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INVESTING: FROM BEN GRAHAM TO PHIL FISHER TO… MICHELANGELO?

Eliminating Stocks Is as Useful to Bottom-Up Investing as Selecting Them

Like many fundamental (serious) investors, my early influencers were Philip Fisher and Benjamin Graham.  Fisher was perhaps the best-known advocate and practitioner of growth-stock investing, while Graham was one of the pioneers of financial analysis, known as the “pope” of value investing.

It could be said that growth investors are looking for the next Microsoft, Apple, Google or Amazon. In contrast, value investors look for neglected stocks that are so cheap that bad news won’t hurt them much, while any good news could trigger a major upward re-evaluation.

 Intellectually, the first approach is more enjoyable: imagination and creativity are at work, and the ego is boosted by the participation in major emerging trends or technologies. The future and the narrative are very important. The other (value) approach is based on horse sense and statistics. It is more critical, almost cynical, and is focused on the concrete past and present: “If I can’t touch it, it does not exist.”

Both approaches, however, seek the same result: to uncover and analyze winning stocks.

Financial Analysis Is Not a Static Discipline

Over time, financial analysis has evolved. Until the 1980s, computers and databases were scarce and systematic screening of stock universes was cumbersome. It was hard to come by specialized information. Discovery of investment “pearls” required extensive search, and legwork was an important source of understanding for analysts. By the 1990s, especially after the spread of the Internet, information became plentiful — in fact superabundant. One can now scan thousands of companies in minutes to find those with good balance sheets, low price/earnings ratios, high growth rates, etc.

I suspect that it is the first phase of that evolution that led legendary investor Warren Buffett to progressively shift from the strict value philosophy of his early mentor Ben Graham to one closer to the growth approach of Phil Fisher. Buffett used to say he wanted to buy shares of companies any idiot could run because sooner or later, one would. Also, his early value philosophy implies selling when a stock becomes significantly overvalued, but he now seems to prefer companies with superior management, whose shares he would prefer to hold forever.

Adding Principles to Technique

Besides these early influences on my investing career, I have progressively adopted, along the way, a few nuggets of wisdom from more recent thinkers and practitioners. These do not so much add to one’s technical skills as provide a philosophical framework for using these skills in a thoughtful manner.

One of my favorite sources of investment thinking is Howard Marks, prolific writer and co-founder of Oaktree Capital Management. Among his advice, gleaned from his famous memos to clients and his book (The Most Important Thing – Columbia University Press – 2011), I have selected some golden rules that are worth reflecting on.

Vive la Différence!

 First, Marks reminds us that investors’ results will be determined more by how many losers they have, and how bad those are, than by the greatness of their winners. Since we will all make some mistakes, he also points out that “You can’t predict [but] you can prepare,” which I believe is a great way to remind us that investing is neither a science nor an all-or-nothing game.

Then, he gets into the goal of investing, which is not to earn average returns: “You want to do better than average. You must think of something [others] haven’t thought of, see things they miss or bring insight they don’t possess… which by definition means your thinking has to be different.”

But being different takes character: “Do you dare to be different? Do you dare to be wrong? And do you dare to look wrong? [My italics] Because you have to dare to be all three of those in order to have a shot at great results.”

Climbing the Levels of Thought

The majority of investors are first-level thinkers: They think the same way as other first-level thinkers, do basically the same things, and they generally reach the same conclusions. But all investors can’t beat the market since, collectively, they are the market. To get better-than-average results, you have to invest differently than the market.

The way to think differently, according to Marks, is to become a second-level thinker because “If something seems simple or obvious, there’s a good chance everyone else is thinking the same thing. And if they’re thinking the same obvious thing, then it’s probably already reflected market prices.

First-level thinking is simplistic and superficial, and just about everyone can do it. All the first-level thinker needs is an opinion about the future, as in, “the outlook for a company is favorable, meaning the stock will go up.” Second-level thinking is deep, complex, and convoluted. For example (paraphrasing Marks):

First-level thinking says, “It’s a good company; let’s buy the stock.” Second-level thinking says, “Yes, it’s a good company. But everyone thinks it’s a great company, and it’s not. So, the stock’s overrated and overpriced; let’s sell.”

Ultimately, it is the abundance of first-level thinking that creates the opportunities for second-level thinkers to succeed, but Marks warns: “You also need the patience and discipline to stick with it because first-level thinkers can continue to drive momentum in the short term like in the late stage of a cycle (second-level thinking is what protects you from its ultimate end).”

