Tropical Value Investing New Home

After a couple years, I have decided to move the blog to WordPress. Now you can find the whole post archive and, more importantly, the new ones (which will only be published in the wordpress blogroll) at

http://tropicalvalueinvesting.wordpress.com/

The most recent post is called The Craft of Research, based on a book that bears the same name. Just go to the home page and it will be on top of all.

What Video-games Have To Teach Us About Investment Research?

"So learning here is social, distributed and part and parcel of a network composed of interconnected people, tools, technologies and companies." "The power of distribution - of storing knowledge in other people, text, tools and technologies - is really the way that all these things are networked together. The really important knowledge is in the network - that is, in the people, their texts, tools and technologies, and, crucially the ways in which they are interconnected - not in any one node, but in the network as a whole. Does the network store lots of powerful knowledge? Does it ensure that this knowledge moves quickly and well to the parts of the system that need it now? Does it adapt to changed conditions by learning new things quickly and well? These are the most crucial knowledge questions we can ask in the modern world."

From James Paul Gee, What video games have to teach us about learning and literacy

How to Compose a Successful Critical Commentary - Daniel Dennett

Remember that last hot investment case debate you had in your firm? How could you politely address that making it smoother for everybody of the team, which at the end of the day yields a more productive meeting?

1. You should attempt to re-express your target's position so clearly, vividly, and fairly that your target says, "Thanks, I wish I'd thought of putting it that way."
2. You should list any points of agreement (especially if they are not matters of general or widespread agreement).
3. You should mention anything you have learned from your target.
4. Only then are you permitted to say so much as a word of rebuttal or criticism. 

- from Intuition Pumps and Other Tools for Thinking 

The Characteristics of Successful Investment Firms - Dr. Charles D. Ellis, CFA

Great to remember what makes people-based businesses thrive.

The Characteristics of Successful Investment Firms - Dr. Charles D. Ellis, CFA

Quantitative (hard) x Qualitative (fluffy) Sides of Investing

It's been quite a while. Reviewing some of my previous posts, I've realized how 'fluffy' I ended up when contrasting my early days thoughts. As an engineer, I confess I used to focus too much on the quantitative side of investing, leaving much of the qualitative analysis aside.

Today I am working for the third start-up in my career (not a so long one since I'm just 27) and now I've finally learnt that 'fluffiness' matters - actually, it dominates over the quantitative side of a investment case. The numbers we analyze when quarterly results are released are just a lagging indicator of what has been happening inside the company for the last 12 months or so. New executives came onboard, a new area was created, the organogram was changed to better adapt the salesforce and the analytical part of distribution & logistics, and so on.

At the end of the day, we are looking for leading indicators that could change the evolution of the numbers we will see a year onward from now. The quantitative side of the story is a due diligence to make sure you are not being fooled at day 1. What we want after-all is a company that can be worth an ORDER OF MAGNITUDE higher than today's market price. Sometimes even 20x valuation multiples can be worth it for compounders or growing cash machines, for example. What you need is a huge tailwind (most of the time, those are business environment related - and when it's related to people, we are usually too late).

To identify those, the best thing we can do is read, read a lot. Qualify our sources as time gets by. Learn what is indispensable to read. Mold our routine to accommodate the mental models consolidation process. At the same time, get down to what matters instead of being a philosopher (nothing against them!).

What did we learn today? That's a pretty simple exercise that can help us a lot to track our evolution. Keep your notebook open.

The Art of Knowing When to Sell

Remember you buy your portfolio everyday.

The greatest skill at cards is to know when to discard; the smallest of current trumps is worth more than the ace of trumps of the last game. - Baltasar Gracian

Ray Dalio: Company Culture and the Power of Thoughtful Disagreement

This video probably summarizes what I have learned this year not only as an investor, but also as a human being. Do you want your company to make a difference? Create and nurture an outstanding culture. It might sound odd to most people, even from people within, but you have to put your beliefs in practice. That's how others companies also work. As Dalio puts its, the real difference is either on people or culture.

