My Investing Notebook

Joel Greenblatt examines at investing behavior and why you're not as smart as you think you are

2012-01-20T21:46:00.000-08:00

Gotham Asset Management managing partner and Columbia professor Joel Greenblatt explains why investors who 'self-managed' his Magic Formula using pre-approved stocks underperformed the professionally managed systematic accounts.

1. Self-managed investors avoided buying many of the biggest winners.

How? Well, the market prices certain businesses cheaply for reasons that are usually very well known. Whether you read the newspaper or follow the news in some other way, you’ll usually know what’s “wrong” with most stocks that appear at the top of the magic formula list. That’s part of the reason they’re available cheap in the first place! Most likely, the near future for a company might not look quite as bright as the recent past or there’s a great deal of uncertainty about the company for one reason or another. Buying stocks that appear cheap relative to trailing measures of cash flow or other measures (even if they’re still “good” businesses that earn high returns on capital), usually means you’re buying companies that are out of favor. These types of companies are systematically avoided by both individuals and institutional investors. Most people and especially professional managers want to make money now. A company that may face short term issues isn’t where most investors look for near term profits. Many self-managed investors just eliminate companies from the list that they just know from reading the newspaper face a near term problem or some uncertainty. But many of these companies turn out to be the biggest future winners.

2. Many self-managed investors changed their game plan after the strategy underperformed for a period of time.

Many self-managed investors got discouraged after the magic formula strategy underperformed the market for a period of time and simply sold stocks without replacing them, held more cash, and/or stopped updating the strategy on a periodic basis. It’s hard to stick with a strategy that’s not working for a little while. The best performing mutual fund for the decade of the 2000’s actually earned over 18% per year over a decade where the popular market averages were essentially flat. However, because of the capital movements of investors who bailed out during periods after the fund had underperformed for awhile, the average investor (weighted by dollars invested) actually turned that 18% annual gain into an 11% LOSS per year during the same 10 year period.[2]

3. Many self-managed investors changed their game plan after the market and their self-managed portfolio declined (regardless of whether the self-managed strategy was outperforming or underperforming a declining market).

This is a similar story to #2 above. Investors don’t like to lose money. Beating the market by losing less than the market isn’t that comforting. Many self-managed investors sold stocks without replacing them, held more cash, and/or stopped updating the strategy on a periodic basis after the markets and their portfolio declined for a period of time. It didn’t matter whether the strategy was outperforming or underperforming over this same period. Investors in that best performing mutual fund of the decade that I mentioned above likely withdrew money after the fund declined regardless of whether it was outperforming a declining market during that same period.

4. Many self-managed investors bought more AFTER good periods of performance.

You get the idea. Most investors sell right AFTER bad performance and buy right AFTER good performance. This is a great way to lower long term investment returns.

So, is there any good news from this analysis of “self-managed” vs. “professionally managed” accounts? (Other than, of course, learning what mistakes NOT to make—which is pretty darn important!) Well, I can share two observations that are, at the very least, fun to think about:

First, most clients ended up asking Formula Investing to “just do it for me” and selected “professionally managed” accounts with over 90% of clients choosing this option. Perhaps most individual investors actually know what’s best after all!

Second, the best performing “self-managed” account didn’t actually do anything. What I mean is that after the initial account was opened, the client bought stocks from the list and never touched them again for the entire two year period. That strategy of doing NOTHING outperformed all other “self-managed” accounts. I don’t know if that’s good news, but I like the message it appears to send—simply, when it comes to long-term investing, doing “less” is often “more”. Well, good work if you can get it, anyway.

Retiring CEO of Costco takes a look back on his legacy

2012-01-20T21:43:00.000-08:00

Jim Sinegal

Q: As you look back, are there any things you'd do differently? Any big mistakes?

A: Listen, you haven't got enough space in your paper to print all the errors we've made. But what we like to say is that we're not going to make that same mistake five times.

We decided one time that we were going to get into the home-improvement business. We decided we were going to have a paint department. Most people who have paint have a thousand, two thousand colors. We had four, and three of them were white. The customers yawned and moved on. We learned from that.

