Last summer I decided that it was time for me to read all of the Berkshire shareholder letters. Defining oneself as a value investor, not having read these letters is like being a Christian not having read the Bible. While reading all the Berkshire letters and rereading Poor Charlie’s Almanack at the same time I could honestly say that I was on the brink of drifting towards the modern school of value investing. Still to this day, I agree on almost all of Buffett and Munger’s points of argument as it relates to the advantages of the modern value investing style and their rationale for leaving the classic school of value investing. But after countless days of thinking and evaluating a possible change, I came to the conclusion that a modern value investing approach would be too hard for me to successfully implement.
Both Buffett and Munger are famous for the too-hard-pile analogy as it relates to individual investment ideas. I would argue that the same analogy can be applied to investing philosophies in general and their implementation. Placing an investment idea in the too-hard-pile is a subjective dependent evaluation and the same is true for the evaluation of an investing philosophy as a whole. In the same way as one has to have an understanding and conviction in the ideas that one invests in, one has to have an even deeper understanding and conviction in the philosophy that one subscribe to and applies. In the end, this has to do with the ability to successfully “stick to your knitting” in both good and bad times. Not having an understanding and conviction in your investing philosophy will bring out the worst enemy of them all. You.
The investor’s chief problem – and even his worst enemy – is likely to be himself. – B. Graham
Even though I was not transformed in the same way that Buffett once was by Munger’s insights I will without hesitation say that reading the Berkshire shareholder letters and Poor Charlie’s Almanack is one of the best investments I have made. As you will see below, there are principles at the core of the manifesto inspired by Buffett and Munger. These were the seeds to the Investment Manifesto and has since then evolved into its absolute foundation.
Sound investment principles produce generally sound investment results – B. Graham
As it relates to Graham’s quote above I would like to use the famous Munger expression:
I have nothing to add. – C. Munger
Therefore, I thought I would go straight to the point of presenting the four core principles of my Investment Manifesto (if you have read Poor Charlie’s Almanack you will recognize them):
1. Preparation. Continuously work on investment idea generation and the accumulation of worldly wisdom.
Opportunity meeting the prepared mind: that’s the game. – C. Munger
2. Discipline. Stay within the boundaries of the Investment Manifesto.
You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital. – W. Buffett
3. Patience. Be selective and cautious in the buying- and selling process.
Resist the natural human bias to act. – C. Munger
4. Decisiveness. Believe in the Investment Manifesto and execute accordingly.
When proper circumstances present themselves, act with decisiveness and conviction. – Poor Charlie’s Almanack
The Exclusion Process
Beyond the investment principles, but still at the core of the Investment Manifesto, lies a focus on the concept of margin of safety. As an analytical tool, margin of safety sorts out those companies that one shouldn’t allow oneself to invest in. In a sense, the margin of safety concept is an exclusion process. A negative screen to sort out companies that one can’t satisfactorily determine their downside protection. Those companies get excluded and automatically put in the too-hard-pile. Thinking about investing, at least initially, as a negative art (i.e. what you shouldn’t want to own) is an underappreciated insight in my opinion. This is based on a belief that risk- (i.e. permanent loss of capital) control should be the number one priority for all investors.
Rule No.1: Never lose money. Rule No.2: Never forget rule No.1. – W. Buffett
The reason for that being:
In order to succeed, you must first survive. – N. Taleb
Margin of Safety
The concept of margin of safety was first developed by Benjamin Graham and David Dodd in the classic value investing book Security Analysis (first published in 1934). However, I think most investors that are familiar with the concept relate it to the 1949 book by Graham, The Intelligent Investor, and more specifically the last chapter in that book “Margin of safety as the Central Concept of Investment”. As most of you will know, margin of safety is a wide concept and one that has been defined in a variety of ways by Graham himself and many others since the books first publications. There is nothing strange or wrong with that. To the contrary, I would say that it is both natural and needed considering the variety of investing philosophies in existence and more specifically how one defines the concepts of value and risk. However, I would argue that the purpose of margin of safety is a universal one that all can ascribe to. That purpose was best defined in the original text of The Intelligent Investor:
It’s available for absorbing the effect of miscalculations or worse-than-average luck. – B. Graham
Based on the margin of safety purpose I can narrow in on my definition of margin of safety. Note that what I present below is my definition of margin of safety, not a universal one. I would strongly suggest that one goes through the same thought process as I present below in order to come up with a definition that you are comfortable with. In order to make the starting point of this margin of safety definition process a little bit less vague consider the following excerpt from Poor Charlie’s Almanack:
Why should we want to play a competitive game in a field where no advantage – maybe a disadvantage – instead of in a field where we have a clear advantage?
We’ve never eliminated the difficulty of that problem. And ninety-eight percent of the time, out attitude toward the market is … [that] we’re agnostics. We don’t know […]
We’re always looking for something where we think we have an insight which gives us a big statistical advantage. And sometimes it comes from psychology, but often it comes from something else. And we only find a few – maybe one or two a year. We have no system for having automatic good judgement on all investment decisions that can be made. Ours is totally different system.
We just look for no-brainer decisions. As Buffett and I say over and over again, we don’t leap seven-foot fences. Instead, we look for one-foot fences with big rewards on the other side. So we’ve succeeded by making the world easy for ourselves, not by solving hard problems. – C. Munger
In other words, your margin of safety definition should start by focusing on what you define as “no-brainer decisions” or “one-foot fences” to hurdle over and where you believe that you have a “big statistical advantage”. The outcome of that evaluation will allow you to invest in ideas where the purpose of the margin of safety will most likely be fulfilled. Essentially, your task is to figure out where you should fish:
There’s a rule of fishing that’s a very good rule. The first rule of fishing is “fish where the fish are,” and the second rule of fishing is “don’t forget rule number one.” And in investing it’s the same thing. Some places have lots of fish, and you don’t have to be that good a fisherman to do pretty well. Other places are so heavily fished that no matter how good a fisherman you are, you aren’t going to do very well. – C. Munger
My Margin of Safety Definition
Based on an evaluation of my investment beliefs, my accumulated investing knowledge and my emotional composition I have developed my margin of safety definition. This definition is based on the following four criteria:
1) Selling below liquidation value (i.e. price below readily ascertainable net asset value)
2) Proven business model (i.e. historically profitable company)
3) Sound financial position (i.e. low risk of bankruptcy)
4) Responsible management (i.e non-fraudulent management with a reasonable track record as operators, investors and financiers)
The population of companies that remain after this exclusion process I call the Liquidation Oxymoron’s. The rationale for that name is that each of those companies will fit the following oxymoronic description:
A going concern selling below liquidation value.
Or with a little bit more nuance and color added to the oxymoronic description:
A company that is worth more dead than alive (i.e. selling below liquidation value) although it’s very much alive (i.e. going concern).
In Part II of the Investment Manifesto I will focus on the Inclusion Process. This will include my thoughts and reasoning for focusing on Upside potential, Catalysts, and Other Factors and Characteristics for the Liquidation Oxymorons.