In Yuval Noah Harari’s recent bestselling book “Sapiens: A Brief History of Humankind,” the author writes a tour de force that covers the history of mankind from our evolution two million years ago to the modern day. The entire book is well worth a read. With regards to investing, there is one section that is especially poignant, where Harari highlights the power of stories or myths. He writes:
“How did Homo sapiens come to dominate the planet? The secret was a very peculiar characteristic of our unique Sapiens language. Our language, alone of all the animals, enables us to talk about things that do not exist at all…. Fiction is nevertheless of immense importance, because it enabled us to imagine things collectively. We can weave common myths such as the biblical creation story, the Dreamtime myths of Aboriginal Australians, and the nationalist myths of modern states. It is these myths that enable Sapiens alone to cooperate flexibly with thousands and even millions of complete strangers….
True, ants and bees can also work together in huge numbers, but they do so in a very rigid manner and only with close relatives. Wolves and chimpanzees cooperate far more flexibly than ants, but they can do so only with small numbers of individuals whom they know intimately. If you tried to bunch together thousands of chimpanzees into Wembley Stadium, Oxford Street, St Paul’s Cathedral or the House of Commons, the result would be pandemonium. Sapiens, in contrast, gather there by the thousands and together they organize and reorganize trade networks, mass celebrations, and political institutions. That’s why we rule the world, whereas ants eat our leftovers and chimps are locked up in zoos and research laboratories…”
He goes on to discuss how, in fact, companies are really “stories” that are built on top of a legal code, which in itself is a story, and how they rely on money/currency, which is yet another abstraction that only works upon our collective embrace.
What does Harari highlighting the human species’ unique ability to buy into stories have to do with investing? In effect, the investment business is stories on top of stories on top of stories. As a fundamental bottoms-up investor trying to find undervalued and overvalued companies, the primary “story” that we pay attention to is that of company-specific operations. Our story has characters like new products, market share gains, and regulations. In essence, my job is to find situations where the collective story is either too optimistic (short the company) or too pessimistic (buy shares).
MR. Macro — A Master Story Teller
To complicate matters, we currently live in a risk on/risk off environment where there are persuasive storytellers weaving tales of doom at a “macro level.” These stories are so large that they envelop even the most boring of companies. When a story is told well, a listener will conclude that no company is worth owning at any price. In his last investor letter, Chris Mittleman of Mittleman Brothers gave these doomsayers a name I love – Mr. Macro. As he wrote,
“We all know about Mr. Market, that manic-depressive business man who Ben Graham described as offering to buy or sell shares in his business at widely disparate prices from one day to the next based on his mood of the moment. Ben Graham and Warren Buffett advised us to take advantage of Mr. Market when the price he offers is attractive, and ignore him when it’s not. There is another character out there, to be more ignored than taken advantage of; and that is Mr. Macro. Mr. Macro reads everything worth reading and knows every macro-economic indicator worth tracking, including the price of tea in China, and where the unsustainable imbalances are, and he plans to grab that next big asymmetric risk/reward payoff so The Big Short II will be about him. He even goes to Davos. He speaks of new normals, zero bounds, contagion, contango, unintended consequences, risk premia, risk parity, risk-on/risk-off, Abenomics, QE, BRICs, PIIGS, Grexit, Brexit, and Mr. Macro is the one who whispers in your ear at each sell-off, “Don’t do it. It’s different this time” For long-term value-oriented investors like us, Mr. Macro is to be ignored with extreme prejudice. Because, as history has proved, opportunities for successful investment outcomes exist in even the most hostile macro environments imaginable…”
When I sit back and think about companies simply being a function of our species’ ability to buy into a collective story, and their short-term value (price) being driven by Mr. Market and Mr. Macro, it sounds arbitrary and haphazard. How can somebody be good at anticipating Mr. Market and Mr. Macro? The short answer is that we are not even trying to. Instead, we use tools for addressing and limiting the noise created by Mr. Market and Mr. Macro. The first is our work environment, which is designed to limit their presence, with a reading room and no CNBC blaring. The long-term nature of our capital limits the need to react to every blip of the market. Rather than trying to anticipate every zig and zag, we try to create value in periods measured in years, not days. In addition, I have sought out a network of fellow investors who worship at the altar of fundamentals, not Mr. Macro. The network helps to highlight situations where the largest gaps between reality and valuation exist. I am also comfortable being slow, methodical, and patient and not participating in an arms race of trying to be the busiest analyst following the most companies. We only need a couple of great investments to achieve material returns. Avoiding the busy trap is a differentiated approach that can yield a differentiated outcome. Lastly, 20 years of studying companies has also provided a deep data set that enables pattern recognition. I put a greater emphasis on certain variables such as insider ownership, recurring revenue, and product value proposition as they have been present in many of my most successful investments. Please note that GDP growth and the number of Fed tightenings this year were not on the list of variables I focus on. Our environment, sources of information, and areas of focus reduce the noise and allow me to create my own stories. However, all of the tools above would be useless without the one superpower that we all possess: basic math.
The Power of Math
Value investor Seth Klarman is the source of one of my favorite investing quotes, “Value investing is at its core the marriage of a contrarian streak and a calculator.” The types of investments we pursue are those that are so off the beaten path that there is no real collective story, or those where the “story” is not supported by the fundamentals. To put it another way, aided by basic numbers such as cash flow, cash on hand, customer retention, and revenue growth, we can construct an alternate story to the consensus. In the best cases, we have a “variant perception” and we actually can articulate what the market is missing or overemphasizing. The path to arriving at a variant perception often involves looking past the distortions of GAAP accounting and interpreting the numbers through the context of management incentives. One of the reasons that spinoffs are an interesting area to invest in is that often the “story” of the stock is still evolving and we can apply pattern recognition, basic math, and an analysis of incentives to make predictions. If there is enough of a discrepancy between our range of outcomes and the current share price, an investment may be in order.
Scott Miller is an instructor at Wide-Moat Investing Summit 2016.
This post has been excerpted from the Greenhaven Road Capital Q1 2016 Letter.
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