In his company's case, the ruthlessly transparent internal environment (forcefully) creates a trustful atmosphere, in which thoughtful disagreement foments knowledge creation. The possible issue: as people are smart in so many different ways, they must appreciate each other and make a team of them - the possible solution: the culture itself. It takes a genius to make it simple, and Dalio indeed did it by building an environment built on truth and thus, trust.

Culture is self-reinforcing.

 
"My biggest advantage is that I know what I don't know."

The Culture of Learning as The Ultimate Competitive Advantage

'The end of work' has been quite of a debated theme, including by Brynjolfsson, McAfee, Drucker, Keynes, Andreessen, among others. As Nobel Prize winner Wassily Leontief has put it,

The role of humans as the most important factor of production is bound to diminish in the same way that the role of horses in agricultural production was first diminished and then eliminated by the end of introduction of tractors.

Fast forward, (robotic) engineering and automation in general have played quite a role in the last decade. As Mr. Gave put it in his book titled "Too Different for Comfort",

Thanks to functionality, and lower prices, the global 'labor-cost arbitrage' trend, which was the predominant macroeconomic feature of the past decade, may now be coming to an end.

Automobile manufacturers were the main beneficiaries of robotization wave #1, followed by electronic devices industry. More recently, we have seen other industries also benefit from the same trend.

The most staggering fact though is that we may be entering into a new revolution within this decade - a Robolution - as lower robots costs and inflationary labor costs converge, favoring robots adoption by industry participants.

But what types of jobs are at risk? Again recurring to Gave's book "Too different for comfort", he categorizes 4 kinds of jobs, being:

That said, categories 3 and 4 certainly fall at risk, while we (equity investors & research analysts) certainly follow under category 2 - non repetitive and complex tasks - and are likely shielded from robots. Thus, if we are indeed safe from robots, how could we lever our skills to better perform our jobs at the individual level, but more importantly, at the company level? Here kicks in Edward Hess and his recently published book "Learn or die: Using science to build a leading-edge learning organization".

Hess' motivation to write the book likely emanated from the conclusion that continually learning better and faster than the competition may be the only sustainable competitive advantage individually and organizationally. Take McGrath's thought-provoking book "The end of competitive advantage: how to keep your strategy moving as fast as your business" as the basis of this. If this assertion is correct, then to perform at a high level on job category 2 we must lever critical thinking, innovative thinking, emotional and social high engagement and other humans. As Hess put it,

the way to unify operational excellence and innovation in an organization is to have a learning culture, because learning underlies operational excellence and it underlies innovation.

In a recent interview with Hess conducted by Shane Parrish from Farnam Street blog, Hess lied a couple tenets of a learning culture, such as de-emphasized hierarchy, intellectual and leadership humility, curiosity, questioning, the right to debate freely, clarity, preparation, a praise for vulnerability, strong processes, accountability, empathy, compassion, humane relationships, no complacency, and so on.

At the end of the day, what we are talking about here is a CULTURE OF LEARNING. At Bridgewater, for instance, the culture is so strong we might call it a doctrine or a religion - if haven't read Ray Dalio's principles yet, please do! As companies with such a peculiar culture say it, "we are not for everyone!"

As I don't to spoil Hess' amazing book, I will finish this post with a couple quotes I got from his previous mentioned interview.

Number one, underlying innovation and operational excellence, go back to root cause analysis, or the five why's. Unpacking assumptions, good digging, the why, why, why, is underlying both processes.

Hierarchy as an elitism is de-emphasized, and there is a real push for highly engaging employees and leadership humility, and intellectual humility. (...) Does the CEO own the learning culture and walk the talk? (...) Has the organization put in place culture, structured leadership behaviors, HR policies, measurement and rewards to enable and promote learning behaviors? (...) You've got to start small and figure out and prioritize what you are really going to start working on.

Arrogance is a huge inhibitor to learning. Arrogance comes also from success in positional authority.

Where can I improve? What happened today? What would I do differently in how I think? What would I do differently in that conversation as to how I relate?

A leadership model that is very, very humanistic and people-oriented.