An Inverted View of The World

One way to think differently was introduced to me by Nassim Taleb, famous trader and professor. In his book Fooled by Randomness (Random House – 2004), Taleb mentioned the famous German mathematician Carl Jacobi, who reportedly instructed his students to “invert, always invert.” The solution to difficult problems, Jacobi held, can often be found by working the problem backward.

Nassim Taleb, who popularized the Black Swan theory, applied this approach in the extreme when trading options. Instead of buying standard options as a reasonably leveraged way of betting on moves of stocks or currencies, he would buy options that could only be exercised at a price very distant from the current level. These cost very little, and most of the time, they would expire without being exercised. As a result, Taleb would incur steady losses, though very small ones since these options cost very little, but when something happened to cause a major move in the price of the options’ underlying asset, Taleb would stand to make a huge profit.

This was the whole idea behind the Black Swan theory: how to handle events that are difficult to predict yet have a major impact. Besides fitting well with Howard Marks’ adage that we can’t predict, but we can prepare, the reference to Jacobi helped me to look at economic and financial problems in an inverted fashion, as a means to detect alternative interpretations to current events or complex situations.

The Tennis Pro, The Painter and The Sculptor

Not all investment wisdom must come from financial gurus. The trigger for this article was advice from my tennis coach, a former world-class player but an unlikely investment adviser – or so I believed. Thinking that I was expending too much effort and strength on my serves, with the result that many wound up in the net, he pointed out that a serve in the net has a 100% chance to lose the point, whereas even a very weak serve on the court might earn the point if the unexpected happened — including a stupid mistake by my adversary.

This approach echoed Howard Marks’ investment comment that our investment performance is determined more by the number and size of our losses than by the greatness of our gains: trying too hard to discover the next big stock market winner might be less rewarding in the long run than avoiding big mistakes.

I have long been fascinated by the divergent processes involved in traditional painting and sculpting. The classic painter starts with a white canvas and adds outlines, paint, colors and shades, touches of light, etc. In contrast, the classic sculptor starts with a block of stone and subtracts material until the statue appears in its ideal form.

Michelangelo, perhaps the most revered artist of the Renaissance, reportedly explained: “The sculpture is already complete within the marble block before I start my work. It is already there, I just have to chisel away the superfluous material.”

I can readily appreciate the appeal of an approach to stock selection that would eliminate the unacceptable to retain only the valuable.

First, Eliminate

For global investors like us at Sicart, the universe of investable companies numbers in the thousands. Especially given today’s abundance of information sources, trying to find the most attractive ones is a little bit like looking for a needle in a haystack.

Searchable databases (a theoretical solution to that challenge) make for an awkward selection process when one starts using too many filters: debt ratios, growth of earnings and cash flows, dividend coverage, ratios of price to sales, earnings or book value, even some more sophisticated indicators of reporting quality.

My experience is that, as the number of filters increases, the quality of the resulting selection becomes more questionable. In the end, the companies that emerge from the process most often have flaws that will eventually disqualify them from inclusion in our portfolios. When those flaws are visible only in the footnotes to the annual report, the time saved on financial analysis is debatable.

Remembering that an investor does not have to own all the stocks that do well to outperform, it seems easier to eliminate all the stocks that prompt doubts – however their shortcomings (financial strength, earnings record, stock price, management behavior, even the elusive “smell factor”) are revealed. At the end of this “carving” process, we should be left with a much smaller sample of companies likely to achieve a superior batting average, although not necessarily the highest. But then, we are not aiming for the moon.

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Jeff Bezos, CEO of Amazon, was recently quoted in Business Insider (9/14/2018) as stating:

“All of my best decisions in business and in life have been made with heart, intuition, guts… not analysis.”

 The case can be made that eliminating stocks is more expeditious and more intuitive than building a portfolio one fastidiously-analyzed stock at a time. I am a great believer in the value of intuition in decision-making, especially in a marketplace where psychological biases and crowd behavior are at least as important determinants of stock prices as fundamental statistics. On the other hand, intuition alone would make investing much like casino gambling.

In fact, after graduating from Princeton in 1987, Bezos served as head of development and director of customer service at Fitel, a financial telecommunications start-up; as a product manager at Bankers Trust; and as senior vice-president at D. E. Shaw & Co., a hedge fund. It was not until 1994 that he founded Amazon.com. My point here is that to be most useful, intuition must rest on a solid base of education and experience, which we try to always remember at Sicart Associates.

François Sicart

September 21, 2018

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.