fluid intelligence becomes crystallized intelligence, they begin to appreciate the incorporeal elements that make a big difference, including incentives, leadership, culture, and values.
We believe that there is no shortcut for this process. A Grahamite foundation is a feature, not a bug, in the education and makeup of a value investor. One cannot reasonably expect to be able to spot exceptional companies if one has not yet sufficiently studied the economics (and accounting) of average businesses to establish the base rate by which to recognize exceptionalism.
Without being fluent in the languages of accounting and microeconomics, analysts are unable to process narratives as descriptors of real-world phenomena that can be independently tested. Thus, it may be the case that many outstanding companies are led by driven, out-of-the-box-thinking, larger-than-life owner-operators that seek to upend or disrupt existing industry structures, but how many failed companies are also led by such personalities? Which outcome is more likely? When base rates are properly established, one typically finds that apparent “outliers” in short-term performance are more often the result of excessive risk taking, luck, or other confounding variables (e.g., monetary policy) that are not endogenous to a business. Genuine outliers are much rarer.
Our own observation is that many investors we respect — from Warren Buffett to Nick Sleep — have traveled on their evolutionary journeys with skills built on classical Grahamite foundations.3 Of course, what we are saying is not new; we are simply restating (less elegantly) Epitectus’ exhortation to “practice yourself, for heaven’s sake in little things, and then proceed to greater.”4
In modern times, Bob Knight wrote in his book, The Power of Negative Thinking,5 that:
“The greatest fundamentalists — in coaching, in warfare, in theology, in business — were and always have been more concerned about losing than about winning… Try putting together a game-winning touchdown drive if your linemen can’t go with the snap count and jump offside, if your backs haven’t mastered putting the ball away to avoid fumbling when hit, if your passer doesn’t check where the defense is as well as where his receivers are going, if the receiver doesn’t look the ball into his hands rather than glance upfield to see where he can go before he has made the catch… All of those teachings are steps toward playing not to lose, the prelude to being able to make the plays that win. There’s no chicken-and-egg question here. Fundamentals come first… Good things come to he who waits… If he works like hell while waiting.”
In his book A Lifetime of Observations and Reflections On and Off the Court,6 John Wooden agreed, writing that “many athletes have tremendous God-given gifts, but they don’t focus on the development of those gifts. Who are these individuals? You’ve never heard of them — and you never will. It’s true in sports and its true everywhere in life. Hard work is the difference. Very hard work.” Instead, the top traits he looks for are industriousness, enthusiasm, condition (mental, moral, and physical), fundamentals, team spirit, and attention to detail.
In his paper, “The Mundanity of Excellence,”7 sociologist Daniel Chambliss found that excellence at different levels of competitive swimming required qualitatively different levels of performance. Olympic swimmers don’t just train harder or work out more than collegiate-level swimmers; they swim differently. Moving up from one level of competition to the next often required fundamental changes to technique, discipline, and attitude. These changes sometimes require deconstructing existing swimming techniques and unlearning previous habits for training, competing, etc., and layering on new skills (e.g., anticipating the starting gun).
We agree with Chambliss. We still have a lot of wood to chop at Discerene if we are to become the investors we aspire to be. Some of the improvements we want to make may require reconstructing our mental models (including long-held ones), retooling our research methods and techniques (including how we ask questions and process information), and reexamining our biases and decision-making habits. We’ve been unafraid to continue to “do the work” on these fronts. Our Partners who’ve traveled with us on our investing journeys continue to witness our not-unforceful growth as investors over the years. We’ve been impatiently patient in this process.
At the end of the day, Chambliss found that excellence is often surprisingly mundane. Elite swimmers did many little things better, but they did not often possess anything extraordinary (e.g., extra lung capacity, etc.) that could be characterized as innate “talent.” We believe that this is also true in investing. Successful investors do not need to have superhuman IQ or EQ, though both may help. We believe that becoming a world-class investor ultimately involves getting good at all the many little things — and fashioning a world-class enterprise accumulating all those little advantages — that together constitute mastery of the craft.8
Nonetheless, in the current age of instant gratification, many whippersnapper stockpickers have sought to skip right past Ben Graham. They sprint, not walk, through their evolution to becoming (too) high-conviction investors swinging hard at “fat pitches” and “multi-baggers.” Predictably, without classical training and proper form, such wild swinging seldom ends well, especially given the non-ergodicity of the investing endeavor.
At Discerene, we prefer to be hardworking, patient marathon runners rather than sprinters. We are careful to build our investing skills on classical foundations. Each year, we continue to develop our empirical datasets and knowledge base of businesses, sharpen our analytical toolkits, expand our mental models, reinforce our psychological conditioning, and hone our judgment. In our second decade as a team, we hope that we have sufficiently worked at our craft to be half-decent at what we do, but we have an insistent and insatiable drive to keep getting better. We believe that this continuous improvement increases the likelihood of achieving satisfactory long-term investment outcomes.
1. See, e.g., Lev and Gu(2016), The End of Accounting and the Path Forward for Investors and Managers, Wiley Finance.
2. To quote an analyst describing his investment philosophy to us.
3. Classical training like wise underpins/underpinned the work of Impressionist painters, atonal composers, jazz musicians, and contemporary dancers.
4. Epitectus (108 AD), Discourses, Book I, Chapter 18.
5. Knight and Hamel (2013), Amazon Publishing.
6. Wooden (1997), Contemporary Books.
7. Chambliss (1989), “The Mundanity of Excellence: An Ethnographic Report on Stratification and Olympic Swimmers,” Sociological Theory Volume 7:1, pages 70-105.
8. See, e.g., https://www.youtube.com/shorts/8d8lIpvc1Jo. See also Lane (2012), 10,000 Hours: Become What You Practice, CreateSpace Independent Publishing Platform; Duckworth (2016), Grit: The Power of Passion and Perseverance, Scribner.