Capitalism’s Holy Grail

Coming up with a system to succeed in the stock market and achieve market beating gains year after year is not an easy task. One might define the capitalist’s holy grail as finding the one system that will acheive the maximum possible returns year upon year.

“If you don’t get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a one-legged man in an ass-kicking contest.” Charlie Munger, “A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business”

No Shortage of Stock Market Strategies

Finding Low price to earnings ratios, high dividend yields, high return on capital and only buying businesses that are priced below their intrinsic asset value would probably set you in the right direction as you entangle the stock market web and attempt to increase the value of your investments.

I have recently read several interviews with the Value Investing meritocracy of Buffet, Munger, Schloss, Robertson and Lynch and begun to invest myself over the past 3 months.

Without discounting the importance of understanding the strategies and financial ratios above, my reading has implied that succeeding in the stock market is less about strictly studying and following the investment strategies of others and more about finding a strategy that you can understand and which also falls within your ‘circle of competence’.

While reading a particular interview with one of the great investors above, you are swayed to believe that their way is the way to succeed, the only way. And seeing as each of their companies has averaged annual returns after fees of over 25% for at least ten years, perhaps you would not be far off the truth (their companies are Berkshire Hathaway, Walter J Schloss Associates, The Tiger Fund and the Magellan Fund if you’re interested).

But the truth is, each of their investment strategies is undeniably linked to their range of personal skills. Schloss sticks to buying businesses with a significant margin of safety below asset or book Value and doesn’t worry too much about the type of business or its management because that is not his area of expertise. Buffett understands and appreciates this method that they both picked up from Benjamin Graham but adds the necessity for the business to be a quality business in a profitable and sustainable industry to his list of investment requirements.

“It is better to buy great business at a fair price than a fair business at a great price”, Buffett says. Schloss feels otherwise.

Stick to Your Circle of Competence

Knowing that each of their investment strategies were fundamentally different from each other despite having commonalities, it became clear that if Warren Buffett were trying to use the strategies employed by Schloss, he would not have been as successful; and vice versa.

I had a tendency before doing all this reading to look for the objectively ideal strategy, the best and most efficient way to invest my money. Now I am seeking a strategy that I can understand, that I will have an edge in applying and that is likely to be successful (this final point is where past analysis is helpful).

Althought I suggest reading the writings of the masters above to get a better defintiion, I will quickly define what I just described as my ‘circle of competence’; an area in which you can excel and ideally an area that you enjoy.

Without intending to turn this piece into a guide to finding your own circle of competence, I found Munger’s article that I linked to above to provide the best guidance I have yet received, in only 5 to 6 pages, to equip someone new to investing (or just life) with the tools you need to succeed.

If you’re Stuck for Fundamentals – Try Some of Munger’s Worldy wisdom

Munger states that we all need a latticework of models to choose from when going through life. He speaks of those who go through life with limited ways of looking at the world as not reaching their full potential:

And the models have to come from multiple disciplines – because all the wisdom of the world is
not to be found in one little academic department. That’s why poetry professors, by and large,
are so unwise in a worldly sense. They don’t have enough models in their heads. So you’ve got
to have models across a fair array of disciplines.

So whilst I recommend reading the article in full, here are the most important models he describes:

1. Mathematics – permutations and combinations –algebra – think in terms of decision trees and permutations and combinations – spend time to devote to apply elementary maths to real life problems.
2. Accounting – know it plus its limitations.
3. Who what where when and why? Science and engineering backed models are best.
4. Statistics? understand well enough – know what a normal or Gaussian distribution looks like and that most things end up distributed like that. “I’m like a poker player who has learned to play pretty well without mastering Pascal”.
5. Engineering – stuff like backup system, breakpoints, the physics notion of a critical mass, cost benefit analysis.
6. Understanding of biology / physiology –Helps to understand what is and what is not going on.
7. Cognitive functioning is helpful to know -The pyshology of misjudgment is the most important part to learn of psychology – 20 little principles that interact with each other. The mind is subject to manipulation – “the mind of man at one and the same time is both the glory and the shame of the universe”.

Try some of my related articles below if you enjoyed this one

This Warren Buffett video is taken from a question and answer session that he made to a group of MBA students at the University of Florida years ago.

Watching the speech in its entirety is very captivating as he is an incredibly switched on character but yet still incredibly humble and funny throughout.

His understanding and communication of the value investing concepts is top notch and has inspired me to read The Intelligent Investor by Benjamin Graham; a book i have been meaning to get to for a while now.

I found the particular Warren Buffet clip above particularly interesting as it really outlines the value investing concept that you shouldn’t really care whether a stock goes up or down on any particular day if you truly believe in the company long term.

This approach of value investing to achieve dividends from valuable companies rather than day to day capital gains trading is likely to be a very appealing strategy if the markets around the world are to fall into recession in the coming months as companies are likely to become undervalued in the market.

As outlined by Buffett in the video, bear markets keep stock prices low and provide the best possible opportunity for profitable investing (not to mention cheaper products in the marketplace).

This is the first of many blogs to come on value investing as i begin Mr Graham’s Intelligent Investor and i will also be posting more excerpts from this 90 minute speech (that i personally video edited and youtubed!!) so make sure you add my RSS feed below.

For more on Warren Buffett’s speech, See Tom’s consulting blog or click here to read more about the differences between Fundamental and Technical Analysis or here to read about Charlie Munger’s successful investing advice, worldly wisdom and your circle of competence.