Tuesday, July 25, 2017

Boyles Asset Management – Q2 2017 Letter Excerpt

Cockroaches, Margins of Safety, and Knowing Thyself

“In general, survival is the only road to riches. Let me say that again: Survival is the only road to riches.” --Financial historian, economist, and educator Peter L. Bernstein (2004 interview with Jason Zweig)

As he did in his 2007 book, A Demon of Our Own Design, Richard Bookstaber returns to the story of the cockroach with his 2017 book, The End of Theory.  The cockroach has survived and thrived for about 300 million years, thanks in large part to a simple survival mechanism.  As described by Bookstaber: 
...the cockroach simply scurries away when little hairs on its legs vibrate from puffs of air, puffs that might signal an approaching predator, like you.  That is all it does.  It doesn’t hear, it doesn’t see, it doesn’t smell.  It ignores a wide set of information about the environment that you would think an optimal system would take into account.  The cockroach would never win the “best designed bug” award in any particular environment, but it does “good enough” and makes it to the finish line in all of them.
This brings to mind the saying that in order to finish first, one must first finish.  But the broader point being made is that it is often simple, coarse rules that lead to survival advantages.  While these rules, or heuristics, may not be the optimal traits for an organism to reach its maximum potential for thriving in an environment, given a specific set of conditions, it allows the flexibility needed to stick around to see the finish line should the conditions change.  The observation credited to Charles Darwin about a surviving species being not the strongest nor the most intelligent, but the one most responsive to change is applicable here.  Uncertainty and change are inherent in nature, as they are in business and life in general, and it is often simple heuristics and ideas that, if pursued with discipline and consistency, can allow one to survive whatever the future may have in store. 

What are some of the candidates for an investing rule that rivals the survival rule of the cockroach?  It is probably a question that one could ask 10 different investors and get 10 different answers, but for those who follow a fundamental, value philosophy, the concept of margin of safety has to be one of the key contenders for a place at the top of any list.  Even the best investors over long periods of time make plenty of mistakes along the way, and so we as investors must accept that things won’t always turn out the way we expect them to, no matter how much effort we put into trying to understand something.  Building in some margin for error in our process can help us reach the long-term survival necessary for success. 

Another candidate for a key rule of survival comes from a more ancient piece of advice: know thyself.  At a recent Talk at Google, investor Mohnish Pabrai told a story about a dinner he attended with Charlie Munger.  At the dinner, Munger talked about the investment firm Capital Group, and an experiment it performed with its investment team. Capital Group assigned teams to manage different portions of its capital under management.  On several occasions, the firm set up a “best ideas fund,” in which it took the highest-conviction stock picks from each of its managers.  But each time it set up one of those funds, that fund underperformed and ultimately failed. After telling this story to his dinner guests, Munger asked the group if they could guess the underlying reason why those funds did not do well.  But dinner was then served, and the riddle was left unsolved. 

Years later, Pabrai remembered the story; when he was with Munger on another occasion, he asked about the Capital Group story.  It turned out that the reason the best ideas funds failed is because of the common feature among each manager’s pick: it was the idea that he or she had spent the most time studying. 

In a 2007 speech at the USC Gould School of Law, Munger warned against the dangers of drifting into intense ideologies, and made the point that as “you start shouting out the orthodox ideology, what you’re doing is pounding it in, pounding it in, pounding it in.”  And there’s a similar effect when it comes to investment research.  When there’s a decent story for a company to tell about its prospects, the more time one spends with it, the more likely one is to believe in its merits. 

The solution to this psychological tendency is not to spend less time on ideas.  We feel that one of the long-term advantages that we can have in the investment world is knowing more about the companies in which we are invested than almost anyone else.  Rather, the mechanism to fight this bias is to try to suspend judgment and opinion about a company’s investment merits until one can thoroughly state the cases both for and against that company’s prospects.  We need to be aware of our own psychology, and how it is affected by the ways in which we spend our time.  And if we ever catch ourselves spending too much time preaching about the ideas we’ve spent the most time on, or not spending enough time trying to understand the case against our best ideas, then—like the puffs of air hitting the hair on a cockroach’s legs—we need to recognize that there may be something amiss.


Disclosure: I am a portfolio manager at Boyles Asset Management, LLC ("Boyles") and the fund managed by Boyles may in the future buy or sell shares of any stocks mentioned above and we are under no obligation to update our activities. This is for information purposes only and is not a recommendation to buy or sell a security. Please do your own research before making an investment decision.