Economics

Nature,Value and Investing

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“Notice that the stiffest tree is most easily cracked, while the bamboo or willow survives by bending with the wind”.

– Bruce Lee

In our early biology class, we learn about Charles Darwin, influential biologist and father to the “survival of the fittest” theory; Darwinism. We know that in a given environment, when two of the same species collide, the one with even the slightest edge, be it the bigger horn, muscle mass, the quarter inch bigger claw, will emerge victorious over the long run. As the dominant species reproduce amongst each other, the inferior species will eventually become extinct. All species are subject to natural selection, and it isn’t so different either in the economic world; as “The Nature of Value” by Nick Gogerty parallels the science of economics, evolution and ecology.

To begin, Gogerty discusses the most essential aspect of economics and investing; price in relation to value. Unfortunately, the popular belief that equates value with price foolishly assumes that everything is worth its current price. Price is a reflection of perceived value, and is often, poorly reflected. For instance, the daily changes of stock price means that the perceived value by market participants have changed, but frequently, the firm’s “true” value has not altered. Because the day to day price changes occur, investors slowly forget about the true intrinsic value of the firm, ultimately leading to under or over-valuations of equities.

Another important factor for the allocator is the firm’s competitive advantage. Gogerty draws from Richard Dawkin’s “The Selfish Gene” to illustrate the resemblance between evolution and economics. Organisms have different types of genes, organizations have what the author calls “inos”. Inos are like genes, collecting knowledge and changes that are expressed as an organization’s capabilities. It’s an informational unit, capable of innovation and adding value to a company. Of course, not all inos are value adding; for instance, a mattress store may open-up a drive thru section, but that doesn’t mean it will add positive value to the firm. Therefore, not all inos become sustainable knowledge or useful in a firm’s quest for survival. However, inos that do add value can be reflected in the firm’s competitive advantage; creating additional value.

Another argument draws from Larry Keeley’s “Ten Types of Innovation”, inos improve simple capabilities, and little by little compound to competitive advantages. The 10 capabilities are: business model, networking, enabling process, core process, product performance, product system, service, channel, brand and customer experience. Every firm, according to their industry, will excel in some, while averaging or lagging in some other of the 10 capabilities; ultimately creating its unique position within its competitive environment. The serious allocator should pay close attention to these 10 important aspects when making decisions.

The capabilities of the firms will place them in their own clusters. Gogerty describes 4 types of clusters: Lollapaloozas, Cash Cows, Lotteries, and Red Queens.

The investor should seek the rare “Lollapalooza” cluster; firms that are stable and growing, with few competitors and high barriers to entry. Firms in this type of category have a higher ability to grow revenues and margins. The Cash Cow cluster is dominated by already stable participants, usually with high yields, and high barriers to entry, but limited growth. Lottery cluster can be described as newer firms, fast growth but unstable and low barriers to entry, therefore, these firms do not have established moats and competitors can easily replicate their strategies. Finally, Red Queen cluster participants compete amongst each other in industries that are very capital intensive. This cluster requires participants to continuously exhaust their resources on new innovations and strategies to survive, but most of the value flows to the customers instead of the shareholders. An example of a Red Queen could be the evolution of the TV industry; firms must continuously exhaust their capital to create new strategies and innovate technology or will fall behind, but notice how increasing technology and competition, has added greater value for the customers (with lower prices and greater technology-notice how TVs got cheaper in the past decade?) rather than returning the value to the shareholders. A long-term value oriented investor should avoid the last two clusters (Lotteries and Red Queens).

Lastly, investing based on the nature of value rather than price can help mitigate risk; purchasing moated firms at a discount and holding it for the long-run has proven to be rewarding.

The latter paragraphs were just a glimpse of the distinctive knowledge you will gain from exploring “The Nature of Value“. It is exceptionally informative and well-written, unique in its own league, and deserves a spot in every serious investor’s library.

Finally, finding economic value is the goal of all value-oriented investor. Finding true value is the quest of all human beings. Where should one search for such meaning? Fortunately, there is an answer to your quest; as Gogerty puts it:

“Prioritizing the value of friends, family and freedom ensures that the wealth of a lifetime will be correctly measured in the creation of memories, loving relationships, and a reputation for integrity. Never compromise these forms of value for mere money”.

Put differently; money makes the world go round; but love makes the ride worthwhile.

Thank you for reading. As always, JMO (just my opinion).

 

The Fault in Ourselves

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“The fault, dear investor, is not in our stars- and not in our stocks- but in ourselves…”

-Benjamin Graham

Winner of the Nobel Prize in Economics, Daniel Kahneman fascinatingly explains the fault that is in our intuition, biases, decision making, and sheds light to rationality. In economics and finance, we are taught theories that assume rationality and well-informed decision making of individuals, but we must learn these theories with much caution, as Kahneman’s Thinking Fast and Slow illustrates that human decision-making is indeed more flawed in reality, and certainly more than we notice. I will illustrate a few of his examples below that will (hopefully) spark your interest, and likely bend your mind, as it did to me.

