“…we try to exert a Ted Williams kind of discipline. In his book The Science of Hitting, Ted explains that he carved the strike zone into 77 cells, each the size of a baseball. Swinging only at balls in his “best” cell, he knew, would allow him to bat .400; reaching for balls in his “worst” spot, the low outside corner of the strike zone, would reduce him to .230. In other words, waiting for the fat pitch would mean a trip to the Hall of Fame; swinging indiscriminately would mean a ticket to the minors.” Warren Buffett, 1997 Berkshire Hathaway Letter to Shareholders
I recently ran across an Investopedia article called “Think Like Warren Buffett” that reminds me of the foundation of Alpha Theory thinking. The article analyzes 8 investment tenets that Warren Buffett employs (which are more fully discussed in Robert G. Hagstrom’s 1999 book “The Warren Buffett Portfolio“) and is worth a read. Here’s a synopsis.
1. Think of Stocks as a Business – this is a way to force yourself to think less about the market’s influence and more about the cash flow generating potential of the “business.” You also redirect your attention towards aggregate value (enterprise value – including the capital structure of the business) and away from share price.
2. Increase the Size of Your Investment – there are several great academic studies (Cohen, Polk, and Silli (2009) and Baks, Busse, and Green (2006) ) that point to the benefits of concentration. My personal observation is that it is very difficult to find good ideas, so when you find one, you should bet accordingly.
3. Reduce Portfolio Turnover – I’m not so convinced that I subscribe to this theory. Buffett has to be less active because he is moving in such large amounts and his moves are seen to have profound effect on a stock. If, like the rest of us, you have flexibility, then you should constantly ensure that position size is well-aligned with the risk-reward balance of each investment. This means trading whenever there is an imbalance.
4. Develop Alternative Benchmarks – This is great for firms with multiple analysts. Measuring performance based on stock movement (especially in the short-term) is futile. Determining ways to measure based on value creation (book value growth, ROIC, etc.) will redirect the conversation away from ephemeral stock prices and towards more permanent value.
5. Learn to Think in Probabilities – Can we say this any louder, “LEARN TO THINK IN PROBABILITIES?” If there is one overarching theme that we find with great investors it’s their tendency to approach investing with a probabilistic framework. It is not enough to say, “I’m pretty confident this stock is going to $40.” You must force yourself to describe how confident you are in probabilistic terms and, more importantly, describe what the risk (downside) is if you are wrong.
6. Recognize the Psychological Aspects of Investing – If we have learned anything over the past 40 years of Behavioral Finance / Neuroeconomic research, it is that humans are poorly designed to make financial decisions. Because of that we must protect ourselves from ourselves. We are our own worst enemies. In fact, Charlie Munger goes through many of these cognitive biases in his speech “Art of Stock Picking.” Review this list of cognitive biases and you’ll likely recognize many of them as errors you make in your daily investment process.
7. Ignore Market Forecasts – This reminds me of my previous post about Bill Ackman-Style Investing: Market and economic direction are multi-variable equations with thousands of inputs. You can find two Nobel Laureate economists with well-defended theses for divergent directions of the US economy. If they cannot figure it out, why should you try? Mental capacity is a precious commodity and should be focused on reasonable prognostication, not on knowing the unknowable.
8. Wait for the Fat Pitch – Have you ever watched poker on TV? They show one hour of poker that actually took 10 hours to play. How is that possible? It is simple: great poker players fold A LOT and there is no need to show folds on TV. There is a 1 in 10 chance that a player’s hand will maintain positive expected return all the way to the river (last card dealt). A good poker player, therefore, will fold 9 out of 10 hands – which is exactly how you eliminate 9 out of 10 hours of poker coverage. In investing, as in poker, you are constantly searching for positive expected return. Of course, so is everyone else, and the more people that are looking for it, the harder it is to find.