We went into the Midwest [Minneapolis and Milwaukee] years and years ago, and we failed. Failure is a very painful process. We had to close those units and we exited the market in as good a position as we could. We offered every employee in our company a job to move with us someplace else. [His assistant, Karen Paulsell, was one of them.] We made sure every supplier was taken care of and paid in full. We refunded every dollar of membership. Even if somebody had been a member for 11 months and their membership was just about to expire anyway, we still gave them the full $25, which was the membership fee at that time.

Greenlight Capital 2011 Letter

2012-01-18T15:46:00.000-08:00

See below.

Related

David Einhorn's Presentation at the Oct 2011 Value Investing Congress
An inside look at David Einhorn’s “big short”
Greenlight Capital Q3 2011
Greenlight Capital Q2 2011

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Ackman and CP: The e-mail that started it all

2012-01-15T07:03:00.000-08:00

From: William A. Ackman
Sent: Tuesday, January 03, 2012 01:30 PM
To: John Cleghorn
Subject: Your letter

John,

Shortly, I will be sending a letter in response to yours which I will publicize shortly thereafter. I would have preferred not to have done so, but in light of your letter I had to set the record straight.

Hopefully, we can move on from public letters to return to a one-on-one dialogue. To that end, I would like to speak to you at your convenience sometime this afternoon if that works for you.

Sincerely,

---------

The following exchange of e-mails began the morning after that message was sent.

From: William A. Ackman
Sent: Wednesday, January 04, 2012 7:22 AM
To: John Cleghorn
Subject: War and Peace

John,

I woke up early this morning thinking about my favorite Canadian railroad and it is causing me to become more interested in military history. We have had what the historians would likely call a border skirmish. It is not clear who fired the first shot, but a few people have been hurt, some egos have been bruised, and the arms dealers (the media) are calling for and attempting to gin up a fight. They of course sell more papers if a fight occurs so their motives are clear.

When a border skirmish takes place, sometimes it leads to full out war and other times, things die down, borders are redrawn and peace can remain in both lands.

The choices from here as I see them are (1) representatives from our side and your side sit down and work this out promptly. Working it out, in my view, is the quick addition to the board of two representatives from our side, and Hunter's hiring as CEO. The second alternative is that we will be forced to launch a proxy contest for the upcoming annual meeting where we will seek to replace a greater number of the existing directors with extremely highly regarded business executives who share our belief that management and board change is necessary at CP.

In the proxy contest, as a first step, we will take the largest public hall you have available in Toronto and will make a presentation to shareholders and the public (which will be simulcast on the Internet) about management and board failure over the last 10 years at CP. We will examine management's and the board's track record and history in CP and in previous career experiences. Among other issues, we will go into detail on the real reasons behind Ed Harris's departure and compare it with what the company said publicly at the time. While we will only do this in the most high-minded manner possible - we will not make any ad hominem attacks on anyone - the process is inherently an uncomfortable one for all parties involved. It is all also expensive in time and money and a distraction for management, particularly at a time when their focus is needed on operations (most importantly, when it is snowing or flooding).

This proxy contest will not go well for the board and Fred. The track record is very poor, shareholders are disgruntled, and we are offering an alternative with a legendary reputation. An analyst at Morgan Stanley, your advisor in this matter, is now writing of a "super-bull" case if Hunter is hired. I have attached a copy of the report to this email. We will win the election likely by a landslide vote. Don't rely on my opinion on this, just ask your proxy advisors.

Based on yesterday and my not receiving a return call from you, the probability of war occurring has gone up meaningfully. War is not my preference and it has been extremely rare for us. We have had only two proxy contests in 25 or so active engagements with public companies over the last eight years.

War is also not inevitable.

I think the failures so far have been largely ones of communication. As a result, I think it is useful to review why we are where we are. When we first met, I explained to you the importance of resolving things quickly and getting on the same page as quickly as possible. We were delighted with the way our first meeting ended. After pulling me off the plane, you explained to me that "Fred agrees with the logic of your presentation" and clearly implied that he was prepared to step down. You explained that his principal motive for allowing Hunter to replace him was to get back at Canadian National because he hates them so much. You then said, "Welcome to Canadian Pacific!" and shook my hand in a warm embrace. You told me that you had a board call set for the following day and that you would get back to me no later than Friday morning, but probably earlier on Thursday.

We viewed the meeting positively, largely because often the biggest barrier to replacing a failed CEO is the CEO himself. With Fred apparently on board with the plan and with your welcome, I believed we were well on our way.