 The purpose of the whole system at Bridgewater is to overcome our humanness in a humane way. (...) The first thing they want to talk about is their vulnerability.

You don't put things off. You deal with them directly, honestly, openly. (...) everything about everybody is public record. 

Indeed, we are all work-in-progress until the last day of our lives. Thinking about how we are thinking is a never ending loop. We can't ever truly get comfortable. As this topic may look too 'soft' for for-profit companies, actually, it's not according to Hess:

There's this whole concept in the business world that if you're humanistic and engaging with people, you'll come across as soft. People will take advantage of you. (...) It's not the case. You can be humanistic and have high standards and high accountability. The companies I write about, every one of them are outstanding performers because they have the highest of standards that they hold themselves to. There is no softness in standards. There's a human element.

Berkshire Beyond Buffet: Excerpt from Chapter 8

Lawrence Cunningham's new book Berkshire Beyond Buffet is scheduled to be released on Oct 21st, though you can find here the chapter 8 from the book. Below, notice Berkshire's tenets for its subsidiaries' CEOs praising independence, trust and an owner's mindset:

"Berkshire corporate policy strikes a balance between autonomy and authority. Buffett issues written instructions every two years that reflect this balance. The missive states the mandates Berkshire places on subsidiary CEOs: (1) guard Berkshire’s reputation; (2) report bad news early; (3) confer about post-retirement benefit changes and large capital expenditures (including acquisitions, which are encouraged); (4) adopt a fifty-year time horizon; (5) refer any opportunities for a Berkshire acquisition to Omaha; and (6) submit written successor recommendations. Otherwise, Berkshire stresses that managers are chosen because of their excellence and are urged to act on that excellence."

It's All About the Top-line

The panel below depicts crystal clear how activists' investing philosophies may widely differ. ValueAct demonstrates how it works collaboratively with executives and board members focusing on top-line initiatives, while others would rather use financial engineering techniques such as spin-offs, reverse merges and fiscal maneuvers and interact more aggressively with management.

At the end of the day, I feel myself prone to the former approach: driving sustainable top-line growth.

Mafia Insights Into Quality Investing: No Kidding!

In one of Gladwell's latest articles entitled "The Crooked Ladder" he puts that old mafias were simply an attempt to be accepted by the society. Moreover, one of the biggest misconceptions in movies and also by us is that the really dangerous guys are those street drug dealers. Actually, those are not. As Gladwell puts it,

That’s why the crooked ladder worked as well as it did. The granddaughter could end up riding horses because the law—whether from indifference, incompetence, or corruption—left her gangster grandfather alone. The idea that, in the course of a few generations, the gangster can give way to an equestrian is perhaps the hardest part of the innovation argument to accept. We have become convinced of the opposite trajectory: the benign low-level drug dealer becomes the malignant distributor and then the brutal drug lord. The blanket policing imposed on 6th Street is justified by the idea that, left unchecked, Mike and Chuck will get worse. Their delinquency will metastasize. The crooked-ladder theorists looked at the Mafia’s evolution during the course of the twentieth century, however, and reached the opposite conclusion: that, over time, the criminal vocation was inevitably domesticated.

At the same time, one of the most insightful takeaways for me is that the real 'bad guys' were the ones who made illicit things at the society's face. On top of that, they focused on niches and represented a really tiny slice of the cost structure of the entire value chain. With that, they had pricing power, outstanding returns on capital and no one bothered about them.

"James Jacobs, a New York University law professor who was involved in anti-Mafia efforts in New York during the nineteen-eighties, points out that the Mafia had every opportunity to take over the entire carting industry in the New York region—just as they could easily have monopolized any of the other industries in which they played a role. Instead, they stayed in the background, content to be the middlemen. At New York’s Fulton Fish Market, one of the largest such markets in the country, the Mob policed the cartel and controlled parking—a crucial amenity in a business where time is of the essence and prompt delivery of fresh fish translates to higher profits. What did they charge for a full day’s parking? Twelve dollars. And when the Mob-controlled cartel was finally rooted out, how much did fish prices decline at the Fulton Fish Market? Two per cent."