To begin, Kahneman explains the mind as two systems, System 1 which is intuition (thinking fast) and System 2, which is your analytical system (thinking slow). For instance, the last time you were mad over something small and had to embarrassingly apologize afterwards, might have been due to your System 1, thinking (too) fast. Your emotions clouded your System 2 (your analyzing system) from working and you acted irrationally. Note that your System 2 is also quite “lazy”, so the majority of the time, you’re on auto-pilot with System 1, and (thankfully) most of the time it’s right. But other times when System 2 is needed, and fails to show up or to properly analyze, decision-making results can be devastating.

Here’s a quick test of your systems.

What’s 2 x 2?                  What’s 2+2?

Right away you knew the answer for both were 4 (that’s your intuitive System 1). Now:

     What’s 28 x 9?               What’s 38 x 17?

Your pupils moderately dilated, your blood pressure slightly increased; your System 2 was engaged into computing the answer, as your System 1 was unable to quickly solve it. For some, it is possible that the latter questions came intuitively via their System 1; they’ve practiced a great deal of mathematics that allowed them to generate the answer automatically. For those who had to employ their lazy System 2, don’t you regret not practicing math a little more when you were younger? I sure do…(252, 646, btw).

Speaking of regret; Kahneman defines it as an emotion and a punishment we do to ourselves. Frequently, we lag in our decision making due to the fear of regret. It stems from a deviation from the norm, or the default position (p.348). For instance, when you buy a stock the default is to hold it, when you enter a relationship, the default is to stay, when you finish seeing your friends, the default is to say goodbye; selling a stock too early, ending a relationship badly and even not saying goodbye can produce regret. Here’s another example: You’re the coach of a team that just badly lost your last game. You’re expected to make a change in players or strategy; failing to do so will produce regret (p.348). Notice how here, a specific action is the default, deviating from that will produce unpleasant emotions. Regret does indeed affect the decision of many, but there is good news: people generally anticipate more regret than they will actually experience, this is because we underestimate the efficacy of our psychological defences (p.352).

Here’s an unnoticeable pitfall people tend to make that may lead to regret, it’s called the The Sunk Cost Fallacy. More often than not, this fallacy makes us stay in things longer than we should. A bad job, a poor performing stock with no turnaround in sight; we would rather continue wasting our resources in a failing project than to stop, admit defeat and have a bad stain in our record .

Somewhat related to the Sunk Cost Fallacy is the disposition effect. A (unfortunately) real example for many investors is the following: when choosing to sell stocks in their portfolio, often times they choose to sell the winning stocks rather than the losers; they want to add a win to their record, instead of closing out losing stocks which would add a loss. Simply put it, gaining is pleasure and losing is pain, and we would much rather choose pleasure than pain. But, pleasure does come with its price, and in this case choosing purely based on a current winner and loser can be irrational and devastating. According to Kahneman, you should have a thorough analysis of your portfolio and sell the stock that is less likely to perform well in the future, not whether it is a winner or loser.

Here’s another pitfall that can significantly influence our optimism or pessimism when decision-making is “Framing“. Consider the following scenario:

How would you feel if I said the following before you entered a life-saving surgery:

90% of the people who receive this surgery survive.

Now If I told you this:

10% of people who receive this surgery die.

Both statements have the same probability of success-failure, but the way it was framed, did indeed give you different mental pictures. Another example of framing within Thinking Fast and Slow is the following:

You receive $70

Would you rather:

Keep $30           or          Lose $40

As you’ve noticed, both options are objectively the same, but most individuals prefer the keeping $30 than the losing $40 option. Being able to reframe this question objectively, and not emotion-bound, takes much effort of your System 2, and since it efforts exhausts our energy, we passively accept decision problems as they are framed (p. 367).

Here’s a final- shortened example of framing that will bend your mind, it comes straight from the framing experiment conducted by Kahneman and his friend, Amos (p.368):

Imagine that the United States is preparing for an outbreak of some unknown disease. It is expected to kill 600 people, but there are two types of action plan that can be implemented to fight this disease:

-Action Plan A: 200 people will be saved.

-Action Plan B: There is a one-third chance that 600 people will be saved, and a two-thirds probability that no one will be saved.

What’s your choice? Think carefully. The majority of respondents chose A; taking the sure option rather than the gamble.

Now the experiment is framed differently. Consider the following options:

-Action Plan A: 400 people will die.

-Action Plan B: There is a one-third probability that nobody will die and a two-thirds probability that 600 people will die.