Things began to go awry when you did not call me on Thursday or Friday. When we finally spoke on Saturday as a result of my reaching out to you, things apparently had changed meaningfully since our Wednesday meeting. On the call, you asked me to arrange a meeting with Hunter that Kathryn McQuade would attend. When I explained that I thought it was inappropriate for a CEO candidate to meet with the CFO of the company rather than the full board who should be doing the job of hiring the CEO, you told me that the board did not have a lot of railroad industry expertise and that Kathryn could help the board evaluate Hunter's plan for turning around CP. I then explained that even if the board were willing to meet with Hunter we did not believe he could do so in light of constraints in his non-compete arrangement. You then asked me to have our counsel speak with yours about the non-compete agreement.

In light of the necessary delay in meeting Hunter, I then suggested that the best approach would be to get Paul Hilal and myself on the board right away so we could assist the board in the management decision. You expressed surprise that we were interested in board seats. When I reminded you that we had requested "a couple of board seats" at our Wednesday meeting, you said that you had no recollection of that request. When I reminded you that at the meeting, I had given the JC Penney analogy where two of our representatives were invited to join the board without being required to sign a standstill, and we then worked with the board in private to recruit a new CEO, you seemed to remember that, but not a specific request for board seats. I then reiterated the request for board seats. You explained that you would have to talk the board about that.

Two weeks or so passed without a communication from you. I called to find out when we would have an opportunity to meet with the board. You then explained that while you were recommending that the board meet with us to consider our candidacy, you would not be able to hear whether the board would be willing to do so until after Thanksgiving because of travel schedules. On the Friday after Thanksgiving, you called and said that nominating committee would be willing to meet and that the lawyers should talk to schedule such a meeting.

Your side proposed December 11th, Sunday night, in Calgary and we flew there for the meeting. While I very much enjoyed meeting the directors and thought I could work well with them on the board, I took it quite negatively that the committee was unwilling to meet with my proposed director, trusted partner and good friend Paul Hilal particularly in light of the fact that he left his newly born baby girl and beautiful wife to travel a fair distance on a Sunday night. I also felt that you were perhaps attempting to run out the clock on us. I didn't completely understand the Canadian proxy rules at the time, and had been erroneously told that we had to file proxy materials shortly. When I learned that we could file materials up to nearly the day of the meeting, it took some of the time pressure off.

While I was happy to hear from you later that the board had unanimously approved my nomination, I told you that I was disappointed you would not consider Paul as a director. You explained that Paul was not a CEO, that I was 'the man' at Pershing Square, and as such the board would not consider him. You also told me that the board had appointed two other directors with railroad industry expertise and that you would ideally like to announce us together in one coordinated press release. You then told me that the lawyers would talk about customary arrangements. When I asked what you meant by that, you explained that the company would like to review confidential information with me that would help me understand the company's business performance and that I would have to sign a confidentiality agreement. I asked whether the other directors had signed such a document and you told me they had done so. You encouraged me to let the lawyers handle it.

When the document finally arrived a day or so before I left town for holiday, it was clear that it was a standstill arrangement rather than a confidentiality agreement. I was disappointed by the proposed agreement principally because I had explained at our very first meeting how we were able to work with the board in the JC Penney situation without signing a standstill, and I had expressed both through our counsel and to you directly that we would not sign such an arrangement.

Two months have passed. We are still left out in the cold. I have been accused by you in a public letter of making false and misleading statements. We are not in a great place.

In order to improve communication, you and I need to speak more often. If you don't like dealing with me, I am happy to speak with someone else on the board. The fact that you have been unwilling to give me your contact information doesn't send a good message about your desire and interest in working with me (the only numbers I have are from times that you called me on my cell phone and the number was listed). Alternatively, in cases like this, most companies set up a special committee tasked with working with us. One of the biggest issues we have had is that weeks go by between communications, perhaps because you need to poll all of your directors every time a decision needs to be made. From our side, it appears that you are delaying responding, and perhaps it is simply the logistics of getting the board together. If you could designate a small committee of directors who have the time to be responsive to this matter, it would be a good idea in my view. I encourage you to ask your advisors about this.