“This is one of the most interesting things about the Mafia,” Jacobs went on. “They did business and cooperated. They weren’t trying to smash everybody. They created these alliances and maintained these equilibriums. . . . You’d think that they would keep expanding their reach.”

At the end of the day, isn't that kind of business we are looking for? Companies that aren't bothered by either suppliers or clients, that are really focused on a niche and don't need to put a lot of capital to work while reap a disproportionate part of the profit pool?

Seth Klarman's version of Ben Horowitz' "The hard thing about hard things"

According to Klarman, the hard thing about hard things is that

"As long as I've been alive, there are structural imbalances. Most of the time they don't matter. Once in a while they really matter. That's what hard, that if you run a portfolio to to be fine in an upward market, if you're in the game, you will have exposures that you wish you didn't have in a worse market." - from The Graham + Dodd Luncheon Symposium Transcript from Oct. 2008

Simon Sinek: Great Leaders Eat Last

As the old saying goes leaders are chosen by the people. In a highly competitive environment, employees tend to be egoistic and afraid. Why not create a great and complementary team based on trust and cooperation? It's not a coincidence that Patagonia's owner Yvon Chouinard hired friends and friends of friends to his company in its early innings. It's all about creating a great environment so people feel comfortable to give their best efforts for the company and his co-workers.


If you have the time, watch the complete speech.



If you are still interested, check his most recent book Great Leaders Eat Last.

Learning By Thinking

"By three methods we may learn wisdom: First, by reflection, which is noblest; Second, by imitation, which is easiest; and third, by experience, which is the bitterest." - Confucius

According to a very recent HBS paper titled Learning by Thinking: How Reflection Aids Performance, Di Stefano, Gino, Pisano and Staats argue that by "reflecting on and articulating the key lessons learned from experience, a person boosts her self-efficacy, which in turn has a positive effect on learning. In this respect, (...) the process of transforming a tacit into codified knowledge requires a cognitive investment that generates a deeper understanding of this knowledge."

In other words, reflection is as important as experience and is often underrated. If you haven't read the post on sense-making, you should, as both subjects (learning and sense-making) are correlated.

Learn smarter, not harder.

Is Patient Capital The Ultimate Competitive Advantage?

"Recently, when Page was challenged on an earnings call about the sums he was pouring into R&D, he made no effort to excuse it. "My struggle in general is to get people to spend money on long-term R&D," he said, noting that the amounts he was investing were modest in light of Google's profits. Then he chided the financial community: Shouldn't they be asking him to make more big, risky, long-term investments, not fewer?"

The struggle to build a long term capital base coupled with patience and the right incentives might be the ultimate competitive advantage.

Barry Schwartz Framework Re-framed: Profile Of An Outstanding Investor

"A wise person knows when and how to make the exception to every rule… A wise person knows how to improvise… Real-world problems are often ambiguous and ill-defined and the context is always changing. A wise person is like a jazz musician — using the notes on the page, but dancing around them, inventing combinations that are appropriate for the situation and the people at hand. A wise person knows how to use these moral skills in the service of the right aims. To serve other people, not to manipulate other people. And finally, perhaps most important, a wise person is made, not born. Wisdom depends on experience, and not just any experience. You need the time to get to know the people that you’re serving. You need permission to be allowed to improvise, try new things, occasionally to fail and to learn from your failures. And you need to be mentored by wise teachers". - Barry Schwartz

Substitute the term "wise person" for "investor". There you go!

Dare to be Great - Howard Marks

Howard Marks latest piece made a commonsensical though forgotten in our day-to-day: overperformance requires differentiation. He breaks down this tenet in 3 more basic principles:

1. Define an explicit investment creed with sound principles;
2. Define what success is for you;
3. Are you willing to be different? And wrong?

As a Brazilian investor, I`m used to hear from potential investors that portfolios of local funds look too similar despite somewhat different investment thesis on the same company. At the end of the day, skill defined as intellectual capability is on average very similar across different investment firms. 