What’s your choice? Again, think carefully. The majority of respondents chose B, as you may have as well. “Decision makers tend to prefer a sure thing over a gamble when the outcomes are good. They tend to reject the sure thing and accept the gamble when both outcomes are bad”(p.368). Note how you’ve accepted a gamble with a 67% (rounded) chance of failure, even though it’s a bad gamble (numerically), it seemed like a good choice in this case.

Here’s the interesting part: You chose to save 200 lives for sure (Action Plan A) in the first question, and chose to gamble with Action Plan B, rather than accept 400 deaths in the second; there’s an inconsistency in the choices you make. Think about it…

We could go on forever in discussing the biases and faults in our intuition provided in this book (there’s a lot more), but let’s end with the Anchoring Effect. This happens when “people consider a particular value for an unknown quantity before estimating it” (p.119). For instance, if you are looking to purchase a house, you are likely to be influenced by the asking price (the anchor). You would feel a price of $1 million is expensive if the asking price was $700k. On the contrary, you would feel a price of $1 million is cheap if the asking price was $1.3 million. If I said the number 30 and asked you to provide an estimate of Shakespeare’s age at death, you’ll likely give a lower number than if I said the number 90. You’ll be inclined to use the number provided as an anchor and work your way up or down from it. This shows that we are susceptible to subconscious biases from an anchor and recognizing that can help us avoid poor decisions. This technique is used in sales and negotiations, so next time you’re negotiating a price, make sure you don’t get anchored by a number.

When you choose to read this book, you’ll learn valuable rationality lessons such as the law of small numbers, optimistic biases, the possibility effect and much, much more in Kahneman’s astonishing literature. After giving Thinking Fast and Slow a read, your thought process and decision-making will surely be enriched, as mine was.

Much of the recognition of our intuitive faults will seem unnatural to do, and indeed hard to consistently notice when we act irrationally. But nothing good comes easy. By being aware that it is easy to fall into the traps of our own irrational decision-making; we can avoid making potentially devastating mistakes, and make more sound decisions. For the investor, the chief problem, and even his worst enemy is very likely to be himself. You should give this one a read, you probably won’t regret it 😉 Find it here.

Kickstart your Day with 5 Funny Economics Jokes

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Here are some economic jokes that will brighten up your day at work, or give your boss a good laugh. And if you’re in the economic discipline like myself, it doesn’t hurt to laugh at yourself once a in a while. Since these jokes have been passed around and modified, they might differ from the “original”, but the core is still the same:

1. A chemist, a physicist and an economist are stuck on a deserted island with no food. A can of food floats ashore. The physicist says “let’s smash it open with a rock”. The chemist says “let’s build a fire, and heat it first”. The economist says “let’s assume that we have a can opener…”

2. Economic forecasters assume everything, except for responsibility.

3. A mathematician, an accountant and an economist all apply for the same job. The interviewer calls in the mathematician and asks: “What do two plus two equal?” The mathematician replies “Four.” The interviewer asks “Four, exactly?” The mathematician firmly looks at the interviewer and says “Yes, four, exactly.”

It’s the accountant’s turn, the same question is asked: “What do two plus two equal?” The accountant answers “On average, four – deviated around ten percent, but on average, four.”

Then the interviewer calls in the economist, tells him to sit down and asks the same question: “What do two plus two equal?” The economist gets up, locks the door, closes the shade, sits down right next to the interviewer and says “What do you want it to equal?”

4. If you teach a parrot to say “supply and demand”, you have an economist.

5. A chemist, an engineer and an economist are shipwrecked with no food except for a single can of soup. They have no tools, and can’t afford to spill the insides as it is their only means of survival. The chemist sets up evaporating pans to collect caustic salts to etch the can lid through. The engineer piles sand to build a drop, that with precise calculation will be tall enough to crack the can open without spilling the insides. And the economist lays down on the beach, relaxing and laughing at them. After a day’s hot labor with nothing achieved, frustrated, the chemist, bursts out at the economist and says, “Okay, you’re so smart, how would you do it?!?!” The economist picks up the can and stands up straight, shining with confidence he presents the can grandly to the other two, and says, “ASSUME this can is open.”

All jokes aside, economics is a great discipline. Many economists have changed the world with their lifelong contributions, notably Adam Smith, John Maynard Keynes, John Kenneth Galbraith and many more. If you are interested in reading a book to understand the very basics of economics, I would recommend: Basic Economics by Thomas Sowell. It was well put together and covered much of the essentials for understanding the basics and flow of the economy. I will have a review for it soon. Meanwhile, you can find the book here. Of course, JMO (just my opinion).

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We all love ourselves more than other people, but care more about their opinion than our own.

-Marcus Aurelius