My impression of you when we first met was quite favorable. You seem like a solid, good man. I would like to resolve this situation amicably in the best interest of shareholders as I am sure you would.

To throw out alternative ideas, I am open to not serving on the board as long as I am comfortable that we are adequately represented by directors that we designate (that of course you have to approve) and we are comfortable with the composition of the rest of the board.

Let's avoid having a border skirmish turn into a nuclear winter. Life is too short.

Please call me when you can.

Sincerely,

Bill

--------

From: John Cleghorn
Sent: Wednesday, January 04, 2012 05:47 PM
To: William A. Ackman
Subject: CP

Bill,

Thank you for your email and for your phone message. Let me reiterate that we would like to reach an agreement which advances the best interests of the company. As you will appreciate, I will be discussing your email with my board.

Best regards,

John

--------

From: William A. Ackman
Sent: Wednesday, January 04, 2012 05:58 PM
To: 'john.cleghorn@sympatico.ca'

Subject: Re: CP

John,

I greatly appreciate your email. I shared the email with my colleagues after I sent it and they said that it may be perceived as overly blunt by you.

When we met, I promised to be extremely straightforward and you promised the same. I hope I did not offend with my directness and I apologize if I did so.

Please also note that I am not talking to the press and that a business story that appeared this afternoon on BNN sourced from 'a source close to the action' was not me or anyone else affiliated with Pershing Square. I don't have any intention of speaking to the press unless and until we are unable to resolve this matter.

I look forward to hearing from you.

Sincerely,

Bill

Standard & Poors 2012 S&P 500 Guide

2012-01-08T07:07:00.000-08:00

For those looking for a modern version of the old Moody's Manual, the S&P 500 2012 Guide might do the trick (although it only covers S&P 500 companies).

Here is what you can expect:

Buy a copy here

The most interesting business book of 2011

2012-01-04T20:43:00.000-08:00

"Read Good Strategy/Bad Strategy for the entertaining experiences of a man who has spent 40 years in the strategy business. But read it principally for its profound yet common sense approach to business." — John Kay

...Another sign of bad strategy is fuzzy strategic objectives. One form this problem can take is a scrambled mess of things to accomplish—a dog’s dinner of goals. A long list of things to do, often mislabeled as strategies or objectives, is not a strategy. It is just a list of things to do. Such lists usually grow out of planning meetings in which a wide variety of stakeholders suggest things they would like to see accomplished. Rather than focus on a few important items, the group sweeps the whole day’s collection into the strategic plan. Then, in recognition that it is a dog’s dinner, the label “long term” is added, implying that none of these things need be done today. As a vivid example, I recently had the chance to discuss strategy with the mayor of a small city in the Pacific Northwest. His planning committee’s strategic plan contained 47 strategies and 178 action items. Action item number 122 was “create a strategic plan.”

A second type of weak strategic objective is one that is “blue sky”—typically a simple restatement of the desired state of affairs or of the challenge. It skips over the annoying fact that no one has a clue as to how to get there. A leader may successfully identify the key challenge and propose an overall approach to dealing with the challenge. But if the consequent strategic objectives are just as difficult to meet as the original challenge, the strategy has added little value.

Good strategy, in contrast, works by focusing energy and resources on one, or a very few, pivotal objectives whose accomplishment will lead to a cascade of favorable outcomes. It also builds a bridge between the critical challenge at the heart of the strategy and action—between desire and immediate objectives that lie within grasp. Thus, the objectives that a good strategy sets stand a good chance of being accomplished, given existing resources and competencies.

And this tidbit from Rumelt:

A final hallmark of mediocrity and bad strategy is superficial abstraction—a flurry of fluff—designed to mask the absence of thought. Fluff is a restatement of the obvious, combined with a generous sprinkling of buzzwords that masquerade as expertise. Here is a quote from a major retail bank’s internal strategy memoranda: “Our fundamental strategy is one of customer-centric intermediation.” Intermediation means that the company accepts deposits and then lends out the money. In other words, it is a bank. The buzzphrase “customer centric” could mean that the bank competes by offering better terms and service, but an examination of its policies does not reveal any distinction in this regard. The phrase “customer-centric intermediation” is pure fluff. Remove the fluff and you learn that the bank’s fundamental strategy is being a bank.

Buy Good Strategy/Bad Strategy. Another good one is the Strategy Paradox.