Although, as Marks cleverly puts it, "there's only one thing in the investment world that isn't two-edged, and that's alpha: superior insight or skill." Even not being a big fan of what the term 'alpha' coins as my principle guides me towards great absolute long term performance, i.e., mid-teens, insight or skill as he frames it is perspective for me, not higher IQ (or EQ). This "eternal preparation" B.S. definitely works, though in the longer term. Our minds are biased towards shorter timeframes, so it's nearly impossible for human beings speak out they are long term investors and indeed become one. As the old proverb says, "easier said than done". 

Another way to be different is through concentration. Without preparation though it is nearly impossible (imprudent would be the best fit here) to have a concentrated portfolio. With experience and mental models lacking, one can't overperform in the long run. So if you want to dare to LOOK wrong, better be prepared.

What Does Sense-making Can Teach Investors?

Sense-making is a qualitative, multi-disciplinary approach to make something sensible, i.e., how we structure the unknown as so to be able to act in it. In other words, it consists in constructing, filtering, framing, creating facticity and rendering the subjective into something more tangible. According to Karl Weick,

sense-making is about plausibility, pragmatism, coherence, reasonableness, creation, invention and instrumentality.

In this synthesis exercise in which accuracy is secondary, I found a couple parallels and antithesis to equity research, investing and managing an asset management firm.

On equity research and investing:

• Sense-making is a synthesis exercise which usually benefits from mental models utilization to simplify complex and open-ended problems – it does not rely on extensive analysis and accuracy as enactment is needed in the learning process. This one is partially correct for investing in my point of view, since extensive analysis is a pre-requisite before synthetizing what the analyst has learned. A complete due diligence is required to mitigate risks, although it will never be complete due to the ever changing landscape and eternal unknown unknowns;
• As I’ve just watched the True Detective TV series, I’ve learned from detectives this time (instead of Munger) that reading and studying different topics from a variety of sources helps us arm our brains with bits & bytes which can be combined later on our professional and personal lives. Although, we need previous knowledge and context to successfully use them “to consolidate bits and pieces into a compact, sensible pattern frequently requires that one look beyond those bits and pieces to understand what they might mean. Often, it is necessary to move outside a system in order to see the patterns within. (…) Of course, there is always more than one metaphor that can capture a situation, which means that any given metaphor is likely to be contested.”
• And when we are unprepared, the man-with-a-hammer syndrome unleashes:  "operators who have specialized expertise do not see the big picture as crises develop and therefore miss key events." We will try to frame the problem within our pre-existing models, unfortunately;
• We are more likely to uncover unanticipated and potentially valuable viewpoints and information armed with open-ended questions. Moreover, in this way we avoid confirmation bias;
• Marcel Proust helped me out in this one: “The real voyage of discovery consists not in seeking new landscapes but in having new eyes.” Again, it's all about having perspective;
• Sense-making benefits from past data (quant, social, etc.) in a given context to extrapolate necessary actions – just like investors learning from post mortem analysis/financial markets history to be better prepared for decision making;
• Consequences are difficult to forecast in advance, though scenario planning could help out with this one;
• Sense-making opposes scenario planning as “explanations that are developed retrospectively to justify committed actions are often stronger than beliefs developed under other, less involving, conditions." This one is screaming for me since I live in Brazil and we are used to see growth embedded in 99% of potential investments here, thus we aren't THAT creative imagining different scenarios. Unfortunately, we usually classify then as improbable as a preconception;
• Learn not only what financial statements represent, but what is behind it: “e very sensitive to operations. Learn from those closest to the front line, to customer, and to new technologies.