Getting Interesting @ Canadian Pacific

2012-01-03T16:19:00.000-08:00

Ackman responds (below) to CP's letter.

Pershing_CP_Jan3_2012

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A Year of Me-Firsts, and of Lessons Relearned

2012-01-01T13:03:00.000-08:00

Gretchen Morgenson with some interesting thoughts:

...the very people our government had pushed to embrace the American dream of homeownership — minority groups, lower-income borrowers, immigrants and others previously shut out of the market — were the very people hurt the most by the foreclosure mess. Washington’s push to increase homeownership opened the door for companies to sell poisonous and tricky loans that have now imperiled many of the most vulnerable.

Ralcorp then and now

2011-12-30T10:10:00.000-08:00

In 2007, when Ralcorp acquired the Post cereal business from Kraft this is what they said:

The transaction will benefit the new Ralcorp in several important ways:

Creates a larger, stronger business with a portfolio of businesses balanced between branded, private-label and frozen bakery food products;

Increases 2007 sales by 50% to $3.3 billion a year from $2.2 billion, with Post cereals accounting for approximately 32% of total annual sales;

Enhances Food EBITDA margins by at least 500 basis points from 10.9% to 16.0% - 16.6%, resulting in pro forma combined 2007 Food EBITDA between $533 million and $553 million, an increase of approximately 120% to 128% over Ralcorp's reported results;

Increases earnings per share by $0.44 to $0.68 for pro forma fiscal 2008 as if the combination had been completed as of the beginning the fiscal year and before one-time costs associated with the transaction; and

Maintains a conservative leverage profile and generates substantial incremental free cash flow to fund investments, acquisitions and share repurchases.

"This is a transforming event for Ralcorp. The addition of Post cereals gives Ralcorp a truly distinctive line of branded cereal products plus a branded infrastructure and platform that we can build on through organic growth and acquisitions," said David P. Skarie, co-chief executive officer and president, Ralcorp Holdings, Inc., who oversees the company's Ralston Foods cereals and snacks and Carriage House businesses and who will be responsible for Post after the transaction is closed. Skarie added, "Ralcorp has substantial experience integrating acquisitions, having made 20 acquisitions in the past 10 years which increased annual sales by over $1.0 billion. We plan to utilize this same experience to facilitate the successful integration of Post. This transaction represents the next logical step in Ralcorp's history of growing sales and profits. Since 2001, Ralcorp's sales and Food EBITDA have increased an average of 11 and 14 percent per year, respectively."

Kevin J. Hunt, Ralcorp's co-chief executive officer and president who manages the Bremner, Nutcracker and frozen bakery businesses further added, "We have an established track record of growing platforms in the food business through acquisition and integration of other food companies. This merger will allow us to continue that growth strategy in a new branded platform as we continue to grow our existing private-label and frozen bakery platforms. The new company will have a strong balance sheet that will allow us to continue to make acquisitions and will allow for opportunistic share repurchases."

"Ralcorp is committed to achieving long-term growth and success with Post. We are confident that with Ralcorp's resources and support, our team will help this important branded business excel in the marketplace," said Skarie.

"The team will focus on the Post cereal brands and it will include Post's existing marketing and sales support team, which will continue to be headquartered in New Jersey, and its existing R&D team, which will continue to be located in Battle Creek, Michigan," Skarie added. "They will build a nationwide sales management and broker network devoted to the Post brands. In addition, the combination of Post's and Ralcorp's operations, purchasing and logistics networks will ensure a smooth transition and realizations of efficiencies."

Now, only 4 years later, this is what they have to say as they spinn-off Post:

Under the plan announced on July 14, 2011, Ralcorp intends to execute a tax-free spin-off of the Post cereal business to Ralcorp shareholders. Upon completion of the transaction, Ralcorp will continue to be the leading producer of private-brand foods and a major producer of foodservice products, and Post will be the third largest seller of ready-to-eat cereals in the U.S. Both companies are expected to benefit by operating as pure-play independent public companies with distinct financial profiles, capital structures appropriate for their respective businesses and their own equity currencies. Ralcorp will continue to trade on the New York Stock Exchange. Post has received approval for listing on the New York Stock Exchange, subject to completion of the separation.

Apple v. Google

2011-12-29T20:57:00.000-08:00

The rivalry explained in terms of Clayton Christensen's book The Innovator's Solution:

Modular architectures are often the solution when interdependent architectures prove too costly. Interdependent architectures are the solution when modular architectures are not good enough or can’t solve new jobs that users discover they need to solve.

Apple’s value systems, priorities and processes are all tuned to interdependent architectures. Google’s value systems, business models and competencies are all tuned to modular architectures.

Apple solves the problems of new markets, Google solve the problems of over-served markets.

So the winning strategy depends on detecting where a product lies in its march up the performance trajectory. Before it’s good enough, interdependent systems win. After it’s good enough, modular architecture wins.

Continue Reading

An inside look at David Einhorn’s “big short”

2011-12-27T16:26:00.000-08:00

REUTERS: Which of the issues you raised in your presentation do you believe Green Mountain has answered so that you would change them?

EINHORN: "Actually, I think everything we said in the presentation is as right now as it was then -- and in many cases even more so. Some of the things we pointed out, like the inexplicable sales of K-Cups in the June quarter, have now been revealed to have been very valid concerns and the rest remain unanswered. And some of them are things will have to sort of play out in the future like the competition."

REUTERS: Management says that fourth-quarter sales were hurt by wholesale orders, and do not indicate any accounting issues. In other words, you were right, but for the wrong reasons. Were you surprised by the earnings miss?

EINHORN: "The thing about an investment like this is that there are really a lot of ways for us to come out well because the risk-reward for the stock is so poor. And there are so many problems that they don't all have to hit at the same time in order for us to get a good result. In terms of what actually did cause them to miss the quarter? It was largely a sales miss, which seemed to follow from the unexplained sales spike that we highlighted in the presentation."

A list of books recommended by Charlie Munger

2011-12-26T11:12:00.000-08:00

Over 40 book recommendations by Charlie Munger.

Compensation: A model for other corporations?

2011-12-21T19:42:00.000-08:00

A model for other corporations: Stop delegating your responsibilities to compensation consultants and do your job.

The compensation committee is responsible for determining the compensation of the Company’s Chief Executive Officer and all of its other officers. In light of this straightforward responsibility, the compensation committee does not operate under a written charter. The compensation committee does not delegate its responsibilities. ... The compensation committee relies on its own good judgment in carrying out its duties and does not waste shareholder money on compensation consultants.

and..

The compensation committee believes the Management Incentive Plan is preferable to a conventional stock option plan. As a mechanism for compensation, a stock option plan is capricious, as individuals awarded options in a particular year would ultimately receive too much or too little compensation for reasons unrelated to their performance. Such variations could cause undesirable effects, as participants receive different results for options awarded in different years. In addition, a conventional stock option plan would fail to properly weigh the disadvantage to shareholders through dilution ...

Also check out the "Director Compensation".

from this proxy.

H/T Rational Walk

Daniel Kahneman: I will tell you a riddle

2011-12-19T19:10:00.000-08:00

Below is an excerpt from Daniel Kahneman's talk at the Legg Mason Capital Management's Thought Leader Forum 2011.

This was just before the release of Kahneman's new book Thinking, Fast and Slow, which is an excellent read.

I will tell you a riddle. It's better if I project it, but I think you can follow me. And anyway, you're not supposed to get it right, so it really doesn't matter. There is a town in which 85 percent of the cabs are green and 15 percent are blue. And there was a hit-and-run accident involving a cab at night, and there a witness. Conditions of visibility were so-so, and the witness basically said, "I'm 80 percent sure that it was a blue cab, one of the smaller company."

And people are asked, presented that problem, and they're asked what is your probability that the cab involved in the accident was blue. Hundreds of people have been asked this question, and the most frequent answer is 80 percent. You know, there was a witness there. He was tested, and actually, you know, we say that under the visibility conditions, he was 80 percent accurate when he said green or when he said blue.

They go with the witness. Actually, this is the wrong answer. The correct answer is slightly less than 50 percent that it's blue, because the base rate continues to be relevant. The number of cabs continues to be relevant. Very hard to see it. You don't see it. I'm not going to explain it now. I mean, some of you do, but that's because you studied base theorem somewhere else, but if you didn't have the mathematics, why not trust the witness.