On risk:

• “Human errors are fundamentally caused by human variability, which cannon be designed anyway - so our function is to be risk mitigators which must be embedded in the capital allocator job description;
• Compounding mistakes: "Small events are carried forward, cumulate with other events, and over time systematically construct an environment that is a rare combination of unexpected simultaneous failures."
• Constant learning, perspective and team complementarity as a knowledge growth vector and risk mitigator: "Capacity and response repertoire affect crisis perception, because people see those events they feel they have the capacity to do something about. As capacities change, so too do perceptions and actions. This relationship is one of the crucial leverage points to improve crisis management." As investors, we should only act or react when we are prepared and comfortable with what we know and what we don’t know;

On governance:

• “The dark side of commitment is that it produces blind spots" – This one I’ve learned from Malcolm Gladwell article in The New Yorker Magazine: do not engage in negotiation with fanatics, nor trust entrepreneurs living their dreams in listed companies. In other words, do not them live their dreams with your money;
• "Turnover is as much a threat to capacity as is understaffing, but for a different reason. Institutional memory is an important component of crisis management"
• "Perception, however, is never free of preconceptions, and when people perceive without institutional memories, they are likely to be influenced by salient distractions or by experience gained in settings that are irrelevant to present problems."
•  “In a globally competitive environment our reward structures are geared toward rewarding immediate action and hence we may be signaling that sense-making is not a valued activity.”
• “Sense-making is inherently collective; it is not nearly as effective to be the lone leader at the top doing all the sense-making by yourself. It is far better to compare your views with those of others – blending, negotiating, and integrating, until some mutually acceptable version is achieved. Soliciting and valuing divergent views and analytic perspectives, and staying open to a wide variety of inputs, results in a greater ability to create large numbers of possible responses, thus facilitating resilient action." - Sutcliffe & Vogus, 2003

At the end of the day, no single discipline or tenet will solve any problem alone, although sense-making might be useful when analyzing the past performance or story of a company in order to understand how things went out. It is like a mapmaking process. Sensemaking also uses mental models from previous experiences and disciplines. 

I do not agree though that it necessarily is a better exercise than scenario planning because it relies on past facts, as (i) facts are not as clean as they see, afterall someone made the fact up and you don't know in what context and motivation and (ii) in a constant changing landscape it's better to elucubrate about the future and try to foresee through group simulations what scenarios can come up.

References:

Enacted sensemaking in crisis situations - Karl Weick

Sensemaking in organizations - Karl Weick

Sensemaking - MIT by Igor Chalhub

How Do We Learn The Most?

“That is the way to learn the most, that when you are doing something with such enjoyment that you don’t notice that the time passes.” - Albert Einstein

Incentives & Financial Shenanigans

After talking a little bit about incentives, nothing better than debating some of the possible outcomes. As we've learned in the previous entry, high paychecks with misaligned terms may be an issue: CEOs feeling pressured about beating analysts' short-term quarterly estimates may 'play dumb' destroying shareholder value in detriment of his own paycheck. As one CEO has put it,

"The most important thing we do is meet our numbers. It's more important than any individual product. It's more important than any individual philosophy. It's more important than any individual cultural change we're making. We must stop everything else when we don't make the numbers." - Joseph Nacchio, speech at January 2001 employee meeting, disclosed in a U.S. SEC complaint (March 2005)

Aggressive accounting may take its form in different ways, such as booking revenues too soon, recognizing undue revenue (nevermind PoC accounting method!), misclassifying items so they don't pass through the P&L, shifting current expenses to the next period, boosting operating income by one-offs and so on.

Since executives are well regarded, competent and competitive people, they do not like to lose - I get that. But how could both (i) investors analyze companies financial results in a proper timeframe and (ii) executives be aligned with the right incentives and KPIs so performance evaluation for both parties would be fair and accretive for the three entities in question, namely investors, executives and the company itself?

As Munger put it in one of his speeches,

“The system is responsible in proportion to the degree that the people who make the decisions bear the consequences.”

I do not aspire to share a proposal, but things such as

1. A shareholder base aligned with the strategic planning horizon of a company;
2. A well calibrated compensation package, with the vesting period aligned with the strategic planning timeframe (even in Brazil there are companies with 10-year vesting periods);
3. A more spaced financial results release (half yearly, maybe?); 

should be steps in the more correct direction. That's my 2 cents. What do you think?

While below you may find the transcript of this another talk, right here you can find the video.

Financial Shenanigans by Manish R. Doshi