Now, let me tell you a variation on that story, and all of you, I think, will immediately feel the difference. There are two cab companies in the city: 50 percent of the cabs are green and 50 percent of the cabs are blue. But 85 percent of the accidents involve green cabs. Now, there was a witness, and the rest of the story is the same. Do you feel the difference? Nobody wants to ignore the fact that 85 percent of the accidents are caused by green cabs. I mean, the drivers in that company must be insane. This is the way that people see it. You immediately infer a causal propensity. You make a causal inference from that statistic, and now that is used.

When people combine that with a witness, they get roughly the correct answer. So there is a real profound difference between the way our mind deals with arbitrary statistics and with causal stories. And sometimes statistics enable us to make a causal story, because, as in this case, you immediately felt that something must be wrong with the green drivers, and then you use it.

Continue Reading. Buy Kahneman's book.

Physics Envy

2011-12-16T05:22:00.000-08:00

Mr. Derman's particular thesis can be stated simply: Although financial models employ the mathematics and style of physics, they are fundamentally different from the models that science produces. Physical models can provide an accurate description of reality. Financial models, despite their mathematical sophistication, can at best provide a vast oversimplification of reality. In the universe of finance, the behavior of individuals determines value—and, as he says, "people change their minds."

In short, beware of physics envy. When we make models involving human beings, Mr. Derman notes, "we are trying to force the ugly stepsister's foot into Cinderella's pretty glass slipper. It doesn't fit without cutting off some of the essential parts." As the collapse of the subprime collateralized debt market in 2008 made clear, it is a terrible mistake to put too much faith in models purporting to value financial instruments. "In crises," Mr. Derman writes, "the behavior of people changes and normal models fail. While quantum electrodynamics is a genuine theory of all reality, financial models are only mediocre metaphors for a part of it."

Throughout "Models Behaving Badly," Mr. Derman treats us to vignettes from his interesting personal history, which gave him a front-row seat for more than one model's misbehavior. Growing up in Cape Town, South Africa, he witnessed the repressive and failed political model of apartheid. Later he became disillusioned with the utopian model of the kibbutz in Israel. He started out professionally in the 1970s as a theoretical physicist. He then migrated to the center of the financial world in the 1980s, using a mix of mathematics and statistics to value securities for the trading desk at Goldman Sachs in New York. He had hoped to use the methods of physics to build a grand, unified theory of security pricing. After 20 years on Wall Street, even before the meltdown, he became a disbeliever.

Read the review. You can buy the book here.

(Transcript) A Conversation with Charlie Munger @ U Michigan 2010

2011-12-11T07:15:00.000-08:00

In 2010 Charlie Munger and Becky Quick had a 2 hour conversation at the University of Michigan. While the video was great (and freely available online), I wanted a transcript. There is something about reading that I like better than watching and didn't want to risk anyone deleting the video online and having 2 hours of classic Charlie lost forever.

Don't miss out and purchase a copy today for $19.99

What you should know:

The transcript is 16,165 words.
There are a few places that were indecipherable.
As with other transcripts I've done, I've made the price really low so that everyone can afford a copy. By purchasing a copy you agree not to share it.
The PDF does not allow copying-and-pasting and contains a light watermark.
I'll send you an email with your personal PDF copy within 24 hours.

Disclaimer
The content of the transcript is intended solely for the entertainment of the reader.

Related:
A Complete morning With Charlie Transcript from the 'last WESCO' meeting.

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Interesting Times

2011-12-08T08:24:00.000-08:00

In light of Warren Buffett's (Berkshire Hathaway's) investment in IBM, I thought this was interesting.

"If I studied IBM or General Motors intensely for a year, I'd know more about them in a superficial sense but I still wouldn't know enough to make an intelligent decision."

—Buffett (@Stanford Law School, March 23, 1990).

A list of lists for book lovers

2011-12-07T05:50:00.000-08:00

If you're still looking for the perfect gift for that book lover on your list, start here:

Five Must-Reads for Tackling Complex Problems

Farnam Street's Behavioral Economics Reading List

The 10 Best Books of 2011 from the NYT

What books influenced Steve Jobs

What is Bill Gates Reading

Five Book recommendations from Dan Ariely on Behavioural Economics

Greg Mankiw Recommends Reading These 18 Economics Books

6 Must-Read Books To Help Navigate the Workplace

What are the most stolen books from bookstores?

5 Books to Improve your Memory

2011 Pulitzer Prize Winners

What is the best book that most people don’t know about?

Seminal Books For Each Decade

Best Economics books of 2011

Amazon’s 10 Best Books of 2011

Amazon’s 10 Best Books of 2010

strategy+business publishes the best business book from each year that they thought was most significant

Business Book of the Year 2011

What have top policy people been reading?

Lewis Lapham’s revolutionary reading list

Bill Gates Picks 4 Reads That Bring Clarity and Solutions to Energy Issues

How does a bubble take place?

2011-12-06T16:09:00.000-08:00

Smith: Right now, we don’t understand why people get caught up in self-reinforcing expectations of rising prices. The first time you’re in this experiment, you may have bought early and you may have sold before the break. Bring those same people back in another two or three days, put them in the same environment, and we get a lower-volume bubble. Typically, it booms earlier and crashes earlier; they are expecting a bubble. Bring them back a third time, and they tend to trade fairly close to fundamental value.

reason: How does this type of experiment map onto, say, the last five years in America?

Smith: If you think about the housing bubble, buyers, sellers, borrowers, lenders, real estate agents, government regulators—everybody believed that prices would rise and continue to rise. And that is the essence of a bubble. Suppose a regulator in 2003 or 2004 said, “Hey, this thing is not sustainable. We’ve got to do something to stop it.” I think he’d have been fired. If the bubble had been stopped in 2003 or 2004, it probably would have been a lot less damaging. But who’s going to know that?

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The Best Economics Books of 2011

2011-12-04T09:48:00.000-08:00

From Tyler Cowen (and Me.)

Best behavioral economics books of the year, Daniel Kahneman, Thinking, Fast and Slow, and Bryan Caplan, Selfish Reasons to Have More Kids.

Best economic history book, Alexander Field, A Great Leap Forward: 1930s Depression and U.S. Economic Growth. (and The Institutional Revolution: Measurement and the Economic Emergence of the Modern World).

Best eBook of the year, Erik Brynjolfsson and Andrew McAfee, Race Against the Machine: How the Digital Revolution is Accelerating Innovation, Driving Productivity, and Irreversibly Transforming Employment and the Economy.

Best economics/business book of the year (by far): Tim Harford’s Adapt.

Best Austrian or Austrian-influenced book of the year: Daniel B. Klein, Knowledge and Coordination: A Liberal Interpretation. It’s not out yet, but you should pre-order it.

Didn't find anything that seemed interesting? Try
Business books of the decade
The Business Book of the Year
What have top policy people been reading?

source

Bad Deals Aren't Illegal

2011-12-04T06:16:00.000-08:00

But bad deals, even really bad deals like Citigroup’s, aren’t illegal. They’re not criminal. They’re not inherently fraudulent. If Citigroup’s clients, all of them sophisticated institutional investors, were foolish or careless enough to buy what Citigroup sold them, then arguably they deserved their losses. Their remedy, presumably, would be never to do business with Citigroup again.

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Ackman vs. Icahn: Two Wall Street Titans, and a Seven-Year Tiff

2011-11-27T07:54:00.001-08:00

This battle, it turns out, was more about big egos than big money — and it has left both men spitting expletives. The scrape finally ended this month, with Mr. Ackman victorious. But, before it was over, the affair occupied a Who’s Who of powerful lawyers and ran up millions of dollars in legal fees, all because of an otherwise forgettable deal the pair cut back in 2004.

“The guy is a shakedown artist,” Mr. Ackman sneers. “His word is worthless.”

Mr. Icahn says: “He’s now the young gunfighter who wants to show he beat the older gunfighter with a big reputation. He just likes pounding himself on the chest.”

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Charlie Rose interviews Seth Klarman

2011-11-26T04:06:00.000-08:00

Charlie Rose interviews Seth Klarman (Nov. 1, 2011)

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The Manual of Ideas Interview with Guy Spier

2011-11-23T17:17:00.000-08:00

Great interview with Guy Spier.

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H/T Value Investing World

Bill Ackman - Pershing Square 3Q 2011 Shareholder Letter

2011-11-22T16:26:00.000-08:00

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PDF

H/T dealbreaker